MFDB Mutual Federal Bancorp Inc (PK)

PART I

 

ITEM 1.                      DESCRIPTION OF BUSINESS

 

General

 

Mutual Federal Bancorp, Inc. (“the Company”) was formed in 2006 as a federally chartered, mid-tier stock holding company of Mutual Federal Savings and Loan Association of Chicago, a federally chartered savings and loan association headquartered in Chicago, Illinois (referred to herein, together with its wholly owned subsidiary, EMEFES Service Corporation, as “the Bank”).  The Board of Directors of Mutual Federal Bancorp, MHC (“MHC”), the former sole stockholder of the Bank, adopted a Stock Issuance Plan pursuant to which (i) MHC established the Company as a direct subsidiary holding company to hold 100% of the stock of the Bank, and (ii) the Company offered and sold shares of its common stock in a public offering representing 30% of its shares outstanding after the offering.    The offering closed on April 4, 2006.  A total of 1,091,062 shares (30%) were sold and 2,545,813 shares (70%) were retained by MHC.

 

Through the Bank, our principal business consists of attracting retail deposits from the general public in the areas surrounding our office location in Chicago, Illinois and investing those deposits, together with funds generated from operations, primarily in one- to four-family fixed-rate residential mortgage loans and multifamily residential mortgage loans, and in investment securities.  We also offer consumer loans secured by deposits as an accommodation to our customers.  Our revenues are derived principally from interest on loans and securities, and from loan origination and servicing fees.  Our primary sources of funds are deposits, FHLB advances,  and principal and interest payments on loans and securities.

 

Business Strategy

 

Our business strategy is to operate as a well-capitalized and profitable community bank dedicated to providing quality customer service.  A main focus of our business strategy has been to emphasize one- to four-family residential mortgage lending, and we intend to continue to emphasize this type of lending.  Management, however, has determined to broaden the range of our products and services to enhance profitability, consistent with maintaining our safety and soundness.  We intend to gradually introduce additional products and services, such as adjustable-rate mortgage loans, home equity lines of credit, interest-bearing checking accounts, money market deposit accounts, and on-line banking and bill payment.  There can be no assurances that we will successfully implement our business strategy.

 

Highlights of our business strategy are as follows:

 

·   Continuing to emphasize fixed-rate one- to four-family residential real estate lending .  Historically, we have emphasized fixed-rate one- to four-family residential lending within our market area.  As of December 31, 2007, $34.2 million, or 63.9%, of our total loan portfolio consisted of fixed-rate one- to four-family residential mortgage loans.  During the year ended December 31, 2007, we originated $4.5 million of one- to four-family residential mortgage loans.  We originate all loans for portfolio and do not sell loans in the secondary market.  While we will continue to emphasize one- to four-family lending, we also originate loans secured by multi-family properties.  As of December 31, 2007, $19.2 million, or 35.9%, of our total loan portfolio consisted of multi-family residential mortgage loans.  During the year ended December 31, 2007, we originated $2.7 million of multi-family residential mortgage loans.

 

 

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·   Seeking growth through expansion .  We believe our best opportunities for growth are through potential acquisitions or through de novo branching, although we currently have no specific plans to acquire an existing financial institution or open a de novo branch.  The capital raised in our stock offering will enable us to identify and pursue potential acquisitions or, should suitable acquisition opportunities not emerge, undertake de novo branching.  Completing an acquisition or opening a new branch will provide us with an additional location, thereby increasing the potential number of households and businesses we could serve.  An acquisition also may provide us with an opportunity to enhance our management depth and augment our current product offerings.  Additionally, any future acquisition may provide us with an opportunity to pursue an alternate branding strategy for the Bank by capitalizing on the brand awareness a potential target may have already established in its market area.

 

Historically, we have not experienced rapid growth in our business, but rather have been able to grow our business consistently over time.  While our business plan provides for us to seek to grow by pursuing acquisition opportunities as well as establishing new branches, if we ultimately are not successful in identifying and completing suitable acquisitions or establishing new branches, we may not be able to grow our business as we hope.

 

·   Expanding and diversifying our lending portfolio .  While fixed-rate residential loans will continue to constitute a significant portion of our total loan portfolio, we intend to expand our loan origination capabilities to include adjustable-rate residential loans and home equity loans or lines of credit to our customers.  We also intend to continue offering loans secured by multi-family properties using our personalized service to attract larger property owners.

 

·   Offering new products and services .  We currently are developing and seek to develop in the future new services and deposit products for our customers, such as interest-bearing checking accounts, money market deposit accounts, and on-line banking and bill payment.  We expect to be able to begin offering these new products and services beginning in 2008.  We believe that these new products will increase our deposit base and our fee income.

 

·   Maintaining high asset quality .  Historically, we have maintained and will continue to emphasize strong asset quality by following conservative underwriting criteria and originating loans secured by real estate.  Our non-performing assets at December 31, 2007 and December 31, 2006 were $259,000 and $443,000, respectively, or 0.35% and 0.59% of total assets.

 

·   Maintaining high levels of interest earning assets .  We intend to maintain our high level of interest earning assets.  At December 31, 2007, our interest earning assets were 96.7% of total assets and our average interest earning assets for 2007 were 162.9% of average interest-bearing liabilities.  These ratios reflect our low level of fixed assets (as we operate from only one banking office) and non-accruing loans, strong capital position and the absence of real estate owned and goodwill on our balance sheet.

 

·   Increasing our real estate lending capacity .  The additional capital raised in the stock offering increased our lending capacity by enabling us to originate more loans and loans with larger balances.  This permitted us to serve borrowers with larger lending needs and to originate larger loans than we have in the past.

 

·   Remaining a community-oriented institution .  The Bank was established in Chicago, Illinois in 1905 and has been operating continuously since that time.  We have been, and continue to

 

 

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 be, committed to meeting the financial needs of the communities in which we operate and remain dedicated to providing high-quality personal and efficient service to our customers.

 

Competition

 

We face intense competition within our market area both in making loans and attracting deposits.  Cook County, Illinois, and specifically the Chicago metropolitan area have a high concentration of financial institutions including money centers and other large commercial banks, community banks and credit unions.  Some of our competitors offer products and services that we currently do not offer, such as trust services, private banking and internet banking.  As of June 30, 2007, based on the FDIC’s annual Summary of Deposits Report, our market share of deposits represented 7.67% of the deposits in our zip code and 0.02% of deposits in Cook County.

 

Our competition for loans and deposits comes principally from commercial banks, savings institutions, mortgage banking firms and credit unions in our market area.  We face additional competition for deposits from short-term money market funds, brokerage firms, mutual funds and insurance companies.  Our primary focus is to build and develop profitable customer relationships across all lines of business while maintaining our role as a community bank.

 

Market Area

 

We operate in a primarily urban market area that has a stable population and household base.  Our primary deposit gathering area is concentrated in the communities immediately surrounding our headquarters located in the southwestern Chicago metropolitan area, which includes predominantly Hispanic neighborhoods.  Our primary lending area is broader than our deposit-gathering area and includes all of Cook County.  At December 31, 2007, 96% of our mortgage loan portfolio consisted of loans secured by real estate located in Cook County, Illinois.

 

The economy of our market area is characterized by a large number of small retail establishments and small industry.  Major employers in our immediate market area include county government facilities, large medical complexes, including hospitals, the University of Illinois at Chicago and a rail and trucking transportation hub.

 

Lending Activities

 

Historically, our principal lending activity has been the origination of first mortgage loans for the purchase or refinancing of one- to four-family residential real property.  We retain all loans that we originate.

 

One- to four-family residential real estate mortgage loans represented $34.2 million, or 63.9%, of our loan portfolio at December 31, 2007.  We also offer multifamily real estate loans.  Multifamily real estate loans represented $19.2 million, or 35.9% of our loan portfolio at December 31, 2007.  We also have a small number of loans secured by deposit accounts as an accommodation to customers.

 

Loan Portfolio Composition .  The following table sets forth the composition of our loan portfolio by type of loan and percentage of portfolio at the dates indicated.

 

 

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		At December 31,
		2007								2006								2005
		Amount				Percent				Amount				Percent				Amount				Percent
		(dollars in thousands)
One- to four-family residential mortgage		$	34,163				63.90	%		$	33,270				63.62	%		$	24,424				63.70	%
Multi-family			19,217				35.94				18,965				36.27				13,839				36.10
Total mortgage loans			53,380				99.84				52,235				99.89				38,263				99.80
Consumer loans			88				0.16				59				.11				77				0.20
Total loans			53,468				100.00	%			52,294				100.00	%			38,340				100.00	%
Less:
Deferred loan origination fees, net			122								121								89
Undisbursed portion of loans			9								9								51
Allowance for loan losses			290								240								170
Total loans, net		$	53,047							$	51,924							$	38,030

Loan Portfolio Maturities and Yields .  The following table summarizes the remaining contractual maturity of our loans at December 31, 2007.  The table does not include the effect of possible prepayments.  We had no adjustable-rate loans at December 31, 2007.

 

		One- to Four-Family								Multi Family								Consumer								Total
		Amount				Weighted Average Rate				Amount				Weighted Average Rate				Amount				Weighted Average Rate				Amount				Weighted Average Rate
		(dollars in thousands)
Due during the years ending December 31, 2008		$	9				6.41	%		$	4				11.50	%		$	88				3.97	%		$	101				4.49	%
2009 to 2010			50				7.08				58				6.15				—				—				108				6.58
2011 to 2012			255				6.65				573				6.97				—				—				828				6.87
2013 to 2017			3,229				6.44				1,633				6.73				—				—				4,862				6.54
2018 to 2027			14,357				6.13				14,724				6.68				—				—				29,081				6.41
2028 and beyond			16,263				6.41				2,225				6.81				—				—				18,488				6.46
Total		$	34,163				6.30	%		$	19,217				6.70	%		$	88				3.97	%		$	53,468				6.44	%

The following table sets forth the remaining contractual maturity of fixed-rate loans at December 31, 2007 that are contractually due after December 31, 2008.  We had no adjustable-rate loans at December 31, 2007.

 

		Due After December 31, 2008
		Fixed				Total
		(dollars in thousands)
One- to four-family residential mortgage loans		$	34,154			$	34,154
Multi-family			19,213				19,213
Total mortgage loans			53,367				53,367
Total loans		$	53,367			$	53,367

One- to Four-Family Residential Loans .  Our primary lending activity consists of the origination of one- to four-family residential mortgage loans that are secured primarily by properties located in Cook County.  At December 31, 2007, $34.2 million, or 63.9% of our loan portfolio, consisted of one- to four-family residential mortgage loans.  Included within these one- to four-family loans were $1.4 million in second mortgage loans at December 31, 2007.  At December 31, 2007, we had 313 one-to four-family loans with an average balance of $109,000.  Generally, one- to four-family residential mortgage loans are originated in amounts up to 80% of the appraised value of the property.  All one- to four-family residential loans are fixed-rate loans generally originated for terms up to 20 years and for owner occupied one- to four-family residential loans, up to 30 years.  At December 31, 2007, our largest loan secured by

 

 

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one- to four-family real estate had a principal balance of $939,000.  We currently do not offer adjustable-rate mortgage loans.

 

All one- to four-family residential mortgage loans that we originate include “due-on-sale” clauses, which give us the right to declare a loan immediately due and payable in the event that, among other things, the borrower sells or otherwise disposes of the real property subject to the mortgage and the loan is not repaid.

 

Our second mortgage loans are fixed-rate and offered in amounts up to 80% of the appraised value of the property securing the loan (including prior liens) and only where we have secured a first-priority lien on the subject property.  Our second mortgage loans generally are made with maturities of 15 years or less and are secured by the borrower’s property.  Our procedures for underwriting these loans include an assessment of an applicant’s prior loan history, credit history and an assessment of the value of the collateral in relation to the proposed loan amount.

 

Regulations limit the amount that a savings institution may lend relative to the appraised value of the real estate securing the loan, as determined by an appraisal of the property at the time the loan is originated.  For all loans originated by the bank, we utilize outside independent appraisers approved by the bank’s board of directors.  All borrowers are required to obtain title insurance.  We also require homeowner’s insurance and fire and casualty insurance and, where circumstances warrant, flood insurance on properties securing real estate loans.

 

Multi-Family Real Estate Loans .  Loans secured by multi-family real estate totaled $19.2 million, or 35.9%, of our total loan portfolio at December 31, 2007.  Multi-family real estate loans generally are secured by small apartment buildings with fewer  than 10 units and includes two- to four-family residential properties that may also include a commercial or income-producing element, such as a first floor store-front business.  Generally, all of our multi-family real estate loans are secured by properties located within our lending area.  At December 31, 2007, we had 103 multi-family real estate loans with an average principal balance of $187,000, and the largest multi-family real estate loan had a principal balance of $1.2 million.  Multi-family real estate loans are offered with fixed interest rates.  Multi-family loans generally are originated for terms of up to 20 years, and in some cases for owner-occupied multi-family properties, up to 30 years.

 

We consider a number of factors in originating multi-family real estate loans.  We evaluate the qualifications and financial condition of the borrower (including credit history), profitability and expertise, as well as the value and condition of the mortgaged property securing the loan.  When evaluating the qualifications of the borrower, we consider the financial resources of the borrower, the borrower’s experience in owning or managing similar property and the borrower’s payment history with us and other financial institutions.  In evaluating the property securing the loan, the factors we consider include the net operating income of the mortgaged property before debt service and depreciation, the debt service coverage ratio (the ratio of net operating income to debt service), and the ratio of the loan amount to the appraised value of the mortgaged property.  Multi-family real estate loans are originated in amounts up to 75% of the lower of the sale price or the appraised value of the mortgaged property securing the loan and up to 80% if owner occupied.  All multi-family real estate loans are appraised by outside independent appraisers approved by the bank’s board of directors.  All multi-family borrowers are required to sign notes in their individual capacity.

 

While loans secured by multi-family real estate offer larger balances and higher yields, such loans generally involve a greater degree of credit risk than one- to four-family residential mortgage loans.  This increased credit risk is a result of several factors, including the concentration of principal in a limited number of loans and borrowers, the effects of general economic conditions on income producing

 

 

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properties, and the increased difficulty of evaluating and monitoring these types of loans.  Furthermore, the repayment of loans secured by multi-family real estate typically depends upon the successful operation of the real estate property securing the loan.  If the cash flow from the project is reduced, the borrower’s ability to repay the loan may be impaired.

 

Consumer Loans .  We offer a small number of consumer loans, secured by deposits, to our customers.  Our consumer loans amounted to $88,000, or 0.2%, of our total loan portfolio at December 31, 2007.

 

Origination and Servicing of Loans .  Loan origination activities are primarily concentrated in Cook County.  New loans are generated primarily from current and former borrowers, walk-in customers, customer referrals, realtors and other parties with whom we do business, and from the efforts of employees and advertising.  Loan applications are underwritten and processed at our single banking office.  We service all loans that we originate.

 

Loan Approval Procedures and Authority .  The loan approval process is intended to assess the borrower’s ability to repay the loan, the viability of the loan, and the adequacy of the value of the property that will secure the loan.  To assess the borrower’s ability to repay, we review the employment and credit history and information on the historical and projected income and expenses of mortgagors.  All owner occupied mortgage loans up to $650,000 and all non-owner occupied  mortgage loans up to $500,000 may be approved by any two members of the loan committee of the board of directors, which consists of the President and three outside directors.  All loans secured by deposits require the approval of an officer.  All other loans must be approved by the bank’s board of directors.

 

Non-Performing and Problem Assets

 

We commence collection efforts when a loan becomes 15 days past due with a system-generated late-charge notice.  Subsequent delinquent notices are issued and the account is monitored on a regular basis thereafter.  Personal, direct contact with the borrower is attempted early in the collection process as a courtesy reminder and later to determine the reason for the delinquency and to safeguard our collateral.  When a loan is more than 30 days past due, the credit file is reviewed and, if deemed necessary, information is updated or confirmed and collateral re-evaluated.  We make efforts to contact the borrower and develop a plan of repayment to cure the delinquency.  A summary report of all loans 90 days or more past due is reported to the board of directors on a monthly basis.  If no repayment plan is in process, the file is referred to counsel for the commencement of foreclosure or other collection efforts.

 

Mortgage loans are reviewed on a regular basis and such loans are placed on non-accrual status when they become more than 90 days delinquent.  When loans are placed on a non-accrual status, unpaid accrued interest is fully reversed, and further income is recognized only to the extent received.

 

Non-Performing Loans and Non-Performing Assets .  Our non-performing loans and non-performing assets are as shown in the following table for the periods indicated.  At each date presented, we had no troubled debt restructurings (loans for which a portion of interest or principal has been forgiven and loans modified at interest rates materially less than current market rates).

 

 

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		At December 31,
		2007				2006				2005
		(dollars in thousands)
Non-accrual loans:
One- to four-family		$	259			$	226			$	184
Multi-family			—				217				—
Consumer			—				—				—
Total non-accrual loans			259				443				184
Accruing loans delinquent 90 days or more:
One- to four-family			—				—				—
Multi-family			—				—				—
Consumer			—				—				—
Total non-performing loans			259				443				184
Real estate owned:
Total real estate owned			—				—				—
Total non-performing assets		$	259			$	443			$	184
Allowance for loan losses attributable to non-performing loans			—				—				—
Ratios:
Non-performing loans to total loans			0.48	%			0.85	%			0.48	%
Non-performing assets to total assets			0.35				0.59				0.29

The following table sets forth certain information with respect to our loan portfolio delinquencies at the dates indicated.

 

		Loans Delinquent for
		60-89 Days								90 Days and Over								Total
		Number				Amount				Number				Amount				Number				Amount
		(dollars in thousands)
At December 31, 2007
One- to four-family			8			$	1,893				1			$	259				9			$	2,152
Multi-family			2				748				—				—				2				748
Consumer			—				—				—				—				—				—
Total			10			$	2,641				1			$	259				11			$	2,900
At December 31, 2006
One- to four-family			1			$	101				4			$	226				5			$	327
Multi-family			1				284				1				217				2				501
Consumer			—				—				—				—				—				—
Total			2			$	385				5			$	443				7			$	828
At December 31, 2005
One- to four-family			4			$	301				2			$	184				6			$	485
Multi-family			1				217				—				—				1				217
Consumer			—				—				—				—				—				—
Total			5			$	518				2			$	184				7			$	702

Real Estate Owned .   Real estate we acquire as a result of foreclosure or by deed in lieu of foreclosure is classified as real estate owned until sold.  When property is acquired it is recorded at fair market value at the date of foreclosure, less estimated selling expenses, establishing a new cost basis.  Holding costs and declines in fair value result in charges to expense after acquisition.  At December 31, 2007, we held no real estate owned.

 

 

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Classified Assets .  OTS regulations provide that loans and other assets considered to be of lesser quality be classified as “substandard,” “doubtful” or “loss” assets.  An asset is considered “substandard” if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any.  “Substandard” assets include those characterized by the “distinct possibility” that the institution will sustain “some loss” if the deficiencies are not corrected.  Assets classified as “doubtful” have all of the weaknesses inherent in those classified “substandard,” with the added characteristic that the weaknesses present make “collection or liquidation in full,” on the basis of currently existing facts, conditions, and values, “highly questionable and improbable.”  Assets classified as “loss” are those considered “uncollectible” and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted.  Not all classified assets constitute non-performing assets.

 

An insured institution is required to establish general allowances for loan losses in an amount deemed prudent by management for loans classified substandard or doubtful, as well as for other problem loans.  General allowances represent loss allowances which have been established to recognize the inherent losses associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets.  When an insured institution classifies problem assets as “loss,” it is required either to establish a specific allowance for losses equal to 100% of the amount of the asset so classified or to charge off such amount.  An institution’s determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the Office of Thrift Supervision which can order the establishment of additional general or specific loss allowances.

 

At December 31, 2007, $259,000 in non-accrual loans were classified as substandard, and none of our other assets were classified as substandard, doubtful or loss.  The loan portfolio is reviewed on a regular basis to determine whether any loans require classification in accordance with applicable regulations.

 

Allowance for Loan Losses

 

Our allowance for loan losses is maintained at a level necessary to absorb probable incurred loan losses.  Management, in determining the allowance for loan losses, considers the losses inherent in our loan portfolio and changes in the nature and volume of loan activities, along with the general economic and real estate market conditions.  The Bank’s loan committee determines the type of loans to be evaluated for impairment on an individual basis and the types of loan to be evaluated on a collective basis based on similarities in loss performance, such as our one-to-four family residential loans and multifamily residential loans.  We then utilize a two-tier approach:  (1) for the types of loans to be evaluated on an individual basis, identification of impaired loans and establishment of specific loss allowances on such loans, and (2) for the types of loans to be evaluated on a collective basis, establishment of general valuation allowances.

 

Once a loan becomes delinquent, we may establish a specific loan loss allowance should we determine that the loan is impaired.  A loan will be considered impaired when, based on current information and events (such as, among other things, delinquency status, the size of the loan, the type and market value of collateral and the financial condition of the borrower), it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement.  All loans identified as impaired are evaluated independently.  We do not aggregate such loans for evaluation purposes.  Specific allowances for impaired loans are established based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical measure, at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent.

 

 

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General loan loss allowances are based upon historical loan loss experience as adjusted after evaluation of other factors that may or may not be present, including changes in the composition of the loan portfolio, current national and local economic conditions, changes in lending policies and procedures and personnel changes in our lending management or staff.  The allowance is increased through provisions charged against current earnings and recoveries of previously charged-off loans.  Loans that are determined to be uncollectible are charged against the allowance.  While management uses available information to recognize probable and reasonably estimable loan losses, future loss provisions may be necessary based on changing economic conditions or other factors.  Payments received on impaired loans are applied first to accrued interest receivable and then to principal.  The allowance for loan losses as of December 31, 2007 was maintained at a level that represents management’s best estimate of probable incurred losses in the loan portfolio.

 

The following table sets forth activity in our allowance for loan losses for the periods indicated.

 

		At or for the Years Ended December 31,
		2007				2006				2005
		(dollars in thousands)
Balance at beginning of year		$	240			$	170			$	150
Charge-offs:
One- to four-family			—				—				—
Multi-family			—				—				—
Consumer			—				—				—
Total charge-offs			—				—				—
Recoveries:
One- to four-family			—				—				—
Multi-family			—				—				—
Consumer			—				—				—
Total recoveries			—				—				—
Net (charge-offs) recoveries			—				—				—
Provision for loan losses			50				70				20
Balance at end of year		$	290			$	240			$	170
Ratios:
Net charge-offs to average loans outstanding			—				—				—
Allowance for loan losses to non-performing loans			1.12				0.54				0.92
Allowance for loan losses to total loans			0.54	%			0.46	%			0.44	%

The Bank has not charged-off a loan since 1996, when it charged-off a loan with an outstanding principal amount of $19,000.  Our non-performing loans decreased to $259,000 at December 31, 2007, from $443,000 at December 31, 2006.  However, loans delinquent for 60-89 days increased to $2.6 million at December 31, 2007, from $385,000 at December 31, 2006.

 

During 2007 the Bank’s loan portfolio increased $1.1 million, or 2.2%, to $53.0 million at December 31, 2007, from $51.9 million at December 31, 2006.  Based on the application of our allowance for loan losses methodology, as discussed previously, management determined that a provision of $50,000 for loan losses was necessary for the year ended December 31, 2007.  During 2006, using the same methodology, management determined that a $70,000 provision for loan losses was necessary for the year ended December 31, 2006.

 

Allocation of Allowance for Loan Losses .  The following tables set forth the allowance for loan losses allocated by loan category, the total loan balances by category and the percent of loans in each

 

 

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category to total loans at the dates indicated.  The allowance for loan losses allocated to each category is not necessarily indicative of future losses in any particular category and does not restrict the use of the allowance to absorb losses in other categories.

 

		At December 31,
		2007												2006
		Allowance for Loan Losses				Loan Balances by Category				Percent of Loans in Each Category to Total Loans				Allowance for Loan Losses				Loan Balances by Category				Percent of Loans in Each Category to Total Loans
		(dollars in thousands)
One- to four-family		$	100			$	34,163				63.90	%		$	83			$	33,270				63.62	%
Multi-family			190				19,217				35.94				157				18,965				36.27
Consumer			—				88				0.16				—				59				0.11
Total allowance		$	290			$	53,468				100.00	%		$	240			$	52,294				100.00	%

Each quarter, management evaluates the total balance of the allowance for loan losses based on several factors that are not loan specific, but are reflective of the inherent losses in the loan portfolio.  This process includes, but is not limited to, a periodic review of loan collectibility in light of historical experience, the nature and volume of loan activity, conditions that may affect the ability of the borrower to repay, underlying value of collateral, if applicable, and economic conditions in our immediate market area.  First, we group loans by delinquency status.  All loans 90 days or more delinquent are evaluated individually, based primarily on the value of the collateral securing the loan.  Specific loss allowances are established as required by this analysis.  All loans for which a specific loss allowance has not been assigned are segregated by type and delinquency status and a loss allowance is established by using loss experience data and management’s judgment concerning other matters it considers significant.  The allowance is allocated to each category of loan based on the results of the above analysis.

 

This analysis process is inherently subjective, as it requires us to make estimates that are susceptible to revisions as more information becomes available.  Although we believe that we have established the allowance at levels to absorb probable and estimable losses, future additions may be necessary if economic or other conditions in the future differ from the current environment.  In addition, the Office of Thrift Supervision, as an integral part of their examination process, periodically reviews our allowance for loan losses, and could require additional reserves.

 

Investments

 

Investments and Mortgage-backed Securities .  Our investment portfolio at December 31, 2007, included $5.6 million in U.S. agency and government-sponsored entity bonds which are all classified as available-for-sale.  Our investment policy objectives are to maintain liquidity, manage risk and maximize returns within the guidelines established by the bank’s board of directors, which specify eligible investments and approved securities dealers.

 

Our investment portfolio also includes mortgage-backed securities and collateralized mortgage obligations, all of which are guaranteed by the United States government or agencies thereof, all of which are classified as available-for-sale.  At December 31, 2007, our mortgage-backed securities portfolio totaled $7.6 million, or 10.5% of total assets.  The portfolio consisted of $4.8 million in fixed-rate mortgage-backed securities, and $2.9 million in adjustable-rate mortgage-backed securities, all guaranteed by the Federal Home Loan Mortgage Corporation, or FHLMC, the Federal National Mortgage Association, or FNMA, or the Government National Mortgage Association, or GNMA.

 

 

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Our equity investments consist of 8,000 shares of FHLMC common stock and 10,000 shares of FHLMC preferred stock, as well as shares of several mutual funds which are invested in U.S. government and agency obligations and mortgage-backed securities guaranteed by FHLMC, FNMA or GNMA.

 

We initially acquired 1,263 shares of FHLMC Participating Preferred Stock, with a cost basis of $59,361 ($47.00 per share), in 1984 as a dividend distribution from the Federal Home Loan Bank of Chicago.  Subsequent stock splits and conversions of the stock in 1988 to Senior Participating Preferred, and in 1992 to voting common stock, increased this investment to a total of 60,624 shares of common stock (with a split adjusted basis of $0.98 per share).  We have consistently monitored the performance of the stock and related market conditions, and have periodically sold shares since 1998.  During 2007 the market price of the common stock dropped as a result of the turmoil in the secondary mortgage market.  During the fourth quarter of 2007, FHLMC also announced  a 50% reduction in the quarterly common stock dividend.   While we do not currently plan to sell the FHLMC common stock, depending on liquidity requirements or market conditions relating to the stock, we may decide that further sales are prudent.

 

We acquired 10,000 shares of FHLMC preferred stock in 1999 at a cost basis of $500,000. The preferred stock pays a non-cumulative preferred dividend of 5.79%.  It is callable in June 2009.  The market price of the preferred stock also fell during 2007, again due to the turmoil in the secondary mortgage market.  At December 31, 2007, the Company reduced its cost basis in the preferred stock to the market price, with a $98,000 pre-tax charge to earnings, because it was unable to forecast a recovery in value in the foreseeable future. While we do not currently plan to sell the FHLMC preferred stock, depending on liquidity requirements or market conditions relating to the stock, we may decide that a sale of some or all of the stock is prudent.

 

The Company has investments in various mutual funds including an adjustable rate mortgage fund, a U.S. government mortgage fund, and a short-term government fund.  The funds are invested in U.S. government and agency obligations and mortgage-backed securities guaranteed by FHLMC, FNMA or GNMA.  The funds are historically stable or, as rates decline, the funds recover their value (that is, the degree of impairment reverses) through increases in their net asset value.  At December 31, 2007, the Company reduced its cost basis to the funds’ net asset value with a $54,000 pre-tax charge for an other-than-temporary decline in fair value, because it was unable to forecast a recovery in the net asset value of these funds in the period the Company estimated it would hold the securities.  While we do not currently plan to sell the funds, depending on liquidity requirements, or market conditions relating to the funds, we may decide that a sale of some or all of the funds is prudent.

 

 

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Available-for-Sale Portfolio .  The following table sets forth the composition of our available-for-sale portfolio at the dates indicated.

 

		At December 31,
		2007								2006								2005
		Amortized Cost				Fair Value				Amortized Cost				Fair Value				Amortized Cost				Fair Value
		(in thousands)
Investment Securities:
U.S. agency and government-sponsored entity bonds		$	5,496			$	5,605			$	6,695			$	6,654			$	8,694			$	8,584
Mutual funds			2,423				2,423				2,357				2,293				2,250				2,195
FHLMC common stock			8				273				8				543				8				523
FHLMC preferred stock			402				402				500				487				500				505
Mortgage-backed Securities:
GNMA			1,049				1,021				1,555				1,532				2,162				2,135
FNMA			3,596				3,618				4,582				4,489				5,757				5,654
FHLMC			2,524				2,531				3,067				3,000				3,798				3,721
FNMA, FHLMC collateralized mortgage obligations			486				472				578				561				722				711
Total securities available for sale		$	15,984			$	16,345			$	19,342			$	19,559			$	23,891			$	24,028

Portfolio Maturities and Yields .  The composition and maturities of the investment securities portfolio and the mortgage-backed securities portfolio at December 31, 2007 are summarized in the following table.  Maturities are based on the final contractual payment dates and do not reflect the impact of prepayments or early redemptions that may occur.  Mutual funds and FHLMC stock are not included because they do not have contractual maturity dates.

 

		One Year or Less								More Than One Year Through Five Years								More Than Five Years Through Ten Years
		Amortized Cost				Weighted Average Yield				Amortized Cost				Weighted Average Yield				Amortized Cost				Weighted Average Yield
		(dollars in thousands)
Available-for-Sale
Investment Securities:
U.S. agency and government-sponsored entity bonds		$	—				—	%		$	5,496				5.04	%		$	—				—	%
Mortgage-backed Securities:
GNMA			1				6.50				11				6.50				52				6.38
FNMA			25				5.78				367				5.34				1,500				4.49
FHLMC			1				9.41				824				4.80				273				4.96
FNMA, FHLMC collateralized mortgage obligations			—				—				—				—				—				—
Total securities available for sale		$	27				5.92	%		$	6,698				5.03	%		$	1,825				4.61	%

 

 

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		More Than Ten Years								Total Securities
		Amortized Cost				Weighted Average Yield				Amortized Cost				Fair Value				Weighted Average Yield
		(dollars in thousands)
Available-for-Sale
Investment Securities:
U.S. agency and government-sponsored entity bonds		$	—				—	%		$	5,496			$	5,605				5.04	%
Mortgage-backed Securities:
GNMA			985				5.31				1,049				1,021				5.37
FNMA			1,704				4.78				3,596				3,618				4.72
FHLMC			1,426				5.05				2,524				2,531				4.96
FNMA, FHLMC collateralized mortgage obligations			486				3.31				486				472				3.31
Total securities available for sale		$	4,601				4.82	%		$	13,151			$	13,247				4.90	%

Sources of Funds

 

General .  Deposits have traditionally been our primary source of funds for use in lending and investment activities.  In addition to deposits, funds are derived from scheduled loan payments, investment calls, maturities and sales, loan prepayments, retained earnings and income on earning assets.  While scheduled loan payments and income on earning assets are relatively stable sources of funds, deposit inflows and outflows can vary widely and are influenced by prevailing interest rates, market conditions and levels of competition.  Borrowings from the Federal Home Loan Bank of Chicago have been be used to compensate for reductions in deposits and to fund loan growth.

 

Deposits .  Deposits are not actively solicited outside of the Chicago metropolitan area, and a majority of our depositors are persons who work or reside in Cook County, Illinois.  We offer deposit instruments, including non-interest-bearing checking accounts, passbook savings and fixed-term certificates of deposit.  Deposit account terms vary, with the principal differences being the minimum balance required, the amount of time the funds must remain on deposit and the interest rate.  We do not accept brokered deposits.

 

Interest rates paid, maturity terms, service fees and withdrawal penalties are established on a periodic basis.  Deposit rates and terms are based primarily on current operating strategies and market rates, liquidity requirements, rates paid by competitors and growth goals.  To attract and retain deposits, we rely upon personalized customer service, long-standing relationships and generally rates in the upper half of those offered in our market area.

 

The flow of deposits is influenced significantly by general economic conditions, changes in money market and other prevailing interest rates, competition and our single office location.  We believe the products we offer allow us to be competitive in obtaining funds and responding to changes in consumer demand.  Based on historical experience, management believes our deposits are relatively stable.  However, the ability to attract and maintain certificates of deposit, and the rates paid on these deposits, have been and will continue to be significantly affected by market conditions.  At December 31, 2007, $20.5 million, or 51.7% of our deposit accounts were certificates of deposit, of which $18.3 million had maturities of one year or less.

 

 

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The following table sets forth the distribution of total deposit accounts, by account type, at the dates indicated.

 

		At December 31,
		2007												2006												2005
		Balance				Percent				Weighted Average Rate				Balance				Percent				Weighted Average Rate				Balance				Percent				Weighted Average Rate
														(dollars in thousands)
Savings deposits		$	18,854				47.47	%			1.24	%		$	20,334				46.95	%			1.24	%		$	21,827				50.15	%			1.20	%
Certificates of deposit			20,534				51.70				4.27				22,246				51.37				4.16				21,348				49.05				3.01
Non-interest-bearing checking accounts			331				0.83				—				728				1.68				—				350				0.80				—
Total deposits		$	39,719				100.00	%			2.80	%		$	43,308				100.00	%			2.72	%		$	43,525				100.00	%			2.08	%

The following table sets forth certificates of deposit by time remaining until maturity as of December 31, 2007.

 

		Maturity
		3 Months or Less				Over 3 to 6 Months				Over 6 to 12 Months				Over 12 Months				Total
		(in thousands)
Certificates of deposit less than $100,000		$	5,264			$	3,307			$	3,157			$	1,795			$	13,523
Certificates of deposit of $100,000 or more (1)			2,351				3,224				1,017				419				7,011
Total of certificates of deposit		$	7,615			$	6,531			$	4,174			$	2,214			$	20,534

_____________

(1)	The weighted average interest rates for these accounts, by maturity period, are:  4.04% for 3 months or less; 4.53% for 3 to 6 months; 4.22% for 6 to 12 months; and 4.82% for over 12 months.  The overall weighted average interest rate for accounts of $100,000 or more was 4.34%.

 

The following table sets forth, by interest rate range, information concerning certificates of deposit as of December 31, 2007.

 

		At December 31, 2007
		Period to Maturity
		Less Than One Year				One to Two Years				Two to Three Years				More Than Three Years				Total				Percent of Total
		(dollars in thousands)
Interest Rate Range:
3.00% to 3.49%		$	1,546			$	—			$	—			$	—			$	1,546				7.53	%
3.50% to 3.99%			4,775				99				98				—				4,972				24.21
4.00% to 4.49%			7,808				768				556				149				9,281				45.20
4.50% to 4.99%			2,314				22				51				14				2,401				11.69
5.00% to 5.99%			1,878				82				374				—				2,334				11.37
Total		$	18,321			$	971			$	1,079			$	163			$	20,534				100.00	%

Borrowings

 

The Bank had $5.0 million in fixed-rate borrowings from the Federal Home Loan Bank at December 31, 2007, with maturities from March 2008 through December 2009, and at a weighted average interest rate of 4.74%.  The Bank may borrow up to $12.2 million under its present credit arrangement with the Federal Home Loan Bank.

 

 

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Properties

 

The following table provides certain information with respect to our banking office as of December 31, 2007 and December 31, 2006:

 

Location	Leased or Owned	Year Acquired		Net Book Value of Real Property at December 31, 2007				Net Book Value of Real Property at December 31, 2006
2212 West Cermak Road Chicago, Illinois 60608	Owned	1964		$	170,000			$	184,000

The net book value of our premises, land and equipment was $250,000 at December 31, 2007 and $289,000 at December 31, 2006.

 

Subsidiary Activities

 

The Company’s only subsidiary is the Bank.  The Bank currently operates one subsidiary, EMEFES Service Corporation, which provides insurance brokerage services to our customers.  Brokerage commissions earned by EMEFES totaled approximately $4,000 for the twelve months ended December 31, 2007.  Presently, there are no plans to expand the insurance brokerage operations.

 

Legal Proceedings

 

We are not involved in any pending legal proceedings as a defendant other than routine legal proceedings occurring in the ordinary course of business.  At December 31, 2007, we were not involved in any legal proceedings, the outcome of which would be material to our financial condition or results of operations.

 

Personnel

 

As of December 31, 2007, we had thirteen full-time employees and one part-time employee.  Our employees are not represented by any collective bargaining group.  Management believes that we have good relations with our employees.

 

FEDERAL AND STATE TAXATION

 

Federal Taxation

 

General .  We are subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below.  Our federal income tax returns have not been audited by the Internal Revenue Service during the past five years.  The following discussion of federal income taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to the Company or the Bank.

 

Method of Accounting .  For federal income tax purposes, the Company and the Bank currently report their income and expenses on the accrual method of accounting and use a tax year ending December 31 for filing their federal income tax returns.  The Company and the Bank file a consolidated federal income tax return.

 

Bad Debt Reserves .  Prior to the Small Business Protection Act of 1996 (the “1996 Act”), the Bank was permitted to establish a reserve for bad debts and to make annual additions to the reserve.  These additions could, within specified formula limits, be deducted in arriving at our taxable income.  

 

 

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Taxable Distributions and Recapture .  Prior to the 1996 Act, bad debt reserves created prior to January 1, 1988 were subject to recapture into taxable income if the Bank failed to meet certain thrift asset and definitional tests.  Federal legislation has eliminated these thrift related recapture rules.  At December 31, 2007, our total federal pre-1988 base year reserve was approximately $2.6 million.  However, under current law, pre-1988 base year reserves remain subject to recapture if the Bank makes certain non-dividend distributions, repurchases any of its stock, pays dividends in excess of tax earnings and profits, or ceases to maintain a bank charter.

 

Alternative Minimum Tax .  The Internal Revenue Code of 1986, as amended (the “Code” or “Internal Revenue Code”), imposes a corporate alternative minimum tax (“AMT”) at a rate of 20% on a base of regular taxable income plus or minus certain AMT adjustments, plus certain tax preferences (“alternative minimum taxable income” or “AMTI”).  The AMT is payable to the extent such AMTI is in excess of an exemption amount and the AMT exceeds the regular corporate income tax.  Net operating losses can generally offset no more than 90% of AMTI.  Certain payments of alternative minimum tax may be used as credits against regular tax liabilities in future years.  The Company has not been subject to the alternative minimum tax and has no such amounts available as credits for carryover.

 

Net Operating Loss Carryovers .  A financial institution may carry back net operating losses to the preceding two taxable years and forward to the succeeding 20 taxable years.  At December 31, 2007, the Company had no net operating loss carryforwards for federal income tax purposes.

 

Corporate Dividends-Received Deduction .  The Company may exclude from its income 100% of dividends received from the Bank as a member of the same affiliated group of corporations.  The corporate dividends-received deduction is 80% in the case of dividends received from corporations with which a corporate recipient owns at least 20% of the stock of the corporation but does not file a consolidated return with such corporation, and corporations which own less than 20% of the stock of a corporation distributing a dividend may deduct only 70% of dividends received or accrued on their behalf.

 

State Taxation

 

We are required to file Illinois income tax returns and pay tax at a stated tax rate of 7.3% of Illinois taxable income.  For these purposes, Illinois taxable income generally means federal taxable income subject to certain adjustments, including without limitation, the exclusion of interest income on United States obligations.

 

SUPERVISION AND REGULATION

 

General

 

Banking is a highly regulated industry.  The MHC, the Company, and the Bank are subject to numerous laws and regulations and supervisions and examination by various regulatory agencies.  Certain of the regulatory requirements that are or will be applicable to us are described below.  This description is not intended to be a complete explanation of such statutes and regulations and their effect on us and is qualified in its entirety by reference to the actual statutes and regulations.  These statutes and regulations may change in the future, and we cannot predict what effect these changes, if made, will have on our operations.

 

The Bank is subject to extensive regulation, examination and supervision by the Office of Thrift Supervision (“OTS”), as its primary federal regulator, and the Federal Deposit Insurance Corporation (the “FDIC”), as the insurer of its deposits.  The Bank is also a member of the Federal Home Loan Bank (the “FHLB”) of Chicago and may be subject to examination by the FHLB of Chicago.  The Bank’s deposit

 

 

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accounts are insured up to applicable limits by the FDIC’s Deposit Insurance Fund.  The Bank must file reports with the OTS and the FDIC concerning its activities and financial condition, in addition to obtaining regulatory approvals prior to entering into certain transactions, such as mergers with, or acquisitions of, other financial institutions.  There are periodic examinations by the OTS and, under certain circumstances, the FDIC to evaluate the Bank’s safety and soundness and compliance with various regulatory requirements.  This regulatory structure is intended primarily for the protection of customers, the insurance fund, and depositors.  The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes.  Any change in such policies, whether by the OTS, the FDIC, or Congress, could have a material adverse impact on us and our operations.

 

The MHC and the Company, as savings and loan holding companies, are required to file certain reports with, are subject to examination by, and otherwise must comply with the rules and regulations, of the OTS.  The Company is also subject to the regulations of the Securities and Exchange Commission under the federal securities laws.

 

Regulation of Federal Savings Institutions

 

Business Activities .  Federal law and regulations, primarily the Home Owners’ Loan Act and the regulations of the OTS, govern the activities of federal savings institutions such as the Bank.  These laws and regulations delineate the nature and extent of the activities in which federal savings institutions may engage.  In particular, certain lending authority for federal savings institutions, with regard to commercial, nonresidential real property loans and consumer loans, is limited to a specified percentage of an institution’s capital or assets.

 

Branching .  Federal savings institutions are authorized to establish branch offices in any state or states of the United States and its territories, subject to the approval or non-objection, as applicable, of the OTS.

 

Capital Requirements .  The OTS capital regulations require federal savings institutions to meet three minimum capital standards:  a 1.5% tangible capital to adjusted total assets ratio, a 4% core capital to adjusted total assets ratio (“leverage ratio”) (3% for institutions receiving the highest examination rating), and an 8% risk-based capital ratio.  In addition to the above ratios, the prompt corrective action standards discussed below also establish, in effect, a minimum of a greater than 2% tangible equity to total assets ratio and a 4% Tier 1 (core) risk-based capital ratio.

 

The risk-based capital standard requires federal savings institutions to maintain a Tier 1, or “core,” capital to risk-weighted assets ratio of at least 4% and a total to risk-based capital ratio of at least 8%.  Risk-weighted assets include the following:  all assets (including certain off-balance-sheet assets), certain recourse obligations, and direct credit substitutes, multiplied by a risk-weight factor of 0% to 100%, which is assigned by the OTS capital regulation based on the risks believed to be inherent in the type of asset.  Core capital is defined as common stockholders’ equity (including retained earnings), certain noncumulative perpetual preferred stock and related surplus, minority interests in equity accounts of consolidated subsidiaries, non-withdrawable accounts and pledged deposits meeting certain criteria, and a certain amount of remaining goodwill, less certain intangible assets, certain servicing rights, certain credit-enhancing interest-only strips, and certain investments in certain subsidiaries.  The components of supplementary capital include certain permanent capital instruments, certain maturing capital investments, allowances for loan and lease losses (limited to a maximum of 1.25% of risk-weighted assets), and up to 45% of unrealized gains on available-for-sale equity securities with readily determinable fair market

 

 

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values.  Overall, the amount of supplementary capital included as part of total capital cannot exceed 100% of core capital.

 

The OTS also has authority to establish individual minimum capital requirements in appropriate cases upon a determination that an institution’s capital level is or may become inadequate in light of the particular circumstances.  At December 31, 2007, the Bank met each of these capital requirements.

 

Prompt Corrective Regulatory Action .  The OTS is required to take certain supervisory actions against institutions that do not meet the minimum capital ratios discussed above, the severity of which depends upon the institution’s degree of undercapitalization.  Generally, a savings institution that has a total risk-based capital ratio of less than 8%, a Tier 1 risk-based capital ratio of less than 4%, or a leverage ratio of less than 4% (or less than 3% for institutions with the highest examination rating) is considered to be “undercapitalized.”  A savings institution that has a total risk-based capital ratio of less than 6%, a Tier 1 risk-based capital ratio of less than 3%, or a leverage ratio of less than 3% is considered to be “significantly undercapitalized,” and a savings institution that has a ratio of tangible equity to total assets equal to or less than 2% is deemed to be “critically undercapitalized.”  Subject to a narrow exception, the OTS is required to appoint a receiver or conservator within specified time frames for an institution that is “critically undercapitalized.”  An institution must file a capital restoration plan with the OTS within 45 days of the date it receives notice that it is “undercapitalized,” “significantly undercapitalized,” or “critically undercapitalized.”  Compliance with the plan must be guaranteed by a parent holding company.  In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution, including, but not limited to, increased monitoring by regulators and restrictions on growth, capital distributions, and expansion.  “Significantly undercapitalized” and “critically undercapitalized” institutions are subject to more extensive mandatory regulatory actions.  The OTS could also take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors.

 

Loans to One Borrower .  Federal law provides that savings institutions generally are subject to the limits on loans to one borrower applicable to national banks.  A savings institution may not make a loan or extend credit, if not fully secured, to a single or related group of borrowers in excess of 15% of its unimpaired capital and surplus.  An additional amount may be lent, equal to 10% of unimpaired capital and surplus, if fully secured by specified readily marketable collateral.

 

Standards for Safety and Soundness .  As required by statute, the federal banking agencies have adopted interagency guidelines prescribing standards for safety and soundness.  The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired.  If the OTS determines that a savings institution fails to meet any standard prescribed by the guidelines, the OTS may require the institution to submit an acceptable plan to achieve compliance with the standard.  The Bank has not received any notice that it has failed to meet any standard prescribed by the guidelines.

 

Limitation on Capital Distributions .  OTS regulations impose limitations upon all capital distributions by a savings institution, including cash dividends, payments to repurchase its shares, and payments to stockholders of another institution in a cash-out merger.  Under the regulations, an application to and the prior approval of the OTS is required before any distribution of capital if the institution does not meet the criteria for “expedited treatment” of applications under OTS regulations (i.e., generally, examination and Community Reinvestment Act ratings in the two highest categories), if the total capital distributions for the calendar year exceed net income for that year plus the amount of retained net income for the preceding two years, if the institution would be undercapitalized following the distribution, or if the distribution would otherwise be contrary to a statute, regulation, agreement with the OTS, or condition imposed by the OTS.  If an application is not required, the institution must still provide

 

 

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prior notice to the OTS of the capital distribution if the institution meets certain criteria (e.g., if the institution is a subsidiary of a holding company).  If the Bank’s capital were ever to fall below its regulatory requirements or the OTS notified it that it was in need of increased supervision, its ability to make capital distributions could be restricted.  In addition, the OTS could prohibit a proposed capital distribution that would otherwise be permitted by the regulation if the OTS determined that such distribution would constitute an unsafe or unsound practice.

 

Qualified Thrift Lender Test .  Federal law requires savings institutions to meet a qualified thrift lender test.  Under the test, a savings institution is required to either qualify as a “domestic building and loan association” under the Internal Revenue Code or maintain at least 65% of its “portfolio assets” (total assets less:  (i) specified liquid assets up to 20% of total assets; (ii) intangibles, including goodwill; and (iii) the value of property used to conduct business) in certain “qualified thrift investments” (primarily residential mortgages and related investments, including certain mortgage-backed securities) in at least nine months out of each twelve-month period.

 

A savings institution that fails the qualified thrift lender test is subject to certain operating restrictions, such as restrictions on investments, activities and branching.  As of December 31, 2007, the Bank maintained 98.8% of its portfolio assets in qualified thrift investments and, therefore, met the qualified thrift lender test.

 

Transactions with Related Parties .  Federal law limits the Bank’s authority to extend credit to, and engage in certain other transactions (collectively, “covered transactions”) with, “affiliates” (e.g., any company that controls or is under common control with an institution, including MHC, the Company, and their non-savings institution subsidiaries).  The aggregate amount of covered transactions with any individual affiliate is limited to 10% of the unimpaired capital and surplus of the savings institution.  The aggregate amount of covered transactions with all affiliates is limited to 20% of the savings institution’s unimpaired capital and surplus.  Loans and other specified transactions with affiliates are required to be secured by collateral in an amount and of a type described in federal law.  The purchase of low-quality assets from affiliates is permitted only under certain circumstances.  Transactions with affiliates must be on terms and under circumstances that are at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliates.  In addition, in general, savings institutions are prohibited from lending to any affiliate that is engaged in activities that are not permissible for bank holding companies; and no savings institution may purchase the securities of any affiliate other than a subsidiary.

 

The Bank’s authority to extend credit to its executive officers, directors, and 10% stockholders (“insiders”), as well as entities affiliated with such persons, is limited.  The Bank is restricted both in the individual and the aggregate amount of loans it may make to insiders based, in part, on the Bank’s capital position and the requirement that certain board approval procedures be followed.  Such loans must be made on terms substantially the same as those offered to non-insiders and not involve more than the normal risk of repayment.  There is an exception for loans made pursuant to a benefit or compensation program that is widely available to all employees of the institution and does not give preference to insiders over other employees.  There are additional restrictions applicable to loans to executive officers.

 

Enforcement .  The OTS has primary enforcement responsibility over federal savings institutions and has the authority to bring actions against the institution and all institution-affiliated parties, including stockholders, attorneys, appraisers, and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution.  Formal enforcement action may range from the issuance of a capital directive or cease and desist order to removal of officers and/or directors or termination of deposit insurance.  An insured institution or institution-affiliated party may also be

 

 

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assessed civil money penalties ranging, for example, from $100 per day to $1.25 million per day in especially egregious cases.  Federal law also establishes criminal penalties for certain violations.

 

Assessments .  Federal savings institutions must pay assessments to the OTS to fund its operations.  The general assessments, paid on a semiannual basis, are based upon the savings institution’s size, condition, and complexity of business.

 

Insurance of Deposit Accounts .  Under FDIC laws and regulations, FDIC-insured institutions, such as the Bank, are required to pay deposit insurance premiums based on the risk they pose to the Deposit Insurance Fund (the “DIF”).  The FDIC has authority to raise or lower assessment rates on insured deposits in order to achieve statutorily required reserve ratios in the insurance funds and to impose special additional assessments.  Each depository institution is assigned to one of three capital groups:  “well capitalized,” “adequately capitalized,” or “undercapitalized.” Within each capital group, institutions are assigned to one of three supervisory subgroups: “A” (institutions with few minor weaknesses); “B” (institutions demonstrating weaknesses that, if not corrected, could result in significant deterioration of the institution and increased risk of loss to the DIF); and “C” (institutions that pose a substantial probability of loss to DIF unless effective corrective action is taken).  Accordingly, there are nine combinations of capital groups and supervisory subgroups to which varying assessment rates would be applicable.  An institution’s assessment rate depends on the capital category and supervisory category to which it is assigned.

 

The FDIC may terminate an institution’s deposit insurance upon a finding that the institution has engaged in unsafe or unsound practices, is in an extremely unsafe or unsound condition, or has violated any applicable law, regulation, rule, order, or condition imposed by the FDIC or the OTS.  We do not know of any practice, condition, or violation that might lead to termination of the Bank’s deposit insurance.

 

Federal Home Loan Bank (FHLB) System .  The Bank is a member of the FHLB of Chicago.  The FHLB system consists of twelve regional Federal Home Loan Banks.  The FHLB provides a central credit facility primarily for member institutions.  The Bank, as a member of the FHLB of Chicago, is required to acquire and hold shares of capital stock in the FHLB in an amount at least equal to 1.0% of the aggregate principal amount of its unpaid loans, or 5% of its aggregate amount of outstanding advances (borrowings) from the FHLB, whichever is greater.  The Bank was in compliance with this requirement with an investment in FHLB stock at December 31, 2007, of $610,000.

 

The Federal Home Loan Banks are required to provide funds for the resolution of insolvent thrifts in the late 1980s and to contribute funds for affordable housing programs.  These requirements could reduce the amount of dividends that the Federal Home Loan Banks pay to their members and could also result in the Federal Home Loan Banks imposing a higher rate of interest on advances to their members.  If dividends were reduced, or if interest on future Federal Home Loan Bank advances were increased, our net interest income would likely also be reduced.

 

Community Reinvestment Act .  Under the Community Reinvestment Act, as implemented by OTS regulations, a savings institution has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low- and moderate-income neighborhoods.  The Community Reinvestment Act does not establish specific lending requirements or programs for financial institutions, nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the Community Reinvestment Act.  The Community Reinvestment Act requires the OTS, in connection with its examination of a savings institution, to assess the institution’s record of meeting the

 

 

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credit needs of its community and to take such record into account in its evaluation of certain applications by such institution.

 

The Community Reinvestment Act requires public disclosure of an institution’s Community Reinvestment Act examination rating and requires the OTS to provide a written evaluation of a bank’s Community Reinvestment Act performance utilizing a four-tiered descriptive rating system.  The Bank received a “satisfactory” rating as a result of its most recent Community Reinvestment Act assessment.

 

Liquidity .  A federal savings institution is required to maintain a sufficient amount of liquid assets to ensure its safe and sound operation.

 

Prohibitions Against Tying Arrangements .  Federal savings institutions are prohibited, subject to certain exceptions, from extending credit or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services of a competitor of the institution.

 

Privacy Requirements.   Federal laws and regulations govern an institution’s treatment of nonpublic personal information about consumers.  Generally, the law requires an institution to provide notice to consumer customers about its privacy policies and practices, requires an institution to disclose nonpublic personal information about consumer customers to nonaffiliated third parties only under certain conditions, and requires an institution to provide consumer customers with a method to “opt out” of the institution’s disclosing the consumer customer’s information to certain nonaffiliated third parties.

 

Anti-Money Laundering and the Bank Secrecy Act.   Under the Bank Secrecy Act (“BSA”), a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction.  Financial institutions are generally required to report cash transactions involving more than $10,000 to the United States Treasury.  In addition, financial institutions are required to file suspicious-activity reports for transactions that involve more than $5,000 and that the financial institution knows, suspects, or has reason to suspect involve illegal funds, are designed to evade the requirements of the BSA, or have no lawful purpose.

 

The USA PATRIOT Act of 2001 (the “PATRIOT Act”), which amended the BSA, contains anti-money laundering and financial transparency laws, as well as enhanced information collection tools and enforcement mechanisms for the U.S. government.  PATRIOT Act provisions include the following:  standards for verifying customer identification when opening accounts; rules to promote cooperation among financial institutions, regulators, and law enforcement; and due diligence requirements for financial institutions that administer, maintain, or manage certain bank accounts.

 

The Bank is subject to BSA and PATRIOT Act requirements.  The OTS carefully reviews an institution’s compliance with these requirements when examining an institution and considers the institution’s compliance when evaluating an application submitted by an institution.  The OTS may require an institution to take various actions to ensure that it is meeting the requirements of these acts.

 

Consumer Protection Laws.   The Bank is subject to many consumer protection laws and regulations, such as the following:

 

·   the Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;

 

·   the Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial

 

 

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institution is fulfilling its obligation to help meet the housing needs of the community it serves;

 

·   the Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed, or other prohibited factors when extending credit;

 

·   the Fair Credit Reporting Act of 1978, governing the use and provision of information to credit reporting agencies; and

 

·   rules and regulations of the various federal agencies charged with the responsibility of implementing such federal laws.

 

Savings and Loan Holding Company Regulation

 

General .  MHC and the Company are savings and loan holding companies within the meaning of federal law.  As such, they are registered with the OTS and are subject to OTS regulations, examinations, supervision, and reporting requirements.  In addition, the OTS has enforcement authority over the Company and MHC and their subsidiaries.  Among other things, this authority permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the Bank.

 

Restrictions Applicable to Savings and Loan Holding Companies .  According to federal law and OTS regulations, savings and loan holding companies, such as MHC and the Company, may engage only in certain activities.  Activities permissible for savings and loan holding companies include:  (1) acquiring control of a savings association; (2) furnishing or performing management services for a subsidiary savings association of such holding company; (3) holding, managing, or liquidating assets owned or acquired from a savings association subsidiary of such holding company; (4) holding or managing properties used or occupied by a savings association subsidiary of such holding company; and (4) any activity approved by the Federal Reserve Board for a bank holding company or financial holding company or previously approved by the OTS for multiple savings and loan holding companies.

 

Federal law prohibits a savings and loan holding company from directly or indirectly, or through one or more subsidiaries, acquiring more than 5% of a savings association or a savings and loan holding company without prior written approval of the OTS.  Federal law also prohibits a savings and loan holding company from acquiring more than 5% of a company engaged in activities other than those authorized for savings and loan holding companies by federal law or acquiring or retaining control of a depository institution that is not insured by the FDIC.  In evaluating applications by savings and loan holding companies to acquire savings institutions, the OTS must consider the financial and managerial resources and future prospects of the company and institution involved, the effect of the acquisition on the risk to the insurance funds, the convenience and needs of the community, and competitive factors.

 

The OTS is prohibited from approving any acquisition that would result in a multiple savings and loan holding company controlling savings institutions in more than one state, unless the laws of the state of the target savings institution specifically permit such acquisitions.  The states vary in the extent to which they permit interstate savings and loan holding company acquisitions.

 

Stock Holding Company Subsidiary Regulation .  The OTS has adopted regulations governing the two-tier holding company form of organization where there are subsidiary stock holding companies that are controlled by mutual holding companies.  This two-tier structure is currently the form of organization that has been adopted for the MHC and the Company, and we anticipate that it will continue in place.  The Company is the stock holding company and is a  subsidiary of MHC, the mutual holding company.

 

 

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Waivers of Dividends by MHC .  OTS regulations require MHC to notify the OTS if it proposes to waive receipt of dividends from the Company.  The OTS reviews dividend waiver notices on a case-by-case basis, and, in general, does not object to any such waiver if:  (i) the mutual holding company’s board of directors determines that such waiver is consistent with such directors’ fiduciary duties to the mutual holding company’s members; (ii) no insider of the mutual holding company, associate of an insider, or tax-qualified or non-tax-qualified employee stock benefit plan of the mutual holding company holds any share of stock in the class of stock to which the waiver would apply; and (iii) the waiver would not be detrimental to the safe and sound operation of the savings association.  The OTS will not consider waived dividends in determining an appropriate exchange ratio in the event of a full conversion to stock form.  We anticipate, but make no representation, that, to the extent the law allows, MHC will waive dividends that the Company may pay, if any.

 

Conversion of Mutual MHC to Stock Form .  OTS regulations permit MHC to convert from the mutual form of organization to the capital stock form of organization.  There can be no assurance when, if ever, a conversion transaction will occur, and it is our understanding that MHC’s board of directors has no current intention or plan to undertake a conversion transaction.

 

Acquisition of Control .  Under the federal Change in Bank Control Act, a notice must be submitted to the OTS if any person (including a company), or group acting in concert, seeks to acquire “control” of a savings and loan holding company or savings institution.  An acquisition of “control” can occur upon the acquisition of 10% or more of the voting stock of a savings and loan holding company or savings institution or in a manner otherwise defined by the OTS.  Under the Change in Bank Control Act, the OTS has 60 days from the filing of a complete notice to act, taking into consideration certain factors, including the financial and managerial resources of the acquirer and the antitrust effects of the acquisition.  Any company that so acquires control would then be subject to regulation as a savings and loan holding company.

 

Sarbanes-Oxley Act of 2002

 

Through the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, public companies (including publicly held holding companies such as the Company) became subject to a broad range of corporate governance and accounting measures.  Sarbanes-Oxley’s principal provisions, many of which have been interpreted and implemented through recently adopted rules, provide for and include, among other things, corporate governance and responsibility measures, including the requirement that the chief executive officer and chief financial officer of a public company certify its financial statements.

 

In addition, Section 404 of Sarbanes-Oxley, as implemented, requires that a public company report management’s evaluation of the effectiveness of such company’s internal control over financial reporting.  Additionally, such company’s senior management must evaluate, as of the end of each fiscal period, any change in the company’s internal control over financial reporting that occurred during the period that materially affected, or is reasonably likely to materially affect, the company’s internal control over financial reporting.  As a result of the expiration of the rules that had extended Section 404 compliance deadlines for smaller public companies, we are required to provide our report on internal control over financial reporting in this annual report covering the fiscal year ended December 31, 2007.  However, management’s report is not subject to attestation by the Company’s independent registered public accounting firm pursuant to temporary rules of the SEC that have delayed the effectiveness of the rules requiring this attestation.

 

 

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ITEM 2.                      DESCRIPTION OF PROPERTY

 

The Company is located and conducts its business at the Bank’s sole office at 2212 West Cermak Road, Chicago, Illinois 60608.  The Bank owns the building at that location.  The Company believes that the current facilities are adequate to meet its present and immediately foreseeable needs.

 

ITEM 3.                      LEGAL PROCEEDINGS

 

The Company and the Bank are not involved in any pending proceedings other than the legal proceedings occurring in the ordinary course of business.  Such legal proceedings in the aggregate are believed by management to be immaterial to the Company’s business, financial condition, results of operations and cash flows.

 

ITEM 4.                      SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

None.

PART II

 

ITEM 5.                      MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

 

The Company’s common stock is traded on the OTC Bulletin Board under the symbol “MFDB.OB.”  At March 19, 2008, the Company had  82 record holders of its common stock.  The table below shows the reported high and low bid price of the Company’s common stock, as reported on the OTC Bulletin Board, and any dividends declared during the periods indicated in 2007 and 2006.  The Company completed its initial public offering on April 4, 2006.

 

2007		High				Low				Dividends Declared
First quarter		$	14.41			$	12.40				—
Second quarter			14.00				12.70				—
Third quarter			13.15				10.05				—
Fourth quarter			12.05				10.35				—
2006
First quarter			—				—				—
Second quarter		$	11.50			$	10.84				—
Third quarter			11.50				10.05				—
Fourth quarter			14.50				11.05				—

Dividend Policy

 

The Company’s board of directors has the authority to declare dividends on the Company’s common stock, subject to statutory and regulatory requirements; however, presently the Company does not pay cash dividends on its common stock.  The payment of dividends in the future, if any, would depend upon a number of factors, including capital requirements, our financial condition and results of operations, tax considerations, statutory and regulatory limitations and general economic conditions.  Special cash dividends, stock dividends or returns of capital may, to the extent permitted by OTS policy and regulations, be paid in addition to, or in lieu of, regular cash dividends.  The Bank has filed consolidated federal and state income tax returns with the Company.  As a result, we anticipate that any

 

 

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cash distributions made by the Company to its stockholders would be treated as cash dividends and not as a non-taxable return of capital for federal and state tax purposes.

 

In the future, if we determine that dividends should be paid, our dividends may depend, in part, upon receipt of dividends from the Bank, because the Company initially will have no source of income other than dividends from the Bank, earnings from the investment of proceeds from the sale of shares of common stock, and interest payments with respect to the loan to the employee stock ownership plan.  A regulation of the OTS imposes limitations on “capital distributions” by savings institutions.  See “Supervision and Regulation—Regulation of Federal Savings Institutions—Limitation on Capital Distributions”.

 

If in the future we decide to pay dividends to our stockholders, we also will be required to pay dividends to MHC, unless MHC elects to waive the receipt of dividends.  We anticipate that MHC will waive receipt of any such dividends.  Any decision to waive dividends will be subject to regulatory approval.  Under OTS regulations, public stockholders would not be diluted for any dividends waived by MHC in the event MHC converts to stock form.  See “Supervision and Regulation—Holding Company Regulation”.

 

Purchase of Equity Securities

 

Period	Total number of shares purchased	Average price paid per share	Total number of shares purchased as part of  publicly announced plans or programs	Maximum number of shares that may yet be purchased under the plans or programs (1)
10/1/07–10/31/07	—	—	—	98,544
11/1/07–11/30/07	—	—	—	98,544
12/1/07–12/31/07	78,000	$11.28	78,000	20,544

_____________

(1)

On May 21, 2007 the Company announced that its Board of Directors had approved a stock repurchase program that authorized the purchase of up to 5%, or 181,844 shares, of the Company’s then outstanding shares of common stock, from time to time in open market or privately negotiated transactions.  Unless terminated or amended earlier by the Board of Directors, the stock repurchase program will end when the Company has repurchased all 181,844 shares authorized for repurchase.

 

ITEM 6.                      MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

 

General

 

This discussion and analysis reflects our consolidated financial statements and other relevant statistical data and is intended to enhance your understanding of our financial condition and results of operations.  You should read the information in this section in conjunction with our audited consolidated financial statements, which begin on page F-1, and the other business and financial information provided in this annual report.

 

Overview

 

Our results of operations depend primarily on our net interest income.  Net interest income is the difference between the interest income we earn on our interest-earning assets, consisting primarily of loans, investment securities, mortgage-backed securities and other interest-earning assets (primarily cash and cash equivalents), and the interest we pay on our interest-bearing liabilities, consisting of savings accounts, time deposits and FHLB advances.  Our results of operations also are affected by our provisions for loan losses, non-interest income and non-interest expense.  Non-interest income currently consists primarily of gains and losses on the sale of securities and miscellaneous other income.  Non-interest expense currently consists primarily of salaries and employee benefits, occupancy, data processing, professional fees, and other operating expenses.  Our results of operations also may be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities.

 

Forward-Looking Statements

 

This report contains forward-looking statements, which can be identified by the use of such words as estimate, project, believe, intend, anticipate, plan, seek, expect and similar expressions.  These forward-looking statements include:

 

·   statements of our goals, intentions and expectations;

 

·   statements regarding our business plans and prospects and growth and operating strategies;

 

 

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·   statements regarding the asset quality of our loan and investment portfolios; and

 

·   estimates of our risks and future costs and benefits.

 

These forward-looking statements are subject to significant risks, assumptions and uncertainties, including, among other things, the following important factors that could affect the actual outcome of future events:

 

·   significantly increased competition among depository and other financial institutions;

 

·   our ability to enter new markets successfully and take advantage of growth opportunities;

 

·   our ability to successfully implement our business plan;

 

·   inflation and changes in the interest rate environment that reduce our margins or reduce the fair value of financial instruments;

 

·   general economic conditions, either nationally or in our market area, that are worse than expected;

 

·   adverse changes in the securities markets;

 

·   legislative or regulatory changes that adversely affect our business;

 

·   changes in consumer spending, borrowing and savings habits;

 

·   changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the Financial Accounting Standards Board, the SEC, and the PCAOB; and

 

·   changes in our organization, compensation and benefit plans.

 

These risks and uncertainties should be considered in evaluating forward-looking statements, and undue reliance should not be placed on such statements.  Because of these and other uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements.

 

Critical Accounting Policies

 

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

 

Allowance for Loan Losses .  The allowance for loan losses is the estimated amount considered necessary to cover probable incurred losses in the loan portfolio at the balance sheet date.  The allowance is established through a provision for loan losses that is charged against income.  In determining the allowance for loan losses, management makes significant estimates and has identified this policy as one of our most critical.

 

Management performs a quarterly evaluation of the adequacy of the allowance for loan losses.  We consider a variety of factors in establishing this estimate including, but not limited to, current economic conditions, delinquency statistics, geographic and industry concentrations, the adequacy of the

 

 

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underlying collateral, the financial strength of the borrower, results of internal loan reviews and other relevant factors.  This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change.

 

The analysis has two components:  specific and general allocations.  Specific allocations are made for loans that are determined to be impaired.  Impairment is measured by determining the present value of expected future cash flows or, for collateral-dependent loans, the fair value of the collateral adjusted for market conditions and selling expenses.  The general allocation is determined by segregating the remaining loans by type of loan, risk weighting (if applicable) and payment history.  We also analyze historical loss experience, delinquency trends, general economic conditions and geographic and industry concentrations.  This analysis establishes factors that are applied to the loan groups to determine the amount of the general allowance for loan losses.  Actual loan losses may be significantly more than the allowances we have established which could have a material negative effect on our financial results.

 

Selected Consolidated Financial and Other Data

 

The following tables set forth our selected historical financial and other data for the periods and at the dates indicated.  The information should be read in conjunction with the Consolidated Financial Statements and Notes thereto contained elsewhere herein.

 

		At December 31,
		2007				2006
		(dollars in thousands)
Selected Financial Condition Data:
Total assets		$	73,011			$	75,063
Loans, net			53,047				51,924
Interest-bearing deposits			1,172				855
Securities available-for-sale			16,345				19,559
Federal Home Loan Bank stock, at cost			610				500
Deposits			39,719				43,308
Equity			26,911				28,233

		Year Ended December 31,
		2007				2006
		(dollars in thousands)
Selected Operating Data:
Total interest and dividend income		$	4,360			$	3,986
Total interest expense			1,297				1,112
Net interest income			3,063				2,874
Provision for loan losses			50				70
Net interest income after provision for loan losses			3,013				2,804
Loss on impairment of securities			(152	)			—
Other non-interest income			46				56
Total non-interest expense			2,393				2,026
Income before income tax expense			514				834
Income tax expense			219				304
Net income		$	295			$	530

 

 

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		At or for the Years Ended December 31,
		2007				2006
Selected Financial Ratios and Other Data:
Performance Ratios:
Return on average assets			0.40	%			0.73	%
Return on average equity			1.06				2.10
Average interest rate spread (1)			3.13				3.20
Net interest margin (2)			4.26				4.10
Efficiency ratio (3)			76.97				69.15
Non-interest expense to average total assets			3.22				2.79
Average interest-earning assets to average interest-bearing liabilities			162.89				156.97
Asset Quality Ratios:
Non-performing assets to total assets			0.35	%			0.59	%
Non-performing loans to total loans			0.48				0.85
Allowance for loan losses to non-performing loans			1.12	x			0.54	x
Allowance for loan losses to total loans			0.54	%			0.46	%
Capital Ratios:
Equity to total assets			36.86	%			37.61	%
Tangible capital (4)			32.85				30.99
Tier 1 (core) capital (4)			32.85				30.99
Tier 1 risk-based ratio (4)			58.14				56.63

 

_____________

(1)	The average interest rate spread represents the difference between the weighted-average yield on interest-earning assets and the weighted-average cost of interest-bearing liabilities for the period.

(2)	The net interest margin represents net interest income as a percent of average interest-earning assets for the period.

(3)	The efficiency ratio represents other expense as a percent of net interest income plus other income less securities gains or plus securities losses.

(4)	Tangible capital and Tier 1 (core) capital ratios are for the Bank only.  Tier 1 risk-based ratio represents Tier 1 capital of the Bank divided by its risk-weighted assets as defined in federal regulations on required capital.

 

 

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Comparison of Financial Condition at December 31, 2007 and December 31, 2006

 

Our total assets decreased by $2.1 million, or 2.7%, to $73.0 million at December 31, 2007, from $75.1 million at December 31, 2006.  The primary reason for the decrease in total assets was that funds from securities repayments and Federal Home Loan Bank advances were used to meet deposit withdrawals and to fund repurchases of the Company’s common stock.

 

Loans receivable increased $1.1 million, or 2.2%, to $53.0 million at December 31, 2007, from $51.9 million at December 31, 2006, reflecting an increase in multi-family residential mortgage loans of $252,000, or 1.3%, to $19.2 million at December 31, 2007, from $19.0 million at December 31, 2006, and an increase in one-to-four family residential mortgage loans of $893,000, or 2.7%, to $34.2 million at December 31, 2007, from $33.3 million at December 31, 2006.  Securities available for sale decreased $3.2 million, or 16.4%, to $16.3 million at December 31, 2007, from $19.6 million at December 31, 2006.

 

Total deposits decreased $3.6 million, or 8.3%, to $39.7 million at December 31, 2007, from $43.3 million at December 31, 2006.  The decrease in deposits resulted, in management’s opinion, primarily from increased competition for funds based on rate and increasing returns in other markets.  We did not utilize any brokered deposits during 2007 or 2006.

 

Stockholders’ equity decreased $1.3 million, or 4.7%, to $26.9 million at December 31, 2007, from $28.2 million at December 31, 2006.  Stockholders’ equity increased by net income of $295,000 and an $89,000 increase in accumulated unrealized gains in the fair value of securities available-for-sale.  The vesting of Company stock grants resulted in a $146,000 charge to earnings and corresponding increase in stockholders’ equity, and the vesting of Company stock options resulted in a $100,000 charge to earnings and corresponding increase in stockholders’ equity.   Stockholders’ equity decreased by $2.0 million as the Company repurchased its stock as treasury stock, primarily to fund employee stock benefit plans.

 

Comparison of Operating Results for the Years Ended December 31, 2007 and 2006

 

General .  Net income decreased $235,000, or 44.3%, to $295,000 for the year ended December 31, 2007, from $530,000 for the year ended December 31, 2006.  The decrease in net income resulted primarily from a $152,000 write-down of equity securities available-for-sale to market value, and a $367,000 increase in operating expenses, partially offset by a $209,000 increase in net interest income.  Return on average assets was 0.40% for the year ended December 31, 2007, compared to 0.73% for the year ended December 31, 2006, and return on equity was 1.06% and 2.10% for these same two periods.

 

Interest Income .  Interest and dividend income increased $374,000, or 9.4%, to $4.4 million for the year ended December 31, 2007, from $4.0 million for the year ended December 31, 2006, primarily due to an increase in the return on interest-earning assets.  A 38 basis point increase in the average yield on interest-earning assets, to 6.07% in 2007, from 5.69% in 2006, combined with a $1.7 million increase in the average balance of interest-earning assets, resulted in the increase.

 

Interest income and fees from loans receivable increased $509,000, or 17.2%, to $3.5 million for the year ended December 31, 2007, from $3.0 million for the year ended December 31, 2006.  The increase was due to an increase in the average balance of loans of $7.0 million, or 15.2%, to $53.0 million in 2007, from $46.0 million in 2006, and to a 12 basis point increase in the average yield on loans to 6.56% in 2007, from 6.44% in 2006.

 

Interest and dividend income from securities and deposits decreased $132,000, or 13.1%, to $876,000 for the year ended December 31, 2007 from $1.0 million for the year ended December 31, 2006.  The decrease resulted from a decrease in the average balance of these investments of $5.2 million, or

 

 

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21.7%, to $18.9 million in 2007, from $24.1 million in 2006, partially offset by an increase in the average yield on securities and deposits to 4.70% in 2007, from 4.24% in 2006.

 

During the last quarter of 2007, the Federal Home Loan Bank of Chicago suspended dividends on its stock.  That resulted in a decrease of $3,000 in dividend income, to $12,000 for the year ended December 31, 2007, compared to $15,000 for the year ended December 31, 2006.  There has been no indication from the FHLB as to when dividends will resume.

 

Also during the last quarter of 2007, the Federal Home Loan Mortgage Corporation announced a 50% reduction in the dividend on their common stock.  The $4,000 quarterly dividend paid during the first three quarters of 2007 on the 8,000 shares we own was reduced to $2,000.  This resulted in dividend income on this investment of $14,000 for 2007, compared to $15,000 for 2006.  There has been no indication from FHLMC as to what future dividends will be paid.

 

Interest Expense .  Total interest expense increased $185,000, or 16.6%, to $1.3 million for the year ended December 31, 2007, from $1.1 million for the year ended December 31, 2006.  The increase in interest expense resulted from a 36 basis point increase in the average cost of deposits, to 2.79% in 2007, from 2.43% in 2006, partially offset by a $2.3 million decrease in the average balance of interest-bearing deposits.  Interest expense on certificates of deposit increased $119,000, or 15.1%, due to a 54 basis point increase in the average rate paid on such deposits, to 4.23% for the year ended December 31, 2007, from 3.69% for the year ended December 31, 2006.

 

During 2007 the Company used advances from the Federal Home Loan Bank to fund its loan pipeline, deposit withdrawals, and the repurchase of Company stock.  Interest on borrowings increased by $89,000, or 164.8%, to $143,000 for the year ended December 31, 2007, compared to $54,000 for the year ended December 31, 2006.  The average rate paid for advances increased 19 basis points, to 5.29% in 2007, from 5.10% in 2006.

 

Net Interest Income .  Net interest income increased $189,000, or 6.6%, to $3.1 million for the year ended December 31, 2007, from $2.9 million for the year ended December 31, 2006.  Our net interest margin increased to 4.26% during 2007, from 4.10% during 2006, and our interest rate spread decreased to 3.13% in 2007, from 3.20% in 2006.  The average yield on interest earning assets increased from 5.69% in 2006 to 6.07% in 2007, complementing a $1.7 million increase in average interest earning assets, with interest income increasing by $374,000.  At the same time the average rate paid on interest bearing liabilities increased from 2.49% in 2006 to 2.94% in 2007, causing interest expense to increase by $185,000 in 2007.

 

Provision for Loan Losses .  We make provisions for loan losses, which are charged to operations, so that our allowance for loan losses is maintained at a level necessary to absorb probable incurred loan losses at the date of the financial statements.  While the Bank has not had a loan charge-off since 1996, the Bank evaluates the level of the allowance for loan losses quarterly.  Management, in determining the allowance for loan losses and the resulting provision necessary, considers the losses inherent in our loan portfolio and changes in the nature and volume of loan activities, along with the general economic and real estate market conditions, as well as peer group data.   The Bank’s loan committee determines the type of loans to be evaluated for impairment on an individual basis and the types of loan to be evaluated on a collective basis based on similarities in loss performance, such as our one-to-four family residential loans and multifamily residential loans.  We then utilize a two-tier approach:  (1) for the types of loans to be evaluated on an individual basis, identification of impaired loans and establishment of specific loss allowances on such loans, and (2) for the types of loans to be evaluated on a collective basis, establishment of loan loss allocations on pools of loans.

 

 

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Once a loan becomes delinquent, we may establish a specific loan loss allowance should we determine that the loan is impaired.  A loan will be considered impaired when, based on current information and events (such as, among other things, delinquency status, the size of the loan, the type and market value of collateral and the financial condition of the borrower), it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement.  All loans identified as impaired are evaluated independently.  We do not aggregate such loans for evaluation purposes.  Specific allowances for impaired loans are established based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical measure, at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent.

 

Loan loss allocations on pools of loans are based upon historical loan loss experience as adjusted after evaluation of other factors that may or may not be present, including changes in the composition of the loan portfolio, current national and local economic conditions, changes in lending policies and procedures, peer group information, and personnel changes in our lending management or staff.  Since we do not have recent loss experience, determining the amount of the allowance for loan losses necessarily involves a high degree of judgment.

 

Assumptions and allocation percentages based on loan types and classification status have been consistently applied.  We have allocated the allowance among categories of loan types as well as classification status at each period-end date.  Management believes multi-family loans present higher inherent risks than one-to-four family residential mortgage loans because historically multi-family loans have higher rates of default and because repayments may be affected to a greater degree by general economic conditions and interest rates.  However, our strict underwriting standards, including a 75% maximum loan-to-value ratio on non-owner-occupied properties, and the fact that our multifamily loans generally have ten units or less, partially mitigates this risk.

 

Non-performing loans decreased to $259,000 at December 31, 2007, from $443,000 at December 31, 2006.  Loans delinquent for 60-89 days increased to $2.6 million at December 31, 2007, from $385,000 at December 31, 2006.  Typically non-performing loans are assigned a higher percentage of allowance allocation.  The allowance for loan losses was $290,000, or 0.54% of gross loans outstanding at December 31, 2007, as compared with $240,000, or 0.46% of loans outstanding at December 31, 2006.  In reviewing the allowance during 2007 and at December 31, 2007, we considered various subjective factors including the increasing delinquency trends in our portfolio, our non-performing loans, and the overall current economic conditions, and determined that a provision of $50,000 was necessary for the year then ended.  In a similar evaluation of the allowance for loan losses during 2006 and at December 31, 2006, management determined that a provision of $70,000, driven primarily by the growth in the loan portfolio, was necessary for the year then ended.

 

Although we believe that we use the best information available to establish the allowance for loan losses, future additions to the allowance may be necessary based on estimates that are susceptible to change as a result of changes in economic conditions and other factors.  In addition, the Office of Thrift Supervision, as an integral part of its examination process, periodically reviews our allowance for loan losses, and could require additional reserves.

 

Non-Interest Income .  Non-interest income decreased $162,000, to a loss of $106,000 for the year ended December 31, 2007, from $56,000 income for year ended December 31, 2006.  The decrease was due primarily to a $152,000 write down of equity securities to market value at December 31, 2007.  Other non-interest income decreased $11,000, to $42,000 in 2007, from $53,000 in 2006. Late charges on delinquent loans, increased $18,000, to $22,000 for the year ended December 31, 2007, compared to $4,000 for 2006.  Other non-interest income in 2006 included a $24,000 recovery of legal fees previously expensed as professional fees.

 

 

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At December 31, 2007, we owned 10,000 shares of FHLMC preferred stock paying a non-cumulative preferred dividend of 5.79%.  Primarily because of the turmoil in the secondary mortgage market during 2007, the market price of this investment declined.  While we do not currently plan to sell this investment, we could not estimate when or if the security would fully recover in value, and wrote the security down to its fair value with a $98,000 pre-tax charge to earnings.

 

The Company has investments in various mutual funds that invest in U. S. government and government agency debt securities, and government agency insured fixed-rate and adjustable-rate mortgage-backed securities.  The net asset value of these funds have historically been stable, and generally increase when interest rates decline.  However, at December 31, 2007, we wrote the funds down to their net asset value with a $54,000 pre-tax charge to earnings because we were unable to forecast a recovery in the net asset value of the funds in the period we estimated we would hold the securities.

 

Non-Interest Expense .  Non-interest expense increased $367,000, or 18.1%, to $2.4 million for the year ended December 31, 2007, compared to $2.0 million for the year ended December 31, 2006.

 

Compensation and employee benefits increased $264,000, or 23.9%, to $1.4 million in 2007, from $1.1 million in 2006, due to salary increases in the ordinary course of business, higher health benefit costs, and newly established stock benefit plans.  The Company’s ESOP expense increased by $23,000, to $75,000 for the year ended December 31, 2007, compared to $52,000 for 2006, primarily because ESOP expense was incurred for only three quarters in 2006.  Grants of common stock and options made during 2007, under the shareholder approved Management Recognition Plan and Stock Option Plan, increased compensation and benefit costs by $146,000 and $100,000, respectively.

 

Professional fees, including legal, accounting and consulting fees, increased $108,000, or 31.7%, to $449,000 in 2007, from $341,000 in 2006, primarily due to increased legal fees associated with the implementation of stock benefit plans, SEC reporting compliance, and other costs associated with being a new public company.

 

Occupancy expense decreased $19,000, or 11.2%, to $151,000 in 2007, from $170,000 in 2006, primarily due to decreased depreciation charges.  Data processing costs increased $4,000, or 3.9%, to $108,000 in 2007, from $104,000 in 2006.  Miscellaneous other expenses increased $10,000, or 3.3%, to $315,000 in 2007, from $305,000 in 2006.  The ratio of non-interest expense to average assets was 3.22% for the year ended December 31, 2007, compared to 2.79% for 2006.

 

Income Tax Expense .  The provision for income taxes decreased $85,000, to $219,000 for the year ended December 31, 2007 from $304,000 for the prior year, due primarily to our reduced income before income taxes.  The effective tax rates for the periods ended December 31, 2007 and 2006 were 42.61% and 36.45%, respectively.  The increase in the effective tax rate was due to stock benefit plan expenses that were not fully deductible for income tax purposes.

 

Average Balance Sheet

 

The following tables set forth average balance sheets, average yields and costs, and certain other information for the periods indicated.  No tax-equivalent yield adjustments were made, as their effects were not material.  All average balances are based on an average of daily balances.  Non-accrual loans were included in the computation of average balances, but have been reflected in the table as loans carrying a zero yield.  The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense.

 

 

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		At December 31,				For the Years Ended December 31,
		2007				2007												2006
		Yield/Rate				Average Outstanding Balance				Interest				Yield/Rate				Average Outstanding Balance				Interest				Yield/Rate
Interest-earning assets:										(dollars in thousands)
Loans			6.44	%		$	52,954			$	3,472				6.56	%		$	45,977			$	2,963				6.44	%
Securities available for sale			4.90				17,552				839				4.78				22,377				948				4.24
Federal Home Loan Bank Stock			—				580				12				2.07				500				15				3.00
Interest-earning deposits			3.52				763				37				4.85				1,253				60				4.79
Total interest-earning assets			6.00	%			71,849				4,360				6.07	%			70,107				3,986				5.69	%
Non-interest-earning assets							2,353												2,470
Total assets						$	74,202											$	72,577
Interest-Bearing  Liabilities: (1)
Savings deposits			1.24	%		$	19,919			$	246				1.24	%		$	22,195			$	269				1.21	%
Certificates of deposit			4.27				21,488				908				4.23				21,409				789				3.69
Total deposits			2.82				41,407				1,154				2.79				43,604				1,058				2.43
Borrowings			4.74				2,703				143				5.29				1,059				54				5.10
Total interest-bearing liabilities			3.04	%			44,110				1,297				2.94	%			44,663				1,112				2.49	%
Non-interest-bearing liabilities							2,162												2,691
Total liabilities							46,272												47,354
Stockholders’ equity							27,930												25,223
Total liabilities and stockholders’ equity						$	74,202											$	72,577
Net interest income										$	3,063											$	2,874
Net interest rate spread (2)															3.13	%											3.20	%
Net interest-earning assets (3)						$	27,739											$	25,444
Net interest margin (4)															4.26	%											4.10	%
Ratio of interest-earning assets to interest-bearing liabilities															162.89	%											156.97	%

_____________

(1)	Non interest-bearing checking deposits are included in non-interest-bearing liabilities.

(2)	Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average interest-bearing liabilities.

(3)	Net interest-earning assets represents total interest-earning assets less total interest-bearing liabilities.

(4)	Net interest margin represents net interest income divided by average total interest-earning assets.

 

Rate/Volume Analysis

 

The following table presents the dollar amount of changes in interest income and interest expense for the major categories of our interest-earning assets and interest-bearing liabilities.  Information is provided for each category of interest-earning assets and interest-bearing liabilities with respect to (i) changes attributable to changes in volume (i.e., changes in average balances multiplied by the prior-period average rate) and (ii) changes attributable to rate (i.e., changes in average rate multiplied by prior-period average balances).  For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate.

 

 

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		Years Ended December 31, 2007 vs. 2006
		Increase (Decrease) Due to								Total Increase
		Volume				Rate				(Decrease)
		(in thousands)
Interest-Earning Assets:
Loans		$	457			$	52			$	509
Securities available for sale			(188	)			79				(109	)
Federal Home Loan Bank Stock			2				(5	)			(3	)
Interest-earning deposits			(23	)			—				(23	)
Total interest-earning assets			248				126				374
Interest-Bearing Liabilities:
Savings deposits			(27	)			4				(23	)
Certificates of deposit			3				116				119
Total deposits			(24	)			120				96
Borrowings			87				2				89
Total interest-bearing liabilities			63				122				185
Change in net interest income		$	185			$	4			$	189

Management of Market Risk

 

General .  The majority of our assets and liabilities are monetary in nature.  Consequently, our most significant form of market risk is interest rate risk.  Our assets, consisting primarily of mortgage loans, have longer maturities than our liabilities, which consist primarily of deposits.  As a result, a principal part of our business strategy is to manage interest rate risk and reduce the exposure of our net interest income to changes in market interest rates.  Our board of directors has approved a series of policies for evaluating interest rate risk inherent in our assets and liabilities; for determining the level of risk that is appropriate given our business strategy, operating environment, capital, liquidity and performance objectives; and for managing this risk consistent with these policies.  Senior management regularly monitors the level of interest rate risk and reports to the board of directors on our compliance with our asset/liability policies and on our interest rate risk position.

 

We have sought to manage our interest rate risk in order to control the exposure of our earnings and capital to changes in interest rates.  During the low interest rate environment that has existed in recent years, we have managed our interest rate risk by maintaining a high equity-to-assets ratio and building and maintaining portfolios of shorter-term fixed rate residential loans and second mortgage loans.  By maintaining a high equity-to-assets ratio, we believe that we are better positioned to absorb more interest rate risk in order to improve our net interest margin.  However, maintaining high equity balances reduces our return on equity ratio, and investments in shorter-term assets generally bear lower yields than longer-term investments.

 

Net Portfolio Value .  In past years, many savings institutions have measured interest rate sensitivity by computing the “gap” between the assets and liabilities that are expected to mature or reprice within certain time periods, based on assumptions regarding loan prepayment and deposit decay rates formerly provided by the OTS.  However, the OTS now requires the computation of amounts by which the net present value of an institution’s cash flow from assets, liabilities and off balance sheet items (the institution’s net portfolio value or “NPV”) would change in the event of a range of assumed changes in market interest rates.  The OTS provides all institutions that file a Consolidated Maturity/Rate Schedule as a part of their quarterly Thrift Financial Report with an interest rate sensitivity report of net portfolio value.  The OTS simulation model uses a discounted cash flow analysis and an option-based pricing approach to measuring the interest rate sensitivity of net portfolio value.  Historically, the OTS model estimated the economic value of each type of asset, liability and off-balance sheet contract under the assumption that the United States Treasury yield curve increases or decreases instantaneously by 100

 

 

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to 300 basis points in 100 basis point increments.  A basis point equals one-hundredth of one percent, and 100 basis points equals one percent.  An increase in interest rates from 3% to 4% would mean, for example, a 100 basis point increase in the “Change in Interest Rates” column below.  The OTS provides us the results of the interest rate sensitivity model, which is based on information we provide to the OTS to estimate the sensitivity of our net portfolio value.

 

The table below sets forth, as of December 31, 2007, the estimated changes in our NPV and our net interest income that would result from the designated instantaneous changes in the U.S. Treasury yield curve.  Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions including relative levels of market interest rates, loan prepayments and deposit decay, and should not be relied upon as indicative of actual results.

 

				NPV												Net Portfolio Value as a Percentage of Present Value of Assets
Change In Interest Rates (Basis Points)				Estimated NPV				Amount of Change				Percentage Change				NPV Ratio				Change in Basis Points
								(dollars in thousands)
	+300			$	20,793			$	(6,334	)			-23	%			29.90	%			-560	bp
	+200				23,010				(4,117	)			-15				31.99				-351
	+100				25,199				(1,928	)			-7				33.92				-158
	+50				26,215				(912	)			-3				34.77				-73
Unchanged					27,127												35.50
	-50				27,939				813				3				36.13				63
	-100				28,745				1,618				6				36.74				124
	-200				30,250				3,123				12				37.82				232

The table above indicates that at December 31, 2007, in the event of a 200 basis point decrease in interest rates, we would experience a 12% increase in net portfolio value.  In the event of a 200 basis point increase in interest rates, we would experience a 15% decrease in net portfolio value.

 

Certain shortcomings are inherent in the methodology used in the above interest rate risk measurement.  Modeling changes in net portfolio value requires making certain assumptions that may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates.  In this regard, the net portfolio value table presented assumes that the composition of our interest-sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured and assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration or repricing of specific assets and liabilities.  Accordingly, although the net portfolio value table provides an indication of our interest rate risk exposure at a particular point in time, such measurements do not provide a precise forecast of the effect of changes in market interest rates on net interest income and will differ from actual results.

 

Liquidity and Capital Resources

 

We maintain liquid assets at levels we consider adequate to meet our liquidity needs.  We adjust our liquidity levels to fund deposit outflows, pay real estate taxes on mortgage loans, repay our borrowings and to fund loan commitments.  We also adjust liquidity as appropriate to meet asset and liability management objectives.

 

Our primary sources of liquidity are deposits, advances from the Federal Home Loan Bank, amortization and prepayment of loans, maturities of investment securities and other short-term investments, and earnings and funds provided from operations.  While scheduled principal repayments on

 

 

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loans are a relatively predictable source of funds, deposit flows and loan prepayments are greatly influenced by market interest rates, economic conditions, and rates offered by our competition.  We set the interest rates on our deposits to maintain a desired level of total deposits.  In addition, we invest excess funds in short-term interest-earning assets, which provide liquidity to meet lending requirements.

 

A portion of our liquidity consists of cash and cash equivalents, which are a product of our operating, investing and financing activities.  At December 31, 2007, $2.3 million of our assets were invested in cash and cash equivalents.  Our primary sources of cash are principal repayments on loans, proceeds from the calls and maturities of investment securities, increases in deposit accounts, and advances from the Federal Home Loan Bank.

 

Our cash flows are derived from operating activities, investing activities and financing activities as reported in our consolidated statements of cash flows included with our consolidated financial statements elsewhere in this report.

 

Our primary investing activities are the origination of loans and the purchase of investment securities.  During the year ended December 31, 2007, our loan originations, net of collected principal, totaled $1.4 million.  During the year ended December 31, 2006, there was a net increase that totaled $14.0 million.  We did not sell any loans during the years ended December 31, 2007 and 2006.  Cash received from calls and maturities of securities totaled $3.3 million and $6.6 million for the years ended December 31, 2007 and 2006, respectively.  We purchased no securities in 2007 and $2.0 million in securities during the year ended December 31, 2006. We sold no securities in 2007 or 2006.  We purchased $110,000 in FHLB stock in 2007 to meet our minimum membership requirement.

 

Deposit flows are generally affected by the level of interest rates, the interest rates and products offered by us and by local competitors, and other factors.  There was a net decrease in total deposits of $3.6 million and $217,000 for the years ended December 31, 2007 and 2006, respectively.  During 2006 depositors used $796,000 in deposits to purchase the Company’s common stock during its public offering.   Deposit growth has been difficult due to the very competitive interest rate environment.

 

Liquidity management is both a daily and long-term function of business management.  If we require funds beyond our ability to generate them internally, borrowing agreements exist with the Federal Home Loan Bank of Chicago, which provide an additional source of funds.  During the year ended December 31, 2007, the Bank borrowed $7.5 million from the Federal Home Loan Bank and repaid $4.5 million of those advances.   During the year ended December 31, 2006, the Bank borrowed $6.0 million from the Federal Home Loan Bank and repaid $4.0 million of those advances.  Our available borrowing limit at December 31, 2007, was $12.2 million.

 

At December 31, 2007, we had outstanding commitments to originate loans of $205,000.  At December 31, 2007, certificates of deposit scheduled to mature in less than one year totaled $18.3 million.  Based on prior experience, management believes that a significant portion of such deposits will remain with us, although there can be no assurance that this will be the case.  In the event we do not retain a significant portion of our maturing certificates of deposit, we will have to utilize other funding sources, such as Federal Home Loan Bank advances, in order to maintain our level of assets.  Alternatively, we would reduce our level of liquid assets, such as our cash and cash equivalents.  In addition, the cost of such deposits may be significantly higher if market interest rates are higher at the time of renewal.

 

Off-Balance Sheet Arrangements

 

In the ordinary course of business, the Bank is a party to credit-related financial instruments with off-balance-sheet risk to meet the financing needs of its customers.  These financial instruments include

 

 

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commitments to extend credit.  The Bank follows the same credit policies in making commitments as it does for on-balance-sheet instruments.

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Therefore, the total commitment amounts do not necessarily represent future cash requirements.

 

At December 31, 2007 and December 31, 2006, the Bank had $205,000 and $576,000, respectively, of commitments to grant mortgage loans.

 

Impact of Recent Accounting Pronouncements

 

FASB Statement 123(R), “Shares-Based Payment,” addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments.  Statement 123(R) requires an entity to recognize the grant-date fair-value of stock options and other equity-based compensation issued to employees in the income statement.  The revised Statement generally requires that an entity account for those transactions using the fair-value-based method; and eliminates an entity’s ability to account for share-based compensation transactions using the intrinsic value method of accounting in APB Opinion No. 25, “Accounting for Stock Issued to Employees,” which was permitted under Statement 123, as originally issued.  The revised Statement requires entities to disclose information about the nature of the share-based payment transactions and the effects of those transactions on the financial statements.  Statement 123(R) is effective for the Bank for fiscal year 2006.

 

On November 29, 2006, the Registrant’s stockholders approved the Mutual Federal Bancorp, Inc. 2006 Stock Option Plan (the “Stock Option Plan”), and  the Mutual Federal Bancorp, Inc. 2006 Recognition and Retention Plan and Trust Agreement (the “MRP”, and collectively with the Stock Option Plan, the “Plans”).   A total of 178,026  and 71,282 shares of Company common stock have been reserved for issuance under the Stock Option Plan and the MRP, respectively. As of December 31, 2006 no shares had been awarded under either plan.  During January 2007 the Company granted 131,871 stock options and 52,748 restricted stock awards, at fair market value ($14.41 per share) on the grant date.  The plans have a term of ten years.  Both the stock options and restricted stock awards will vest equally over five years.  Compensation expense related to vesting of the restricted stock awards granted was $146,000 for the year ended December 31, 2007, and will approximate $152,000 per year beginning in 2008.  The Company is also required to record compensation expense related to the stock options in accordance with  Statement on Financial Accounting Standard No. 123 ( R ) .  Compensation expense related to vesting of stock options granted was $100,000 for the year ended December 31, 2007, and will approximate $104,000 per year beginning in 2008.

 

Impact of Inflation and Changing Prices

 

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

 

 

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ITEM 7.                      FINANCIAL STATEMENTS

 

See Index to Financial Statements on page F-1.

 

ITEM 8.                      CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

None.

 

ITEM 8A.                      CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures

 

As of the end of the period covered by this report, we carried out an evaluation, under the supervision, and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as contemplated by Exchange Act Rule 13a-15.  Based upon, and as of the date of that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures are effective, in all material respects, in timely alerting them to material information relating to the Company (and its consolidated subsidiaries) required to be included in the periodic reports the Company is required to file and submit to the Securities and Exchange Commission under the Exchange Act.

 

Report on Management’s Assessment of Internal Control Over Financial Reporting

 

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2007 based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).  Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2007.

 

This annual report is the first report of the Company in which management is required to provide its assessment on the effectiveness of the Company’s internal controls. This annual report does not include an attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s independent registered public accounting firm pursuant to temporary rules of the SEC that permit the Company to provide only management’s report in this annual report.

 

Changes in Internal Control over Financial Reporting

 

There have been no changes in our internal control over financial reporting during the period covered by this report that have materially affected or are reasonably likely to materially affect our internal controls.

 

ITEM 8B.                      OTHER INFORMATION

 

None.

 

 

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PART III

 

ITEM 9.                      DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS, CONTROL PERSONS AND CORPORATE GOVERNANCE; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT

 

The information required in response to this item regarding the Company’s directors and executive officers will be contained in the Company’s definitive Proxy Statement (the “Proxy Statement”) for its Annual Meeting of Stockholders to be held on May 14, 2008 under the captions and subcaptions “Proposal 1.—Election of Directors,” “Corporate Governance—Board Meetings,” “Corporate Governance—Board Committees,” “Executive Officers Who Are Not Directors,” “Beneficial Ownership,” and “Section 16(a) Beneficial Ownership Reporting Compliance,” and the information included therein is incorporated herein by reference.

 

The information regarding material changes to the procedures by which security holders may recommend nominees to the registrant’s board of directors, if any, will be contained in the Proxy Statement under the heading “Corporate Governance—Director Nomination Procedures,” and the information included therein is incorporated herein by reference.

 

The information regarding the audit committee of the Company’s board of directors and its audit committee financial expert, if any, will be contained in the Proxy Statement under the heading “Corporate Governance—Board Committees—Audit Committee,” and the information included therein is incorporated herein by reference.

 

The Company has adopted a code of ethics as required by the rules of the Securities and Exchange Commission.  The code of ethics applies to all of the Company’s directors, officers, including the Company’s Chief Executive Officer and Chief Financial Officer, as well as to the Company’s other employees.  A copy of our code of ethics will be provided to any person, without charge, upon request made to Julie H. Oksas, Corporate Secretary, Mutual Federal Bancorp, Inc., 2212 W. Cermak Road, Chicago, IL 60608.

 

ITEM 10.                      EXECUTIVE COMPENSATION

 

The information required in response to this item will be contained in the Proxy Statement under the captions “Executive Compensation” and “Director Compensation,” and the information included therein is incorporated herein by reference.

 

ITEM 11.                      SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

 

The information required in response to this item concerning the security ownership of certain beneficial owners and management, and information, if any, regarding any change in control arrangements, will be contained in the Proxy Statement under the subcaption “Beneficial Ownership,” and the information included therein is incorporated herein by reference.

 

Equity Compensation Plan Information

 

The following table provides information, as of December 31, 2007, relating to equity compensation plans of the Company pursuant to which equity securities are authorized for issuance.

 

 

39

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Plan category		Number of securities to be issued upon exercise of outstanding options, warrants and rights (a)				Weighted-average exercise price of outstanding options, warrants and rights (b)				Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) (c)
Equity compensation plans approved by security holders			184,619			$	14.41				64,669
Equity compensation plans not approved by security holders			—				—				—
Total			184,619			$	14.41				64,669

 

ITEM 12.                      CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

 

The information required in response to this item regarding certain relationship and related party transactions will be contained in the Proxy Statement under the caption “Transactions with Related Persons,” and the information included therein is incorporated herein by reference.  The information regarding the independence of the Company’s directors will be contained in the Proxy Statement under the heading “Corporate Governance—Director Independence,” and the information included therein is incorporated herein by reference.

 

ITEM 13.                      EXHIBITS

 

The exhibits filed or incorporated by reference as a part of this Form 10-KSB are listed in the Exhibit Index, which is incorporated herein by reference.

 

ITEM 14.                      PRINCIPAL ACCOUNTANT FEES AND SERVICES

 

The information required in response to this item will be contained in the Proxy Statement under the captions “Audit Fees,” “Audit-Related Fees,” “Tax Fees” and “All Other Fees” and the information included therein is incorporated herein by reference.

 

40

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MUTUAL FEDERAL BANCORP, INC.
CHICAGO, ILLINOIS

 

Consolidated Financial Statements

December 31, 2007 and 2006

 

	Page
Report of Independent Registered Public Accounting Firm	F-2
Consolidated Statements of Financial Condition	F-3
Consolidated Statements of Income	F-4
Consolidated Statements of Stockholders’ Equity	F-5
Consolidated Statements of Cash Flows	F-7
Notes to Consolidated Financial Statements	F-8

 

 

F-1

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of

Mutual Federal Bancorp, Inc.

 

 

We have audited the accompanying consolidated statements of financial condition of the Mutual Federal Bancorp, Inc. (“the Company”) as of December 31, 2007 and 2006, and the related statements of income, stockholders’ equity, and cash flows for the years then ended.  These financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting.  Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2007 and 2006, and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

 

 

/s/Crowe Chizek and Company LLC

                                                                        

 

Oak Brook, Illinois

March 18 , 2008

 

 

F-2

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MUTUAL FEDERAL BANCORP, INC.

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollar amounts in thousands except share data)

---

		December 31,
		2007				2006
ASSETS
Cash and cash equivalents		$	2,264			$	2,268
Securities available-for-sale			16,345				19,559
Loans, net of allowance for loan losses of $290 at December 31, 2007 and $240 at December 31, 2006			53,047				51,924
Federal Home Loan Bank stock, at cost			610				500
Premises and equipment, net			250				289
Accrued interest receivable			360				339
Other assets			135				184
Total assets		$	73,011			$	75,063
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Non-interest-bearing deposits		$	331			$	728
Interest-bearing deposits			39,388				42,580
Total deposits			39,719				43,308
Advance payments by borrowers for taxes and insurance			236				401
Advances from the Federal Home Loan Bank			5,000				2,000
Accrued interest payable and other liabilities			1,037				1,055
Common stock in ESOP subject to contingent repurchase obligation			108				66
Total liabilities			46,100				46,830
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.01 par value, 1,000,000 shares authorized at December 31, 2007 and 2006			—				—
Common stock, $0.01 par value, 12,000,000 shares authorized, 3,636,875 shares issued at December 31, 2007; $0.01 par value, 12,000,000 shares authorized, 3,636,875 shares issued and outstanding at December 31, 2006			36				36
Additional paid-in capital			9,738				10,175
Treasury stock, at cost			(1,286	)			—
Retained earnings			19,077				18,782
Reclassification of  ESOP shares			(108	)			(66	)
Unearned ESOP shares			(768	)			(827	)
Accumulated other comprehensive income			222				133
Total stockholders’ equity			26,911				28,233
Total liabilities and stockholders’ equity		$	73,011			$	75,063

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See accompanying notes to consolidated financial statements.

 

 

F-3

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MUTUAL FEDERAL BANCORP, INC.

CONSOLIDATED STATEMENTS OF INCOME

(Dollar amounts in thousands except per share data)

---

		December 31,
		2007				2006
Interest and dividend income:
Loans, including fees		$	3,472			$	2,963
Securities			839				948
Interest earning deposits			37				60
Federal Home Loan Bank stock dividends			12				15
Total interest and dividend income			4,360				3,986
Interest expense:
Deposits			1,154				1,058
Advances from the Federal Home Loan Bank			143				54
Total interest expense			1,297				1,112
Net interest income			3,063				2,874
Provision for loan losses			50				70
Net interest income after provision for loan losses			3,013				2,804
Non-interest income:
Insurance commissions and fees			4				3
Loss on impairment of securities			(152	)			—
Other income			42				53
Total non-interest income			(106	)			56
Non-interest expense:
Compensation and benefits			1,370				1,106
Occupancy and equipment			151				170
Data processing			108				104
Professional fees			449				341
Other expense			315				305
Total non-interest expense			2,393				2,026
Income before income taxes			514				834
Income tax expense			219				304
Net income		$	295			$	530
Earnings per share (basic and diluted)		$	0.08			$	0.12

 

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See accompanying notes to consolidated financial statements.

 

 

F-4

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MUTUAL FEDERAL BANCORP, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

(Dollar amounts in thousands)

---

 

		Common Stock				Additional Paid-in Capital				Treasury Stock				Retained Earnings				Amount Reclassified On ESOP Shares				Unearned ESOP Shares				Accumulated Other Comprehensive Income				Total
Balance at January 1, 2006		$	1			$	—			$	—			$	18,252			$	—			$	—			$	83				18,336
Comprehensive income:
Net income			—				—				—				530				—				—				—				530
Change in net unrealized gain (loss) on securities available-for-sale, net of taxes			—				—				—				—				—				—				50				50
Total comprehensive income																															580
Proceeds from sale of 3,636,875 shares of common stock, net of issuance costs			35				10,169				—				—				—				(873	)			—				9,331
Reclassification due to release and change in fair value of common stock in ESOP subject to contingent repurchase obligation of ESOP shares			—				—				—				—				(66	)			—				—				(66	)
ESOP shares committed to be released (4,537)			—				6				—				—				—				46				—				52
Balance at December 31, 2006			36				10,175				—				18,782				(66	)			(827	)			133				28,233
Net income			—				—				—				295				—				—				—				295
Change in net unrealized gain (loss) on securities available-for-sale, net of taxes			—				—				—				—				—				—				89				89
Total comprehensive income																															384
Treasury stock purchases, 161,444 shares at cost			—				—				(1,985	)			—				—				—				—				(1,985	)
MRP share grants, 52,748 shares at cost			—				(699	)			699				—				—				—				—				—
MRP shares earned			—				146				—				—				—				—				—				146

 

 

F-5

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MUTUAL FEDERAL BANCORP, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

(Dollar amounts in thousands)

---

		Common Stock				Additional Paid-in Capital				Treasury Stock				Retained Earnings				Amount Reclassified On ESOP Shares				Unearned ESOP Shares				Accumulated Other Comprehensive Income				Total
Stock option shares earned			—				100				—				—				—				—				—				100
Reclassification due to release and change in fair value of common stock in ESOP subject to contingent repurchase obligation  of ESOP shares			—				—				—				—				(42	)			—				—				(42	)
ESOP shares committed to be released (5,928 shares)							16				—				—				—				59				—				75
Balance at December 31, 2007		$	36			$	9,738			$	(1,286	)		$	19,077			$	(108	)		$	(768	)		$	222			$	26,911

See accompanying notes to consolidated financial statements.

 

 

F-6

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MUTUAL FEDERAL BANCORP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollar amounts in thousands)

---

 

		December 31,
		2007				2006
Cash flows from operating activities
Net income		$	295			$	530
Adjustments to reconcile net income to net cash from operating activities:
Provision for loan losses			50				70
Depreciation			58				59
Loss on impairment of securities			152				—
Net amortization of securities			26				61
Dividends reinvested on securities			(119	)			(106	)
ESOP expense			75				52
MRP expense			146				—
Option expense			100				—
Increase in accrued interest receivable and other assets			(28	)			(147	)
Decrease in accrued interest payable and other liabilities			(18	)			(1,242	)
Net cash provided by (used in) operating activities			737				(723	)
Cash flows from investing activities
Activity in securities available-for-sale:
Proceeds from maturities, calls, and principal repayments			3,300				6,594
Purchases			—				(2,000	)
Purchase of FHLB stock			(110	)			—
Loan originations and payments, net			(1,395	)			(13,964	)
Proceeds from sale of real estate owned, acquired through foreclosure			222				—
Additions to premises and equipment			(19	)			(43	)
Net cash provided by (used in) investing activities			1,998				(9,413	)
Cash flows from financing activities
Net decrease in deposits			(3,589	)			(217	)
Net (decrease) increase in advance payments by borrowers for taxes and insurance			(165	)			40
Advances from the Federal Home Loan Bank			7,500				6,000
Repayment of Federal Home Loan Bank advances			(4,500	)			(4,000	)
Proceeds of common stock offering			—				9,331
Treasury stock purchases			(1,985	)			—
Net cash (used in) provided by financing activities			(2,739	)			11,154
Net (decrease) increase in cash and cash equivalents			(4	)			1,018
Cash and cash equivalents at beginning of period			2,268				1,250
Cash and cash equivalents at end of period		$	2,264			$	2,268
Supplemental disclosure of cash flow information
Cash paid during the year for:
Interest		$	1,252			$	1,086
Income taxes			259				294
Loans transferred to real estate owned		$	222			$	—

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See accompanying notes to consolidated financial statements.

 

 

F-7

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MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Nature of Operations and Principles of Consolidation :  The consolidated financial statements include Mutual Federal Bancorp, Inc., and its wholly owned subsidiary Mutual Federal Savings and Loan Association of Chicago and its wholly owned subsidiary, EMEFES Service Corporation, together referred to as “the Bank.”  Intercompany transactions and balances are eliminated in consolidation.  As of December 31, 2007 and 2006, Mutual Federal Bancorp, MHC, was the majority (70%) stockholder of the Company.  The MHC is owned by the depositors of the Bank.  The financial statements do not include the transactions and balances of the MHC.  EMEFES Service Corporation is an insurance agency that sells insurance products to the Bank’s customers.  The insurance products are underwritten and provided by a third party.  The information as of and for the year ended December 31, 2006, includes the Company’s information beginning April 4, 2006.  The information presented in this report for periods up to and including March 31, 2006, is for the Bank only.

 

The Board of Directors of Mutual Federal Bancorp, MHC (the “MHC”), the former sole stockholder of the Bank, adopted the Stock Issuance Plan pursuant to which (i) the MHC established a subsidiary holding company, Mutual Federal Bancorp, Inc., a federal corporation (the “Company”), as a direct subsidiary to hold 100% of the stock of the Bank, and (ii) the Company offered and sold shares of its common stock in a public offering representing 30% of its shares outstanding after the offering.  The offering closed on April 4, 2006.  A total of 1,091,062 shares (30%) were sold and 2,545,813 shares (70%) were retained by MHC.

 

The Bank provides financial services through its office in Chicago.  Its primary deposit products are checking, savings, and term certificate accounts, and its primary lending products are residential mortgage loans and loans on deposit accounts.  Substantially all loans are secured by specific items of collateral, including one- to four-family and multifamily residential real estate, and deposit accounts. There are no significant concentrations of loans to any one customer.  However, the customers’ ability to repay their loans is dependent on the real estate and general economic conditions in the Chicago area.

 

Use of Estimates :  To prepare financial statements in conformity with U.S. generally accepted accounting principles, management makes estimates and assumptions based on available information.  These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ.  The allowance for loan losses is particularly subject to change.

 

Cash Flows :  Cash and cash equivalents include cash and deposits with other financial institutions available in less than 90 days.  Net cash flows are reported for customer loan and deposit transactions, and advance payments by borrowers for taxes and insurance.

 

Securities :  Debt securities are classified as available-for-sale when they might be sold before maturity.  Equity securities with readily determinable fair values are classified as available-for-sale.  Securities available-for-sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income, net of income tax.

 

Interest income includes amortization of purchase premium or discount.  Gains and losses on sales are recorded on the trade date and determined using the specific identification method.

 

 

F-8

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Table of Contents 2

 

MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

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

 

Federal Home Loan Bank (FHLB) Stock:   The Bank is a member of the FHLB system.  Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts.  FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value.  Both cash and stock dividends are reported as income.

 

Loans :  Loans that management has the intent and ability to hold until maturity or payoff are reported at the principal balance outstanding, net of undisbursed loan proceeds, deferred loan fees and costs, and an allowance for loan losses.  Interest income is accrued on the unpaid principal balance.  Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method.

 

Interest income on mortgage loans is discontinued at the time the loan becomes 90 days delinquent.  Past-due status is based on the contractual terms of the loan.  In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.

 

All interest accrued but not received for loans placed on nonaccrual is reversed against interest income.  Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual.  Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

 

Allowance for Loan Losses :  The allowance for loan losses is a valuation allowance for probable incurred credit losses.  Loan losses are charged against the allowance when management believes that the uncollectibility of a loan balance is confirmed.  Subsequent recoveries, if any, are credited to the allowance.  Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors.  Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.

 

 

F-9

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Table of Contents 2

 

MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

The allowance consists of specific and general components.  The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful.  The general component covers non-classified loans and is based on historical loss experience adjusted for current factors.

 

A loan is impaired when full payment under the loan terms is not expected.  Large multifamily residential real estate loans are individually evaluated for impairment.  If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.  Large groups of smaller balance homogeneous loans, such as one- to four-family and small multifamily residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures.

 

Premises and Equipment :  Land is carried at cost.  Premises and equipment are stated at cost less accumulated depreciation.  Buildings and related components are depreciated using the straight-line method, with useful lives ranging from 5 to 33 years.  Furniture, fixtures, and equipment are depreciated using the straight-line method with useful lives ranging from 3 to 7 years.

 

Foreclosed Assets :  Assets acquired through or instead of loan foreclosures are initially recorded at fair value, less estimated costs to sell, when acquired, establishing a new cost basis.  If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense.  Costs after acquisition are expensed.  There were no foreclosed assets at December 31, 2007 and 2006.

 

Long-Term Assets :   Premises and equipment and other long-term assets are reviewed for impairment when events indicate that their carrying amount may not be recoverable from future undiscounted cash flows.  If impaired, the assets are recorded at fair value.

 

Loan Commitments and Related Financial Instruments :  Financial instruments include off-balance-sheet credit instruments, such as commitments to make loans issued to meet customer financing needs.  The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay.  Such financial instruments are recorded when they are funded.

 

Advertising Expense :  The Association expenses all advertising costs as they are incurred.  Total advertising costs for the years ended December 31, 2007 and 2006 were $46 and $35, respectively.

 

Income Taxes :  Income tax expense is the total of the current-year income tax due or refundable and the change in deferred tax assets and liabilities.  Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates.  A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.

 

 

F-10

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MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

The Company adopted FASB Interpretation 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), as of January 1, 2007.  A tax position is recognized as a benefit only if it is "more likely than not" that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur.  The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination.  For tax positions not meeting the "more likely than not" test, no tax benefit is recorded.  The adoption had no ef fect on the Company’s financial statements.

The Company recognizes interest and penalties related to income tax matters as income tax expense.  The Company does not have any amounts accrued for interest and penalties.  The Company is no longer subject to examination by taxing authorities for years before 2005.

Comprehensive Income :  Comprehensive income consists of net income and other comprehensive income.  Other comprehensive income includes unrealized gains and losses on securities available-for-sale that are also recognized as a separate component of equity.

 

Loss Contingencies :  Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated.  Management does not believe that there now are such matters that will have a material effect on the consolidated financial statements.

 

Earnings Per Common Share :  Basic earnings per share are computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period.  Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company.  Shares of common stock held in the Company’s ESOP are pledged as collateral for the Company’s loan to the ESOP and are not considered outstanding for earnings per share calculations until the shares are released from collateral and allocated to participants.  Earnings per share for 2006 is calculated beginning with April 4, 2006, the date of conversion.  Net income for the period from April 4, 2006 through December 31, 2006 was $423.

 

Fair Value of Financial Instruments :  Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note.  Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items.  Changes in assumptions or in market conditions could significantly affect the estimates.

 

Operating Segments :  Internal financial information is primarily reported and aggregated in one line of business, banking.  While the chief decision-makers monitor the revenue streams of the various products and services, the identifiable segments are not material and operations are managed and financial performance is evaluated on a company-wide basis.  Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable operating segment.

 

 

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Table of Contents 2

 

MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

Employee Stock Ownership Plan :  The cost of shares issued to the employee stock ownership plan (“ESOP”) but not yet allocated to participants is presented in the consolidated balance sheet as a reduction of stockholders’ equity.  Compensation expense is recorded based on the market price of the shares as they are committed to be released for allocation to participant accounts.  Because participants may require the Company to purchase their ESOP shares upon termination of their employment, the market value of all earned and allocated ESOP shares is reclassified from stockholders’ equity.  Unearned ESOP shares are reported as a reduction of stockholders’ equity.

 

Effect of Newly Issued Accounting Standards :   In September 2006, the FASB issued Statement No. 157, Fair Value Measurements .  This Statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  This Statement establishes a fair value hierarchy about the assumptions used to measure fair value and clarifies assumptions about risk and the effect of a restriction on the sale or use of an asset.  The standard is effective for fiscal years beginning after November 15, 2007.  The impact of adoption is not material.

 

In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities .  The standard provides companies with an option to report selected financial assets and liabilities at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities.  The new standard is effective for the Company on January 1, 2008. The Company has elected the fair value option for various mutual funds included in securities available-for-sale as of January 1, 2008.   The impact of adoption is not material, as the Company wrote the investments down to fair value as of December 31, 2007.

 

 

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Table of Contents 2

 

MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

NOTE 2 – SECURITIES

 

The amortized cost and fair value of securities available-for-sale and the related gross unrealized gains and losses recognized in accumulated other comprehensive income were as follows:

 

		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Fair Value
December 31, 2007
U.S. agency and government-sponsored entity bonds		$	5,496			$	109			$	—			$	5,605
GNMA certificates			1,049				4				(32	)			1,021
FNMA certificates			3,596				32				(10	)			3,618
FHLMC certificates			2,524				16				(9	)			2,531
Collateralized mortgage obligations			486				—				(14	)			472
FHLMC common stock			8				265				—				273
FHLMC preferred stock			402				—				—				402
Mutual funds			2,423				—				—				2,423
Total available-for-sale		$	15,984			$	426			$	(65	)		$	16,345
December 31, 2006
U.S. agency and government- sponsored entity bonds		$	6,695			$	6			$	(47	)		$	6,654
GNMA certificates			1,555				8				(31	)			1,532
FNMA certificates			4,582				9				(102	)			4,489
FHLMC certificates			3,067				7				(74	)			3,000
Collateralized mortgage obligations			578				—				(17	)			561
FHLMC common stock			8				535				—				543
FHLMC preferred stock			500				—				(13	)			487
Mutual funds			2,357				—				(64	)			2,293
Total available-for-sale		$	19,342			$	565			$	(348	)		$	19,559

At December 31, 2007 and 2006, there were no holdings of securities of any one issuer, other than U.S. agency and U.S. government-sponsored entities, in an amount greater than 10% of equity.  Mutual fund securities at December 31, 2007 and 2006 include $2,423 and $2,293 in mutual funds managed by a single issuer and invested primarily in short-term government obligations and pools of adjustable rate mortgage loans.

 

There were no securities pledged at December 31, 2007 and 2006.

 

There were no security sales in the year ended December 31, 2007 and 2006.

 

 

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Table of Contents 2

 

MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 2 – SECURITIES (Continued)

 

The amortized cost and fair values of debt securities available-for-sale at December 31, 2007 by contractual maturity were as follows.

 

		Amortized Cost				Fair Value
Due in one year or less		$	—			$	—
Due from one to five years			5,496				5,605
Due from five to ten years			—				—
CMO’s and mortgage backed securities			7,655				7,642
Total		$	13,151			$	13,247

Securities with unrealized losses aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position are as follows:

 

		December 31, 2007
		Less Than 12 Months								12 Months or More								Total
Description of Securities		Fair Value				Unrealized Loss				Fair Value				Unrealized Loss				Fair Value				Unrealized Loss
GNMA certificates		$	94			$	(1	)		$	713			$	(31	)		$	807			$	(32	)
FNMA certificates			—				—				1,124				(10	)			1,124				(10	)
FHLMC certificates			—				—				642				(9	)			642				(9	)
Collateralized mortgage obligations			—				—				469				(14	)			469				(14	)
Total temporarily impaired		$	94			$	(1	)		$	2,948			$	(64	)		$	3,042			$	(65	)

		December 31, 2006
		Less Than 12 Months								12 Months or More								Total
Description of Securities		Fair Value				Unrealized Loss				Fair Value				Unrealized Loss				Fair Value				Unrealized Loss
U.S. agency and government-sponsored entity bonds		$	—			$	—			$	4,153			$	(47	)		$	4,153			$	(47	)
GNMA certificates			—				—				1,063				(31	)			1,063				(31	)
FNMA certificates			—				—				3,791				(102	)			3,791				(102	)
FHLMC certificates			—				—				2,684				(74	)			2,684				(74	)
Collateralized mortgage obligations			—				—				557				(17	)			557				(17	)
FHLMC preferred stock			487				(13	)			—				—				487				(13	)
Mutual funds			—				—				2,293				(64	)			2,293				(64	)
Total temporarily impaired		$	487			$	(13	)		$	14,541			$	(335	)		$	15,028			$	(348	)

 

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Table of Contents 2

MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 2 – SECURITIES (Continued)

 

At December 31, 2007, there were 18 debt securities with unrealized losses that have depreciated 2.2% from the Company’s amortized cost basis.  At December 31, 2006, there were 43 debt securities with unrealized losses that had depreciated 2.3% from the Company’s amortized cost basis.  These unrealized losses related principally to current interest rates for similar types of securities.  In analyzing an issuer’s financial condition, management considers whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and what the results are of reviews of the issuer’s financial condition.  The fair value is expected to recover as securities approach their maturity date.  As management has the ability to hold debt securities until forecasted recovery, which may be maturity, no declines are deemed to be other than temporary.

 

The Company has investments in various mutual funds including an adjustable rate mortgage fund, a U.S. government mortgage fund, and a short-term government fund.  The underlying securities are U.S. government and government agency securities and government agency insured fixed-rate and adjustable-rate mortgage-backed securities.  The funds are historically stable or, as rates decline, the funds recover their value (that is, the degree of impairment reverses) through increases in their net asset value.  At December 31, 2007, the Company recognized a $54 pre-tax charge for an other-than-temporary decline in fair value, because it was unable to forecast a recovery in the net asset value of these funds in the period the Company estimated it would hold the securities.

 

The Company owns 10,000 shares of Federal Home Loan Mortgage Corporation (“FHLMC”) 5.79% non-cumulative preferred stock with an original cost basis of $500.  At December 31, 2007, the Company recognized a $98 pre-tax charge for an other-than-temporary decline in fair value, because it was unable to forecast a recovery in the fair value of this security in the foreseeable future.

 

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MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 3 – LOANS

 

Loans are as follows:

 

		2007				2006
First mortgage loans
Principal balances
Secured by one- to four-family residences		$	34,163			$	33,270
Secured by multi-family properties			19,217				18,965
			53,380				52,235
Less:
Loans in process			9				9
Net deferred loan origination fees			122				121
Total first mortgage loans			53,249				52,105
Loans on savings accounts			88				59
			53,337				52,164
Less allowance for loan losses			290				240
		$	53,047			$	51,924

 

 

F-16

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Table of Contents 2

 

MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

NOTE 3 – LOANS  (Continued)

 

Activity in the allowance for loan losses is summarized as follows:

 

		2007				2006
Balance at beginning of year		$	240			$	170
Loans charged off			—				—
Recoveries			—				—
Provision charged to income			50				70
Balance at end of year		$	290			$	240

Non-accrual loans, which include all loans past due 90 days and over at December 31, 2007 and 2006 were $259 and $443, respectively.  There were no loans with allocated allowances at December 31, 2007 and 2006.

 

Loans to principal officers, directors, and their affiliates in 2007 were as follows.

 

Balance at January 1, 2007		$	238
New loans			—
Repayments			16
Balance at December 31, 2007		$	222

NOTE 4 – PREMISES AND EQUIPMENT

 

Year-end premises and equipment were as follows.

 

		2007				2006
Land		$	97			$	97
Building			355				355
Building improvements			140				152
Parking lot improvements			19				44
Furniture and equipment			468				645
Total cost			1,079				1,293
Accumulated depreciation			(829	)			(1,004	)
		$	250			$	289

Depreciation expense was $58 and $59 for the years ended December 31, 2007 and 2006.

 

 

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Table of Contents 2

 

MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 5 – ACCRUED INTEREST RECEIVABLE

 

Accrued interest receivable is summarized as follows:

 

		2007				2006
Securities		$	89			$	116
Loans			271				223
		$	360			$	339

NOTE 6 – DEPOSITS

 

Deposits, by major category, are as follows:

 

		2007				2006
Non-interest-bearing checking		$	331			$	728
Savings			18,854				20,334
Certificates of deposit			20,534				22,246
		$	39,719			$	43,308

The aggregate amount of certificates of deposit with a minimum denomination of $100 was approximately $7,011 and $7,498 at December 31, 2007 and 2006, respectively.  Deposit balances over $100 are not federally insured.

 

Scheduled maturities of certificates of deposit for the year ended December 31, 2007 are as follows:

 

2008		$	18,321
2009			971
2010			1,079
2011			7
2012			156
		$	20,534

Deposits of related parties totaled approximately $1,275 and $1,020 at December 31, 2007 and 2006, respectively.

 

Interest expense on deposit accounts is summarized as follows:

 

		2007				2006
Savings		$	246			$	269
Certificates of deposit			908				789
		$	1,154			$	1,058

 

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Table of Contents 2

 

MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 7 – FEDERAL HOME LOAN BANK ADVANCES

 

At year end, advances from the Federal Home Loan Bank were as follows:

 

		2007				2006
Maturities in March 2008 through December 2009, fixed rate at rates from 3.99% to 5.22%, averaging 4.74%		$	5,000			$	—
Overnight advances, floating rate, at 5.50%			—				2,000
Total		$	5,000			$	2,000
Required payments over the next two years are:
2008		$	3,000
2009			2,000

Each advance is payable at its maturity date, with a prepayment penalty for fixed rate advances.   A blanket lien on all one- to four-family first mortgages was pledged as collateral in the event that the Company requests future advances.  The Company’s remaining available credit limit, limited to twenty times its current investment in FHLB stock, at December 31, 2007, was $7.2 million.

 

NOTE 8 – BENEFIT PLANS

 

As of January 1, 2006, the Company adopted an employee stock ownership plan (“ESOP”) for the benefit of substantially all employees.  The ESOP borrowed $873 from the Company and used those funds to acquire 87,285 shares of the Company’s common stock on April 4, 2006, in connection with the Company’s minority stock offering, at a price of $10.00 per share.

 

Shares purchased by the ESOP with the loan proceeds are held in a suspense account and are allocated to ESOP participants on a pro rata basis as principal and interest payments are made by the ESOP to the Company.  The loan is secured by shares purchased with the loan proceeds and will be repaid by the ESOP with funds from the Company’s contributions to the ESOP and earnings on ESOP assets.  The ESOP will make annual fixed principal payments of $44, plus interest at 7.0% on the unpaid loan balance.

 

As shares are released from collateral, the Company reports compensation expense equal to the current market price of the shares and the shares become outstanding for earnings-per-share (“EPS”) computations.  For the year ended December 31, 2007 and 2006, the Company contributed $101 and $78 to the plan and reported compensation expense of $75 and $52 and released 5,928 shares and 4,537 shares of common stock.

 

 

F-19

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Table of Contents 2

 

MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 8 – BENEFIT PLANS (Continued)

 

Upon termination of their employment, participants in the ESOP who elect to receive their benefit distributions in the form of Company common stock may require the Company to purchase the common stock distributed at fair value.  This contingent repurchase obligation is reflected in the Company’s financial statements as “common stock in ESOP subject to contingent repurchase obligation” and reduces stockholders’ equity by an amount that represents the market value of all the Company’s common stock held by the ESOP and allocated to participants, without regard to whether it is likely that the shares would be distributed or that the recipients of the shares would be likely to exercise their right to require the Company to purchase the shares.  At December 31, 2007 and 2006, there are 10,321 and 4,537 allocated ESOP shares and a contingent repurchase obligation of $108 and $66.  In addition, the fair value of unearned ESOP shares at December 31, 2007 and 2006, was $807 and $1.2 million.

 

On November 29, 2006 ,  the Registrant’s stockholders approved the Mutual Federal Bancorp, Inc. 2006 Stock Option Plan (the “Stock Option Plan”), and  the Mutual Federal Bancorp, Inc. 2006 Recognition and Retention Plan and Trust Agreement (the “MRP Plan”, and collectively with the Stock Option Plan, the “Plans”).   A total of 178,206 and 71,282 shares of Company common stock have been reserved for issuance under the SOP and the MRP, respectively.

 

On January 16, 2007, the Company awarded 52,748 shares of common stock, with a fair value of $14.41 per share, to the Company’s officers and directors under its 2006 Management Recognition and Retention Plan.  The Company also awarded 131,871 options to purchase the Company’s common stock at a strike price of $14.41 per share, to the Company’s officers and directors under its 2006 Stock Option Plan.  The awards vest over a five year period.  Total compensation cost that has been charged against income for those plans for the year ended December 31, 2007, was $146 for the Management Recognition Plan and $100 for the Stock Option Plan.  The total income tax benefit was $66 for this period.

 

Stock Option Plan

 

The Company’s 2006 Stock Option Plan, which is shareholder-approved, permits the grant of stock options to its officers, directors and employees for up to 178,206 shares of common stock.  The Company believes that such awards better align the interests of its employees with those of its shareholders.  Option awards are granted with an exercise price that is no less than the market price of the Company’s common stock at the date of grant; have vesting periods of five years and have 10-year contractual terms.  The Company anticipates purchasing shares to satisfy share option exercises.

 

The fair value of each option award is estimated on the date of grant using a closed form option valuation (Black-Scholes) model that uses the assumptions noted in the table below.  Since the Company stock has only been trading since April 6, 2006, the Company has used the price volatility of similar entities to estimate volatility.  The Company has no historical data on which to base forfeiture estimates, and has assumed no forfeitures.  The expected term of options granted is based on the calculation for “plain vanilla options” permitted by SAB 107, and represents the period of time that options granted are expected to be outstanding, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.

 

 

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MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 8 – BENEFIT PLANS (Continued)

 

The fair value of options granted during 2007 was determined using the following weighted-average assumptions as of grant date:

 

Risk-free interest rate			4.50	%
Expected term			6.50	years
Expected stock price volatility			9.40	%
Dividend yield			0.00	%

A summary of the activity in the stock option plan for 2007 follows:

 

		Shares				Weighted Average Exercise Price				Weighted Average Remaining Contractual Term				Aggregate Intrinsic Value
Outstanding at January 1, 2007			—				—				—				—
Granted			131,871			$	14.41				10.0				—
Exercised			—				—				—				—
Forfeited or expired			—				—				—				—
Outstanding at December 31, 2007			131,871			$	14.41				9.0				—
Exercisable at December 31, 2007			—			$	—				—				—
Expected to vest at December 31, 2007			131,871			$	14.41				—				—

Information related to the stock option plan during 2007 follows:

 

Intrinsic value of options exercised			—
Cash received from option exercises			—
Tax benefit realized from option exercises			—
Weighted average fair value of options granted		$	3.96

As of December 31, 2007, there was $422 of total unrecognized compensation cost related to non-vested stock options granted under the Plan.  The cost is expected to be recognized over a weighted-average remaining period of 4.0 years.

 

Stock Award Plan

 

A Management Recognition and Retention Plan (“MRP”) provides for the issuance of shares to directors and officers.  Compensation expense is recognized over the vesting period of the shares based on the market value of the shares at issue date.  Total shares issuable under the plan are 71,282 at December 31, 2007.

 

 

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MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

NOTE 8 – BENEFIT PLANS (Continued)

 

A summary of changes in the Company’s non-vested shares for the year follows:

 

		Shares				Weighted Average Grant Price				Weighted Average Grant-Date Fair Value
Non-vested at January 1, 2007			—				—				—
Granted			52,748			$	14.41			$	760
Vested			—				—				—
Forfeited			—				—				—
Non-vested at December 31, 2007			52,748			$	14.41			$	760

As of December 31, 2007, there was $614 of total unrecognized compensation cost related to non-vested shares granted under the Plan.  The cost is expected to be recognized over a weighted-average remaining period of 4.0 years.

 

The Company has a 401(k) profit sharing plan covering substantially all employees who have attained the age of 21 and have completed three months of service.  Employee contributions are matched at 100% up to 3% of compensation and 50% of contributions over 3%, but do not exceed 5% of compensation.  The matching contribution expense was $23 and $25 for the years ended December 31, 2007 and 2006.  The 401(k) profit sharing plan also provides for a discretionary profit sharing contribution determined annually by the Board of Directors.  The Board approved no discretionary contributions for the years ended December 31, 2007 and 2006.

 

The Company has nonqualified deferred compensation agreements with officers and directors.  Under the terms of these agreements, the officers and directors may defer compensation and directors’ fees and earn interest on the balance.  Interest is computed at the Company’s interest rate for one-year certificates of deposit.  Interest expense for the years ended December 31, 2007 and 2006 approximated $15 and $14.  In addition, for the years ended December 31, 2007 and 2006, approximately $24 was distributed each year.  The agreements were amended during 2005 to terminate deferrals after 2004.  At December 31, 2007 and 2006, $387 and $396 of deferred compensation was included in accrued interest payable and other liabilities on the statements of financial condition.

 

The Company provides supplemental health care benefits to cover the Medicare costs for employees who reach the age of 65 and have at least 10 years of service with the Company.  At December 31, 2007 and 2006, a liability of $64 and $83 is included in accrued expenses and other liabilities in the statements of financial condition.  The Company recorded expense of $5 and $8 for the years ended December 31, 2007 and 2006.  During 2005 the Bank amended the Plan to cap the maximum amount of premium that it would pay per qualified individual per month, and provided that new entrants after September 30, 2006, would pay the entire premium.  The other related disclosures are not considered significant to the consolidated financial statements.

 

 

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MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

NOTE 9 – INCOME TAXES

 

Income tax expense was as follows.

 

		2007				2006
Federal
Current		$	323			$	282
Deferred			(124	)			(9	)
			199				273
State
Current			45				24
Deferred			(25	)			7
			20				31
		$	219			$	304

Effective tax rates differ from federal statutory rate of 34% applied to income before income taxes due to the following.

 

		2007				2006
Provision calculated at statutory federal rate		$	175			$	284
Effect of:
State taxes, net of federal benefit			13				24
Stock based compensation			25				—
Other, net			6				(4	)
Total		$	219			$	304
Effective tax rate			42.6	%			36.5	%

Year-end deferred tax assets and liabilities were due to the following.

 

		2007				2006
Deferred tax assets:
Allowance for loan losses		$	111			$	90
Deferred compensation			150				154
Accrued post retirement benefit			25				32
Stock based compensation			67				—
Write down of impaired securities			59				—
			412				276
Deferred tax liabilities:
Federal Home Loan Bank stock dividends		$	(61	)		$	(61	)
Depreciation			(8	)			(12	)
Net unrealized gain on securities available-for-sale			(141	)			(84	)
Other			(3	)			(12	)
			(213	)			(169	)
Net deferred tax asset		$	199			$	107

 

 

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MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 9 – INCOME TAXES (Continued)

 

Federal income tax laws provided additional bad debt deductions through 1987, totaling $2,552.  Accounting standards do not require a deferred tax liability to be recorded on this amount, which otherwise would total $991 at year end 2007.  If the Bank were liquidated or otherwise ceases to be a bank or if tax laws were to change, this liability of $991 would be expensed and paid.  Management has not recorded a valuation allowance based on taxes paid in prior years.

 

NOTE 10 – LOAN COMMITMENTS AND OTHER RELATED ACTIVITIES

 

Some financial instruments, such as loan commitments, are issued to meet customer financing needs.  These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met, and usually have expiration dates.  Commitments may expire without being used.  Off-balance-sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated.  The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment.

 

The contractual amount of fixed rate loan commitments at December 31, 2007 and 2006 were $205 and $576.  Commitments to make loans are generally made for periods of 60 days or less.  The fixed-rate loan commitments at December 31, 2007 have interest rates ranging from 6.25% to 6.75% and maturities ranging from 10 years to 15 years.

 

NOTE 11 – CAPITAL REQUIREMENTS AND RESTRICTIONS ON RETAINED EARNINGS

 

The Bank is subject to regulatory capital requirements administered by federal banking agencies.  Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices.  Capital amounts and classifications are also subject to qualitative judgments by regulators.  Failure to meet capital requirements can initiate regulatory action.

 

Prompt corrective action regulations provide five classifications:  well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition.  If adequately capitalized, regulatory approval is required to accept brokered deposits.  If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required.  At year-end 2007 and 2006, the most recent regulatory notifications categorized the Association as well capitalized under the regulatory framework for prompt corrective action.

 

There are no conditions or events since that notification that management believes have changed the institution’s category.  Actual and required capital amounts and ratios are presented below:

 

 

F-24

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Table of Contents 2

 

MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 11 – CAPITAL REQUIREMENTS AND RESTRICTIONS ON RETAINED EARNINGS (Continued)

 

		Actual								For Capital Adequacy Purposes								To Be Well Capitalized Under Prompt Corrective Action Provisions
		Amount				Ratio				Amount				Ratio				Amount				Ratio
December 31, 2007
Total capital to risk-weighted assets		$	24,318				59.14	%		$	3,290				8.00	%		$	4,112				10.00	%
Tier 1 (core) capital to risk-weighted assets			23,909				58.14				1,645				4.00				2,467				6.00
Tier 1 (core) capital to adjusted total assets			23,909				32.85				2,911				4.00				3,639				5.00
Tangible capital (to adjusted total assets)			23,909				32.85				1,092				1.50				—				—
December 31, 2006
Total capital to risk- weighted assets		$	23,649				57.79	%		$	3,274				8.0	%		$	4,092				10.0	%
Tier 1 (core) capital to risk-weighted assets			23,174				56.63				1,637				4.0				2,455				6.0
Tier 1 (core) capital to adjusted total assets			23,174				30.99				2,991				4.0				3,739				5.0
Tangible capital (to adjusted total assets)			23,174				30.99				1,122				1.5				—				—

The following is a reconciliation of the Bank’s equity under accounting principles generally accepted in the United States of America (“GAAP”) to regulatory capital.

 

		2007				2006
GAAP equity		$	24,131			$	23,307
Unrealized gain on securities available-for-sale			(222	)			(133	)
Tier 1 capital			23,909				23,174
General allowance for loan losses			290				240
Allowable portion (45%) of unrealized gains on equity securities available-for-sale			119				235
Total regulatory capital		$	24,318			$	23,649

Federal regulations require the Bank to comply with a Qualified Thrift Lender (“QTL”) test, which requires that 65% of assets be maintained in housing-related finance and other specified assets.  If the QTL test is not met, limits are placed on growth, branching, new investment, FHLB advances, and dividends or the institution must convert to a commercial bank charter.  Management considers the QTL test to have been met.

 

 

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Table of Contents 2

 

MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 11 – CAPITAL REQUIREMENTS AND RESTRICTIONS ON RETAINED EARNINGS (Continued)

 

Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies.  Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net profits, combined with the retained net profits of the preceding two years, subject to the capital requirements described above.  At January 1, 2008, the Bank could, without prior approval, declare dividends of approximately $1.1 million.

 

NOTE 12 – OTHER COMPREHENSIVE INCOME

 

Other comprehensive income (loss) components and related tax effects were as follows:

 

		2007				2006
Unrealized holding gains (losses) on securities available-for-sale		$	297			$	80
Reclassification adjustment for gains (losses) realized in income			(152	)			—
Net unrealized gains (losses)			145				80
Tax effect			(56	)			(30	)
Other comprehensive income		$	89			$	50

NOTE 13 – FAIR VALUES OF FINANCIAL INSTRUMENTS

 

Carrying amount and estimated fair values of financial instruments were as follows:

 

		December 31, 2007								December 31, 2006
		Carrying Amount				Fair Value				Carrying Amount				Fair Value
Financial assets:
Cash and cash equivalents		$	2,264			$	2,264			$	2,268			$	2,268
Securities available-for-sale			16,345				16,345				19,559				19,559
Loans, net			53,047				53,966				51,924				52,209
Federal Home Loan Bank stock			610				610				500				500
Accrued interest receivable			360				360				339				339
Financial liabilities:
Deposits			39,719				39,805				43,308				43,227
Advances from Federal Home Loan Bank			5,000				5,012				2,000				2,000
Advance payments by borrowers for taxes and insurance			236				236				401				401
Accrued interest payable			115				115				70				70

The methods and assumptions used to estimate fair value are described as follows.

 

 

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Table of Contents 2

 

MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

NOTE 13 – FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued)

 

Carrying amount is the estimated fair value for cash and cash equivalents, Federal Home Loan Bank stock, accrued interest receivable and payable, advance payments by borrowers for taxes and insurance, demand deposits, and variable-rate loans, deposits and advances that reprice frequently and fully.  Security fair values are based on market prices or dealer quotes and, if no such information is available, on the rate and term of the security and information about the issuer.  For fixed-rate loans or deposits and for variable-rate loans or deposits with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk.  The fair value of off-balance-sheet items is not material.

 

NOTE 14 – PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION

Condensed financial information for the parent company only, Mutual Federal Bancorp, Inc., follows:

 

CONDENSED BALANCE SHEETS

December 31, 2007 and 2006

 

		2007				2006
ASSETS
Cash and cash equivalents		$	1,838			$	4,088
Investment in banking subsidiary			24,131				23,307
ESOP note receivable			796				840
Other assets			256				72
Total assets		$	27,021			$	28,307
LIABILITIES AND EQUITY
Accrued expenses and other liabilities		$	2			$	8
Common stock in ESOP subject to contingent repurchase obligation			108				66
Stockholders’ equity			26,911				28,233
Total liabilities and stockholders’ equity		$	27,021			$	28,307

CONDENSED STATEMENTS OF INCOME

For the year ended December 31, 2007 and the period April 4, 2006 through December 31, 2006

 

Interest income		$	97			$	59
Other expense			(360	)			(246	)
Income (loss) before income tax and undistributed subsidiary income			(263	)			(187	)
Income tax benefit			95				73
Equity in undistributed subsidiary income			463				537
Net income		$	295			$	423

 

 

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Table of Contents 2

 

MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

NOTE 14 – PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION (Continued)

 

CONDENSED STATEMENTS OF CASH FLOWS

For the year ended December 31, 2007 and the period April 4, 2006 through December 31, 2006

 

		2007				2006
Cash flows from operating activities
Net income		$	295			$	423
Adjustments:
Equity in undistributed subsidiary income			(463	)			(537	)
Stock based compensation			49				—
Change in other assets			(184	)			(72	)
Change in other liabilities			(6	)			7
Net cash from operating activities			(309	)			(179	)
Cash flows from investing activities
Investments in subsidiary			—				(4,224	)
ESOP loan made			—				(873	)
ESOP loan payments received			44				33
Net cash from investing activities			44				(5,064	)
Cash flows from financing activities
Proceeds from stock issue			—				9,331
Purchase of treasury stock			(1,985	)			—
Net cash from financing activities			(1,985	)			9,331
Net change in cash and cash equivalents			(2,250	)			4,088
Beginning cash and cash equivalents			4,088				—
Ending cash and cash equivalents		$	1,838			$	4,088

 

NOTE 15 – EARNINGS PER SHARE

 

Basic earnings per share are computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period.  Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company.  Basic and fully diluted weighted average shares outstanding for the year ended December 31, 2007, are 3,535,838.  During the year ended December 31, 2007, the average fair value of the Company’s common stock was less than $14.41 and the stock option and stock grant awards had no dilutive effect on earnings per share.   Earnings per share prior to the minority stock issuance on April 4, 2006, is no longer meaningful.  Earnings per share for the year ended December 31, 2006, includes net income for the period from April 4, 2006 through December 31, 2006.

 

 

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Table of Contents 2

 

MUTUAL FEDERAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2007 AND 2006

(Dollar amounts in thousands)

 

 

The factors used in the earnings per share computation for the years ended December 31, 2007, and 2006 follow:

 

		2007				2006
Basic
Net income		$	295			$	423
Weighted average common shares outstanding			3,615,622				3,636,875
Less: average unallocated ESOP shares			(79,784	)			(84,989	)
Average shares			3,535,838				3,551,886
Basic earnings per common share		$	0.08			$	0.12
Diluted
Net Income		$	295			$	423
Weighted average common shares outstanding for basic earnings per common share			3,535,838				3,551,886
Add: dilutive effects of assumed exercises of stock options			—				—
Average shares and dilutive potential common shares			3,535,838				3,551,886
Diluted earnings per common share		$	0.08			$	0.12

 

 

F-29

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Signatures

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the  21st day of March, 2008.

 

	MUTUAL FEDERAL BANCORP, INC.
	By:	/s/ Stephen M. Oksas
		Stephen M. Oksas
		President and Chief Executive Officer

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Stephen M. Oksas, John L. Garlanger and Julie H. Oksas, and each of them, the true and lawful attorney-in-fact and agents of the undersigned, with full power of substitution and resubstitution, for and in the name, place and stead of the undersigned, to sign any and all amendments to this Annual Report on Form 10-KSB, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, and hereby grants to such attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully as to all intents and purposes as each of the undersigned might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitutes, may lawfully do or cause to be done by virtue hereof.

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated.

 

Name		Title		Date
/s/ Stephen M. Oksas		Chairman, President, Chief Executive Officer and Director (Principal Executive Officer)		March  21 , 2008
Stephen M. Oksas
/s/ John L. Garlanger		Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)		March 21, 2008
John L. Garlanger
/s/Stanley Balzekas III		Director		March 21, 2008
Stanley Balzekas III

/s/Robert P. Kazan		Director		March 21, 2008
Robert P. Kazan

/s/Leonard F. Kosacz		Director		March 21, 2008
Leonard F. Kosacz

/s/Julie H. Oksas		Executive Vice President and Director		March 21, 2008
Julie H. Oksas

 

 

S-1

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Name		Title		Date
/s/Stephanie Simonaitis		Director		March 21, 2008
Stephanie Simonaitis

/s/Amy P. Keane		Director		March 21, 2008
Amy P. Keane

 

S-2

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EXHIBIT INDEX

 

Exhibit No.		Description of Exhibit
3.1		Charter of Mutual Federal Bancorp, Inc. (incorporated by reference to Exhibit 3.1 to Registrant’s Form SB-2 filed with the Commission on November 18, 2005).
3.2		Bylaws of Mutual Federal Bancorp, Inc., as amended (incorporated by reference to Exhibit 3.2 to Registrant’s Form 10-QSB filed with the Commission on May 11, 2007).
4.1		Specimen Common Stock Certificate of Mutual Federal Bancorp, Inc. (incorporated by reference to Exhibit 4.1 to Registrant’s Form SB-2 filed with the Commission on November 18, 2005).
10.1		Form of Employee Stock Ownership Plan (incorporated by reference to Exhibit 10.1 to Registrant’s Amendment No. 1 to Form SB-2 filed with the Commission on February 4, 2006).
10.2		Executive Employment Agreement dated as of April 4, 2006 among Mutual Federal Bancorp, Inc., Mutual Federal Savings and Loan Association of Chicago and Stephen M. Oksas (incorporated by reference to Exhibit 10.1 to the Company’s Form 10-QSB for the quarterly period ended March 31, 2006 filed with the Commission on May 8, 2006).
10.3		Executive Employment Agreement dated as of April 4, 2006 among Mutual Federal Bancorp, Inc., Mutual Federal Savings and Loan Association of Chicago and Julie H. Oksas (incorporated by reference to Exhibit 10.2 to the Company’s Form 10-QSB for the quarterly period ended March 31, 2006 filed with the Commission on May 8, 2006).
10.4		Executive Employment Agreement dated as of April 4, 2006 among Mutual Federal Bancorp, Inc., Mutual Federal Savings and Loan Association of Chicago and John L. Garlanger (incorporated by reference to Exhibit 10.3 to the Company’s Form 10-QSB for the quarterly period ended March 31, 2006 filed with the Commission on May 8, 2006).
10.5		ESOP Loan Agreement dated as of April 4, 2006 between Mutual Federal Bancorp, Inc. and First Bankers Trust Services, Inc., as trustee of the Mutual Federal Bancorp, Inc. Employee Stock Ownership Trust (incorporated by reference to Exhibit 10.4 to the Company’s Form 10-QSB for the quarterly period ended March 31, 2006 filed with the Commission on May 8, 2006).
10.6		Mutual Federal Bancorp, Inc. 2006 Stock Option Plan (incorporated by reference to Appendix A to the Company’s proxy statement for its Special Meeting of Stockholders held on November 29, 2006 filed with the Commission on October 16, 2006).
10.7		Mutual Federal Bancorp, Inc. 2006 Recognition and Retention Plan and Trust Agreement (incorporated by reference to Appendix B to the Company’s proxy statement for its Special Meeting of Stockholders held on November 29, 2006 filed with the Commission on October 16, 2006).
10.8		Form of Employee Stock Ownership Plan (incorporated by reference to Exhibit 10.1 to the Company’s Amendment No. 1 to Form SB-2 filed with the Commission on February 4, 2006).
14.1		Code of Ethics (incorporated by reference to Exhibit 14.1 to the Company’s Form 10-K for the year ended December 31, 2006 filed with the Commission on March 29, 2007).
21.1		Subsidiaries of the Company
23.1		Consent of Crowe Chizek and Company LLC

 

 

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24.1	Power of Attorney (set forth on signature page)
31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

2