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Article by DailyStocks_admin    (11-18-08 03:45 AM)

Filed with the SEC from Nov 06 to Nov 12:
HF Financial (HFFC)
PL Capital Advisors considers HF Financial stock undervalued, even after adjusting for potential losses on the company's holdings of trust preferred securities. PL Capital plans to ask the bank holding company's management about its plans for mitigating the impact of these securities, which are held by HF Financial's main operating subsidiary, Home Federal Bank in South Dakota.
PL Capital also wants information on what the company plans to do with funds raised through the U.S. government's capital-purchase program. PL Capital owns 290,350 shares (7.3%).

BUSINESS OVERVIEW

The Company

HF Financial Corp., a unitary thrift holding company, was formed in November 1991 for the purpose of owning all of the outstanding stock of Home Federal Bank (the "Bank") issued in the mutual to stock conversion of the Bank. The Company acquired all of the outstanding stock of the Bank on April 8, 1992. The Company is incorporated under the laws of the State of Delaware and generally is authorized to engage in any activity that is permitted by the Delaware General Corporation Law. Unless otherwise indicated, all matters discussed in this Form 10-K relate to the Company, and its direct and indirect subsidiaries, including without limitation, the Bank. See "Subsidiary Activities" below for further information regarding the subsidiary operations of the Company and the Bank.

The executive offices of the Company and its direct and indirect subsidiaries are located at 225 South Main Avenue, Sioux Falls, South Dakota, 57104. The Company's telephone number is (605) 333-7556.

Website and Available Information

The website for the Company and the Bank is located at www.homefederal.com . Information on this website does not constitute part of this Form 10-K.

The Company makes available, free of charge, its Form 10-K, its quarterly reports on Form 10-Q, its current reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), as soon as reasonably practicable after such forms are filed with or furnished to the SEC. Copies of these documents are available to stockholders upon request addressed to the Secretary of the Company at 225 South Main Avenue, Sioux Falls, South Dakota, 57104.

The Bank

The Bank was founded in 1929 and is a federally chartered stock savings bank headquartered in Sioux Falls, South Dakota. The Bank provides full-service consumer and commercial business banking, including an array of financial products, to meet the needs of its market place. The Bank attracts deposits from the general public and uses such deposits, together with borrowings and other funds, to originate one- to four-family residential, commercial business, consumer, multi-family, commercial real estate, construction and agricultural loans. The Bank's consumer loan portfolio includes, among other things, automobile loans, home equity loans, loans secured by deposit accounts and student loans. The Bank also purchases mortgage-backed securities and invests in U.S. Government and agency obligations and other permissible investments. The Bank does not hold any non-investment grade bonds (i.e., "junk bonds"). The Bank receives loan servicing income on loans serviced for others and commission income from credit life insurance on consumer loans. The Bank, through its wholly-owned subsidiaries, offers annuities, mutual funds, life insurance and other financial products and equipment leasing services.

The Bank's deposits are insured up to applicable limits by the Deposit Insurance Fund ("DIF"), which is administered by the Federal Deposit Insurance Corporation ("FDIC"), and the Bank is subject to primary regulation and examination by the Office of Thrift Supervision ("OTS").

Segments

Operating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the chief operating decision makers in deciding how to allocate resources and in assessing performance. The Company's reportable segments are "banking" (including leasing activities) and "other." The "banking" segment is conducted through the Bank and Mid America Capital Services, Inc. ("Mid America Capital") and the "other" segment is composed of smaller non-reportable segments, the Company and inter-segment eliminations. For financial information by segment see Note 1 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Form 10-K.

Subsidiary Activities

In addition to the Bank, the Company had six other wholly-owned subsidiaries as of June 30, 2008: HF Financial Group, Inc. ("HF Group"), HF Financial Capital Trust III ("Trust III"), HF Financial Capital Trust IV ("Trust IV"), HF Financial Capital Trust V ("Trust V"), HF Financial Capital Trust VI ("Trust VI") and HomeFirst Mortgage Corp. (the "Mortgage Corp.").

In August 2002, the Company formed HF Group, a South Dakota corporation, to market software to facilitate employee benefits administration, payroll processing and management and governmental reporting. HF Group has an approved line of credit with the Company of $100,000, with no funds advanced as of June 30, 2008. Intercompany interest income and interest expense are eliminated in the preparation of consolidated financial statements.

In December 2002, the Company formed Trust III, a Delaware corporation, for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust III.

In September 2003, the Company formed Trust IV, a Delaware corporation, for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust IV.

In December 2006, the Company formed Trust V, a Delaware corporation, for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust V.

In July 2007, the Company formed Trust VI, a Delaware corporation, for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust VI.

The Mortgage Corp., a South Dakota corporation, was previously engaged in the business of originating one- to four-family residential mortgage loans, which were sold into the secondary market. The Mortgage Corp. had no activity during fiscal 2008.

As a federally chartered thrift institution, the Bank is permitted by OTS regulations to invest up to 2.00% of its assets in the stock of, or loans to, service corporation subsidiaries. The Bank may invest an additional 1.00% of its assets in service corporations where such additional funds are used for inner-city or community development purposes. The Bank currently has less than 1.00% of its assets in investments in its subsidiary service corporations as defined by the OTS. In addition to investments in service corporations, the Bank is permitted to invest an unlimited amount in operating subsidiaries engaged solely in activities in which the Bank may engage directly.

The Bank has five wholly-owned subsidiaries, Hometown Insurors, Inc. ("Hometown"), Mid America Capital, Home Federal Securitization Corp. ("HFSC"), Mid-America Service Corporation ("Mid-America") and PMD, Inc. ("PMD").

Hometown, a South Dakota corporation, provides financial and insurance products to customers of the Bank and members of the general public in the Bank's market area. Insurance products offered by Hometown primarily include annuities and life insurance products. Hometown obtains its funding via a line of credit from the Bank. Banking regulations do not limit the amount of funding provided to an operating subsidiary. As of June 30, 2008, the Bank had advanced no funds on an approved line of credit of $100,000. Intercompany interest income and interest expense are eliminated in the preparation of consolidated financial statements.

Mid America Capital, a South Dakota corporation, specializes in equipment finance leasing. Mid America Capital obtains its funding through a line of credit from the Bank. Banking regulations do not limit the amount of funding provided to an operating subsidiary. As of June 30, 2008, Mid America Capital had advanced $16.2 million on an approved line of credit of $35.0 million with the Bank. Intercompany interest income and interest expense are eliminated in the preparation of consolidated financial statements.

HFSC, a Delaware corporation, existed for the sole purpose of buying motor vehicle installment loans from the Bank to be securitized. HFSC had no activity during fiscal 2008. See "Off-Balance Sheet Financing Arrangements" of this Form 10-K for more information on the automobile securitization.

Mid-America, a South Dakota corporation, in the past provided residential appraisal services to the Bank and other lenders in the Bank's market. Mid-America had no activity during fiscal 2008.

PMD, a South Dakota corporation, in the past was engaged in the business of buying, selling and managing repossessed real estate properties. PMD had no activity during fiscal 2008.

Market Area

Based on total assets at June 30, 2008, the Bank is the largest savings association headquartered in South Dakota. The Bank has a total of 33 banking centers in its market area and one internet branch located at www.homefederal.com. The Bank's primary market area includes communities located in eastern and central South Dakota, including the Sioux Falls metropolitan statistical area (MSA), Pierre, Mitchell, Aberdeen, Brookings, Dakota Dunes, Watertown, and Yankton. The Bank also has a branch in Marshall, Minnesota, which serves customers located in southwestern Minnesota, and its banking center located in Dakota Dunes, South Dakota serves customers located in northwestern Iowa. The Bank's primary market area features a variety of agri-business, banking, financial services, health care and light manufacturing firms. The internet branch allows access to customers beyond traditional geographical areas.

Mid America Capital provides services to customers primarily in a five-state area in the upper Midwest, but originations can and have expanded nationwide based on relationships developed with existing Bank customers and other vendor relationships.

HF Group provided services to customers in the three-state region of South Dakota, Minnesota and Iowa.

Lending Activities

The Bank originates a variety of loans including business banking loans, commercial and agricultural loans; mortgage lending, including one- to four-family residential mortgages; and consumer loans, including loans for automobile purchases, home equity and home improvement loans and student loans.

Business Banking

Commercial Business Lending. In order to serve the needs of the local business community and improve the interest rate sensitivity and yield of its assets, the Bank originates adjustable- and fixed-rate commercial loans. Interest rates on commercial business loans generally adjust or float with a designated national index plus a specified margin. The Bank's commercial business lending activities encompass loans with a variety of purposes and security, including loans to finance accounts receivable, inventory and equipment and business expansion within the Bank's market area. The Bank originates commercial business loans directly and through programs sponsored by the Small Business Administration ("SBA") of which a portion of such loans are also guaranteed in part by the SBA. The Bank generally originates commercial business loans for its portfolio and retains the servicing with respect to such loans. The Bank anticipates continued expansion and emphasis of its commercial business lending, subject to market conditions and the Home Owners' Loan Act ("HOLA") restrictions. See "Regulation— Business Activities " below for HOLA restrictions.

Commercial business loans typically are made on the basis of the borrower's ability to make repayment from the cash flow of the borrower's business. As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself (which, in turn, may be dependent upon the general economic environment). The Bank's commercial business loans are occasionally secured by the assets of the business, such as accounts receivable, equipment and inventory. However, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. Whenever possible, the Bank's commercial business loans include personal guarantees of the borrowers. In addition, the loan officer may perform on-site visits, obtain financial statements and perform a financial review of the loan.

Multi-Family and Commercial Real Estate Lending. The Bank engages in multi-family and commercial real estate lending primarily in South Dakota and the adjoining Midwestern states. These lending activities may include existing property or new construction development or purchased loans.

Loans secured by multi-family and commercial real estate properties are generally larger and involve a greater degree of credit risk than one- to four-family residential mortgage loans. Because payments on loans secured by multi-family and commercial real estate properties are often dependent on the successful operation or management of the properties, repayment of such loans may be subject to adverse conditions in the real estate market or the economy. If the cash flow from the project is reduced (for example, if leases are not obtained or renewed), the borrower's ability to repay the loan may be impaired. In addition, loans secured by property outside of the Bank's primary market area may contain a higher degree of risk due to the fact that the Bank may not be as familiar with market conditions where such property is located. The Bank does not have a material concentration of multi-family or commercial real estate loans outside of South Dakota and the adjoining Midwestern states.

The Bank presently originates adjustable-rate, short-term balloon payment, fixed-rate multi-family and commercial real estate loans. The Bank's multi- family and commercial real estate loan portfolio is secured primarily by apartment buildings and owner occupied and non-owner occupied commercial real estate. The terms of such loans are negotiated on a case-by-case basis. Commercial real estate loans generally have terms that do not exceed 25 years. The Bank has a variety of rate adjustment features, call provisions and other terms in its multi-family and commercial real estate loan portfolio. Generally, the loans are made in amounts up to 80.00% of the appraised value of the collateral property and with debt service coverage ratios of 115.00% or higher. The debt service coverage is the ratio of net cash from operations before payment of debt service. However, these percentages may vary depending on the type of security and the guarantor. Such loans provide for a negotiated margin over a designated national index. The Bank analyzes the financial condition of the borrower, the borrower's credit history, the borrower's prior record for producing sufficient income from similar loans, references and the reliability and predictability of the net income generated by the property securing the loan. The Bank generally requires personal guarantees of borrowers.

Depending on the circumstances of the security of the loan or the relationship with the borrower, the Bank may decide to sell participations in the loan. The sale of participation interests in a loan are necessitated by the amount of the loan or the limitation of loans-to-one borrower. See "Regulation— Loans-to-One Borrower " for a discussion of the loans-to-one borrower regulations. In return for servicing these loans for the participants, the Bank generally receives a fee of 0.25% to 0.38%. Also, income is received at loan closing from loan fees and discount points. Appraisals on properties securing multi-family and commercial real estate loans originated by the Bank are performed by appraisers approved pursuant to the Bank's appraisal policy.

The HOLA includes a provision that limits the Bank's non-residential real estate lending to no more than four times its total capital. This maximum limitation, which at June 30, 2008 was $350.6 million, has not materially limited the Bank's lending practices.

Under HOLA, the maximum amount which the Bank may lend to any one borrower is 15.00% of the Bank's unimpaired capital and surplus, or $13.3 million at June 30, 2008. Loans in an amount equal to an additional 10.00% of unimpaired capital and surplus may be made to the same borrower if such loans are fully secured by readily marketable collateral. The Bank may request a waiver from the OTS to exceed the 15.00% loans-to-one borrower limitation on a case-by-case basis. See "Regulation— Loans-to-One Borrower " for more information and a discussion of the loans-to-one borrower regulations.

Construction and Development Lending. The Bank makes construction loans to individuals for the construction of their residences as well as to builders and, to a lesser extent, developers, for the construction of one- to four-family residences and condominiums and the development of one- to four-family lots in the Bank's primary market area.

Construction loans to individuals for their residences are structured to be converted to mortgage loans at the end of the construction phase, which typically runs six to 12 months. These construction loans have rates and terms which match the one- to four-family residential mortgage loans offered by the Bank. Residential construction loans are generally underwritten pursuant to the same guidelines used for originating residential mortgage loans.

The Bank also makes loans to developers for the purpose of developing one- to four-family lots. These loans typically have terms of one year and carry floating interest rates based on a national designated index. Loan commitment and partial release fees are charged. These loans generally provide for the payment of interest and loan fees from loan proceeds. The principal balance of these loans is typically paid down as lots are sold. Builder construction and development loans are obtained principally through continued business from developers and builders who have previously borrowed from the Bank, as well as broker referrals and direct solicitations of developers and builders. The application process includes a submission to the Bank of plans, specifications and costs of the project to be constructed or developed. These items are used as a basis to determine the appraised value of the subject property. Loans are based on the lesser of current appraised value and/or the cost of construction (land plus building).

The Bank makes loans for the construction of multi-family residential properties. Such loans are generally made at adjustable rates, which adjust periodically based on the appropriate Treasury Note maturity.

Construction loans are generally originated with a maximum loan-to-value ratio of 80.00% and land development loans are generally originated with a maximum loan-to-value ratio of 60.00%, based upon an independent appraisal. Because of the uncertainties inherent in estimating development and construction costs and the market for the project upon completion, it is relatively difficult to evaluate accurately the total loan funds required to complete a project, the related loan-to-value ratios and the likelihood of ultimate success of the project. Construction and development loans to borrowers other than owner occupants also involve many of the same risks discussed above regarding multi-family and commercial real estate loans and tend to be more sensitive to general economic conditions than many other types of loans.

Prior to making a commitment to fund a construction loan, the Bank requires an appraisal of the property, or, for larger projects, both an appraisal and a study of the feasibility of the proposed project. The Bank's construction loan policy provides for the inspection of properties by independent in-house and outside inspectors at the commencement of construction and prior to disbursement of funds during the term of the construction loan.

Agricultural Loans. In order to serve the needs of the local agricultural community and improve the interest rate sensitivity and yield of its assets, the Bank originates agricultural loans through its agricultural division. The agricultural division offers loans to its customers such as: (1) operating loans which are used to fund operating expenses, which typically have a one year term and are indexed to the national prime rate; (2) term loans on machinery, equipment and breeding stock that may have a term up to seven years and require annual payments; (3) agricultural farmland term loans which are used to fund land purchases or refinances; (4) specialized livestock loans to fund facilities and equipment for confinement enterprises; and (5) loans to fund ethanol plant development. Agriculture real estate loans typically will have personal guarantees of the borrowers, a first lien on the real estate, interest rates adjustable to the national prime rate or Treasury Note rates, and annual, quarterly or monthly payments. Operating and term loans are secured by farm chattels (crops, livestock, machinery, etc.), which are the operating assets of the borrower. The Bank also originates agricultural loans directly and through programs sponsored by the Farmers Service Agency ("FSA") of which a portion of such loans are also guaranteed in part by the FSA.

Loan customers are required to supply current financial statements, tax returns and cash flow projections which are updated on an annual basis. In addition, on major loans, the loan officer will perform an annual farm visit, obtain financial statements and perform a financial review of the loan.

Mortgage Lending

One- to Four-Family Residential Mortgage Lending. One- to four-family residential mortgage loan originations are primarily generated by the Bank's marketing efforts, its present customers, walk-in customers and referrals from real estate agents and builders. The Bank has focused its lending efforts primarily on the origination of loans secured by first mortgages on owner-occupied, one- to four-family residences.

The Bank currently makes 10-, 15-, 20- and 30-year fixed- and adjustable-rate ("ARM") one- to four-family residential mortgage loans in amounts up to 95.00% of the appraised value of the collateral property provided that private mortgage insurance is obtained in an amount sufficient to reduce the Bank's exposure at or below the 80.00% level. The Bank generally offers an ARM loan having a fixed rate for the initial three to five years, which then converts to a one-year ARM loan for the remainder of the life of the loan. These loans provide for an annual cap and a lifetime cap at a set percent over the fully-indexed rate.

The Bank also offers balloon loans, which are sold on the secondary market and have a fixed-rate for the first five or seven years of the loan. At the end of the five- or seven-year period, the loan converts to a 23- or 25-year fixed-rate loan at the then current market rate provided that the borrower qualifies at the new rate. If the borrower fails to qualify at the new rate, the loan becomes payable in full. The Bank also offers a portfolio loan product that is a five- or seven-year balloon loan that is underwritten to secondary market standards but if fully payable at the end of the balloon term.

To meet the needs of the Bank's borrowers and financial needs of the communities it serves, the Bank has developed two distinct types of loan programs. The Integrity Mortgage Program is a limited documentation program that is generally available to the upper credit profile customer. The Olympic Plus Program is a program for individuals that do not meet secondary market standards but are eligible for private mortgage insurance. The program underwriting guidelines match those as established by the private mortgage insurance company. Borrowers may choose from either an ARM or balloon product as a financing option.

The Bank also offers fixed-rate 10- to 30-year mortgage loans that conform to secondary market standards. Interest rates charged on these fixed-rate loans are competitively priced on a daily basis according to market conditions. Residential loans generally do not include prepayment penalties.

The Bank also originates fixed-rate one- to four-family residential mortgage loans through the South Dakota Housing Development Authority ("SDHDA") program. These loans generally have terms not to exceed 30 years and are insured by the Federal Housing Administration ("FHA"), Veterans Administration ("VA"), Rural Development or private mortgage insurance. The Bank receives an origination fee of 1.00% of the loan amount from the borrower and a servicing fee of generally 0.38% from the SDHDA for these services. The Bank is the largest servicer of loans for the SDHDA. At June 30, 2008, the Bank serviced $932.9 million of mortgage loans for the SDHDA. See Note 4 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8, "Financial Statements and Supplementary Data" in this Form 10-K for information on loan servicing.

In underwriting one- to four-family residential mortgage loans, the Bank evaluates both the borrower's ability to make monthly payments and the value of the property securing the loan. The property that secures the real estate loans made by the Bank is appraised by an appraiser approved under the Bank's appraisal policy. The Bank requires borrowers to obtain title, fire and casualty insurance in an amount not less than the amount of the loan. Real estate loans originated by the Bank contain a "due-on-sale" clause allowing the Bank to declare the unpaid principal balance due and payable upon the sale of the collateral property.

The Bank offers on-line mortgage capabilities through QuickClick™ Online Mortgage Solutions, a service that allows customers to check rates, research loan options and complete mortgage applications via the Bank's website. This service is currently available to branch locations in South Dakota and Minnesota.

Consumer Lending

Other Consumer Lending. The Bank's management considers its consumer loan products to be an important component of its lending strategy. Specifically, consumer loans generally have shorter terms to maturity and carry higher rates of interest than one- to four-family residential mortgage loans. In addition, the Bank's management believes that the offering of consumer loan products helps to expand and create stronger ties to its existing customer base by increasing the number of customer relationships and providing cross-marketing opportunities.

Loans secured by second mortgages, together with loans secured by all prior liens, are generally limited to 100.00% or less of the appraised or assessed value of the property securing the loan and generally have maximum terms that do not exceed 10 to 15 years.

The student loans originated by the Bank are guaranteed as to principal and interest by the South Dakota Education Assistance Corporation. The Bank typically sells such student loans with servicing rights released approximately 120 days after funds have been disbursed to the student.

Consumer loan terms vary according to the type of collateral, length of contract and creditworthiness of the borrower. The Bank offers both open- and closed-end credit. Overdraft lending is extended through lines of credit that are tied to a checking account. The credit lines generally bear interest at 18.00% and are generally limited to no more than $2,000. Loans secured by deposit accounts at the Bank are currently originated for up to 90.00% of the account balance (although historically the Bank has loaned up to 100.00% of the account balance), with a hold placed on the account restricting the withdrawal of the account balance. The interest rate on such loans is typically equal to 2.00% above the contract rate.

The underwriting standards employed by the Bank for consumer loans include an application, a determination of the applicant's payment history on other debts, and an assessment of the ability to meet existing obligations and payments on the proposed loan. Although creditworthiness of the applicant is a primary consideration, the underwriting process also includes a comparison of the value of the security, if any, in relation to the proposed loan amount.

MANAGEMENT DISCUSSION FROM LATEST 10K
Executive Summary

The Company's net income for fiscal 2008 was $5.8 million, or $1.45 per diluted share, compared to $5.4 million, or $1.33 per diluted share for fiscal 2007. Return on average equity was 9.12% at June 30, 2008, compared to 9.01% at June 30, 2007.

Net interest income for fiscal 2008 was $29.9 million, an increase of $4.2 million or 16.5% over the same period a year ago. The net interest margin was 3.11%, compared to 2.80% for the same period a year ago, an increase of 31 basis points. On a fully taxable equivalent basis, the net interest margin for fiscal 2008 was 3.16%, compared to 2.85% in fiscal 2007. The cost of funds rate on interest-bearing liabilities decreased from 4.39% in fiscal 2007 to 3.87% in fiscal 2008, a change of 52 basis points. For the same period, yields on earning assets decreased from 6.75% to 6.58%, a decrease of 17 basis points. Increases in volume from fiscal 2007 to fiscal 2008 of average earning assets and interest-bearing liabilities were 4.8% and 4.2% respectively. The Company was positioned to benefit from a steeper, more positive yield curve slope, and as such the net interest margin ratio benefitted as the Federal Funds Rate decreased 325 basis points in fiscal 2008.

Variability of the net interest margin ratio may be affected by many aspects, including Federal Reserve policies for short-term interest rates, competitive and global economic factors and customer preferences for various products and services.

The Company held $12.4 million in trust preferred securities at June 30, 2008. These are comprised of rated, pooled securities issued primarily by banks throughout the United States. The cash flows of the securities are derived from interest spreads between the issuer and the investor. These cash flows are used primarily to pay contractual interest. Principal payments are received primarily by the issuer paying off the securities at redeemable dates. In general, if certain ratios within the investment structure are reduced below established levels, excess interest cash flows are redirected to pay down principal in various tranches established by the investment structure.

The allowance for loan and lease losses remained at $5.9 million at June 30, 2008, compared to $5.9 million at June 30, 2007, an increase of $61,000 or 1.0%. The ratio of allowance for loan and lease losses to total loans and leases was 0.75% as of June 30, 2008 compared to 0.76% at June 30, 2007. Total nonperforming assets at June 30, 2008 were $3.7 million as compared to $4.0 million at June 30, 2007. The ratio of nonperforming assets to total assets improved to 0.34% for June 30, 2008, compared to 0.40% at June 30, 2007. The allowance for loan and lease losses is calculated based on loan and lease levels, loan and lease loss history, credit quality of the loan and lease portfolio, and environmental factors such as economic health of the region and management experience. This risk rating analysis is designed to give the Company a consistent and systematic methodology to determine proper levels for the allowance at a given time.

As of June 30, 2008, the Company continued to record a receivable in the amount of $223,000 from the sale of certain loan participation interests in December 2005. The balance of this receivable represents the remaining amount the Company expects to be paid on the receivable and the Company has requested such payment from the lead bank. In addition, on June 26, 2006, the Company filed a $3.8 million lawsuit against this lead bank for their role in this participation loan, alleging fraud, breach of fiduciary duty, conspiracy, and negligent misrepresentation. See Part 1, Item 3 "Legal Proceedings" of this Form 10-K.

Total deposits at June 30, 2008, were $784.2 million, a decrease of $31.6 million, or 3.9%, from June 30, 2007. Out-of-market certificates of deposit declined $44.3 million to $27.3 million at June 30, 2008, as the Company pursued other sources of wholesale funding. Interest expense on deposits was $24.7 million for fiscal 2008, a decrease of $3.8 million, or 13.4%, over the same period a year ago. A primary factor affecting interest expense was the decrease in money market rates and other non-maturity deposit product rates.

The total risk-based capital ratio was 10.83% at June 30, 2008, compared to 11.05% at June 30, 2007. This continues to place the Bank in the "well-capitalized" category within OTS regulation at June 30, 2008, and is consistent within the "well-capitalized" OTS category in which the Company plans to operate. The Company historically has been able to manage the size of its assets through secondary market loan sales of single-family mortgages, student loans and a loan securitization.

Noninterest expense for fiscal 2008 was $30.6 million, compared to $29.6 million a year ago, an increase of $1.0 million or 3.4%. Compensation and employee benefits for fiscal 2008 accounted for an increase of $1.2 million, or 6.7%, from the same period a year ago. Net healthcare costs, inclusive of self-funded health claims, administration fees and fully-insured dental premiums offset by stop loss insurance receivable and employee reimbursements for fiscal 2008 were $1.5 million, compared to $2.1 million for the same period a year ago, a decrease of $667,000 or 31.0%. This change is primarily due to lower health claims expense and recognition of stop loss insurance receipts.

Noninterest income for fiscal 2008 was $11.3 million, compared to $13.2 million for the same period a year ago, a decrease of $1.9 million or 14.1%. Excluding the one-time $2.8 million gain on sale of branches during fiscal 2007, the increase was $900,000 or 8.6%. This core increase was driven primarily by increases in loan servicing income and fees on deposits. Loan servicing income increased in fiscal 2008 by $408,000 or 22.6% from fiscal 2007. Fees on deposits increased in fiscal 2008 by $256,000 or 5.0% from fiscal 2007.

The Company focuses on balancing operating costs with operating revenue levels in order to provide better efficiency ratios over time and continues to review its operations for ways to reduce its cost structure while continuing to support long-term revenue enhancements. The operating efficiency ratio for fiscal 2008 was 70.75%, compared to 76.56% for the same period a year ago, a decrease of 581 basis points. The operating efficiency ratio excludes the impact of net interest expense on the variable priced trust preferred securities and the one-time gain on sale of branches. The Company has issued trust preferred securities primarily to provide funding for stock repurchases and to repay other borrowings. Net interest expense on the $27.8 million of trust preferred securities outstanding decreased to $2.1 million for fiscal 2008, compared to $2.7 million for the same period a year ago, a decrease of $563,000 or 20.9%. The average rate paid on these securities decreased 203 basis points, from 9.61% in fiscal 2007 to 7.58% in fiscal 2008. The total efficiency ratio was 74.27% at June 30, 2008, compared to 76.24% for the same period a year ago, a decrease of 197 basis points. Contributing to this improvement in the efficiency ratio from a year ago include an increase in Company revenue to $41.2 million for fiscal 2008, or a 14.3% increase compared to the same period a year ago excluding the one-time gain on sale of branches of $2.8 million. It is the Company's continuing goal to move the operating efficiency ratio towards the 50% level over the long term. Management believes that this can be accomplished through steady growth of the balance sheet and the containment of incremental operating expenses.

Recent events in the financial markets produce uncertainties to management about future operating results and the future financial condition of the Company. The interdependencies of the national economy and financial markets do affect the macro economics reviewed by management and may produce outcomes in the future which have not impacted the Company previously.

General

The Company is a financial services provider and, as such, has inherent risks that must be managed in order to achieve net income. Primary risks that affect net income include credit risk, liquidity risk, operational risk, regulatory compliance risk and reputation risk. The Company's net income is derived by management of the net interest margin, the ability to collect fees from services provided, by controlling the costs of delivering services and the management of loan and lease losses. The primary source of revenues comes from the net interest margin, which represents the difference between income on interest-earning assets (i.e. loans and investment securities) and expense on interest-bearing liabilities (i.e. deposits and borrowed funding). The net interest margin is affected by regulatory, economic and competitive factors that influence interest rates, loan demand and deposit flows. Fees earned include charges for deposit services, trust services and loan services. Personnel costs are the primary expenses required to deliver the services to customers. Other costs include occupancy and equipment and general and administrative expenses.

Financial Condition Data

At June 30, 2008 the Company had total assets of $1,103.5 million, an increase of $102.0 million from the level at June 30, 2007. The increase in assets was due primarily to increases in securities of $82.8 million, FHLB stock of $6.2 million, and net loans and leases receivable of $16.2 million offset by a decrease in cash and cash equivalents of $1.3 million. The increase in liabilities of $100.1 million was due to increases in advances from the FHLB and other borrowing of $129.9 million, offset by a decrease in deposits of $31.6 million from the levels at June 30, 2007. In addition, stockholders' equity increased to $64.2 million at June 30, 2008, from $62.3 million at June 30, 2007, primarily due to net income of $5.8 million offset by cash dividends paid of $1.7 million.

The increase in securities of $82.8 million was due primarily to an increase in purchases of U.S. agency mortgage-backed securities, over sales, amortization and repayments of principal. The increase in FHLB stock of $6.2 million was the result of increased stock requirement by FHLB based upon an increase in outstanding advances.

The increase in net loans and leases receivable of $16.2 million was due primarily to an increase in purchases and originations over sales, amortization and repayments of principal. During the first quarter of fiscal 2008, the Company announced that it had ceased origination of indirect auto loans. Indirect auto loan outstanding balances declined $38.8 million during the fiscal year to $44.3 million at June 30, 2008. In addition, deferred fees and discounts decreased by $775,000 primarily due to a decrease of $832,000 for deferred fees and discounts on indirect automobile loans that include prepaid dealer reserves.

The decrease in cash and cash equivalents of $1.3 million was primarily due to the timing of items in clearing.

Advances from the FHLB and other borrowings increased $129.9 million for the year ended June 30, 2008, primarily due to the Company increasing its short- and long-term advances by a net of $99.9 million, while increasing overnight Federal Funds advances by $29.9 million during the fiscal year ended June 30, 2008.

The $31.6 million decrease in deposits was primarily due to decreases in out-of-market certificates of deposit of $44.3 million, and money market accounts of $40.9 million, offset by increases in in-market certificates of deposit of $34.1 million and savings accounts of $12.3 million.

Analysis of Net Interest Income

Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income depends upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them.

Average Balances, Interest Rates and Yields. The following table presents for the periods indicated, the total dollar amount of interest income from average interest-earning assets and the resulting yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates, and the net interest margin. The table does not reflect any effect of income taxes. Average balances consist of daily average balances for the Bank with simple average balances for all other companies. The average balances include nonaccruing loans and leases. The yields on loans and leases include origination fees, net of costs, which are considered adjustments to yield.

Rate/Volume Analysis of Net Interest Income

The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between the increases and decreases due to fluctuating outstanding balances that are due to the levels and volatility of interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume). 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.

Application of Critical Accounting Policies

GAAP requires management to utilize estimates when reporting financial results. The Company has identified the policies discussed below as Critical Accounting Policies because the accounting estimates require management to make certain assumptions about matters that may be uncertain at the time the estimate was made and a different method of estimating could have been reasonably made that could have a material impact on the presentation of the Company's financial condition, changes in financial condition or results of operations.

Allowance for Loan and Lease Losses —GAAP requires the Company to set aside reserves or maintain an allowance against probable loan and lease losses in the loan and lease portfolio. Management must develop a consistent and systematic approach to estimate the appropriate balances that will cover the probable losses. Due to the uncertainty of future events, the approach includes a process that may differ significantly from other methodologies and still produce an estimate that is in accordance with GAAP.

The allowance is compiled by utilizing the Company's loan and lease risk rating system, which is structured to identify weaknesses in the loan and lease portfolio. The risk rating system has evolved to a process whereby management believes the system will properly identify the credit risk associated with the loan and lease portfolio. Due to the stratification of loans and leases for the allowance calculation, the estimate of the allowance for loan and lease losses could change materially if the loan and lease risk rating system would not properly identify the strength of a large or a few large loan and lease customers. Although management believes that it uses the best information available to determine the allowance, unforeseen market or borrower conditions could result in adjustments and net earnings being significantly affected if circumstances differ substantially from the assumptions used in making the final determinations.

Mortgage Servicing Rights ("MSR") —The Company records a servicing asset for contractually separated servicing from the underlying mortgage loans. The asset is initially recorded at fair value and represents an intangible asset backed by an income stream from the serviced assets. The asset is amortized in proportion to and over the period of estimated net servicing income.

At each balance sheet date, the MSRs are analyzed for impairment, which occurs when the fair value of the MSRs is lower than the amortized book value. The Company's MSRs are primarily servicing rights acquired on South Dakota Housing Development Authority first time homebuyers program. Due to the lack of quoted markets for the Company's servicing portfolio, the Company estimates the fair value of the MSRs using present value of future cash flow analysis. If the analysis produces a fair value that is greater than or equal to the amortized book value of the MSRs, no impairment is recognized. If the fair value is less than the book value, an expense for the difference is charged to earnings by initiating a MSR valuation account. If the Company determines this impairment is temporary, any future changes in fair value are recorded as a change in earnings and the valuation. If the Company determines the impairment to be permanent, the valuation is written off against the MSRs which results in a new amortized balance.

The Company has included MSRs as a critical accounting policy because the use of estimates for determining fair value using present value concepts may produce results which may significantly differ from other fair value analysis perhaps even to the point of recording impairment. The risk to earnings is when the underlying mortgages payoff significantly faster than the assumptions used in the previously recorded amortization. Estimating future cash flows on the underlying mortgages is a difficult analysis and requires judgment based on the best information available. The Company looks at alternative assumptions and projections when preparing a reasonable and supportable analysis. Based on the Company's quarterly analysis of MSRs, there was no impairment to the MSRs at June 30, 2008.

Self-Insurance —The Company has a self-insured healthcare plan for its employees up to certain limits. To mitigate a portion of these risks, the Company has a stop-loss insurance policy through a commercial insurance carrier for coverage in excess of $65,000 per individual occurrence. The estimate of self-insurance liability is based upon known claims and an estimate of incurred, but not reported ("IBNR") claims. IBNR claims are estimated using historical claims lag information received by a third party claims administrator. Due to the uncertainty of health claims, the approach includes a process that may differ significantly from other methodologies and still produce an estimate that is in accordance with GAAP. Although management believes that it uses the best information available to determine the accrual, unforeseen health claims could result in adjustments to the accrual. These adjustments could significantly affect net earnings if circumstances differ substantially from the assumptions used in estimating the accrual.

Asset Quality

When a borrower fails to make a required payment on a loan within 10 to 15 days after the payment is due, the Bank generally institutes collection procedures by issuing a late notice. The customer is contacted again when the payment is between 17 and 40 days past due. In most cases, delinquencies are cured promptly; however, if a loan has been delinquent for more than 40 days, the Bank attempts additional written as well as verbal contacts and, if necessary, personal contact with the borrower in order to determine the reason for the delinquency and to effect a cure, and, where appropriate, reviews the condition of the property and the financial circumstances of the borrower. Based upon the results of any such investigation, the Bank may: (i) accept a repayment program which under appropriate circumstances could involve an extension in the case of consumer loans for the arrearage from the borrower, (ii) seek evidence, in the form of a listing contract, of efforts by the borrower to sell the property if the borrower has stated that he is attempting to sell, or (iii) initiate foreclosure proceedings. When a loan payment is delinquent for 90 days, the Bank generally will initiate foreclosure proceedings unless management is satisfied the credit problem is correctable.

Loans are generally classified as nonaccrual when there are reasonable doubts as to the collectability of principal and/or interest and/or when payment becomes 90 days past due, except loans which are well secured and in the process of collection. Interest collections on nonaccrual loans, for which the ultimate collectability of principal is uncertain, are applied as principal reductions.

Leases are generally classified as nonaccrual when there are reasonable doubts as to the collectability of principal and/or interest. Leases may be placed on nonaccrual when the lease has experienced either four consecutive months with no payments or once the account is five months in arrears. Interest collections on nonaccrual leases, for which the ultimate collectability of principal is uncertain, are applied as principal reductions.

When a lessee fails to make a required lease payment within 10 days after the payment is due, Mid America Capital generally institutes collection procedures. The lessee may be contacted by telephone on the 10th, but no later than the 30th day of delinquency. A late notice is automatically issued by the system on the 11th day of delinquency and is sent to the lessee. The lease may be referred to legal counsel when the lease is past due beyond four payments and no positive response has been received or when other considerations are present.

Nonperforming assets (nonaccrual loans and leases, accruing loans and leases delinquent more than 90 days and foreclosed assets) decreased to $3.7 million at June 30, 2008 from $4.0 million at June 30, 2007, a decrease of $258,000. In addition, the ratio of nonperforming assets to total assets, which is one indicator of credit risk exposure, improved to 0.34% at June 30, 2008, from 0.40% at June 30, 2007.

Nonaccruing loans and leases increased $134,000 to $2.3 million at June 30, 2008 compared to $2.2 million at June 30, 2007. Included in nonaccruing loans and leases at June 30, 2008 were eight loans totaling $503,000 secured by one- to four-family real estate, two commercial real estate loans totaling $429,000, one agricultural real estate loan totaling $42,000, eleven commercial business loans totaling $555,000, two agricultural business loans totaling $201,000, one equipment finance lease totaling $27,000 and 37 consumer loans totaling $566,000.

The Company's nonperforming loans and leases, which represent nonaccrual and past due 90 days and still accruing, have decreased $393,000 from the levels at June 30, 2007. The risk rating system in place is designed to identify and manage the nonperforming loans and leases. Commercial and agricultural loans and equipment finance leases will have specific reserve allocations based on collateral values or based on the present value of expected cash flows if the loans or leases are deemed impaired. Loans and leases that are not performing do not necessarily result in a loss.

As of June 30, 2008, the Company had $643,000 of foreclosed assets. The balance of foreclosed assets at June 30, 2008 consisted of $443,000 in equipment finance leases, $124,000 in consumer collateral and $76,000 in single-family residences.

At June 30, 2008, the Company had designated $22.2 million of its assets as special mention and classified $11.5 million of its assets that management has determined need to be closely monitored because of possible credit problems of the borrowers or the cash flows of the secured properties. At June 30, 2008, the Company had $21.8 million in multi-family, commercial real estate and agricultural participation loans purchased, of which $3.9 million were classified at June 30, 2008. These loans and leases were considered in determining the adequacy of the allowance for loan and lease losses. The allowance for loan and lease losses is established based on management's evaluation of the risks probable in the loan and lease portfolio and changes in the nature and volume of loan and lease activity. Such evaluation, which includes a review of all loans and leases for which full collectability may not be reasonably assured, considers the estimated fair market value of the underlying collateral, present value of expected principal and interest payments, economic conditions, historical loss experience and other factors that warrant recognition in providing for an adequate loan and lease loss allowance.

Although the Company's management believes that the June 30, 2008 recorded allowance for loan and lease losses was adequate to provide for probable losses on the related loans and leases, there can be no assurance that the allowance existing at June 30, 2008 will be adequate in the future.

In accordance with the Company's internal classification of assets policy, management evaluates the loan and lease portfolio on a monthly basis to identify loss potential and determines the adequacy of the allowance for loan and lease losses quarterly. Loans are placed on nonaccrual status when the collection of principal and/or interest becomes doubtful. Foreclosed assets include assets acquired in settlement of loans.


MANAGEMENT DISCUSSION FOR LATEST QUARTER

Executive Summary



The Company’s net income for the first quarter of Fiscal 2009 was $2.0 million, or $0.49 in diluted earnings per share, compared to $1.3 million, or $0.33 in diluted earnings per share, for the first quarter of Fiscal 2008. Return on average equity was 12.12% at September 30, 2008 compared to 8.61% at September 30, 2007.



The net interest margin on a fully taxable equivalent basis for the three months ended September 30, 2008 was 3.35%, compared to 2.92% for the same period a year ago, an increase of 43 basis points. The increase over the same period last year is primarily attributable to lower costs on liabilities and a higher volume of earning assets. During the first quarter of Fiscal 2008, there was $125,000 expense of unamortized debt issue costs related to the early redemption of the Trust II Trust Preferred Securities, causing a decrease of four basis points to the net interest margin.

Net interest income for the first three months of Fiscal 2009 was $8.7 million, an increase of $2.0 million, or 30.3%, over the same period a year ago. For the three months ended September 30, 2008, average interest-earning assets and average interest-bearing liabilities increased 13.0% and 14.2%, respectively, compared to the same period a year ago. Yields on earning assets decreased to 5.99% in the first three months of Fiscal 2009, compared to 6.86% a year ago, a decrease of 87 basis points. For the same period, cost of funds decreased to 3.01%, compared to 4.49%, a decrease of 148 basis points.



Net interest margin ratio may vary due to many factors, including Federal Reserve policies for short-term interest rates, competitive and economic factors and customer preferences for various products and services. On September 18, 2007 the Federal Reserve decreased the Fed Funds Target Rate by 50 basis points, the first decrease in short-term interest rates since June 25, 2003. This action was followed by further Fed Funds rate cuts of 275 basis points through the remainder of Fiscal 2008.



The Company had previously issued trust preferred securities primarily to provide funding for stock repurchases and to repay other borrowings. Interest expense on the $27.8 million of trust preferred securities outstanding decreased to $421,000 for the three months ended September 30, 2008, compared to $665,000 for the same period a year ago, a decrease of $244,000 or 36.7%. This decrease is due in part to the expense of $125,000 unamortized debt issue costs related to the early redemption of the Trust II Trust Preferred Securities in the first quarter of Fiscal 2008. The average rate paid on these securities decreased 300 basis points, from 9.50% at September 30, 2007 to 6.50% at September 30, 2008.



The allowance for loan and lease losses increased to $6.2 million at September 30, 2008, compared to $5.5 million at September 30, 2007, an increase of $690,000 or 12.6%. The ratio of allowance for loan and lease losses to total loans and leases was 0.76% as of September 30, 2008 compared to 0.70% at September 30, 2007. Total nonperforming assets at September 30, 2008 were $3.6 million as compared to $3.6 million a year ago, a decrease of $14,000 or 0.4%. The ratio of nonperforming assets to total assets decreased to 0.32% at September 30, 2008, compared to 0.36% at September 30, 2007. The allowance for loan and lease losses is calculated based on loan and lease levels, loan and lease loss history, credit quality of the loan and lease portfolio, and environmental factors such as economic health of the region and management experience. This risk rating analysis is designed to give the Company a consistent and systematic methodology to determine proper levels for the allowance at a given time.



The Company made a strategic decision during the first quarter of Fiscal 2008 to stop originating indirect automobile loans, and to continue to service the existing portfolio. As of September 30, 2008, the Consumer Indirect loan portfolio balance was $37.4 million, a decrease of $6.9 million from June 30, 2008. The Company entered this line of business in the 1990’s as part of an interest rate risk reduction strategy, as well as for further diversification of the balance sheet.



As of September 30, 2008, the Company continued to record a receivable in the amount of $223,000 from the sale of certain loan participation interests in December 2005. The balance of this receivable represents the remaining amount the Company expects to be paid on the receivable and the Company has requested such payment from the lead bank. In addition, on June 26, 2006, the Company filed a $3.8 million lawsuit against this lead bank for their role in this participation loan, alleging fraud, breach of fiduciary duty, conspiracy, and negligent misrepresentation. See Part 1, Item 3 “Legal Proceedings” of the Fiscal 2008 Form 10-K. Subsequent to the end of the quarter ended September 30, 2008 and referenced in the 8K filed October 27, 2008, the lawsuit was settled for $2.75 million inclusive of the remaining amount of receivables from certain loan participation interests in the amount of $223,000. The settlement amount, less attorney fees of $292,000, will be recorded as other non-interest income for the second quarter of Fiscal 2009. See Part II, Item 1 “Legal Proceedings” of this Form 10-Q for more details.



Total deposits at September 30, 2008 were $765.0 million, a decrease of $19.2 million, or 2.5%, from June 30, 2008. In-market deposits decreased from $757.0 million at June 30, 2008 to $729.9 million at September 30, 2008, a decrease of $27.1 million, or 3.6%. For the same period, out-of-market deposits increased from $27.3 million to $35.1 million, or 28.6%. Public funds have decreased, from $156.3 million at June 30, 2008 to $126.6 million at September 30, 2008. This decline of $29.7 million is due to typical seasonal fluctuations with the expectation that the second quarter of Fiscal 2009 balance will increase from the first quarter. Interest expense on deposits was $4.6 million for the three months ended September 30, 2008, a decrease of $2.9 million, or 39.0%, over the same period a year ago. The primary factors affecting interest expense on deposits was the decrease in the average rates paid from the three month period ended September 30, 2007 compared to the three month period ended September 30, 2008. Checking and money market deposits decreased from 3.59% to 1.38%, savings deposits decreased from 2.98% to 1.47%, and certificates of deposits decreased from 4.93% to 3.76% during this timeframe.



On July 28, 2008, the Company announced an increase in its quarterly cash dividend, from 10.75 cents per share to 11.25 cents per share, resulting in an annualized increase of 4.7%. On October 27, 2008, the Company declared a quarterly cash dividend payable of 11.25 cents per share on November 13, 2008 for shareholders of record November 6, 2008.



The total risk-based capital ratio of 10.76% at September 30, 2008 is slightly below the 10.83% at June 30, 2008, with a decrease of seven basis points. This continues to place the Bank in the “well capitalized” category within OTS regulation at September 30, 2008 and is consistent with the “well capitalized” OTS category in which the Company plans to operate. The Company historically has been able to manage the size of its assets through secondary market loan sales of single-family mortgages and student loans.



On September 30, 2008, the Company had in effect a stock buyback program in which up to 10% of the common stock of the Company outstanding on May 1, 2008 could be acquired through April 30, 2009. The Company did not utilized its stock buyback program during the first quarter of Fiscal 2009, but is authorized to repurchase an additional 388,794 shares of common stock through April 30, 2009. See Part II, Item 2 “Unregistered Sales of Equity Securities and Use of Proceeds” of this Form 10-Q for more details.



Non-interest income was $3.0 million for the quarter ended September 30, 2008 compared to $2.8 million at September 30, 2007, an increase of $234,000 or 8.3%. The primary factors affecting non-interest income were increases of $52,000 in loan servicing income, $138,000 in fees on deposits and $80,000 in gain on sale of securities, net.



Non-interest expense was $8.4 million for the quarter ended September 30, 2008 compared to $7.1 million at September 30, 2007, an increase of $1.3 million or 17.6%. Compensation and employee benefit expense increased $678,000 primarily due to increases in regular employee compensation of $244,000, variable pay relating to employee incentives of $270,000, net healthcare costs of $137,000, and recruiting expense of $41,000. Marketing increased $75,000, primarily due to increased promotional activity. Foreclosed real estate and other properties, net, increased $74,000 due to the increased activity in repossessed equipment. Other expense increased $385,000 primarily due to increases in federal deposit insurance premiums, audit and regulatory exams, and legal expenses of $118,000, $62,000, and $150,000, respectively. Previously, the Company had credits to offset federal deposit insurance premiums. In the first quarter of Fiscal 2009, these credits expired causing the expense to increase. No future credits exist to offset this cost in the future. Audit and regulatory exams expenses increased due to increased requirements and procedures. Legal costs increased due in part to a lawsuit, which was settled subsequent to September 30, 2008. See Part II, Item 1 “Legal Proceedings” of this Form 10-Q.



General



The Company is a financial services provider and, as such, has inherent risks that must be managed in order to achieve net income. Primary risks that affect net income include credit risk, liquidity risk, operational risk, regulatory compliance risk and reputation risk. The Company’s net income is derived by managing net interest margin, the ability to collect fees from services provided, by controlling the costs of delivering services and the management of loan and lease losses. The primary source of revenues comes from the net interest margin, which represents the difference between income on interest-earning assets (i.e. loans and investment securities) and expense on interest-bearing liabilities (i.e. deposits and borrowed funding). The net interest margin is affected by regulatory, economic and competitive factors that influence interest rates, loan demand and deposit flows. Fees earned include charges for deposit services, trust services and loan services. Personnel costs are the primary expenses required to deliver the services to customers. Other costs include occupancy and equipment and general and administrative expenses.

Financial Condition Data



At September 30, 2008, the Company had total assets of $1.1 billion, an increase of $24.2 million from the level at June 30, 2008. The increase in assets was due primarily to increases in net loans and leases receivable of $18.1 million and loans held for sale of $4.6 million. These increases were partially offset by a decrease in cash and cash equivalents of $2.4 million. The increase in liabilities of $23.0 million from June 30, 2008 to September 30, 2008 was primarily due to increases in advances from the FHLB and other borrowings of $38.8 million, non-public funds deposits of $10.5 million, and advances by borrowers for taxes and insurance of $5.9 million. These increases were somewhat offset by a decrease in public funds deposits of $29.7 million and a decrease in accrued expenses and other liabilities of $2.6 million. In addition, stockholders’ equity increased $1.6 million to $65.8 million at September 30, 2008 from $64.2 million at June 30, 2008, primarily due to net income of $2.0 million and partially offset by an increase in unrealized losses on securities available for sale, net of income tax benefit of $411,000.



The increase in net loans and leases receivable of $18.1 million at September 30, 2008 as compared to June 30, 2008, was primarily the result of increases in agricultural loans of $15.8 million to $176.0 million, increases in commercial business and real estate of $4.1 million to $307.6 million, increases of consumer direct loans of $3.8 million to $109.6 million and an increase in construction and development loans of $3.6 million to $9.4 million. These increases were partially offset by decreases in one-to four-family loans of $2.3 million to $97.7 million and decreases in consumer indirect loans of $6.9 million to $37.4 million at September 30, 2008 as compared to June 30, 2008. Loans held for sale increased by $4.6 million at September 30, 2008, as compared to June 30, 2008, due primarily to seasonal fluctuation of single family and student loan activity.



Cash and cash equivalents decreased $2.4 million at September 30, 2008 as compared to June 30, 2008. See the Consolidated Statement of Cash Flows for an in-depth analysis in the change in cash and cash equivalents for the three months ended September 30, 2008.



Advances from the FHLB and other borrowings increased $38.8 million to $237.3 million. The overall increase in FHLB borrowings was primarily the result of an increase in loans and leases receivable, the increase in loans held for sale, and the decrease in public fund deposits. These outflows were somewhat offset by the increase in non-public funds.



The $19.2 million decrease in deposits was due to decreases in public funds of $29.7 million which are categorized in multiple types of deposits. The reduction of public funds in the first quarter of Fiscal 2009 is a seasonal trend that is affected primarily by the collection of property taxes and payment to the school systems’ general funds. During the second quarter Fiscal 2009, the Company expects to see an increase in these public funds deposits with the disbursement of property taxes expected in November 2008. Conversely, non-public funds increased $10.5 million to somewhat offset these reduced deposits in the first quarter. Certificates of deposit increased by $25.3 million to $378.6 million at September 30, 2008. In-market certificates of deposit accounted for $17.5 million of the increase while out-of-market certificates of deposit increased $7.8 million at September 30, 2008 as compared to June 30, 2008.

Analysis of Net Interest Income



Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income depends upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them.



Average Balances, Interest Rates and Yields. The following table presents for the periods indicated, the total dollar amount of interest income from average interest-earning assets and the resulting yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates, and the net interest margin. The table does not reflect any effect of income taxes, except where noted. Average balances consist of daily average balances for the Bank with simple average balances for all other subsidiaries of the Company. The average balances include nonaccruing loans and leases. The yields on loans and leases include origination fees, net of costs, which are considered adjustments to yield.

Rate/Volume Analysis of Net Interest Income


The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between the increases and decreases due to fluctuating outstanding balances due to the levels and volatility of interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume). 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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