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Article by DailyStocks_admin    (04-04-08 07:07 AM)

Harrington West Financial Group Inc. CEO CRAIG J CERNY bought 32,452 shares on 3-27-2008 at. 7.75

BUSINESS OVERVIEW

General
We are Harrington West Financial Group, Inc., a Delaware corporation and a diversified, community-based, financial institution holding company headquartered in Solvang, California, with executive offices in Scottsdale, Arizona. We conduct our operations primarily through our wholly-owned subsidiary, Los Padres Bank, FSB, a federally chartered savings bank, located in central California and Scottsdale, Arizona, and its division in the Kansas City metropolitan area, Harrington Bank. Los Padres Bank provides an array of financial products and services for businesses and retail customers through its sixteen full-service offices. At December 31, 2006, we had consolidated total assets of $1.2 billion, total deposits of $732.8 million and stockholders’ equity of $67.7 million.
We are focused on providing our diversified products and personalized service approach in three distinct markets: (i) the central coast of California, (ii) the Kansas City metropolitan area and (iii) the Phoenix/Scottsdale metropolitan area. Los Padres Bank operates eleven offices on the central coast of California, three offices in the Kansas City metropolitan area under the Harrington Bank brand name, and two banking offices in the Phoenix/Scottsdale, Arizona metropolitan area, since we opened our second office in the Scottsdale Airpark in late March 2005. In 2006, we opened our third Harrington Bank office in Johnson County, Kansas in the Kansas City metro and will open a Los Padres banking office in Surprise, Arizona in approximately the third quarter 2007. Each of our markets has its own local independent management team operating under the Los Padres or Harrington names. Our loan underwriting, corporate administration and treasury functions are centralized in Solvang, California to create operating efficiencies. Our commercial lending operations are centralized in Mission, Kansas.
Los Padres Bank is primarily engaged in attracting deposits from individuals and businesses and using these deposits, together with borrowed funds, to originate commercial real estate, commercial business, single-family and multi-family residential and consumer loans. We also generate fee income from the brokering of mortgage loans, deposit services, early prepayments of some loans, and loan originations. We maintain a portfolio of highly liquid mortgage-backed and related securities as a means of managing our excess liquidity and enhancing our profitability. We utilize various interest rate contracts as a means of managing our interest rate risk. We also operate Harrington Wealth Management Company, which provides trust and investment management services to individuals and small institutional clients on a fee basis, by employing a customized asset allocation approach and investing predominantly in low fee, indexed mutual funds and exchange traded funds.

Lending Activities
General . At December 31, 2006, Los Padres Bank’s net loan portfolio totaled $757.0 million, representing approximately 65.6% of our $1.2 billion of total assets at that date. Los Padres Bank’s primary focus with respect to its lending operations has historically been the direct origination of single-family residential, multi-family residential, consumer and commercial real estate loans. While we continue to emphasize single-family residential loan products that meet our customer’s needs, we now generally broker such loans on behalf of third party investors in order to generate fee income and have been increasing our emphasis on loans secured by commercial real estate, consumer loans, construction and land acquisition and commercial and industrial loans. We also offer multi-family residential loans.

The following table sets forth certain information at December 31, 2006, regarding the dollar amount of loans maturing in our loan portfolio based on the contractual terms to maturity or scheduled amortization, but does not include potential prepayments. Loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less.

Scheduled contractual amortization of loans does not reflect the expected term of our loan portfolio. The average life of loans is substantially less than their contractual terms because of prepayments and due-on-sale clauses, which gives us the right to declare a conventional loan immediately due and payable in the event that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase when current mortgage loan rates are higher than rates on existing mortgage loans and, conversely, decrease when rates on existing mortgage loans are lower than current mortgage loan rates. Under the latter circumstance, the weighted average yield on loans decreases as higher-yielding loans are repaid or refinanced at lower rates.

Origination, Purchase and Sale of Loans. The lending activities of Los Padres Bank are subject to the written, non-discriminatory underwriting standards and loan origination procedures established by Los Padres Bank’s board of directors and management. Loan originations are obtained by a variety of sources, including referrals from real estate brokers, builders, existing customers, walk-in customers and advertising. In its present marketing efforts, Los Padres Bank emphasizes its community ties, customized personal service, competitive rates and terms, and its efficient underwriting and approval process. Loan applications are taken by lending personnel, and the loan department supervises the obtainment of credit reports, appraisals and other documentation involved with a loan. Property valuations are performed by independent outside appraisers approved by Los Padres Bank’s board of directors. Los Padres Bank requires title, hazard and, to the extent applicable, flood insurance on all security property.
Mortgage loan applications are initially processed by loan officers who do not have approval authority. All real estate loans which are either at or below the Federal Home Loan Mortgage Corporation’s (“Freddie Mac”), lending limit and which meet all of the bank’s underwriting guidelines can be approved by designated senior management of Los Padres Bank. All consumer loans up to $250,000 may be approved by designated senior management of Los Padres Bank. All loans in excess of these amounts up to $1.0 million ($500,000 for commercial and industrial loans) require the approval of two members of Los Padres Bank’s Executive Loan Committee, which consists of designated senior management of Los Padres Bank. Loans in excess of $1.0 million ($500,000 for commercial and industrial loans), but not exceeding $5.0 million, require the approval of a majority of Los Padres Bank’s Loan Committee, consisting of designated senior management of Los Padres Bank. All loans in excess of $5.0 million, up to Los Padres Bank’s legal lending limit, must be approved by either Los Padres Bank’s Loan Oversight Committee, comprised of both designated senior management and certain members of the Board of Directors, or the Board of Directors of Los Padres Bank.
A savings institution generally may not make loans to any one borrower and related entities in an amount which exceeds 15% of its unimpaired capital and surplus, although loans in an amount equal to an additional 10% of unimpaired capital and surplus may be made to a borrower if the loans are fully secured by readily marketable securities. At December 31, 2006, Los Padres Bank’s regulatory limit on loans-to-one borrower was $13.6 million and its five largest loans or groups of loans-to-one borrower, including related entities, aggregated $13.1 million, $13.1 million, $13.0 million, $13.0 million, and $13.0 million. These five largest loans or loan concentrations were secured by commercial real estate and development of single-family homes. All of these loans or loan concentrations were performing in accordance with their payment terms at December 31, 2006.
The risks associated with lending are well defined. Credit risk is managed through the adherence, with few exceptions, to specific underwriting guidelines. We rely on our internal credit approval and administrative process to originate loans as well as our internal asset review process, which oversees our loan quality in order to ensure that our underwriting standards are maintained. We believe that the low level of our non-performing assets is evidence of our adherence to our underwriting guidelines.
As a federally chartered savings bank, Los Padres Bank has general authority to originate and purchase loans secured by real estate located throughout the United States. Despite this nationwide lending authority, we estimate that at December 31, 2006, the majority of the loans in Los Padres Bank’s portfolio are secured by properties located or made to customers residing in each of our primary market areas located in the California central coast, the Kansas City metropolitan area, and the Phoenix/Scottsdale metropolitan area.
Single-Family Residential Real Estate Loans. Los Padres Bank has historically concentrated its lending activities on the origination of loans secured by first mortgage liens on existing single-family residences. The single-family residential loans originated by Los Padres Bank are generally made on terms, conditions and documentation, which permit the sale of such loans to Freddie Mac, the Federal National Mortgage Association (“Fannie Mae”), and other institutional investors in the secondary market. Since January 2001, as a means of generating additional fee income and in order to reflect management’s decision to emphasize holding higher spread earning loans in its portfolio, Los Padres Bank has been brokering conforming permanent single-family residential loans on behalf of third parties in order to generate fee income. During the years ended December 31, 2006 and 2005, Los Padres Bank brokered $48.5 million and $39.0 million, respectively, of such single-family residential loans on behalf of third parties.
Los Padres Bank still holds a portfolio of single-family residential loans. Los Padres Bank will retain in its portfolio single-family residential loans that, due to the nature of the collateral, carry higher risk adjusted spreads. Examples of these types of loans include construction loans that have converted into permanent loans and non-conforming single-family loans, whether as a result of a non-owner occupied or rural property, balloon payment or other exception from agency guidelines. At December 31, 2006, Los Padres Bank had $106.7 million of single-family residential loans in its portfolio, which amounted to 13.9% of total loans receivable as of such date. At December 31, 2006, total loans due after one year had $73.6 million or 69.0% of Los Padres Bank’s single-family residential loans with fixed interest rates and $33.1 million or 31.0% with interest rates which adjust in accordance with a designated index. Single-family residential loans have terms of up to 30 years and generally have loan-to-value ratios of 80% or less, or 90% or less to the extent the borrower carries private mortgage insurance for the balance in excess of the 80% loan-to-value ratio.
Multi-Family Residential and Commercial Real Estate Loans. At December 31, 2006, Los Padres Bank had an aggregate of $79.9 million and $264.9 million invested in multi-family residential and commercial real estate loans, respectively, or 10.4% and 34.6% of total loans receivable, respectively.
Los Padres Bank’s multi-family residential loans are secured by multi-family properties of five units or more, while Los Padres Bank’s commercial real estate loans are secured by industrial, warehouse and self-storage properties, office buildings, office and industrial condominiums, retail space and strip shopping centers, mixed-use commercial properties, mobile home parks, nursing homes, hotels and motels. Substantially all of these properties are located in Los Padres Bank’s primary market areas. Los Padres Bank typically originates commercial real estate loans for terms of up to 20 years based upon a 30-year loan amortization period and multi-family residential loans for terms of up to 20 years based upon up to a 30-year amortization schedule. Los Padres Bank will originate these loans on both a fixed-rate or adjustable-rate basis, with the latter adjusting on a periodic basis of up to one year based on the London Interbank Offered Rate (“LIBOR”), the one-year U.S. Treasury index of constant comparable maturities, a designated prime rate, or the 11th District Cost of Funds Index. Adjustable-rate loans may have an established ceiling and floor, and the maximum loan-to-value for these loan products is generally 75%. As part of the criteria for underwriting commercial real estate loans, Los Padres Bank generally requires a debt coverage ratio (the ratio of net cash from operations before payment of debt service to debt service) of 1.3:1 or more. It is also Los Padres Bank’s general policy to seek additional protection to mitigate any weaknesses identified in the underwriting process. Additional coverage may be provided through secondary collateral and personal guarantees from the principals of the borrowers.
Commercial real estate lending entails different and significant risks when compared to single-family residential lending because such loans typically involve large loan balances to single borrowers and because the payment experience on such loans is typically dependent on the successful operation of the project or the borrower’s business. In addition, the balloon payment features of these loans may require the borrower to either sell or refinance the underlying property in order to make the payment. These risks can also be significantly affected by supply and demand conditions in the local market for apartments, offices, warehouses or other commercial space. Los Padres Bank attempts to minimize its risk exposure by requiring that the loan does not exceed established loan-to-value and debt coverage ratios, and by monitoring the operation and physical condition of the collateral.
Construction Loans. Los Padres Bank originates loans to finance the construction of single-family and multi-family residences and commercial properties located in its primary market area. At December 31, 2006, Los Padres Bank’s construction loans amounted to $112.6 million or 14.7% of total loans receivable, $57.7 million of which were for the construction of residential properties, $25.5 million of which were for land acquisition and the development of residential properties, and $29.4 million of which were for the construction of commercial properties.
Los Padres Bank primarily provides construction loans to individuals building their primary or secondary residence as well as to local developers with whom Los Padres Bank is familiar and who have a record of successfully completing projects. Residential construction loans to developers generally are made with terms not exceeding two years, have interest rates which are fixed or adjust, with the latter adjusting on a periodic basis of up to one year based upon a designated prime rate or LIBOR, and are generally made with loan-to-value ratios of 80% or less. Residential construction loans to individuals are interest only loans for the term of the construction and then generally convert to a permanent loan. Los Padres Bank’s construction/permanent loans have been successful due to its ability to offer borrowers a single closing and, consequently, reduced costs. Los Padres Bank also offers adjustable-rate loans based on a designated prime rate or other indices with terms of up to two years for the construction of commercial properties. Such loans are generally made at a maximum loan-to-value ratio of 85% of discounted appraised value or less.
Construction lending and acquisition and development lending are generally considered to involve a higher degree of risk of loss than long-term financing on improved, owner-occupied real estate. Risk of loss on construction loans and acquisition and development loans is dependent largely upon the accuracy of the initial appraisal of the property’s projected value at completion of construction as well as the estimated cost, including interest, of construction. During the construction phase, a number of factors could result in delays and cost overruns. If either estimate proves to be inaccurate or the borrower is unable to provide additional funds, the lender may be required to advance funds beyond the amount originally committed to permit completion of the project and/or be confronted at the maturity of the construction loan with a project whose value is insufficient to assure full payment. Los Padres Bank attempts to minimize the foregoing risks primarily by limiting its construction lending to experienced developers and by limiting the total amount of loans to builders for speculative construction projects. It is also Los Padres Bank’s general policy to obtain regular financial statements and tax returns from builders so that it can monitor their financial strength and ability to repay.
Land acquisition and development. Los Padres Bank has increased its loans for land acquisition and development (loans for the initial acquisition of land and off-site improvements) from $36.1 million at December 31, 2005 to $54.7 million at December 31, 2006. The increase is caused by the expansion of our products to meet our customer needs. Land acquisition and development loans are typically issued with short terms, bearing adjustable-rates of interest based on a designated prime rate or LIBOR and are generally made with loan-to-value ratios of 70% or less.
Commercial and Industrial Loans . Los Padres Bank is placing increased emphasis on the origination of commercial business loans because of the higher risk-adjusted spreads generally associated with these types of loans. At December 31, 2006, Los Padres Bank’s commercial and industrial loans amounted to $119.1 million or 15.6% of total loans receivable.
The commercial and industrial loans that Los Padres Bank is originating include lines of credit, term loans and letters of credit. These loans are typically secured by collateral and are used for general business purposes, including working capital financing, equipment financing, capital investment and general investment. Depending on the collateral pledged to secure the extension of credit, maximum loan-to-value ratios are 80% or less. Loan terms generally vary from one to seven years. The interest rates on such loans are generally variable and are indexed to the Wall Street Journal Prime Rate, plus a margin. Commercial and industrial loans typically have shorter maturity terms and higher interest spreads than mortgage loans, but generally involve more credit risk than mortgage loans because of the type and nature of the collateral. Los Padres Bank’s business customers are typically small to medium sized, privately-held companies with local or regional businesses that operate in Los Padres Bank’s primary markets.
Consumer and Other Loans . Los Padres Bank is authorized to make loans for a wide variety of personal or consumer purposes. Los Padres Bank has been originating consumer loans in recent years in order to provide a wider range of financial services to its customers and because such loans generally carry higher interest rates than mortgage loans. The consumer and other loans offered by Los Padres Bank include home equity lines of credit, home improvement loans, vehicle loans, secured and unsecured personal lines of credit and deposit account secured loans. At December 31, 2006, $27.5 million or 3.7% of Los Padres Bank’s total loans receivable consisted of consumer loans.
Home equity lines of credit are originated by Los Padres Bank for up to 90% of the appraised value, less the amount of any existing prior liens on the property. Los Padres Bank also offers home improvement loans in amounts up to 80% of the appraised value, less the amount of any existing prior liens on the property. Home improvement loans have a maximum term of 15 years and carry fixed or adjustable interest rates. Home equity lines of credit have a maximum repayment term of 15 years and carry interest rates that adjust monthly in accordance with a designated prime rate. Los Padres Bank will secure each of these types of loans with a mortgage on the property, generally a second mortgage, and may originate the loan even if another institution holds the first mortgage. At December 31, 2006, home equity lines of credit and home improvement loans totaled $24.7 million or 89.7% of Los Padres Bank’s total consumer loan portfolio and an aggregate of $46.0 million were committed and un-drawn under these loans and lines of credit.
Los Padres Bank currently offers loans secured by deposit accounts, which amounted to $427,000 or 1.6% of Los Padres Bank’s total consumer and other loan portfolio at December 31, 2006. Such loans are originated for up to 90% of the deposit account balance, with a hold placed on the account restricting the withdrawal of the account balance.
At December 31, 2006, vehicle loans, secured and unsecured personal line of credit loans amounted to $868,000 or 3.2% of Los Padres Bank’s total consumer and other loan portfolio.
Consumer loans generally have shorter terms and higher interest rates than mortgage loans but generally involve more credit risk than mortgage loans because of the type and nature of the collateral. In addition, consumer lending collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness and personal bankruptcy. Los Padres Bank believes that the generally higher yields earned on consumer loans compensate for the increased credit risk associated with such loans and Los Padres Bank intends to continue to offer consumer loans in order to provide a full range of services to its customers.
Asset Quality
General . Los Padres Bank’s Internal Asset Review Committee and the Internal Asset Oversight Committee, consisting of Los Padres Bank’s senior executive officers and certain members of the Board of Directors, monitors the credit quality of Los Padres Bank’s assets, reviews classified and other identified loans and determines the proper level of reserves to allocate against Los Padres Bank’s loan portfolio, in each case subject to guidelines approved by Los Padres Bank’s board of directors.
Loan Delinquencies . When a borrower fails to make a required payment on a loan, Los Padres Bank attempts to cure the deficiency by contacting the borrower and seeking payment. Contacts are generally made following the sixteenth day after a payment is due, at which time a late payment is assessed. In most cases, deficiencies are cured promptly. If a delinquency extends beyond 16 days, the loan and payment history is reviewed and efforts are made to collect the payment. While Los Padres Bank generally prefers to work with borrowers to resolve such problems, when the account becomes 45 days delinquent, Los Padres Bank will institute foreclosure by issuing a Notice of Intent to Foreclose or other proceedings, as necessary, to minimize any potential loss. After 75 days and the loan is not brought current or no workout agreement has been initiated, a Notice of Default is recorded.
Non-Performing Assets . Los Padres Bank will place loans on non-accrual status when, in the judgment of management, the probability of collection of interest is deemed to be insufficient to warrant further accrual. When such a loan is placed on non-accrual status, previously accrued but unpaid interest is deducted from interest income. Los Padres Bank generally does not accrue interest on loans past due 60 days or more.

CEO BACKGROUND

Paul O. Halme has served as a director of the Company since May 2002 and as a director of the Bank since 2000. Mr. Halme is an attorney and a partner in the law firm of Halme and Clark in Solvang, California. Mr. Halme was named Man of the Year in 2003 for his support of nonprofit charities in his community. He is a founder and the first President of the Santa Ynez Valley Bar Association. He currently serves as Chair of the Paloheimo Foundation Board which supports specific museums and educational beneficiaries including The Pasadena Museum of History, Pasadena, California, El Rancho De Las Golondrinas, outdoor museum of Spanish Colonial History, Santa Fe, New Mexico, The School of American Research, Santa Fe, New Mexico and The Southwest Museum, Los Angeles, California. Mr. Halme is a Knight First Class Order of the Lion of Finland awarded in recognition of his support of cultural and educational exchange between the country of Finland and the United States.

William W. Phillips, Jr. is the President and a director of the Company, and he is the President, Chief Operating Officer, and a director of the Bank. Mr. Phillips has been the Company’s President since 1998 and a director since May 2002. Mr. Phillips became a director of the Bank in 1997. Mr. Phillips has served as the President and Chief Operating Officer of the Bank since 1997. Prior to being the President and Chief Operating Officer of the Bank, Mr. Phillips served as its Senior Vice President and Treasurer. Mr. Phillips has more than 28 years of experience in the banking industry and has served the Bank in progressively responsible capacities since its origination in 1983. Mr. Phillips was reappointed Chief Financial Officer in June 2004, but subsequently relinquished that title with the promotion of Kerril Steele to Chief Financial Officer in January 2007.

Craig J. Cerny has served as the Company’s Chairman of the Board and Chief Executive Officer since August 1995, when he formed the Company to acquire Los Padres Bank, FSB (the “Bank”). Mr. Cerny has been the Chief Executive Officer of the Bank since October 2001 and the Chairman of the Board of the Bank since May 2002. Mr. Cerny has also served as a director and the Chief Investment Officer of the Bank since April 1996. Until January 2002, Mr. Cerny was the Chief Executive Officer, President and a director of Harrington Financial Group, Inc., Richmond, Indiana (“HFGI”), and Chairman of the Board, Chief Executive Officer and President of HFGI’s subsidiary, Harrington Bank, FSB, positions he held since February 1992. In January 2002, HFGI and Harrington Bank merged with an unaffiliated financial institution after the sale of, among other things, the assets of HFGI’s Shawnee Mission, Kansas operations to the Bank. Prior to holding these positions, Mr. Cerny served as a principal and member of the board of directors of Smith Breeden Associates, Inc. (“Smith Breeden”), which will render interest rate risk and investment management advice to the company until April 30, 2007. Mr. Cerny was employed at Smith Breeden from April 1985 to December 1996, where he was active in their bank consulting and investment advisory practice. Mr. Cerny remains a stockholder in Smith Breeden.

Timothy Hatlestad has served as a director of the Bank since 2003 and as a director of the Company since 2006. Mr. Hatlestad is President and CEO of Resource Marketing Group, Inc., owner of RE/MAX Commercial Investment and RE/MAX Achievers, which is a real estate brokerage, property management, development and real estate investment firm with fourteen offices in the Phoenix metropolitan area. The company is recognized as one of the largest real estate brokerage firms in Arizona as well as the United States. Mr. Hatlestad was the 2006 First Vice President of the CCIM Institute, an organization dedicated to advanced commercial investment real estate education; and was the 2005 President of the 48,000+ member Arizona Association of REALTORS ® .

John J. McConnell has served as a director of the Company and as a director of the Bank since 1996. Dr. McConnell also served as a director of HFGI until January 2002. Dr. McConnell is the Emanuel T. Weiler Distinguished Professor of Management (in Finance) at the Krannert School of Management, Purdue University, where he has been a faculty member since 1976. He served on the Board of Directors of the Federal Home Loan Bank of Indianapolis from 1983 to 1986 and has been a consultant for various government agencies, trade associations, law firms, and corporations.

William D. Ross has served as a director of the Company since 1996 and a director of the Bank since its incorporation in 1982. Mr. Ross served as the Company’s President from 1996 until 1998 and as the Chief Executive Officer of the Bank from 1983 to 1998 and was Chairman of the Bank from 1997 to May 2002. Mr. Ross has spent more than 47 years in the banking business.

Susan C. Weber , age 60, has been with the Bank since 1983. Mrs. Weber has served as the Company’s Senior Vice President and Secretary since 1999. Mrs. Weber has served as Executive Vice President and Chief Lending Officer of the Bank since 1999, and she has been a director of the Bank since 2001. When Mrs. Weber joined the Bank in 1983 as Vice President and Loan Manager, she was instrumental in establishing its loan department. Shortly thereafter, Mrs. Weber was promoted to Vice President and Chief Loan Officer and, in June 1997, she was promoted to Senior Vice President and Chief Loan Officer. Mrs. Weber has more than 31 years experience in the banking industry.

Mark R. Larrabee , age 49, has been President of the Kansas Region and Chief Commercial Lending Officer of the Bank since November 2001, when the Bank acquired the Kansas operations of Harrington Bank, FSB. In December 2001, Mr. Larrabee was also named a director of the Bank. Mr. Larrabee held similar positions at Harrington Bank, FSB since February 1998. From January 1996 to February 1998, Mr. Larrabee served as Executive Vice President for Country Club Bank, Kansas City, Missouri. Prior to joining Country Club Bank, Mr. Larrabee was Senior Vice President for Bank IV Kansas, National Association, Overland Park, Kansas, from October 1992 to January 1996. Bank IV had acquired Mr. Larrabee’s previous employer, Mission Hills Bank, Mission Woods, Kansas, where he was a founder and had served as Executive Vice President and Chief Commercial Lending Officer from March 1984 until the October 1992 acquisition.

Vernon H. Hansen , age 54, joined the Bank in July 2002 as President of its newly formed Arizona Region. Mr. Hansen has been in the Phoenix, Arizona metropolitan market since 2000, and has a 35 year background in commercial and community banking, including duties as President, Branch Manager, Chief Credit Officer and Lending Officer. Prior to joining the Bank, Mr. Hansen served as Executive Vice President — Chief Lending Officer for Bank of the Southwest in Tempe, Arizona from May 2001 to July 2002, and Vice President — Chief Credit Officer for Matrix Capital Bank in Phoenix and Denver from January 1997 to May 2001. Mr. Hansen was also employed by the Federal Deposit Insurance Corporation as a bank examiner earlier in his career.

Kerril K. Steele , age 51, joined Los Padres Bank in February 2004 and was promoted to Chief Financial Officer for both the Company and the Bank in January 2007. Prior to that she served as Vice President, Corporate Controller and was promoted to Senior Vice President, Principal Accounting Officer in December 2004. Ms. Steele is a certified public accountant and was formerly Director of Corporate Accounting for World Minerals, Inc., a subsidiary of a Fortune 500 Company. Ms. Steele received her public training with KPMG, LLP with a focus on audit and taxation of financial institutions.

Steven J. Berg , age 56, has served as the Company’s Corporate Counsel and as Senior Vice President and Compliance Officer of the Bank since October 1996. At the time Mr. Berg joined the Bank, Mr. Berg was in private law practice in Santa Barbara and Goleta, California, where he focused on banking and creditors’ rights law. Prior to that, Mr. Berg served in various legal positions, including general counsel with Santa Barbara Federal Savings & Loan Association. Mr. Berg entered private law practice in 1976.

Kim D. Chambers , age 39, serves as Senior Vice President and Mortgage Lending Manager. Since joining the Bank in 1997, Mrs. Chambers has served in various capacities including several managerial positions. Mrs. Chambers was previously employed with Chase Manhattan Mortgage as an underwriter and processing/funding supervisor.

Allen Hafizi, age 45, currently serves as Senior Vice President, Loan Service Manager. Mr. Hafizi joined the Bank in 2006. Prior to joining Los Padres Bank, Mr. Hafizi was employed for four years at Pacific State Bank as Vice President, Note Department Manager, CRA and Lending Compliance officer. Prior to 2002, Mr. Hafizi has been employed in various banking related positions since 1989.

Richard E. Harrison , age 41, currently serves as President and Chief Operating Officer of Harrington Wealth Management, a wholly owned subsidiary of the Bank. Mr. Harrison joined Harrington Wealth Management in February of 1993. Mr. Harrison, with approximately 20 years of trust and investment management experience, is the manager of all trust and investment related functions for Harrington Wealth Management. Prior to joining Harrington Wealth Management, he served in trust and investment management positions with Union Federal Savings Bank of Indianapolis and Irwin Union Bank. He also served as a trust examiner with the Indiana Department of Financial Institutions. Mr. Harrison earned a B.S. in Finance from Indiana University and an M.B.A. with honors from the University of Indianapolis. He is also a graduate of the American Bankers Association Trust School.

John R. Mason, age 43, joined the Bank in February 2007 in the position of Chief Investment Officer and Director of Financial Analysis. Mr. Mason has a 20 year career in finance, accounting, and investment management and was most recently a portfolio manager for US Central, FCU. Prior to this position, Mr. Mason was a principal of Smith Breeden Associates, Inc., an investment and interest rate risk management adviser to the Company, responsible for consulting with banking clients on asset/liability and fixed income portfolio matters. Mr. Mason spent over six years from 1991 to 1997 at Roosevelt Bank, FSB, a savings bank with $7 billion in assets, most recently as Chief Investment Officer with responsibility for financial planning and analysis. Mr. Mason is a Certified Public Accountant and Chartered Financial Analyst.

Michele K. Morrison , age 47, has been with the Bank since its inception in 1983. Ms. Morrison has served as Senior Vice President and Chief Savings Officer of the Bank since 1999. Prior to 1999, she has held several positions within Savings Administration for the Bank. Ms. Morrison has more than 25 years experience in the banking industry.

Steen Weber , age 45, has been with the Bank since 1986, currently serving as Senior Vice President and Credit Risk Manager since 2001. Prior to 2001, Mr. Weber held several positions within the Loan Department for the Bank and as a Vice President and Business Development Officer for Harrington Wealth Management Company.

SHARE OWNERSHIP

(1) Includes 89,400 shares held by the Rhonda Cerny Trust, Mr. Cerny’s wife, 14,058 shares held by Harrington Wealth Management as agent for the Cerny Family Trust, and 81,450 shares underlying stock options exercisable within 60 days of the voting record date.

(2) Includes 91,832 shares held by the Phillips Family Trust and 67,900 shares underlying stock options exercisable within 60 days of the voting record date.

(3) Includes 10,000 shares held by Marie Steiner Ross, Mr. Ross’s wife, and 34,440 shares underlying stock options exercisable within 60 days of the voting record date.

(4) Includes 19,500 shares underlying stock options exercisable within 60 days of the voting record date.

(5) Includes 8,107 shares held by the Weber Family Trust and 45,750 shares underlying stock options exercisable within 60 days of the voting record date.

(6) Includes 17,250 shares underlying stock options exercisable within 60 days of the voting record date.

(7) Includes 3,600 shares held by Aimee Larrabee, Mr. Larrabee’s wife, and 19,000 shares underlying stock options exercisable within 60 days of the voting record date.

(8) Includes 4,175 shares underlying stock options exercisable within 60 days of the voting record date.

(9) Includes 2,650 shares underlying stock options exercisable within 60 days of the voting record date.

(10) Includes 354,970 shares underlying stock options exercisable within 60 days of the voting record date held by directors and executive officers.

(11) Mr. Douglas T. Breeden’s ownership is reported as of December 31, 2006 in his Form 13G and is based on 5,460,393 shares issued and outstanding.

(12) The Banc Funds Co. LLC ownership is reported as of December 31, 2006 in their Form 13G and is based on 5,460,393 shares issued and outstanding.

(13) Northaven Management Inc. ownership is reported as of December 31, 2006 in their Form 13G and is based on 5,460,393 issued and outstanding.

MANAGEMENT DISCUSSION FROM LATEST 10K
Mission
Our mission is to develop diversified and highly profitable community-focused, banking operations in the markets of the Central Coast of California, the Kansas City metro, and the Phoenix/Scottsdale metro. Although these markets are geographically dispersed, we have considerable market knowledge of each of these areas, local management with extensive experience in banking and the particular market, relationship development potential due to our ties to the communities, and each market offers favorable demographic and economic characteristics. All of these banking operations are operated under the Los Padres Bank, FSB charter so that we can gain operating efficiencies from centralized administration and operating systems. However, each region’s banking operation is distinct to its market and its clientele, and lead by a local management team responsible for developing and expanding the banking operations on a profitable basis. The Kansas City banking offices operate under the Harrington Bank (dba) brand name, and the California and Arizona offices operate under the Los Padres Bank brand name.
Multiple Market Strategy
We believe this multiple market banking strategy provides the following benefits to our shareholders:
1. Diversification of the loan portfolio and economic and credit risk.
2. Options to capitalize on the most favorable growth markets.

3. The capability to deploy the Company’s diversified product mix and emphasize those products that are best suited for the market.
4. The ability to price products strategically among the markets in an attempt to maximize profitability.
We plan to grow the banking operations in these markets opportunistically and expect the opening of two to three banking offices every 18 months through new branching. We evaluate financial institution acquisition opportunities but are value oriented. Acquisitions are expected to be accretive to earnings per share within a 12-month period.
2006 marked HWFG’s eleventh year of operations and was highlighted by a high degree of success in executing our strategy to grow our core banking franchise of loans, deposits and HWM fees, while we made further progress in identifying and acquiring new banking sites in our markets for future expansion.
Since HWFG’s acquisition of Los Padres Bank almost 11 years ago, we have approximately increased our loans by 4 times, our deposits by 4 times and our earnings by 18 times. We have had a great deal of success over these 10 years and look forward to more positive results in the future.
Since 1997, we have grown from 4 banking offices to 16 banking offices including the Thousand Oaks deposit acquisition, opening the Scottsdale Airpark office in mid 2005 and opening in the Olathe, Kansas in August, 2006. We have 11 full service banking offices on the Central Coast of California from Thousand Oaks to Atascadero along Highway 101, 3 banking offices in Johnson County, Kansas in the fastest growing area of the Kansas City metro, and 2 offices in Scottsdale, Arizona. We will open our third banking office in the Phoenix metro area in the first quarter of 2007. We are working on additional expansion opportunities in each market.
Product Line Diversification
We have broadened our product lines over the last 6 years to diversify our revenue sources and to become a full service community banking company. In 1999, we added Harrington Wealth Management Company, a federally registered trust and investment management company, to provide our customers a consultative and customized investment process for their trust and investment funds. In 2000, we added a full line of commercial banking and deposit products for small to medium sized businesses and expanded our consumer lending lines to provide Home Equity Lines of Credit. In 2001, we added internet banking and bill pay services to augment our in-branch services and consultation. In 2002, we further expanded our mortgage banking and brokerage activities in all of our markets. In 2004 we added the Overdraft Privilege Program and Uvest. Uvest expanded Harrington Wealth Management’s services to include brokerage and insurance products.
Modern Financial Skills
We believe we have considerable expertise in investment and asset liability management from the CEO’s background in this field for over 20 years, during which he spent 13 years consulting on risk management practices with banking institutions and advising on billions of mortgage assets managed on a short duration basis. We attempt to control interest rate risk to a low level through the use of interest rate risk management tools, and we utilize excess capital in a low duration and high credit quality investment portfolio of largely mortgage related securities to enhance our earnings. Our goal is to produce a pre-tax return on these investments of 1.00% to 1.25% over the related funding sources. We believe our ability to price loans and investments on an option-adjusted spread basis and then manage the interest rate risk of longer term, fixed rate loans allows us to compete effectively against other institutions.

Control Banking Risks
We seek to control banking risks. We have established a disciplined credit evaluation and underwriting environment that emphasizes the assessment of collateral support, cash flows, guarantor support, and stress testing. We manage operational risk through stringent policies, procedures, and controls and interest rate risk through our modern financial and hedging skills.
Performance Measurement
We evaluate our performance based upon the primary measures of return on average equity, which we are trying to maintain in the low to mid-teens, earnings per share growth, and additional franchise value creation through the growth of deposits, loans and wealth management assets. We may forego some short term profits to invest in operating expenses for branch development in an effort to earn future profits.
Profitability Drivers
The factors that we expect to drive our profitability in the future are as follows:
1. Growing our non-costing consumer and commercial deposits and continuing to change the mix of deposits to fewer time based certificates of deposit. This strategy is expected to lower our deposit cost and increase our net interest margin over time. We have emphasized the development of low cost business accounts and our full-service, free checking and money market accounts for consumers. .

2. Changing the mix of our loans to higher risk-adjusted spread earning categories such as business lending, commercial real estate lending, small tract construction and construction-to-permanent loan lending, and selected consumer lending activities such as home equity line of credit loans.

3. Diversifying and growing our banking fee income through existing and new fee income sources such as our overdraft protection program and other deposit fees, loan fee income from mortgage banking, prepayment penalty fees and other loan fees, Harrington Wealth Management trust and investment fees, and other retail banking fees.

Results of Operations
Summary of Earnings . We reported net income for the year ended December 31, 2006 of $8.2 million, compared to $8.3 million and $8.2 million for the years ended December 31, 2005 and 2004. Our net income declined by $108 thousand or 1.30% during 2006 as compared to 2005 and increased $127 thousand or 1.55% in 2005 as compared to 2004. On a diluted earnings per share basis, we earned $1.48, $1.48, and $1.46 for the years ended December 31, 2006, 2005 and 2004, respectively.
HWFG’s net earnings have been affected by the strategic decision to reduce the investment securities portfolio in 2006 by $77.6 million to a $309.8 million balance at December 31, 2006 and to allow all of HWFG’s $129.0 million of total return mortgage and asset backed swaps to mature in 2006. This reduction of earning investment assets was undertaken for two reasons: (1) the net margins on these investments had tightened to the extent that holding them did not present a favorable risk return tradeoff, and (2) the reduction of these investments allowed HWFG to substantially grow its diversified net loan portfolio by $84.1 million or 12.5% in 2006 to $757.0 million, thus re-deploying its equity capital in the community banking franchise. The reduction in the net interest income from investments and the positive carry on total return swaps was substantially offset by the net interest income from the loan growth, resulting in nominal growth in net interest income from 2005 to 2006. HWFG anticipates that incremental net interest income from loan growth will exceed any reduction in net interest income from the further reduction of investments in 2007 if investment spreads remain tight. HWFG is focused on further building a diversified loan portfolio, low and non-costing deposits, and Harrington Wealth Management (HWM) and other banking fees.
Net Interest Income . Net interest income is determined by (i) our interest rate margin, which is the difference between the yields earned on our interest-earning assets and the rates paid on our interest-bearing liabilities and (ii) the relative amounts of interest-earning assets and interest-bearing liabilities.
Net interest income after provision for loan losses increased by $466 thousand or 2.0% to $30.2 million during the year ended December 31, 2006 over 2005. Although the asset mix change contributed favorably to net interest margin, deposit cost pressure (spread to LIBOR rates) and some lag in the repricing of floating rate loans and securities, the net interest margin remained stable at 2.83% from December 31, 2006 as compared to the same period 2005. We believe our hedging activities will result in our maintaining relatively stable margins over time (refer to the Asset and Liability Management section of this discussion for a detailed discussion of what our strategies are for hedging of interest rate exposure and why we believe that our management of interest rate fluctuations give us a competitive advantage over other financial institutions).
Net interest income after provision for loan losses increased by $825 thousand or 2.9% to $29.7 million during the year ended December 31, 2005 over 2004. The increase in net interest income is partly due to a $63.2 million or 6.3% increase in the average balance of interest-earning assets, while the interest rate margin decreased slightly by 10 basis points to 2.83% for 2005 from 2.93% for 2004. The decline in net interest margin reflects the slight lag in the repricing of floating rate borrowings and floating rate loans and hedges, and the prepayment of higher rate loans.

Interest Income . Total interest income increased by $12.0 million or 19.4% for 2006 over 2005 from $62.1 million to $74.1 million. Interest income increased during the current year due to the re-pricing of adjustable rate loans and securities, and an increase in the volume of loans. Total interest income increased by $9.8 million or 18.7% for 2005 over 2004 from $52.3 million to $62.1 million. The Federal Reserve Board maintained a low federal funds rate during 2004, and since a substantial portion of our earning assets reprice with the general level of interest rates, our average yield on earning assets declined commensurate with the increases in federal fund rates.
Interest Expense . Total interest expense increased by $11.4 million or 35.9% during the year ended December 31, 2006 over 2005, from $31.9 million to $43.3 million. During 2006, the cost of floating rate borrowings and deposits increased with general market rates. Also, our average interest-bearing liabilities increased by $15.8 million or 15.7%, due primarily to the increase in borrowings to support our growth and the growth in deposits in new offices in Ventura, California and Overland Park, Kansas.
Provision for Loan Losses . We established provisions for loan losses of $565,000, $435,000, and $650,000 during the years ended December 31, 2006, 2005, and 2004, respectively. Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management. For more detailed information regarding the methodology used to maintain the allowance for loan losses, refer to the Asset Quality section in Item 1 – Business.
Other Income . Total other income has fluctuated over the periods presented, due to our management of our securities portfolio, which is intended to enhance both net interest income as well as creating net gains on securities and hedges by capitalizing on changes in option-adjusted spreads. Other income includes net gains and losses from our trading activities, extinguishment of debt and other gains and losses plus banking fee income.
As HWFG reduced the investment and total rate of return swap portfolio in 2006, it realized net gains from sales and expiring total rate of return swaps of $411 thousand in 2006 compared to $936 thousand in 2005. These gains emanate from the purchase of securities and total rate of return swaps at relatively wide spread to LIBOR based benchmarks, and as the spreads tighten, gains are realized.
Banking fee and other income was $4.1 million in 2006 versus $3.9 million in 2005, a 3.5% increase HWM fees, deposit related fees, and other retail banking fees demonstrated strong growth in 2006, while prepayment penalty fees were down $583 thousand in 2006 from 2005, as refinancing activity waned.

Other Expenses . Operating expenses were controlled in 2006, in light of the expansion of banking operations in the year and the expensing of stock options. Operating expenses were $22.2 million in 2006 compared to $21.1 million in 2005, a 5.1% increase, including the opening and ongoing expenses for a new Harrington banking office in the Kansas City metro, and $448 thousand of stock option expense not incurred in 2005 due to implementing FAS 123R in 2006.

Total other expenses increased by $1.1 million or 5.1% to $22.2 million during the year ended December 31, 2006 over the prior year, and increased by $1.7 million or 8.5% to $21.1 million during the year ended December 31, 2005 over 2004. The growth in other operating expenses has been largely attributed to the expenses required to support the growth of our banking offices and expansion of lending staff.
The principal category of our other expenses is salaries and employee benefits, which increased by $1.3 million or 11.7% during the year ended December 31, 2006, compared to the prior year. Salaries and employee benefits increased by $644,000, or 6.1% during 2005. The increases during periods ended December 31, 2006 and 2005 were primarily due to the implementation of FAS 123(R) and the hiring of additional employees in connection with the opening of new branch offices in Overland Park, Kansas in the end of 2006, Thousand Oaks location in 2005 and the Ventura, California location in the middle of 2004, together with our general growth in operations. The Company has plans to open three more banking offices in the Phoenix metro through 2008 to bring the offices in this market to five. An office in Surprise, Arizona in the Northeast Valley is scheduled to commence construction in March 2007 and be completed in the fall of 2007. A parcel in Gilbert, Arizona in the Southeast Valley was acquired in December 2006, and a banking office is expected to be completed thereon in mid 2008. A banking office in North Phoenix in the Deer Valley Airpark will likely be completed near the end of 2008 or early 2009.
Premises and equipment expenses decreased by $140,000 or 3.6% during the year ended December 31, 2006, as compared to the prior year, and increased by $731,000 or 23.2% during 2005. The increase in premises and equipment expense during the year ended December 31, 2005 was primarily due to the banking office openings and general growth in operations.
We have contracted with Smith Breeden to provide investment advisory services and interest rate risk analysis. Certain of our directors are also principals of Smith Breeden. The consulting fees paid by us to Smith Breeden during the years ended December 31, 2006 and 2005, amounted to $405,000 and $425,000, respectively. Expenses related to audit and tax services for 2006 was $385,000, compared to $380,000 in 2005. We have also made expenditures in administration and systems to support our growth and have increased consulting and internal support to implement new corporate governance regulations, such as the Sarbanes Oxley Act (SOA).

The increases in miscellaneous other expenses since 2004, primarily reflects our growth in our number of offices over the periods as well as expenses associated with our public company status and new corporate governance regulations.
Income Taxes . We incurred income tax expense of $4.3 million, $5.2 million and $5.4 million during the years ended December 31, 2006, 2005 and 2004. The amount of our income tax expense is a function of the amount of our income before income taxes during the periods presented. Our effective tax rates were 34.1%, 38.3% and 39.8%, the years ended December 31, 2006, 2005 and 2004. HWFG benefited from a favorable tax ruling from the Franchise Tax Board of California in 2006, confirming the apportionment of income to states in which HWFG does business and from higher income being reported in states with lower tax rates, a benefit of HWFG’s multiple market strategy. Tax exempt income from bank-owned life insurance and tax exempt loans also helped lower HWFG’s combined tax rate in 2006.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

Results of Operations
The Company reported net income of $498 thousand for the three months ended September 30, 2007, as compared to $2.1 million for the three months ended September 30, 2006. The Company reported net income of $3.5 million for the nine months ended September 30, 2007, as compared to $6.3 million for the nine months ended September 30, 2006. On a diluted earnings per share basis, the Company earned $.09 per share for the three months ended September 30, 2007 and $.38 for the three months ended September 30, 2006. Net earnings were reduced by a pre-tax mark to market loss of $387 thousand on commercial mortgage backed securities (CMBS) total return swaps (TROR) in HWFG’s trading portfolio and a $1.9 million pre-tax write-down of all $2.4 million of HWFG’s non-insured sub-prime, net interest margin (NIM) securities due to deteriorating credit quality of the underlying loans.(see page 20 for a detailed explanation). Return on average equity was 3.0% in the September 2007 quarter compared to 12.8 % in the same period in 2006, respectively.
Net interest margin was 2.95% in the September 2007 quarter, expanding 10 bps and 7 bps from the June 2007 and September 2006 quarters, respectively. Net interest income was $8.0 million in the September 2007 quarter compared to $7.6 million in the June 2007 quarter (increasing 5.5%) and $7.7 million in the September 2006 quarter (increasing 4.4%). Favorable funding dynamics, widening credit spreads, the positive effect from repositioning the investment portfolio in the June 2007 quarter, and growth in average earning assets drove the improvement in margin and net interest income. HWFG believes it is prudent to focus on building the core franchise of loans and deposits under its loan, investment and deposit pricing disciplines and sacrificing some growth, if competitive conditions warrant. HWFG will remain opportunistic in making investments based on available risk-adjusted spreads sufficient to meet its targeted return in equity and risk-adjusted spreads.
Management measures the performance of the investment portfolio as the spread between its total return (interest income plus net gains and losses on securities and hedges) and one month LIBOR with a goal of achieving a spread of .75% to 1.00%. Management expects to manage the size of the investment portfolio opportunistically as equity capital levels warrant and based on the growth of core banking assets and liabilities. (See page 16 for a description of the investment portfolio).
The following tables set forth, for the periods presented, information regarding (i) the total dollar amount of interest income from interest-earning assets and the resultant average yields; (ii) the total dollar amount of interest expense on interest-bearing liabilities and the resultant average rate; (iii) net interest income before provision for loan losses; (iv) interest rate spread; and (v) net interest margin. Information is based on average daily balances during the periods presented.

The Company reported interest income of $20.2 million for the three months ended September 30, 2007, compared to $19.0 million for the three months ended September 30, 2006, an increase of $1.3 million or 6.67%. The Company reported interest income of $58.9 million for the nine months ended September 30, 2007, compared to $54.8 million for the nine months ended September 30, 2006, an increase of $4.0 million or 7.35%. The primary reason for the increase during the periods was the increase in the volume of net loans receivable and a higher yield on securities and loans due to the repositioning of the investment portfolio in the June 2007 quarter and the addition of higher yielding investment grade mortgage securities.
The Company reported total interest expense of $12.2 million for the three months ended September 30, 2007, compared to $11.3 million for the three months ended September 30, 2006, an increase of $925 thousand or 8.20%. For the nine months ended September 30, 2007, the Company reported total interest expense of $35.5 million, compared to $31.6 million for the nine months ended September 30, 2006, an increase of $3.9 million or 12.28%. The increase in interest expense during the period was attributable to an increase in both the volume and cost of interest-bearing deposits during the periods ending September 30, 2007.

The provision reflects the reserves required based upon, among other things, the Company’s analysis of the composition, credit quality and shift to growth of its single-family real estate and construction loans and decrease in commercial and industrial and other segments of the loan portfolios. Our allowance for loan losses has four components: (i) an allocated allowance for specifically identified problem loans, (ii) a formula allowance for non-homogenous loans, (iii) a formula allowance for large groups of smaller balance homogenous loans and (iv) an unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a model based on historical losses as an indicator of future losses and as a result could differ from the losses incurred in the future; however, since this history is updated with the most recent loss information, the differences that might otherwise occur may be mitigated. The specific allowance uses various techniques to arrive at an estimate of loss. Historical loss information, discounted cash flows, fair market value of collateral and secondary market information are all used to estimate those losses.
Banking fee and other income was $1.0 million in the September 2007 quarter compared with $1.1 million in the June 2007 quarter and $931 thousand in the September 2006 quarter. Harrington Wealth Management Fee income, BOLI income, and Deposit fee income drove the growth in banking fees over the comparable September 2006 and 2007 quarters, while prepayment penalty fee income decreased due to lower levels of prepayments.

Operating expenses were stable at $5.7 million in the September 2007 quarter compared to $5.7 million in the June 2007 quarter and up only 3.7% over the $5.5 million of the September 2006 quarter. Operating expenses increased 4.3% in 2007 as compared to the first nine months of 2006. HWFG continues to invest in business development officers in its loan and HWM divisions and grow the number of its banking centers on a measured basis, while attempting to control other costs. During the last year, HWFG added a banking center in the Kansas City metro and added four new commercial lenders and two business development officers throughout the franchise. The cost of additional lenders and business development officers and higher benefit costs have been offset by lower incentive compensation, consulting fees, and market expenses in 2007. As previously announced, HWFG terminated its Portfolio and Rate Risk Analysis Agreement with Smith Breeden Associates Inc, as of April 30, 2007, and fully implemented these functions on an in-house basis with marginal cost savings in the quarter.
HWFG’s tax rate stabilized at 37.4% in the September 2007 quarter compared to the 34.7% tax rate in the September 2006 quarter, where HWFG benefited from a favorable tax ruling by the Franchise Tax Board of California on the apportionment of income to the states where HWFG does business.

Financial Condition
The purpose of this section is to elaborate on the nature of and reasons for the changes in HWFG’s balance sheet and its financial condition in the September 2007 quarter. Although HWFG’s core mission is to develop its loans, deposits, and HWM and other banking fees in its multiple markets, HWFG has, since its founding in 1996, invested in primarily mortgage and related securities when opportunities are favorable in an effort to create incremental profits and increase the book value of equity. In the September 2007 quarter, HWFG capitalized on the unprecedented dislocations in the mortgage markets by adding mortgage related securities at high risk-adjusted spreads based on its analysis.
Securities
The U.S. residential mortgage market is estimated to be in excess of $10 trillion in outstanding principal amount. The sub-prime portion of this market is approximately 12% of the total or $1.2 trillion. Sub-prime mortgage loans are generally considered the lowest credit segment in the mortgage market as the borrowers have low credit scores (FICO scores under 660). HWFG is not a program originator of sub-prime loans but does invest in investment grade sub-prime securities, largely rated AAA or AA by one or more rating agency, in a portion of its investment portfolio when HWFG’s analysis indicates the spreads and return potential of these securities are high relative to the underlying risk.
Few sub-prime mortgages are held by the entities that originated them. Most of these mortgages are pooled and securitized into a trust structure. The trust will then issue bonds to finance the sub-prime mortgages, and these mortgages and related securities will be serviced by a third party. The securities issued typically consist of senior and subordinate bonds, or tranches, and a small equity piece referred to as over-collateralization (OC). OC is the amount by which the assets owned by the trust exceed the liabilities (the sub-prime securities) issued. Senior bonds are typically rated AAA and have payment priority over the subordinate tranches. The subordinate tranches are typically issued with ratings from AA down to BB. A subordinate security with a higher credit rating has payment priority over those with lower ratings in the event of credit loss. The credit performance of these securities vary widely based on the year of origination, the underwriting standards, the servicer’s expertise and the loan to value of the underlying loans. The sub-prime market is therefore very fragmented, allowing for excess returns through favorable analysis and selection of securities.
In order for the securities, or tranches, issued by the mortgage trust to attain high ratings, the rating agencies require certain levels of protection in the form of OC and subordination. Collectively these are referred to as credit enhancement. The amount of credit enhancement required is based on the characteristics of the loans in the trust. These characteristics are used by rating agencies to project the likelihood of future defaults and losses on the collateral. For the lowest rated tranche, this support will generally be limited to the OC. To increase the rating of the security to AAA, however, further protection in the form of subordination covers expected losses by many times. For example, credit enhancement of 20% or greater in many AA and AAA securities is made up of 4% OC and 16% subordination from the tranches junior to these securities in payment priority in the event of loss.
Based on the extremely poor performance of sub-prime loans originated between late 2005 and early 2007, it appears that rating agencies’ models were inaccurate in their projections of delinquencies and defaults and perhaps relied too heavily on historical performance, which focused on a very low mortgage rate and very high home price appreciation environment. As a result, the “sizing” of the required credit enhancement for a given rating appears too small based on recent performance of sub-prime mortgages originated in this period. Over the course of 2007, rating agencies have revised downward their original ratings on hundreds of sub-prime mortgage securities which were issued during the 2005-2007 time period.
A significant portion of the sub-prime write-downs incurred by larger financial institutions and investment banks in the September 2007 quarter have been on Collateralized Debt Obligations (CDO) with largely BBB and BBB- sub-prime securities as the collateral for these CDOs. These BBB securities were then tranched to provide the higher rated CDO securities priority on the cash flows of these BBB securities. However, with the large delinquencies of the underlying sub-prime loans issued in the 2005 to 2007 period and the very low subordination of the BBB securities, a leveraging of credit risk occurred and even some AAA rated CDO securities have incurred write-downs. HWFG has not invested in sub-prime CDO’s.
HWFG does not rely solely on the rating agencies’ analysis and ratings of sub-prime securities. Management performs its own independent analysis of the expected cash flows for more extreme delinquency, default, and estimates of losses incurred in the foreclosure and sale process to determine whether credit enhancement is sufficient for the spread to be earned relative to the risk of default. HWFG also reviews the nature of the issuers and their underwriting performance as well as the capabilities and performance of the servicers of the underlying loans and securities.
In the September 2007 quarter, as delinquency and loss factors increased significantly and ratings were adjusted by the agencies on the sub-prime securities, spreads on almost all mortgage loan and related securities widened precipitously as credit conditions deteriorated and a sharp re-pricing of credit risk developed on almost all fixed income credit classes. Historically, periods of extreme market stress present excellent opportunities for HWFG to add high quality securities at wide risk-adjusted spreads. The AFS portfolio had been reduced by $114.5 million over the last two years of tighter spreads, higher home valuations, and more liberal underwriting standards, it was in a position to respond to the liquidity crisis and capitalize on the resulting higher spread environment in the September 2007 quarter.
In the September 2007 quarter, HWFG added $98.4 million of high credit quality mortgage related investments to its available for sale (AFS) portfolio, which increased to $355.3 million net of pay-downs at September 20, 2007 from $286.4 million at June 30, 2007.

On an ongoing basis HWFG monitors and evaluates the credit ratings and performance of its entire portfolio of mortgage related securities. HWFG performs stress testing of the cash flows on lower rated securities by projecting higher levels of delinquency, default, and losses on underlying foreclosed loans. During the third quarter evaluation, it was determined that a small portion of the sub-prime portfolio (1.4% of book value) had become impaired, which relies on the spread between the sub-prime loans and issued securities plus prepayment penalty fees rather than the principal and interest of the loans like almost all of HWFG’s other sub-prime securities. That is, all $2.4 million book value of non-insured, NIM sub-prime securities were deemed other than temporarily impaired, and these securities were written down by $1.9 million to market value through earnings in the September 2007 quarter. The NIM securities were purchased on average approximately 18 months ago, have paid down approximately 79% of the original principal amount, and were originally investment-grade rated. Several factors are evaluated in management’s stress-testing and conclusions. These factors include a dramatic increase in the level of delinquencies, losses on the liquidation of collateral, declines in over-collateralization amounts and ratings downgrades on some of the securities. Based on its ongoing monitoring, HWFG expects to earn all interest and principal on its other AFS mortgage investment securities; however, a more severe deterioration of the housing and credit markets, beyond stress test levels, could lead to additional write-offs.

With the re-pricing of risk and widening of spreads, HWFG also reinitiated a holding of commercial mortgage backed securities (CMBS) total rate of return (TROR) swaps to capitalize on the wider spreads. A position of $70 million notional amount of AAA rated CMBS TROR swaps was added at progressively wider spread levels throughout the quarter. This investment earns a spread (about 80 bps) between the AAA rated CMBS 8.5+ year index yield and the adjusted 10 year LIBOR swap rate on the notional amount of the swaps plus the gain or loss from the change in this spread over the holding period of six months. For example, a 10 bps tightening or widening of this spread on $70 million notional amount of AAA CMBS results in approximately a $492 thousand gain or loss, respectively. At September 30, 2007, spreads widened a weighted average of approximately 8 bps from initiation of the swaps, resulting in a pre-tax mark to market loss of $387 thousand loss in the September 2007 quarter. Prior to reinitiating a CMBS TROR swap position in the September 2007 quarter, HWFG had earned $5.9 million pre-tax on TROR swaps in the period from 2003 to 2006. HWFG’s analysis of CMBS spreads continues to indicate a favorable profit opportunity, in that spreads remain wide on a historical basis and are expected to tighten.

Loans
The Company’s primary focus with respect to its lending operations has historically been the direct origination of single-family and multi-family residential, commercial real estate, business, and consumer loans. As part of its strategic plan to diversify its loan portfolio, the Company, starting in 2000, has been increasing its emphasis on loans secured by commercial real estate, industrial loans and consumer loans.
Loan growth has been slower over the last year at 3.1% relative to HWFG’s historical and target performance, as HWFG has maintained a cautious position on the housing and economic environment. Net loans reached $766.0 million at September 30, 2007 compared to $743.3 million at September 30, 2006. Competition remains robust with undisciplined pricing by some market participants. HWFG anticipates that the spread widening, if sustained, in the securitized loan markets will eventually spill over into the banking markets, and HWFG’s loan growth will trend toward its historical and target levels of 8% to 12% over the next year.
The Company recognizes that certain types of loans are inherently riskier than others. For instance, the commercial real estate loans that the Company makes are riskier than home mortgages because they are generally larger, often rely on income from small-business tenants, and historically have produced higher default rates on an industry wide basis. Likewise commercial loans are riskier than consumer and mortgage loans because they are generally larger and depend upon the success of often complex businesses. Furthermore construction loans and land acquisition and development loans present higher credit risk than do other real estate loans due to their speculative nature. Unsecured loans are also inherently riskier than collateralized loans. However, these loans also provide a higher risk-adjusted margin and diversification benefits to the loan portfolio.
Loan quality was stable in the quarter. Non-performing loans were $1.9 million or .16% of the total assets at September 30, 2007 vs. $98 thousand, or .01% of total assets as of December 31, 2006. Virtually all of the $1.9 million in non-performing loans at September 30, 2007 relates to an upscale, single family development loan participation in California, where the lead participant was unable to reach terms with the borrower by quarter’s end on a suitable extension and forbearance agreement. HWFG increased its allowance for loan losses by $200 thousand in the quarter to $6.3 million or .82% of total loans at September 30, 2007. Although non-performing loans were stable, given the current housing market, credit conditions, and HWFG’s credit risk analysis, this provision was made.

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