-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, SHldC9T8EAoEYxiMmF7cJ9rNkN7GNCOrgSH3002SMeSuxtGrEaAp5YJ8LNiWXjlp cFtmTA15mr93eBQSj+AB1w== 0000939057-96-000022.txt : 19960626 0000939057-96-000022.hdr.sgml : 19960626 ACCESSION NUMBER: 0000939057-96-000022 CONFORMED SUBMISSION TYPE: 10KSB40 PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19960331 FILED AS OF DATE: 19960625 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: SECURITY FEDERAL CORPORATION CENTRAL INDEX KEY: 0000818677 STANDARD INDUSTRIAL CLASSIFICATION: SAVINGS INSTITUTION, FEDERALLY CHARTERED [6035] IRS NUMBER: 570858504 STATE OF INCORPORATION: DE FISCAL YEAR END: 0331 FILING VALUES: FORM TYPE: 10KSB40 SEC ACT: 1934 Act SEC FILE NUMBER: 000-16120 FILM NUMBER: 96585412 BUSINESS ADDRESS: STREET 1: P O BOX 810 CITY: AIKEN STATE: SC ZIP: 29802 BUSINESS PHONE: 8036413000 MAIL ADDRESS: STREET 1: P O BOX 810 CITY: AIKEN STATE: SC ZIP: 29802 10KSB40 1 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ___________________________ FORM 10-KSB [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended March 31, 1996 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number: 0-16120 SECURITY FEDERAL CORPORATION (Exact name of registrant as specified in its charter) Delaware 57-08580504 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1705 Whiskey Road South, Aiken, South Carolina 29803 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (803) 641-3000 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $0.01 per share (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [x] NO [ ] Indicate by check mark whether disclosure of delinquent filers pursuant to Item 405 of Regulation S-B is not contained herein, and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or other information statements incorporated by reference in Part III of this Form 10-KSB or any amendments to this Form 10-KSB. [X] The registrant's revenues for the fiscal year ended March 31, 1996 were $17,290,356. As of June 14, 1996, there were issued and outstanding 413,184 shares of the registrant's Common Stock. The aggregate market value of the voting stock held by non-affiliates of the registrant, computed by reference to the average of the bid and asked price of such stock as of June 14, 1996, was $8.3 million. (The exclusion from such amount of the market value of the shares owned by any person shall not be deemed an admission by the registrant that such person is an affiliate of the registrant). DOCUMENTS INCORPORATED BY REFERENCE Part III of Form 10-KSB - Proxy Statement for 1996 Annual Meeting of Shareholders. Transitional Small Business Disclosure Format (check one) Yes No X PART I Item 1. Business Security Federal Corporation Security Federal Corporation (the "Company") was incorporated under the laws of the State of Delaware in July 1987 by authorization of the Board of Directors of Security Federal Savings Bank of South Carolina ("Security Federal" or the "Bank") for the purpose of becoming a savings and loan holding company that acquired all of the outstanding stock of Security Federal issued upon the conversion of Security Federal from the mutual to the stock form (the "Conversion"). Effective April 8, 1996, the Bank changed its name to Security Federal Bank. As a Delaware corporation, the Company is authorized to engage in any activity permitted by Delaware General Corporation Law. The Company is a unitary savings and loan holding company. Through the unitary holding company structure, it is possible to expand the size and scope of the financial services offered beyond those currently offered by the Bank. The holding company structure also provides the Company with greater flexibility than the Bank would have to diversify its business activities, through existing or newly formed subsidiaries, or through acquisitions or mergers of stock thrift institutions as well as other companies. Although there are no current arrangements, understandings or agreements regarding any such acquisition, the Company is in a position to take advantage of any favorable acquisition opportunities that may arise. Future activities of the Company, other than the continuing operations of Security Federal, will be funded through dividends from Security Federal and through borrowings from third parties. See "Regulation -- Savings and Loan Holding Company Regulation" and "Taxation." Activities of the Company may also be funded through sales of additional securities or income generated by other activities of the Company. At this time, there are no plans regarding such activities. At March 31, 1996, the Company had assets of approximately $214.8 million, deposits of approximately $172.4 million and shareholders' equity of approximately $15.4 million. The executive office of the Company is located at 1705 Whiskey Road South, Aiken, South Carolina 29803, telephone (803) 641-3000. Security Federal Bank General. Security Federal, a federally chartered stock savings bank, is headquartered in Aiken, South Carolina. Security Federal, which has ten branch offices in Aiken and Bamberg counties, was originally chartered under the name Aiken Building and Loan Association on March 27, 1922. The association received its federal charter and changed its name to Security Federal Savings and Loan Association of Aiken on March 7, 1962, and later changed its name to Security Federal Savings Bank of South Carolina, on November 11, 1986. The Bank converted from the mutual to the stock form of organization on October 30, 1987. Security Federal increased its branch network to nine in October 1993 with the completion of its acquisition of four former NationsBank of South Carolina, N.A. branches located in Aiken County. In February 1996, Security Federal opened a new branch office in the Aiken Walmart Superstore, which became the Bank's tenth location. The principal business of Security Federal is the acceptance of savings deposits from the general public and the origination of mortgage loans to enable borrowers to purchase or refinance one- to four-family residential real estate. The Bank also makes loans secured by multi-family residential and commercial real estate and consumer and commercial loans. In addition, the Bank originates construction loans on single family residences, multi-family dwellings and projects, commercial real estate, and loans for the acquisition, development and construction of residential subdivisions and commercial projects. Security Federal's income is derived primarily from interest and fees earned in connection with its lending activities, and its principal expenses are interest paid on savings deposits and borrowings and operating expenses. Through its wholly owned subsidiary, Security Financial Services Corporation ("SFSC"), Security Federal has been and is involved in real estate development activity. The Aiken area's largest employer, the Savannah River Site, had significant downsizing of personnel which creates some uncertainty regarding the local economy. In addition, real estate sales have been slower than in past years. Management continues to monitor the Bank's allowance for loan losses for the impact of local economic changes. See "-- Loan Delinquencies and Defaults." Lending Activities General. The primary source of revenue for the Bank is interest and fee income from lending activities. The principal lending activity of the Bank is making conventional first mortgage real estate loans to enable borrowers to purchase or refinance one- to four-family residential real property. The Bank also makes loans secured by multi-family residential and commercial real estate and consumer and commercial loans. The Bank continues to emphasize the origination of adjustable rate residential mortgage loans, subject to market conditions, for retention in its portfolio. In addition, the Bank originates construction loans on single family residences, multi-family dwellings and projects, commercial real estate, and loans for the acquisition, development and construction of residential subdivisions and commercial projects. Adjustable rate mortgage loans ("ARMs") have been offered on all types of properties since 1980 and, at March 31, 1996, constituted approximately 36.9% of the Bank's total outstanding loan portfolio. The loan-to-value ratio, maturity and other provisions of loans made by the Bank reflect its policy of making the maximum loan permissible consistent with applicable regulations, established lending policies and market conditions. The Bank requires title insurance (or acceptable legal opinions on smaller loans secured by real estate) and fire insurance, and flood insurance where applicable, on loans secured by improved real estate. Loan Portfolio Composition. The following table sets forth information concerning the composition of the Bank's loan portfolio in dollar amounts in percentages, by type of loan and by type of security, and presents a reconciliation of total loans receivable before net items. At March 31, 1996 1995 1994 1993 1992 Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent (Dollars in Thousands) TYPE OF LOAN: Fixed Rate Loans Real Estate: Residential(1).. $ 11,846 7.6% $ 15,998 10.4% $ 16,467 12.3% $ 28,286 25.1% $ 34,968 29.0% Commercial(2). . 2,280 1.6 2,580 1.7 6,032 4.5 5,822 5.2 4,563 3.8 Total real estate loans . 14,126 9.2 18,578 12.1 22,499 16.8 34,108 30.3 39,531 32.8 Commercial business. . . . 15,804 10.2 11,986 7.8 7,258 5.4 1,641 1.5 922 0.8 Consumer(3). . . 22,635 14.6 20,450 13.3 18,347 13.7 9,506 8.4 9,058 7.5 Total fixed rate loans. . . 52,565 34.0 51,014 33.2 48,104 35.9 45,255 40.2 49,511 41.1 Adjustable rate loans Real Estate: Residential(1). . 48,718 31.5 51,004 33.1 32,704 24.4 26,355 23.4 38,350 31.8 Commercial(2) . . 8,350 5.4 10,428 6.8 15,425 11.5 14,087 12.5 9,588 8.0 Total real estate loans . 57,068 36.9 61,432 39.9 48,129 35.9 40,442 35.9 47,938 39.8 Commercial business. . . . . 22,960 14.8 17,732 11.5 13,757 10.3 10,425 9.2 7,622 6.3 Consumer(3). . . . 22,175 14.3 23,639 15.4 23,958 17.9 16,567 14.7 15,482 12.8 Total adjustable rate loans . . . 102,203 66.0 102,803 66.8 85,844 64.1 67,434 59.8 71,042 58.9 Total loans . . 154,768 100.0% 153,817 100.0% 133,948 100.0% 112,689 100.0% 120,553 100.0% Less Loans in process . 474 2,419 6,628 4,356 3,461 Deferred fees and discounts . . 395 466 237 269 236 Allowance for loan losses . . . 1,759 1,955 1,735 1,191 819 Total loans receivable . . .$152,140 $148,977 $125,348 $106,873 $116,037 (1) Includes $2.5 million, $2.5 million, $750,477, $378,193 and $1.0 million in multi-family dwellings for fiscal years ended March 31, 1996, 1995, 1994, 1993 and 1992, respectively. Includes residential construction loans. (2) Includes acquisition, development and commercial construction loans. (3) Includes home improvement loans.
At March 31, 1996 1995 1994 1993 1992 Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent (Dollars in Thousands) TYPE OF SECURITY: Real Estate Loans: Residential(1). . $ 59,613 38.5% $ 60,528 39.3% $ 38,703 28.9% $ 52,444 46.5% $ 61,816 51.3% Commercial. . . . 9,977 6.5 11,203 7.3 15,310 11.4 13,052 11.7 11,997 10.0 Construction or development(2). . 1,604 1.0 8,279 5.4 16,615 12.4 9,054 8.0 13,656 11.3 Total real estate loans . . 71,194 46.0 80,010 52.0 70,628 52.7 74,550 66.2 87,469 72.6 Commercial business. . . . . 38,764 25.1 29,718 19.3 21,015 15.7 12,066 10.7 8,544 7.0 Consumer loans: Deposit account . 1,299 0.8 1,145 0.8 1,565 1.2 618 0.5 1,015 0.9 Home equity . . . 14,767 9.6 16,029 10.4 16,735 12.5 15,621 13.9 14,638 12.1 Home improvement. 18,154 11.7 16,283 10.6 13,796 10.3 4,658 4.1 2,755 2.3 Other . . . . . . 10,590 6.8 10,632 6.9 10,209 7.6 5,176 4.6 6,132 5.1 Total consumer loans. . . . . 44,810 28.9 44,089 28.7 42,305 31.6 26,073 23.1 24,540 20.4 Total loans . 154,768 100.0% 153,817 100.0% 133,948 100.0% 112,689 100.0% 120,553 100.0% Less: Loans in process . 474 2,419 6,628 4,356 3,461 Deferred fees and discounts. . 395 466 237 269 236 Allowance for loan losses. . . 1,759 1,955 1,735 1,191 819 Total loans receivable . . $152,140 $148,977 $125,348 $106,873 $116,037 (1) Includes $2.5 million, $2.5 million, $750,477, $378,193 and $1.0 million in multi-family dwellings for fiscal years ended March 31, 1996, 1995, 1994, 1993 and 1992, respectively. (2) Includes residential and commercial real estate construction and development loans.
The following schedule illustrates the interest rate sensitivity of Security Federal's loan portfolio at March 31, 1996. Mortgages which have adjustable or renegotiable interest rates are shown as maturing in the period when the contract is due. This schedule does not reflect the effects of possible prepayments or enforcement of due-on-sale clauses. At March 31, 1996 Real Estate Commercial Residential(1) Commercial Consumer(2) Business Total (Dollars in Thousands) Six months or less(3). . . . . . $ 1,356 $ 678 $ 4,246 $ 4,925 $11,205 Over six months to one year. . . . 1,459 717 3,475 8,872 14,524 Over one year to three years . . 1,831 1,022 11,318 11,411 25,582 Three to five years. . . . . . . 2,117 2,192 11,828 7,996 24,133 Over five to ten years . . . . . . 5,861 3,369 7,352 5,299 21,881 Over ten to twenty years . . . 24,088 2,652 6,591 260 33,591 More than twenty years . . . . . . 23,378 -- -- -- 23,738 Total(4). . . . $60,090 $10,630 $44,810 $38,764 $154,294 (1) Includes multi-family dwellings. (2) Includes home improvement loans and equity line of credit loans. (3) Includes demand loans, loans having no stated maturity and overdraft loans (4) Loan amounts are net of undisbursed funds for loans in process of $474,000. The total amount of loans due after March 31, 1997, which have predetermined interest rates is $38.5 million, while the total amount of loans due after such date which have floating or adjustable interest rates is $90.0 million. Loan Originations, Purchases and Sales. The following table shows the loan origination, purchase, sale and repayment activities of the Bank for the periods indicated. Year Ended March 31, 1996 1995 1994 1993 1992 (In Thousands) Originated(1): Real estate: Adjustable rate - residential. . $ 3,684 $28,608 $ 9,485 $ 1,229 $4,863 Adjustable rate - commercial . . -- 187 5,145 3,821 6,123 Total adjustable rate. . . . . 3,684 28,795 14,630 5,050 10,986 Fixed rate - residential . . . . 5,332 4,729 49,966 55,188 28,206 Fixed rate - commercial. . . . . -- -- -- 1,209 250 Total fixed rate . . . . . . . 5,332 4,729 49,966 56,397 28,456 Non-real estate: Consumer . . . . . . . . . . . . $16,994 $18,362 6,205 6,199 7,610 Commercial business. . . . . . . 27,465 25,529 10,626 7,290 6,660 Total non-real estate . . . . 44,459 43,891 16,381 13,489 14,270 Total loans originated. $53,475 $77,415 $81,427 $74,936 $53,712 Loans acquired in acquisition: Non-real estate: Consumer . . . . . . . . . . . . $ -- $ -- $13,507 $ -- $ -- Commercial business. . . . . . . -- -- 2,717 -- -- Total loans acquired. . . . . $ -- $ -- $16,224 $ -- $ -- Sold(1): Fixed rate: Real estate - residential. . . . $ 5,496 $ 3,090 $47,651 $50,439 $20,047 Adjustable rate: Real estate - residential. . . -- 4,450 -- -- -- Principal repayments . . . . . . 42,604 42,396 34,309 34,962 30,543 Increase (decrease) in other items, net. . . . . . . . . . (2,212) (3,760) 2,784 1,300 541 Net increase (decrease). . . . . 3,163 $23,629 $18,475 $(9,165) $3,663 (1) Does not include loans in the amount of $6.9 million, $8.4 million, $17.4 million, $12.4 million and $17.7 million that were originated with prior commitments to be purchased by institutional investors and sold during the fiscal years ended March 31, 1996, 1995, 1994, 1993 and 1992, respectively. In addition to interest earned on loans, the Bank receives loan origination fees or "points" for originating loans. Loan points are a percentage of the principal amount of the mortgage loan which are charged to the borrower for the creation of the loan. The Bank's loan origination fees generally range from 1% to 2% on conventional residential mortgages, commercial real estate loans and commercial business loans. The total fee income (including amounts amortized to income as yield adjustments) for the fiscal year ended March 31, 1996 was $304,575. Loan origination and commitment fees are volatile sources of income. Such fees vary with the volume and type of loans and commitments made and purchased and with competitive conditions in mortgage markets, which in turn are governed by the demand for and availability of money. The following table shows deferred loan origination fees recognized as income by the Bank expressed as a percentage of the dollar amount of total mortgage loans originated (and retained in the Bank's portfolio) and purchased during the periods indicated and the dollar amount of deferred loan origination fees at the end of each respective period. At or for the Year Ended March 31, 1996 1995 1994 (Dollars in Thousands) Deferred loan origination fees/expense earned during the period(1) . . . . $102,906 $126,815 $317,502 Mortgage loan origination fees earned as a percentage of total loans originated during the period. . 1.1% 0.4% 0.5% Deferred loan origination fees/expense in loan portfolio at end of period . . . . . . . . . . . . . . $394,768 $466,250 $236,649 (1) Includes amounts amortized to interest income as yield adjustments. Does not include fees earned on loans sold. The Bank also receives other fees and charges related to existing loans, conversion fees, assumption fees, late charges, and other fees collected in connection with a change in borrower or other loan modifications. Security Federal currently sells substantially all conforming fixed-rate loans with terms of 15 years or greater in the secondary mortgage market. These loans are sold in order to provide a source of funds and as one of the strategies available to close the gap between the maturities of its interest-earning assets and interest-bearing liabilities. Currently, most fixed-rate, long-term mortgage loans are being originated based on Federal National Mortgage Association ("FNMA") and Federal Home Loan Mortgage Corporation ("FHLMC") underwriting standards. Secondary market sales have been made primarily to the FHLMC or FNMA and, to a lesser extent, other savings and loan associations, banks, and other investors. The FHLMC and FNMA are quasi-governmental agencies that purchase residential mortgage loans from federally insured financial institutions and certain other lenders. All loans sold were sold without recourse to Security Federal. Security Federal ordinarily retains the servicing of the loans (i.e., collection of principal and interest payments), for which it generally recognizes a fee of 1/4 to 1/2 of one percent per annum of the unpaid principal balance of each loan. At March 31, 1996, Security Federal serviced approximately $153.3 million in mortgage loans, including approximately $93.3 million which the Bank serviced for others. At March 31, 1996, the Bank held $612,919 of loans for sale. All of such loans were originated for other financial institutions based upon prior commitments to purchase the loans at a set price. As a result, these loans present no market risk to Security Federal. These loans are normally delivered and paid for within 30 days after the date of closing. The Bank actively solicits mortgage loan applications from existing customers, real estate agents, builders, real estate developers and others. The Bank also receives mortgage loan applications as a result of customer referrals and from walk-in customers. Detailed loan applications are obtained to determine the borrower's creditworthiness and ability to repay, and the more significant items on these applications are verified through the use of credit reports, financial statements and confirmations. After analysis of the loan application and property or collateral involved, including an appraisal of the property (residential appraisals are obtained through independent fee appraisers), the lending decision is made in accordance with the underwriting guidelines of the Bank. These guidelines are generally consistent with FHLMC and FNMA guidelines for residential real estate loans. With respect to commercial real estate loans, the Bank also reviews the capital adequacy of the business, the income potential of the property, the ability of the borrower to repay the loan and honor its other obligations, and general economic and industry conditions. Upon receipt of a loan application and all required related information from a prospective borrower, the loan application is submitted for approval or rejection. The residential mortgage loan underwriter approves loans which meet FHLMC and FNMA underwriting requirements, not to exceed $203,150 per loan, and the government loan direct endorser approves FHA loans not to exceed $97,350 and VA loans not to exceed $203,000. However, the Bank does submit some FHA and VA loans to the Department of Housing and Urban Development for approval. The Chairman, Chief Executive Officer, Senior Mortgage Officer or Senior Consumer/Commercial Loan Officer approve loans of $200,000 or less, except as set forth above. Loans in excess of $200,000 require approval of one of the above and the Chairman of the Board and any loan in an amount in excess of $300,000 must be approved by the Bank's Executive Committee, which operates as the Bank's Loan Committee. The loan approval limits shown are the aggregate of all loans to any one borrower or entity. It is the general policy of Security Federal to issue loan commitments to qualified borrowers for a specified time period. These commitments are generally for a period of 45 days or less. With management approval, commitments may be extended for a longer period. The total outstanding amount of mortgage loan commitments issued by Security Federal as of March 31, 1996, was approximately $603,745 (excluding undisbursed portions of construction loans in process). Security Federal also had outstanding commitments available on retail lines of credit (including home equity and other consumer loans) totalling $16.7 million as of March 31, 1996. See Note 13 of Notes to Consolidated Financial Statements. Relationships With Mortgage Brokers and Other Financial Institutions (Correspondents). Commencing in 1984, the Bank established relationships with various South Carolina and Georgia mortgage brokers and other financial institutions ("correspondents") which originate loans for Security Federal using the Bank's existing loan programs. In such instances, the correspondent handles all the loan processing and credit reports. All loans closed under this lending program must be approved by Security Federal prior to closing and must meet Security Federal's underwriting standards. Loans are typically closed in the name of Security Federal. Both Security Federal and the correspondent receive fees in connection with the origination of the loans. Typically, Security Federal receives a fee of from 1% to 2% on each residential and commercial mortgage loan closed through this program. The Bank performs the servicing on correspondent-originated loans after the closing. During the fiscal year ended March 31, 1996, the Bank did not originate any residential mortgage loans through this lending program. The Bank intends to continue to utilize this program to supplement direct originations, although the ultimate success (and existence) of the program is subject to market conditions and other factors beyond the Bank's control. Most real estate loans originated by the Bank contain a "due-on-sale" clause providing that the Bank may declare the unpaid principal balance due and payable upon the disposition of the mortgaged property. The Bank enforces these due-on-sale clauses to the extent permitted by law, taking into consideration other business factors. Permanent Residential Mortgage lending. Residential real estate mortgage loans constituted approximately 38.5% of the Bank's total outstanding loan portfolio at March 31, 1996. Prior to 1980, the Bank generally made residential real estate mortgage loans on a long-term fixed-rate basis to be held in its own portfolio. In accordance with then applicable federal regulations, the Bank's single-family residential mortgage loans historically provided for fixed rates of interest and for repayment of principal for terms of up to 30 years. However, the Bank's fixed- single-family residential loans normally have remained outstanding for significantly shorter periods because theborrowers have prepaid the loans in full upon sale of the security property, due to the due-on-sale clauses generallycontained in the Bank's first mortgages, or upon the refinancing of the original loan. Most of the Bank's fixed-rate mortgage loans are underwritten according to standards that would allow them to be sold into the secondary market. The Bank currently sells in the secondary market substantially all of its fixed-rate loans with terms to maturity of 15 years or greater. For the fiscal year ended March 31, 1996, $6.9 million in loans were originated with prior commitments to purchase such loans by other institutional investors at a fixed price. These loans were carried in the Bank's "loans held for sale" portfolio. In addition, during fiscal 1996, $5.5 million in loans were originated and sold to FHLMC and FNMA. At March 31, 1996, fixed-rate, residential mortgage loans totalled $11.8 million, or 7.6% of the Bank's loan portfolio. Since 1980, Security Federal has also offered a variety of ARMs which offer adjustable rates of interest, payments, loan balances or terms to maturity which vary according to specified indices. The Bank's ARMs generally have a loan term of 15 to 30 years with rate adjustments every one to three years during the term of the loan. Most of the Bank's ARMs contain a 100 or 200 basis point limit as to the maximum amount of change in the interest rate at any adjustment period and a 500 or 600 basis point limit over the life of the loan. The Bank generally originates ARMs to hold in its portfolio. Such loans are generally made consistent with FHLMC and FNMA guidelines. At March 31, 1996, residential ARMs totalled $48.7 million, or 31.5% of the Bank's loan portfolio. For the year ended March 31, 1996, the Bank originated $9.0 million in residential real estate loans, 40.9% of which had adjustable rates of interest. There are unquantifiable risks resulting from possible increased costs to the borrower as a result of periodic repricing. Despite the benefits of ARMs to the Bank's asset/liability management program, such loans also pose potential additional risks, primarily because as interest rates rise, the underlying payment by the borrower rises, increasing the potential for default. At the same time, marketability of the underlying property may be adversely affected by higher interest rates. When making a one- to four-family residential mortgage loan, the Bank evaluates both the borrower's creditworthiness and his or her general ability to make principal and interest payments and the value of the property that will secure the loan. The Bank generally makes loans on one- to four-family residential properties in amounts of 95% or less of the appraised value thereof. Where loans are made in amounts which exceed 80% of the appraised value of the underlying real estate, the Bank's general policy is to require private mortgage insurance on a portion of the loan. In general, the Bank restricts its residential lending to South Carolina and the nearby Augusta, Georgia market. During fiscal 1988, the Bank began to use loan originators who are employed on a commission basis solely to originate mortgage loans and opened a loan production office in 1988. Due to lower than expected loan demand, in December 1994, the Bank closed its Columbia, South Carolina loan production office. The Bank also provides construction financing for single family dwellings both to owner-occupants and to builders for resale. Construction loans are generally made for periods of six months to one year. Typically, interest rates on interim construction loans are made on a fixed-rate basis. At March 31, 1996, residential construction loans on one- to four-family dwellings totalled $951,000, or 0.6% of the Bank's loan portfolio. In addition to the factors mentioned above concerning the creditworthiness of the borrower, on loans of this type the Bank seeks to evaluate the financial condition and prior performance of the builder. Commercial Real Estate Loans. The commercial real estate and other non-residential loans ("commercial real estate loans") originated by the Bank are primarily secured by business properties, churches, income property developments, and undeveloped land. At March 31, 1996, the Bank had approximately $10.6 million, or 7.0% of the Bank's total loan portfolio, in commercial real estate loans. Commercial real estate lending entails significant additional credit risk when compared to residential lending. Commercial real estate loans typically involve large loan balances to single borrowers or groups of related borrowers. The payment experience of such loans is typically dependent upon the successful operation of the business or real estate project. These risks can be significantly affected by supply and demand conditions in the market for office and retail space and for condominiums and apartments and, as such, may be subject, to a greater extent than residential loans, to adverse conditions in the local economy. At March 31, 1996, approximately $2.5 million, or 23.4% of the Bank's commercial real estate loans, were secured by real estate located out of the State of South Carolina. The real estate securing these loans is primarily located in Georgia and North Carolina. Properties securing commercial loans originated by the Bank are appraised at the time of the loan by appraisers designated by the Bank. Although the Bank is permitted to invest in loans up to 100% of the appraised value of a property on commercial real estate loans, the Bank currently seeks to invest in loans in amounts of 80% or less of the appraised value of the underlying collateral. In underwriting these loans, it is the policy of the Bank to consider, among other things, the terms of the loan, the creditworthiness and experience of the borrower, the location and quality of the collateral, competition in the market, the debt service coverage ratio and the past performance of the project or business. Of the Bank's commercial real estate loans at March 31, 1996, only three had principal balances in excess of $1.0 million. At March 31, 1996, all of these commercial real estate loans were performing in accordance with their terms. Federal law restricts the Bank's permissible lending limits to one borrower to the greater of $500,000 or 15% of unimpaired capital and surplus. The Bank has not typically made loans to one borrower equal to the amount federal law allows or approximately $2.3 million at March 31, 1996. Permanent commercial real estate loans are generally offered with payments based on a 15- to 30-year amortization schedule but with adjustments in the interest rate every one to three years. Such interest rate adjustments are generally based on the rate for one year U.S. Treasury Securities, or the prime rate of interest, plus a margin and may not exceed 200 basis points at any adjustment period or 17% over the life of the loan. The Bank has from time to time made commercial real estate loans to affiliates. These loans are made in the ordinary course of business on substantially the same terms, rates and collateral as those of comparable transactions prevailing at the time, and do not involve more than the normal risk of collectibility or present other unfavorable features. In addition, all loans made by the Bank to its affiliates comply with Office of Thrift Supervision ("OTS") regulations restricting loans and other transactions with affiliated persons of the Bank. Acquisition, Development and Construction Loans. To a lesser extent, the Bank also originates loans for land acquisition, development and/or construction ("ADC Loans") on properties intended for single-family residences and for commercial projects such as apartments, office buildings, business properties, shopping centers, hotels and motels. All of the properties securing the Bank's ADC loan portfolio are located within the State of South Carolina. Residential ADC Loans are generally made for periods of up to three years while commercial ADC Loans are generally made for periods of up to eighteen months. ADC Loans are made generally on an interest-only payment basis at either a fixed-rate or at an indexed rate. Typically loans with a term over one year will be tied to an indexed rate and are adjustable monthly or annually during the term of the loan. The Bank generally does not require a developer to obtain a completion bond guaranteeing the completion of the financed project in the event that the developer, for any reason, is unable to perform. However, the Bank generally requires a personal guarantee of the developer in any instance in which it has not obtained a completion bond. In such cases, the Bank endeavors to ascertain the enforceability of such guaranty by making inquiry, among other things, into the underwriting criteria discussed below. In addition, supporting documentation is obtained including personal financial statements, copies of tax returns for the previous three years, credit reports and bank references. A direct check is made on all creditor references. At March 31, 1996, the Bank had outstanding ADC Loans, none of which had any profit participation features, aggregating $653,000, or .4% of its total loan portfolio. This number does not, however, include ADC Loans to one of the Company's real estate partnerships, Willow Woods, since generally accepted accounting principles treat such loans as either intercompany transactions or investments in joint ventures, respectively. At March 31, 1996, Security Federal had ADC Loans to Willow Woods aggregating $75,120, and an available line of credit of $47,973. As with commercial real estate loans, ADC Loan financing is generally considered to involve a higher degree of credit risk than long-term financing of residential or commercial properties. The Bank's risk of loss on an ADC Loan is dependent largely upon the accuracy of the initial estimate of the property's value at completion of construction or development and the estimated cost (including interest) of construction. The Bank generally makes ADC Loans in amounts up to 75% of the lesser of the appraised value or actual cost of the underlying collateral. If the estimate of construction costs and the salability of the property upon completion of the project proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to permit completion of the development. The Bank's underwriting criteria are designed to evaluate and minimize the risks of each ADC Loan. Among other factors, the Bank considers evidence of the availability of permanent financing or a takeout commitment to the borrower, the reputation of the borrower and his or her financial condition, the amount of the borrower's equity in the project, an independent or in-house appraisal and review of cost estimates, preconstruction sale and leasing information and cash flow and holding period projections of the borrowers. For a discussion of the Bank's policy with respect to loans to affiliates see "-- Commercial Real Estate Loans." Except for two loans to the Bank's subsidiary discussed above, there were no acquisition, development, and construction loans to affiliates of the Bank outstanding at March 31, 1996. See "Subsidiary Activities." Commercial Business Loans. During fiscal 1989, the Bank began to originate commercial business loans. The Bank originates commercial business loans for the purpose of financing inventory, furniture, fixtures and equipment. In addition, secured and unsecured credit lines are made available. Commercial business loans are normally short-term with a maturity from three to sixty months. Commercial business loans are made on both a fixed and adjustable rate basis. Adjustable rate loans adjust monthly or annually based on movements of the prime rate of interest as quoted in The Wall Street Journal. The underwriting standards employed by the Bank for commercial business loans include a determination of the borrower's current financial condition, ability to pay, past earnings and payment history. In addition, the current financial condition and payment history of all principals are reviewed. Normally, the Bank requires the principal or owners of a business to guarantee all loans made to their business by the Bank. Although the creditworthiness of the business and its principals is of primary consideration, the underwriting process also includes a comparison of the value of the security, if any, in relation to the proposed loan amount. At March 31, 1996, commercial business loans totalled $38.8 million, or 25.1% of the Bank's loan portfolio. Although commercial business loans, like consumer loans, involve a higher level of risk than one-to four-family residential mortgage loans, they generally carry higher yields and have shorter terms to maturity than such residential mortgage loans. Consumer Loans. The Bank originates consumer loans for any personal, family or household purpose, including but not limited to the financing of home improvements, automobiles, boats, mobile homes, recreational vehicles and education. In addition, the Bank has expanded its home equity lending program. Home equity loans are secured by mortgage lines on the borrower's principal or second residence. At March 31, 1996, the Bank had $14.8 million of home equity lines of credit outstanding and $16.7 million of additional commitments of such lines of credit. The Bank also makes secured and unsecured lines of credit available. Although consumer loans involve a higher level of risk than one- to four-family residential mortgage loans, they generally carry higher yields and have shorter terms to maturity than such loans. The Bank has increased its origination of consumer loans during the past several years and at March 31, 1996, the Bank had total consumer loans of $44.8 million, or 28.9% of the Bank's loan portfolio. The underwriting standards employed by the Bank for consumer loans include a determination of the applicant's payment history on other debts and an assessment of ability to meet existing obligations and payments on the proposed loan. The stability of the applicant's monthly income is determined by verification of gross monthly income from primary employment, and additionally from any verifiable secondary income. Although credit-worthiness of the applicant is of primary consideration, the underwriting process also includes a comparison of the value of the security, if any, in relation to the proposed loan amount. During fiscal 1988, the Bank established a separate consumer/commercial loan department to develop products and to expand its existing consumer and commercial business loan products. A full-time manager was hired to supervise this department, and presently has authority to approve consumer and commercial business loans up to $200,000, of which no more than $100,000 may be unsecured. The President has authority to approve consumer and commercial business loans up to $200,000 and the Chairman may approve loans up to $200,000. The Chairman and President or Consumer/Commercial loan manager can approve loans up to $300,000 and consumer and commercial business loans in excess of this amount must be approved by the Bank's Executive Committee, which operates as the Bank's Loan Committee. Commencing in fiscal 1989, the Bank developed a credit card program. As of March 31, 1996, 905 Visa credit cards had been issued by the Bank with total approved credit lines of $1.5 million, of which $614,847 was outstanding. Loan Delinquencies and Defaults General. The Bank's collection procedures provide that when a real estate loan is approximately 20 days past due, the borrower is contacted by mail and payment is requested. If the delinquency continues, subsequent efforts are made to contact the delinquent borrower and establish a program to bring the loan current. In certain instances, the Bank may modify the loan or grant a limited moratorium on loan payments to enable the borrower to reorganize his financial affairs. If the loan continues in a delinquent status for 60 days or more, the Bank generally initiates foreclosures proceedings after the customer has been notified by certified mail. At March 31, 1996, the Bank had property acquired as the result of foreclosures, in-substance foreclosure or by deed in lieu of foreclosure and classified as "real estate owned" valued at $718,763. Delinquent Loans. The following table sets forth information concerning delinquent mortgage and other loans at March 31, 1996. The amounts presented represent the total remaining principal balances of the related loans (before specific reserves for losses), rather than the actual payment amounts which are overdue. Real Estate Non-Real Estate Commercial Residential Commercial Consumer Business Number Amount Number Amount Number Amount Number Amount (Dollars in Thousands) Loans delinquent for: 30 - 59 days . . 5 $ 306 -- $ -- 41 $512 4 $ 94 60 - 89 days . . 9 452 -- -- 20 226 2 490 90 days and over . . . . . 6 453 2 542 12 154 7 255 Total delinquent loans . . . . . 20 $1,211 2 $542 73 $892 13 $839 Classified Assets. Federal regulations provide for the classification of loans and other assets such as debt and equity securities considered to be of lesser quality as "substandard," "doubtful" or "loss" assets. The regulation requires savings associations to classify their own assets and to establish prudent general allowances for loan losses for assets classified "substandard" or "doubtful". For the portion of assets classified as "loss", an institution is required to either establish specific allowances of 100% of the amount classified or charge off such amount. In addition, the OTS may require the establishment of a general allowance for losses based on assets classified as "substandard" and "doubtful" or based on the general quality of the asset portfolio of an association. Assets which do not currently expose the savings association to sufficient risk to warrant classification in one of the aforementioned categories but possess potential weaknesses are designated "special mention" by management. At March 31, 1996, approximately $191,357, $3,658,111 (including $2.9 million of loans and $718,763 in real estate acquired through foreclosure) and $17,119 of the Bank's assets were classified "special mention", "substandard" and "doubtful", respectively. On such date, the Bank had $1,808 loans classified as "loss." As of March 31, 1996, there were loans totalling $486,712 which were troubled debt restructuring within the meaning of FASB No. 15 of which $911 was classified substandard. In addition, the OTS may require the establishment of a general allowance for losses based on assets classified as "substandard" and "doubtful" or based on the general quality of the asset portfolio of an association. The Bank's classification of assets is consistent with OTS examination classifications. For additional information regarding the treatment of impaired loans, see "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Accounting and Reporting Changes." Non-performing Assets. The following table sets forth the amounts and categories of risk elements in the Bank's loan portfolio. Loans are placed on non-accrual status when the collection of principal and/or interest becomes doubtful. In addition, all loans are placed on non-accrual status when the loan becomes 60 days or more contractually delinquent. All consumer loans more than 90 days delinquent are charged against the consumer loan allowance for loan losses unless there is adequate collateral which is in the process of being repossessed or foreclosed on. Except for loans restructured during fiscal 1995 contained in the table below, the Bank has had no troubled debt restructuring which involve forgiving a portion of interest or principal on any loans or making loans at a rate materially less than that of market rates. Other loans of concern are those loans (not delinquent more than 60 days) that management has determined need to be closely monitored as the potential exists for increased risk on these loans in the future. Nonperforming loans are reviewed on a loan by loan basis. Specific reserves associated with these loans will vary based on estimates of recovery for each loan. March 31, 1996 1995 1994 1993 1992 (Dollars in Thousands) Non-Accruing Loans Delinquent 60 to 90 Days: Residential . . . . . . . . . $ 452 $ 148 $ -- $ -- $ 823 Commercial real estate. . . . -- 172 -- -- 147 Consumer. . . . . . . . . . . 226 47 121 101 99 Commercial business . . . . . 490 9 438 -- -- Total . . . . . . . . . . . $1,168 $ 376 $ 559 $ 101 $1,069 Total as a percentage of total assets . . . . . . .54% 0.18% 0.28% 0.07% 0.75% Non-Accruing Loans Delinquent More than 90 Days: Residential . . . . . . . . . $ 453 $ 264 $ 573 $ 398 $ 281 Commercial real estate. . . . 542 -- 298 -- 76 Consumer. . . . . . . . . . . 154 122 120 86 382 Commercial business . . . . . 255 50 -- -- -- Total . . . . . . . . . . . $1,404 $ 436 $ 991 $ 484 $ 739 Total as a percentage of total assets . . . . . . .65% .21% .50% .25% .52% Troubled debt restructuring. $ 487 $ 780 $ -- $ -- $ -- Real estate owned. . . . . . $ 719 $1,521 $1,684 $ 721 $ 989 Allowance for loan losses. . $1,759 $1,955 $1,735 $1,191 $ 819 ___________ Included in non-accrusing loan totals. For the fiscal year ended March 31, 1996, the interest income which would have been recognized with respect to non-accruing loans, had such loans been current in accordance with their original terms, totalled $82,670. At March 31, 1996, non-accrual loans, which were also considered impaired, totalled $2,572,000 compared to $812,000 at March 31, 1995. During the past five years, the Bank has classified all loans as non-accrual when they were 60 days or more delinquent. Included in non-accruing loans at March 31, 1996 were 15 one- to four-family real estate mortgage loans totalling $905,000 and 32 consumer loans totalling $380,000. Of the $380,000 in consumer loans on non-accrual status at fiscal year end, no loan exceeded $80,000 at fiscal year end. The principal component of the $745,000 in commercial business loans on non-accrual status at fiscal year end was a loan totalling $487,000 to a leasing company, which is also classified as a troubled debt restructuring. There is no loss anticipated on this loan at this time. The $542,000 in non-accruing commercial real estate loans consist of two loans. One loan for $356,000 is secured by an office building, and the other loan for $186,000 is secured by residential building lots. Both of these loans are well secured and no loss is anticipated at this time. At March 31, 1996, real estate acquired through foreclosure had an outstanding book value of $718,763 and consisted of six properties. Of the $718,763 in real estate owned at March 31, 1996, $439,005 relates to a commercial property which is located in Little River Township, South Carolina consisting of 22 residential lots with infrastructure. On May 13, 1994, the Bank entered into an agreement with the borrower to accept a deed-in-lieu of foreclosure on such property. Under the terms of the agreement, Security Federal granted the borrower a right of reconveyance on all developed lots, undeveloped lots and undeveloped raw land remaining after retirement of all debts, including direct and indirect project costs. At March 31, 1996, the Bank had sold 56 lots and two model homes for an aggregate sales price of approximately $1,950,000. Provision for Losses on Loans and Real Estate. Security Federal recognizes that credit losses will be experienced during the course of making loans and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a secured loan, the quality of the underlying security for the loan. The Bank seeks to establish and maintain sufficient reserves for estimated losses on specifically identified loans and real estate where such losses can be estimated. Additionally, general reserves for estimated possible losses are established on specified portions of the Bank's portfolio such as consumer loans and higher risk residential construction mortgage loans based on management's estimate of the potential loss for loans which normally can be classified as higher risk. Specific and general reserves are based on, among other criteria (1) the risk characteristics on the loan portfolio, (2) current economic conditions on a local as well as a statewide basis, (3) actual losses experienced historically, and (4) the level of reserves for possible losses in the future. Additionally, a reserve is maintained for uncollected interest on loans over 60 days past due. At March 31, 1996, total reserves relating to loans were $1.8 million. In determining the adequacy in the reserve for loan losses, management reviews past experience of loan charge-offs, the level of past due and non-accrual loans, the size and mix of the portfolio, general economic conditions in the market area, and individual loans to identify potential credit problems. Commercial business and consumer loans have increased to $83.6 million or 54.0% of the Bank's total loan portfolio, at March 31, 1996, and it is anticipated there will be a continued emphasis on this type of credit. Although commercial business and consumer loans carry a higher level of credit risk than conventional residential mortgage loans, the level of reserves reflects management's continuing evaluation of this risk based on upon the Bank's past loss experience. At fiscal year end, the Bank's ratio of loans delinquent more than 60 days to total assets was 1.20%. These delinquent loans are considered to be well secured and are in the process of collection. Management believes that reserves for loan losses are at a level adequate to provide for potential loan losses. Although management believes that it has considered all relevant factors in its estimation of future losses, future adjustments to reserves may be necessary if conditions change substantially from the assumptions used in making the original estimations. The fiscal 1995 allowance was increased in anticipation of a charge-off on a non-performing loan which was ultimately realized in fiscal 1996. Regulators will from time to time evaluate the allowance for loan losses which are subject to adjustments based upon the information available to the regulators at the time of their examinations. The following table sets forth an analysis of the Bank's allowance for loan losses. March 31, 1996 1995 1994 1993 1992 (Dollars in Thousands) Balance at beginning of year . . . . . . . . $1,955 $1,735 $1,191 $ 819 $862 Provision charged to operations. . . . . . . 230 300 335 463 25 Allowance on acquired loans. . . . . . . . .. -- -- 324 -- -- Charge-offs: Residential real estate . 5 -- 25 10 -- Commercial real estate. . -- 3 61 -- -- Commercial business . . . 330 -- -- -- -- Consumer. . . . . . . . . 137 102 39 121 84 Total charge-offs . . . 472 105 125 131 84 Recoveries: Residential real estate . -- -- -- -- -- Consumer. . . . . . . . . 46 25 10 40 16 Total recoveries. . . . 46 25 10 40 16 Balance at end of year . . $1,759 $1,955 $1,735 $1,191 $819 Ratio of net charge-offs during the year to average loans outstanding during the year . . . . 0.28% 0.06% 0.10% 0.08% 0.06% PAGE The distribution of the Bank's allowance for loan losses at the dates indicated is summarized as follows: At March 31, 1996 1995 1994 1993 1992 Percent Percent Percent Percent Percent of Loans of Loans of Loans of Loans of Loans in Each in Each in Each in Each in Each Category Category Category Category Category to Total to Total to Total to Total to Total Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans (Dollars in Thousands) Residential . . . . $ 460 26.2% $ 460 43.4% $ 312 36.8% $ 395 48.5% $332 60.8% Commercial real estate. . . . . . 131 7.4 96 8.5 128 16.0 146 17.7 63 11.8 Consumer. . . . . . 568 32.3 800 28.7 792 31.5 442 23.1 315 20.4 Commercial business . . . .. 600 34.1 599 19.4 503 15.7 208 10.7 109 7.0 Total. . . . . . $1,759 100.0% $1,955 100.0% $1,735 100.0% $1,191 100.0% $819 100.0% PAGE Service Corporation As a federally chartered savings bank, Security Federal is permitted by OTS regulations to invest up to 2% of its assets in the stock of, or loans to, service corporation subsidiaries, and may invest an additional 1% of its assets in service corporations where such additional funds are used for inner-city or community development purposes. At March 31, 1996, Security Federal's net investment in its service corporations (including loans to service corporations) totaled $669,218. In addition to investments in service corporations, federal institutions are permitted to invest an unlimited amount in operating subsidiaries engaged solely in activities which a federal savings bank may engage in directly. Security Financial Services Corporation. SFSC was incorporated in 1975 by the Bank. The service corporation's primary activity is investment brokerage services. Real Estate Partnership. The Company also develops real estate through two real estate partnerships which it purchased from SFSC at market value in December 1995. Each project is designed primarily to develop and sell residential lots in and around the Bank's primary lending area. Total investment of the Company (excluding loans totalling $75,120 to Willow Woods) in both projects at March 31, 1996, was approximately $567,726. The Company has no plans for additional real estate ventures. During fiscal 1988, SFSC completed construction on the first phase of Currytowne, a joint venture development of single-family residential lots located in Edgefield County, South Carolina near North Augusta. This phase contains 84 lots. By fiscal 1996 year end, 39 lots had been sold. During fiscal 1990, SFSC entered into a joint venture agreement, known as Willow Woods, to develop 97.2 acres of land in Aiken County into approximately 150 single family residential lots. SFSC is a 50% partner in the joint venture. The first phase of this development containing 51 lots was completed in May of 1991, and as of March 31, 1996, 49 lots have been sold. Construction on the second phase of Willow Woods was completed in May 1994 and contains 40 single family residential lots, of which eight had been sold as of March 31, 1996. Investment Activities Investment securities. Federal thrift institutions have authority to invest in various types of liquid assets, including U.S. Treasury obligations and securities of various federal agencies, certificates of deposit at insured institutions, bankers' acceptances and federal funds. Federal thrift institutions may also invest a portion of their assets in certain commercial paper and corporate debt securities. Federal thrift institutions are also authorized to invest in mutual funds whose assets conform to the investments that a federal thrift institution is authorized to make directly. There are various restrictions on the foregoing investments. For example, the commercial paper must be appropriately rated by at least two nationally recognized investment rating services and the corporate debt securities must be appropriately rated by at least one such service. In addition, the average maturity of an institution's portfolio of corporate debt securities may not, at any one time, exceed six years, and the commercial paper must mature within nine months of issuance. Moreover, an institution's total investment in the commercial paper and corporate debt securities of any one issuer may not exceed 1% of the institution's assets except that an institution may invest 5% of its assets in the shares of any appropriate mutual fund. See "Regulation -- Federal Regulation of Savings Associations." As a member of the Federal Home Loan Bank ("FHLB") System, Security Federal must maintain minimum levels of investments that are liquid assets as defined in Federal regulations. See "Regulation -- Federal Regulation of Savings Associations -- Federal Home Loan Bank System." Liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to the return on loans. Historically, the Bank has maintained its liquid assets above the minimum requirements imposed by the OTS regulations and at a level believed adequate to meet requirements of normal daily activities, repayment of maturing debt and potential deposit outflows. Cash flow projections are regularly reviewed and updated to assure that adequate liquidity is provided. As of March 31, 1996, the Bank's liquidity ratio (liquid assets as a percentage of net withdrawable savings and current borrowings) was 8.73%. The following table sets forth the composition of the Company's portfolio of securities and other investments, not including mortgage-backed securities. At March 31, 1996 1995 1994 Book Value Book Value Book Value (Dollars in Thousands) Interest-bearing deposits with banks . . . . . . . . . . . $ -- $ -- $ 95 Other interest earning assets. . . 2,858 1,014 1,502 Total. . . . . . . . . . . . . $ 2,858 $ 1,014 $ 1,597 Securities: Available for sale: U.S. Treasury and agency obligations. . . . . . . . . .. 30,972 $ 3,931 $ 8,794 SLMA securities . . . . . . . . . -- -- 750 Total securities available for sale. . . . . . . . . . . 30,972 3,931 9,544 Held to Maturity: U.S. Government and agency obligations. . . . . . . . . . . 5,492 34,367 35,559 FNMA securities . . . . . . . . . 1,006 2,018 2,029 FFCB securities . . . . . . . . . -- 500 1,201 FHLMC bonds . . . . . . . . . . . 1,000 -- -- Total securities held to maturity. . . . . . . . . . . 7,498 36,885 38,789 Total securities . . . . . . . . . 38,471 40,816 48,333 FHLB stock . . . . . . . . . . . . 1,233 1,415 1,111 Total securities and FHLB stock (1). . . . . . . . . . . . $39,704 $42,231 $49,444 (1) Does not include mortgage-backed securities. At March 31, 1996, the Company did not have any investment securities (exclusive of obligations of the U.S. Government and federal agencies) issued by any one entity with a total book value in excess of 10% of stockholders' equity. The following table sets forth the maturities or repricing of investment securities and FHLB stock at March 31, 1996, and the weighted average yields of such securities and FHLB stock (calculated on the basis of the cost and effective yields weighted for the scheduled maturity of each security). Maturing or Repricing After After One But Five But Within Within Within After One Year Five Years Ten Years Ten Years Amount Yield Amount Yield Amount Yield Amount Yield (In Thousands) U.S. Government and other agency obligations . $26,544 4.75% $11,927 5.18% $ -- -- $ -- -- FHLB stock . . -- -- 1,233 8.25 -- -- -- -- Total. . . . $26,544 4.75% $13,160 5.37% $ -- -- $ -- -- For information regarding the market value of the Bank's securities portfolios, see Notes 3 and 4 of Notes to Consolidated Financial Statements. The Bank has sold securities under an agreement to repurchase when it is cost effective to acquire funds from this source. The Bank did not engage in such transactions during fiscal 1996. Mortgage-backed securities. Security Federal has a portfolio of mortgage-backed securities which it holds for investment. Such mortgage-backed securities can serve as collateral for borrowings and, through repayments, as a source of liquidity. Under the Bank's risk-based capital requirement, mortgage-backed securities have a risk weight of 20% (or 0% in the case of GNMA securities) in contrast to the 50% risk weight carried by residential loans. See "Regulation." The Bank had $2.5 million, $1.7 million and $3.3 million of mortgage-backed securities issued by the FHLMC at March 31, 1996, 1995 and 1994, respectively. The Bank held no other mortgage-backed securities at such dates. The following table sets forth the composition of the mortgage-backed securities portfolio at the dates indicated. There were no mortgage-backed securities classified as available for sale at the dates indicated. At March 31, 1996 1995 1994 Book Value Book Value Book Value (Dollars in Thousands) Held to Maturity: FHLMC . . . . . . . . . $2,542 $1,711 $3,276 At March 31, 1996, the Company did not have any mortgage-backed securities (exclusive of obligations of agencies of the U.S. Government) issued by any one entity with a total book value in excess of 10% of stockholders equity. For information regarding the market values of Security Federal's mortgage-backed securities portfolio, see Notes 3 and 4 of the Notes to Consolidated Financial Statements. The following table sets for the maturities and the weighted average yields of the mortgage-backed securities at March 31, 1996. Not considered in the preparation of the table below is the effect of prepayments. Due in _________________________________________________________________ March 31, 1996 Less than 1 to 5 5 to 10 Over 10 Balance Year Years Years Years Outstanding Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield (Dollars in Thousands) Federal Home Loan Mortgage Corporation. . . $119 8.14% $854 7.25% $471 8.32% $1,098 7.71% $2,542 7.69%
Sources of Funds Deposit accounts have traditionally been a principal source of the Bank's funds for use in lending and for other general business purposes. In addition to deposits, the Bank derives funds from loan repayments, cash flows generated from operations (including interest credited to deposit accounts), FHLB of Atlanta advances, the sale of securities under agreements to repurchase, and loan sales. Scheduled loan payments are a relatively stable source of funds while deposit inflows and outflows and the related cost of such funds have varied widely. FHLB of Atlanta advances and the sale of securities under agreements to repurchase may be used on a short-term basis to compensate for seasonal reductions in deposits or deposit inflows at less than projected levels and may be used on a longer term basis in support of expanded lending activities. The availability of funds from loan sales is influenced by general interest rates. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." In the past, Security Federal has engaged in selling its 15 and 30-year fixed rate loans in the secondary market. The decline in the amount of fixed rate loans sold during fiscal 1996 was the result of a increase in interest rates and an increase in demand for adjustable rate mortgage loans. In addition, the Bank originates loans for other financial institutions with their prior commitment to purchase the loan at a set price. The amount of these loans originated and sold depends primarily on loan demand. During fiscal 1996, the Bank originated $6.9 million of such loans for other financial institutions. See "-- Loan Originations, Purchases and Sales." Deposits. The Bank attracts both short-term and long-term deposits from the general public by offering a wide assortment of accounts and rates. In recent years, market conditions have required the Bank to rely increasingly on short-term accounts and other deposit alternatives that are more responsive to market interest rates than the passbook accounts and regulated fixed interest rate, fixed-term certificates that were the Bank's primary source of deposits before 1978. The Bank offers regular passbook accounts, checking accounts, various money market accounts, fixed interest rate certificates with varying maturities, negotiated rate $100,000 or above jumbo certificates of deposit ("Jumbo CDs") and individual retirement accounts. At March 31, 1996, the Bank had no brokered deposits. In addition, the Bank believes that, based on its experience over the past several years, its passbook and transaction accounts are stable sources of deposits. The following table sets forth the dollar amount of savings deposits in the various types of deposit programs for the periods indicated. At March 31, 1996 1995 1994 Percent Percent Percent Amount of Total Amount of Total Amount of Total (Dollars in Thousands) Interest Rate Range: Passbook accounts 2.50% - 3.00% . . . . $13,615 7.9% $14,492 8.7% $16,101 9.3% NOW and other transaction accounts 0% - 2.00% . 42,252 24.5 41,212 24.8 43,559 25.1 Money market funds 2.50% - 3.50% . . . . 13,770 8.0 16,776 10.1 19,204 11.1 Total non- certificates. . . . 69,637 40.4 72,480 43.6 78,864 45.5 Certificates: 0.00-5.99% . . . . . . 73,946 42.9 70,537 42.4 84,828 48.9 6.00-7.99% . . . . . . 28,792 16.7 23,238 14.0 8,608 5.0 8.00-9.99% . . . . . . -- -- 20 0.0 312 0.1 10.00-12.99% . . . . . -- -- -- -- 821 0.5 Total certificates. . . . 102,738 59.6 93,795 56.4 94,569 54.5 Total deposits. . . .$172,375 100.0% $166,275 100.0% $173,433 100.0% In particular, the Bank relies to a limited extent upon locally obtained Jumbo CDs to maintain its deposit levels. At March 31, 1996, Jumbo CDs constituted 5.7% of the Bank's total deposits. Security Federal has not relied heavily on Jumbo CDs to manage interest rate sensitivity. Security Federal has, however, exhibited an ability to attract and maintain such deposits to desired levels during recent periods. The following table sets forth the deposit flows at the Bank during the periods indicated. Years Ended March 31, 1996 1995 1994 (Dollars in Thousands) Opening balance. . . . . . $166,275 $173,433 $115,461 Deposits acquired in branch acquisition. . . . -- -- 61,124 Deposits . . . . . . . . . 734,010 686,287 458,705 Withdrawals. . . . . . . . 734,018 698,942 466,416 Interest credited. . . . . 6,108 5,497 4,559 Ending balance . . . . . . 172,375 166,275 173,433 Net increase (decrease). . $ 6,100 $ (7,158) $ 57,972 Percent increase (decrease). . . . . . . . 3.7% (4.1)% 50.2% The following table shows rate and maturity information for the Bank's certificates of deposit as of March 31, 1996. 0.00- 4.00- 5.00- 6.00- 7.00- Percent 3.99% 4.99% 5.99% 6.99% 7.99% Total of Total (Dollars in Thousands) Certificate accounts maturing in quarter ending(1): June 30, 1996. . . . $1,444 $3,866 $14,101 $13,865 $ 12 $ 31,988 31.14% September 30, 1996 . 118 182 16,503 6,817 255 23,875 23.24 December 31, 1996. . -- 587 12,790 1,872 -- 15,249 14.84 March 31, 1997 . . . -- 44 11,178 1,090 100 12,412 12.08 June 30, 1997. . . . -- -- 6,696 1,853 53 8,602 8.37 September 30, 1997 . -- 10 2,807 316 26 3,159 3.08 December 31, 1997. . -- 26 1,450 145 -- 1,621 1.58 March 31, 1998 . . . -- 75 968 1,586 -- 2,629 2.56 June 30, 1998. . . . -- 57 730 51 -- 838 0.82 September 30, 1998 . -- 6 262 23 -- 291 0.28 December 31, 1998. . -- 1 345 20 -- 366 .035 March 31, 1999 . . . -- -- 98 66 -- 164 0.16 Thereafter . . . . . -- -- 902 513 129 1,544 1.50 Total. . . . . . . $ 262 $4,854 $68,830 $28,217 $575 $102,738 100.00% ___________________ (1) Certain adjustable-rate certificates are shown as maturing at the earlier of repricing or maturity date. The following table indicates the amount of the Bank's deposits of $100,000 or more by time remaining until maturity at March 31, 1996. Passbook, NOW and Certificates of Deposit Money Market Accounts (Dollars in Thousands) Maturity Period Three months or less . . . $2,548 $8,301 Over three through six months. . . . . . . . 2,792 -- Over six through twelve month. . . . . . . . . . 2,299 -- Over twelve months . . . . 2,208 -- Total . . . . . . . . . $9,847 $8,301 Borrowings As a member of the FHLB of Atlanta, the Bank is required to own capital stock in the FHLB of Atlanta and is authorized to apply for advances from the FHLB of Atlanta. Each FHLB credit program has its own interest rate, which may be fixed or variable, and range of maturities. The FHLB of Atlanta may prescribe the acceptable uses to which these advances may be put, as well as limitations on the size of the advances and repayment provisions. See Note 10 of Notes to Consolidated Statements for disclosure regarding the maturities and rate structure of the Bank's FHLB advances. Federal law contains certain collateral requirements for FHLB advances. See "Regulation -- Federal Regulation of Savings Associations -- Federal Home Loan Bank System." In the past, the Bank has used the sale of securities under agreements to repurchase as a source of funds. The securities sold pursuant to these agreements consist of mortgage loans which have been convened to FHLMC participation certificates. The Bank has sold securities under agreements to repurchase to both FHLMC and Wachovia Bank and Trust Company. These funds are used whenever its costs are favorable compared to alternative sources of funds. The following table sets forth the maximum month-end balance and average balance of FHLB advances at the dates indicated. Years Ended March 31, 1996 1995 1994 (In Thousands) Maximum Balance: FHLB advances. . . . . . . $31,370 $30,076 $8,616 Average Balance: FHLB advances. . . . . . . $27,569 $22,621 $7,167 The following table sets forth information as to the Bank's borrowings and the weighted average interest rates thereon at the dates indicated. March 31, 1996 1995 1994 (Dollars in Thousands) Balance: FHLB advances. . . . . . $22,864 $26,033 $8,616 Weighted Average Interest Rate: At Fiscal Year End FHLB advances . . . . . 6.29% 6.65% 6.48% During Fiscal Year FHLB advances . . . . . 6.39% 5.86% 7.27% Competition The Bank serves the counties of Aiken and Bamberg, South Carolina through its ten branch offices located in Aiken, Denmark, North Augusta, Graniteville, Langley, Clearwater and Wagener, South Carolina. On October 21, 1993 the Bank expanded its market area through the acquisition of four branch offices of NationsBank of South Carolina, N.A. The branches are located in Langley, Graniteville, Clearwater and Wagener, Aiken County, South Carolina. Security Federal faces strong competition both in originating loans and in attracting deposits. Competition in originating loans comes primarily from other thrift institutions, commercial banks, mortgage bankers and credit unions who also make loans in the Bank's market area. The Bank competes for loans principally on the basis of the interest rates and loan fees it charges, the types of loans it makes and the quality of services it provides to borrowers. The Bank faces substantial competition in attracting deposits from other thrift institutions, commercial banks, money market and mutual funds, credit unions and other investment vehicles. The ability of the Bank to attract and retain deposits depends on its ability to provide an investment opportunity that satisfies the requirements of investors as to rate of return, liquidity, risk and other factors. The Bank attracts a significant amount of deposits through its branch offices primarily from the communities in which those branch offices are located. Therefore, competition for those deposits is principally from other thrift institutions and commercial banks located in the same communities. The Bank competes for these deposits by offering a variety of deposit accounts at competitive rates, convenient business hours, and convenient branch locations with interbranch deposit and withdrawal privileges at each. The authority to offer money market deposits, and expanded lending and other powers authorized for thrift institutions by federal law, have resulted in increased competition for both deposits and loans between thrift institutions and other financial institutions such as commercial banks and credit unions. REGULATION General The Bank is subject to extensive regulation, examination and supervision by the OTS as its chartering agency, and the FDIC, as the insurer of its deposits. The activities of federal savings institutions are governed by the Home Owners' Loan Act, as amended (the "HOLA") and, in certain respects, the Federal Deposit Insurance Act ("FDIA") and the regulations issued by the OTS and the FDIC to implement these statutes. These laws and regulations delineate the nature and extent of the activities in which federal savings associations may engage. Lending activities and other investments must comply with various statutory and regulatory capital requirements. In addition, the Bank's relationship with its depositors and borrowers is also regulated to a great extent, especially in such matters as the ownership of deposit accounts and the form and content of the Bank's mortgage documents. The Bank must file reports with the OTS and the FDIC concerning its activities and financial condition in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with, or acquisitions of, other financial institutions. There are periodic examinations by the OTS and the FDIC to review the Bank's compliance with various regulatory requirements. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such policies, whether by the OTS, the FDIC or Congress, could have a material adverse impact on the Company, the Bank and their operations. The Company, as a savings and loan holding company, is also required to file certain reports with, and otherwise comply with the rules and regulations of, the OTS. Federal Regulation of Savings Associations Office of Thrift Supervision. The OTS is an office in the Department of the Treasury subject to the general oversight of the Secretary of the Treasury. The OTS generally possesses the supervisory and regulatory duties and responsibilities formerly vested in the Federal Home Loan Bank Board. Among other functions, the OTS issues and enforces regulations affecting federally insured savings associations and regularly examines these institutions. Federal Home Loan Bank System. The FHLB System, consisting of 12 FHLBs, is under the jurisdiction of the Federal Housing Finance Board ("FHFB"). The designated duties of the FHFB are to: supervise the FHLBs; ensure that the FHLBs carry out their housing finance mission; ensure that the FHLBs remain adequately capitalized and able to raise funds in the capital markets; and ensure that the FHLBs operate in a safe and sound manner. The Bank, as a member of the FHLB of Atlanta, is required to acquire and hold shares of capital stock in the FHLB of Atlanta in an amount equal to the greater of (i) 1.0% of the aggregate outstanding principal amount of residential mortgage loans, home purchase contracts and similar obligations at the beginning of each year, or (ii) 1/20 of its advances (borrowings) from the FHLB of Atlanta. The Bank is in compliance with this requirement with an investment in FHLB of Atlanta stock of $1.2 million at March 31, 1996. Among other benefits, the FHLB provides a central credit facility primarily for member institutions. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes advances to members in accordance with policies and procedures established by the FHFB and the Board of Directors of the FHLB of Atlanta. Federal Deposit Insurance Corporation. The FDIC is an independent federal agency established originally to insure the deposits, up to prescribed statutory limits, of federally insured banks and to preserve the safety and soundness of the banking industry. In 1989 the FDIC also became the insurer, up to the prescribed limits, of the deposit accounts held at federally insured savings associations and established two separate insurance funds: the BIF and the SAIF. As insurer of deposits, the FDIC has examination, supervisory and enforcement authority over all savings associations. PAGE The Bank's accounts are insured by the SAIF. The FDIC insures deposits at the Bank to the maximum extent permitted by law. The Bank currently pays deposit insurance premiums to the FDIC based on a risk-based assessment system established by the FDIC for all SAIF-member institutions. Under applicable regulations, institutions are assigned to one of three capital groups which are based solely on the level of an institution's capital --"well capitalized," "adequately capitalized," and "undercapitalized" -- which are defined in the same manner as the regulations establishing the prompt corrective action system under Section 38 of the FDIA, as discussed below. These three groups are then divided into three subgroups which reflect varying levels of supervisory concern, from those which are considered to be healthy to those which are considered to be of substantial supervisory concern. The matrix so created results in nine assessment risk classifications, with rates currently ranging from 0.23% of insured deposits for well capitalized, financially sound institutions with only a few minor weaknesses to 0.31% of insured deposits for undercapitalized institutions that pose a substantial risk of loss to the SAIF unless effective corrective action is taken. Until the second half of 1995, the same amounts applied to BIF member institutions. The FDIC is authorized to raise assessment rates in certain circumstances. The Bank's assessments expensed for the year ended March 31, 1996, equaled $387,722. Effective January 1, 1996, the FDIC substantially reduced deposit insurance premiums for well-capitalized, well-managed financial institutions that are members of the BIF. Under the new assessment schedule, approximately 92% of BIF members pay the statutory minimum annual assessment of $2,000. With respect to SAIF member institutions, the FDIC has retained the existing rate schedule of 0.23% to 0.31% of insured deposits. The Bank is a member of the SAIF rather than the BIF. The FDIC may terminate the deposit insurance of any insured depository institution if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is aware of no existing circumstances which could result in termination of the deposit insurance of the Bank. Liquidity Requirements. Under OTS regulations, each savings institution is required to maintain an average daily balance of liquid assets (cash, certain time deposits and savings accounts, bankers' acceptances, and specified U.S. Government, state or federal agency obligations and certain other investments) equal to a monthly average of not less than a specified percentage (currently 5.0%) of its net withdrawable accounts plus short-term borrowings. OTS regulations also require each savings institution to maintain an average daily balance of short-term liquid assets at a specified percentage (currently 1.0%) of the total of its net withdrawable savings accounts and borrowings payable in one year or less. Monetary penalties may be imposed for failure to meet liquidity requirements. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." Prompt Corrective Action. Under Section 38 of the FDIA, as added by the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), each federal banking agency is required to implement a system of prompt corrective action for institutions which it regulates. The federal banking agencies have promulgated substantially similar regulations to implement this system of prompt corrective action. Under the regulations, an institution shall be deemed to be (i) "well capitalized" if it has a total risk-based capital ratio of 10.0% or more, has a Tier I risk-based capital ratio of 6.0% or more, has a leverage ratio of 5.0% or more and is not subject to specified requirements to meet and maintain a specific capital level for any capital measure; (ii) "adequately capitalized" if it has a total risk-based capital ratio of 8.0% or more, a Tier I risk-based capital ratio of 4.0% or more and a leverage ratio of 4.0% or more (3.0% under certain circumstances) and does not meet the definition of "well capitalized;" (iii) "undercapitalized" if it has a total risk-based capital ratio that is less than 8.0%, a Tier I risk-based capital ratio that is less than 4.0% or a leverage ratio that is less than 4.0% (3.0% under certain circumstances); (iv) "significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6.0%, a Tier I risk-based capital ratio that is less than 3.0% or a leverage ratio that is less than 3.0%; and (v) "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%. Section 38 of the FDIA and the implementing regulations also provide that a federal banking agency may, after notice and an opportunity for a hearing, reclassify a well capitalized institution as adequately capitalized and may require an adequately capitalized institution or an undercapitalized institution to comply with supervisory actions as if it were in the next lower category if the institution is in an unsafe or unsound condition or has received in its most recent examination, and has not corrected, a less than satisfactory rating for asset quality, management, earnings or liquidity. (The OTS may not, however, reclassify a significantly undercapitalized institution as critically undercapitalized.) An institution generally must file a written capital restoration plan which meets specified requirements, as well as a performance guaranty by each company that controls the institution, with the appropriate federal banking agency within 45 days of the date that the institution receives notice or is deemed to have notice that it is undercapitalized, significantly undercapitalized or critically undercapitalized. Immediately upon becoming undercapitalized, an institution shall become subject to the provisions of Section 38 of the FDIA, which sets forth various mandatory and discretionary restrictions on its operations. At March 31, 1996, the Bank was categorized as "well capitalized" under the prompt corrective action regulations of the OTS. Standards for Safety and Soundness. The FDIA requires the federal banking regulatory agencies to prescribe, by regulation, standards for all insured depository institutions relating to: (i) internal controls, information systems and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate risk exposure; (v) asset growth; and (vi) compensation, fees and benefits. The federal banking agencies recently adopted final regulations and Interagency Guidelines Prescribing Standards for Safety and Soundness ("Guidelines") to implement safety and soundness standards required by the FDIA. The Guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. The agencies also proposed asset quality and earnings standards which, if adopted in final, would be added to the Guidelines. Under the final regulations, if the OTS determines that the Bank fails to meet any standard prescribed by the Guidelines, the agency may require the Bank to submit to the agency an acceptable plan to achieve compliance with the standard, as required by the FDIA. The final regulations establish deadlines for the submission and review of such safety and soundness compliance plans. Qualified Thrift Lender Test. All savings associations are required to meet a qualified thrift lender ("QTL") test set forth in Section 10(m) of the HOLA and regulations of the OTS thereunder to avoid certain restrictions on their operations. A savings institution that fails to become or remain a QTL shall either become a national bank or be subject to the following restrictions on its operations: (i) the association may not make any new investment or engage in activities that would not be permissible for national banks; (ii) the association may not establish any new branch office where a national bank located in the savings institution's home state would not be able to establish a branch office; (iii) the association shall be ineligible to obtain new advances from any FHLB; and (iv) the payment of dividends by the association shall be subject to the rules regarding the statutory and regulatory dividend restrictions applicable to national banks. Also, beginning three years after the date on which the savings institution ceases to be a QTL, the savings institution would be prohibited from retaining any investment or engaging in any activity not permissible for a national bank and would be required to repay any outstanding advances to any FHLB. In addition, within one year of the date on which a savings association controlled by a company ceases to be a QTL, PAGE the company must register as a bank holding company and become subject to the rules applicable to such companies. A savings institution may requalify as a QTL if it thereafter complies with the QTL test. Currently, the QTL test requires that 65% of an institution's "portfolio assets" (as defined) consist of certain housing and consumer-related assets on a monthly average basis in nine out of every 12 months. Assets that qualify without limit for inclusion as part of the 65% requirement are loans made to purchase, refinance, construct, improve or repair domestic residential housing and manufactured housing; home equity loans; mortgage-backed securities (where the mortgages are secured by domestic residential housing or manufactured housing); FHLB stock; and direct or indirect obligations of the FDIC. In addition, the following assets, among others, may be included in meeting the test subject to an overall limit of 20% of the savings institution's portfolio assets: 50% of residential mortgage loans originated and sold within 90 days of origination; 100% of consumer and educational loans (limited to 10% of total portfolio assets); and stock issued by the FHLMC or the FNMA. Portfolio assets consist of total assets minus the sum of (i) goodwill and other intangible assets, (ii) property used by the savings institution to conduct its business, and (iii) liquid assets up to 20% of the institution's total assets. At March 31, 1996, the qualified thrift investments of the Bank were approximately 69% of its portfolio assets. Capital Requirements. Under OTS regulations a savings association must satisfy three minimum capital requirements: core capital, tangible capital and risk-based capital. Savings associations must meet all of the standards in order to comply with the capital requirements. The Company is not subject to any minimum capital requirements. OTS capital regulations establish a 3% core capital or leverage ratio (defined as the ratio of core capital to adjusted total assets). Core capital is defined to include common stockholders' equity, noncumulative perpetual preferred stock and any related surplus, and minority interests in equity accounts of consolidated subsidiaries, less (i) any intangible assets, except for certain qualifying intangible assets; (ii) certain mortgage servicing rights; and (iii) equity and debt investments in subsidiaries that are not "includable subsidiaries," which is defined as subsidiaries engaged solely in activities not impermissible for a national bank, engaged in activities impermissible for a national bank but only as an agent for its customers, or engaged solely in mortgage-banking activities. In calculating adjusted total assets, adjustments are made to total assets to give effect to the exclusion of certain assets from capital and to account appropriately for the investments in and assets of both includable and nonincludable subsidiaries. Institutions that fail to meet the core capital requirement would be required to file with the OTS a capital plan that details the steps they will take to reach compliance. In addition, the OTS's prompt corrective action regulation provides that a savings institution that has a leverage ratio of less than 4% (3% for institutions receiving the highest CAMEL examination rating) will be deemed to be "undercapitalized" and may be subject to certain restrictions. See "-- Federal Regulation of Savings Associations -- Prompt Corrective Action." As required by federal law, the OTS has proposed a rule revising its minimum core capital requirement to be no less stringent than that imposed on national banks. The OTS has proposed that only those savings associations rated a composite one (the highest rating) under the CAMEL rating system for savings associations will be permitted to operate at or near the regulatory minimum leverage ratio of 3%. All other savings associations will be required to maintain a minimum leverage ratio of 4% to 5%. The OTS will assess each individual savings association through the supervisory process on a case-by-case basis to determine the applicable requirement. No assurance can be given as to the final form of any such regulation, the date of its effectiveness or the requirement applicable to the Bank. Savings associations also must maintain "tangible capital" not less than 1.5% of the Bank's adjusted total assets. "Tangible capital" is defined, generally, as core capital minus any "intangible assets" other than purchased mortgage servicing rights. Each savings institution must maintain total risk-based capital equal to at least 8% of risk-weighted assets. Total risk-based capital consists of the sum of core and supplementary capital, provided that supplementary capital cannot exceed core capital, as previously defined. Supplementary capital includes (i) permanent capital instruments such as cumulative perpetual preferred stock, perpetual subordinated debt, and mandatory convertible subordinated debt, (ii) maturing capital instruments such as subordinated debt, intermediate-term preferred stock and mandatory convertible subordinated debt, and (iii) general valuation loan and lease loss allowances up to 1.25% of risk-weighted assets. The risk-based capital regulation assigns each balance sheet asset held by a savings institution to one of four risk categories based on the amount of credit risk associated with that particular class of assets. Assets not included for purposes of calculating capital are not included in calculating risk-weighted assets. The categories range from 0% for cash and securities that are backed by the full faith and credit of the U.S. Government to 100% for repossessed assets or assets more than 90 days past due. Qualifying residential mortgage loans (including multi-family mortgage loans) are assigned a 50% risk weight. Consumer, commercial, home equity and residential construction loans are assigned a 100% risk weight, as are nonqualifying residential mortgage loans and that portion of land loans and nonresidential construction loans which do not exceed an 80% loan-to-value ratio. The book value of assets in each category is multiplied by the weighing factor (from 0% to 100%) assigned to that category. These products are then totalled to arrive at total risk-weighted assets. Off-balance sheet items are included in risk-weighted assets by converting them to an approximate balance sheet "credit equivalent amount" based on a conversion schedule. These credit equivalent amounts are then assigned to risk categories in the same manner as balance sheet assets and included risk-weighted assets. The OTS has incorporated an interest rate risk component into its regulatory capital rule. Under the rule, savings associations with "above normal" interest rate risk exposure would be subject to a deduction from total capital for purposes of calculating their risk-based capital requirements. A savings association's interest rate risk is measured by the decline in the net portfolio value of its assets (i.e., the difference between incoming and outgoing discounted cash flows from assets, liabilities and off-balance sheet contracts) that would result from a hypothetical 200 basis point increase or decrease in market interest rates divided by the estimated economic value of the association's assets, as calculated in accordance with guidelines set forth by the OTS. A savings association whose measured interest rate risk exposure exceeds 2% must deduct an interest rate risk component in calculating its total capital under the risk-based capital rule. The interest rate risk component is an amount equal to one-half of the difference between the institution's measured interest rate risk and 2%, multiplied by the estimated economic value of the association's assets. That dollar amount is deducted from an association's total capital in calculating compliance with its risk-based capital requirement. Under the rule, there is a two quarter lag between the reporting date of an institution's financial data and the effective date for the new capital requirement based on that data. The ule also provides that the Director of the OTS may waive or defer an association's interest rate risk component on a case-by-case basis. Under certain circumstances, a savings association may request an adjustment to its interest rate risk component if it believes that the OTS-calculated interest rate risk component overstates its interest rate risk exposure. In addition, certain "well-capitalized" institutions may obtain authorization to use their own interest rate risk model to calculate their interest rate risk component in lieu of the OTS-calculated amount. The OTS has postponed the date that the component will first be deducted from an institution's total capital until savings associations become familiar with the process for requesting an adjustment to its interest rate risk component. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory Capital" for a table that sets forth in terms of dollars and percentages the OTS tangible, core and risk-based capital requirements, the Bank's historical amounts and percentages at March 31, 1996, and pro forma amounts and percentages based upon the assumptions stated therein. Limitations on Capital Distributions. OTS regulations impose uniform limitations on the ability of all savings associations to engage in various distributions of capital such as dividends, stock repurchases and cash-out mergers. In addition, OTS regulations require the Bank to give the OTS 30 days' advance notice of any proposed declaration of dividends, and the OTS has the authority under its supervisory powers to prohibit the payment of dividends. The regulation utilizes a three-tiered approach which permits various levels of distributions based primarily upon a savings association's capital level. A Tier 1 savings association has capital in excess of its fully phased-in capital requirement (both before and after the proposed capital distribution). A Tier 1 savings association may make (without application but upon prior notice to, and no objection made by, the OTS) capital distributions during a calendar year up to 100% of its net income to date during the calendar year plus one-half its surplus capital ratio (i.e., the amount of capital in excess of its fully phased-in requirement) at the beginning of the calendar year or the amount authorized for a Tier 2 association. Capital distributions in excess of such amount require advance notice to the OTS. A Tier 2 savings association has capital equal to or in excess of its minimum capital requirement but below its fully phased-in capital requirement (both before and after the proposed capital distribution). Such an association may make (without application) capital distributions up to an amount equal to 75% of its net income during the previous four quarters depending on how close the association is to meeting its fully phased-in capital requirement. Capital distributions exceeding this amount require prior OTS approval. Tier 3 associations are savings associations with capital below the minimum capital requirement (either before or after the proposed capital distribution). Tier 3 associations may not make any capital distributions without prior approval from the OTS. The Bank is currently meeting the criteria to be designated a Tier 1 association and, consequently, could at its option (after prior notice to, and no objection made by, the OTS) distribute up to 100% of its net income during the calendar year plus 50% of its surplus capital ratio at the beginning of the calendar year less any distributions previously paid during the year. Loans to One Borrower. Under the HOLA, savings institutions are generally subject to the national bank limit on loans to one borrower. Generally, this limit is 15% of the Bank's unimpaired capital and surplus, plus an additional 10% of unimpaired capital and surplus, if such loan is secured by readily-marketable collateral, which is defined to include certain financial instruments and bullion. The OTS by regulation has amended the loans to one borrower rule to permit savings associations meeting certain requirements, including capital requirements, to extend loans to one borrower in additional amounts under circumstances limited essentially to loans to develop or complete residential housing units. At March 31, 1996, the Bank's limit on loans to one borrower was $2.3 million. At March 31, 1996, the Bank's largest aggregate amount of loans to one borrower was $2.1 million. Activities of Thrift Institutions and Their Subsidiaries. When a savings association establishes or acquires a subsidiary or elects to conduct any new activity through a subsidiary that the association controls, the savings association must notify the FDIC and the OTS 30 days in advance and provide the information each agency may, by regulation, require. Savings associations also must conduct the activities of subsidiaries in accordance with existing regulations and orders. The OTS may determine that the continuation by a savings association of its ownership control of, or its relationship to, the subsidiary constitutes a serious risk to the safety, soundness or stability of the association or is inconsistent with sound banking practices or with the purposes of the FDIA. Based upon that determination, the FDIC or the OTS has the authority to order the savings association to divest itself of control of the subsidiary. The FDIC also may determine by regulation or order that any specific activity poses a serious threat to the SAIF. If so, it may require that no SAIF member engage in that activity directly. Transactions with Affiliates. Savings associations must comply with Sections 23A and 23B of the Federal Reserve Act ("Sections 23A and 23B") relative to transactions with affiliates in the same manner and to the same extent as if the savings association were a Federal Reserve member bank. A savings and loan holding company, its subsidiaries and any other company under common control are considered affiliates of the subsidiary savings association under the HOLA. Generally, Sections 23A and 23B: (i) limit the extent to which the insured association or its subsidiaries may engage in certain covered transactions with an affiliate to an amount equal to 10% of such institution's capital and surplus and place an aggregate limit on all such transactions with affiliates to an amount equal to 20% of such capital and surplus, and (ii) require that all such transactions be on terms substantially the same, or at least as favorable to the institution or subsidiary, as those provided to a non-affiliate. The term "covered transaction" includes the making of loans, the purchase of assets, the issuance of a guaranty and similar types of transactions. Three additional rules apply to savings associations: (i) a savings association may not make any loan or other extension of credit to an affiliate unless that affiliate is engaged only in activities permissible for bank holding companies; (ii) a savings association may not purchase or invest in securities issued by an affiliate (other than securities of a subsidiary); and (iii) the OTS may, for reasons of safety and soundness, impose more stringent restrictions on savings associations but may not exempt transactions from or otherwise abridge Section 23A or 23B. Exemptions from Section 23A or 23B may be granted only by the Federal Reserve Board, as is currently the case with respect to all FDIC-insured banks. The Bank has not been significantly affected by the rules regarding transactions with affiliates. The Bank's authority to extend credit to executive officers, directors and 10% shareholders, as well as entities controlled by such persons, is currently governed by Sections 22(g) and 22(h) of the Federal Reserve Act, and Regulation O thereunder. Among other things, these regulations require that such loans be made on terms and conditions substantially the same as those offered to unaffiliated individuals and not involve more than the normal risk of repayment. Regulation O also places individual and aggregate limits on the amount of loans the Bank may make to such persons based, in part, on the Bank's capital position, and requires certain board approval procedures to be followed. The OTS regulations, with certain minor variances, apply Regulation O to savings institutions. Savings and Loan Holding Company Regulation Company Acquisitions. The HOLA and OTS regulations issued thereunder generally prohibit a savings and loan holding company, without prior OTS approval, from acquiring more than 5% of the voting stock of any other savings association or savings and loan holding company or controlling the assets thereof. They also prohibit, among other things, any director or officer of a savings and loan holding company, or any individual who owns or controls more than 25% of the voting shares of such holding company, from acquiring control of any savings association not a subsidiary of such savings and loan holding company, unless the acquisition is approved by the OTS. Company Activities. As a unitary savings and loan holding company, the Company generally is not subject to activity restrictions. If the Company acquires control of another savings association as a separate subsidiary other than in a supervisory acquisition, it would become a multiple savings and loan holding company. There generally are more restrictions on the activities of a multiple savings and loan holding company than on those of a unitary savings and loan holding company. The HOLA provides that, among other things, no multiple savings and loan holding company or subsidiary thereof which is not an insured association shall commence or continue for more than two years after becoming a multiple savings and loan association holding company or subsidiary thereof, any business activity other than: (i) furnishing or performing management services for a subsidiary insured institution, (ii) conducting an insurance agency or escrow business, (iii) holding, managing, or liquidating assets owned by or acquired from a subsidiary insured institution, (iv) holding or managing properties used or occupied by a subsidiary insured institution, (v) acting as trustee under deeds of trust, (vi) those activities previously directly authorized by regulation as of March 5, 1987 to be engaged in by multiple holding companies or (vii) those activities authorized by the Federal Reserve Board as permissible for bank holding companies, unless the OTS by regulation, prohibits or limits such activities for savings and loan holding companies. Those activities described in (vii) above also must be approved by the OTS prior to being engaged in by a multiple holding company. Qualified Thrift Lender Test. The HOLA requires any savings and loan holding company that controls a savings association that fails the QTL test, as explained under "-- Federal Regulation of Savings Associations -- Qualified Thrift Lender Test," must, within one year after the date on which the association ceases to be a QTL, register as and be deemed a bank holding company subject to all applicable laws and regulations. TAXATION Federal Taxation General. The Company and the Bank will report their income on a fiscal year basis using the accrual method of accounting and will be subject to federal income taxation in the same manner as other corporations with some exceptions, including particularly the Bank's reserve for bad debts discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the Bank or the Company. Tax Bad Debt Reserves. Savings institutions such as the Bank which meet certain definitional tests primarily relating to their assets and the nature of their business ("qualifying thrifts") are permitted to establish a reserve for bad debts and to make annual additions thereto, which additions may, within specified formula limits, be deducted in arriving at their taxable income. The Bank's deduction with respect to "qualifying loans," which are generally loans secured by certain interests in real property, may be computed using an amount based on the Bank's actual loss experience, or a percentage equal to 8% of the Bank's taxable income, computed with certain modifications and reduced by the amount of any permitted additions to the nonqualifying reserve. The Bank's deduction with respect to nonqualifying loans must be computed under the experience method which essentially allows a deduction based on the Bank's actual loss experience over a period of several years. Each year the Bank selects the most favorable way to calculate the deduction attributable to an addition to the tax bad debt reserve. The Bank used the experience method bad debt deduction for the years ended March 31, 1994, 1995 and 1996. The Bank currently satisfies the qualifying thrift definitional tests. If the Bank failed to satisfy such tests in any taxable year, it would be unable to make additions to its bad debt reserve calculated as a percentage of taxable income. Instead, the Bank would be required to deduct bad debts as they occur and would additionally be required to recapture its bad debt reserve deductions ratably over a multi-year period. Among other things, the qualifying thrift definitional tests require the Bank to hold at least 60% of its assets as "qualifying assets." Qualifying assets generally include cash, obligations of the United States or any agency or instrumentality thereof, certain obligations of a state or political subdivision thereof, loans secured by interests in improved residential real property or by savings accounts, student loans and property used by the Bank in the conduct of its banking business. The Bank's ratio of qualifying assets to total assets exceeded 60% through March 31, 1996. Although there can be no assurance that the Bank will continue to satisfy the 60% test, management believes that this level of qualifying assets can be maintained by the Bank. The amount of the addition to the reserve for losses on qualifying real property loans under the percentage-of-taxable-income method cannot exceed the amount necessary to increase the balance of the reserve for losses on qualifying real property loans at the close of the taxable year to 6% of the balance of the qualifying real property loans outstanding. Also, if the qualifying thrift uses the percentage of taxable income method, then the qualifying thrift's aggregate addition to its reserve for losses on qualifying real property loans cannot, when added to the addition to the reserve for losses on nonqualifying loans, exceed the amount by which: (i) 12% of the amount that the total deposits or withdrawable accounts of depositors of the qualifying thrift at the close of the taxable year exceeds (ii) the sum of the qualifying thrift's surplus, undivided profits and reserves at the beginning of such year. The Bank does not expect this overall limitation to restrict the Bank's deduction for additions to its bad debt reserve for the year ending March 31, 1997. At March 31, 1996, the Bank's total bad debt reserve for tax purposes was approximately $2.2 million. Proposed legislation would eliminate future bad debt deductions and would require thrifts to recapture into income over a six-year period their post-1987 additions to their bad debt tax reserves, thereby generating additional tax liability. The Bank does not have any post-1987 additions to its bad debt tax reserve. Distributions. To the extent that the Bank makes "nondividend distributions" to the Company that are considered as made: (i) from the reserve for losses on qualifying real property loans, to the extent the reserve for such losses exceeds the amount that would have been allowed under the experience method; or (ii) from the supplemental reserve for losses on loans ("Excess Distributions"), then an amount based on the amount distributed PAGE will be included in the Bank's taxable income. Nondividend distributions include distributions in excess of the Bank's current and accumulated earnings and profits, distributions in redemption of stock, and distributions in partial or complete liquidation. However, dividends paid out of the Bank's current or accumulated earnings and profits, as calculated for federal income tax purposes, will not be considered to result in a distribution from the Bank's bad debt reserve. Thus, any dividends to the Company that would reduce amounts appropriated to the Bank's bad debt reserve and deducted for federal income tax purposes would create a tax liability for the Bank. The amount of additional taxable income attributable to an Excess Distribution is an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Thus, if the Bank makes a "nondividend distribution," then approximately one and one-half times the amount so used would be includable in gross income for federal income tax purposes, assuming a 35% corporate income tax rate (exclusive of state and local taxes). See "Regulation" for limits on the payment of dividends by the Bank. The Bank does not intend to pay dividends that would result in a recapture of any portion of its tax bad debt reserve. Corporate Alternative Minimum Tax. The Code imposes a tax on alternative minimum taxable income ("AMTI") at a rate of 20%. The excess of the tax bad debt reserve deduction using the percentage of taxable income method over the deduction that would have been allowable under the experience method is treated as a preference item for purposes of computing the AMTI. In addition, only 90% of AMTI can be offset by net operating loss carryforwards. AMTI is increased by an amount equal to 75% of the amount by which the Bank's adjusted current earnings exceeds its AMTI (determined without regard to this preference and prior to reduction for net operating losses). For taxable years beginning after December 31, 1986, and before January 1, 1996, an environmental tax of .12% of the excess of AMTI (with certain modification) over $2.0 million is imposed on corporations, including the Bank, whether or not an Alternative Minimum Tax ("AMT") is paid. Dividends-Received Deduction and Other Matters. The Company may exclude from its income 100% of dividends received from the Bank as a member of the same affiliated group of corporations. The corporate dividends-received deduction is generally 70% in the case of dividends received from unaffiliated corporations with which the Company and the Bank will not file a consolidated tax return, except that if the Company or the Bank owns more than 20% of the stock of a corporation distributing a dividend, then 80% of any dividends received may be deducted. The Company, the Bank and its consolidated subsidiary have been audited or their books closed without audit by the IRS with respect to consolidated federal income tax returns through March 31, 1992. See Note 11 of Notes to Consolidated Financial Statements for additional information regarding income taxes of the Bank. State Taxation South Carolina. South Carolina has adopted the Code as it relates to savings banks, effective for taxable years beginning after December 31, 1986. The Bank is subject to South Carolina income tax at the rate of 6%. Delaware. As a Delaware holding company not earning income in Delaware, the Company is exempted from Delaware corporate income tax, but is required to file an annual report with and pay an annual franchise tax to the State of Delaware. Item 2. Properties At March 31, 1996, Security Federal owned the buildings and land for its main office, four of its branch offices, including the operations center, leased the land and owned the improvements thereon for one of its offices, owned part and leased part of one branch office and leased the remaining three offices. The property related to the offices owned by Security Federal had a depreciated cost (including land) of approximately $1.8 million at March 31, 1996. At March 31, 1996, the aggregate net book value of leasehold improvements (excluding furniture and equipment) associated with leased premises was $262,357. See Note 6 of Notes to Consolidated Financial Statements. The following table sets forth the net book value of the offices owned (including land) and leasehold improvements on properties leased by Security Federal at March 31, 1996. Date Lease Facility Gross Owned or Expiration Opened/ Square Net Book Location Leased Date Acquired Footage Value Main Office: 1705 Whiskey Road S. Owned N/A 1980 10,000 $544,872 Aiken, South Carolina Full Service Branch Offices: 149 E. Baruch Street Owned N/A 1984 2,258 217,063 Denmark, South Carolina 100 Laurens Street, N.W. Leased 1998 1959 4,500 -- Aiken, South Carolina 313 East Martintowne Road Owned(1) N/A 1973 4,356 52,751 North Augusta, South Carolina 1665 Richland Avenue, W. Owned N/A 1984 1,942 241,378 Aiken, South Carolina Montgomery & Canal Leased 1997 1993(2) 1,600 39,733 Streets Masonic Shopping Center Graniteville, South Carolina 2812 Augusta Road Owned N/A 1993(2) 2,509 222,827 Langley, South Carolina Highway 125 and Highways 1 and 78 Leased 1998 1993(2) 2,287 4,912 Midland Valley Shopping Center Clearwater, South Carolina 118 Main Street North Owned 2000 1993(2) 3,600 164,966 Wagener, South Carolina Walmart Superstore 2035 Whiskey Road Leased 2001 1996 517 217,712 Aiken, South Carolina Operations Center: 871 East Pine Log Road Owned N/A 1988 5,000 404,682 Aiken, South Carolina (1) Security Federal has a lease on the land for this office which expires in 2003. (2) Represents acquisition date. Item 3. Legal Proceedings The Company is involved as plaintiff or defendant in various legal actions arising in the course of its business. It is the opinion of management, after consultation with counsel, that the resolution of these legal actions will not have a material adverse effect on the Company's financial condition and results of operations. Item 4. Submission of Matter to Vote or Security Holders No matter was submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the quarter ended March 31, 1996. PART II Item 5. Market for the Issuer's Common Stock and Related Security Holder Matters Price Range of Common Stock The table below shows the range of high and low bid prices as reported by the Robinson-Humphrey Company, Inc. located in Aiken, South Carolina, which makes a market in the Company's stock. Those prices represent actual transactions and do not include retail markups, markdowns or commissions. Quarter Ending HIGH LOW 03/31/94 $20.25 $20.25 06/30/94 20.6875 20.375 09/30/94 21.1875 21.5625 12/31/94 21.50 21.00 03/31/95 21.875 21.75 06/30/95 21.875 21.875 09/30/95 24.75 24.75 12/31/95 26.50 24.50 03/31/96 27.25 26.25 As of March 31, 1996, the Company had approximately 288 stockholders of record. Dividends Dividends will be paid upon the determination of the Board of Directors that such payment is consistent with the long-term interests of the Company. The factors affecting this determination include the Company's current and projected earnings, operating results, financial condition, regulatory restrictions, future growth plans and other relevant factors. The Company declared and paid quarterly dividends of $0.05 per share during each of the fiscal years ended March 31, 1995 and 1996. The Company's ability to pay dividends is dependent upon its receipt of dividends from the Bank. The Bank may not declare or pay a cash dividend on its stock or repurchase shares of its stock if the result thereof would be to cause its regulatory capital to be reduced below the amount required for the liquidation account or fail to meet applicable regulatory capital requirements. Pursuant to OTS regulations, Tier 1 associations, which are associations that before and after the proposed distribution meet or exceed their fully phased-in capital requirements, may make capital distributions during any calendar year equal to 100% of net income for the year to date plus 50% of the amount by which the association's total capital exceeds its fully phased-in capital requirement, as measured at the beginning of the calendar year. However, a Tier 1 association deemed to be in need of more than normal supervision by the OTS and may be downgraded to a Tier 2 or Tier 3 association as a result of such a determination. The Bank meets the requirements for a Tier 1 association and has not been notified by the OTS of a need for more than normal supervision. The Bank is also required to give the OTS 30 days' notice prior the declaration of a dividend of the Company. Unlike the Bank, there is no regulatory restriction on the payment of dividends by the Company. However, it is subject to the requirements of Delaware law which generally limit dividends to an amount equal to the excess of a corporation's net assets over paid-in capital; or if there is no such excess, to its net profits for the current and immediately preceding fiscal year. Item 6. Management's Discussion and Analysis of Financial Condition and Results of Operations General The investment and other activities of the parent company, Security Federal Corporation (the Company), have had no significant impact on the results of operations for the periods presented in the financial statements. In December, 1995, the Company bought the interests of Security Federal Bank (the Bank) in two real estate development partnerships, Currytowne and Willow Woods, at fair market value. This transaction took place because regulations had required the Bank to deduct its interest in the partnerships from regulatory capital. The comments presented in the following discussion of financial results are indicative of the activities mainly of the Bank, a wholly-owned subsidiary of the Company. The Bank changed its name to Security Federal Bank in April 1996. The principal business of the Bank is the acceptance of savings deposits from the general public and the origination of mortgage loans to enable borrowers to purchase or refinance one-to-four family residential real estate. The Bank also makes loans secured by multi-family residential and commercial real estate and consumer and commercial loans. In addition, the Bank originates construction loans on single family residences, multi-family dwellings and projects, commercial real estate, and loans for the acquisition, development and construction of residential subdivisions and commercial projects. The Bank's net income is highly dependent on its interest rate spread, which is the difference between the average yield earned on its loan and investment portfolio and the average rate paid on its deposits and borrowings. The spread is impacted by interest rates, deposit flows and loan demands. Levels of non-interest income and operating expense are also significant factors in earnings. Branch Acquisitions On October 21, 1993, the Bank acquired certain assets and certain deposits and other liabilities of four branch offices of NationsBank of South Carolina, N.A. The branches are located in Langley, Graniteville, Clearwater, and Wagener, all of Aiken County, South Carolina. As consideration for the purchase price of the offices, the Company paid a premium of approximately $4.4 million or 7.17% of the deposit liabilities, and paid net book value including accrued interest for the loans, face value of the coin and currency, and a set amount for the buildings and equipment for the respective locations. The deposit premium, after adjusting for the costs associated with the transaction was allocated to core deposit intangible (CDI) ($1.9 million) and goodwill ($2.0 million). See note 2 of the Notes to Consolidated Financial Statements for additional information regarding this transaction. This transaction was an important strategic move for the Bank, providing access to a strong and loyal customer base, expanding the Bank's branch network in Aiken County which management believes will better enable the Bank to serve it's customer base, and providing opportunity for future growth. Most of the cash provided by this transaction was used to purchase U.S. Treasury, U.S. Government agencies and other securities with varying maturities. Asset and Liability Management The Bank maintains a program of asset and liability management that seeks to limit its vulnerability to material and prolonged increases or decreases in interest rates, or "interest rate risk." The principal determinant of the exposure of the Bank's earnings to interest rate risk is the timing difference (gap) between the repricing or maturity of the Bank's interest-earning assets and the repricing or maturity of its interest-bearing liabilities. If the maturities of the Bank's assets and liabilities were perfectly matched, and if the interest rates borne by its assets and liabilities were equally flexible and moved concurrently (neither of which is the case), the impact on net interest income of any material and prolonged changes in interest rates would be minimal. The Bank's asset and liability policies are directed toward the objectives of increasing the interest rate sensitivity of the Bank's assets by shortening their maturities or periods to reprice while reducing the interest rate sensitivity of the Bank's interest-bearing liabilities by extending their maturities. Management believes it has reduced the Bank's vulnerability to increases in interest rates through its current emphasis on originating adjustable rate mortgage loans and shorter term consumer and commercial loans compared to the early 1980's. The success of management's strategy is evidenced by the composition of the loan portfolio which includes $102.2 million of adjustable rate consumer, commercial, and mortgage loans or approximately 66.0% of total gross loans at March 31, 1996. At March 31, 1996, the negative mismatch of interest earning assets repricing or maturing within one year with interest bearing liabilities repricing or maturing within one year decreased to $24.2 million or 11.3% of total assets as compared to $34.5 million or 16.4% at March 31, 1995. This improvement in the one year gap was the result of increased originations of consumer and commercial loans the past two years. Another reason for improvement was the shortening of maturities in the Bank's investment portfolio. During the past year, the Bank originated approximately $3.7 million in adjustable rate residential and commercial real estate loans which are generally not sold, but held for investment. Also, as part of the Bank's asset liability program, Security Federal originated a total of $44.4 million in consumer and commercial loans, which are usually short term in nature. During fiscal 1996, 90.0% of total loan originations were comprised of consumer, commercial, and adjustable rate mortgage loans compared to 93.5% of total originations in fiscal 1995. The Bank's portfolio of consumer and commercial loans was $83.6 million at March 31, 1996, an increase of $9.8 million from March 31, 1995, and an increase of $45.4 million from March 31, 1994. Consumer and commercial loans combined have increased from 47.3% of total loans at March 31, 1994 and 48.0% at March 31, 1995 to 54% at March 31, 1996. Due to a decrease in real estate activity and refinancings in fiscal 1996, the Bank originated only $5.3 million and $4.7 million in fixed rate residential loans in fiscal 1996 and 1995 respectively, compared to $50.0 million in fiscal 1994. Thus, the bank only sold $5.5 million in fiscal 1996 and $3.1 million in fiscal 1995 to secondary market agencies, compared to $47.7 million and $50.0 million in fiscal years 1994, and 1993, respectively. Other fixed rate residential loans passed directly on to other investors, other than Freddie Mac or Fannie Mae, totaled $6.9 million in fiscal 1996, and $8.4 million in fiscal 1995, and $17.4 million in fiscal 1994. At March 31, 1996, fixed rate residential loans amounted to $11.8 million or 7.6% of the total loan portfolio, compared to $16.0 million or 10.4% at the end of the previous year. Certificates of deposit in excess of $100,000 (jumbo certificates) are normally considered to be highly interest rate sensitive because of their relatively short maturities. Many financial institutions have used jumbo certificates to manage interest rate sensitivity and liquidity. The Bank has not relied on jumbo certificates for liquidity or asset liability management. As of March 31, 1996, the Bank had $9.8 million outstanding in jumbo certificates as compared to $13.7 million at March 31, 1995. The following table sets forth the maturity schedule of certificates of deposit with balances of $100,000 or greater at March 31, 1996. (In Thousands) Within 3 months $ 2,548 After 3, within 6 months 2,792 After 6, within 12 months 2,299 After 12 months 2,208 $ 9,847 A negative gap position is expected to have an adverse effect on net interest income during periods of rising interest rates. A negative one-year gap position occurs when the dollar amount of rate sensitive liabilities maturing or repricing within one year exceeds the dollar amount of rate-sensitive assets maturing or repricing during that same time period. As a result, during periods of rising interest rates, the interest paid on interest bearing liabilities will increase faster than interest received from earning assets, thus, reducing net interest income. In periods of falling interest rates, the reverse is true, resulting in an expected increase in net interest income. The following table sets forth the Bank's interest-bearing liabilities and interest-earning assets repricing or maturing within one year. The table at the top of page 40 sets forth the Bank's interest bearing liabilities and interest-earning assets repricing or maturing within one year. The table on page eight presents all the Bank's interest bearing liabilities and interest earning assets into repricing or maturity time periods. Both tables present adjustable rate loans in the periods they are scheduled to reprice, not mature. They also assume investments reprice at the earlier of maturity or the next scheduled interest rate change, if any. NOW accounts, money market accounts, and regular savings accounts are assumed to reprice in the less than three month category, although other banks may assume slower repricing with assumed decay rates. At March 31, 1996 1995 (Dollars in Thousands) Loans (1) $109,503 106,542 Mortgage-backed securities 119 105 Investments: Held-to-maturity 3,006 7,001 Available-for-sale 23,538 987 Other interest-earning assets 2,858 1,014 Total interest rate sensitive assets repricing within one year 139,024 115,649 Deposits 145,805 130,162 FHLB advances and other borrowed money 17,389 19,951 Total interest rate sensitive liabilities repricing within one year 163,194 150,113 Gap $(24,170) (34,464) Interest rate sensitive assets/interest rate sensitive liabilities 85.19% 77.04% Gap as a percent of total assets (11.3) (16.4) (1) Loans are net of undisbursed funds and loans in process The OTS uses a Net Portfolio Value ("NPV") approach to the quantification of interest rate risk. In essence, this approach calculates the difference between the present value of expected cash flows from assets, liabilities and off-balance sheet contracts. The difference is the present value of equity. It includes the value of core deposits, and loan servicing in the base net value of the Bank. Management believes that the Bank's level of interest rate risk is acceptable under this approach as well. Net Portfolio Value NPV as % of PV of Assets Change Dollar Dollar Percent NPV in Rates Amount Change Change Ratio Change 400 bp* 16,314 (2,707) (14)% 7.77% (99) bp 300 bp 17,321 (1,700) (9)% 8.17% (59) bp 200 bp 18,178 (843) (4)% 8.49% (26) bp 100 bp 18,790 (231) (1)% 8.71% (5) bp 0 bp 19,021 -- -- 8.76% -- (100) bp 18,840 (181) (1)% 8.63% (13) bp (200) bp 18,331 (690) (4)% 8.37% (39) bp (300) bp 18,223 (798) (4)% 8.27% (49) bp (400) bp 18,823 (198) (1)% 8.46% (29) bp *bp = basis points The following table sets forth the interest sensitivity of the Bank's assets and liabilities at March 31, 1996, on the basis of the factors and assumptions set forth in the table on the top of page 38. Remaining Time Before Asset/Liability Matures or Can be Repriced More More More More More Than Than Than Than Than Three One Three Five Ten Three Months Year Years Years Years More Months Thru Thru Thru Thru Thru Than or One Three Five Ten Twenty Twenty Less Year Years Years Years Years Years Total (Dollars in Thousands) Interest Earnings Assets Loans (1). . . $48,003 $61,500 $25,386 $5,531 $4,888 $5,338 $ 3,648 $154,294 Mortgage-backed securities held -to- maturity, at cost . . . 29 90 562 292 471 562 536 2,542 Investment securities: Held-to-maturity, at cost . . 1,500 1,506 2,992 1,500 -- -- -- 7,498 Available-for- sale, at fair value . . . 2,997 20,541 7,434 -- -- -- -- 30,972 Interest-bearing deposits with banks . . . . 2,858 -- -- -- -- -- -- 2,858 FHLB stock, at cost . . . . -- -- 1,233 -- -- -- -- 1,233 Total financial assets . . . $55,387 $83,637 $37,607 $7,323 $5,359 $5,900 $4,184 $199,397 Interest Bearing Liabilities Deposits: Certificates of deposit. . . 31,988 51,536 17,670 1,544 -- -- -- 102,738 NOW . . . . . 34,896 -- -- -- -- -- -- 34,896 Money market deposit accounts . . 13,770 -- -- -- -- -- -- 13,770 Passbook accounts . . 13,615 -- -- -- -- -- -- 13,615 Borrowings . . 6,800 10,589 4,117 1,384 324 -- -- 23,214 Total interest bearing liabilities . $101,069 $62,125 $21,787 $2,928 $ 324 $ -- $ -- $188,233 Current period gap . . . . . (45,682) 21,512 15,820 4,395 5,035 5,900 4,184 11,164 Cumulative gap . . . . . (45,682) (24,170) (8,350) (3,955) 1,080 6,980 11,164 11,164 Cumulative gap as a percent of total assets . . . (21.3%) (11.3%) (3.9%) (1.8%) .5% 3.2% 5.2% 5.2% (1) Loans are net of undisbursed funds and loans in process In evaluating the Bank's exposure to interest rate risk, certain shortcomings inherent in the method of analysis presented in the foregoing tables must be considered. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rates. Additionally, the interest rates of certain types of assets and liabilities may fluctuate in advance of changes in market interest rates. Loan repayment rates and withdrawals of deposit likely will differ substantially from the assumed rates previously set forth in the event of significant changes in interest rates due to the option of borrowers to prepay their mortgage loans and the ability of depositors to withdraw funds prior to maturity. Further, certain assets such as adjustable rate mortgages, have features which restrict changes in interest rates on a short-term basis as well as over the life of the asset. Financial Condition Total assets at March 31, 1996 were $214.8 million, a $4.9 million increase from March 31, 1995. This increase was primarily a result of an increase in net loans receivable during the year and an increase in cash and cash equivalents at year end. Total net loans receivable were at $152.1 million at March 31, 1996, an increase of $3.2 million or 2.1% from the prior year. Residential real estate loans decreased $6.3 million or 9.5% to $60.0 million at March 31, 1996. Commercial real estate loan balances decreased to $10.6 million at fiscal year end from $13.0 million at March 31, 1995, a decrease of $2.4 million or 18.3%. Consumer loans increased to $44.8 million at March 31, 1996 from $44.1 million at the commencement of the year, an increase of $721,000 or 1.6%. Commercial loans increased $9.0 million or 30.4%, to $38.8 million at year end. Management continues to emphasize origination of consumer and commercial loans to increase yields and improve interest rate risk. Consumer loans are generally considered to involve greater degrees of collateral and credit risks than residential mortgage loans. Non-accrual loans totaled $2.6 million at March 31, 1996 compared to $812,000 a year earlier. Although this is a significant increase from last year, the majority of these loans are well secured and are in the process of collection. The Bank classifies all loans as non-accrual when they become 60 or more days delinquent. The Bank had $487,000 of troubled debt restructuring at year end, comprised of one loan which was also on non-accrual status and is considered impaired. The loan is secured and no loss is estimated at this time. At March 31, 1995, the Bank had $780,000 of troubled debt restructurings none of which were classified as non-accrual. Real estate acquired in settlement of loans (REO) amounted to $719,500 at March 31, 1996 compared to $1.5 million at fiscal year end 1995. The Aiken area's largest employer, the Savannah River Site, had a significant downsizing of personnel which leads to some uncertainties for the local economy. In addition, area real estate sales have been slower in the area than in past years. Future additions to the Bank's allowance for loan losses are dependent on, among other things, the performance of the Bank's loan portfolio, the economy, changes in real estate values, and interest rates. There can be no assurance that additions to the allowance will not be required in future periods. Management continues to monitor its loan portfolio for the impact of local economic changes. Deposits at the Bank increased by $6.1 million or 3.7% to $172.4 million at March 31, 1996 from $166.3 million at March 31, 1995. Advances from the Federal Home Loan Bank (FHLB), decreased to $22.9 million at March 31, 1996, down from $26.0 million a year earlier, a decrease of $3.1 million. Total shareholders' equity totaled $15.4 million at March 31, 1996, an increase of $945,000 or 6.5%, compared to $14.5 million a year earlier. The increase was attributable to net income of $1.1 million and an increase in paid in capital of $39,380 due to the exercise of stock options, partially offset by $82,236 in dividends paid and a $71,970 increase in unrealized net loss on securities available for sale. Results of Operations The following table 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 changes related to higher or lower outstanding balances and the changes due to the 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 rate (i.e., changes in rate multiplied by old volume) and (ii) changes in volume (i.e., changes in volume multiplied by old rate.) 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. 1996 Compared to 1995 1995 Compared to 1994 Volume Rate Net Volume Rate Net (Dollars in Thousands) Interest-earning assets: Loans: Real estate loans $ 156 (232) (76) 498 -- 498 Other loans 1,002 665 1,667 1,669 499 2,168 Total loans 1,158 433 1,591 2,167 499 2,666 Mortgage-backed securities (25) -- (25) (96) (34) (130) Investments (261) 108 (153) 660 326 986 Other interest- earning assets (2) 9 7 (191) 81 (110) Total interest- earning assets $ 870 550 1,420 2,540 872 3,412 Interest-bearing liabilities: Deposits: Certificate accounts 252 1,320 1,572 304 257 561 NOW accounts (33) (2) (35) 35 110 145 Money Market accounts (128) (2) (130) 12 53 65 Passbook accounts (53) 2 (51) 133 (12) 121 Total deposits 38 1,318 1,356 484 408 892 Borrowings 313 130 443 924 (119) 805 Total interest- bearing liabilities 351 1,448 1,799 1,408 289 1,697 Effect on net income $ 519 (898) (379) 1,132 583 1,715 The following table presents, for the periods indicated, the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. No tax equivalent adjustments were made. All average balances are monthly average balances which are representative of daily average balances. At March 31, Years Ended March 31, 1996 1996 1995 1994 Yield/ Average Yield/ Average Yield/ Average Yield/ Rate Balance Int. Rate Balance Int. Rate Balance Int. Rate (Dollars in Thousands) Interest- earning assets: Mortgage loans 7.37% $ 75,083 $ 5,652 7.53% $ 73,037 $ 5,728 7.84% $66,670 5,230 7.84% Other loans 9.69 78,641 7,843 9.97 68,148 6,176 9.06 49,294 4,008 8.13 Total loans 8.63 153,724 13,495 8.78 141,185 11,904 8.43 115,964 9,238 7.97 Mortgage- backed securi- ties 7.69 1,549 110 7.10 1,908 135 7.08 3,201 265 8.28 Ivest- ments 4.96 41,999 2,123 5.06 47,197 2,276 4.82 32,621 1,290 3.95 Other interest- earning assets 5.35 1,764 94 5.33 1,809 87 4.81 6,605 197 2.98 Total interest- earning assets 7.88% $199,036$15,822 7.95% $192,099 $14,402 7.50%$158,391$10,990 6.94% Interest- bearing liabilities: Certificate ac- counts 5.65% $ 97,173 $ 5,529 5.69% $ 91,716 $ 3,957 4.31% $84,538 $3,396 4.02% NOW ac- counts 1.63 32,729 560 1.71 34,659 595 1.72 32,280 450 1.39 Money Market ac- counts 2.81 14,655 416 2.84 19,171 546 2.85 18,709 481 2.57 Passbook ac- counts 2.50 14,003 348 2.49 16,120 399 2.48 10,763 278 2.58 Total interest- bearing de- posits 4.30 158,560 6,853 4.32 161,666 5,497 3.40 146,290 4,605 3.15 Other Borrow- ings 8.00 87 7 8.00 -- -- -- -- -- -- FHLB ad- vances 6.29 27,569 1,762 6.39 22,621 1,326 5.86 7,167 521 7.27 Total interest- bearing liabili- ties 4.56% $186,216 $8,622 4.73% $184,287 $6,823 3.70%$153,457 $5,126 3.34% Effect on net interest income $7,200 $7,579 $5,864 Interest rate spread 3.32% 3.22% 3.80% 3.60% Net yield on earning assets 3.62% 3.95% 3.70% Comparison of the Years Ended March 31, 1996 and 1995 General. The Company earned net income of $1,059,574 for the year ended March 31, 1996, a $57,420 increase over net income of $1,002,154 for fiscal 1995. This increase was due primarily to an increase in other income and a decrease in general and administrative expenses, offset partially by a decrease in net interest income. Net interest income. Net interest income was $7.2 million for fiscal 1996 compared to $7.6 million in 1995, a decrease of $379,000. The primary reason for the decrease was that a higher percentage of interest bearing liabilities repriced compared to interest earning assets. Total interest bearing assets increased in yield by an average of 45 basis points while interest bearing liabilities increased by an average cost of 103 basis points during fiscal 1996. Interest on loans increased by $1.6 million to $13.5 million from $11.9 million in 1995 primarily due to average loans increasing by $12.5 million in 1996. Interest on mortgage-backed securities dropped to $110,000 from $135,000 due to a lower average balance outstanding in 1996. Investment interest decreased to $2.1 million from $2.3 million in fiscal 1996 compared to 1995 because of a decrease in average outstanding investments. Other interest income increased $6,500 in 1996 due to slightly higher yields on overnight investments. Total interest income increased by $1.4 million in 1996 up to $15.8 million from $14.4 million in 1995. Interest on deposits increased to $6.8 million in 1996 compared to $5.5 million in 1995, due to the cost of interest bearing deposits rising in 1996. Interest on borrowings increased to $1.8 million in fiscal 1996 from $1.3 million in fiscal 1995 due to an increase in average borrowings and an increase in the average rate on borrowings. Total interest expense increased to $8.6 million in 1996 compared to $6.8 million in 1995, an increase of $1.8 million. Provision for Loan Losses. The provision for loan losses during fiscal 1996 was $230,000 as compared to $300,000 for 1995. Net charge-offs increased by $346,000 in fiscal 1996 of which 81.0% of this total consisted of one commercial loan. The ratio of the allowance for loan losses to total loans at March 31, 1996 was 1.14% as compared to 1.30% a year earlier. Based on its monthly reviews of the loan portfolio, management believes the allowance for loan losses is adequate based on its estimate of losses inherent in the loan portfolio, although there can be no guarantee as to these estimates. Other Income. Other income increased $156,000 in fiscal 1996 compared to 1995. The Bank had no gains on sale of investments in fiscal 1996 compared to a $2,500 loss in fiscal 1995. Gain on sale of loans which is a volatile source of income decreased by $37,000 in 1996. Loan servicing fees decreased by $6,000 while service fees on deposit accounts increased by $75,000. The increase in deposit account fees was attributable to an increase in demand accounts through efforts to attract commercial deposits and a special consumer checking account package which commenced in August 1995. As discussed earlier, the Company, is a partner in two real estate joint ventures, Willow Woods Associates, near Aiken, and Currytowne Associates in Edgefield County, South Carolina. Due to the sluggish real estate market, lot sales have been slower than anticipated. Income from real estate operations decreased by $135,000 in fiscal 1996 compared to fiscal 1995. A provision for real estate losses of $45,000 was charged for fiscal 1996 to real estate operations while no provision for real estate operations was expensed in fiscal 1995. Other income, which consists of net gain on real estate acquired in settlement of loans (REO), insurance commissions, and miscellaneous fees, increased by $256,000 in fiscal 1996 mainly due to an increase in net gain on sale of REO of $113,000 and a reversal of a $100,000 allowance for losses on REO in fiscal 1996 that was no longer necessary. General and Administrative Expenses. General and administrative expenses decreased by $250,000 in fiscal 1996 due mainly to a $264,000 decrease in salaries and employee benefits, as a result of employee attrition and a restructuring in officer positions. Occupancy expense remained almost constant with a slight $4,800 decrease. Advertising expense increased by $67,000 in fiscal 1996 in order to promote new checking account products, certificates of deposit and the new Wal*Mart branch that opened in February 1996. Depreciation and maintenance of equipment expense decreased by $54,000. Amortization of intangibles remained the same in fiscal 1996 and 1995 at $465,000. Federal insurance premiums expense decreased by $31,000 in fiscal 1996. Other expenses consisting of legal, real estate owned expense, data processing and miscellaneous expenses rose by $38,000 in fiscal 1996. Income Taxes. Income taxes increased by $39,000 to $539,000 in fiscal 1996 compared to $500,000 expensed in 1995 as a result of an increase in taxable income. The effective tax rate was approximately 34% and 33%, respectively. Comparison of the Years Ended March 31, 1995 and 1994 General. The Company earned net income of $1,002,154 for the year ended March 31, 1995, a $433,261 increase over net income of $568,893 for fiscal 1994. This increase was due primarily to an increase in net interest income, offset partially by a decrease in other income and an increase in general and administrative expense. Net interest income. Net interest income was $7.6 million for fiscal 1995 compared to $5.9 million in 1994, an increase of $1.7 million. The primary reason for the increase was that 1995 was the first full year of operations following the four branches being acquired in October, 1993. Average interest earning assets increased $33.7 million from 1994 to 1995 primarily due to the assets acquired as a result of the branch acquisitions. Interest on loans increased by $2.7 million to $11.9 million from $9.2 million in 1994 primarily due to average loans increasing by $25.2 million in 1995. Interest on mortgage-backed securities dropped to $134,901 from $265,534 due to principal paydowns with no new investments. Investment interest increased to $2.3 million from $1.3 million in fiscal 1995 compared to 1994 because of an increase in average outstanding investments. Other interest income decreased $109,878 in 1995 due to lower average balances in lower-earning overnight funds. Total interest income increased by $3.4 million in 1995 up to $14.4 million from $11.0 million in 1994. Interest on deposits increased to $5.5 million in 1995 compared to $4.6 million in 1994. Average interest bearing deposits increased $15.4 million while the average cost of interest-bearing deposits increased to 3.40% from 3.15% in 1994. Interest on borrowings increased to $1.3 million in fiscal 1995 from $521,107 in fiscal 1994 due to an increase in average borrowings. Total interest expense increased to $6.8 million in 1995 compared to $5.1 million in 1994, an increase of $1.7 million. Provision for Loan Losses. The provision for loan losses during fiscal 1995 was $300,000 as compared to $335,000 for 1994. The ratio of the allowance for loan losses to total loans at March 31, 1995 was 1.30% as compared to 1.37% a year earlier. Based on its monthly reviews of the loan portfolio, management believes the allowance for loan losses is adequate, although there can be no guarantee as to these estimates. Other Income. Other income decreased $487,039 in fiscal 1995 compared to 1994. Net gain on sale of investments decreased by $64,279. Gain on sale of loans decreased by $464,038 in 1995 due to a decrease in the origination of fixed rate loans which are generally sold. With mortgage interest rates rising during fiscal 1995, originations of adjustable rate loans increased, which are generally retained for portfolio. Loan servicing fees increased by $27,845 while service fees on deposit accounts increased by $124,268. The increase in deposit account fees was attributable to the increase in demand accounts acquired in the branch acquisitions. The Bank, through its subsidiary Security Financial Services Corporation (SFSC), is a partner in two real estate joint ventures, Willow Woods Associates, near Aiken, and Currytowne Associates in Edgefield County, South Carolina. Due to the sluggish real estate market, lot sales have been slower than anticipated. However, income from real estate operations increased by $44,854 in fiscal 1995 compared to fiscal 1994. A provision for real estate losses of $60,000 was charged for 1994 to real estate operations while no provision for real estate operations was expensed in fiscal 1995. This was partially offset by decreased sales income due to a lower volume of lot sales. Other income, which consists of net gain on real estate acquired in settlement of loans (REO), insurance commissions, and miscellaneous fees, decreased by $155,689 in fiscal 1995 mainly due to a decrease in net gain on sale of REO of $103,000. General and Administrative Expenses. General and administrative expenses increased by $566,442 in fiscal 1995 primarily due to the increased costs associated with a full year of operations of the acquired branches. Compensation and employee benefits increased by $367,159 due to an increase in average number of employees from the increased number of branches. FDIC insurance premiums increased by $186,643 in fiscal 1995 compared to fiscal 1994 due to an increase in average deposits. Amortization of intangibles which consist of goodwill and a core deposit value created by the branch acquisitions increased by $163,082 due to a full year of amortization. Other PAGE expenses decreased by $102,523 due to disposal of obsolete equipment in 1994 whereas no equipment was disposed of in fiscal 1995. Income Taxes. Income taxes increased by $233,823 to $499,729 in fiscal 1995 compared to $265,906 expensed in 1994 as a result of an increase in taxable income. The effective tax rate remained constant at 33% over both years. Regulatory Capital The following table reconciles the Bank's stockholders' equity to its various regulatory capital positions: March 31 1996 1995 (in thousands) Stockholders' equity (1) (2) $ 15,131 14,032 Reduction for nonqualifying assets -- (1,119) Reduction for goodwill and other intangibles 2,916 (3,376) Tangible capital 12,215 9,537 Qualifying core deposit intangible 1,120 1,361 Core capital 13,335 10,898 Supplemental capital 1,757 1,756 Risk-based capital $ 15,092 12,654 (1) For 1996 and 1995, includes unrealized losses of $123,000 and $51,000 respectively on certain available for sale securities. (2) For 1996 and 1995, excludes equity of Security Federal Corporation, the Parent. The following table compares the Bank's capital levels relative to regulatory requirements at March 31, 1996. Amount Percent Actual Actual Excess Excess Required Required Amount Percent Amount Percent (dollars in thousands) Tangible capital $ 3,149 1.50% $ 12,215 5.82% $ 9,066 4.32% Core capital 6,332 3.00 13,335 6.32 7,003 3.32 Risk-based capital 11,425 8.00 15,092 10.57 3,667 2.57 Liquidity and Capital Resources Liquidity refers to the ability of the Bank to generate sufficient cash flows to fund current loan demand, to repay maturing borrowings, to fund maturing deposit withdrawals and to meet operating expenses. The Bank's primary sources of funds include loan repayments, loan sales, increased deposits, advances from the FHLB, the use of securities sold under agreements to repurchase and cash flow generated from operations. The need for funds varies among periods depending on funding needs as well as the rate of amortization and prepayment on loans. The use of FHLB advances and securities sold under agreements to repurchase vary depending on their relative costs. Advances from the FHLB decreased $3.2 million in fiscal 1996, while they increased $17.4 million in fiscal 1995. Management views advances as a relatively inexpensive source of funds given that, unlike deposits, there are no FDIC premiums associated with FHLB advances and advances are less labor intensive than deposits. Deposits grew $6.0 million in fiscal 1996 due to increases in certificates of deposit and market efforts to attract demand deposits. The principal use of the Bank's funds is the origination of mortgages and other loans. Total demand in the Bank's primary market areas decreased slightly during fiscal 1996 compared to fiscal 1995 and fiscal 1994 respectively, due to an increase in interest rates, the slow real estate market, and high refinancing volume in fiscal 1994. This resulted in loan originations of $53.5 million in fiscal 1996 as compared to $77.4 million in fiscal 1995, while they were $81.4 million in fiscal 1994. Outstanding loan commitments for which the Bank has not obtained prior commitments to purchase from other institutional investors amounted to $603,745 at March 31, 1996 compared to $349,000 at March 31, 1995. In addition, unused lines of credit on home equity loans, credit cards and other loans amounted to $17.6 million at March 31, 1996. Management does not anticipate that the percentage of funds drawn on unused lines of credit will increase substantially over amounts currently utilized. Funding of undisbursed loans in process of $474,575 at March 31, 1996, and commitments to originate loans and future advances on lines of credit are expected to be provided from loan amortizations and prepayments, deposit inflows and short-term borrowing capacity. The Bank is required under applicable federal regulations to maintain a liquidity ratio at specified levels which are subject to change. Currently, a minimum of 5.0% of the combined total of deposits and certain borrowings must be maintained in the form of cash or eligible investments. At March 31, 1996, the Bank's liquidity ratio was 8.73% which is in line with management's goal to keep a high percentage of earning assets in higher yielding assets such as loans. Management believes that liquidity during fiscal 1997 can be met through the Bank's deposit base and borrowing ability, and then in the next few years, will be bolstered from maturing investments. See "Consolidated Statements of Cash Flows" in the consolidated financial statements. Accounting and Reporting Changes Financial Accounting Standards Board (FASB) Statement 107, "Disclosures about Fair Value of Financial Instruments" became effective for the Bank for the fiscal year ended March 31, 1996. FASB No. 107 requires the Bank to disclose the fair value of all financial instruments. In May 1993, the FASB issued Statement 114 "Accounting by Creditors for Impairment of a Loan" which became effective for the Bank beginning April 1, 1995. This statement requires a lender to consider a loan to be impaired if the lender believes it is probable that it will be unable to collect all principal and interest due according to the contractual terms of the loan. If a loan is impaired, the lender will be required to record a loan valuation allowance equal to the present value of the estimated future cash flows discounted at the loan's effective rate. This accounting change will significantly change the troubled debt restructuring accounting by lenders presently allowed under FASB Statement 15. Adoption of this statement did not have a material adverse effect on the financial condition or results of operation of the Bank. In May 1993, the FASB issued Statement 115 "Accounting for Certain Investments in Debt and Equity Securities." The statement expands the required use of fair value accounting for investments in debt and equity securities, and allows debt securities to be classified as "held to maturity" and reported in financial statements at amortized cost only if the reporting entity has the positive intent and ability to hold those securities to maturity. Furthermore, the statement makes clear that securities which might be sold in response to changes in market interest rates, changes in the security's prepayment risk, increase in loan demand, or other similar factors cannot be classified as "held to maturity." Adoption of this statement on March 31, 1994 did not have a material adverse effect on the financial condition or results of operation of the Bank. In November 1995, the FASB issued a guide to the implementation of SFAS No. 115 which allows for the one-time transfer of certain investments classified as held to maturity to available for sale. The Bank transferred $27.9 million of investment securities to available for sale as of December 31, 1995. The change in market value on these securities is reflected in equity as an unrealized gain or loss on securities available for sale, net of applicable income taxes. PAGE In October 1994, the FASB issued SFAS No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments." The statement requires disclosures about amounts, nature, and terms of derivative financial instruments. The statement amends SFAS No. 105 "Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments." The statement is effective for the Bank for the fiscal year ending March 31, 1996. In light of the Bank's current portfolio, the adoption of this statement did not have a significant impact on the Bank. In March, 1995 the FASB issued SFAS No. 121, "Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to be Disposed of." This statement requires that long-lived assets and certain identifiable intangibles to be held and used by an entity be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Statement is effective for the Bank in fiscal year ending March 31, 1997. Based on the Bank's present assets, this Statement is not expected to have a significant impact on the Bank. In May, 1995, the FASB issued Statement 122, "Accounting for Mortgage Servicing Rights, an amendment of FASB Statement No. 65." The Statement requires that rights to service mortgage loans for others be recognized as a separate asset, however those rights are acquired. The Statement also requires that an entity assess its capitalized mortgage servicing rights for impairment based on the fair value of those rights. The Statement applies prospectively in the Bank's fiscal year ended March 31, 1997 to transactions in which an enterprise sells or securitizes mortgage loans with servicing rights retained and to impairment evaluations of all amounts capitalized as mortgage servicing rights, including those purchased prior to adoption of the Statement. Based on the Bank's current mortgage banking activities, this Statement is not expected to have a material impact on the Bank. Other Matters The United States Congress is currently proposing a plan under which the Bank Insurance Fund (BIF), which is the primary deposit insurance fund for commercial banks, would be merged with the Savings Association Insurance Fund (SAIF), which is the primary insurance fund for thrifts and savings banks. In connection with this merger, all members of the SAIF fund would be required to pay a one-time assessment of between 80 and 90 basis points per every $100 of SAIF insured deposit balances as of March 31, 1995. Based on the Bank's deposit balances as of March 31, 1995, the one-time assessment would be approximately $950,000 before tax and approximately $600,000 after tax, if that expense would be tax deductible. In exchange for this one-time assessment, qualifying members of the SAIF fund would receive a reduction in their annual premiums. The measure has not yet passed Congress, and the final provisions and payment date are as yet unknown. Impact of Inflation and Changing Prices The consolidated financial statements, related notes, and other financial information presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars, without considering changes in relative purchasing power over time due to inflation. Unlike most industrial companies, substantially all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution's performance than does the effect of inflation. Item 7. Financial Statements The audited financial statements of the Company and its subsidiary and the independent auditor's report thereon are set forth on the following pages. Independent Auditors' Report The Board of Directors Security Federal Corporation: We have audited the consolidated balance sheets of Security Federal Corporation and Subsidiary (the "Company") as of March 31, 1996 and 1995 and the related consolidated statements of income, shareholders' equity, and cash flows for each of the years in the three-year period ended March 31, 1996. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company at March 31, 1996 and 1995, and the results of its operations and its cash flows for each of the years in the three-year period ended March 31, 1996 in conformity with generally accepted accounting principles. As discussed in note 1 to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," on April 1, 1993 and adopted the provisions of Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" on March 31, 1994. Greenville, South Carolina May 9, 1996 SECURITY FEDERAL CORPORATION AND SUBSIDIARY Consolidated Balance Sheets March 31, 1996 and 1995 Assets 1996 1995 Cash and cash equivalents $ 9,823,664 5,697,391 Investment and mortgage-backed securities: Available for sale (amortized cost of $31,170,866 and $4,013,080 in 1996 and 1995, respectively) 30,972,406 3,930,626 Held to maturity (market value of $9,913,951, and $37,080,638 in 1996 and 1995, respectively) 10,040,724 38,596,245 41,013,130 42,526,871 Loans receivable, net: Held for sale 612,919 776,631 Held for investment (net of allowance of $1,758,688 and $1,955,119 in 1996 and 1995, respectively) 151,526,807 148,200,563 152,139,726 148,977,194 Accrued interest receivable: Loans 882,274 755,265 Mortgage-backed securities 23,799 22,328 Investments 450,952 464,229 1,357,025 1,241,822 Premises and equipment, net 3,187,185 3,251,171 Federal Home Loan Bank stock, at cost 1,233,200 1,415,100 Real estate acquired in settlement of loans 718,763 1,531,251 Real estate held for development and sale 1,389,579 1,442,723 Other assets 3,953,859 3,865,211 Total assets $214,816,131 209,948,734 Liabilities and Shareholders' Equity Liabilities: Deposits 172,374,727 166,274,637 Advances from Federal Home Loan Bank 22,864,000 26,033,000 Other borrowings 350,000 -- Advance payments by borrowers for taxes and insurance 385,708 442,456 Other liabilities 3,407,478 2,709,171 Total liabilities 199,381,913 195,459,264 Commitments and contingencies Shareholders' equity: Serial preferred stock, $.01 par value; authorized 200,000 shares; issued and outstanding shares, none -- -- Common stock, $.01 par value; authorized 1,000,000 shares; issued and outstanding shares, 413,184 in 1996 and 409,246 in 1995 4,132 4,092 Additional paid-in capital 3,919,262 3,879,922 Unrealized net loss on securities available for sale, net of income taxes (123,125) (51,155) Retained earnings, substantially restricted 11,633,949 10,656,611 Total shareholders' equity 15,434,218 14,489,470 Total liabilities and shareholders' equity $214,816,131 209,948,734 See accompanying notes to consolidated financial statements. SECURITY FEDERAL CORPORATION AND SUBSIDIARY Consolidated Statements of Income For the years ended March 31, 1996, 1995 and 1994 1996 1995 1994 Interest income: Loans $ 13,494,840 11,903,824 9,237,564 Mortgage-backed securities 109,998 134,901 265,534 Investment securities 2,123,667 2,276,122 1,289,521 Other 93,789 87,295 197,173 Total interest income 15,822,294 14,402,142 10,989,792 Interest expense: NOW and money market 976,423 1,141,084 931,426 Passbook 347,937 398,600 277,841 Certificates of deposit 5,529,003 3,957,123 3,395,896 Advances and other borrowed money 1,769,178 1,326,248 521,107 Total interest expense 8,622,541 6,823,055 5,126,270 Net interest income 7,199,753 7,579,087 5,863,522 Provision for loan losses (230,000) (300,000) (335,000) Net interest income after provision for loan losses 6,969,753 7,279,087 5,528,522 Other income: Gain (loss) on sales of investment securities -- (2,504) 61,775 Gain on sales of loans 124,677 161,922 625,960 Loan servicing fees 312,653 318,695 290,850 Service fees on deposits 584,420 509,181 384,913 Income from real estate operations 34,068 168,795 123,941 Other 412,244 156,254 311,943 Total other income 1,468,062 1,312,343 1,799,382 General and administrative expenses: Compensation and employee benefits 3,181,844 3,446,231 3,079,072 Occupancy 368,731 373,519 379,209 Advertising 197,575 130,748 154,820 Depreciation and maintenance of equipment 651,676 705,787 723,944 Amortization of intangibles 465,240 465,240 302,158 Federal insurance premiums 387,722 419,040 232,397 Other 1,586,756 1,548,982 1,651,505 Total general and adminis- trative expenses 6,839,544 7,089,547 6,523,105 Income before income taxes and cumulative effect of change in accounting for income taxes 1,598,271 1,501,883 804,799 Income taxes 538,697 499,729 265,906 Income before cumulative effect of change in accounting for income taxes 1,059,574 1,002,154 538,893 Cumulative effect of change in accounting for income taxes -- -- 30,000 Net income $ 1,059,574 1,002,154 568,893 Net income per common share: Before cumulative effect of change in accounting for income taxes $ 2.58 2.48 1.36 Cumulative effect of change in accounting for income taxes -- -- .08 Net income per common share $ 2.58 2.48 1.44 Cash dividend per common share $ .20 .20 .20 Weighted average shares outstanding 410,937 404,750 393,772 See accompanying notes to consolidated financial statements. SECURITY FEDERAL CORPORATION AND SUBSIDIARY Consolidated Statements of Shareholders' Equity For the years ended March 31, 1996, 1995 and 1994 Indirect Guarantee of Unrealized Employee Net Loss Additional Stock on Securities Common Paid-in Ownership Available Retained Stock Capital Trust Debt for Sale Earnings Total Balance at March 31, 1993 $ 3,938 3,685,436 (15,779) -- 9,245,198 12,918,793 Principal repayment of ESOP note -- -- 15,779 -- -- 15,779 Net income -- -- -- -- 568,893 568,893 Cash dividend -- -- -- -- (78,754) (78,754) Unrealized net loss on securities available for sale, net of tax -- -- -- (44,116) -- (44,116) Balance at March 31, 1994 3,938 3,685,436 -- (44,116) 9,735,337 13,380,595 Exercise of stock options 154 194,486 -- -- -- 194,640 Net income -- -- -- -- 1,002,154 1,002,154 Cash dividend -- -- -- -- (80,880) (80,880) Change in un- realized net loss on securities available for sale, net of tax -- -- -- (7,039) -- (7,039) Balance at March 31, 1995 4,092 3,879,922 -- (51,155) 10,656,611 14,489,470 Exercise of stock options 40 39,340 -- -- -- 39,380 Net income -- -- -- -- 1,059,574 1,059,574 Cash dividend -- -- -- -- (82,236) (82,236) Change in unreal- ized net loss on securities available for sale, net of tax -- -- -- (71,970) -- (71,970) Balance at March 31, 1996 $ 4,132 3,919,262 -- (123,125) 11,633,949 15,434,218 See accompanying notes to consolidated financial statements. SECURITY FEDERAL CORPORATION AND SUBSIDIARY Consolidated Statements of Cash Flows For the years ended March 31, 1996, 1995 and 1994 1996 1995 1994 Cash flows from operating activities: Net income $ 1,059,574 1,002,154 568,893 Adjustments to reconcile net income to net cash provided (used) by operating activities: Depreciation 596,677 588,825 526,764 Amortization of purchase accounting adjustments 465,240 465,240 224,290 Discount accretion and premium amortization 210,445 235,467 (93,265) Provisions for losses on loans and real estate 175,000 300,000 395,000 Gain on sale of loans (124,677) (161,922) (625,960) Gain on sale of mortgage- backed securities -- -- (158,433) (Gain) loss on sale of investments -- (2,504) 96,658 (Gain) loss on sale of real estate (180,030) (155,342) (299,211) FHLB stock dividends -- -- (43,300) Amortization of deferred fees on loans (115,867) 110,274 (498,631) Loss on disposition of premises and equipment -- 5,452 89,859 Proceeds from sale of loans held for sale 12,527,406 16,219,422 64,776,520 Origination of loans for sale (12,239,017) (12,979,526) (61,604,678) (Increase) decrease in accrued interest receivable: Loans (127,009) 459,596 (67,744) Mortgage-backed securities (1,471) (3,453) 117,449 Investments 13,277 70,180 (461,745) Increase (decrease) in advance payments by borrowers (56,748) 87,610 14,312 Other, net (419,255) (1,152,180) 3,137,425 Net cash provided (used) by operating activities 1,783,545 5,089,296 6,294,203 Cash flows from investing activities: Increase in cash from branch acquisitions -- -- 39,117,870 Principal repayments on mortgage- backed securities 221,819 561,015 2,265,351 Purchase of investment securities (3,034,529) (500,000) (69,878,442) Proceeds from sales of investment securities -- 1,500,000 7,406,875 Proceeds from sale of mortgage-backed securities -- -- 2,997,318 Proceeds from maturities of investment securities 4,000,000 7,205,155 21,508,342 Purchase of FHLB stock (389,600) (1,053,900) -- Redemption of FHLB stock 571,500 750,000 -- (Increase) decrease in loans to customers (3,544,427) (27,779,097) (6,164,053) Investment in real estate held for development (262,968) (355,155) (242,744) Proceeds from sale of real estate held for development 350,180 625,674 464,035 Proceeds from sale of real estate acquired through foreclosure 1,725,210 804,714 385,717 Increase (decrease) in interest- bearing deposits with banks -- 95,000 -- Proceeds from sales of premises and equipment -- 2,522 -- Net cash provided (used) by investing activities (895,506) (18,396,427) (3,847,670) (Continued) PAGE SECURITY FEDERAL CORPORATION AND SUBSIDIARY Consolidated Statements of Cash Flows For the years ended March 31, 1996, 1995 and 1994 1996 1995 1994 Cash flows from financing activities: Increase (decrease) in deposit accounts $6,100,090 (7,158,055) (2,984,047) Proceeds from FHLB advances 100,904,000 153,775,000 17,000,000 Repayment of FHLB advances (104,073,000) (136,358,000) (15,186,000) Proceeds from other borrowings 350,000 -- -- Dividends to shareholders (82,236) (80,880) (78,754) Proceeds from exercise of stock options 39,380 194,640 -- Net cash provided (used) by financing activities 3,238,234 10,372,705 (1,248,801) Net increase (decrease) in cash and cash equivalents 4,126,273 (2,934,426) 1,197,732 Cash and cash equivalents at beginning of period 5,697,391 8,631,817 7,434,085 Cash and cash equivalents at end of period $ 9,823,664 5,697,391 8,631,817 Supplemental disclosure of cash flow information: Cash paid during the period for: Interest $ 8,402,928 5,398,792 4,559,022 Income taxes $ 424,000 545,242 881,240 Supplemental schedule of non cash transactions: Additions to real estate acquired through foreclosure, net $ 711,760 661,650 1,255,720 Transfer of securities held to maturity to available for sale $ 27,867,170 -- 9,543,589 Change in unrealized net loss on securities available for sale $ 71,970 7,039 44,116 See accompanying notes to consolidated financial statements. Notes to Consolidated Financial Statements (1) Significant Accounting Policies The following is a description of the more significant accounting and reporting policies used in the preparation and presentation of the accompanying consolidated financial statements. All significant intercompany transactions have been eliminated in consolidation. (a) Basis of Consolidation The accompanying consolidated financial statements include the accounts of Security Federal Corporation (the "Company") and its wholly owned subsidiary, Security Federal Bank (the "Bank") and its wholly subsidiary, Security Financial Services Corporation ("SFSC"). SFSC consists primarily of investment brokerage services. Also included in consolidation are two real estate partnerships, which the Company purchased from SFSC in December 1995 at fair market value. (b) Cash and Cash Equivalents For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks, interest-bearing balances in other banks, and federal funds sold. Cash equivalents have maturities of three months or less. (c) Investment and Mortgage-Backed Securities In May 1993 the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 115 (Statement 115), "Accounting for Certain Investments in Debt and Equity Securities". Under Statement 115 investment securities, including mortgage-backed securities, are classified into one of three categories, held to maturity, available for sale or trading. Management determines the appropriate classification of debt securities at the time of purchase. Investment securities are classified as held to maturity when the Company has the positive intent and ability to hold the securities to maturity. These securities are recorded at cost, adjusted for amortization of premiums and accretion of discounts over the estimated life of the security using a method that approximates a level yield. Prepayment assumptions on mortgage-backed securities are anticipated. Management classifies investment securities not considered as held to maturity as available for sale, which are stated at fair value, with unrealized gains and losses, net of tax, reported in a separate component of shareholders' equity. Gains and losses from sales of investments and mortgage-backed securities available for sale are determined using the specific identification method. The Company has no trading securities. As permitted by Statement 115, the Company initially adopted the statement as of March 31, 1994, the effect of which was to decrease shareholders' equity by $44,116. In November 1995, the FASB issued a guide to implementation of SFAS No. 115 on accounting for certain investments in debt and equity securities which allows for the one-time transfer of certain investments classified as held to maturity to available for sale. The Bank transferred $27.9 million of investments to available for sale. At March 31, 1995, the Bank maintained liquid assets in excess of the amount required by regulations. The required amount is 5% of the average daily balances of deposits and short-term borrowings. Liquid assets consist primarily of cash, including time deposits and investment securities with remaining maturities of less than five years. (1) Significant Accounting Policies, Continued (d) Allowance for Loan Losses The Company provides for loan losses on the allowance method. Accordingly, all loan losses are charged to the related allowance and all recoveries are credited to the allowance for loan losses. Additions to the allowance for loan losses are provided by charges to operations based on various factors which, in management's judgment deserve current recognition in estimating possible losses. Such factors considered by management include the market value of the underlying collateral, stated guarantees by the borrower if applicable, the borrower's ability to repay from other economic resources, growth and composition of the loan portfolios, the relationship of the allowance for loan losses to outstanding loans, loss experience, delinquency trends, and general economic conditions. Management evaluates the carrying value of the loans periodically and the allowance is adjusted accordingly. While management uses the best information available to make evaluations, future adjustment to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluations. Allowances for loan losses are subject to periodic evaluations by various regulatory authorities and may be subject to adjustments based upon the information that is available to them at the time of their examinations. On April 1, 1995, the Bank adopted the provisions of SFAS No. 114 Accounting by Creditors for Impairment of a Loan, and SFAS No. 118 Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures. SFAS No. 114 requires creditors to evaluate loans for impairment and value those loans for which it is probable that the creditor will be unable to collect all amounts due according to the terms of the loan agreement at the present value of expected cash flows, market price of the loan, if available, or value of the underlying collateral. Expected cash flows are required to be discounted at the loan's effective interest rate. SFAS No. 118 amends SFAS No. 114 to allow a creditor to use existing methods for recognizing interest income on an impaired loan, and requires disclosure of income recognition methods used. The adoption of this standard required no increase to the allowance for loan losses and had no impact on net income for fiscal year 1996. (e) Loans Held for Sale Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Net unrealized losses are provided for in a valuation allowance by charges to operations. (f) Real Estate Acquired in Settlement of Loans Real estate acquired in settlement of loans represents real estate acquired through foreclosure and is initially recorded at the lower of cost (principal balance of the former mortgage loan less any specific valuation allowances) or estimated fair value less costs to sell. Subsequent improvements are capitalized. Costs of holding real estate, such as property taxes, insurance, general maintenance and interest expense, are expensed as a period cost. Fair values are reviewed regularly and allowances for possible losses are established when the carrying value of the real estate owned exceeds the fair value less estimated costs to sell. Fair values are generally determined by reference to an outside appraisal. (g) Real Estate Held for Development and Sale Real estate purchased for development and sale and investments in real estate partnerships are stated at the lower of cost or estimated net realizable value. Costs directly related to such real estate are capitalized until construction required to bring these properties to a saleable condition is completed. Capitalized costs include direct costs incurred during the improvement period. (1) Significant Accounting Policies, Continued Gains on the sale of real estate purchased for development and sale are recorded at the time of sale provided certain criteria relating to property type, cash down payment, loan terms, and other factors are met. If these criteria are not met at the date of sale, the gain is deferred and recognized using the installment or cost recovery method until they are satisfied, at which time the remaining deferred gain is recorded as income. Market values of real estate purchased for development and sale are reviewed regularly and allowances for losses are established when the carrying value exceeds the estimated net realizable value. In determining the estimated net realizable value, the Company deducts from the estimated selling price the projected cost to complete and dispose of the property and the estimated cost to hold the property to an expected date of sale. (h) Premises and Equipment Premises and equipment are carried at cost, net of accumulated depreciation. Depreciation of premises and equipment is provided principally on a straight-line method over the estimated useful life of the related asset. Estimated lives are seven to thirty years for buildings and improvements and generally five to ten years for furniture, fixtures and equipment. (i) Income Taxes The Bank adopted SFAS No. 109 "Accounting for Income Taxes effective April 1, 1993." Under SFAS No. 109 deferred tax expense or benefit is recognized for the net change during the year in the deferred tax liability or asset. That amount together with income taxes currently payable is the total amount of income tax expense or benefit for the year. Upon adoption of SFAS No. 109 the Bank realized an addition to net income of $30,000. Deferred taxes are provided for differences in financial reporting bases for assets and liabilities as compared with their tax bases. Basically, a current tax liability or asset is established for taxes presently payable or refundable and a deferred tax liability or asset is established for future tax items. A valuation allowance, if applicable, is established for deferred tax assets that may not be realized. Tax bad debt reserves in excess of the base year amount (established as taxable years ending March 31, 1988 or later), would create a deferred tax liability. Deferred income taxes are provided for differences between the provision for loan losses for financial statement purposes and those allowed for income tax purposes. Effective April 1, 1993, the Company adopted Statement 109 and has reported the cumulative effect of that change in the method of accounting for income taxes in the 1994 consolidated statement of income. (j) Loan Fees and Costs Associated with Originating Loans The net of loan fees received and direct incremental costs of originating loans are deferred and amortized over the contractual life of the related loan. The net fees are recognized as yield adjustments by applying the interest method. Prepayments are not anticipated. (1) Significant Accounting Policies, Continued (k) Intangible Assets Goodwill, which represents the excess of purchase price over fair value of net assets acquired, is amortized on a straight-line basis over the expected periods to be benefited. The Company assesses the recoverability of this intangible asset by determining whether the amortization of the goodwill balance over its remaining life can be recovered through projected undiscounted future results. The amount of goodwill impairment, if any, is measured based on projected discounted future results using a discount rate reflecting the Company's average cost of funds. Deposit based premiums, representing the cost of acquiring deposits from other financial institutions, are being amortized by charges to operations over the expected periods to be benefited. The effective amortization period for intangible assets is approximately 10 years. (l) Interest Income Interest on loans is accrued and credited to income monthly based on the principal balance outstanding and the contractual rate on the loan. The Company places loans on non-accrual status when they become greater than sixty days delinquent or when in the opinion of management, full collection of principal or interest is unlikely. The Company provides an allowance for uncollectible accrued interest on loans which are sixty days delinquent for all interest accrued prior to the loan being placed on non-accrual status. The loans are returned to an accrual status when full collection of principal and interest appears likely. (m) Fair Value of Financial Instruments SFAS No. 107 "Disclosures about Fair Value of Financial Instruments" requires disclosure in the financial statements regarding the fair value of on and off-balance sheet financial instruments for which it is practicable to do so. Fair values are based on quoted market prices where available and on estimates of present value or other valuation techniques. These estimates are made at a specific point in time and are subjective in nature involving uncertainties and significant judgment. In addition, SFAS No. 107 excludes all non-financial instruments and certain financial instruments from its disclosure requirements. Accordingly, the aggregate fair values presented do not represent the underlying fair value of the Bank. Fair values for consolidated financial statement reporting purposes are estimated for loans with similar financial characteristics. These loans are segregated by type of loan, considering credit risk, interest rate and prepayment characteristics. Each loan category is further segmented into fixed and adjustable rate categories. The fair value of performing loans is calculated by discounting scheduled cash flows through estimated maturity dates. Expected cash flows are discounted using the Bank's current rates that reflect the credit and interest rate risks inherent in each category of loans. A prepayment assumption is used as an estimate of the portion of loans that will be repaid prior to their scheduled maturity. (n) Earnings Per Share Net income per share is computed by dividing consolidated net income by the weighted average number of shares of common stock equivalents outstanding during the period. Common share equivalents include, if applicable, dilutive stock option share equivalents determined by using the treasury stock method. (o) Reclassifications Certain amounts in prior years' consolidated financial statements have been reclassified to conform with current year classifications. (2) Branch Acquisition On October 21, 1993 the Bank acquired certain assets and certain deposits and other liabilities of four branch offices of NationsBank of South Carolina, N.A. (the "branches"). In connection with the purchase, the Bank paid a deposit premium of approximately $4.4 million. The Company accounted for the acquisition under the purchase method of accounting. The application of the purchase method of accounting resulted in the adjustment of the assets and liabilities acquired based upon their fair market values on the date of acquisition. The Company's consolidated statements of income include the operating results of the acquired branches after October 21, 1993. The assets acquired and liabilities assumed (after purchase accounting adjustments) of the branches at the acquisition date are summarized as follows: Assets acquired: Loans receivable, net $ 15,969,139 Building and equipment 916,155 Premium on deposits and goodwill 3,926,792 Other assets 1,203,799 Total assets $ 22,015,885 Liabilities assumed: Deposit accounts 61,123,824 Other liabilities 9,931 Total liabilities 61,133,755 Cash received $ 39,117,870 At March 31, 1996, the Bank's remaining balances in goodwill and core deposit intangible were $1,693,074 and $1,119,641, respectively. (3) Investment and Mortgage-Backed Securities, Held to Maturity The amortized cost, gross unrealized gains, gross unrealized losses and market values of investment securities held to maturity are as follows: March 31, 1996 Gross Gross Amortized Unrealized Unrealized Market Cost Gains Losses Value FNMA securities $ 1,006,250 7,030 2,016 1,011,264 FHLB securities 5,492,366 -- 138,422 5,353,944 FHLMC bond 1,000,000 -- 10,900 989,100 Mortgage-backed securities 2,542,108 32,651 15,116 2,559,643 $10,040,724 39,681 166,454 9,913,951 March 31, 1995 Gross Gross Amortized Unrealized Unrealized Market Cost Gains Losses Value U.S. Treasury obligations $27,867,170 -- 992,492 26,874,678 FNMA securities 2,017,770 -- 77,676 1,940,094 FHLB securities 5,500,700 -- 376,029 5,124,671 FFCB securities 500,000 -- 650 499,350 FHLMC bond 1,000,000 -- 69,560 930,440 Mortgage-backed securities 1,710,605 18,979 18,179 1,711,405 $38,596,245 18,979 1,534,586 37,080,638 The amortized cost and market value of investments securities held to maturity at March 31, 1996, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers have the right to prepay obligations with or without call or prepayment penalties. Amortized Fair Cost Value In one year or less $ 506,250 504,234 After one year through five years 6,992,366 6,850,074 Mortgage-backed securities 2,542,108 2,559,643 $ 10,040,724 9,913,951 At March 31, 1996 investment securities of $4,852,500 were pledged as collateral for certain deposit accounts and Federal Home Loan Bank of Atlanta borrowings. (4) Investment and Mortgage-Backed Securities, Available for Sale The amortized cost, gross unrealized gains, gross unrealized losses and market value of investment and mortgage-backed securities available for sale are as follows: March 31, 1996 Gross Gross Amortized Unrealized Unrealized Market Cost Gains Losses Value U.S. Treasury notes $31,170,866 1,782 200,242 30,972,406 March 31, 1995 Gross Gross Amortized Unrealized Unrealized Market Cost Gains Losses Value U.S. Treasury notes $ 4,013,080 -- 82,454 3,930,626 The amortized cost and market value of investment securities available for sale at March 31, 1996, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers have the right to prepay obligations with or without call or prepayment penalties. Amortized Fair Cost Value In one year or less $ 23,617,943 23,537,490 After one year through five years 7,552,923 7,434,916 $ 31,170,866 30,972,406 (4) Investment and Mortgage-Backed Securities, Available for Sale, Continued Proceeds from the sales of investment and mortgage-backed securities during the years ended March 31, 1996, 1995 and 1994, as well as the gross gains and losses realized are summarized as follows: 1996 1995 1994 Investments: Proceeds from sales $ -- 1,498,085 7,406,875 Gross gains $ -- 1,523 -- Gross losses $ -- 4,027 96,658 Mortgage-backed securities: Proceeds from sales $ -- -- 2,997,318 Gross gains $ -- -- 158,433 Gross losses $ -- -- -- (5) Loans Receivable, Net Loans receivable, net at March 31, consisted of the following: 1996 1995 Residential real estate $ 59,951,018 66,226,289 Consumer 44,810,133 44,089,104 Commercial real estate 10,629,652 13,007,516 Commercial business 38,764,035 29,718,456 Loans held for sale 612,919 776,631 154,767,757 153,817,996 Less: Allowance for loan losses 1,758,688 1,955,119 Loans in process 474,575 2,419,433 Deferred loan fees 394,768 466,250 2,628,031 4,840,802 $152,139,726 148,977,194 (5) Loans Receivable, Net, Continued Changes in the allowance for loan losses for the years ended March 31, are summarized as follows: 1996 1995 1994 Balance at beginning of year $ 1,955,119 1,735,073 1,190,793 Provision for loan losses 230,000 300,000 335,000 Allowance on acquired loans -- -- 324,479 Charge-offs (471,938) (105,073) (124,689) Recoveries 45,507 25,119 9,490 Balance at end of year $ 1,758,688 1,955,119 1,735,073 The following table sets forth the amount of the Company's non-accrual loans and the status of the related interest income at March 31: 1996 1995 Non-accrual loans $ 2,572,000 812,000 Interest income which would have been recognized under original terms 82,670 55,308 Interest income actually recognized 54,200 10,303 Loans serviced for others at March 31, 1996, 1995, and 1994, were $93,309,923, $97,636,672, and $100,284,182 respectively. At March 31, 1996, impaired loans amounted to $2,572,000. These loans are well secured and no loss is estimated at this time. For the year ended March 31, 1996, the average recorded investment in impaired loans was $1,879,000 and $54,200 of interest income was recognized on loans while they were impaired. All of this income was recognized using the accrual method of accounting. The Bank originates residential and commercial real estate loans throughout its primary market area located in the south and central regions of South Carolina. Although this region has a diverse economy, much of the area is dependent on the nearby Savannah River Site. Employment at the Savannah River Site is expected to decline in the future. The future impact on the local economy and real estate market could affect the financial status of the Bank's customers. The degree of impact will be affected by the timing and terms associated with the Savannah River Site employment reduction, growth of other sectors of the local economy, etc. Future additions to the Bank's allowance for loan losses are dependent on the performance of the Bank's loan portfolio, the economy, changes in real estate values, and interest rates. There can be no assurance that additions to the allowance will not be required in future periods. Management continues to monitor its loan portfolio for the impact of local economic changes. (6) Premises and Equipment, Net Premises and equipment, net at March 31, are summarized as follows: 1996 1995 Land $ 440,323 371,313 Buildings and improvement 2,998,995 2,711,637 Furniture and equipment 2,936,904 3,337,682 6,376,222 6,420,632 Less accumulated depreciation (3,189,037) (3,169,461) $ 3,187,185 3,251,171 Depreciation expense for the years ended March 31, 1996, 1995, and 1994, was $596,677, $588,825, and $526,764, respectively. The Bank has entered into noncancelable operating leases related to buildings and land. At March 31, 1996, future minimum payments under noncancelable operating leases with initial or remaining terms of one year or more are as follows (by fiscal year): 1997 $ 62,980 1998 61,390 1999 48,777 2000 30,165 2001 26,138 Thereafter 6,500 $ 235,950 Total rental expense amounted to $53,778, $65,127 and $57,081 for the years ended March 31, 1996, 1995 and 1994, respectively. Rental expense has been reduced by sublease revenue of $4,349 in 1994. Five lease agreements with monthly expenses of $1,978, $2,014, $500, $407 and $350 have renewal options of 10, 10, 60, 20 and 10 years, respectively. (7) FHLB Stock Investment in the stock of the Federal Home Loan Bank is required by law for every Federally insured savings institution. No ready market exists for this stock and it has no quoted market value. However, because redemption of this stock has been at par it is carried at cost. The Bank, as a member of the FHLB of Atlanta, is required to acquire and hold shares of capital stock in the FHLB of Atlanta in an amount equal to the greater of (i) 1.0% of the aggregate outstanding principal amount of residential mortgage loans, home purchase contracts and similar obligations at the beginning of each year, or (ii) 1/20 of its advances (borrowings) from the FHLB of Atlanta. The Bank is in compliance with this requirement with an investment in FHLB of Atlanta stock of $1,233,200 as of March 31, 1996. (8) Real Estate Operations The Company participates in two real estate joint ventures. The Company owns 50 percent (in 1994 SFSC sold 10 percent of its interest in the operations but retained the controlling interest) and 62.5 percent of the joint ventures which have been consolidated into the Company's financial statements. Income from real estate operations was as follows: 1996 1995 1994 Real estate acquired for development and sale: Sales $ 350,180 625,674 1,280,480 Cost of sales (296,508) (460,299) (1,105,515) Gross profit 53,672 165,375 174,965 Amortization (deferral) of gain on sale of real estate 25,396 3,420 8,976 Provision for real estate losses (45,000) -- (60,000) Income from real estate operations 34,068 168,795 123,941 Other expenses, net 38,535 115,236 37,590 Net income $ (4,467) 53,559 86,351 The following is a summary of the allowance for estimated losses on real estate: 1996 1995 1994 Balance at beginning of year $150,000 150,000 90,000 Provision for real estate losses 45,000 -- 60,000 Balance at end of year $195,000 150,000 150,000 Condensed combined financial information for the joint ventures as of March 31 is as follows: 1996 1995 Real estate held for development, net $ 1,389,579 1,442,723 Other assets 71,129 240,400 Total assets 1,460,708 1,683,123 Liabilities (principally a loan payable to the Bank 277,339 479,394 Partners equity $ 1,183,369 1,203,729 (9) Deposits Deposits outstanding by type of account at March 31 are summarized as follows: 1996 1995 Weighted Weighted Amount Rate Range Amount Rate Range Checking $42,251,949 1.35% 0 - 1.75% 41,211,492 1.40% 0 - 1.88% Money Market 13,769,693 2.81% 2.75 - 3.00% 16,776,207 3.27 2.20 - 3.44 Passbook accounts 13,615,436 2.50% 0 - 3.00% 14,491,809 2.61 0 - 2.62 69,637,078 1.86% 0 - 3.00% 72,479,508 2.07% 0 - 3.44% Certificate accounts: 0 - 4.99% 5,116,366 44,023,933 5.00 - 6.99% 97,046,823 48,182,486 7.00 - 8.99% 574,460 1,588,710 9.00 - 12.99% -- -- Total certificates of deposit 102,737,649 5.65% 3.30 - 7.75% 93,795,129 5.17 3.45 - 8.10% $172,374,727 4.12% 0 - 7.75% 166,274,637 3.82% 0 - 8.10% The aggregate amount of short-term certificates of deposit with a minimum denomination of $100,000 was $9,846,903 and $13,704,756 at March 31, 1996 and 1995, respectively. The amounts and scheduled maturities of certificates of deposit at March 31, are as follows: 1996 1995 Within 1 year $ 83,523,749 65,839,088 After 1 but within 2 years 16,010,769 19,407,870 After 2 but within 3 years 1,659,385 6,548,849 After 3 but within 4 years 1,237,789 1,253,421 After 4 but within 5 years 305,957 745,901 Thereafter -- -- $102,737,649 93,795,129 (10) Advances From Federal Home Loan Bank Advances from the Federal Home Loan Bank at March 31 are summarized by year of maturity and weighted average interest rate below: 1996 1995 Weighted Weighted Amount Rate Amount Rate 1996 $ - --% 19,969,000 6.40% 1997 17,214,000 5.94 414,000 8.45 1998 3,452,000 6.60 3,452,000 6.60 1999 490,000 8.65 490,000 8.65 2000 528,000 8.70 528,000 8.70 Thereafter 1,180,000 8.53 1,180,000 8.53 $ 22,864,000 6.29% 26,033,000 6.65% Pursuant to collateral agreements with the FHLB, the Company has pledged all of its stock in the FHLB and qualifying first mortgage loans as collateral for these advances. Advances are subject to prepayment penalties. (11) Income Taxes Income tax expense for the years ended March 31, is comprised of the following: 1996 1995 1994 Current: Federal $ 571,810 660,413 440,568 State -- -- 16,417 571,810 660,413 456,985 Deferred: Federal (27,879) (122,537) (163,892) State (5,234) (38,147) (27,187) (33,113) (160,684) (191,079) $ 538,697 499,729 265,906 (11) Income Taxes, Continued The Company's income taxes differ from those computed at the statutory federal income tax rate, as follows: 1996 1995 1994 Tax at statutory income tax rate $ 543,412 510,640 273,632 State income tax expense (benefit),net (3,454) (25,177) (7,108) Other (1,261) 14,266 (618) $ 538,697 499,729 265,906 The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at March 31 are presented below. 1996 1995 Deferred tax assets: Provision for loan losses $ 500,572 474,150 Net fees deferred for financial reporting 35,712 176,989 Unrealized loss on securities available for sale 44,036 31,299 Other real estate basis for tax purposes over financial statement basis 74,022 56,940 Other 137,667 79,125 Total gross deferred tax assets 792,009 818,503 Deferred tax liabilities: FHLB stock basis over tax basis 178,999 178,999 Depreciation 193,791 296,960 Other 44,811 13,986 Total gross deferred tax liability 417,601 489,945 Net deferred tax asset $ 374,408 328,558 A portion of the change in the net deferred tax asset relates to unrealized gains and losses on securities available for sale. The related current period deferred tax benefit of $12,737 has been recorded directly to shareholder's equity. The balance of the change in the net deferred tax asset results from the current period deferred tax benefit of $33,113. The net deferred tax asset is included in other assets in the accompanying consolidated balance sheets. No valuation allowance for deferred tax assets was required at April 1, 1995, and for the years ended March 31, 1995 and 1996. The realization of net deferred tax assets may be based on utilization of carrybacks to prior taxable periods, anticipation of future taxable income in certain periods, and the utilization of tax planning strategies. Management has determined that it is more likely than not that the net deferred tax asset can be supported based upon these criteria. (11) Income Taxes, Continued Retained earnings at March 31, 1996 includes tax bad debt reserves of approximately $2.2 million, for which no provision for federal income tax has been made. If, in the future, these amounts are used for any purpose other than to absorb bad debt losses, including dividends, stock redemptions, or distributions in liquidation, or the Company ceases to be qualified as a savings and loan, they may be subject to federal income tax at the then prevailing corporate tax rate. (12) Employee Benefit Plans The Company participates in a multi-employer defined benefit plan. The plan provides defined benefits to substantially all full-time employees of the Company with one or more years of service. Separate actuarial valuations are not available for each participating employer, nor are plan assets segregated. There were no contributions to the plan required for the years ended March 31, 1996, 1995 and 1994. Plan assets exceed the present value of accumulated plan benefits at June 30, 1995, the latest actuarial valuation date. The Company participates in a multiple employer defined contribution employee benefit plan covering substantially all employees with one or more years of service. The Company matches a portion of employees contributions, and the related expenses were $47,116, $96,905, and $77,666 for the years ended March 31, 1996, 1995 and 1994, respectively. The annual contribution is determined at the discretion of the Company's Board of Directors. The Company established an Employee Stock Ownership Plan ("ESOP") to acquire shares of the Company's common stock for the exclusive benefit of the employee participants. The ESOP borrowed $196,880 from a savings institution and purchased 19,688 shares of the Company's common stock. These shares were pledged as collateral for the ESOP debt which was paid in full in fiscal 1994. For the years ended March 31, 1995, 1994 and 1993 the Company recorded expenses related to the ESOP trust of $70,931, $51,291 and $68,472, respectively; of these amounts $518 and $3,190, was for interest on the ESOP note in 1994 and 1993, respectively. During the years ended March 31, 1994 and 1993 the plan repaid $15,779 and $91,138, respectively, of the note payable. Since the plan currently has no unallocated stock, there was no contribution for the year ended March 31, 1996. (12) Employee Benefit Plans, Continued Certain officers of the Company participate in an incentive stock option plan. Options are granted at exercise prices not less than the fair market value of the Company's common stock on the date of grant. No new options were granted during 1996. A total of 39,377 shares have been granted, exercisable over a period from one to ten years from the date of grant at $10.00 per share. During fiscal 1996, 3,938 options were exercised at $10.00 per share. There were 3,938 options granted but unexercisable at March 31,1996. (13) Commitments In conjunction with its lending activities, the Bank enters into various commitments to extend credit and issue letters of credit. Loan commitments (unfunded loans and unused lines of credit) and letters of credit are issued to accommodate the financing needs of the Bank's customers. Loan commitments are agreements by the Bank to lend at a future date, so long as there are no violations of any conditions established in the agreement. Letters of credit commit the Bank to make payments on behalf of customers when certain specified events occur. Financial instruments where the contract amount represents the Bank's credit risk include commitments under pre-approved but unused lines of credit of $16,700,000, and $23,129,798 and letters of credit of $129,000 and $124,000 at March 31, 1996 and 1995, respectively. These loan and letter of credit commitments are subject to the same credit policies and reviews as loans on the balance sheet. Collateral, both the amount and nature, is obtained based upon management's assessment of the credit risk. Since many of the extensions of credit are expected to expire without being drawn, the total commitment amounts do not necessarily represent future cash requirements. In addition to these loan commitments noted above, the Bank had unused credit card loan commitments of $885,000 and $963,497 at March 31, 1996 and 1995, respectively. Outstanding commitments on mortgage loans not yet closed amounted to $603,745 at March 31, 1996. Such commitments, which are funded subject to certain limitations, extend over varying periods of time with the majority being funded within 90 days. At March 31, 1996, the Bank had outstanding commitments to sell approximately $613,000 of loans. (14) Regulatory Matters Federal regulations require savings institutions to have a minimum regulatory tangible capital equal to 1.5% of adjusted total assets, a minimum core capital ratio equal to 3.0% of adjusted total assets, and risk-based capital equal to 8.0% of risk-weighted assets. As of March 31, 1996, the Bank had regulatory tangible capital equal to 5.82% of total adjusted assets, regulatory core capital equal to 6.32% of total adjusted assets, and risk-based capital equal to 10.57% of risk-weighted assets. As a result, the Bank meets all three of the aforementioned capital requirements. OTS regulations impose various restrictions or requirements on institutions with respect to their ability to pay dividends or make other distributions of capital. (15) Related Party Transactions At March 31, 1996, the total aggregate indebtedness to the Bank by executive officers and directors of the Bank whose individual indebtedness exceeded $60,000 at any time over the period since April 1, 1994 was $440,017. There were no additions to loans to executive officers over $60,000 during fiscal 1996. Repayments on these loans totaled approximately $11,600. Loans to all employees, officers and directors of the Bank, in the aggregate, constituted approximately 8.2% of the total shareholders' equity of the Bank at March 31, 1996. The Company paid insurance premiums to an insurance agency in which three directors of the Company are also officers, directors and shareholders. The Company incurred expense in the amount of $79,208, and $90,877 for the years ended March 31, 1995 and 1994, respectively, which represented insurance and bond premiums for insurance coverage written for the Company. Of these amounts, $8,062, and $10,874 were the actual commissions earned by the agency. Also, the Bank paid $875, and $1,412 during these years to the agency out of escrow accounts maintained for customers of the Bank. The Company paid approximately $2,000 in premiums in fiscal 1996. The Company rents office space from a company in which a director and an officer of the Company and the Bank have an ownership interest. The Bank incurred expenses of $23,625, $22,995 and $25,511 respectively, for rent and taxes for the years ended March 31, 1996, 1995 and 1994. Management is of the opinion that the transactions with respect to insurance coverage and office rent are made on terms that are comparable to those which would be made with unaffiliated persons. (16) Security Federal Corporation Condensed Financial Statements (Parent Company Only) The following is condensed financial information of Security Federal Corporation (parent company only); the primary asset of which is its investment in the bank subsidiary, and the principal source of income for the Company is equity in undistributed earnings from the Bank. Condensed Balance Sheet Data March 31, 1996 and 1995 1996 1995 Assets Cash $ 71,795 490,147 Investment in Security Federal Bank 5,007,910 13,981,572 Investment in Real Estate Partnerships 567,726 -- Furniture and equipment, net 0 290 Income tax receivable from Bank 39,654 18,691 Other assets 97,133 -- Total assets $15,784,218 14,490,700 Liabilities and Shareholders' Equity Loans Payable 350,000 -- Accounts payable -- 1,230 Shareholders' equity 15,434,218 14,489,470 Total liabilities and shareholders' equity $15,784,218 14,490,700 Condensed Statements of Income Data For the years ended March 31, 1996, 1995 and 1994 1996 1995 1994 Income: Equity in undistributed earnings of Security Federal Bank $ 1,098,307 1,038,428 545,022 Equity in undistributed earnings of Real Estate Partnerships 889 -- -- Dividend income -- -- 50,000 Miscellaneous income 927 10 2,595 1,100,123 1,038,438 597,617 Expenses: Miscellaneous 40,549 36,284 28,724 Net income $ 1,059,574 1,002,154 568,893 (16) Security Federal Corporation Condensed Financial Statements (Parent Company Only) Continued Condensed Statements of Cash Flow Data For the years ended March 31, 1996, 1995 and 1994 1996 1995 1994 Operating activities: Net income $ 1,059,574 1,002,154 568,893 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 290 348 348 Equity in undistributed earnings of Security Federal Bank (1,098,307) (1,038,428) (545,022) Equity in undistributed earnings of real estate partnership (889) -- -- (Increase) decrease in income taxes receivable and other assets (118,096) (3,896) 1,408 Increase (decrease) in accounts payable (1,230) (14,160) (9,394) Net cash provided by operating activities (158,658) (53,982) 16,233 Investing activities: Purchase of Real Estate Partnerships from Bank (561,000) -- -- Investment in Real Estate (5,838) -- -- Net cash used in investing activities (566,838) -- -- Financing activities: Proceeds of loan 350,000 -- -- Dividends paid (82,236) (80,880) (78,754) Exercise of stock options 39,380 194,640 -- Net cash used in financing activities 307,144 113,760 (78,754) Net increase (decrease) in cash and cash equivalents (418,352) 59,778 (62,521) Cash and cash equivalents at beginning of year 490,147 430,369 492,890 Cash and cash equivalents at end of year $ 71,795 490,147 430,369 (17) Carrying Amounts and Fair Value of Financial Instruments The carrying amounts and fair value of financial instruments as of March 31, are summarized below: (In Thousands) 1996 Carrying Estimated Amount Fair Value Financial Assets Cash and cash equivalents $ 9,824 $ 9,824 Investment and mortgage backed securities 41,013 40,886 Loans receivable, net 152,140 152,537 Federal Home Loan Bank Stock 1,233 1,233 Financial Liabilities Deposits: Checking, Savings, and MMDA accounts $ 69,637 69,637 Certificate accounts 102,738 103,091 Advances from Federal Home Loan Bank 22,864 21,082 Other borrowed money 350 350 The Bank had, at March 31, 1996 $18.2 million of off-balance sheet financial commitments. These commitments are to originate loans and unused consumer lines of credit and credit card lines. Since these obligations are based on current market rates, if funded, the original principal is considered to be a reasonable estimate of fair market value. Fair value estimates are made at a specific point in time, based on relevant market data and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale the Bank's entire holdings of a particular financial instrument. Because no active market exists for a significant portion of the Bank's financial instruments fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, current interest rates and prepayment trends, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in any of these assumptions used in calculating fair value would also significantly affect the estimates. Further, the fair value estimates were calculated as of March 31, 1996. Fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. For example, the Bank has significant assets and liabilities that are not considered financial assets or liabilities including deposit franchise value, loan servicing portfolio, deferred tax liabilities, and premises and equipment. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of these estimates. (18) Contingencies The United States Congress is currently proposing a plan under which the Bank Insurance Fund (BIF), hich is the primary deposit insurance fund for commercial banks, would be merged with the Savings Association Insurance Fund ("SAIF"), which is the primary insurance fund for thrifts and savings banks. In connection with this merger, all members of the SAIF fund would be required to pay a one-time assessment of between 80 and 90 basis points per every $100 of SAIF insured deposit balances as of March 31, 1995. Based on the Bank's deposit balances as of March 31, 1995, the one-time assessment would be approximately $950,000 before tax and approximately $600,000 after tax, if that expense would be tax deductible. In exchange for this one-time assessment, qualifying members of the SAIF fund would receive a reduction in their annual premiums. The measure has not yet passed Congress, and the final provisions and payment date are as yet unknown. In the normal course of business, the Company and subsidiary are periodically involved in litigation. In the opinion of the Company's management none of these cases should have a material adverse effect on the consolidated financial statements. Item 8. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure Not applicable. PART III Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act Information concerning Directors and Executive Officers of the Company is incorporated herein by reference from the Company's definitive Proxy Statement for the Annual Meeting of Shareholders, a copy of which will be filed not less than 120 days after the close of the fiscal year. Section 16(a) of the Exchange Act requires the Company's directors and executive officers, and persons who own more than 10% of a registered class of the Company's equity securities, to file with the SEC initial reports of ownership and reports of changes in ownership of Company common stock and other equity securities of the Company by the tenth of the month following a change. Officers, directors and greater than 10% stockholders are required by SEC regulation to furnish the Company with copies of all Section 16(a) forms they file. To the Company's knowledged, based solely on a review of the copies of such reports furnished to the Company and written representations that no other reports were required, during the fiscal year ended March 31, 1996, all Section 16(a) filing requirements beneficial owners were complied with. Item 10. Executive Compensation Information concerning executive compensation is incorporated herein by reference from the Company's definitive Proxy Statement for the Annual Meeting of Shareholders, a copy of which will be filed not less than 120 days after the close of the fiscal year. Item 11. Security Ownership of Certain Beneficial Owners and Management Information concerning security ownership of certain beneficial owners and management is incorporated herein by reference from the Company's definitive Proxy Statement for the Annual Meeting of Stockholders, a copy of which will be filed not less than 120 days after the close of the fiscal year. Item 12. Certain Relationships and Related Transactions Information concerning certain relationships and transactions is incorporated herein by reference from the Company's definitive Proxy Statement for the Annual Meeting of Shareholders, a copy of which will be filed not less than 120 days after the close of the fiscal year. PART IV Item 13. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Exhibits: 3.1 Articles of Incorporation and amendments thereto ** 3.2 Bylaws ** 4 Instruments defining the rights of security holders, * including indentures 10 Executive Compensation Plans and Arrangements: Salary Continuation Agreements ** Amendment One to Salary Continuation Agreements *** Stock Option Plan ** Incentive Compensation Plan ** 21 Subsidiaries of Registrant 21 23 Consent of KPMG Peat Marwick LLP 23 * Filed on August 12, 1987, as exhibits to the Company's Form 8-A registration statement pursuant to Section 12(g) of the Securities Exchange Act of 1934 or as a part of reports filed pursuant to Section 13 of such Act. All of such previously filed documents are hereby incorporated herein by reference in accordance with Item 601 of Regulation S-B. ** Filed on June 28, 1993, as exhibits to the Company's Annual Report on Form 10-KSB pursuant to Section 12(g) of the Securities Exchange Act of 1934. All of such previously filed documents are hereby incorporated herein by reference in accordance with Item 601 of Regulation S-B. *** Filed as exhibits to the Company's Quarterly Report on Form 10-QSB for the quarter ended September 30, 1993 pursuant to Section 12(g) of the Securities Exchange Act of 1934. All of such previously filed documents are hereby incorporated herein by reference in accordance with Item 601 of Regulation S-B. (b) Reports on Form 8-K. No current reports on Form 8-K were filed by the Company during the three months ended March 31, 1996. SIGNATURES Pursuant to the requirements of section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SECURITY FEDERAL CORPORATION Date: June 25, 1996 By: /s/ Timothy W. Simmons ______________________ Timothy W. Simmons President and Chief Executive Officer (Duly Authorized Representative) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By: /s/ Timothy W. Simmons June 25, 1996 ________________________________________ Timothy W. Simmons President and Chief Executive Officer (Principal Executive Officer) By: /s/ Roy G. Lindburg June 25, 1996 ________________________________________ Roy G. Lindburg, Treasurer and Chief Financial Accounting Officer (Principal Financial and Accounting Officer) By: /s/ T. Clifton Weeks June 25, 1996 _______________________________________ T. Clifton Weeks Chairman of the Board and Director By: /s/ Gasper L. Toole, III June 25, 1996 _______________________________________ Gasper L. Toole, II Director By: /s/ Robert E. Johnson June 25, 1996 _______________________________________ Robert E. Johnson Director By: /s/ Harry O. Weeks, Jr. June 25, 1996 ______________________________________ Harry O. Weeks, Jr. Director By: /s/ Robert E. Alexander June 25, 1996 ______________________________________ Robert E. Alexander Director By: /s/ Thomas L. Moore June 25, 1996 ______________________________________ Thomas L. Moore Director By: /s/ William Clyburn June 25, 1996 ______________________________________ William Clyburn Director PAGE INDEX TO EXHIBITS Exhibit Number 21 Subsidiaries of the Registrant 23 Consent of KPMG Peat Marwick LLP Exhibit 21 Subsidiaries of the Registrant State of Percentage Parent Subsidiary Incorporation of Ownership Security Federal Security Federal Corporation Bank United States 100% Security Federal Bank Security Financial Services Corporation South Carolina 100% Exhibit 23 Consent of KPMG Peat Marwick LLP INDEPENDENT AUDITORS' CONSENT Board of Directors Security Federal Corporation: We consent to incorporation by reference in the Registration Statement No. 33-80008 on Form S-8 of our report dated May 17, 1996, relating to the consolidated balance sheets of Security Federal Corporation and subsidiary (the "Company") as of March 31, 1996 and 1995 and the related consolidated statements of income, shareholders' equity and cash flows for each of the years in the three-year period ended March 31, 1996, which report appears in the March 31, 1996 annual report on Form 10-KSB of the Company. Our report dated May 17, 1996, refers to the fact that the Company adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," on April 1, 1993 and adopted the provisions of SFAS No. 115, "Accounting for Certain Investment in Debt and Equity Securities" on March 31, 1994. /s/KPMG Peat Marwick LLP __________________________ KPMG Peat Marwick LLP Greenville, South Carolina June 25, 1996 EX-27 2
9 YEAR MAR-31-1996 MAR-31-1996 9823664 0 0 0 30972406 10040724 9913951 153898414 1758688 214816131 172374727 23599708 3407478 0 0 0 3923394 11510824 214816131 13494840 2233665 93789 15822294 6853363 8622541 7199753 230000 0 6839544 1598271 1059574 0 0 1059574 2.58 2.58 7.95 2572000 0 487000 0 1955000 472000 46000 1759000 1759000 0 0
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