-----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, E0kyFa3EdFZbNyBrVtC6sK2vd6mnfiuNCKp1WgCViZUQVjq6HoBLlPOK2urx1cLK DriO6fi/nWgEkftzAJHBPQ== 0000939057-07-000218.txt : 20070627 0000939057-07-000218.hdr.sgml : 20070627 20070627115458 ACCESSION NUMBER: 0000939057-07-000218 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 20070331 FILED AS OF DATE: 20070627 DATE AS OF CHANGE: 20070627 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SECURITY FEDERAL CORP CENTRAL INDEX KEY: 0000818677 STANDARD INDUSTRIAL CLASSIFICATION: SAVINGS INSTITUTION, FEDERALLY CHARTERED [6035] IRS NUMBER: 570858504 STATE OF INCORPORATION: SC FISCAL YEAR END: 0331 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-16120 FILM NUMBER: 07942974 BUSINESS ADDRESS: STREET 1: 238 RICHLAND AVENUE WEST CITY: AIKEN STATE: SC ZIP: 29801 BUSINESS PHONE: 8036413000 MAIL ADDRESS: STREET 1: 238 RICHLAND AVENUE WEST CITY: AIKEN STATE: SC ZIP: 29801 FORMER COMPANY: FORMER CONFORMED NAME: SECURITY FEDERAL CORPORATION DATE OF NAME CHANGE: 19920703 10-K 1 k07.txt SECURITY FEDERAL CORPORATION FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ________________________ FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended March 31, 2007 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to __________ Commission File Number: 0-16120 SECURITY FEDERAL CORPORATION - ------------------------------------------------------------------------------ (Exact Name of Registrant as Specified in its Charter) South Carolina 57-08580504 - ----------------------------------------------- ------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 238 Richland Avenue West, Aiken, South Carolina 29801 - ----------------------------------------------- ------------------------- (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 if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES NO X --- --- Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 of Section 15(d) of the Act. YES NO X --- --- 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act (Check one): Large accelerated filer Accelerated filer Non-accelerated filer X --- --- --- Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES NO X --- --- As of June 19, 2007, there were issued and outstanding 2,609,474 shares of the registrant's Common Stock, which are traded on the over-the-counter market through the OTC "Electronic Bulletin Board" under the symbol "SFDL." 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 September 30, 2006, was $42.4 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 1. Portions of the Registrant's Annual Report to Stockholders for the Fiscal Year Ended March 31, 2007. (Parts I and II) 2. Portions of the Registrant's Proxy Statement for the 2007 Annual Meeting of Stockholders. (Part III) 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 for the purpose of becoming the savings and loan holding company for Security Federal Bank ("Security Federal" or the "Bank") upon the Bank's conversion from mutual to the stock form (the "Conversion"). Effective August 17, 1998, the Company changed its state of incorporation from Delaware to South Carolina. As a South Carolina corporation, the Company is authorized to engage in any activity permitted by South Carolina 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. There are no current arrangements, understandings or agreements regarding any such acquisition. 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 sales of additional securities or other activities. At March 31, 2007, the Company had assets of approximately $738.1 million, deposits of approximately $523.7 million and shareholders' equity of approximately $42.7 million. The executive office of the Company is located at 238 Richland Avenue West, Aiken, South Carolina 29801, and its telephone number is (803) 641-3000. Security Federal Bank - --------------------- General. Security Federal is a federally chartered stock savings bank headquartered in Aiken, South Carolina. Security Federal, with 11 branch offices in Aiken and Lexington Counties, was originally chartered under the name Aiken Building and Loan Association on March 27, 1922. It 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. Effective April 8, 1996, the Bank changed its name to Security Federal Bank. The Bank converted from the mutual to the stock form of organization on October 30, 1987. In October 1993, Security Federal increased its branch network to nine offices 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 Wal-Mart Superstore. The Bank opened a branch in West Columbia, Lexington County, South Carolina, in December 2000, which provided the Bank with the opportunity to expand its market area. In August 2003, the Bank opened a new branch in Lexington, South Carolina. During February 2004, the Bank completed the sale of its Denmark, South Carolina branch office to South Carolina Bank and Trust, N.A. of Orangeburg, South Carolina. In January 2006, the Bank closed its branch in the Aiken Wal-Mart Superstore and replaced it with a free standing branch on an out parcel in the Aiken Exchange Shopping Center. The principal business of Security Federal is accepting deposits from the general public and originating mortgage loans to enable borrowers to purchase or refinance one- to four-family residential real estate. The Bank also makes multi-family residential and commercial real estate loans, consumer loans, commercial loans, as well as construction loans on single family residences, multi-family dwellings and commercial real estate, and loans for the acquisition, development and construction of residential subdivisions and commercial projects. Additional financial services are provided by three of the Bank's wholly owned subsidiaries, Security Federal Insurance, Inc., Security Federal Investments, Inc. and Security Federal Trust, Inc. 2 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. Completion of Acquisition - ------------------------- The Company completed its acquisition of the insurance and premium finance businesses of Collier Jennings Financial Corporation and its subsidiaries, Collier-Jennings, Inc., The Auto Insurance Store, Inc., and Collier-Jennings Premium Pay Plans, Inc. (the "Collier-Jennings Companies"), effective as of June 30, 2006. Collier Jennings Financial Corporation is held as a subsidiary of Security Federal Insurance, Inc., a subsidiary of the Bank. Selected Consolidated Financial Information - ------------------------------------------- This information is incorporated by reference to page 7 of the 2007 Annual Report to Stockholders ("Annual Report"). Yields Earned and Rates Paid - ---------------------------- This information is incorporated by reference to page 15 of the Annual Report. Rate/Volume Analysis - -------------------- This information is incorporated by reference to page 14 of the Annual Report. Lending Activities - ------------------ General. The primary source of revenue for the Bank is interest and fee income from lending activities. One of the principal lending activities 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 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 commercial real estate, and loans for the acquisition, development and construction of residential subdivisions and commercial projects. Residential adjustable rate mortgage loans ("ARMs") constituted approximately 25.6% of the Bank's total outstanding loan portfolio at March 31, 2007. 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. 3 Loan Portfolio Composition. The following table sets forth information concerning the composition of the Bank's loan portfolio in dollar amounts and in percentages by type of loan, and presents a reconciliation of total loans receivable before net items. At March 31, --------------------------------------------------------------------------------------- 2007 2006 2005 2004 2003 --------------- --------------- --------------- --------------- --------------- Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent ------ ------- ------ ------- ------ ------- ------ ------- ------ ------- (Dollars in Thousands) TYPE OF LOAN: - ------------- Fixed rate loans - ---------------- Residential real estate.......... $ 11,620 2.6% $ 11,594 3.0% $ 31,336 9.3% $ 43,911 15.8% $ 43,091 16.8% Commercial business and commercial real estate..... 126,987 28.2 99,446 25.4 77,202 22.8 62,799 22.6 53,509 20.8 Consumer......... 37,123 8.2 32,342 8.3 27,047 8.0 26,508 9.5 30,165 11.7 -------- ----- -------- ----- -------- ----- -------- ----- -------- ----- Total fixed rate loans.... 175,730 39.0 143,382 36.7 135,585 40.1 133,218 47.9 126,765 49.3 -------- ----- -------- ----- -------- ----- -------- ----- -------- ----- Adjustable rate loans - --------------------- Residential real estate.......... 115,422 25.6 111,753 28.6 93,564 27.7 67,516 24.3 60,528 23.5 Commercial business and commercial real estate..... 132,221 29.4 109,768 28.0 85,015 25.2 58,313 20.9 53,488 20.8 Consumer......... 26,687 5.9 26,271 6.7 23,797 7.0 19,133 6.9 16,429 6.4 -------- ----- -------- ----- -------- ----- -------- ----- -------- ----- Total adjustable rate loans.... 274,330 61.0 247,792 63.3 202,376 59.9 144,962 52.1 130,445 50.7 -------- ----- -------- ----- -------- ----- -------- ----- -------- ----- Total loans.... 450,060 100.0% 391,174 100.0% 337,961 100.0% 278,180 100.0% 257,210 100.0% ===== ===== ===== ===== ===== Less - ---- Loans in process......... 6,443 9,185 14,627 12,356 8,991 Deferred fees and discounts... 281 175 161 165 152 Allowance for loan losses..... 7,297 6,705 6,284 5,764 4,911 -------- -------- -------- -------- -------- Total loans receivable.... $436,039 $375,109 $316,889 $259,895 $243,156 ======== ======== ======== ======== ======== The total amount of loans due after March 31, 2008, which have predetermined or fixed interest rates is $141.7 million, while the total amount of loans due after that date which have floating or adjustable interest rates is $166.3 million.
4 The following table sets forth information concerning the composition of the Bank's loan portfolio in dollar amounts and in percentages by type of loan, and presents a reconciliation of total loans receivable before net items. At March 31, --------------------------------------------------------------------------------------- 2007 2006 2005 2004 2003 --------------- --------------- --------------- --------------- --------------- Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent ------ ------- ------ ------- ------ ------- ------ ------- ------ ------- (Dollars in Thousands) TYPE OF LOAN: - ------------- Real Estate Loans: Residential real estate.......... $109,532 24.3% $ 99,561 25.4% $105,516 31.2% $ 95,863 34.5% $ 86,707 33.7% Residential construction.... 17,510 3.9 23,786 6.1 19,384 5.8 15,564 5.6 16,912 6.6 -------- ----- -------- ----- -------- ----- -------- ----- -------- ----- Total real estate loans... 127,042 28.2 123,347 31.5 124,900 37.0 111,427 40.1 103,619 40.3 -------- ----- -------- ----- -------- ----- -------- ----- -------- ----- Commercial business and commercial real estate...... 259,208 57.6 209,214 53.5 162,217 48.0 121,112 43.5 106,997 41.6 Consumer loans: Deposit account.. 1,647 0.4 1,180 0.3 1,145 0.3 1,383 0.5 1,726 0.7 Home equity lines........... 20,086 4.4 20,059 5.1 16,918 5.0 13,694 4.9 13,140 5.1 Consumer first and second mortgages....... 22,868 5.1 22,144 5.7 22,327 6.6 15,080 5.4 18,551 7.2 Premium finance.. 892 0.2 -- -- -- -- -- -- -- -- Other............ 18,317 4.1 15,230 3.9 10,454 3.1 15,484 5.6 13,177 5.1 -------- ----- -------- ----- -------- ----- -------- ----- -------- ----- Total consumer loans.......... 63,810 14.2 58,613 15.0 50,844 15.0 45,641 16.4 46,594 18.1 -------- ----- -------- ----- -------- ----- -------- ----- -------- ----- Total loans..... 450,060 100.0% 391,174 100.0% 337,961 100.0% 278,180 100.0% 257,210 100.0% ===== ===== ===== ===== ===== Less: Loans in process.......... 6,443 9,185 14,627 12,356 8,991 Deferred fees and discounts.... 281 175 161 165 152 Allowance for loan losses........... 7,297 6,705 6,284 5,764 4,911 -------- -------- -------- -------- -------- Total loans receivable...... $436,039 $375,109 $316,889 $259,895 $243,156 ======== ======== ======== ======== ========
5 The following schedule illustrates the maturities of Security Federal's loan portfolio at March 31, 2007. 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, 2007 ------------------------------------------------ Commercial Business and Residential Commercial Real Estate Consumer Real Estate Total ------------ ------------ ----------- -------- (In Thousands) Six months or less (1)....... $ 7,867 $ 6,088 $ 70,316 $ 84,271 Over six months to one year.. 5,361 3,174 42,840 51,375 Over one year to three years. 884 9,385 62,850 73,119 Three to five years.......... 368 11,922 54,659 66,949 Over five to ten years....... 2,187 10,507 15,324 28,018 Over ten years............... 103,932 22,734 13,219 139,885 -------- --------- -------- -------- Total (2)................... $120,599 $ 63,810 $259,208 $443,616 ======== ========= ======== ======== - ------------- (1) Includes demand loans, loans having no stated maturity, overdraft loans and equity line of credit loans. (2) Loan amounts are net of undisbursed funds for loans in process of $6.4 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, -------------------------------------------- 2007 2006 2005 2004 2003 ------- ------- ------- ------ ------- (In Thousands) Originated: Adjustable rate - residential real estate.................... $ 40,380 $ 45,259 $ 43,578 $ 47,263 $ 45,260 Fixed rate - residential real estate (1)..................... 30,542 28,946 41,746 73,291 92,388 Consumer........................ 34,748 33,621 29,290 26,829 25,439 Commercial business and commercial real estate......... 283,749 198,360 134,439 91,562 64,097 -------- -------- -------- -------- -------- Total consumer/commercial business real estate.......... 318,497 231,981 163,729 118,391 89,536 -------- -------- -------- -------- -------- Total loans originated...... $389,419 $306,186 $249,053 $238,945 $227,184 ======== ======== ======== ======== ======== Purchased....................... $ 10,200 $ 5,060 $ 6,536 $ 3,500 $ -- Acquired in acquisition of Collier Jennings Financial Corporation.................... 708 -- -- -- -- Less: Sold: Fixed rate - residential real estate........................ $ 30,333 $ 29,903 $ 25,957 $ 63,497 $ 80,345 Fixed rate - commercial real estate........................ 8,106 -- -- -- -- Adjustable rate - commercial real estate................... 3,240 2,300 -- -- -- Principal repayments............ 299,763 225,830 169,851 157,979 139,108 Increase (decrease) in other items, net..................... (2,044) (5,007) 2,787 4,230 (1,106) Net increase.................... $ 60,929 $ 58,220 $ 56,994 $ 16,739 $ 8,837 - --------- (1) Includes newly originated fixed rate loans held for sale and construction/permanent loans converted to fixed rate loans and sold. 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 6 creation of the loan. The Bank's loan origination fees are generally 1% on conventional residential mortgages, and 0.25% to 1% on 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, 2007 was $1.2 million. Loan origination and commitment fees are volatile sources of income. These 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 mortgage 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, ------------------------------------ 2007 2006 2005 --------- -------- -------- (Dollars in Thousands) Net deferred mortgage loan origination fees earned during the period (1)..................... $173 $170 $185 Mortgage loan origination fees earned as a percentage of total portfolio mortgage loans originated during the period.................. 0.4% 0.4% 0.4% Net deferred mortgage loan origination fees in loan portfolio at end of period............................. $114 $175 $161 ___________ (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 the Bank's interest-earning assets and interest-bearing liabilities. Currently, most fixed rate, long-term mortgage loans are being originated based on Federal National Mortgage Association ("Fannie Mae") and Federal Home Loan Mortgage Corporation ("Freddie Mac") underwriting standards. Secondary market sales have been made primarily to Freddie Mac, or other banks or investors. Freddie Mac is a quasi-governmental agency that purchases residential mortgage loans from federally insured financial institutions and certain other lenders. All loans sold to Freddie Mac are without recourse to Security Federal and generally all other loans sold to other investors are without recourse. For the past few years, substantially all loans have been sold on a service released basis. In fiscal 2007, Security Federal sold $30.3 million in fixed rate residential loans on a service released basis on the secondary market. Loans closed but not yet settled with Freddie Mac or other investors, are carried in the Bank's "loans held for sale" portfolio. At March 31, 2007, the Bank had $1.5 million of loans held for sale. These loans are fixed rate residential loans that have been originated in the Bank's name and have closed. Virtually all of these loans have commitments to be purchased by investors and the majority of these loans were locked in by price with the investors on the same day or shortly thereafter that the loan was locked in with the Bank's customers. Therefore, these loans present very little market risk for the Bank. The Bank usually delivers to and receives funding from the investor within 30 days. Security Federal originates all of its loans held for sale on a "best efforts" basis. Best efforts means that the Bank suffers no penalty if it is unable to deliver a loan to a potential investor. The Bank also originates and holds adjustable and fixed rate construction loans. The construction loans are for one year terms. At March 31, 2007, the Bank held $17.5 million, or 3.9% of the total loan portfolio, in construction 7 loans to individuals in its residential portfolio. At March 31, 2007, the Bank also held approximately $7.7 million in longer term fixed rate residential mortgage loans. These loans, which were 1.7% of the entire loan portfolio at March 31, 2007, had converted from ARM loans to fixed rate loans during the previous 60 months, and had remaining maturities of 10 to 29 years. The Bank no longer originates ARM loans with conversion features nor has any loans in its portfolio with conversion features. Loan Solicitation and Processing. 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. The more significant items on loan 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 Freddie Mac and Fannie Mae 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 underwriters approve loans which meet Freddie Mac and Fannie Mae underwriting requirements, not to exceed $417,000 per loan, Federal Housing Administration ("FHA") loans not to exceed $200,161 and Veterans' Administration ("VA") loans not to exceed $417,000. The Chairman of the Company, the Chief Executive Officer of the Bank, or the President of the Bank individually have the authority to approve loans of $300,000 or less, except as set forth above for conforming conventionally underwritten, single family mortgage loans, which are approved by the underwriters. The two Executive Vice Presidents/Lending have the authority to approve loans up to $250,000. Loans in excess of $300,000 up to $350,000 require the approval of any two of the Chairman of the Company, the Chief Executive Officer of the Bank, the President of the Bank or either of the two Executive Vice Presidents/Lending. Commercial, consumer and all non- conforming real estate loans in excess of $350,000 up to $500,000 require approval of any two of the Chairman of the Company, the Chief Executive Officer of the Bank, or the President of the Bank, and any loan in an amount in excess of $500,000 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, not including loans that are the borrower's primary residence, and are conventionally underwritten. The general policy of Security Federal is 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. As of March 31, 2007, Security Federal had no residential mortgage loan commitments for portfolio loans issued (excluding undisbursed portions of construction loans in process). Security Federal had outstanding commitments available on retail lines of credit (including home equity and other consumer loans) totaling $33.0 million as of March 31, 2007. See Note 16 of the Notes to Consolidated Financial Statements contained in the Annual Report. Permanent Residential Mortgage Lending. Permanent residential real estate mortgage loans constituted approximately 24.3% of the Bank's total outstanding loan portfolio at March 31, 2007. Security Federal offers 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 initial rate adjustments every one, three, five or seven years during the term of the loan. After the initial rate adjustment, the loan rate then adjusts annually. Most of the Bank's ARMs contain a 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. These loans are generally made consistent with Freddie Mac and Fannie Mae guidelines. At March 31, 2007, residential ARMs totaled $115.4 million, or 25.6% 8 of the Bank's loan portfolio. For the year ended March 31, 2007, the Bank originated $70.9 million in residential real estate loans, 56.9% 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, these 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 the portion of the loan in excess of 80% of the appraised value. In general, the Bank restricts its residential lending to South Carolina and the nearby Augusta, Georgia market. The Bank also provides construction financing for single family dwellings to owner-occupants. Construction loans are generally made for periods of six months to one year with either adjustable or fixed rates. At March 31, 2007, residential construction loans on one- to four-family dwellings to owner-occupants totaled $17.5 million, or 3.9%, of the Bank's loan portfolio. On loans of this type, the Bank seeks to evaluate the financial condition and prior performance of the builder, as well as 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. On construction loans offered to individuals (non-builders), the Bank offers a construction/permanent loan. The construction portion of the loan has an adjustable rate (typically prime) or a fixed rate (typically prime plus 0.25%) during the construction period. After construction, the loan then automatically converts to an ARM loan. The borrower also has the option, after the construction period only, to convert the loan to a fixed rate loan which the Bank then sells on the secondary market immediately on a service released basis. Commercial Business and Commercial Real Estate Loans. The commercial business and commercial real estate loans originated by the Bank are primarily secured by business properties, churches, income property developments, undeveloped land, business equipment, furniture and fixtures, inventory and receivables. At March 31, 2007, the Bank had approximately $259.2 million, or 57.6%, of the Bank's total loan portfolio, in commercial business and commercial real estate loans. Approximately $174.9 million, or 67.5% of these loans were secured primarily by real estate at March 31, 2007. Included in these loans is approximately $26.9 million in loans for the construction of single family dwellings to builders with a term of typically one year. Not included in these loans are approximately $15.9 million in acquisition and development loans with terms of typically two to three years. Loans secured by commercial real estate are typically written for terms of 10 to 20 years. Commercial loans not secured by real estate are typically based on terms of three to 60 months. Fixed rate loans typically balloon at the end of three to seven years. Adjustable rate loans are usually tied to the prime interest rate or LIBOR as quoted in the Wall Street Journal, and adjust daily, monthly or annually. Some adjustable rate loans have interest rate caps, although most of these loans have a five year balloon. Commercial business and commercial real estate lending entails significant additional credit risk when compared to residential lending. Commercial loans typically involve large loan balances to single borrowers or groups of related borrowers. The payment experience of these 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, condominiums and apartments, and by adverse conditions in the local economy. Although commercial loans generally involve more risk than residential loans, they also typically provide a greater yield and are more sensitive to changes in interest rates. The Bank's underwriting standards for commercial business and commercial real estate lending 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. Typically, the Bank requires the principal or owners of a business to guarantee all loans made to their business by the Bank. Although the 9 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. Properties securing commercial loans originated by the Bank are generally 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 a commercial loan, the Bank currently seeks to invest in loans with a loan to value ratio of 75% to 85%. At March 31, 2007, the Bank did not have any commercial business or commercial real estate loans to one borrower in excess of $7.0 million. 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 only infrequently made loans to one borrower equal to the amount federal law allows, or approximately $7.7 million as calculated at March 31, 2007. Consumer Loans. The Bank originates consumer loans for any personal, family or household purpose, including the financing of home improvements, loans to individuals for residential lots for a future home, automobiles, boats, mobile homes, recreational vehicles and education. The Bank also makes consumer first and second mortgage loans secured by residences. These loans typically do not qualify for sale in the secondary market, but are generally not considered sub-prime lending. 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, 2007, the Bank had $20.1 million of home equity lines of credit outstanding and $26.5 million of additional commitments of home equity 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 provide higher yields and have shorter terms to maturity than one- to four-family residential mortgage loans. At March 31, 2007, the Bank had total consumer loans of $63.8 million, or 14.2% of the Bank's loan portfolio. The Bank's underwriting standards 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 from any verifiable secondary income. Although creditworthiness 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. The Bank also has a credit card program. As of March 31, 2007, the Bank had issued 2,960 Visa credit cards with total approved credit lines of $5.2 million, of which $1.6 million 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 foreclosure proceedings after the customer has been notified by certified mail. At March 31, 2007, the Bank had property acquired as the result of foreclosures and other property repossessed classified as repossessed assets valued at $25,000. 10 Delinquent Loans. The following table sets forth information concerning delinquent loans at March 31, 2007. The amounts presented represent the total remaining principal balances of the delinquent 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, number of loans are actual) Loans delinquent for: 30 - 59 days............ 13 $1,378 14 $4,893 62 $1,186 6 $ 71 60 - 89 days............ 5 621 4 1,001 9 97 1 30 90 days and over........ 7 353 7 547 7 142 1 13 ------ ------ ------ ---- Total delinquent loans.. 25 $2,352 25 $6,441 78 $1,425 8 $114 ====== ====== ====== ====
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 regulations require 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 Office of Thrift Supervision ("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. See "Regulation - - Federal Regulation of Savings Institutions."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, 2007, approximately $10.8 million of the Bank's loans were classified "substandard" compared to $14.1 million at March 31, 2006. In fiscal 2005, the Bank began applying stricter standards in securitizing its loan portfolio for classification purposes in conjunction with the formation of a Credit Administration Department. At March 31, 2007, $2.3 million were classified as "special mention" compared to $5.6 million at March 31, 2006. The Bank had no loans classified as "doubtful" or "loss" at March 31, 2007. As of March 31, 2007, there were loans totaling $204,000 which were troubled debt restructurings within the meaning of Statement of Financial Accounting Standard ("SFAS") No. 15. The Bank's policy is to classify all troubled debt restructurings as substandard. The Bank's classification of assets is consistent with OTS regulatory classifications. Non-performing Assets. 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 90 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. At March 31, 2007, the Bank did not have any troubled debt restructurings which involve forgiving a portion of interest or principal on any loans or making loans at a rate materially less than market rate. 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 monthly on a loan by loan basis. Charge-offs, whether partial or in full, associated with these loans will vary based on estimates of recovery for each loan. 11 The following table sets forth the amounts and categories of risk elements in the Bank's loan portfolio. At March 31, ---------------------------------------------- 2007 2006 2005 2004 2003 ------ ------ ------ ------ ------ (Dollars in Thousands) Loans Delinquent 60 to 89 Days: Residential................ $ 621 $ 182 $ 73 $ 72 $ 45 Consumer................... 97 5 13 73 435 Commercial business and real estate............... 1,031 420 13 88 311 ------ ------ ------ ------ ------ Total..................... $1,749 $ 607 $ 99 $ 233 $ 791 ====== ====== ====== ====== ====== Total as a percentage of total assets............. 0.24% 0.09% 0.02% 0.04% 0.18% Non-Accruing Loans Delinquent 90 Days or More: Residential................ $ 353 $ 412 $ 569 $ 559 $ 585 Consumer................... 142 133 140 243 229 Commercial business and real estate............... 560 646 1,721 1,242 226 ------ ------ ------ ------ ------ Total..................... $1,055 $1,191 $2,430 $2,044 $1,040 ====== ====== ====== ====== ====== Total as a percentage of total assets............. 0.14% 0.18% 0.42% 0.39% 0.23% Troubled debt restructurings............. $ 203 $ 418 $ 434 $ 646(1) $ 674(2) Repossessed assets.......... $ 25 $ 91 $ 53 $ 51 $ 151 Allowance for loan losses... $7,297 $6,705 $6,284 $5,764 $4,911 - ------------ (1) $201,000 of troubled debt restructurings are included in non-accruing loans. (2) $210,000 of troubled debt restructurings are included in non-accruing loans. For the fiscal year ended March 31, 2007, 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 and with respect to troubled debt restructurings, had such loans been current in accordance with their original terms, totaled $107,000 compared to $111,000 for the year ended March 31, 2006. At March 31, 2007, non-accruing loans totaled $1.1 million, compared to $1.2 million and $2.4 million at March 31, 2006 and 2005, respectively. Included in non-accruing loans at March 31, 2007 were seven residential real estate loans totaling $353,000, eight commercial loans totaling $560,000 and seven consumer loans totaling $142,000. Of the seven consumer loans on non-accrual status at fiscal year end, no loan exceeded $50,000. Of the eight commercial loans on non-accrual status at fiscal year end, no loan exceeded $350,000. The Bank had five loans totaling $204,000 at fiscal year end which were troubled debt restructurings compared to six loans of $418,000 at March 31, 2007. The five troubled debt restructurings were two consumer loans totaling $129,000 secured by residential dwellings, a $10,000 consumer loan secured by a second mortgage on a residence, a $52,000 commercial loan secured by two rental properties, and a $12,000 unsecured commercial loan. The $10,000 consumer loan was 30 days delinquent at March 31, 2007. The remaining four loans were current at March 31, 2007. At March 31, 2007, repossessed assets had an outstanding carrying value of $25,000 and consisted of a single family dwelling. Provision for Losses on Loans and Repossessed Assets. Security Federal recognizes that it will experience credit losses 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 12 normally can be classified as higher risk. Specific and general reserves are based on, among other criteria (1) the risk characteristics of 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, the Bank maintains a reserve for uncollected interest on loans 90 days or more past due. At March 31, 2007, total reserves relating to loans were $7.3 million. In determining the adequacy of 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, commercial real estate and consumer loans have increased to $323.0 million, or 71.8% of the Bank's total loan portfolio at March 31, 2007, and it is anticipated there will be a continued emphasis on this type of credit. Although commercial 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 0.38%. These delinquent loans are considered to be well secured and are in the process of collection. Management uses four methods or calculations to estimate the adequacy of the reserve using the factors mentioned above. The reserve is management's best estimate for the reserve. There can be no guarantee that the estimate is adequate or accurate. Management believes that reserves for loan losses are at a level adequate to provide for inherent 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. Regulators will from time to time evaluate the allowance for loan losses which is subject to adjustment based upon the information available to the regulators at the time of their examinations. Management believes the Bank has no undue concentration of loans in any one particular industry. At March 31, 2007, the Bank had no allowance for losses on real estate owned. The following table sets forth an analysis of the Bank's allowance for loan losses. At March 31, ------------------------------------------------- 2007 2006 2005 2004 2003 -------- -------- -------- -------- -------- (Dollars in Thousands) Balance at beginning of year....................... $6,705 $6,284 $5,764 $4,911 $3,689 Allowance acquired in acquisition................ 22 -- -- -- -- Provision charged to operations................. 600 660 780 1,200 1,800 Charge-offs: Residential real estate.... 9 25 29 38 17 Commercial business and commercial real estate.... 16 159 257 164 299 Consumer................... 108 117 157 467 594 ------ ------ ------ ------ ------ Total charge-offs......... 133 301 443 669 910 ------ ------ ------ ------ ------ Recoveries: Residential real estate.... -- 4 -- - -- Commercial business and commercial real estate.... 23 33 112 16 40 Consumer................... 81 25 71 306 292 ------ ------ ------ ------ ------ Total recoveries.......... 103 62 183 322 332 ------ ------ ------ ------ ------ Balance at end of year...... $7,297 $6,705 $6,284 $5,764 $4,911 ====== ====== ====== ====== ====== Ratio of net charge-offs during the year to average loans outstanding during the year................... 0.01% 0.07% 0.09% 0.14% 0.24% ===== ===== ===== ===== ===== 13 The distribution of the Bank's allowance for loan losses at the dates indicated is summarized in the following table. The entire allowance is available to absorb losses from all loan categories. At March 31, ---------------------------------------------------------------------------------- 2007 2006 2005 2004 2003 -------------- ------------- ------------- ------------- ------------- Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans ------ ----- ------ ----- ------ ----- ------ ----- ------ ----- (Dollars in Thousands) Residential........... $ 619 28.2% $ 568 31.5% $ 531 37.0% $ 500 40.1% $ 473 40.3% Consumer.............. 3,339 14.2 3,068 15.0 2,876 15.0 2,632 16.4 2,219 18.1 Commercial business and commercial real estate.......... 3,339 57.6 3,069 53.5 2,877 48.0 2,632 43.5 2,219 41.6 ------ ----- ------ ----- ------ ----- ------ ----- ------ ----- Total................ $7,297 100.0% $6,705 100.0% $6,284 100.0% $5,764 100.0% $4,911 100.0% ====== ===== ====== ===== ====== ===== ====== ===== ====== =====
Service Corporation - ------------------- As a federally chartered savings bank, Security Federal is permitted by OTS regulations to invest up to 3% of its assets in the stock of service corporations, provided that any investment in excess of 2% of its assets must be primarily for community, inner-city or community development purposes. At March 31, 2007, Security Federal's net investment in its service corporations (including loans to service corporations) totaled $2.6 million. 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 Federal Insurance, Inc. ("SFINS"), Security Federal Investments, Inc. ("SFINV") and Security Federal Trust, Inc. ("SFT"). SFINS, SFINV and SFT, wholly owned subsidiaries of the Bank, were formed during fiscal 2002 and began operating during the December 2001 quarter. SFINS is an insurance agency offering auto, business, health, home and life insurance, and premium finance. SFINV offers mutual funds, annuities and discount brokerage services. SFT offers a full range of trust and financial planning services. The operations of SFINS, SFINV and SFT are included in the Company's Consolidated Financial Statements. Security Financial Services Corporation ("SFSC"). SFSC was incorporated in 1975 as a wholly owned subsidiary of the Bank. Its primary activity was investment brokerage services. SFSC is currently inactive. Investment Activities - --------------------- Investment securities. The Bank has 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. The Bank may also invest a portion of its assets in certain commercial paper and corporate debt securities. The Bank is 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. Furthermore, 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 Institutions 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. 14 Historically, the Bank has maintained its liquid assets above the minimum requirements imposed by OTS regulations and at a level believed adequate to meet requirements of normal daily activities, repayment of maturing debt and potential deposit outflows. Management regularly reviews and updates cash flow projections to assure that adequate liquidity is provided. 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, ---------------------------- 2007 2006 2005 -------- ------- -------- (In Thousands) Interest bearing deposit at FHLB............. $ 1,795 $ 3,715 $ 164 -------- -------- -------- Total...................................... $ 1,795 $ 3,715 $ 164 ======== ======== ======== Investment Securities: Available for Sale: FHLB securities............................ $ 38,373 $ 24,005 $ 4,970 Federal Farm Credit Bank securities........ 9,214 2,941 -- Fannie Mae bonds........................... 2,930 979 -- Freddie Mac bonds.......................... 64 230 485 Equity Securities.......................... 104 103 -- -------- -------- -------- Total securities available for sale....... 50,685 28,258 5,455 -------- -------- -------- Held to Maturity: FHLB securities............................ 55,995 66,002 67,002 Federal Farm Credit Bank securities........ 7,989 8,986 8,999 -------- -------- -------- Total securities held to maturity......... 63,984 74,988 76,001 -------- -------- -------- Total securities (1)......................... 114,669 103,246 81,456 FHLB stock................................... 8,209 7,150 6,235 -------- -------- -------- Total securities and FHLB stock (1).......... $122,878 $110,396 $ 87,691 ======== ======== ======== - ----------- (1) Does not include mortgage-backed securities. At March 31, 2007, 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. FHLB securities, Federal Farm Credit Bank securities, Fannie Mae bonds and Freddie Mac bonds are all securities that are issued by government sponsored enterprises (GSEs). GSE securities are not backed by the full faith and credit of the United States government. 15 The following table sets forth the maturities or repricing of investment securities and FHLB stock at March 31, 2007, 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). Callable securities are shown at their likely call dates based on current interest rates. The table was prepared using amortized cost. Maturing or Repricing ------------------------------------------------------------- After One After Five Within But Within But Within After One Year Five Years Ten Years Ten Years ------------- ------------- ------------- ------------- Amount Yield Amount Yield Amount Yield Amount Yield ------- ----- ------ ----- ------ ----- ------ ----- (Dollars in Thousands) U.S. Government sponsored enterprises... $42,528 4.31% $63,991 4.73% $7,230 4.82% $ 945 5.06% FHLB stock (1)........... 8,209 5.90 - -- -- -- -- -- Other equity securities.... 103 0.20 - -- -- -- -- -- ------- ---- ------- ---- ------ ---- ----- ---- Total (2)..... $50,840 4.56% $63,991 4.73% $7,230 4.82% $ 945 5.06% ======= ==== ======= ==== ====== ==== ===== ==== - ----------- (1) FHLB stock has no stated maturity date. (2) Excludes mortgage-backed securities and equity securities totaling $136.2 million with a yield of 4.73%. For information regarding the market value of the Bank's securities portfolios, see Notes 3 and 4 of the Notes to Consolidated Financial Statements contained in the Annual Report. Mortgage-backed Securities. Security Federal has a portfolio of mortgage-backed securities which it holds in both an available for sale and a held to maturity portfolio. 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 Government National Mortgage Association ("Ginnie Mae") securities) in contrast to the 50% risk weight carried by residential loans. See "Regulation." The following table sets forth the composition of the mortgage-backed securities available for sale portfolio at fair value at the dates indicated. At March 31, --------------------------- 2007 2006 2005 ------- -------- -------- (In Thousands) Available for Sale: Freddie Mac............................ $ 18,591 $ 21,196 $ 26,146 Fannie Mae............................. 67,675 74,498 81,492 Ginnie Mae............................. 48,815 39,493 51,722 -------- -------- -------- Total................................. $135,081 $135,187 $159,360 ======== ======== ======== The following table sets forth the composition of the mortgage-backed securities held to maturity portfolio at the dates indicated. At March 31, ----------------------------------- 2007 2006 2005 ---------- ---------- ----------- Book Value Book Value Book Value ---------- ---------- ----------- (In Thousands) Held to Maturity Freddie Mac........................... $ -- $ -- $260 ========== ========== =========== At March 31, 2007, 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. 16 Freddie Mac and Fannie Mae mortgage-backed securities are GSE issued securities. GSE securities are not backed by the full faith and credit of the United States government. Ginnie Mae mortgage-backed securities are backed by the full faith and credit of the United States government. 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 contained in the Annual Report. The following table sets forth the final maturities or initial repricings, whichever occurs first, and the weighted average yields of the mortgage-backed securities at March 31, 2007. Not considered in the preparation of the table below is the effect of scheduled payments or anticipated prepayments. The table is prepared using amortized cost. The Earliest of Maturing or Repricing March 31, 2007 -------------------------------------------------------------------- --------------- Less Than 1 to 5 5 to 10 Over Balance 1 Year Years Years Ten Years Outstanding -------------- -------------- -------------- -------------- --------------- Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield ------ ----- ------ ----- ------ ----- ------ ----- ------ ----- (Dollars in Thousands) Fannie Mae....... $14,912 4.42% $25,004 4.36% $16,466 4.30% $12,040 5.17% $ 68,422 4.50% Freddie Mac...... 184 4.30 9,963 3.90 3,962 4.31 4,837 5.06 18,946 4.29 Ginnie Mae....... 27,256 5.09 16,141 5.26 622 6.02 4,770 5.74 48,789 5.22 ------- ---- ------- ---- ------- ---- ------- ---- -------- ---- Total............ $42,352 4.85% $51,108 4.56% $21,050 4.35% $21,647 5.27% $136,157 4.73% ======= ==== ======= ==== ======= ==== ======= ==== ======== ====
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" contained in the Annual Report. Deposits. The Bank attracts both short-term and long-term deposits from the general public by offering a wide assortment of account types 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 savings accounts and regulated fixed interest rate, fixed-term certificates that were the Bank's primary source of deposits before 1978. The Bank offers regular savings 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, 2007, the Bank had no brokered deposits. In addition, the Bank believes that, based on its experience over the past several years, its savings and transaction accounts are stable sources of deposits. 17 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, ------------------------------------------------------ 2007 2006 2005 ---------------- ---------------- ---------------- Percent Percent Percent of of of Amount Total Amount Total Amount Total ------ ----- ------ ----- ------ ----- (Dollars in Thousands) Interest Rate Range - ------------------- for 2007: --------- Savings accounts 0 % - 1.51%......... $ 17,459 3.3% $ 17,795 3.7% $ 17,744 4.1% NOW and other transaction accounts 0% - 2.96%.......... 105,515 20.1 105,348 22.0 88,170 20.5 Money market funds 1.09% - 4.41%....... 145,492 27.8 151,494 31.6 164,088 38.1 -------- ----- -------- ----- -------- ----- Total non- certificates...... $268,466 51.2% $274,637 57.3% $270,002 62.7% ======== ===== ======== ===== ======== ===== Certificates: - ------------- 0.00-1.99%........... $ - --% $ 60 --% $ 23,435 5.5% 2.00-2.99%........... 2,972 0.6 26,836 5.6 80,954 18.8 3.00-3.99%........... 36,045 6.9 72,832 15.2 37,001 8.6 4.00-4.99%........... 35,617 6.8 94,241 19.7 9,096 2.1 5.00-5.99%........... 180,638 34.5 10,623 2.2 9,796 2.3 6.00-6.99%........... -- -- - -- 3 -- -------- ----- -------- ----- -------- ----- Total certificates...... 255,272 48.8 204,592 42.7 160,285 37.3 -------- ----- -------- ----- -------- ----- Total deposits..... $523,738 100.0% $479,229 100.0% $430,287 100.0% ======== ===== ======== ===== ======== ===== The Bank relies to a limited extent upon locally obtained Jumbo CDs to maintain its deposit levels. At March 31, 2007, Jumbo CDs constituted 21.1% of the Bank's total deposits. Security Federal has not relied heavily on Jumbo CDs to manage interest rate sensitivity. The following table sets forth the deposit flows at the Bank during the periods indicated. Years Ended March 31, ---------------------------------- 2007 2006 2005 --------- --------- --------- (Dollars in Thousands) Opening balance................. $ 479,229 $ 430,287 $ 389,593 Net deposits.................... 44,509 48,942 40,694 Ending balance.................. 523,738 479,229 430,287 --------- --------- --------- Net increase.................... $ 44,509 $ 48,942 $ 40,694 --------- --------- --------- Percent increase................ 9.3% 11.4% 10.4% ========= ========= ========= 18 The following table shows rate and maturity information for the Bank's certificates of deposit as of March 31, 2007. 2.00- 3.00- 4.00- 5.00- 2.99% 3.99% 4.99% 5.99% Total ----- ----- ----- ----- ----- (In Thousands) Certificate accounts maturing in quarter ending: June 30, 2007............... $2,467 $ 6,582 $ 9,189 $ 45,378 $ 63,616 September 30, 2007.......... 221 11,176 8,801 27,374 47,572 December 31, 2007........... 55 9,187 3,300 66,160 78,702 March 31, 2008.............. 36 2,930 7,353 35,743 46,062 June 30, 2008............... 111 2,329 2,828 650 5,918 September 30, 2008.......... 2 851 887 1,444 3,184 December 31, 2008........... 43 512 219 134 908 March 31, 2009.............. 20 736 84 41 881 June 30, 2009............... 17 759 53 57 886 September 30, 2009.......... -- 167 149 118 434 December 31, 2009........... -- 379 265 101 745 Thereafter.................. -- 437 2,489 3,438 6,364 ------ ------- ------- -------- -------- Total...................... $2,972 $36,045 $35,617 $180,638 $255,272 ====== ======= ======= ======== ======== The following table indicates the amount of the Bank's deposits of $100,000 or more by time remaining until maturity at March 31, 2007. Certificates Savings, NOW and of Deposit Money Market Accounts ---------- --------------------- (In Thousands) Maturity Period - --------------- Three months or less............... $ 32,587 $104,994 Over three through six months...... 18,663 -- Over six through twelve months..... 52,275 -- Over twelve months................. 7,074 -- -------- -------- Total............................. $110,599 $104,994 ======== ======== 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 the Notes to Consolidated Financial Statements contained in the Annual Report for information 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 Institutions - Federal Home Loan Bank System." At March 31, 2007, the Company had $5.2 million in junior subordinated debentures. Half of the debentures have a fixed rate of 6.88%, which balloons in September 2011. The other half of the debentures have a fixed rate that floats quarterly at 170 basis points over the three-month LIBOR rate, or 7.06% at March 31, 2007. The blended rate was 6.97% at March 31, 2007. The debentures are callable by the Company in September 2011, and quarterly thereafter, with a final maturity date of December 15, 2036. See Note 11 of the Notes to Consolidated Financial Statements contained in the Annual Report for more information. 19 The following table sets forth the maximum month-end balance and average balance of FHLB advances, other borrowings and junior subordinated debentures for the periods indicated. Years Ended March 31, -------------------------------- 2007 2006 2005 -------- -------- --------- (In Thousands) Maximum Balance: FHLB advances...................... $ 159,376 $ 132,513 $ 115,258 Other borrowings................... 8,088 7,290 5,915 Junior subordinated debentures..... 5,155 - -- Average Balance: FHLB advances...................... $ 145,299 $ 121,526 $ 105,272 Other borrowings................... 7,080 6,201 5,488 Junior subordinated debentures..... 2,721 - -- At March 31, 2007, the Bank had $8.1 million in retail repurchase agreements with an average rate of 4.41%. These repurchase agreements are included in "Other Borrowings" in the consolidated financial statements and the table above. The following table sets forth information as to the Bank's borrowings and the weighted average interest rates thereon at the dates indicated. At March 31, -------------------------------- 2007 2006 2005 -------- -------- --------- (Dollars in Thousands) Balance: FHLB advances.................... $153,049 $131,363 $112,038 Other borrowings................. 8,088 7,290 5,594 Junior subordinated debentures... 5,155 - -- Weighted Average Interest Rate at Fiscal Year End: FHLB advances.................... 4.36% 3.74% 3.41% Other borrowings................. 4.41 4.43 2.54 Junior subordinated debentures... 6.97 - -- During Fiscal Year: FHLB advances.................... 4.23% 3.55% 3.54% Other borrowings................. 4.49 3.38 1.53 Junior subordinated debentures... 7.05 - -- Competition - ----------- The Bank serves the counties of Aiken and Lexington, South Carolina through its eleven branch offices located in Aiken, North Augusta, Graniteville, Langley, Clearwater, Wagener, Lexington and West Columbia, South Carolina. We are currently constructing a branch office in Columbia County, Evans, Georgia, which is scheduled to open in December 2007. 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 20 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. Personnel - --------- At March 31, 2007, the Bank employed 184 full-time and 27 part-time employees. The Bank employees are not represented by any collective bargaining agreement. Management of the Bank considers its relations with its employees to be good. Executive Officers of the Registrant. The following table sets forth information regarding the executive officers of the Company and the Bank. Age at Position March 31, ------------------------------------------- Name 2007 Company Bank - ------------- ------------ -------------------- --------------------- Timothy W. Simmons 61 President and Chief Chairman of the Board Executive Officer and Chief Executive Officer T. Clifton Weeks 80 Chairman of the Board Roy G. Lindburg 46 Treasurer and Chief Treasurer and Chief Financial Officer Financial Officer J. Chris Verenes 51 President Biographical Information. The following is a description of the principal occupation and employment of the executive officers of the Corporation and the Bank during at least the past five years: Timothy W. Simmons has been President of the Company since 1987 and Chief Executive Officer since June 1994. Mr. Simmons was elected President and Chief Operating Officer of the Bank in January 1987 and served in these capacities from March 1987 to December 2001. In May 1988, Mr. Simmons became Chief Executive Officer of the Bank and in January 2002, he was elected Chairman of the Bank's Board of Directors. T. Clifton Weeks has been Chairman of the Board of the Company since July 1987 and was Chief Executive Officer of the Company from July 1987 until June 1994. Mr. Weeks served as Chairman of the Board of the Bank from January 1987 until January 2002 and was Chief Executive Officer of the Bank from 1987 until May 1988. Prior thereto, he served as President and Managing Officer of the Bank beginning in 1958. Roy G. Lindburg has been Chief Financial Officer of the Company and the Bank since January 1995. He was named Executive Vice President in 2005. J. Chris Verenes was elected President of the Bank effective January 26, 2004. Prior to that, he held a variety of management positions with Washington Group International, an engineering and construction company that manages and operates major government sites throughout the United States for the Department of Energy. He was Director of Planning and Administration from 2001 to January 2004, Chief of Staff during 2001, Director of Strategic Programs for the business unit from 2000 to 2001 and Deputy Manager of Business from 1996 to 2000. Prior to his employment by Washington Group International, Mr. Verenes served as Controller for Riegel Textile Corporation, as Director of Control Data and Business and Technology Center, and as Executive Director of the South Carolina Democratic Party. 21 REGULATION The following is a brief description of certain laws and regulations which are applicable to the Company and the Bank. The description of these laws and regulations, as well as descriptions of laws and regulations contained elsewhere herein, does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations. Legislation is introduced from time to time in the United States Congress that may affect our operations. In addition, the regulations governing us may be amended from time to time by the OTS. Any such legislation or regulatory changes in the future could adversely affect us. We cannot predict whether any such changes may occur. General - ------- The Bank, as a federally-chartered savings institution, is subject to extensive regulation, examination and supervision by the OTS, as its primary federal regulator, and the FDIC, as its deposits insurer. The Bank is a member of the FHLB System and its deposit accounts are insured up to applicable limits by the Deposit Insurance Fund administered by the FDIC. The Bank must file reports with the OTS and the FDIC concerning its activities and financial condition in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with, or acquisitions of, other financial institutions. There are periodic examinations by the OTS and, under certain circumstances, the FDIC to evaluate the Bank's safety and soundness and compliance with various regulatory requirements. This regulatory structure is intended primarily for the protection of the insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such policies, whether by the OTS, the FDIC or Congress, could have a material adverse impact on the Company and the Bank and their operations. The Company, as a savings and loan holding company, is required to file certain reports with, are subject to examination by, and otherwise must comply with the rules and regulations of the OTS. The Company is also subject to the rules and regulations of the SEC under the federal securities laws. See "-- Savings and Loan Holding Company Regulations." Federal Regulation of Savings Institutions - ------------------------------------------ Office of Thrift Supervision. The OTS has extensive authority over the operations of savings institutions. As part of this authority, the Bank is required to file periodic reports with the OTS and is subject to periodic examinations by the OTS and the FDIC. The OTS also has extensive enforcement authority over all savings institutions and their holding companies, including the Bank and the Company. This enforcement authority includes, among other things, the ability to assess civil money penalties, issue cease-and-desist or removal orders and initiate injunctive actions. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with the OTS. Except under certain circumstances, public disclosure of final enforcement actions by the OTS is required. In addition, the investment, lending and branching authority of the Bank also are prescribed by federal laws, which prohibit the Bank from engaging in any activities not permitted by these laws. For example, no savings institution may invest in non-investment grade corporate debt securities. In addition, the permissible level of investment by federal institutions in loans secured by non-residential real property may not exceed 400% of total capital, except with approval of the OTS. Federal savings institutions are also generally authorized to branch nationwide. The Bank is in compliance with the noted restrictions. All savings institutions are required to pay assessments to the OTS to fund the agency's operations. The general assessments, paid on a semi-annual basis, are determined based on the savings institution's total assets, including consolidated subsidiaries. The Bank's OTS assessment for the fiscal year ended March 31, 2007 was $144,000. The Bank's general permissible lending limit for loans-to-one-borrower is equal to the greater of $500,000 or 15% of unimpaired capital and surplus (except for loans fully secured by certain readily marketable collateral, in which case this limit is increased to 25% of unimpaired capital and surplus). At March 31, 2007, the Bank's lending limit under 22 this restriction was $7.7 million and, at that date, the Bank's largest single loan to one borrower was $7.0 million, which was performing according to its original terms. The OTS, as well as the other federal banking agencies, has adopted guidelines establishing safety and soundness standards on such matters as loan underwriting and documentation, asset quality, earnings standards, internal controls and audit systems, interest rate risk exposure and compensation and other employee benefits. Any institution that fails to comply with these standards must submit a compliance plan. Federal Home Loan Bank System. The Bank is a member of the FHLB of Atlanta, which is one of 12 regional FHLBs that administer the home financing credit function of savings institutions. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans or advances to members in accordance with policies and procedures, established by the Board of Directors of the FHLB, which are subject to the oversight of the Federal Housing Finance Board. All advances from the FHLB are required to be fully secured by sufficient collateral as determined by the FHLB. In addition, all long-term advances are required to provide funds for residential home financing. At March 31, 2007, the Bank had $153.0 million of outstanding advances from the FHLB of Atlanta under an available credit facility of $221.2 million, which is limited to available collateral. See Business - Sources of Funds - Borrowings. As a member, the Bank is required to purchase and maintain stock in the FHLB of Atlanta. At March 31, 2007, the Bank had $8.2 million in FHLB stock, which was in compliance with this requirement. In past years, the Bank has received substantial dividends on its FHLB stock. Over the past two fiscal years these dividends have averaged 5.14% and were 5.83% for the fiscal year ended March 31, 2007. Under federal law, the FHLBs are required to provide funds for the resolution of troubled savings institutions and to contribute to low- and moderately-priced housing programs through direct loans or interest subsidies on advances targeted for community investment and low- and moderate-income housing projects. These contributions have affected adversely the level of FHLB dividends paid and could continue to do so in the future. These contributions could also have an adverse effect on the value of FHLB stock in the future. A reduction in value of the Bank's FHLB stock may result in a corresponding reduction in the Bank's capital. Federal Deposit Insurance Corporation. The Bank's deposits are insured up to applicable limits by the Deposit Insurance Fund of the FDIC. The Deposit Insurance Fund is the successor to the Bank Insurance Fund and the Savings Association Insurance Fund, which were merged effective March 31, 2006. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the insurance fund. The FDIC also has the authority to initiate enforcement actions against savings institutions, after giving the OTS an opportunity to take such action, and may terminate the deposit insurance if it determines that the institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition. The FDIC recently amended its risk-based assessment system for 2007 to implement authority granted by the Federal Deposit Insurance Reform Act of 2005, which was enacted in 2006 ("Reform Act"). Under the revised system, insured institutions are assigned to one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other factors. An institution's assessment rate depends upon the category to which it is assigned. Risk category I, which contains the least risky depository institutions, is expected to include more than 90% of all institutions. Unlike the other categories, Risk Category I contains further risk differentiation based on the FDIC's analysis of financial ratios, examination component ratings and other information. Assessment rates are determined by the FDIC and currently range from five to seven basis points for the healthiest institutions (Risk Category I) to 43 basis points of assessable deposits for the riskiest (Risk Category IV). The FDIC may adjust rates uniformly from one quarter to the next, except that no single adjustment can exceed three basis points. No institution may pay a dividend if in default of the FDIC assessment. The Reform Act also provided for a one-time credit for eligible institutions based on their assessment base as of December 31, 1996. Subject to certain limitations with respect to institutions that are exhibiting weaknesses, credits can be used to offset assessments until exhausted. The Bank's one-time credit is expected to be approximately $235,000. 23 The Reform Act also provided for the possibility that the FDIC may pay dividends to insured institutions once the Deposit Insurance Fund reserve ratio equals or exceeds 1.35% of estimated insured deposits. In addition to the assessment for deposit insurance, institutions are required to make payments on bonds issued in the late 1980s by the Financing Corporation to recapitalize a predecessor deposit insurance fund. This payment is established quarterly and during the calendar year ending March 31, 2007 averaged 1.22 basis points of assessable deposits. The Reform Act provided the FDIC with authority to adjust the Deposit Insurance Fund ratio to insured deposits within a range of 1.15% and 1.50%, in contrast to the prior statutorily fixed ratio of 1.25%. The ratio, which is viewed by the FDIC as the level that the fund should achieve, was established by the agency at 1.25% for 2007. The FDIC has authority to increase insurance assessments. A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank. There can be no prediction as to what insurance assessment rates will be in the future. Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OTS. Management of the Bank is not aware of any practice, condition or violation that might lead to termination of the Bank's deposit insurance. Capital Requirements. The OTS's capital regulations require federal savings institutions to meet three minimum capital standards: a 1.5% tangible capital to total assets ratio, a 4% leverage ratio (3% for institutions receiving the highest rating on the CAMELS examination rating system) and an 8% risk-based capital ratio. In addition, the prompt corrective action standards discussed below also establish, in effect, a minimum 2% tangible capital standard, a 4% leverage ratio (3% for institutions receiving the highest rating on the CAMELS system) and, together with the risk-based capital standard itself, a 4% Tier I risk-based capital standard. The OTS regulations also require that, in meeting the tangible, leverage and risk-based capital standards, institutions must generally deduct investments in and loans to subsidiaries engaged in activities as principal that are not permissible for a national bank. The risk-based capital standard requires federal savings institutions to maintain Tier I (core) and total capital (which is defined as core capital and supplementary capital) to risk-weighted assets of at least 4% and 8%, respectively. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, recourse obligations, residual interests and direct credit substitutes, are multiplied by a risk-weight factor of 0% to 100%, assigned by the OTS capital regulation based on the risks believed inherent in the type of asset. Core (Tier I) capital is defined as common stockholders' equity (including retained earnings), certain noncumulative perpetual preferred stock and related surplus and minority interests in equity accounts of consolidated subsidiaries, less intangibles other than certain mortgage servicing rights and credit card relationships. The components of supplementary capital currently include cumulative preferred stock, long-term perpetual preferred stock, mandatory convertible securities, subordinated debt and intermediate preferred stock, the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets and up to 45% of unrealized gains on available-for-sale equity securities with readily determinable fair market values. Overall, the amount of supplementary capital included as part of total capital cannot exceed 100% of core capital. The OTS also has authority to establish individual minimum capital requirements in appropriate cases upon a determination that an institution's capital level is or may become inadequate in light of the particular circumstances. At March 31, 2007, the Bank met each of these capital requirements. For additional information, see Note 13 of the Notes to Consolidated Financial Statements included in the Annual Report. Prompt Corrective Action. The OTS is required to take certain supervisory actions against undercapitalized savings institutions, the severity of which depends upon the institution's degree of undercapitalization. Generally, an institution that has a ratio of total capital to risk-weighted assets of less than 8%, a ratio of Tier I (core) capital to risk-weighted assets of less than 4%, or a ratio of core capital to total assets of less than 4% (3% or less for institutions with the highest examination rating) is considered to be "undercapitalized." An institution that has a total risk-based capital ratio less than 6%, a Tier I capital ratio of less than 3% or a leverage ratio that is less than 3% is considered to 24 be "significantly undercapitalized" and an institution that has a tangible capital to assets ratio equal to or less than 2% is deemed to be "critically undercapitalized." Subject to a narrow exception, the OTS is required to appoint a receiver or conservator for a savings institution that is "critically undercapitalized." OTS regulations also require that a capital restoration plan be filed with the OTS within 45 days of the date a savings institution receives notice that it is "undercapitalized," "significantly undercapitalized" or "critically undercapitalized." In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution, including, but not limited to, increased monitoring by regulators and restrictions on growth, capital distributions and expansion. "Significantly undercapitalized" and "critically undercapitalized" institutions are subject to more extensive mandatory regulatory actions. The OTS also could take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors. At March 31, 2007, the Bank was categorized as "well capitalized" under the prompt corrective action regulations of the OTS. Qualified Thrift Lender Test. All savings institutions, including the Bank, are required to meet a qualified thrift lender ("QTL") test to avoid certain restrictions on their operations. This test requires a savings institution to have at least 65% of its total assets, as defined by regulation, in qualified thrift investments on a monthly average for nine out of every 12 months on a rolling basis. As an alternative, the savings institution may maintain 60% of its assets in those assets specified in Section 7701(a)(19) of the Internal Revenue Code. Under either test, such assets primarily consist of residential housing related loans and investments. A savings institution that fails to meet the QTL is subject to certain operating restrictions and may be required to convert to a national bank charter. Recent legislation has expanded the extent to which education loans, credit card loans and small business loans may be considered "qualified thrift investments." As of March 31, 2007, the Bank maintained 91.2% of its portfolio assets in qualified thrift investments and, therefore, met the qualified thrift lender test. Limitations on Capital Distributions. OTS regulations impose various restrictions on savings institutions with respect to their ability to make distributions of capital, which include dividends, stock redemptions or repurchases, cash-out mergers and other transactions charged to the capital account. Generally, savings institutions, such as the Bank, that before and after the proposed distribution are well-capitalized, may make capital distributions during any calendar year equal to up to 100% of net income for the year-to-date plus retained net income for the two preceding years. However, an institution deemed to be in need of more than normal supervision by the OTS may have its dividend authority restricted by the OTS. The Bank may pay dividends to the Company in accordance with this general authority. Savings institutions proposing to make any capital distribution need not submit written notice to the OTS prior to such distribution unless they are a subsidiary of a holding company or would not remain well-capitalized following the distribution. Savings institutions that do not, or would not meet their current minimum capital requirements following a proposed capital distribution or propose to exceed these net income limitations, must obtain OTS approval prior to making such distribution. The OTS may object to the distribution during that 30-day period based on safety and soundness concerns. See " Capital Requirements." Activities of Savings Institutions and their Subsidiaries. When a savings institution establishes or acquires a subsidiary or elects to conduct any new activity through a subsidiary that it controls, the savings institution must notify the FDIC and the OTS 30 days in advance and provide the information each agency may, by regulation, require. Savings institutions also must conduct the activities of subsidiaries in accordance with existing regulations and orders. The OTS may determine that the continuation by a savings institution of its ownership control of, or its relationship to, the subsidiary constitutes a serious risk to the safety, soundness or stability of the institution or is inconsistent with sound banking practices or with the purposes of the Federal Deposit Insurance Act. Based upon that determination, the FDIC or the OTS has the authority to order the savings institution 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 Deposit Insurance Fund. If so, it may require that no member of the Deposit Insurance Fund engage in that activity directly. 25 Transactions with Affiliates. The Bank's authority to engage in transactions with "affiliates" is limited by OTS regulations and by Sections 23A and 23B of the Federal Reserve Act as implemented by the Federal Reserve Board's Regulation W. The term "affiliates" for these purposes generally means any company that controls or is under common control with an institution. The Company and its non-savings institution subsidiaries are affiliates of the Bank. In general, transactions with affiliates must be on terms that are as favorable to the institution as comparable transactions with non-affiliates. In addition, certain types of transactions are restricted to an aggregate percentage of the institution's capital. Collateral in specified amounts must usually be provided by affiliates in order to receive loans from an institution. In addition, savings institutions are prohibited from lending to any affiliate that is engaged in activities that are not permissible for bank holding companies and no savings institution may purchase the securities of any affiliate other than a subsidiary. The Sarbanes-Oxley Act of 2002 generally prohibits a company from making loans to its executive officers and directors. However, there is a specific exception for loans by a depository institution to its executive officers and directors in compliance with federal banking laws. Under such laws, the Bank's authority to extend credit to executive officers, directors and 10% stockholders ("insiders"), as well as entities such persons control, is limited. The law restricts both the individual and aggregate amount of loans the Bank may make to insiders based, in part, on the Bank's capital position and requires certain Board approval procedures to be followed. Such loans must be made on terms substantially the same as those offered to unaffiliated individuals and not involve more than the normal risk of repayment. There is an exception for loans made pursuant to a benefit or compensation program that is widely available to all employees of the institution and does not give preference to insiders over other employees. There are additional restrictions applicable to loans to executive officers. Community Reinvestment Act. Under the Community Reinvestment Act, every FDIC-insured institution has a continuing and affirmative obligation consistent with safe and sound banking practices to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The Community Reinvestment Act does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the Community Reinvestment Act. The Community Reinvestment Act requires the OTS, in connection with its examination of the Bank, to assess the institution's record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications, such as a merger or the establishment of a branch, by the Bank. An unsatisfactory rating may be used as the basis for the denial of an application by the OTS. Due to the heightened attention being given to the Community Reinvestment Act in the past few years, the Bank may be required to devote additional funds for investment and lending in its local community. The Bank was examined for Community Reinvestment Act compliance and received a rating of satisfactory in its latest examination. Affiliate Transactions. The Company and the Bank are separate and distinct legal entities. Various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company, generally limiting any single transaction to 10% of the Bank's capital and surplus and limiting all such transactions to 20% of the Bank's capital and surplus. These transactions also must be on terms and conditions consistent with safe and sound banking practices that are substantially the same as those prevailing at the time for transactions with unaffiliated companies. Federally insured savings institutions are subject, with certain exceptions, to certain restrictions on extensions of credit to their parent holding companies or other affiliates, on investments in the stock or other securities of affiliates and on the taking of such stock or securities as collateral from any borrower. In addition, these institutions are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or the providing of any property or service. Enforcement. The OTS has primary enforcement responsibility over savings institutions and has the authority to bring action against all "institution-affiliated parties," including shareholders, and any attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital directive or cease and desist order to removal of officers or directors, receivership, conservatorship or termination of deposit insurance. Civil penalties cover a wide range of violations and can amount to $25,000 per day, or $1.1 million per day in especially egregious cases. The FDIC has the authority to recommend to the Director of the OTS that enforcement action be taken with respect to a 26 particular savings institution. If action is not taken by the Director, the FDIC has authority to take such action under certain circumstances. Federal law also establishes criminal penalties for certain violations. Standards for Safety and Soundness. As required by statute, the federal banking agencies have adopted Interagency Guidelines prescribing Standards for Safety and Soundness. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the OTS determines that a savings institution fails to meet any standard prescribed by the guidelines, it may require the institution to submit an acceptable plan to achieve compliance with the standard. Environmental Issues Associated with Real Estate Lending. The Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), a federal statute, generally imposes strict liability on all prior and present "owners and operators" of sites containing hazardous waste. However, Congress asked to protect secured creditors by providing that the term "owner and operator" excludes a person whose ownership is limited to protecting its security interest in the site. Since the enactment of the CERCLA, this "secured creditor exemption" has been the subject of judicial interpretations which have left open the possibility that lenders could be liable for cleanup costs on contaminated property that they hold as collateral for a loan. To the extent that legal uncertainty exists in this area, all creditors, including the Bank, that have made loans secured by properties with potential hazardous waste contamination (such as petroleum contamination) could be subject to liability for cleanup costs, which costs often substantially exceed the value of the collateral property. Privacy Standards. The Gramm-Leach-Bliley Financial Services Modernization Act of 1999 ("GLBA"), modernized the financial services industry by establishing a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms and other financial service providers. The Bank is subject to OTS regulations implementing the privacy protection provisions of the GLBA. These regulations require the Bank to disclose its privacy policy, including identifying with whom it shares "non-public personal information," to customers at the time of establishing the customer relationship and annually thereafter. Anti-Money Laundering and Customer Identification. Congress enacted the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the "USA Patriot Act") in response to the terrorist events of September 11, 2001. The USA Patriot Act gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. In March 2006, Congress re-enacted certain expiring provisions of the USA Patriot Act. Savings and Loan Holding Company Regulation - ------------------------------------------- General. The Company is a unitary savings and loan holding company subject to regulatory oversight of the OTS. Accordingly, the Company is required to register and file reports with the OTS and is subject to regulation and examination by the OTS. In addition, the OTS has enforcement authority over the Company and its non-savings institution subsidiaries which also permits the OTS to restrict or prohibit activities that are determined to present a serious risk to the Bank. Mergers and Acquisitions. The Company must obtain approval from the OTS before acquiring more than 5% of the voting stock of another savings institution or savings and loan holding company or acquiring such an institution or holding company by merger, consolidation or purchase of its assets. In evaluating an application for the Company to acquire control of a savings institution, the OTS would consider the financial and managerial resources and future prospects of the Company and the target institution, the effect of the acquisition on the risk to the insurance fund, the convenience and the needs of the community and competitive factors. Activities Restrictions. The Company and its non-savings institution subsidiaries are subject to statutory and regulatory restrictions on their business activities specified by federal regulations, which include performing services and holding properties used by a savings institution subsidiary, activities authorized for savings and loan holding 27 companies as of March 5, 1987, and non-banking activities permissible for bank holding companies pursuant to the Bank Holding Company Act of 1956 or authorized for financial holding companies pursuant to the GLBA. If the Bank fails the QTL test, the Company must, within one year of that failure, register as, and will become subject to, the restrictions applicable to bank holding companies. See " Federal Regulation of Savings Institutions Qualified Thrift Lender Test." Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act") was signed into law in response to public concerns regarding corporate accountability in connection with several accounting scandals. The stated goals of the Sarbanes-Oxley Act are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. The Sarbanes-Oxley Act generally applies to all companies, both U.S. and non-U.S., that file or are required to file periodic reports with the Securities and Exchange Commission ("SEC") under the Securities Exchange Act of 1934, including the Company. The Sarbanes-Oxley Act includes very specific additional disclosure requirements and new corporate governance rules, and required the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and related rules. The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees. TAXATION Federal Taxation - ---------------- General. The Company and the Bank report their income on a fiscal year basis using the accrual method of accounting and are 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. Bad Debt Reserve. Historically, savings institutions such as the Bank which met certain definitional tests primarily related to their assets and the nature of their business ("qualifying thrift") were permitted to establish a reserve for bad debts and to make annual additions thereto, which may have been deducted in arriving at their taxable income. The Bank's deductions with respect to "qualifying real property loans," which are generally loans secured by certain interest in real property, were 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 non-qualifying reserve. Due to the Bank's loss experience, the Bank generally recognized a bad debt deduction equal to 8% of taxable income. The thrift bad debt rules were revised by Congress in 1996. The new rules eliminated the 8% of taxable income method for deducting additions to the tax bad debt reserves for all thrifts for tax years beginning after December 31, 1995. These rules also required that all institutions recapture all or a portion of their bad debt reserves added since the base year (last taxable year beginning before January 1, 1988). The Bank has no post-1987 reserves subject to recapture. For taxable years beginning after December 31, 1995, the Bank's bad debt deduction has been determined under the experience method using a formula based on actual bad debt experience over a period of years. The unrecaptured base year reserves will not be subject to recapture as long as the Bank continues to carry on the business of banking. In addition, the balance of the pre-1988 bad debt reserves continue to be subject to provisions of present law referred to below that require recapture in the case of certain excess distributions to shareholders. Distributions. To the extent that the Bank makes "nondividend distributions" to the Company, these distributions will be considered to result in distributions from the balance of its bad debt reserve as of December 31, 1987 (or a lesser amount if the Bank's loan portfolio decreased since December 31, 1987) and then from the supplemental reserve for losses on loans ("Excess Distributions"), and an amount based on the Excess Distributions will be included 28 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. The amount of additional taxable income created from 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, after the Conversion, the Bank makes a "nondividend distribution," then approximately one and one-half times the Excess Distribution would be includable in gross income for federal income tax purposes, assuming a 34% corporate income tax rate (exclusive of state and local taxes). See "Regulation Federal Regulation of Savings Institutions Limitations on Capital Distributions" 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 carryovers. 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 0.12% 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 is paid. Dividends-Received Deduction. The Company may exclude from its income 100% of dividends received from the Bank as a member of the same affiliated group of corporations. The corporate dividends-received deduction is 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. Audits. The Company, the Bank and its consolidated subsidiaries have been audited or their books closed without audit by the IRS with respect to consolidated federal income tax returns through March 31, 1999. See Note 12 of the Notes to Consolidated Financial Statements contained in the Annual Report for additional information regarding income taxes. State Taxation - -------------- South Carolina has adopted the Internal Revenue 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%. The Bank has not been audited by the State of South Carolina during the past five years. The Company's income tax returns have not been audited by federal or state authorities within the last five years. For additional information regarding income taxes, see Note 12 of the Notes to Consolidated Financial Statements contained in the Annual Report. Item 1A. Risk Factors. An investment in our common stock involves various risks which are particular to Security Federal Corporation, our industry, and our market area. Before making an investment decision, you should carefully consider the risks and uncertainties described below, together with all of the other information included in this report. In addition to the risks and uncertainties described below, other risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially and adversely affect our business, financial condition and results of operations. The value or market price of our common stock could decline due to any of these identified or other risks, and you could lose all or part of your investment. 29 An economic downturn, especially one affecting Aiken and Lexington Counties in South Carolina and surrounding areas, could reduce our customer base, our level of deposits, demand for our financial products, and increase our delinquency rates on loans. Unlike larger national or other regional banks that are more geographically diversified, we provide banking and financial services to customers located primarily in two counties of South Carolina. Our success depends on the growth in population, income levels, deposits, and housing starts in our primary market area. If the communities in our market area do not continue to expand, our business may not succeed. A local economic downturn could adversely affect the real estate markets in the communities in our market area, which would increase our loan losses on residential and commercial real estate. In that case, our allowance for loan losses may not be adequate, which would negatively impact our earnings. Further, a significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets or other factors could impact these state and local markets and, in turn, also have a material adverse effect on our financial condition and results of operations. Our loan portfolio in Lexington County and surrounding area is relatively unseasoned. We also plan to build a branch office in Evans, Georgia, which is another new lending area. We could experience higher than normal loan losses in newer loan markets. Although we have hired experienced lending officers in Lexington County, that market area is relatively new to us. Many of our loans in that market are acquisition and development loans and loans to builders for speculative housing, which have a higher degree of risk than single family permanent mortgage loans. Although we have not had increased delinquencies in that market, we have not experienced an economic cycle of declining real estate values in Lexington County. We also plan to enter the metro Augusta, Georgia market by opening a branch in Evans, which will be a new market area for us. We plan on hiring experienced lenders, although this may be difficult because competition for experienced commercial lenders is fierce. Because these market areas are new to us, we may experience increased loan losses that would require additional reserves and which would negatively impact our earnings. Fluctuations in interest rates could reduce our profitability and affect the value of our assets. Our profitability depends substantially upon our net interest income. Net interest income is the difference between the interest earned on loans and investments and interest paid on deposits and borrowings. Market interest rates for loans and deposits are highly sensitive to competition for these products. We expect that we will periodically experience imbalances in the interest rate sensitivities of our assets and liabilities and the relationships of various interest rates to each other. Over any period of time, our interest-earning assets may be more sensitive to changes in market interest rates than our interest-bearing liabilities, or vice versa. In addition, the individual market interest rates underlying our loan and deposit products may not change to the same degree over a given time period. In any event, if market interest rates should move contrary to our position, our earnings may be negatively affected. In addition, loan volume and quality and deposit volume and mix can be affected by market interest rates. Changes in levels of market interest rates could materially adversely affect our net interest spread, asset quality, origination volume and overall profitability. Interest rates have recently been at historically low levels. However, since March 31, 2004, the U.S. Federal Reserve has increased its target for the federal funds rate seventeen times, from 1.00% to 5.25%. While these short-term market interest rates (which we use as a guide to price our deposits) have increased, the pricing of our loans have more than offset the rise in funding cost. In a sustained rising interest rate environment, the asset yields are expected to closely match rising funding costs. A sustained falling interest rate environment would negatively impact margins. Opportunities to reduce non-maturity deposit rates become more difficult to realize in a protracted decline in rates, while asset yields come under constant pressure. We principally manage interest rate risk by managing our volume and mix of our earning assets and funding liabilities. In a changing interest rate environment, we may not be able to manage this risk effectively. If we are unable to manage interest rate risk effectively, our business, financial condition and results of operations could be materially harmed. 30 An inadequate allowance for loan losses would reduce our earnings. We are exposed to the risk that our borrowers will be unable to repay their loans according to their terms and that any collateral securing the payment of their loans will not be sufficient to assure full repayment. Credit losses are inherent in the lending business and could have a material adverse effect on our operating results. Volatility and deterioration in the economy may also increase our risk for credit losses. We evaluate the collectibility of our loan portfolio and provide an allowance for loan losses that we believe is adequate based upon such factors as: * cash flow of the borrower and/or the project being financed; * in the case of a collateralized loan, the changes and uncertainties as to the future value of the collateral; * the credit history of a particular borrower; * changes in economic and industry conditions; and * the duration of the loan. If our evaluation is incorrect and borrower defaults cause losses exceeding our allowance for loan losses, our earnings could be materially and adversely affected. We cannot assure you that our allowance will be adequate to cover loan losses inherent in our portfolio. We may experience losses in our loan portfolio or perceive adverse trends that require us to significantly increase our allowance for loan losses in the future, which would also reduce our earnings. In addition, Security Federal Bank's regulators, as an integral part of their examination process, may require us to make additional provisions for loan losses. Our funding sources may prove insufficient to replace deposits and support our future growth. We rely on customer deposits and advances from the FHLB of Atlanta and other borrowings to fund our operations. Although we have historically been able to replace maturing deposits and advances if desired, no assurance can be given that we would be able to replace such funds in the future if our financial condition or the financial condition of the FHLB or market conditions were to change. Our financial flexibility will be severely constrained if we are unable to maintain our access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs. In this case, our profitability would be adversely affected. Competition with other financial institutions could adversely affect our profitability. The banking and financial services industry is very competitive. Legal and regulatory developments have made it easier for new and sometimes unregulated competitors to compete with us. Consolidation among financial service providers has resulted in fewer very large national and regional banking and financial institutions holding a large accumulation of assets. These institutions generally have significantly greater resources, a wider geographic presence or greater accessibility. Our competitors may be able to offer more services, more favorable pricing or greater customer convenience than we do. In addition, our competition has grown from new banks and other financial services providers that target our existing or potential customers. As consolidation continues among large banks, we expect additional institutions to try to exploit our market. Technological developments have allowed competitors, including some non-depository institutions, to compete more effectively in local markets and have expanded the range of financial products, services and capital available to our target customers. If we are unable to implement, maintain and use such technologies effectively, we may not be able to offer products or achieve cost-efficiencies necessary to compete in our industry. In addition, some of these competitors have fewer regulatory constraints and lower cost structures. 31 We are exposed to a failure or breach of our technology. As a financial services company, we are heavily dependent on our core processing system and computer networks to conduct our business. Although we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations. Although we do our own core bank processing in-house, we rely on third-party service providers for much of our communications, information, operating and financial control systems technology. If any of our third-party service providers experience financial, operational or technological difficulties, or if there is any other disruption in our relationships with them, we may be required to locate alternative sources of such services, and we cannot assure that we could negotiate terms that are as favorable to us, or could obtain services with similar functionality, as found in our existing systems, without the need to expend substantial resources, if at all. Any of these circumstances could have an adverse effect on our business. Our ability to pay dividends is limited and we may be unable to pay future dividends. This could lead to appreciation of our common stock price as the sole return on an investor's investment. Security Federal Corporation is a separate and distinct legal entity from its subsidiaries. We receive substantially all of our revenue from dividends from Security Federal Bank. These dividends are the principal source of funds to pay dividends on our common stock and interest and principal on our debt. Various federal and/or state laws and regulations limit the amount of dividends that Security Federal Bank may pay us. Also, our right to participate in a distribution of assets upon a subsidiary's liquidation or reorganization is subject to the prior claims of the subsidiary's creditors. In the event Security Federal Bank is unable to pay dividends to us, we may not be able to service our debt, pay obligations or pay dividends on our common stock. The inability to receive dividends from Security Federal Bank could have a material adverse effect on our business, financial condition and results of operations. Thus, no assurances can be made that we will continue to increase or even pay our quarterly dividend. We may need to raise capital to support our growth. We may not be able to raise capital at the time we need it. In order to sustain the high rate of growth we have experienced during the past few years, we may need to raise additional capital in the near future. Although there are various ways to raise capital, those methods may not be available at the time we need to raise additional capital. In the event we are unable to raise the capital we need, our growth, and future earnings, would be curtailed. The integration of the Collier Jennings Companies may be difficult, which could have a negative impact on earnings. We recently acquired the Collier Jennings Companies, a local insurance agency. The integration of the Collier-Jennings Companies may be difficult and may cause us not to realize expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from the acquisition. The process of integrating operations could cause an interruption of, or loss of momentum in, the activities of our business. The diversion of management's attention and any delays or difficulties encountered in connection with the acquisition could have an adverse effect on our business and results of operations following the acquisition or otherwise adversely affect our ability to achieve the anticipated benefits of the acquisition. We are subject to extensive regulation from numerous governmental agencies, which could restrict our activities and impose financial requirements or limitations on the conduct of our business. We are subject to extensive federal and state regulation and supervision, primarily through Security Federal Bank. Banking regulations are primarily intended to protect depositors' funds, the federal deposit insurance fund and 32 the banking system as a whole, not shareholders. These regulations affect our lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on our business, financial condition and results of operations. While we have policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur. We are dependent on key individuals, and the loss of one or more of these key individuals could limit our growth and adversely affect earnings. Timothy W. Simmons, our Chief Executive Officer, is a very experienced banker and has long-standing ties to our community. The loss of Mr. Simmons, or other key personnel, could have a negative impact on earnings. The competition for seasoned, experienced, banking personnel is highly competitive in South Carolina. The cost of attaining and retaining these individuals could increase in the future, which would negatively impact our operations. Our success depends on our ability to continue to attract, manage and retain other qualified personnel as we grow. We cannot assure you that we will continue to attract or retain such personnel. Changes in accounting standards may affect our performance. Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time there are changes in the financial accounting and reporting standards that govern the preparation of our financial statements. These changes can be difficult to predict and can materially impact how we report and record our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in restating prior period financial statements. Our recent results may not be indicative of future results, and may not be an adequate measure of the risk of investing in our stock. We may not be able to sustain our historical growth rate or our recent growth rates in loans and deposits. If we are unable to sustain our growth, this would negatively affect our earnings and the value of our common stock. Item 2. Properties ---------- At March 31, 2007, Security Federal owned the buildings and land for six of its branch offices, and the operations center, leased the land and owned the improvements thereon for two of its offices, and leased the remaining five offices, including its main office. The Company also leased three offices for Security Federal Insurance/Collier Jennings. The property related to the offices owned by Security Federal had a depreciated cost (including land) of approximately $5.8 million at March 31, 2007. At March 31, 2007, the aggregate net book value of leasehold improvements (excluding furniture and equipment) associated with leased premises was $2.9 million. In addition to the properties related to current Company offices, Security Federal owned six other properties at March 31, 2007. Three lots owned for future branch sites, one in Aiken County, South Carolina, one in Lexington County, South Carolina, and the other in Richland County, South Carolina, had a combined book value of $2.2 million. Another property, in Columbia County, Georgia, which is currently under construction for a future branch location in Evans, Georgia, had a book value (construction in process and land) of approximately $1.9 million at March 31, 2007. The branch is expected to be open in December 2007. Another lot in Aiken County, to be used for a possible new Operations Center, had a book value of $236,000. The other property consisting of land and a building, located adjacent to the 1705 Whiskey Road office, is currently leased and had a book value of approximately $202,000 at March 31, 2007. See Note 6 of the Notes to Consolidated Financial Statements contained in the Annual Report. 33 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, 2007. Lease Date Expir- Facility Gross Owned or ation Opened/ Square Net Book Location Leased Date Acquired Footage Value - ---------------------------- ------ ----- -------- ------- -------- Main Office: 238 Richland Avenue, W. Leased 2016 2006 3,840 $834,000 Aiken, South Carolina Full Service Branch Offices 100 Laurens Street, N.W. Leased 2016 1959 3,840 838,000 Aiken, South Carolina 1705 Whiskey Road S. Owned N/A 1980 10,000 864,000 Aiken, South Carolina 313 East Martintown Road Owned (1) N/A 1973 4,356 567,000 North Augusta, South Carolina 1665 Richland Avenue, W. Owned N/A 1984 1,942 263,000 Aiken, South Carolina Montgomery & Canal Streets Leased 2007 1993 (2) 3,576 246,000 Masonic Shopping Center Graniteville, South Carolina 2812 Augusta Road Owned N/A 1993 (2) 2,509 97,000 Langley, South Carolina Highway 125 and Highways 1 Leased 2008 1993 (2) 2,287 25,000 and 78 Midland Valley Shopping Center Clearwater, South Carolina 118 Main Street North Owned N/A 1993 (2) 3,600 194,000 Wagener, South Carolina 1185 Sunset Boulevard Leased 2015 2000 10,000 610,000 West Columbia, South Carolina 2587 Whiskey Road Owned N/A 2006 4,000 1,555,000 Aiken, South Carolina 5446 Sunset Boulevard Owned (3) N/A 2003 9,200 1,527,000 Lexington, South Carolina Operations Center: 871 East Pine Log Road Owned N/A 1988 10,000 752,000 Aiken, South Carolina (table continued on the following page) 34 Lease Date Expir- Facility Gross Owned or ation Opened/ Square Net Book Location Leased Date Acquired Footage Value - ---------------------------- ------ ----- -------- ------- -------- Insurance Investments & Trust Leased 2016 2006 1,948 291,000 Offices 234 Richland Avenue, West Aiken, South Carolina Insurance Office & Insurance Leased 2011 2006 4,600 32,000 Operations Center 517-521 Belvedere Clearwater Road North Augusta, South Carolina Insurance Office Leased 2008 2006 1,500 -- 1557 F. Gordon Highway Augusta, Georgia - ----------- (1) Security Federal has a lease on the land for trust of which expires in 2023, but has options through 2063. (2) Represents acquisition date. (3) Security Federal has a lease on the land for this office which expires in 2018, but has options through 2063. 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 Matters to a Vote of 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, 2007. PART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities ------------------------------------------------------------------ The information contained in the section captioned "Shareholders Information Price Range of Common Stock" and " Dividends" in the Annual Report is incorporated herein by reference. Stock Repurchases. The following table sets forth the Company's repurchases of its outstanding common stock during the fourth quarter of the year ended March 31, 2007. 35 Total Number of Shares Maximum Purchased as Number Total Part of of Shares that Number of Average Publicly May Yet Be Shares Price Paid Announced Purchased Period Purchased per Share Plans Under the Plans - ---------------- ----------- ------------ ------------ ----------------- January 1 - January 31...... 6,476 $23.79 6,476 99,659 February 1 - February 28..... -- -- -- -- March 1 - March 31........ 2,485 24.15 2,485 97,174 ------- ------- ------- ------- Total............ 8,961 $23.89 8,961 97,174 ======= ======= ======= ======= These stock repurchases are being conducted pursuant to a repurchase program announced by the Company in May 2004, for the purchase of up to 5% of its outstanding shares, or approximately 126,000 shares, subject to market conditions. Equity Compensation Plan Information. The equity compensation plan information presented under subparagraph (d) in Part III, Item 12 of this report is incorporated herein by reference. Performance Graph. The following graph compares the cumulative total shareholder return on the Company's Common Stock with the cumulative total return on the NASDAQ Composite Index and a peer group of the SNL All Thrift Index. Total return assumes the reinvestment of all dividends and that the value of Common Stock and each index was $100 on March 31, 2002. [PERFORMANCE GRAPH APPEARS HERE] Period Ending ------------------------------------------------------------ Index 03/31/02 03/31/03 03/31/04 03/31/05 03/31/06 03/31/07 - ---------------- ---------- -------- -------- -------- -------- -------- Security Federal Corporation $100.00 93.49 97.54 107.38 113.99 117.53 NASDAQ Composite 100.00 72.68 108.07 108.34 126.79 131.23 SNL Thrift Index 100.00 111.47 165.58 162.76 183.33 193.84 36 Item 6. Selected Financial Data ----------------------- The information contained in the section captioned "Selected Consolidated Financial and Other Data" in the Annual Report is incorporated herein by reference. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations --------------------------------------------------------------- The information contained in the section captioned "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Annual Report is incorporated herein by reference. Item 7A. Quantitative and Qualitative Disclosures About Market Risk ---------------------------------------------------------- Market risk is the risk of loss from adverse changes in market prices and rates. Our market risk arises principally from interest rate risk inherent in our lending, investing, deposit and borrowings activities. Management actively monitors and manages its interest rate risk exposure. In addition to other risks that we manage in the normal course of business, such as credit quality and liquidity, management considers interest rate risk to be a significant market risk that could have a potentially have a material effect on our financial condition and result of operations. The information contained in the section captioned "Management's Discussion and Analysis of Financial Condition and Results of Operations Asset and Liability Management" in the Annual Report is incorporated herein by reference. Item 8. Financial Statements and Supplementary Data ------------------------------------------- Report of Independent and Registered Accounting Firm* Consolidated Balance Sheets, March 31, 2007 and 2006* Consolidated Statements of Income For the Years Ended March 31, 2007, 2006 and 2005* Consolidated Statements of Changes in Shareholders' Equity and Comprehensive Income For the Years Ended March 31, 2007, 2006 and 2005* Consolidated Statements of Cash Flows For the Years Ended March 31, 2007, 2006 and 2005* Notes to Consolidated Financial Statements* Quarterly Financial Data (unaudited)* * Contained in the Annual Report filed as an exhibit hereto and incorporated herein by reference. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure --------------------------------------------------------------- None. Item 9A. Controls and Procedures ----------------------- (a) Evaluation of Disclosure Controls and Procedures: An evaluation of the Company's disclosure controls and procedures (as defined in Section 13a-15(e) of the Securities Exchange Act of 1934 (the "Act")) was carried out under the supervision and with the participation of the Company's Chief Executive Officer, Chief Financial Officer and several other members of the Company's senior management as of the end of the period covered by this report. The Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures as currently in effect are effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is (i) accumulated and communicated to the Company's management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. (b) Changes in Internal Controls: In the year ended March 31, 2007, the Company did not make any significant changes in, nor take any corrective actions regarding, its internal controls or other factors that could significantly affect these controls. 37 Item 9B. Other Information ----------------- There was no information to be disclosed by the Company in a report on Form 8-K during the fourth quarter of fiscal 2007 that was not so disclosed. PART III Item 10. Directors, Executive Officers and Corporate Governance ------------------------------------------------------ The information contained under the section captioned " Proposal 1 - Election of Directors" in the Proxy Statement is incorporated herein by reference. For information regarding the executive officers of the Company and the Bank, see the information contained herein under the section captioned "Item 1. Business - Personnel - Executive Officers of the Registrant." Audit Committee Financial Expert. The Audit Committee of the Company is composed of Directors Harry O. Weeks (Chairperson), Clyburn and Moore. Each member of the Audit Committee is "independent" as defined in the Nasdaq Stock Market listing standards. The Board of Directors has determined there is no "audit committee financial expert" as defined by the SEC. The Board believes that the current members of the Audit Committee are qualified to serve based on their collective experience and background. Each member of the Audit Committee is independent as that term is used in Rule 10A-3 of the Exchange Act. Code of Ethics. The Board of Directors has adopted a Code of Ethics for the Company's officers (including its senior financial officers), directors and employees. The Code is applicable to the Company's principal executive officer and senior financial officers, and requires individuals to maintain the highest standards of professional conduct. A copy of the Code of Ethics was filed as and exhibit to the Company's Annual Report on Form 10-K for the year ended March 31, 2006. The Company has not made the Code of Ethics available on its website. The Company will provide a copy of the Code of Ethics free of charge upon request. Requests should be made to: Secretary, Security Federal Corporation, P.O. Box 810, Aiken, South Carolina 29802. Compliance with Section 16(a) of the Exchange Act. The information contained under the section captioned "Section 16(a) Beneficial Ownership Reporting Compliance" is included in the Company's Proxy Statement and is incorporated herein by reference. Item 11. Executive Compensation ---------------------- The information contained in the section captioned "Executive Compensation" in the Proxy Statement is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters ------------------------------------------------------------------ (a) Security Ownership of Certain Beneficial Owners. The information contained in the section captioned "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement is incorporated herein by reference. (b) Security Ownership of Management. The information contained in the section captioned "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement is incorporated herein by reference. 38 (c) Changes In Control The Company is not aware of any arrangements, including any pledge by any person of securities of the Company, the operation of which may at a subsequent date result in a change in control of the Company. (d) Equity Compensation Plan Information The following table sets forth certain information with respect to securities to be issued under the Company's equity compensation plans as of March 31, 2007. (c) Number of securities remaining (a) available for Number of future issuance securities (b) under equity to be issued Weighted-average compensation upon exercise of exercise price plans (excluding outstanding of outstanding securities options, warrants options, warrants reflected in Plan category and rights and rights column (a)) - -------------------- ----------------- ----------------- ------------------ Equity compensation plans approved by security holders: 1999 Stock Option Plan............ 63,600 $19.75 12,750 2002 Stock Option Plan............ 22,000 21.29 10,250 2006 Stock Option Plan............ 14,000 23.06 36,000 Equity compensation plans not approved by security holders: N/A N/A N/A ----------------- ----------------- ------------------ Total.......... 99,600 $20.55 59,000 ================= ================= ================== Item 13. Certain Relationships and Related Transactions, and Director Independence ------------------------------------------------------------ Related Transactions. The information contained in the section captioned "Meetings and Committees of the Board of Directors and Corporate Governance Matters - Corporate Governance - Related Party Transactions" in the Proxy Statement is incorporated herein by reference. Director Independence. The information contained in the section captioned "Meetings and Committees of the Board of Directors and Corporate Governance Matters - Corporate Governance - Director Independence" in the Proxy Statement is incorporated herein by reference. Item 14. Principal Accountant Fees and Services -------------------------------------- The information contained under the section captioned "Auditor " is included in the Company's Proxy Statement and is incorporated herein by reference. PART IV Item 15. Exhibits and Financial Statement Schedules ------------------------------------------ (a) 1. Financial Statements. --------------------- For a list of the financial statements filed as part of this report see Part II Item 8. 39 2. Financial Statement Schedules. ------------------------------ All schedules have been omitted as the required information is either inapplicable or contained in the Consolidated Financial Statements or related Notes contained in the Annual Report filed as an exhibit hereto. 3. Exhibits: --------- 3.1 Articles of Incorporation, as amended (1) 3.2 Bylaws (2) 4 Instruments defining the rights of security holders, including indentures (3) 10.1 1993 Salary Continuation Agreements (4) 10.2 Amendment One to 1993 Salary Continuation Agreements (5) 10.3 Form of 2006 Salary Continuation Agreement (6) 10.4 1999 Stock Option Plan (2) 10.5 1987 Stock Option Plan (4) 10.6 2002 Stock Option Plan (7) 10.7 2004 Employee Stock Purchase Plan (8) 10.8 Incentive Compensation Plan (4) 13 Annual Report to Stockholders 14 Code of Ethics (9) 21 Subsidiaries of Registrant 23 Consent of Elliott Davis, LLC 31.1 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act 31.2 Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act 32 Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act ________ (1) Filed on June 26, 1998, as an exhibit to the Company's Proxy Statement and incorporated herein by reference. (2) Filed on March 2, 2000, as an exhibit to the Company's Registration Statement on Form S-8 and incorporated herein by reference. (3) Filed on August 12, 1987, as an exhibit to the Company's Registration Statement on Form 8-A and incorporated herein by reference. (4) Filed on June 28, 1993, as an exhibit to the Company's Annual Report on Form 10-KSB and incorporated herein by reference. (5) Filed as an exhibit to the Company's Quarterly Report on Form 10-QSB for the quarter ended September 30, 1993 and incorporated herein by reference. (6) Filed on May 24, 2006 as an exhibit to the Company's Current Report on Form 8-K dated May 18, 2006 and incorporated herein by reference. (7) Filed on June 19, 2002, as an exhibit to the Company's Proxy Statement and incorporated herein by reference. (8) Filed on June 18, 2004, as an exhibit to the Company's Proxy Statement and incorporated herein by reference. (9) Filed on June 29, 2006, as an exhibit to the Company's Annual Report on Form 10-K and incorporated herein by reference. 40 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 26, 2007 By: /s/Timothy W. Simmons -------------------------------------- Timothy W. Simmons President, Chief Executive Officer and Director (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 26, 2007 ------------------------------------ Timothy W. Simmons President, Chief Executive Officer and Director (Principal Executive Officer) By: /s/Roy G. Lindburg ------------------------------------ June 26, 2007 Roy G. Lindburg Treasurer, Chief Financial Officer and Director (Principal Financial and Accounting Officer) By: /s/T.Clifton Weeks June 26, 2007 ------------------------------------ T. Clifton Weeks Chairman of the Board and Director By:/s/J. Chris Verenes June 26, 2007 ------------------------------------- J. Chris Verenes President of the Bank and Director of the Company and the Bank By:/s/Gasper L. Toole III June 26, 2007 ------------------------------------- Gasper L. Toole III Director By:/s/Harry O. Weeks Jr. June 26, 2007 ------------------------------------- Harry O. Weeks Jr. Director By:/s/Robert E. Alexander June 26, 2007 ------------------------------------- Robert E. Alexander Director By:/s/Thomas L. Moore June 26, 2007 ------------------------------------- Thomas L. Moore Director By:/s/William Clyburn June 26, 2007 ------------------------------------- William Clyburn Director INDEX TO EXHIBITS Exhibit Number - -------------- 13 Annual Report to Stockholders 21 Subsidiaries of the Registrant 23 Consent of Elliott Davis, LLC 31.1 Certification of Chief Executive Officer of Security Federal Corporation Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification of Chief Financial Officer of Security Federal Corporation Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32 Certification of Chief Executive Officer and Chief Financial Officer of Security Federal Corporation Pursuant to Section 906 of the Sarbanes-Oxley Act Exhibit 13 Annual Report to Stockholders ANNUAL REPORT 2007 SECURITY FEDERAL CORPORATION ============================================================================== MARCH 31, 2007 LETTER TO SHAREHOLDERS Fellow Shareholders: In keeping with our conservative but steady growth strategy, Security Federal Corporation, holding company of Security Federal Bank, is pleased to announce an increase in earnings for the year ending March 31, 2007. The Company reported net income of $4.1 million or $1.59 per share (basic) for the year ending March 31, 2007, an8.2% increase from net income of $3.8 million or $1.51 per share (basic) for the year ending March 31, 2006. The increase in net income is a result of a $1.5million increase in net interest income and a $1.2million increase in non-interest income offset partially by a $2.1 million increase in general and administrative expenses for the year ending March 31, 2007 when compared to the year ending March 31, 2006. Total assets at March 31, 2007 were $738.1 million compared to $658.7 million at March 31, 2006, an increase of 12.1% for the year. Net loans receivable increased $60.9million or 16.2% to $436.0million at March 31, 2007 from$375.1 million at March 31, 2006. Total deposits were $523.7 million at March 31, 2007 compared to $479.2million at March 31, 2006, an increase of 9.3%. Federal Home Loan Bank Advances, debentures and other borrowings increased $27.6million or 20.0% to $166.3million at March 31, 2007 from $138.7 million at March 31, 2006. We are pleased to announce that a quarterly dividend of $.07 per share will be paid on or about June 15, 2007 to shareholders of records as of May 31, 2007. This is a $.01 increase over the previous quarter and is the sixty-sixth consecutive quarterly dividend to shareholders since the Bank's conversion in October of 1987 from a mutual to a stock form of ownership. The dividend was declared as a result of the Bank's continued profitability. Security Federal Bank has eleven full service branches located in Aiken, Clearwater, Graniteville, Langley, Lexington, North Augusta, Wagener, and West Columbia, South Carolina. Additional financial services are offered through the Bank's three wholly owned subsidiaries, Security Federal Insurance, Security Federal Investments, and Security Federal Trust. Sincerely, Sincerely, /s/T. Clifton Weeks /s/Timothy W. Simmons T. Clifton Weeks Timothy W. Simmons Chairman President & Chief Executive Officer CONTENTS: 2 Letter to Shareholders 3 Laying the Groundwork 4-6 Financial Highlights 7 Selected Consolidated Financial & Other Data 8 Management's Discussion and Analysis of Financial Condition & Results of Operations 23 Report of Elliott Davis, LLC, Independent Auditors 24 Consolidated Balance Sheets 25 Consolidated Statements of Income 26 Consolidated Statements of Shareholders' Equity Comprehensive Income 27 Consolidated Statements of Cash Flows 29 Notes to Consolidated Financial Statements 58 Shareholders Information 60 Security Federal Bank Board of Directors 61 Bank Advisory Boards 62 Management Team & Branch Locations 63 Our Locations 2 GROUNDWORK IS BEING LAID FOR THE FUTURE J. Chris Verenes, President, Security Federal Bank Branch Investment While Security Federal is number one in deposits in Aiken County, expanding into other markets is in our long-term best interest. As a result, we have branched out into the Midlands' market with the addition of our West Columbia and Lexington branches. We are currently renovating a building in the Vista area of downtown Columbia that will open in the fall of this year. Additionally, we have purchased lots in two of the fastest growing markets in the Midlands Richland Northeast and Ballentine. These new locations will begin to provide us with a branch network system in the Midlands which is important to fully servicing the regional shopping patterns of Midlands' residents. We plan to open our first Georgia branch in the fast growing Augusta Evans market in December of this year. We will be relocating our Clearwater branch in the next 18 months to a more favorable location that will allow us to better serve our customers. Expansion of our branch network will pressure our short-term earnings but improve our performance over the long-term. Financial Services Investment In order to diversify our sources of revenue, we continue to build our Financial Services' subsidiaries. Our Trust and Investment subsidiaries are establishing an outstanding reputation and continue to grow. Last year, we merged with the Collier Jennings Insurance Agency and the integration is going well. This merger enables us to provide automobile insurance, homeowners insurance and premium financing, in addition to life insurance. Investments for the Long-Term During the past year, we continued to make significant capital investments, increase dividends and repurchase our stock while growing our earnings 8.2%. We are pleased with the steady and consistent growth of Security Federal, but must not lose sight of the need to competitively position the corporation for the next ten years. While there is a tendency for corporations to make short-term decisions focused on quarterly results, Security Federal has historically displayed the patience to make sound decisions based on the long-term interest of our customers, employees and stockholders. We will continue to patiently balance our near-term needs and goals in tandem with the necessary long-term investments that we believe are critical to Security Federal's future success. This philosophy should continue to serve us well just as it has since we were founded in 1922. 3 FINANCIAL HIGHLIGHTS Years Ended March 31st 2007 2006 Net Income 4,127,000 3,813,000 Earnings Per Share - Basic 1.59 1.51 Book Value Per Share 16.36 14.82 Total Interest Income 42,098,000 32,617,000 Total Interest Expense 23,933,000 15,969,000 Net Interest Income Before Provision For Loan Losses 18,165,000 16,648,000 Provision For Loan Losses 600,000 660,000 Net Interest Income After Provision For Loan Losses 17,565,000 15,988,000 Net Interest Margin 2.76% 2.79% Total Loans Originated 379,593,000 301,832,000 Adjustable Rate Loans As A Percentage of Total Gross Loans 61.0% 63.3% 4 Financial Highlights - ------------------------------------------------------------------------------ 2007 2006 2005 2004 2003 ------ ------ ------ ------ ------ Net Income (In Thousands) $4,127 $3,813 $3,505 $4,263* $3,231 *Includes the sale of the Denmark branch. 2007 2006 2005 2004 2003 ------ ------ ------ ------ ------ Total Assets (In Millions) $ 738 $ 659 $ 586 $ 528 $ 445 2007 2006 2005 2004 2003 ------ ------ ------ ------ ------ Return on Equity 10.24% 10.27% 10.28% 13.67% 11.37% Allowance for Loan Losses (1) 2007 2006 2005 2004 2003 ------ ------ ------ ------ ------ 1.65% 1.76% 1.94% 2.17% 1.98% (1) Allowance for losses as a percentage of total loans. 5 Financial Highlights - ------------------------------------------------------------------------------ 2007 2006 2005 2004 2003 ------ ------ ------ ------ ------ Book Value Per Share $16.36 $14.82 $13.92 $13.30 $11.98 2007 2006 2005 2004 2003 ------ ------ ------ ------ ------ Earnings Per Share - Basic $1.59 $1.51 $1.39 $1.70 $1.29 Security Federal Corporation Stock Prices (at March 31st of each year) 2007 2006 2005 2004 2003 2002 2001 - ------ ------ ------ ------ ------ ------ ------ 24.75 24.25 23.00 21.00 20.26 21.67 20.00 2000 1999 1998 1997 1996 1995 1994 - ------ ------ ------ ------ ------ ------ ------ 18.00 15.00 7.33 5.17 4.54 3.65 3.37 1993 1992 1991 1990 1989 1988 - ------ ------ ------ ------ ------- ------ 2.75 2.54 2.46 2.40 1.83 1.75 6 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Selected Consolidated Financial and Other Data At Or For The Year Ended March 31, -------------------------------------------------- 2007 2006 2005 2004 2003 -------- -------- -------- -------- -------- Balance Sheet Data (Dollars In Thousands, Except Per Share Data) - ----------------------- Total Assets $738,110 $658,678 $585,978 $528,005 $444,904 Cash And Cash Equivalents 13,438 14,351 7,916 6,749 8,239 Investment And Mortgage- Backed Securities 249,750 238,433 241,076 245,715 182,117 Total Loans Receivable, Net (1) 436,038 375,109 316,889 259,895 243,156 Deposits 523,738 479,229 430,287 389,593 358,474 Advances From Federal Home Loan Bank 153,049 131,363 112,038 96,336 49,772 Total Shareholders' Equity 42,693 37,602 35,111 33,472 30,040 Income Data - ----------------------- Total Interest Income 42,098 32,617 25,770 23,011 23,660 Total Interest Expense 23,933 15,969 11,525 9,606 10,016 -------- -------- -------- -------- -------- Net Interest Income 18,165 16,648 14,245 13,405 13,644 Provision For Loan Losses 600 660 780 1,200 1,800 -------- -------- -------- -------- -------- Net Interest Income After Provision For Loan Losses 17,565 15,988 13,465 12,205 11,844 Other Income(2) 3,861 2,840 2,524 5,235 3,811 General And Administrative Expense 15,157 13,027 10,773 10,725 10,483 Income Taxes 2,142 1,778 1,711 2,452 1,941 -------- -------- -------- -------- -------- Net Income $ 4,127 $ 3,813 $ 3,505 $ 4,263 $ 3,231 ======== ======== ======== ======== ======== Per Common Share Data - ----------------------- Net Income Per Common Share (Basic) $ 1.59 $ 1.51 $ 1.39 $ 1.70 $ 1.29 ======== ======== ======== ======== ======== Cash Dividends Declared $ 0.24 $ 0.16 $ 0.11 $ 0.08 $ 0.0602 ======== ======== ======== ======== ======== Other Data - ----------------------- Interest Rate Spread Information: Average During Period 2.47% 2.52% 2.44% 2.66% 3.19% End Of Period 2.51% 2.59% 2.45% 2.59% 3.00% Net Interest Margin (Net Interest Income/Average Earning Assets) 2.76% 2.79% 2.64% 2.84% 3.46% Average Interest-Earning Assets To Average Interest-Bearing Liabilities 108.00% 110.25% 109.07% 109.05% 110.47% Equity To Total Assets 5.78% 5.71% 5.99% 6.34% 6.75% Non-Performing Assets To Total Assets (3) 0.15% 0.20% 0.42% 0.40% 0.27% Return On Assets (Ratio Of Net Income To Average Total Assets) 0.59% 0.62% 0.63% 0.87% 0.79% Return On Equity (Ratio Of Net Income To Average Equity) 10.24% 10.27% 10.28% 13.67% 11.37% Equity To Assets Ratio (Ratio Of Average Equity To Average Total Assets) 5.78% 6.03% 6.09% 6.36% 6.90% Dividend Pay-Out Ratio On Common Shares 15.11% 10.67% 7.96% 4.75% 4.69% Number Of Full-Service Offices 11 11 11 11 11 (1) INCLUDES LOANS HELD FOR SALE. (2) FOR 2004, INCLUDES APPROXIMATELY $1.5 MILLION IN GAIN ON SALE OF BRANCH (3) NON-PERFORMING ASSETS CONSIST OF NON-ACCRUAL LOANS AND REPOSSESSED ASSETS. 7 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operation General The following discussion is presented to provide the reader with an understanding of the financial condition and results of operations of Security Federal Corporation and its subsidiaries. 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. The information presented in the following discussion of financial results is indicative of the activities of Security Federal Bank (the "Bank"), a wholly owned subsidiary of the Company. The Bank is a federally chartered thrift that was founded in 1922. The Bank also has four wholly owned subsidiaries, Security Federal Insurance Inc. ("SFINS"), Security Federal Investments Inc. ("SFINV"), Security Federal Trust Inc. ("SFT"), and Security Federal Financial Services Corporation ("SFSC"). SFINS, SFINV, and SFT were formed in the fiscal year ended March 31, 2002 and began operating during the December 2001 quarter. SFINS has a wholly owned subsidiary, Collier Jennings Financial Corporation, which has as subsidiaries Collier Jennings Inc., The Auto Insurance Store Inc., and Security Federal Premium Pay Plans Inc. Security Federal Corporation has a wholly owned subsidiary, Security Federal Statutory Trust (the "Trust"), which issued and sold fixed and floating rate capital securities of the Trust. However, under current accounting guidance, the Trust is not consolidated in the financial statements. SFSC was formed in 1975 and is currently inactive. Unless the context indicates otherwise, references to the Company shall include the Bank and its subsidiaries. The principal business of the Bank is accepting deposits from the general public and originating consumer and commercial business loans as well as mortgage loans that enable borrowers to purchase or refinance one to four family residential real estate. The Bank also originates construction loans on single-family residences, multi-family dwellings and projects, and commercial real estate, as well as loans for the acquisition, development and construction of residential subdivisions and commercial projects. The Bank's net income is dependent on its interest rate spread which is the difference between the average yield earned on its loan and investment portfolios and the average rate paid on its deposits and borrowings. The Bank's interest spread is influenced by interest rates, deposit flows, and loan demands. Levels of non-interest income and operating expense are also significant factors in earnings. Forward-Looking Statements This document, including information included or incorporated by reference, contents, and future filings by the Company on Form 10-K, Form 10-Q, and Form 8-K, and future oral and written statements by the Company and its management may contain forward-looking statements about the Company and its subsidiaries which we believe are within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, without limitation: statements with respect to anticipated future operating and financial performance; growth opportunities; interest rates; acquisition and divestiture opportunities; and synergies, efficiencies, and cost-savings. Words such as "may," "could," "should," "would," "believe," "anticipate," "estimate," "expect," "intend," "plan," and similar expressions are intended to identify these forward-looking statements. Forward-looking statements by the Company and its management are based on beliefs, plans, objectives, goals, expectations, anticipations, estimates, and intentions of management and are not guarantees of future performance. Factors which could affect results include interest rate trends, the general economic climate in the Company's market area and the nation as a whole, the ability of the Company to control costs and expenses, deposit flows, demand for mortgages and other loans, real estate values and vacancy rates, competition, pricing, loan delinquency rates and changes in federal regulation. These factors should be considered in evaluating "forward-looking statements," and undue reliance should not be placed on any such statements. The Company disclaims any obligation to update or revise any forward-looking statements based on the occurrence of future events, the receipt of new information, or otherwise. The important factors we discuss below and elsewhere in this document, identified in the Company's filings with the Securities and Exchange Commission ("SEC"), and presented by our management from time to time could cause actual results to differ materially from those indicated by the forward-looking statements made in this document. Critical Accounting Policies The Company has adopted various accounting policies which govern the application of accounting principles generally accepted in the United States in the preparation of the Company's financial statements. The significant accounting policies of the Company are described in Note 1 of the Notes to the Consolidated Financial Statements. 8 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operation Critical Accounting Policies, Continued Certain accounting policies involve significant judgments and assumptions by management, which have a material impact on the carrying value of certain assets and liabilities; management considers these accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of assets and liabilities and the results of operations of the Company. Of these significant accounting policies, the Company considers its policies regarding the allowance for loan losses to be its most critical accounting policy because of the significant degree of management judgment involved in determining the amount of allowance for loan losses. The Company has developed policies and procedures for assessing the adequacy of the allowance for loan losses, recognizing that this process requires a number of assumptions and estimates with respect to its loan portfolio. The Company's assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers, which is not known to management at the time of the issuance of the consolidated financial statements. Refer to the discussion under the section entitled "Financial Condition" and "Provision for Loan Losses" section in the "Comparison of the Years Ended March 31, 2007 and 2006" and "Comparison of the Years Ended March 31, 2006 and 2005" herein for a further discussion of the Company's estimation process and methodology related to the allowance for loan losses. Asset and Liability Management The Bank's program of asset and liability management seeks to limit the Bank's 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 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. A positive gap position generally has an adverse effect on net interest income during periods of falling interest rates. A positive one-year gap position occurs when the dollar amount of rate sensitive assets maturing or repricing within one year exceeds the dollar amount of rate sensitive liabilities maturing or repricing during that same one-year period. In a period of falling interest rates, the interest received on interest earning assets will increase slower than the interest paid on interest-bearing liabilities, causing a decrease in net interest income. During periods of rising interest rates, the interest received on interest earning assets will increase faster than interest paid on interest-bearing liabilities, thus increasing net interest income. A negative gap position generally has 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 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. The reverse is true in periods of declining interest rates resulting generally in an increase in net interest income. The Bank's Board of Directors reviews the Interest Rate Exposure Report generated for the Bank by the Office of Thrift Supervision. This report measures the interest rate sensitivity of the Bank's net portfolio value ("NPV") on a quarterly basis under different interest rate scenarios. The Bank's sensitivity measure is well within the Bank's policy on changes in NPV. The Bank's asset and liability policies are directed toward maximizing long-term profitability while managing acceptable interest rate risk within the Bank's policies. At March 31, 2007, the positive mismatch of interest-earning assets repricing or maturing within one year with interest-bearing liabilities repricing or maturing within one year was $1.7 million or 0.2% of total assets compared to $26.7 million or 4.1% at March 31, 2006. For more information on the Bank's repricing position at March 31, 2007, see the tables on pages 11 and 12. 9 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operation Asset and Liability Management, Continued During the past year, the Bank originated, for investment purposes, approximately $40.3 million in adjustable rate residential real estate loans ("ARM's"), which are held for investment and not sold. The Bank's loan portfolio included $274.3 million of adjustable rate consumer loans, commercial loans, and mortgage loans or, approximately 61.0% of total gross loans at March 31, 2007. During fiscal 2007, the Bank originated $318.5 million in consumer and commercial loans, which are usually short term in nature. The Bank's portfolio of consumer and commercial loans was $323.0 million at March 31, 2007, $267.8 million at March 31, 2006, and $213.1 million at March 31, 2005. Consumer and commercial loans combined were 71.8% of total loans at March 31, 2007, 68.5% of total loans at March 31, 2006, and 63.0% at March 31, 2005. At March 31, 2007, the Bank held approximately $7.7 million in longer term fixed rate residential mortgage loans. These loans, which amounted to 1.7% of the total loan portfolio, had converted from ARM loans to fixed rate loans during the previous 60 months. These fixed rate loans have remaining maturities ranging from 10 to 29 years. As of March 31, 2007, the Bank no longer has any ARM loans that have conversion features to fixed rate loans. On new originations, the Bank sells virtually all of its 15 and 30 year fixed rate mortgage loans at origination. Fixed rate residential loans sold to Freddie Mac and other institutional investors, on a service-released basis, totaled $30.3 million in fiscal 2007, $29.9 million in fiscal 2006, and $26.0 million in fiscal 2005. The Bank sells all its fixed rate mortgage loans on a service-release basis. Certificates of deposit of $100,000 or more, referred to as "Jumbo Certificates," are normally considered to be 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, 2007, the Bank had $110.6 million outstanding in Jumbo Certificates compared to $61.9 million at March 31, 2006. The Bank has no brokered deposits. The majority of the Bank's deposits originate from the Bank's immediate market area. The following table sets forth the maturity schedule of certificates of deposit with balances of $100,000 or greater at March 31, 2007. At March 31, 2007 (In Thousands) ----------------- Within 3 Months $ 32,587 After 3, Within 6 Months 18,663 After 6, Within 12 Months 52,275 After 12 Months 7,074 -------- $110,599 ======== 10 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operation Asset and Liability Management, Continued The following table sets forth the Bank's interest-bearing liabilities and interest-earning assets repricing or maturing within one year. The table on the following page presents the Bank's entire 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 and fixed rate loans are shown in the time frame of corresponding principal amortization schedules. Adjustable and fixed rate loans are also adjusted for the Company's estimates of pre-payments. Mortgage-backed securities are shown at repricing dates, but also include prepayment estimates. Both tables also assume investments reprice at the earlier of maturity; the likely call date, if any, based on current interest rates; or the next scheduled interest rate change, if any. NOW's are assumed to have a decay rate of 20% the first year, money market accounts to have a decay rate of 65% the first year, and statement savings accounts to have a decay rate of 20% the first year. The balance, for all three products, is deemed to reprice in the one to three year category. Callable fixed rate Federal Home Loan Bank ("FHLB") advances are included in borrowings, and are deemed to mature at the expected call date or maturity, based on the stated interest rate of the advance and current market rates. Junior subordinated debentures are shown at their repricing date or call date. At March 31 ---------------------- 2007 2006 -------- -------- (Dollars In Thousands) Loans (1) $279,508 $254,588 Mortgage-Backed Securities: Available For Sale 81,072 78,367 Investment Securities: Held To Maturity 27,000 10,000 Available For Sale 16,707 3,475 Other Interest-Earning Assets & FHLB Stock 10,004 10,865 -------- -------- Total Interest Rate Sensitive Assets Repricing Within 1 Year $414,291 $357,295 -------- -------- Deposits 346,914 280,329 FHLB Advances And Other Borrowed Money 65,665 50,290 -------- -------- Total Interest Rate Sensitive Liabilities Repricing Within 1 Year $412,579 $330,619 -------- -------- Gap $ 1,712 $ 26,676 ======== ======== Interest Rate Sensitive Assets/Interest Rate Sensitive Liabilities 100.04% 108.07% Gap As A Percent Of Total Assets 0.2% 4.1% (1) LOANS ARE NET OF UNDISBURSED FUNDS AND LOANS IN PROCESS. 11 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operation Asset and Liability Management, Continued The following table sets forth the interest sensitivity of the Bank's assets and liabilities at March 31, 2007, on the basis of the factors and assumptions set forth in the table on the previous page. (Dollars In Thousands) < Three 3 - 12 1 - 3 3 - 5 5 - 10 >10 Months Months Years Years Years Years Total -------- -------- -------- -------- -------- ------- -------- Interest-Earnings Assets - ------------------------------ Loans (1) $190,642 $ 88,866 $ 84,345 $ 58,657 $ 17,482 $ 3,624 $443,616 Mortgage-Backed Securities: Available For Sale, At Fair Value 19,404 61,668 38,431 9,293 4,034 2,251 135,081 Investment Securities: (2) Held To Maturity, At Cost 11,000 16,000 24,000 9,984 3,000 - 63,984 Available For Sale, At Fair Value 3,073 13,634 17,917 16,061 - - 50,685 FHLB Stock, At Cost - 8,209 - - - - 8,209 Other Interest-Earning Assets 1,795 - - - - - 1,795 -------- -------- -------- -------- -------- ------- -------- Total Financial Assets $225,914 $188,377 $164,693 $ 93,995 $ 24,516 $ 5,875 $703,370 ======== ======== ======== ======== ======== ======= ======== Interest-Bearing Liabilities - ------------------------------ Deposits: Certificate Accounts $ 63,616 $172,336 $ 13,390 $ 5,930 $ - $ - $255,272 NOW Accounts 6,450 6,450 51,603 - - - 64,503 Money Market Accounts 47,285 47,285 50,922 - - - 145,492 Statement Savings Accounts 1,746 1,746 13,967 - - - 17,459 Borrowings 30,665 35,000 48,000 37,278 15,349 - 166,292 -------- -------- -------- -------- -------- ------- -------- Total Interest-Bearing Liabilities $149,762 $262,817 $177,882 $ 43,208 $ 15,349 $ - $649,018 ======== ======== ======== ======== ======== ======= ======== Current Period Gap $ 76,152 $(74,440) $(13,189) $ 50,787 $ 9,167 $ 5,875 $ 54,352 Cumulative Gap $ 76,152 $ 1,712 $(11,477) $ 39,310 $ 48,477 $54,352 $ 54,352 Cumulative Gap As A Percent Of Total Assets 10.3% 0.2% (1.6)% 5.3% 6.6% 7.4% 7.4% (1) LOANS ARE NET OF UNDISBURSED FUNDS AND LOANS IN PROCESS. (2) CALLABLE SECURITIES ARE SHOWN AT THEIR LIKELY CALL DATES BASED ON MANAGEMENT'S ESTIMATES AT MARCH 31, 2007.
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 deposits will likely 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 loans and the ability of depositors to withdraw funds prior to maturity. Further, certain assets, such as ARMs, have features that restrict changes in interest rates on a short-term basis as well as over the life of the asset. 12 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operation Financial Condition Total assets at March 31, 2007 were $738.1 million, an increase of $79.4 million or 12.1% from $658.7 million at March 31, 2006. This increase was primarily the result of an increase in net loans receivable. Total net loans receivable were $436.0 million at March 31, 2007, an increase of $60.9 million or 16.2% from $375.1 million at March 31, 2006. Residential real estate loans held for investment increased $3.5 million or 2.9% to $125.5 million at March 31, 2007. Typically, long term, newly originated fixed rate mortgage loans are not retained in the portfolio but are sold immediately. ARMs are typically retained in the portfolio. At March 31, 2007, the Bank held 90.9% of its residential mortgage loans in ARMs, while it had 9.1% in fixed rate mortgages. Consumer loans increased $5.2 million or 8.9% while commercial business and commercial real estate loans increased $50.0 million or 23.9% to $259.2 million at fiscal year end March 31, 2007 from $209.2 million at March 31, 2006. A large portion of the increased activity in commercial lending took place in the Midlands area of South Carolina including Columbia, Lexington, and West Columbia. A significant portion of these loans is acquisition and development loans. Loans held for sale, which was $1.5 million at March 31, 2007, increased $209,000 from the previous fiscal year end. Total investments and mortgage-backed securities increased $11.3 million or 4.8% to $249.7 million at March 31, 2007. Cash and cash equivalents were $13.4 million at March 31, 2007 compared to $14.4 million at March 31, 2006. Property and equipment increased $4.2 million or 36.3% to $15.9 million in fiscal 2007 as the Bank completed renovations on its downtown Aiken branch building and headquarters, began renovations of its Whiskey Road Aiken branch building, invested in two lots in the metro Columbia, South Carolina area for future branches, and purchased another lot for future relocation of its Clearwater branch. The cash value of Bank Owned Life Insurance ("BOLI") was $5.8 million at March 31, 2007 compared to $5.0 million at March 31, 2006. The increase was due to accumulated BOLI earnings of $243,000 and an additional BOLI purchase of $541,000 during the fiscal year ended March 31, 2007. BOLI, which earns tax-free yields, is utilized to partially offset the cost of the Company's employee benefits programs and provide key person insurance on certain officers of the Company. Repossessed assets acquired in settlement of loans decreased $66,000 to $25,000 at March 31, 2007 from $91,000 at March 31, 2006. The sole repossessed asset at March 31, 2007 was a single-family dwelling. Non-accrual loans totaled $1.1 million at March 31, 2007 compared to $1.2 million a year earlier. Non-accrual loans averaged $1.3 million in fiscal 2007 compared to $1.6 million during fiscal 2006. The Bank classifies all loans as non-accrual when they become 90 days or more delinquent. The Bank had five loans that were troubled debt restructurings totaling $204,000 at March 31, 2007 compared to six loans totaling $418,000 at March 31, 2006. The five troubled debt restructurings consisted of two consumer loans secured by first mortgages on residential dwellings totaling $130,000, a $10,000 consumer loan secured by a second mortgage on a residential dwelling, a $52,000 commercial loan secured by two rental properties, and a $12,000 unsecured commercial loan. The $10,000 consumer loan was 30 days delinquent at March 31, 2007 while the other 4 loans were current in payments. All troubled debt restructurings are also considered impaired. At March 31, 2007, the Bank held $1.5 million in impaired loans compared to $2.1 million at March 31, 2006. In July 2006, the Company acquired Collier Jennings Financial, an insurance agency specializing in consumer automobile insurance and premium financing. The resulting goodwill and other intangibles were $1.2 million and $533,000 at March 31, 2007, respectively. Collier Jennings is now a subsidiary of Security Federal Insurance. The Bank reviews its loan portfolio and allowance for loan losses on a monthly basis. 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 continually monitors its loan portfolio for the impact of local economic changes. The ratio of allowance for loan losses to total loans was 1.65% at March 31, 2007 compared to 1.76% at March 31, 2006. Deposits at the Bank increased $44.5 million or 9.3% to $523.7 million at March 31, 2007 from $479.2 million at March 31, 2006. The Bank was very successful in attracting certificate of deposit accounts with aggressive pricing and advertising. Advances from the FHLB increased to $153.0 million at March 31, 2007 from $131.4 million a year earlier, an increase of $21.6 million or 16.5%. Other borrowed money, which consists of retail repurchase agreements, increased $798,000 or 11.0% to $8.1 million at March 31, 2007 from $7.3 million at March 31, 2006. The Company issued its first trust preferred security issuance in September 2006. Gross proceeds of the issuance were $5.2 million and are classified as junior subordinated debentures on the consolidated balance sheet. 13 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operation Financial Condition, Continued Total shareholders' equity was $42.7 million at March 31, 2007, an increase of $5.1 million or 13.5% from $37.6 million a year earlier. The increase was attributable to net income of $4.1 million, proceeds from the exercise of stock options of $438,000, a decrease in the employee stock ownership debt of $216,000, and a net decrease in accumulated other comprehensive loss of $1.3 million, offset partially by the purchase of $413,000 of treasury stock, and $623,000 in dividends paid. 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. The table also 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: (1) changes in rate (changes in rate multiplied by prior year volume); (2) changes in volume (changes in volume multiplied by prior year rate); and (3) net change (the sum of the prior columns). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change attributable to volume and the change attributable to rate. Fiscal Year 2007 Fiscal Year 2006 Compared To 2006 Compared To 2005 ------------------------ ------------------------ Volume Rate Net Volume Rate Net ------ ------ ------ ------ ------ ------ (In Thousands) Interest-Earning Assets: Loans: (1) Real Estate Loans $ 385 $ 558 $ 943 $ 553 $ 266 $ 819 Other Loans 4,534 2,294 6,828 3,728 2,041 5,769 ------ ------ ------ ------ ------ ------ Total Loans 4,919 2,852 7,771 4,281 2,307 6,588 Mortgage-Backed Securities (2) (629) 948 318 (609) 479 (130) Investments (2) 635 745 1,380 350 185 535 Other Interest-Earning Assets (9) 21 12 2 32 34 ------ ------ ------ ------ ------ ------ Total Interest-Earning Assets $4,916 $4,565 $9,481 $4,024 $3,003 $7,027 ====== ====== ====== ====== ====== ====== Interest-Bearing Liabilities: Deposits: Certificate Accounts $2,092 $2,499 $4,591 $ 959 $1,349 $2,308 NOW Accounts (5) 119 114 22 330 352 Money Market Accounts (303) 1,437 1,134 (232) 1,295 1,063 Savings Accounts (9) 0 (9) 2 - 2 ------ ------ ------ ------ ------ ------ Total Deposits 1,775 4,055 5,830 751 2,974 3,725 Borrowings 1,158 976 2,134 602 117 719 ------ ------ ------ ------ ------ ------ Total Interest-Bearing Liabilities 2,933 5,031 7,964 1,353 3,091 4,444 ------ ------ ------ ------ ------ ------ Effect On Net Income $1,983 $ (466) $1,517 $2,671 $ (88) $2,583 ====== ====== ====== ====== ====== ====== (1) INTEREST ON NON-ACCRUAL LOANS IS NOT INCLUDED IN INCOME, ALTHOUGH THEIR LOAN BALANCES ARE INCLUDED IN AVERAGE LOANS OUTSTANDING. (2) SECURITIES AVAILABLE FOR SALE ARE COMPUTED USING THEIR HISTORICAL COST. 14 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operation Results of Operations, Continued The following table presents the total dollar amount of interest income from average interest-earning assets for the periods indicated 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. Averages For Fiscal Years Ended March 31, -------------------------------------------------------------------------------- Yield/ 2007 2006 2005 Rate at ------------------------- ------------------------- ------------------------- March 31, Average Yield/ Average Yield/ Average Yield/ 2007 Balance Interest Rate Balance Interest Rate Balance Interest Rate -------- ------- -------- ------ ------- -------- ------ ------- -------- ------ (Dollars In Thousands) Interest-Earning Assets: Mortgage Loans 6.05% $118,793 $ 7,285 6.13% $112,223 $ 6,342 5.65% $102,365 $ 5,568 5.44% Other Loans 8.23% 289,925 23,896 8.24% 232,793 17,068 7.33% 179,251 11,433 6.38% ---- -------- ------- ---- -------- ------- ---- -------- ------- ---- Total Loans (1) 7.67% 408,718 31,181 7.63% 345,016 23,410 6.79% 281,616 17,001 6.04% Mortgage-Backed Securities (2) 4.73% 133,923 5,773 4.31% 150,107 5,455 3.63% 167,582 5,585 3.33% Investments (2) 4.66% 115,253 5,070 4.40% 99,473 3,690 3.71% 89,813 3,155 3.51% Other Interest- Earning Assets 5.31% 1,412 74 5.23% 1,775 62 3.49% 1,647 28 1.70% ---- -------- ------- ---- -------- ------- ---- -------- ------- ---- Total Interest- Earning Assets 6.56% $659,306 $42,098 6.39% $596,371 $32,617 5.47% $540,658 $25,769 4.77% ==== ======== ======= ==== ======== ======= ==== ======== ======= ==== Interest-Bearing Liabilities: Certificate Accounts 4.99% $229,120 $10,497 4.58% $175,703 $ 5,906 3.36% $142,459 $ 3,598 $2.53% NOW Accounts 1.03% 62,578 811 1.30% 63,000 697 1.11% 58,092 345 0.59% Money Market Accounts 4.14% 146,781 5,798 3.95% 156,508 4,664 2.98% 166,735 3,601 2.16% Savings Accounts 0.98% 16,895 166 0.98% 17,969 175 0.98 17,657 173 0.98% ---- -------- ------- ---- -------- ------- ---- -------- ------- ---- Total Interest- Bearing Accounts 3.89% 455,374 17,272 3.79% 413,180 11,442 2.77% 384,943 7,717 2.01% Other Borrowings 4.41% 7,080 318 4.49% 6,201 210 3.38% 5,488 84 1.53% Jr. Subordinated Debt 6.97% 2,721 192 7.05% - - - - - - FHLB Advances 4.36% 145,299 6,151 4.23% 121,526 4,317 3.55% 105,272 3,724 3.54% ---- -------- ------- ---- -------- ------- ---- -------- ------- ---- Total Interest- Bearing Liabilities 4.05% $610,474 $23,933 3.92% $540,907 $15,969 2.95% $495,703 $11,525 $2.33% ==== ======== ======= ==== ======== ======= ==== ======== ======= ==== Net Interest Income $18,165 $16,648 $14,244 ======= ======= ======= Interest Rate Spread 2.51% 2.47% 2.52% 2.44% ==== ==== ==== ==== Net Yield On Earning Assets 2.76% 2.79% 2.64% ==== ==== ==== (1) INTEREST ON NON-ACCRUAL LOANS IS NOT INCLUDED IN INCOME, ALTHOUGH THEIR LOAN BALANCES ARE INCLUDED IN AVERAGE LOANS OUTSTANDING. (2) SECURITIES AVAILABLE FOR SALE ARE COMPUTED USING THEIR HISTORICAL COST. 15
SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operation Comparison of the Years Ended March 31, 2007 and 2006 General The Company's earnings were $4.1 million for the year ended March 31, 2007, compared to $3.8 million for the year ended March 31, 2006. The $314,000 or 8.2% increase in earnings was attributable primarily to an increase in net interest income and other income offset partially by an increase in general and administrative expenses. Net Interest Income Net interest income increased $1.5 million or 9.1% to $18.2 million in fiscal 2007 from $16.7 million in fiscal 2006. The increase was attributable to an increase of $62.9 million to $659.3 million in average interest-earning assets during fiscal 2007. The Bank's interest rate spread decreased five basis points to 2.47% during fiscal 2007. The yield of average earning assets increased 92 basis points to 6.39%, while the cost of average interest bearing liabilities increased 97 basis points to 3.92%. Interest income on loans increased $7.8 million to $31.2 million during the year ended March 31, 2007 from $23.4 million during fiscal 2006. The increase was attributable to an increase in average total loans outstanding of $63.7 million and an 84 basis point increase in the yield earned on the Bank's loans during fiscal 2007. Interest income on investment securities, mortgage-backed securities, and other investments increased $1.7 million as a result of an increase in yield of 70 basis points in the overall investment portfolio. The aggregate average balance in the overall investment portfolio, including mortgage-backed securities, investments, and other interest-earning assets, decreased $767,000 during fiscal 2007 compared to fiscal 2006 to help fund the growth in loans. Interest expense on deposits increased $5.8 million or 51.0% to $17.3 million during the year ended March 31, 2007. Average interest bearing deposits increased $42.2 million while the average cost of those deposits increased 102 basis points during the year. Interest expense on FHLB advances and other borrowings increased $1.9 million or 42.9% to $6.5 million during fiscal 2007. The increase was a result of an increase in average FHLB advances and other borrowings outstanding during the year of $24.6 million while the average costs of those borrowings increased 71 basis points to 4.25% in fiscal 2007 compared to 3.54% in fiscal 2006. Interest expense on junior subordinated debentures was $192,000 during fiscal 2007, with a weighted average cost of 7.05%. The Company issued its first junior subordinated debentures in September 2006. Net proceeds of the issuance were $5.0 million. Provision for Loan Losses The Company's provision for loan losses decreased $60,000 to $600,000 during the year ended March 31, 2007 from $660,000 in fiscal 2006. The amount of the provision is determined by management's on-going monthly analysis of the loan portfolio. Management uses three methods to measure the estimate of the adequacy of the allowance for loan losses. These methods incorporate percentage of classified loans, five-year averages of historical loan losses in each loan category and current economic trends, and the assignment of percentage targets of reserves in each loan category. Management has used all three methods for the past seven fiscal years. Non-accrual loans, which are loans delinquent 90 days or more, were $1.1 million at March 31, 2007 compared to $1.2 million at March 31, 2006. Net charge-offs were $30,000 in fiscal 2007 compared to $239,000 in fiscal 2006. The ratio of the allowance for loan losses to total loans at March 31, 2007 was 1.65% compared to 1.76% at March 31, 2006. Management believes the allowance for loan losses is adequate based on its best estimates of the losses inherent in the loan portfolio, although there can be no guarantee as to these estimates. In addition, bank regulatory agencies may require additions to the allowance for loan losses based on their judgments and estimates as part of their examination process. Because the allowance for loan losses is an estimate, there can be no guarantee that actual loan losses would not exceed the allowance for loan losses or that additional increases in the allowance for loan losses will not be required in the future. 16 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operation Other Income Other income increased $1.2 million from $2.6 million during fiscal 2006 to $3.9 million during fiscal 2007. Gain on sale of loans was $461,000 in fiscal 2007 compared to $467,000 during fiscal 2006. Service fees on deposit accounts increased $107,000 or 9.5% to $1.2 million during fiscal 2007 as a result of an increase in the number of demand accounts. Income from insurance agency commissions increased $608,000 to $650,000 due to the acquisition of Collier Jennings Financial ("Collier Jennings") at the beginning of the September 2006 quarter. Other agency income from Collier Jennings was $68,000 during fiscal 2007. Trust income increased $119,000 or 32.7% to $482,000 during fiscal 2007 due to an increase in trust account balances. Income from Bank Owned Life Insurance was $243,000 during fiscal year 2007. The Company did not own any Bank Owned Life Insurance until March 31, 2006. Other miscellaneous income including annuity and investment brokerage commissions, Bank credit life insurance on loans, and other miscellaneous income increased $142,000 or 24.7% to $718,000 during fiscal 2007 due primarily to an increase in the gain on sale of repossessed assets and increased annuity and investment brokerage commissions. The Bank's three financial subsidiaries, SFINS, SFINV, and SFT began operating in the latter part of the fiscal year ended March 31, 2002. SFINS is an insurance agency handling property and casualty insurance and life and health insurance and became profitable during the fiscal year ended March 31, 2004. In fiscal 2006, SFINS incurred a slight loss due to an increase in staff. In fiscal 2007 SFINS incurred an $83,000 loss due to infrastructure being put in place for the assimilation of Collier Jennings. SFINV markets mutual funds, discount brokerage, and annuities. SFT is a full-service trust company. SFINV and SFT had losses of $33,000 and $35,000, respectively, in fiscal 2007. General and Administrative Expenses General and administrative expenses increased $2.1 million or 16.4% to $15.2 million during the year ended March 31, 2007 compared to the same period one year earlier due primarily to the Collier Jennings insurance agency acquisition, which added approximately $1.1 million in general and administrative expenses. Without that acquisition, general and administrative expenses increased $1.0 million or 7.7%. Compensation and employee benefits increased $1.8 million or 23.8% to $9.4 million as a result of the Collier Jennings acquisition, the hiring of additional business development officers and auditing staff, and normal annual salary adjustments. Excluding the acquisition, compensation and employee benefits expense increased $1.2 million or 16.4%. Occupancy expense increased $147,000 or 11.6% to $1.4 million as a result of the depreciation of branch renovations and the leasing of additional office space. Marketing expense increased $125,000 or 72.5% from $172,000 to $297,000 to advertise consumer loans and certificates of deposit during the year. Depreciation and maintenance of equipment expense increased $216,000 or 19.7% to $1.3 million. FDIC insurance premiums were $58,000 in both fiscal 2007 and 2006. Other miscellaneous expenses, which encompasses repossessed assets expense, legal, professional, and consulting expenses, stationery and office supplies, and other expenses decreased $231,000 or 8.1% during fiscal 2007. Income Taxes The provision for income taxes increased $364,000 to $2.1 million or 20.5% during the year ended March 31, 2007 compared to the year ended March 31, 2006, a result of an increase in taxable income. The effective tax rate was 34.2% for fiscal 2007 and 31.8% for fiscal 2006. 17 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operation Comparison of the Years Ended March 31, 2006 and 2005 General The Company's earnings were $3.8 million for the year ended March 31, 2006, compared to $3.5 million for the year ended March 31, 2005. The $307,000 or 8.8% increase in earnings was attributable primarily to an increase in net interest income offset partially by an increase in general and administrative expenses. Net Interest Income Net interest income increased $2.4 million or 16.9% to $16.6 million in fiscal 2006 from $14.2 million in fiscal 2005. The increase was attributable to an increase of $55.7 million to $596.4 million in average interest-earning assets during fiscal 2006. The Bank's interest rate spread increased eight basis points to 2.52% during fiscal 2006. The yield of average earning assets increased 70 basis points to 5.47%, while the cost of average interest bearing liabilities increased 62 basis points to 2.95%. Interest income on loans increased $6.4 million to $23.4 million during the year ended March 31, 2006 from $17.0 million during fiscal 2005. The increase was attributable to an increase in average total loans outstanding of $63.4 million and a 75 basis point increase in the yield earned on the Bank's loans during fiscal 2006. Interest income on investment securities, mortgage-backed securities, and other investments increased $439,000 as a result of an increase in yield of 28 basis points in the overall investment portfolio. The aggregate average balance in the overall investment portfolio, including mortgage-backed securities, investments, and other interest earning assets, decreased $7.7 million in fiscal 2006 compared to fiscal 2005 to fund loan growth. Interest expense on deposits increased $3.7 million or 48.3% to $11.4 million during the year ended March 31, 2006 from $7.7 million during the year ended March 31, 2005. Average interest bearing deposits increased $28.2 million while the average cost of those deposits increased 77 basis points during the year. Interest expense on FHLB advances and other borrowings increased $719,000 or 18.9% to $4.5 million during fiscal 2006 from $3.8 million during fiscal 2005. The increase was a result of an increase in average FHLB advances and other borrowings outstanding during the year of $17.0 million while the average costs of those borrowings remained relatively stable at 3.54% and 3.44% for fiscal 2006 and 2005, respectively. Provision for Loan Losses The Company's provision for loan losses decreased $120,000 to $660,000 during the year ended March 31, 2006 from $780,000 in fiscal 2005. The amount of the provision is determined by management's on-going monthly analysis of the loan portfolio. Management uses three methods to measure the estimate of the adequacy of the allowance for loan losses. These methods incorporate percentage of classified loans, five-year averages of historical loan losses in each loan category and current economic trends, and the assignment of percentage targets of reserves in each loan category. Management has used all three methods for the past seven fiscal years. Non-accrual loans, which are loans delinquent 90 days or more, were $1.2 million at March 31, 2006 compared to $2.4 million at March 31, 2005. Net charge-offs were $239,000 in fiscal 2006 compared to $260,000 in fiscal 2005. The ratio of the allowance for loan losses to total loans at March 31, 2006 was 1.76% compared to 1.94% at March 31, 2005. Management believes the allowance for loan losses is adequate based on its best estimates of the losses inherent in the loan portfolio, although there can be no guarantee as to these estimates. In addition, bank regulatory agencies may require additions to the allowance for loan losses based on their judgments and estimates as part of their examination process. Because the allowance for loan losses is an estimate, there can be no guarantee that actual loan losses would not exceed the allowance for loan losses or that additional increases in the allowance for loan losses will not be required in the future. 18 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operation Other Income Other income increased $105,000 from $2.5 million during fiscal 2005 to $2.6 million during fiscal 2006. Gain on sale of loans increased $32,000 or 7.3% to $467,000 during fiscal 2006. Service fees on deposit accounts decreased $94,000 or 7.7% to $1.1 million during fiscal 2006 as a result of an increase in the average interest rate used to offset commercial analysis charges on business demand accounts. Trust fees increased $137,000 or 60.6% to $363,000 during fiscal 2006. Other miscellaneous income including life and casualty insurance commissions, annuity and investment brokerage commissions, credit life insurance, gain on sale of repossessed assets, and other miscellaneous income decreased $19,000 or 3.00% to $618,000 during fiscal 2006 due primarily to an decrease in the gain on sale of repossessed assets of $50,000. The Bank's three financial subsidiaries, SFINS, SFINV, and SFT began operating in the latter part of the fiscal year ended March 31, 2002. SFINS is an insurance agency handling property and casualty insurance and life and health insurance and became profitable during the fiscal year ended March 31, 2004. During fiscal 2006, SFINS incurred a slight loss due to an increase in staff. SFINV markets mutual funds, discount brokerage, and annuities. SFT is a full-service trust company. SFINV and SFT have not yet attained profitability. General and Administrative Expenses General and administrative expenses increased $2.2 million or 20.9% to $13.0 million during the year ended March 31, 2006 from $10.8 million for the same period one year earlier. Compensation and employee benefits increased $1.3 million or 21.2% to $7.6 million as a result of the hiring of additional business development officers, accounting and auditing staff, normal annual salary adjustments, and an increase in the discretionary contribution to the Employee Stock Ownership Plan as a result of meeting profitability targets. Occupancy expense increased $178,000 or 16.4% to $1.3 million as a result of the depreciation of branch renovations and the leasing of additional office space. Advertising expense decreased $10,000 or 5.6% to $172,000 while depreciation and maintenance of equipment expense increased $46,000 or 4.4% to $1.1 million. FDIC insurance premiums were $58,000 in both fiscal 2006 and 2005. Other miscellaneous expenses, which encompasses repossessed assets expense, legal, professional, and consulting expenses, stationery and office supplies, and other sundry expenses increased $717,000 or 33.5% during fiscal 2006 due primarily to increases in audit, legal, and consulting fees to comply with the ever increasing regulatory burden and an increase in investment management fees in Security Federal Trust. Income Taxes The provision for income taxes increased $67,000 to $1.8 million or 3.9% during the year ended March 31, 2006 compared to $1.7 million for the year ended March 31, 2005, a result of an increase in taxable income. The effective tax rate was 31.8% for fiscal 2006 and 32.8% for fiscal 2005. 19 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operation Regulatory Capital The following table reconciles the Bank's shareholders' equity to its various regulatory capital positions: March 31, -------------------- 2007 2006 ------- ------- (In Thousands) Bank's Shareholders' Equity (1) $47,318 $39,473 Reduction For Goodwill And Other Intangibles 1,730 - ------- ------- Tangible Capital 45,588 39,473 ------- ------- Core Capital 45,588 39,473 ------- ------- Supplemental Capital 6,016 5,104 Less Assets Required To Be Deducted 22 9 ------- ------- Total Risk-Based Capital $51,582 $44,568 ======= ======= (1) FOR FISCAL 2007 AND 2006, EXCLUDES UNREALIZED LOSS OF $748 THOUSAND AND $2.1 MILLION, RESPECTIVELY ON AVAILABLE FOR SALE SECURITIES. The following table compares the Bank's capital levels relative to regulatory requirements at March 31, 2007: Amount Percent Actual Actual Excess Excess Required Required Amount Percent Amount Percent -------- -------- ------ ------- ------ ------- (Dollars In Thousands) Tangible Capital $14,737 2.0% $45,588 6.2% $30,851 4.2% Tier 1 Leverage (Core) Capital 29,474 4.0% 45,588 6.2% 16,114 2.2% Tier 1 Risk-Based (Core) Capital 19,251 4.0% 45,588 9.5% 26,337 5.5% Total Risk-Based Capital 38,503 8.0% 51,582 10.7% 13,079 2.7% 20 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operation Liquidity and Capital Resources Liquidity refers to the ability of the Bank to generate sufficient cash flows to fund current loan demand, repay maturing borrowings, fund maturing deposit withdrawals, and meet operating expenses. The Bank's primary sources of funds include loan repayments, loan sales, increased deposits, advances from the FHLB, 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 varies depending on loan demand, deposit inflows, and the use of investment leverage strategies to increase net interest income. The principal use of the Bank's funds is the origination of mortgages and other loans and the purchase of investments and mortgage-backed securities. Loan originations on loans held for investment were $358.9 million in fiscal 2007 compared to $277.2 million in fiscal 2006 and $222.5 million in fiscal 2005. The bulk of the increase in originations in fiscal 2007, 2006, and 2005 was due primarily to an increase in commercial loan originations, which increased $85.4 million, $63.9 million, and $45.9 million, respectively. Purchases of investments and mortgage-backed securities were $63.4 million in fiscal 2007 compared to $59.4 million in fiscal 2006 and $81.3 million in fiscal 2005. Another use of the Bank's funds is the building and renovation of branch offices. The Bank plans to consider expanding its branch network in Aiken and Lexington Counties and surrounding areas during the next few years. Unused lines of credit on home equity loans, credit cards, and commercial loans amounted to $90.7 million at March 31, 2007. Home equity loans are made on a floating rate basis with final maturities of 10 to 15 years. Credit cards are generally made on a floating rate basis, and are renewed annually or every other year. Management does not anticipate that the percentage of funds drawn on unused lines of credit will increase substantially over amounts currently utilized. In addition to the above commitments, the Bank has undisbursed loans-in-process of $6.4 million at March 31, 2007, which will disburse over an average of 90 days. These commitments to originate loans and future advances of lines of credit are expected to be funded from loan amortizations and prepayments, deposit inflows, maturing investments, and short-term borrowing capacity. The following table sets forth the length of time until maturity for unused commitments to extend credit and standby letters of credit at March 31, 2007. After After One Three Greater Within Through Through Than One Three Twelve Within One (In Thousands) Month Months Months One Year Year Total ------- -------- ------- -------- ------- ------- Unused lines of credit $4,652 $2,523 $39,070 $46,245 $44,438 $90,683 Standby letters of credit 90 243 635 968 - 968 ------ ------ ------- ------- ------- ------- Total $4,742 $2,766 $39,705 $47,213 $44,438 $91,651 ====== ====== ======= ======= ======= ======= Management believes that future liquidity can be met through the Bank's deposit base, which increased $44.5 million during fiscal 2007, and from maturing investments. Also, the Bank has another $68.2 million in unused borrowing capacity at FHLB at March 31, 2007. Historically the Bank's cash flow from operating activities has been relatively stable. The cash flows from investing activities varies with the need to invest excess funds or utilize leverage strategies with the purchase of mortgage-backed and investment securities. The cash flows from financing activities vary with the need for FHLB advances. See "Consolidated Statements of Cash Flows" in the Consolidated Financial Statements contained herein. 21 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operation Contractual Obligations In the normal course of business, the Company enters into contractual obligations that meet various business needs. These contractual obligations include time deposits to customers, borrowings from the FHLB of Atlanta, other borrowings, junior subordinated debentures, and lease obligations for facilities. See Notes 6, 9, 10, and 11 of the Notes to the Consolidated Financial Statements included herein for additional information. The following table summarizes the Company's long-term contractual obligations at March 31, 2007: One to Three Less than Three to Five One Year Years Years Thereafter Total --------- ------- ------- ---------- ------- (In Thousands) Time deposits $235,952 $13,390 $ 5,930 $ - $255,272 FHLB Advances 55,000 48,000 34,700 15,349 153,049 Other Borrowings 8,088 - - - 8,088 Jr. Sub. Debentures - - 5,155 - 5,155 Operating Lease Obligations 443 876 845 3,180 5,344 Purchase Obligation - Building Contract 2,583 - - - 2,583 -------- ------- ------- ------- -------- Total $302,066 $62,266 $46,630 $18,529 $429,491 ======== ======= ======= ======= ======== Off-Balance Sheet Arrangements In the normal course of business, the Company makes off-balance sheet arrangements, including credit commitments to its customers to meet their financial needs. These arrangements involve, to varying degrees, elements of credit and interest rate risk not recognized in the consolidated statement of financial condition. The Bank makes personal, commercial, and real estate lines of credit available to customers and does issue standby letters of credit. Commitments to extend credit to customers are subject to the Bank's normal credit policies and are essentially the same as those involved in extending loans to customers. See Note 14 of the Notes to the Consolidated Financial Statements included herein for additional information. 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 ("GAAP") that 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. 22 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Shareholders and Board of Directors Security Federal Corporation and Subsidiaries Aiken, South Carolina We have audited the accompanying consolidated balance sheets of Security Federal Corporation and Subsidiaries as of March 31, 2007 and 2006, and the related consolidated statements of income, shareholders' equity and comprehensive income and cash flows for each of the years in the three year period ended March 31, 2007. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated 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 consolidated financial position of Security Federal Corporation and Subsidiaries as of March 31, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the years in the three year period ended March 31, 2007, in conformity with accounting principles generally accepted in the United States of America. /s/Elliott Davis, LLC Columbia, South Carolina June 19, 2007 23 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Consolidated Balance Sheets March 31, ---------------------------- 2007 2006 ------------ ------------ ASSETS: Cash And Cash Equivalents $13,438,129 $14,351,208 Investment And Mortgage-Backed Securities: Available For Sale: (Amortized Cost of $186,970,867 and $166,808,236 at March 31, 2007 and 2006, Respectively) 185,766,296 163,445,066 Held To Maturity: (Fair Value of $63,286,641 and $73,084,450 at March 31, 2007 and 2006, Respectively) 63,983,589 74,987,805 ------------ ------------ Total Investment And Mortgage-Backed Securities 249,749,885 238,432,871 ------------ ------------ Loans Receivable, Net: Held For Sale 1,529,748 1,320,644 Held For Investment: (Net of Allowance of $7,296,791 and $6,704,734 at March 31, 2007 and 2006, Respectively) 434,508,612 373,788,432 ------------ ------------ Total Loans Receivable, Net 436,038,360 375,109,076 ------------ ------------ Accrued Interest Receivable: Loans 1,459,193 1,096,014 Mortgage-Backed Securities 550,682 508,432 Investments 1,181,639 945,620 ------------ ------------ Total Accrued Interest Receivable 3,191,514 2,550,066 ------------ ------------ Premises And Equipment, Net 15,895,192 11,662,976 Federal Home Loan Bank Stock, At Cost 8,209,200 7,149,800 Repossessed Assets Acquired In Settlement Of Loans 24,909 91,022 Bank Owned Life Insurance 5,783,620 5,000,001 Intangible Assets, Net 532,500 - Goodwill 1,197,954 - Other Assets 4,048,928 4,330,795 ------------ ------------ Total Assets $738,110,191 $658,677,815 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY: Liabilities: Deposit Accounts $523,737,592 $479,229,339 Advances From Federal Home Loan Bank 153,049,272 131,363,000 Other Borrowings 8,088,194 7,289,773 Junior Subordinated Debentures 5,155,000 - Advance Payments By Borrowers For Taxes And Insurance 486,101 501,998 Mandatorily Redeemable Financial Instruments 1,417,312 - Other Liabilities 3,483,512 2,691,946 ------------ ------------ Total Liabilities 695,416,983 621,076,056 ------------ ------------ Commitments (Notes 6 and 16) Shareholders' Equity: Serial Preferred Stock, $.01 Par Value; Authorized 200,000 Shares; Issued And Outstanding, None - - Common Stock, $.01 Par Value; Authorized 5,000,000 Shares, Issued And Outstanding Shares, 2,637,942 And 2,609,116, Respectively, at March 31, 2007 And 2,558,234 And 2,537,378, Respectively, at March 31, 2006 25,814 25,582 Additional Paid-In Capital 4,850,029 4,404,110 Treasury Stock, (At Cost 28,826 and 11,312 shares at March 31, 2007 and 2006, respectively) (651,220) (238,656) Indirect Guarantee Of Employee Stock Ownership Trust Debt - (215,503) Accumulated Other Comprehensive Loss (747,316) (2,086,509) Retained Earnings, Substantially Restricted 39,215,901 35,712,735 ------------ ------------ Total Shareholders' Equity 42,693,208 37,601,759 ------------ ------------ Total Liabilities And Shareholders' Equity $738,110,191 $658,677,815 ============ ============ SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 24 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Consolidated Statements of Income For the Years Ended March 31, --------------------------------------- 2007 2006 2005 ----------- ----------- ----------- Interest Income: Loans $31,180,719 $23,410,189 $17,001,126 Mortgage-Backed Securities 5,772,667 5,455,369 5,584,979 Investment Securities 5,070,355 3,689,641 3,155,436 Other 73,873 62,008 27,764 ----------- ----------- ----------- Total Interest Income 42,097,614 32,617,207 25,769,305 ----------- ----------- ----------- Interest Expense: NOW And Money Market Accounts 6,609,207 5,360,351 3,945,513 Passbook Accounts 165,664 175,237 173,250 Certificate Accounts 10,497,490 5,906,157 3,597,761 FHLB Advances And Other Borrowed Money 6,468,828 4,527,182 3,808,221 Junior Subordinated Debentures 191,811 - - ----------- ----------- ----------- Total Interest Expense 23,933,000 15,968,927 11,524,745 ----------- ----------- ----------- Net Interest Income 18,164,614 16,648,280 14,244,560 Provision For Loan Losses 600,000 660,000 780,000 ----------- ----------- ----------- Net Interest Income After Provision For Loan Losses 17,564,614 15,988,280 13,464,560 ----------- ----------- ----------- Other Income: Gain On Sale Of Investment Securities - 48,962 - Gain On Sale Of Loans 460,750 467,481 435,635 Service Fees On Deposit Accounts 1,239,579 1,132,194 1,226,118 Commissions From Insurance Agency 649,548 41,803 26,567 Other Agency Income 67,613 - - Trust Income 482,376 363,413 226,266 Bank Owned Life Insurance Income 242,619 - - Other 718,046 575,715 609,732 ----------- ----------- ----------- Total Other Income 3,860,531 2,629,568 2,524,318 ----------- ----------- ----------- General And Administrative Expenses: Compensation And Employee Benefits 9,384,640 7,579,695 6,255,794 Occupancy 1,411,006 1,263,839 1,086,017 Advertising 297,330 172,409 182,699 Depreciation And Maintenance Of Equipment 1,309,696 1,094,149 1,047,815 FDIC Insurance Premiums 58,325 57,702 57,830 Amortization Of Intangibles 67,500 - - Other 2,628,612 2,859,587 2,142,636 ----------- ----------- ----------- Total General And Administrative Expenses 15,157,109 13,027,381 10,772,791 ----------- ----------- ----------- Income Before Income Taxes 6,268,036 5,590,467 5,216,087 Provision For Income Taxes 2,141,483 1,777,616 1,710,592 ----------- ----------- ----------- Net Income $ 4,126,553 $ 3,812,851 $ 3,505,495 =========== =========== =========== Net Income Per Common Share (Basic) $ 1.59 $ 1.51 $ 1.39 =========== =========== =========== Net Income Per Common Share (Diluted) $ 1.58 $ 1.48 $ 1.37 =========== =========== =========== Cash Dividend Per Share On Common Stock $ .24 $ 0.16 $ 0.11 =========== =========== =========== Weighted Average Shares Outstanding (Basic) 2,594,525 2,532,999 2,524,123 =========== =========== =========== Weighted Average Shares Outstanding (Diluted) 2,608,552 2,575,061 2,561,437 =========== =========== =========== SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 25 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Consolidated Statements of Changes in Shareholders' Equity and Comprehensive Income For the Years Ended March 31, 2007, 2006 and 2005 Accumulated Additional Indirect Other Common Paid - In Treasury Guarantee Comprehensive Retained Stock Capital Stock Of ESOP Debt Income (Loss) Earnings Total ------ ---------- ---------- ------------ ------------- ---------- ------- Balance At March 31, 2004 $25,333 $4,013,674 $ - $(336,972) $ 689,755 $29,080,125 $33,471,915 Net Income - - - - 3,505,495 3,505,495 Other Comprehensive Income, Net Of Tax: Unrealized Holding Losses On Securities Available For Sale, Net Of Taxes - - - - (1,651,259) - (1,651,259) ----------- Comprehensive Income - - - - - - 1,854,236 Purchase Of Treasury Stock At Cost, 8,077 Shares (165,089) (165,089) Exercise Of Stock Options 105 168,130 - - - - 168,235 Decrease in Indirect Guarantee Of ESOP Debt - - - 60,755 - - 60,755 Cash Dividends - - - - - (278,987) (278,987) ------- ---------- --------- --------- ----------- ----------- ----------- Balance At March 31, 2005 $25,438 $4,181,804 $(165,089) $(276,217) $ (961,504) $32,306,633 $35,111,065 ======= ========== ========= ========= =========== =========== ===========
- ------------------------------------------------------------------------------------------------------------ Accumulated Additional Indirect Other Common Paid - In Treasury Guarantee Comprehensive Retained Stock Capital Stock Of ESOP Debt Income (Loss) Earnings Total ------ ---------- ---------- ------------ ------------- ---------- ------- Balance At March 31, 2005 $25,438 $4,181,804 $(165,089) $(276,217) $ (961,504) $32,306,633 $35,111,065 Net Income - - - - - 3,812,851 3,812,851 Other Comprehensive Income, Net Of Tax: Unrealized Holding Losses On Securities Available For Sale, Net of Taxes - - - - (1,094,649) - (1,094,649) Reclassification Adjustment For Gains Included In Net Income, Net of Taxes (30,356) (30,356) ----------- Comprehensive Income - - - - - - 2,687,846 Purchase of Treasury Stock At Cost, 3,235 Shares - - (73,567) - - - (73,567) Exercise Of Stock Options 144 222,306 - - - - 222,450 Decrease in Indirect Guarantee Of ESOP Debt - - - 60,714 - - 60,714 Cash Dividends - - - - - (406,749) (406,749) ------- ---------- --------- --------- ----------- ----------- ----------- Balance At March 31, 2006 $25,582 $4,404,110 $(238,656) $(215,503) $(2,086,509) $35,712,735 $37,601,759 ======= ========== ========= ========= =========== =========== ===========
- ------------------------------------------------------------------------------------------------------------ Accumulated Additional Indirect Other Common Paid - In Treasury Guarantee Comprehensive Retained Stock Capital Stock Of ESOP Debt Income (Loss) Earnings Total ------ ---------- ---------- ------------ ------------- ---------- ------- Balance At March 31, 2006 $25,582 $4,404,110 $(238,656) $(215,503) $(2,086,509) $35,712,735 $37,601,759 Net Income - - - - - 4,126,553 4,126,553 Other Comprehensive Income, Net Of Tax: Unrealized Holding Gains On Securities Available For Sale, Net Of Taxes - - - - 1,339,193 - 1,339,193 ----------- Comprehensive Income - - - - - - 5,465,746 Purchase of Treasury Stock At Cost, 17,514 Shares (412,564) - - - (412,564) Exercise Of Stock Options 232 438,233 - - - - 438,465 Decrease in Indirect Guarantee Of ESOP Debt - - - 215,503 - - 215,503 Stock Compensation Expense 7,686 7,686 Cash Dividends - - - - - (623,387) (623,387) ------- ---------- --------- --------- ----------- ----------- ----------- Balance At March 31, 2007 $25,814 $4,850,029 $(651,220) $ - $ (747,316) $39,215,901 $42,693,208 ======= ========== ========= ========= =========== =========== =========== SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 26
SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows For the Years Ended March 31, ------------------------------------------ 2007 2006 2005 ------------ ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net Income $ 4,126,553 $ 3,812,851 $ 3,505,495 Adjustments To Reconcile Net Income To Net Cash Provided By Operating Activities: Depreciation Expense 1,011,963 965,226 859,809 Amortization of Intangible Assets 67,500 - - Stock Option Compensation Expense 7,686 - - Discount Accretion And Premium Amortization 405,777 927,981 1,193,221 Provisions For Losses On Loans And Real Estate 600,000 660,000 780,000 Gain On Sales Of Loans (460,750) (467,481) (435,635) Gain On Sales Of Investment Securities - (48,962) - (Gain) Loss On Sale Of Real Estate (48,678) 21,416 (50,329) Amortization Of Deferred Fees On Loans (283,252) (170,009) (184,642) Loss (Gain) On Disposition Of Premises And Equipment 165 32,344 (3,525) Proceeds From Sale Of Loans Held For Sale 30,793,793 30,370,085 26,392,654 Origination Of Loans Held For Sale (30,542,147) (28,945,486) (26,530,912) (Increase) Decrease In Accrued Interest Receivable: Loans (363,179) (194,142) 717 Mortgage-Backed Securities (42,250) 47,501 (6,392) Investments (236,019) (223,876) 56,981 (Decrease) Increase In Advance Payments By Borrowers (15,897) 84,588 99,989 Other, Net 88,888 295,799 (1,708,142) ------------ ------------ ------------ Net Cash Provided By Operating Activities 5,110,153 7,167,835 3,969,289 ------------ ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Purchase Of Mortgage-Backed Securities Available For Sale (30,261,270) (31,386,556) (53,211,974) Principal Repayments On Mortgage-Backed Securities Available For Sale 34,829,410 49,386,450 47,852,116 Principal Repayments On Mortgage-Backed Securities Held To Maturity - 10,407 89,769 Purchase Of Investment Securities Held To Maturity - - (26,041,400) Purchase Of Investment Securities Available For Sale (33,152,147) (28,031,364) (2,015,626) Maturities Of Investment Securities Available For Sale 8,019,815 4,924,531 13,111,305 Maturities Of Investment Securities Held To Maturity 11,000,000 1,000,000 21,000,000 Proceeds From Sale of Mortgage-Backed Securities Available For Sale - 3,797,360 - Proceeds From Sale of Mortgage-Backed Securities Held To Maturity - 249,650 - Purchase Of FHLB Stock (7,232,000) (6,897,300) (4,967,800) Redemption Of FHLB Stock 6,172,600 5,982,000 3,550,100 Increase In Loans Receivable (61,061,837) (59,900,035) (56,631,543) Proceeds From Sale Of Repossessed Assets 139,700 173,547 432,595 Purchase And Improvement Of Premises And Equipment (5,244,344) (4,746,502) (2,211,117) Proceeds From Sale of Premises and Equipment - - 3,525 Increase In Bank Owned Life Insurance (783,619) (5,000,001) - ------------ ------------ ------------ Net Cash Used By Investing Activities (77,573,692) (70,437,813) (59,040,050) ------------ ------------ ------------ (Continued) 27 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows, Continued For the Years Ended March 31, ------------------------------------------ 2007 2006 2005 ------------ ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Increase In Deposit Accounts 44,508,253 48,941,948 40,694,746 Proceeds From FHLB Advances 279,973,450 262,655,000 148,738,000 Repayment Of FHLB Advances (258,287,178) (243,330,000) (133,036,000) Proceeds Of Other Borrowings, Net 798,421 1,695,616 117,134 Proceeds From Junior Subordinated Debentures 5,155,000 - - Proceeds From Exercise Of Stock Options 438,465 222,450 168,235 Purchase of Treasury Stock (412,564) (73,567) (165,089) Dividends To Shareholders (623,387) (406,749) (278,988) ------------- ------------- ------------ Net Cash Provided By Financing Activities 71,550,460 69,704,698 56,238,038 ------------- ------------- ------------ Net Increase (Decrease) In Cash And Cash Equivalents (913,079) 6,434,720 1,167,277 Cash And Cash Equivalents At Beginning Of Year 14,351,208 7,916,488 6,749,211 ------------- ------------- ------------ Cash And Cash Equivalents At End Of Year $ 13,438,129 $ 14,351,208 $ 7,916,488 ============= ============= ============ SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash Paid During The Period For: Interest $ 23,339,597 $ 15,679,123 $ 11,413,369 ============= ============= ============ Income Taxes $ 1,869,292 $ 2,276,825 $ 2,221,012 ============= ============= ============ Supplemental Schedule Of Non Cash Transactions: Additions To Repossessed Assets $ 24,909 $ 232,985 $ 384,397 ============= ============= ============ Decrease (Increase) In Unrealized Net Loss On Securities Available For Sale, Net Of Taxes $ 1,339,193 $ (1,125,005) $ (1,651,259) ============= ============= ============ Issuance Of A Mandatorily Redeemable Financial Instrument Through The Issuance Of Common Stock $ 1,417,312 $ - $ - ============= ============= ============ SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 28 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES 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 and Nature of Operations ----------------------------------------------- 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 the Bank's wholly owned subsidiaries, Security Federal Insurance, Inc. ("SFINS"), Security Federal Investments, Inc. ("SFINV"), Security Federal Trust Inc. ("SFT"), and Security Financial Services Corporation ("SFSC"). Security Federal Corporation has a wholly owned subsidiary, Security Federal Statutory Trust (the "Trust"), which issued and sold fixed and floating rate capital securities of the Trust. However, under current accounting guidance, the Trust is not consolidated in the financial statements. The Bank is primarily engaged in the business of accepting savings and demand deposits and originating mortgage loans and other loans to individuals and small businesses for various personal and commercial purposes. SFINS, SFINV, and SFT were formed during fiscal 2002 and began operating during the December 2001 quarter. SFINS is an insurance agency offering auto, business, health, home and life insurance. SFINS has a wholly owned subsidiary, Collier Jennings Financial Corporation which has as subsidiaries Collier Jennings Inc., The Auto Insurance Store Inc., and Security Federal Premium Plan Plans Inc. SFINV engages primarily in investment brokerage services. SFT offers trust, financial planning and financial management services. (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 original maturities of three months or less. (c) Investment and Mortgage-Backed Securities ----------------------------------------- Investment securities, including mortgage-backed securities, are classified in 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 and 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 that are not considered to be held to maturity as available for sale. These type of investments are stated at fair value with unrealized gains and losses, net of tax, reported in a separate component of shareholders' equity ("accumulated other comprehensive income (loss)"). Gains and losses from sales of investment and mortgage-backed securities available for sale are determined using the specific identification method. The Company has no trading securities. (d) Loans Receivable Held for Investment ------------------------------------ Loans are stated at their unpaid principal balance. Interest income is computed using the simple interest method and is recorded in the period earned. 29 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (1) Significant Accounting Policies, Continued (e) Allowance for Loan Losses ------------------------- The Company provides for loan losses using 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 fair 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 adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making these 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 at the time of their examinations. The Company values impaired loans at the loan's fair value if it is probable that the Company will be unable to collect all amounts due according to the terms of the loan agreement at the present value of expected cash flows, the market price of the loan, if available, or the value of the underlying collateral. Expected cash flows are required to be discounted at the loan's effective interest rate. When the ultimate collectibility of an impaired loan's principal is in doubt, wholly or partially, all cash receipts are applied to principal. When this doubt does not exist, cash receipts are applied under the contractual terms of the loan agreement first to interest then to principal. Once the recorded principal balance has been reduced to zero, future cash receipts are applied to interest income to the extent that any interest has been foregone. Further cash receipts are recorded as recoveries of any amounts previously charged off. (f) Loans Receivable Held for Sale ------------------------------ Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value in the aggregate. Net unrealized losses are provided for in a valuation allowance by charges to operations. (g) Repossessed Assets Acquired in Settlement of Loans -------------------------------------------------- Repossessed assets represent real estate and other assets acquired through foreclosure or repossession and are 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 asset owned exceeds the fair value less estimated costs to sell. Fair values are generally determined by reference to an outside appraisal. (h) Premises and Equipment ---------------------- Premises and equipment are carried at cost, net of accumulated depreciation. Depreciation of premises and equipment is amortized on a straight-line method over the estimated useful life of the related asset. Estimated lives are seven to 30 years for buildings and improvements and generally three to 10 years for furniture, fixtures and equipment. Maintenance and repairs are charged to current expense. The cost of major renewals and improvements are capitalized. (i) Intangible Assets and Goodwill ------------------------------ Intangible Assets consist of the customer list and employment contracts resulting from the Company's acquisition of Collier Jennings Financial Corporation in July 2006. The goodwill also is a result of the excess of the cost over the fair value of net assets resulting from the Collier Jennings acquisition. Intangible assets are amortized over their estimated economic lives using methods that reflect the pattern in which the economic benefits are utilized. Goodwill is reviewed for impairment annually or whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. 30 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (1) Significant Accounting Policies, Continued ------------------------------------------ (j) Income Taxes ------------ 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. Deferred taxes are provided for in differences in financial reporting bases for assets and liabilities compared with their tax bases. Generally, 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 in differences between the provision for loan losses for financial statement purposes and those allowed for income tax purposes. (k) Loan Fees and Costs Associated with Originating Loans ----------------------------------------------------- Loan fees received, net of 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. (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 90 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 that are contractually 90 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) Advertising Expense ------------------- Advertising and public relations costs are generally expensed as incurred. External costs relating to direct mailing costs are expensed in the period in which the direct mailings are sent. Advertising and public relations costs of $297,330, $172,409, and $182,699 were included in the Company's results of operations for 2007, 2006, and 2005, respectively. 31 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (1) Significant Accounting Policies, Continued ------------------------------------------ (n) Fair Value of Financial Instruments ----------------------------------- The Company discloses the fair value of on- and off-balance sheet financial instruments when it is practicable to do so. Fair values are based on quoted market prices, where available, on estimates of present value, or on other valuation techniques. These estimates are made at a specific point in time, are subjective in nature, and involve uncertainties and significant judgment. In addition, the Company does not disclose the fair value of non-financial instruments. Accordingly, the aggregate fair values presented do not represent the underlying fair value of the Company. Fair value approximates carrying value for the following financial instruments due to the short-term nature of the instrument: cash and cash equivalents. Securities are valued using quoted fair market prices. Fair value for the Company's off-balance sheet financial instruments is based on the discounted present value of the estimated future cash flows. Fair value for variable rate loans that reprice frequently, loans held for sale, and loans that mature in less than three months is based on the carrying value. Fair value for fixed rate mortgage loans, personal loans, and other loans (primarily commercial) maturing after three months is based on the discounted present value of the estimated future cash flows. Discount rates used in these computations approximate the rates currently offered for similar loans of comparable terms and credit quality. Fair value for demand deposit accounts and interest-bearing accounts with no fixed maturity date is equal to the carrying value. Certificates of deposit accounts and securities sold under repurchase agreements maturing within one year are valued at their carrying value. The fair value of certificates of deposit accounts and securities sold under repurchase agreements after one year are estimated by discounting cash flows from expected maturities using current interest rates on similar instruments. Fair value for long-term FHLB advances is based on discounted cash flows using the Company's current incremental borrowing rate. Discount rates used in these computations approximate rates currently offered for similar borrowings of comparable terms and credit quality. Junior subordinated debentures are estimated using discounted cash flow analysis based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. 32 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (1) Significant Accounting Policies, Continued ------------------------------------------ (o) Stock-Based Compensation ------------------------ On April 1, 2006, the Company adopted the fair value recognition provisions of Financial Accounting Standards Board ("FASB") SFAS 123 (R), Shared-Based Payment, to account for compensation costs under its stock option plans. The Company previously utilized the intrinsic value method under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (as amended) (APB 25"). Under the intrinsic value method prescribed by APB 25, no compensation costs were recognized for the Company's stock options because the option exercise price in its plans equals the market price on the date of grant. Prior to April 1, 2006, the Company only disclosed the pro forma effects on net income and earnings per share as if the fair value recognition provisions of SFAS 123 (R) have been utilized. In adopting SFAS 123 (R), Company elected to use the modified prospective method to account for the transition from the intrinsic value method to the fair value recognition method. Under the modified prospective method, compensation cost is recognized from the adoption date forward for all new stock options granted and for any outstanding unvested awards as if the fair value method had been applied to those awards as of the date of grant. The following table illustrates the effect on net income and net income per common share as if the Company had applied fair value recognition provisions to stock-based employee compensation for the years ended March 31, 2007, 2006, and 2005. 2007 2006 2005 ---------- ---------- ---------- Net Income, As Reported $4,126,553 $3,812,851 $3,505,495 Deduct: Total stock-based employee compensation expense determined under fair-value based method for all awards, net of tax $ - $ (365,483) $ (150,807) ---------- ---------- ---------- Net Income, Pro Forma $4,126,553 $3,447,368 $3,354,688 ========== ========== ========== Net Income Per Common Share (Basic), As Reported $ 1.59 $ 1.51 $ 1.39 ========== ========== ========== Net Income Per Common Share (Basic), Pro Forma $ 1.59 $ 1.36 $ 1.33 ========== ========== ========== Net Income Per Common Share (Diluted), As Reported $ 1.58 $ 1.48 $ 1.37 ========== ========== ========== Net Income Per Common Share (Diluted), Pro Forma $ 1.58 $ 1.34 $ 1.31 ========== ========== ========== On March 30, 2006, the Board of Directors approved accelerating the vesting of 98,800 unvested stock options. The accelerated vesting was effective as of March 30, 2006. All of the other terms and conditions applicable to the outstanding stock options remained unchanged. The decision to accelerate vesting of these options will avoid recognition of pre-tax compensation expense by the Company upon the adoption of SFAS 123(R). In the Company's view, the future compensation expense could outweigh the incentive and retention value associated with the stock options. The future compensation expense, net of income taxes, that was avoided, based upon the effective date of April 1, 2006, was approximately $275,000. The Company believes that the acceleration of vesting stock options meets the criteria for variable accounting under FIN No. 44. Based upon past experience, the Company believes the grantees of these stock options will remain as a director or employee of the Company. 33 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (1) Significant Accounting Policies, Continued ------------------------------------------ (p) Earnings Per Share ------------------ Net income per share is computed by dividing consolidated net income by the weighted average number of common shares outstanding during the period. The treasury stock method is used to compute the dilutive effect of stock options in the diluted weighted average number of common shares. For the Year Ended ---------------------------------------------------------- March 31, 2007 March 31, 2006 ----------------------------- --------------------------- Per Share Per Share Income Shares Amounts Income Shares Amounts ------ ------ --------- ------ ------ --------- Basic EPS $4,126,553 2,594,525 $ 1.59 $3,812,851 2,532,999 $ 1.51 Dilutive effect of: Stock Options - 14,027 (0.01) - 32,666 (0.02) ESOP - - - - 10,396 (0.01) ---------- --------- ------ ---------- --------- ------ Diluted EPS $4,126,553 2,608,552 $ 1.58 $3,812,851 2,576,061 $ 1.48 ========== ========= ====== ========== ========= ====== For the Year Ended March 31, 2005 -------------------------------- Per share Income Shares amounts ------ ------ --------- Basic EPS $3,505,495 2,524,123 $ 1.39 Dilutive effect of: Stock Options - 22,726 (0.012) ESOP - 14,588 (0.008) ---------- --------- ------- Diluted EPS $3,505,495 2,561,437 $ 1.37 ========== ========= ======= (q) Use of Estimates ---------------- The preparation of financial statements in conformity with GAAP requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of income and expenses during the reporting periods. Actual results could differ from those estimates. 34 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (1) Significant Accounting Policies, Continued ------------------------------------------ (r) Recently Issued Accounting Standards ------------------------------------ The following is a summary of recent authoritative pronouncements that could affect accounting, reporting, and disclosure of financial information by the Company: In February 2006, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting ("SFAS") No. 155, "Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140." This Statement amends SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," and SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." This Statement resolves issues addressed in SFAS No. 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets." FAS 155 permits fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, clarifies which interest only-strips and principal-only strips are not subject to the requirements of Statement 133, establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and amends Statement 140 to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for al financial instruments acquired or issued after the beginning of an entity's first fiscal year that begins after September 15, 2006. The Company does not believe that the adoption of SFAS No. 155 will have a material impact on its financial position, results of operations and cash flows. In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of Financial Assets an amendment of FASB Statement No. 140." This Statement amends FASB No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract; requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable; permits an entity to choose its subsequent measurement methods for each class of separately recognized servicing assets and servicing liabilities; at its initial adoption, permits a one-time reclassification of available-for-sale securities to trading securities by entities with recognized servicing rights, without calling into question the treatment of other available-for-sale securities under Statement 115, provided that the available-for-sale securities are identified in some manner as offsetting the entity's exposure to changes in fair value of servicing assets or servicing liabilities that a servicer elects to subsequently measure at fair value; and requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional disclosures for all separately recognized servicing assets and servicing liabilities. An entity should adopt SFAS No. 156 as of the beginning of its first fiscal year that begins after September 15, 2006. The Company does not believe the adoption of SFAS No. 156 will have a material impact on its financial position, results of operations and cash flows. In July 2006, the FASB issued FASB Interpretation No. 48 ("FIN 48"), "Accounting for Uncertainty in Income Taxes". FIN 48 clarifies the accounting for uncertainty in income taxes recognized in enterprises' financial statements in accordance with FASB Statement No. 109, "Accounting for Income Taxes". FIN 48 prescribes a recognition threshold and measurement attributable for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transitions. FIN 48 is effective for fiscal years beginning afterbeginning after December 15, 2006. The Company is currently analyzing the effects of FIN 48 Company the its financial position, results of operations or cash flows.is currently analyzing the effects of FIN 48. In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements." SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This standard does not require any new fair value measurements, but rather eliminates inconsistencies found in various prior pronouncements. SFAS 157 is effective for the Company on January 1, 2008 and is not expected to have a significant impact on the Company's financial statements. 35 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (1) Significant Accounting Policies, Continued ------------------------------------------ (r) Recently Issued Accounting Standards ------------------------------------ In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans" ("SFAS 158"), which amends SFAS 87 and SFAS 106 to require recognition of the overfunded or underfunded status of pension and other postretirement benefit plans on the balance sheet. Under SFAS 158, gains and losses, prior service costs and credits, and any remaining transition amounts under SFAS 87 and SFAS 106 that have not yet been recognized through net periodic benefit cost will be recognized in accumulated other comprehensive income, net of tax effects, until they are amortized as a component of net periodic cost. The measurement date the date at which the benefit obligation and plan assets are measured is required to be the company's fiscal year end. SFAS 158 is effective for publicly held companies for fiscal years ending after December 15, 2006, except for the measurement date provisions, which are effective for fiscal years ending after December 15, 2008. The Company does not have a defined benefit pension plan. Therefore, that would be required to be accounted for under SFAS 158 and the is currently analyzing the effects of SFAS 158 but does not expect its implementation of SFAS 158 didwill not have any impact will have a significant impact on the Company's financial conditions or results of operations. In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115." This statement permits, but does not require, entities to measure many financial instruments at fair value. The objective is to provide entities with an opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Entities electing this option will apply it when the entity first recognizes an eligible instrument and will report unrealized gains and losses on such instruments in current earnings. This statement 1) applies to all entities, 2) specifies certain election dates, 3) can be applied on an instrument-by-instrument basis with some exceptions, 4) is irrevocable and 5) applies only to entire instruments. One exception is demand deposit liabilities, which are explicitly excluded as qualifying for fair value. With respect to SFAS 115, available-for-sale and held-to-maturity securities at the effective date are eligible for the fair value option at that date. If the fair value option is elected for those securities at the effective date, cumulative unrealized gains and losses at that date shall be included in the cumulative-effect adjustment and thereafter, such securities will be accounted for as trading securities. SFAS 159 is effective for the Company on January 1, 2008. Earlier adoption is permitted in 2007 if the Company also elects to apply the provisions of SFAS 157, "Fair Value Measurement." The Company is currently analyzing the fair value option provided under SFAS 159. In September, 2006, The FASB ratified the consensuses reached by the FASB's Emerging Issues Task Force ("EITF") relating to EITF 06-4 "Accounting for the Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements". EITF 06-4 addresses employer accounting for endorsement split-dollar life insurance arrangements that provide a benefit to an employee that extends to postretirement periods should recognize a liability for future benefits in accordance with SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", or Accounting Principles Board ("APB") Opinion No. 12, "Omnibus Opinion 1967". EITF 06-4 is effective for fiscal years beginning after December 15, 2007. Entities should recognize the effects of applying this Issue through either (a) a change in accounting principle through a cumulative-effect adjustment to retained earnings or to other components of equity or net assets in the statement of financial position as of the beginning of the year of adoption or (b) a change in accounting principle through retrospective application to all prior periods. The Company does not believe the adoption of EITF 06-4 will have a material impact on its financial position, results of operations and cash flows. In September 2006, the FASB ratified the consensus reached related to EITF 06-5, "Accounting for Purchases of Life Insurance Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance." EITF 06-5 states that a policyholder should consider any additional amounts included in the contractual terms of the insurance policy other than the cash surrender value in determining the amount that could be realized under the insurance contract. EITF 06-5 also states that a policyholder should determine the amount that could be realized under the life insurance contract assuming the surrender of an individual-life-by-individual-life policy (or certificate by certificate in a group policy). EITF 06-5 is effective for fiscal years beginning after December 15, 2006. The Company does not believe the adoption of EITF 06-5 will have a material impact on its financial position, results of operations and cash flows. 36 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (1) Significant Accounting Policies, Continued ------------------------------------------ (r) Recently Issued Accounting Standards ------------------------------------ In September 2006, the SEC issued Staff Accounting Bulleting No. 108 ("SAB 108"). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a potential current year misstatement. Prior to SAB 108, Companies might evaluate the materiality of financial statement misstatements using either the income statement or balance sheet approach, with the income statement approach focusing on new misstatements added in the current year, and the balance sheet approach focusing on the cumulative amount of misstatement present in a company's balance sheet. Misstatements that would be material under one approach could be viewed as immaterial under another approach, and not be corrected. SAB 108 now requires that companies view financial statement misstatements as material if they are material according to either the income statement or balance sheet approach. The Company has analyzed SAB 108 and determined that upon adoption it will have no impact on the reported results of operations or financial conditions. In December 2006, the FASB issued a Staff Position ("FSP") on EITF 00-19-2, "Accounting for Registration Payment Arrangements ("FSP EITF 00-19-2"). This FSP specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with SFAS No. 5, "Accounting for Contingencies." If the transfer of consideration under a registration payment arrangement is probable and can be reasonably estimated at inception, the contingent liability under the registration payment arrangement is included in the allocation of proceeds from the related financing transaction (or recorded subsequent to the inception of a prior financing transaction) using the measurement guidance in SFAS No. 5. This FSP is effective immediately for registration payment arrangements and the financial instruments subject to those arrangements that are entered into or modified subsequent to the issuance of the FSP. For prior arrangements, the FSP is effective for financial statements issued for fiscal years beginning after December 15, 2006 and interim periods within those years. The Company does not believe the adoption of this FSP will have a material impact on its financial position, results of operations and cash flows. Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the consolidated financial statements upon adoption. (s) Risks and Uncertainties ----------------------- In the normal course of its business, the Company encounters two significant types of risk: economic and regulatory. There are three main components of economic risk: interest rate risk, credit risk, and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or on different bases, than its interest-earning assets. Credit risk is the risk of default on the Company's loan portfolio that results from borrowers' inability or unwillingness to make contractually required payments. Market risk reflects changes in the value of collateral underlying loans receivable, the valuation of real estate held by the Company, and the valuation of loans held for sale and mortgage-backed securities available for sale. The Company is subject to the regulations of various government agencies. These regulations can and do change significantly from period to period. The Company also undergoes periodic examinations by the regulatory agencies, which may subject it to further changes with respect to asset valuations, amounts of required loss allowances, and operating restrictions, resulting form the regulators' judgments based on information available to them at the time of their examination. (t) Reclassifications ----------------- Certain amounts in prior years' consolidated financial statements have been reclassified to conform to current year classifications. 37 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (2) Acquisition ----------- On June 30, 2006, the Company completed the acquisition of the insurance and premium finance businesses of Collier-Jennings Financial Corporation and it subsidiaries Collier-Jennings, Inc., The Auto Insurance Store, Inc., and Collier-Jennings Premium Pay Plans, Inc (the "Collier-Jennings Companies"). The purpose of the acquisition was to expand the insurance services and increase non-interest income. The shareholder of the Collier-Jennings Companies received $180,000 in cash and 54,512 shares of the Company's common stock valued at $26 per share for an approximate purchase price of $1,597,312. The Company will release the shares to the former shareholder of the Collier-Jennings Companies over a three-year period. The stock is mandatorily redeemable by the shareholder of Collier-Jennings Companies at his option in cumulative increments of 20% per year for a five-year period at the greater of $26 per share or one and one-half times the book value of the Company's stock. A summary of the purchase price of the transaction is as follows: The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at June 30, 2006, the date of acquisition, including subsequent adjustments to the allocation of the purchase price. Cash And Cash Equivalents $ 43,192 Accounts Receivable 784,247 Premises And Equipment 41,696 Other Assets 56,289 Intangible Assets 600,000 Goodwill 1,197,954 ---------- Total Assets Acquired 2,723,378 ---------- Notes Payable 386,185 Other Liabilities 739,881 ---------- Total Liabilities Assumed 1,126,066 ---------- Net Assets Acquired $1,597,312 ========== (3) Investment and Mortgage-Backed Securities, Available for Sale ------------------------------------------------------------- The amortized cost, gross unrealized gains, gross unrealized losses, and fair values of investment and mortgage-backed securities available for sale are as follows: March 31, 2007 ----------------------------------------------------- Gross Gross Unrealized Unrealized Amortized Cost Gains Losses Fair value -------------- ---------- ---------- ------------ FHLB Securities $ 38,487,381 $ 17,627 $ 131,886 $ 38,373,122 Federal Farm Credit Securities 9,217,205 8,580 11,504 9,214,281 FNMA Bonds 2,942,530 - 12,141 2,930,389 FHLMC Bonds 64,071 - 94 63,977 Mortgage-Backed Securities 136,156,742 276,292 1,352,007 135,081,027 Equity Securities 102,938 562 - 103,500 ------------ -------- ---------- ------------ $186,970,867 $303,061 $1,507,632 $185,766,296 ============ ======== ========== ============ 38 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (3) Investment and Mortgage-Backed Securities, Available for Sale, Continued ------------------------------------------------------------------------ March 31, 2006 ----------------------------------------------------- Gross Gross Unrealized Unrealized Amortized Cost Gains Losses Fair value -------------- ---------- ---------- ------------ FHLB Securities $ 24,269,864 $ - $ 265,031 $ 24,004,833 Federal Farm Credit Securities 2,965,989 - 25,049 2,940,940 FNMA Bonds 1,000,000 - 20,620 979,380 FHLMC Bonds 230,693 - 534 230,159 Mortgage-Backed Securities 138,238,752 126,648 3,178,584 135,186,816 Equity Securities 102,938 - - 102,938 ------------ -------- ---------- ------------ $166,808,236 $126,648 $3,489,818 $163,445,066 ============ ======== ========== ============ FHLB securities, Federal Farm Credit securities, FNMA bonds, FHLMC bonds, and FNMA and FHLMC mortgage-backed securities are issued by government-sponsored enterprises ("GSE's"). GSE's are not backed by the full faith and credit of the United States government. Included in the tables above and below in mortgage-backed securities are GNMA mortgage- backed securities, which are backed by the full faith and credit of the United States government. At March 31, 2007, the Bank held an amortized cost and fair value of $48.8 million in GNMA mortgage-backed securities included in mortgage-backed securities listed above. The amortized cost and fair value of investment and mortgage-backed securities available for sale at March 31, 2007 are shown below by contractual maturity. Expected maturities will differ from contractual maturities because borrowers have the right to prepay obligations with or without call or prepayment penalties. Amortized Cost Fair Value -------------- ---------- Less Than One Year $ 5,544,938 $ 5,528,733 One - Five Years 22,933,608 22,875,414 More Than Five Years 22,335,579 22,281,122 Mortgage-Backed Securities 136,156,742 135,081,027 ------------ ------------ $186,970,867 $185,766,296 ============ ============ At March 31, 2007 and 2006, the amortized cost and fair value of investment and mortgage-backed securities available for sale pledged as collateral for certain deposit accounts, FHLB advances and other borrowings were $80.5 million and $79.5 million and $56.8 million and $56.0 million, respectively. The Bank received approximately $3.8 million in proceeds from sales of available for sale securities with approximately $42,000 recorded in gross gains and $3,500 in gross losses during the year ended March 31, 2006. There were no sales of available for sale securities in the years ended March 31, 2007 and 2005. The following table shows gross unrealized losses and fair value, aggregated by investment category, and length of time that individual available for sale securities have been in a continuous unrealized loss position, at March 31, 2007. Less than 12 Months 12 Months or More Total -------------------- ---------------------- ---------------------- Fair Unrealized Fair Unrealized Fair Unrealized Value Losses Value Losses Value Losses ------- ---------- ------- ---------- ------- ----------- Agency securities $15,156,780 $33,884 $17,461,591 $ 121,741 $32,618,371 $ 155,625 Mortgage-backed securities $10,054,833 $52,982 $75,881,409 $1,299,025 $85,936,241 $1,352,007
39 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (3) Investment and Mortgage-Backed Securities, Available for Sale, Continued ------------------------------------------------------------------------ Securities classified as available-for-sale are recorded at fair market value. Approximately 94.2% of the unrealized losses, or 121 individual securities, consisted of securities in a continuous loss position for 12 months or more. The Company has the ability and intent to hold these securities until such time as the value recovers or the securities mature. The Company believes, based on industry analyst reports and credit ratings, that the deterioration in value is attributable to changes in market interest rates and is not in the credit quality of the issuer and therefore, these losses are not considered other-than- temporary. (4) Investment and Mortgage-Backed Securities, Held to Maturity ----------------------------------------------------------- The amortized cost, gross unrealized gains, gross unrealized losses, and fair values of investment and mortgage-backed securities held to maturity are as follows: March 31, 2007 --------------------------------------------------- Gross Gross Unrealized Unrealized Amortized Cost Gains Losses Fair Value -------------- ---------- ---------- ----------- FHLB Securities $55,994,852 $21,560 $573,841 $55,442,571 Federal Farm Credit Securities 7,988,737 - 144,667 7,844,070 ----------- ------- -------- ----------- $63,983,589 $21,560 $718,508 $63,286,641 =========== ======= ======== =========== March 31, 2006 --------------------------------------------------- Gross Gross Unrealized Unrealized Amortized Cost Gains Losses Fair Value -------------- ---------- ---------- ----------- FHLB Securities $66,002,180 $ - $1,618,360 $64,383,820 Federal Farm Credit Securities 8,985,625 - 284,995 8,700,630 ----------- ------- ---------- ----------- $74,987,805 $ - $1,903,355 $73,084,450 =========== ======= ========== =========== FHLB securities and Federal Farm Credit securities are issued by government-sponsored enterprises ("GSE's"). GSE's are not backed by the full faith and credit of the United States government. The amortized cost and fair value of investment and mortgage-backed securities held to maturity at March 31, 2007, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities due to call features on certain investments. Amortized Cost Fair Value -------------- ---------- Less Than One Year $ 9,000,000 $ 8,960,320 One - Five Years 25,988,130 25,755,350 More Than Five Years 28,995,459 28,570,971 ----------- ----------- $63,983,589 $63,286,641 =========== =========== At March 31, 2007 and 2006, the amortized cost and fair value of investment and mortgage-backed securities held to maturity pledged as collateral for certain deposit accounts, FHLB advances and other borrowings were $51.0 million and $50.4 million and $49.0 million and $47.6 million, respectively. The Bank received approximately $250,000 in proceeds from the sale of three held to maturity securities with approximately $10,324 recorded in gross gains and no gross losses during the year ended March 31, 2006. All three securities had paid down at least ninety percent therefore meeting the intent of SFAS 115, "Accounting for Certain Investment in Debt and Equity Securities". There were no sales of held to maturity securities during the years ended March 31, 2007 and 2005. 40 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (4) Investment and Mortgage-Backed Securities, Held to Maturity, Continued ---------------------------------------------------------------------- The following table shows gross unrealized losses and fair value, aggregated by investment category, and length of time that individual held to maturity securities have been in a continuous unrealized loss position, at March 31, 2007. Less than 12 Months 12 Months or More Total -------------------- -------------------- ------------------- Fair Unrealized Fair Unrealized Fair Unrealized Value Losses Value Losses Value Losses ------- ---------- ------- ---------- ------- ---------- Agency securities $1,978,750 $12,740 $59,265,081 $705,768 $61,243,831 $718,508 Approximately 98.2% of the unrealized losses, or 60 individual securities, consisted of securities in a continuous loss position for 12 months or more. The Company's held-to-maturity portfolio is recorded at amortized cost. The Company has the ability and intends to hold these securities to maturity. The Company believes, based on industry analysis reports and credit ratings, that the deterioration in value is attributable to changes in market interest rates and not in credit quality of the issuer and therefore, these losses are not considered other-than-temporary. 41 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (5) Loans Receivable, Net --------------------- Loans receivable, net, at March 31 consisted of the following: 2007 2006 ------------ ------------ Residential Real Estate Loans $125,512,411 $122,026,698 Consumer Loans 63,809,478 58,612,669 Commercial Business And Real Estate Loans 259,207,877 209,214,332 Loans Held For Sale 1,529,748 1,320,644 ------------ ------------ 450,059,514 391,173,943 ------------ ------------ Less: Allowance For Loan Losses 7,296,791 6,704,734 Loans In Process 6,443,372 9,185,133 Deferred Loan Fees 280,991 175,000 ------------ ------------ 14,021,154 16,064,867 ------------ ------------ Total Loans Receivable, Net $436,038,360 $375,109,076 ============ ============ Changes in the allowance for loan losses for the years ended March 31 are summarized as follows: 2007 2006 2005 ---------- ---------- ---------- Balance At Beginning Of Year $6,704,734 $6,284,055 $5,763,935 Allowance Acquired in Acquisition 21,697 - - Provision For Loan Losses 600,000 660,000 780,000 Charge Offs (132,712) (301,650) (443,132) Recoveries 103,072 62,329 183,252 ---------- ---------- ---------- Total Allowance For Loan Losses $7,296,791 $6,704,734 $6,284,055 ========== ========== ========== 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. 2007 2006 ---------- ---------- Non-Accrual Loans $1,055,000 $1,191,000 ========== ========== Interest Income That Would Have Been Recognized Under Original Terms $ 107,000 $ 111,000 ========== ========== At March 31, 2007 and 2006, impaired loans amounted to $1.5 million and $2.1 million, respectively. Losses on impaired loans are accounted for in the allowance for loan loss. For the years ended March 31, 2007 and 2006, the average recorded investment in impaired loans was $1.6 million and $1.4 million, respectively. The Bank blanket pledges its portfolio of single-family mortgage loans to secure FHLB advances. 42 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (6) Premises and Equipment, Net --------------------------- Premises and equipment, net, at March 31 are summarized as follows: 2007 2006 ----------- ----------- Land $ 5,141,399 $ 2,810,406 Buildings And Improvements 10,790,875 8,693,773 Furniture And Equipment 7,337,134 6,270,596 Construction In Progress 1,816,230 1,902,474 ----------- ----------- 25,085,638 19,677,249 Less Accumulated Depreciation (9,190,446) (8,014,273) ----------- ----------- Total Premises And Equipment, Net $15,895,192 $11,662,976 =========== =========== Depreciation expense for the years ended March 31, 2007, 2006, and 2005 was approximately $1,012,000, $965,000, and $860,000, respectively. The Bank has entered into non-cancelable operating leases related to buildings and land. At March 31, 2007, future minimum payments under non-cancelable operating leases with initial or remaining terms of one year or more are as follows (by fiscal year): 2008 $ 442,602 2009 438,656 2010 437,192 2011 437,192 2012 407,792 Thereafter 3,179,976 ---------- $5,343,410 ========== Total rental expense amounted to $343,000, $295,000, and $289,000 for the years ended March 31, 2007, 2006 and 2005, respectively. Five lease agreements with monthly expenses of $8,250, $7,083, $5,734 $743, and $700 have multiple renewal options totaling 20, 45, 30, 40, and 10 years, respectively. (7) Intangible Assets and Goodwill ------------------------------ Intangible assets and goodwill are the result of the Collier Jennings acquisition in July 2006. Intangible assets and goodwill consisted of the following: Year Ended March 31, 2007 -------------- Customer List Balance at beginning of year $ - Acquired 375,000 Amortization (33,750) ---------- Balance at end of year 341,250 ---------- Employment Contracts Balance at beginning of year - Acquired 225,000 Amortization 33,750 ---------- Balance at end of year 191,250 ---------- Total Intangibles 532,500 Goodwill 1,197,954 ---------- Total $1,730,454 ========== 43 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (8) FHLB Stock ---------- Every federally insured savings institution is required to invest in FHLB stock. No ready market exists for this stock and it has no quoted fair value. However, because redemption of this stock has historically 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 a membership component, which is 0.20% of total assets at December 31, 2006 and 2005 plus a transaction component which equals 4.5% of outstanding advances (borrowings) from the FHLB of Atlanta. The Bank is in compliance with this requirement with an investment in FHLB of Atlanta stock of $8.2 million and $7.1 million as of March 31, 2007 and 2006, respectively. (9) Deposits -------- Deposits outstanding by type of account are summarized as follows: At March 31, 2007 At March 31, 2006 ----------------------------- ----------------------------- Interest Interest Weighted Rate Weighted Rate Rate Range Amount Rate Range --------- -------- -------- -------- ------- -------- Checking Accounts $105,515,095 0.63% 0.00-2.96% $105,347,713 0.97% 0.00-2.96% Money Market Accts. 145,491,774 4.14% 1.09-4.41% 151,494,548 3.50% 1.09-3.93% Passbook Accounts 17,458,680 0.98% 0.00-1.51% 17,795,109 0.98% 0.00-1.51% ------------ ---- --------- ------------ ---- --------- Total 268,465,549 2.55% 0.00-4.41% 274,637,370 2.36% 0.00-3.93% ------------ ---- --------- ------------ ---- --------- Certificate Accounts: 0.00 - 1.99% - 59,797 2.00 - 2.99% 2,971,616 26,836,415 3.00 - 3.99% 36,044,826 72,831,817 4.00 - 4.99% 35,617,605 94,240,989 5.00 - 5.99% 180,637,996 10,622,951 ------------ ------------ Total 255,272,043 4.99% 2.83-5.85% 204,591,969 3.98% 1.74-5.30% ------------ ---- --------- ------------ ---- --------- Total Deposits $523,737,592 3.74% 2.83-5.85% $479,229,339 3.05% 0.00-5.30% ============ ==== ========= ============ ==== ========= The aggregate amount of short-term certificates of deposit with a minimum denomination of $100,000 was $110.6 million and $61.9 million at March 31, 2007 and 2006, respectively. The amounts and scheduled maturities of all certificates of deposit at March 31 are as follows: March 31, --------------------------- 2007 2006 ------------ ------------ Within 1 Year $235,951,662 $164,023,363 After 1 Year, Within 2 10,891,655 31,427,049 After 2 Years, Within 3 2,498,279 3,423,264 After 3 Years, Within 4 2,781,426 2,104,277 After 4 Years, Within 5 3,149,021 3,614,016 Thereafter - - ------------ ------------ $255,272,043 $204,591,969 ============ ============ 44 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (10) Advances From Federal Home Loan Bank (FHLB) And Other Borrowings ---------------------------------------------------------------- Advances from the FHLB at March 31 are summarized by year of maturity and weighted average interest rate below: 2007 2006 -------------------------- --------------------------- Year Ending March 31 Amount Weighted Rate Amount Weighted Rate ------------ ------------- ------------ ------------- 2007 - - 18,000,000 2.83% 2008 10,000,000 4.25% 5,000,000 3.09% 2009 25,000,000 4.75% 20,000,000 3.28% 2010 5,000,000 3.09% 5,000,000 3.09% 2011 10,000,000 4.76% 20,000,000 4.37% 2012 19,700,000 4.77% 5,000,000 4.64% Thereafter 83,349,272 4.20% 58,363,000 3.99% ------------ ---- ------------ ---- $153,049,272 4.36% $131,363,000 3.74% ============ ==== ============ ==== These advances are secured by a blanket collateral agreement with the FHLB by pledging the Bank's portfolio of residential first mortgage loans and investment securities with amortized cost and fair value of $85.3 million and $84.8 million at March 31, 2007 and $64.5 million and $63.0 million at March 31, 2006, respectively. Advances are subject to prepayment penalties. The following tables show callable FHLB advances as of the dates indicated. These advances are also included in the above table. All callable advances are callable at the option of the FHLB. If an advance is called, the Bank has the option to payoff the advance without penalty, re-borrow funds on different terms, or convert the advance to a three-month floating rate advance tied to LIBOR. As of March 31, 2007 - ------------------------------------------------------------------------------ Borrow Date Maturity Date Amount Int. Rate Type Call Dates - ----------- ------------- -------- --------- -------- --------------- 11/07/02 11/07/12 $5,000,000 3.354% 1 Time Call 11/07/07 02/20/04 02/20/14 5,000,000 3.225% 1 Time Call 02/20/09 04/16/04 04/16/14 3,000,000 3.330% 1 Time Call 04/16/08 09/16/04 09/16/09 5,000,000 3.090% 1 Time Call 09/17/07 06/24/05 06/24/15 5,000,000 3.710% 1 Time Call 06/24/10 07/22/05 07/22/15 5,000,000 3.790% 1 Time Call 07/22/08 11/10/05 11/10/15 5,000,000 4.400% 1 Time Call 11/10/09 11/23/05 11/23/15 5,000,000 3.933% Multi-Call 11/23/07 and quarterly thereafter 11/29/05 11/29/13 5,000,000 4.320% 1 Time Call 05/29/09 12/14/05 12/14/11 5,000,000 4.640% 1 Time Call 09/14/09 01/12/06 01/12/16 5,000,000 4.450% 1 Time Call 01/12/11 03/01/06 03/03/14 5,000,000 4.720% 1 Time Call 03/03/10 03/24/06 03/24/16 5,000,000 4.120% Multi-Call 06/26/07 and quarterly thereafter 03/24/06 03/25/13 5,000,000 4.580% 1 Time Call 03/25/08 04/21/06 04/22/13 5,000,000 4.53% Multi-Call 06/26/07 and quarterly thereafter 06/02/06 06/02/16 5,000,000 5.16% 1 Time Call 06/02/11 07/11/06 07/11/16 5,000,000 4.80% Multi-Call 07/11/08 and quarterly thereafter 10/25/06 10/25/11 5,000,000 4.83% 1 Time Call 10/27/08 11/29/06 11/29/16 5,000,000 4.025% Multi-Call 11/29/07 and quarterly thereafter 01/19/07 07/21/14 5,000,000 4.885% 1 Time Call 07/21/11 03/09/07 03/09/12 4,700,000 4.286% Multi-Call 06/11/07 and quarterly thereafter 45 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (10) Advances From Federal Home Loan Bank (FHLB) And Other Borrowings, ----------------------------------------------------------------- Continued --------- As of March 31, 2006 - ------------------------------------------------------------------------------ Borrow Date Maturity Date Amount Int. Rate Type Call Dates - ----------- ------------- -------- --------- -------- --------------- 11/07/02 11/07/12 $ 5,000,000 3.354% 1 Time Call 11/07/07 10/24/03 10/24/08 10,000,000 2.705% Multi-Call 10/24/06 and quarterly thereafter 02/20/04 02/20/14 5,000,000 3.225% 1 Time Call 02/20/09 04/16/04 04/16/14 3,000,000 3.330% 1 Time Call 04/16/08 09/16/04 09/16/09 5,000,000 3.090% 1 Time Call 09/17/07 06/24/05 06/24/15 5,000,000 3.710% 1 Time Call 06/24/10 06/24/05 06/24/10 5,000,000 4.092% 1 Time Call 06/24/06 07/22/05 07/22/15 5,000,000 3.790% 1 Time Call 07/22/08 10/21/05 10/21/10 5,000,000 3.864% 1 Time Call 10/23/06 11/10/05 11/10/15 5,000,000 4.400% 1 Time Call 11/10/09 11/23/05 11/23/15 5,000,000 3.933% Multi-Call 11/23/07 and quarterly thereafter 11/29/05 11/29/13 5,000,000 4.320% 1 Time Call 05/29/09 12/14/05 12/14/11 5,000,000 4.640% 1 Time Call 09/14/09 01/12/06 01/12/16 5,000,000 4.450% 1 Time Call 01/12/11 03/24/06 03/24/16 5,000,000 4.120% Multi-Call 03/26/07 03/24/06 03/25/13 5,000,000 4.580% 1 Time Call 03/25/08 03/01/06 03/03/14 5,000,000 4.720% 1 Time Call 03/03/10 At March 31, 2007 and 2006, the Bank had $68.2 million and $66.2 million in additional borrowing capacity, respectively at the FHLB. The Bank had $8.1 million and $7.3 million in other borrowings (non-FHLB advances) at March 31, 2007 and 2006, respectively. These borrowings consisted of repurchase agreements with certain commercial demand deposit customers for sweep accounts. The interest rate paid on these borrowings floats monthly with money market type rates. At March 31, 2007 and 2006, the interest rate paid on these borrowings was 4.41% and 4.43%, respectively. The Bank had pledged as collateral for these borrowings investment securities with amortized costs and fair values of $23.4 million and $23.4 million at March 31, 2007 and $25.5 million and $24.9 million at March 31, 2006, respectively, as collateral for these borrowings. (11) Junior Subordinated Debentures ------------------------------ On September 21, 2006, Security Federal Statutory Trust (the "Trust"), a wholly-owned subsidiary of the Company, issued and sold fixed and floating rate capital securities of the Trust (the "Capital Securities"), which are reported on the consolidated balance sheet as junior subordinated debentures, generating proceeds of $5.0 million. The Trust loaned these proceeds to the Company to use for general corporate purposes, primarily to provide capital to the Bank. The Capital Securities accrue and pay distributions annually at a rate per annum equal to a blended rate of 6.97% at March 31, 2007. One-half of the Capital Securities issued in the transaction has a fixed rate of 6.88% and the remaining half has a floating rate of three-month LIBOR plus 170 basis points, which was 7.06% at March 31, 2007. The distribution rate payable on the Capital Securities is cumulative and payable quarterly in arrears. The Company has the right, subject to events of default, to defer payments of interest on the Capital Securities for a period not to exceed 20 consecutive quarterly periods, provided that no extension period may extend beyond the maturity date of December 15, 2036. The Company has no current intention to exercise its right to defer payments of interest on the Capital Securities. The Capital Securities mature or are mandatorily redeemable upon maturity on December 15, 2036, and or upon earlier optional redemption as provided in the indenture. The Company has the right to redeem the Capital Securities in whole or in part, on or after September 15, 2011. The Company may also redeem the capital securities prior to such dates upon occurrence of specified conditions and the payment of a redemption premium. 46 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (12) Income Taxes ------------ Income tax expense is comprised of the following: For the Years Ended March 31, ---------------------------------- 2007 2006 2005 ---------- --------- --------- Current: Federal $1,995,334 1,534,117 1,610,169 State 136,437 155,772 163,495 ---------- --------- --------- Total Current Tax Expense 2,131,771 1,689,889 1,773,664 ---------- --------- --------- Deferred: Federal 7,241 77,600 (55,791) State 2,471 10,127 (7,281) ---------- --------- --------- Total Deferred Tax Expense 9,712 87,727 (63,072) ---------- --------- --------- Total Income Tax Expense $2,141,483 1,777,616 1,710,592 ========== ========= ========= The Company's income taxes differ from those computed at the statutory federal income tax rate, as follows: For the Years Ended March 31, ---------------------------------- 2007 2006 2005 ---------- --------- --------- Tax At Statutory Income Tax Rate $2,131,132 1,900,759 1,773,470 State Tax And Other 10,351 (123,143) (62,878) ---------- --------- --------- Total Income Tax Expense $2,141,483 1,777,616 1,710,592 ========== ========= ========= The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are presented below. At March 31, ----------------------- 2007 2006 ---------- ---------- Deferred Tax Assets: Provision For Loan Losses $2,769,862 $2,545,116 Goodwill Tax Basis Over Financial Statement Basis 152,917 249,495 Net Fees Deferred For Financial Reporting 164,914 187,191 Unrealized Loss on Securities Available for Sale 457,470 1,276,659 Other 177,591 163,664 ---------- ---------- Total Gross Deferred Tax Assets 3,722,754 4,422,125 ---------- ---------- Deferred Tax Liabilities: FHLB Stock Basis Over Tax Basis 126,565 126,565 Depreciation 182,310 218,318 Other 55,400 88,484 Intangibles 198,622 - ---------- ---------- Total Gross Deferred Tax Liability 562,897 433,367 ---------- ---------- Net Deferred Tax Asset $3,159,857 $3,988,758 ========== ========== No valuation allowance for deferred tax assets was required at March 31, 2007 and 2006. 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 the net deferred tax asset can be supported based upon these criteria. 47 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (13) Regulatory Matters ------------------ The Bank is subject to various regulatory capital requirements that are administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and discretionary actions by regulators that could have a material adverse effect on the Company. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classifications are also subject to qualitative judgments by regulators with regard to components, risk weightings, and other factors. As of March 31, 2007 and 2006, the Bank was categorized as "well capitalized" under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank had to maintain total risk-based capital, Tier 1 risk-based capital, and Tier 1 leverage ratios at 10%, 6%, and 5%, respectively. There are no conditions or events that management believes have changed the Bank's classification. The Bank's regulatory capital amounts and ratios are as follows as of the dates indicated: To Be Well Capitalized Under Prompt Corrective Actual For Capital Adequacy Action Provisions --------------- -------------------- ------------------ Amount Ratio Amount Ratio Amount Ratio ------ ----- ------- ------- ------ ----- (Dollars in Thousands) March 31, 2007 Tier 1 Risk-Based Core Capital (To Risk Weighted Assets) $45,588 9.5% 19,251 4.0% 28,877 6.0% Total Risk-Based Capital (To Risk Weighted Assets) 51,582 10.7% 38,503 8.0% 48,128 10.0% Tier 1 Leverage (Core) Capital (To Adjusted Tangible Assets) 45,588 6.2% 29,474 4.0% 36,843 5.0% Tangible Capital (To Tangible Assets) 45,588 6.2% 14,737 2.0% 36,843 5.0% March 31, 2006 Tier 1 Risk-Based Core Capital (To Risk Weighted Assets) $39,473 9.7% $16,328 4.0% $24,492 6.0% Total Risk-Based Capital (To Risk Weighted Assets) 44,568 10.9% 32,669 8.0% 40,836 10.0% Tier 1 Leverage (Core) Capital (To Adjusted Tangible Assets) 39,473 6.0% 26,431 4.0% 33,039 5.0% Tangible Capital (To Tangible Assets) 39,473 6.0% 13,224 2.0% 33,039 5.0% The payment of dividends by the Company depends primarily on the ability of the Bank to pay dividends to the Company. The payment of dividends by the Bank to the Company is subject to substantial restrictions and would require prior notice to the Office of Thrift Supervision ("OTS"). (14) Employee Benefit Plans ---------------------- The Company is participating in a multiple employer defined contribution employee benefit plan covering substantially all employees with six months or more of service. The Company matches a portion of the employees' contributions and the plan has a discretionary profit sharing provision. The total employer contributions were $349,000, $113,000, and $36,000 for the years ended March 31, 2007, 2006, and 2005, respectively. 48 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (14) Employee Benefit Plans, Continued --------------------------------- The Company has an Employee Stock Ownership Plan ("ESOP") for the exclusive benefit of employee participants. The discretionary contributions for the years ended March 31, 2007, 2006, and 2005 were zero, $231,000 and $75,000, respectively. The ESOP from time to time borrows funds from financial institutions to purchase the Company's stock. The balance of the loan was zero and $216,000 at March 31, 2007 and 2006, respectively. The entire balance of the loan was paid off in June 2006. The Company carried the debt as a liability and a reduction in equity, although the Company neither endorses nor guarantees the loan. The loan is repaid by Company contributions to the trustee, who in turn makes the loan payment to the financial institution. Because of the high cost of maintaining the ESOP, including legal, accounting, and audit fees, and the fact the ESOP has no more stock to allocate, the Company is in the process of terminating the plan. The Company has an Employee Stock Purchase Plan ("ESPP"). The ESPP allows employees of the Company to purchase stock quarterly at a 15% discount through payroll deduction. The ESPP, which was approved by stockholders in July 2005, began operating in January 2007. Participation is voluntary. Employees are limited to investing $25,000 or 5% of their annual salary, whichever is lower, during the year. At March 31, 2007, there were 28 employees participating. Certain officers of the Company participate in a supplemental retirement plan. These benefits are not qualified under the Internal Revenue Code and they are not funded. During the year ended March 31, 2007, the Company incurred an expense of $167,000 for this plan. Certain officers of the Company participate in an incentive stock option plan. Options are granted at exercise prices not less than the fair value of the Company's common stock on the date of the grant. The following is a summary of the activity under the Company's incentive stock option plan for the years ended March 31, 2007, 2006, and 2005. 2007 2006 2005 ---------------- ----------------- ----------------- Weighted Weighted Weighted Avg. Avg. Avg. Exercise Exercise Exercise Shares Price Shares Price Shares Price ------ -------- ------ -------- ------ -------- Balance, Beginning of Year 118,046 $19.50 135,292 $19.09 131,639 $18.23 Options granted 14,000 23.03 6,500 23.91 32,000 20.89 Options exercised 25,196 17.40 14,396 15.45 10,547 15.95 Options forfeited 7,250 19.27 9,350 19.52 17,800 19.58 ------- ------- ------- Balance, March 31 99,600 $20.55 118,046 $19.50 135,292 $19.09 ======= ======= ======= Options Exercisable 85,600 $20.14 118,046 $19.50 20,672 $15.82 ======= ======= ======= Options Available For Grant 59,000 13,750 10,000 ======= ======= ======= Stock options outstanding as of March 31, 2007 are as follows: Weighted Average Number of Remaining Range of Exercise Prices Option Shares Contractual Weighted Average Low/High Outstanding Life (Years) Exercise Price ------------- ------------ ---------------- $ 15.00 / $20.00 30,600 2.56 16.67 $ 20.01 / $24.22 69,000 7.81 22.07 ------ ---- ------ 99,600 6.19 $20.14 ====== ==== ====== The aggregate intrinsic value of the stock options outstanding and exercisable at March 31, 2007 amounted to $485,455. Total compensation expense related to stock options was $7,700 for the period ended March 31, 2007. As of March 31, 2007, there was $124,000 of total unrecognized compensation cost related to non-vested stock options. The cost is expected to be recognized over a weighted average period of 9 years. 49 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (14) Employee Benefit Plans, Continued --------------------------------- At March 31, 2007, the Company had the following options outstanding: Outstanding Grant Date Options Option Price Expiration Date ---------- ----------- ------------ --------------- 10/19/99 51,000 $16.67 9/30/05 to 9/30/09 1/16/03 1,500 $22.39 12/31/12 9/1/03 3,000 $24.00 8/31/13 12/1/03 3,000 $23.65 11/30/13 1/01/04 8,500 $24.22 12/31/13 3/8/04 13,000 $21.43 2/28/14 6/7/04 2,000 $24.00 5/31/14 1/1/05 26,000 $20.55 12/31/14 1/1/05 2,000 $22.61 12/31/15 1/1/06 6,500 $22.91 12/31/16 8/24/06 14,000 $23.03 08/24/16 50 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (14) Employee Benefit Plans, Continued --------------------------------- The options listed on the previous page vested immediately on March 30, 2006 as a result of an action taken by the Board of Directors except for the 14,000 options granted during the year ended March 31, 2007. All options, issued prior to January 16, 2003, must be exercised between now and within one year of the original vesting schedule, except those granted during the year ended March 31, 2004 until March 31, 2006, may be exercised anytime between now and the end of the tenth year after the grant date. Options granted after March 31, 2006 vest 20% per year every year after the end of five years after the date of the grant. Those options granted after March 31, 2006 may be exercised as they vest in years six through ten, or until the end of year ten after the grant date. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for grants: Dividend yield of $0.24, $0.16, and $0.08 per share for options granted during the years ended March 31, 2007, 2006, and 2005, respectively, expected volatility of 30.2% for options granted in 2007, 39.8% for options granted in 2006, and 21.2% for options granted in 2005, risk-free interest rate of 4.36% for options granted in 2007, 4.42% for options granted in 2006, and 4.82% for options granted in 2005, and expected lives of six to ten years. (15) Bank Owned Life Insurance ------------------------- On March 31, 2006 and July 1, 2006, the Company purchased bank owned life insurance. The cash value of the life insurance policies are recorded as a separate line item in the accompanying balance sheets at $5.8 million and $5.0 million at March 31, 2007 and 2006, respectively. The insurance provides key person life insurance on certain officers of the company. The earnings-portion of the insurance policies grows tax deferred and helps offset the cost of the Company's benefits program. The Company recorded earnings of $243,000 for the growth in the cash value of life insurance during the year ended March 31, 2007. 51 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (16) Commitments and Contingencies ----------------------------- In the ordinary course of business, the Company has various outstanding commitments and contingent liabilities that are not reflected in the accompanying consolidated financial statements. In addition, the Company is a defendant in certain claims and legal actions arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material adverse effect on the consolidated financial condition of the Company. 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 $87.1 million and $68.0 million, undisbursed loans in process totaled $6.4 million and $9.2 million, and letters of credit of $1.0 million and $1.4 million at March 31, 2007 and 2006, respectively. At March 31, 2007 and 2006, the fair value of standby letters of credit was immaterial. 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 $3.6 million and $2.9 million at March 31, 2007 and 2006, respectively. Outstanding commitments on mortgage loans not yet closed amounted to $0 and $351,000 at March 31, 2007 and 2006, respectively. These commitments, which are funded subject to certain limitations, extend over varying periods of time with the majority being funded within 45 days. At March 31, 2007 and 2006, the Bank had outstanding commitments to sell approximately $1.5 and $1.3 million of loans, respectively, which encompassed the Bank's held for sale loans. The Bank also has commitments to sell mortgage loans not yet closed, on a best efforts basis. Best efforts means the Bank suffers no penalty if they are unable to deliver the loans to the potential buyers. The fair value of the Bank's commitment to originate mortgage loans at committed interest rates and to sell such loans to permanent investors is insignificant. 52 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (17) Related Party Transactions -------------------------- Certain directors, executive officers and companies with which they are affiliated, are customers of and have banking transactions with the Bank in the ordinary course of business. These loans were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable arms-length transactions. A summary of loan transactions with directors, including their affiliates, and executive officers follows: For the years ended March 31, ------------------------------ 2007 2006 2005 -------- -------- -------- Balance, beginning of year $420,239 $550,010 $528,974 New loans 274,797 255,278 115,827 Less loan payments 42,935 385,049 94,791 -------- -------- -------- Balance, end of year $652,101 $420,239 $550,010 ======== ======== ======== Loans to all employees, officers, and directors of the Company, in the aggregate constituted approximately 8.52% and 5.54% of the total shareholders' equity of the Company at March 31, 2007 and 2006, respectively. At March 31, 2007 and 2006, deposits from executive officers and directors of the Bank and Company and their related interests in aggregate approximated $4.7 million and $2.8 million, respectively. 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 Company incurred expenses of $65,000, $51,000, and $41,000 for rent for the years ended March 31, 2007, 2006, and 2005, respectively. The Company increased the amount of office space covered by that lease during fiscal 2007. On July 1, 2006, the Company began renting office space from another executive officer. On that lease, the Company incurred rent expense of $31,000 during the year ended March 31, 2007. Management is of the opinion that the transactions with respect to office rent are made on terms that are comparable to those which would be made with unaffiliated persons. 53 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (18) 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 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 At March 31, ------------------------- 2007 2006 ----------- ----------- Assets: Cash $ 2,377,723 $ 294,984 Investment Securities, Available For Sale 103,286 102,938 Investment in Security Federal Statutory Trust 155,000 - Investment In Security Federal Bank 46,569,777 37,387,118 Accounts Receivable And Other Assets 81,695 41,330 ----------- ----------- Total Assets $49,287,481 $37,826,370 =========== =========== Liability And Shareholders' Equity: Accounts Payable And Other Liabilities $ 21,961 $ 9,108 Junior Subordinated Debentures 5,155,000 - Mandatorily Redeemable Financial Instrument 1,417,312 - Indirect Guarantee Of ESOP Debt - 215,503 Shareholders' Equity 42,693,208 37,601,759 ----------- ----------- Total Liabilities And Shareholders' Equity $49,287,481 $37,826,370 =========== =========== Condensed Statements of Income Data For the Years Ended March 31, ------------------------------------ 2007 2006 2005 ---------- ---------- ---------- Income: Equity In Earnings Of Security Federal Bank $4,246,503 $3,821,229 $3,512,277 Interest Income 5,767 - - Miscellaneous Income 7,887 - - ---------- ---------- ---------- Total Income 4,260,157 3,821,229 3,512,277 ---------- ---------- ---------- Expenses: Interest Expense 191,811 - - Other Expenses 15,310 13,762 11,190 ---------- ---------- ---------- Total Expenses 207,121 13,762 11,190 ---------- ---------- ---------- Income Before Income Taxes 4,053,036 3,807,467 3,501,087 Income Tax Benefit (73,517) (5,384) (4,408) ========== ========== ========== Net Income $4,126,553 $3,812,851 $3,505,495 ========== ========== ========== 54 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (18) Security Federal Corporation Condensed Financial Statements (Parent ------------------------------------------------------------------- Company Only), Continued ------------------------ Condensed Statements of Cash Flow Data For the Years Ended March 31, -------------------------------------- 2007 2006 2005 ---------- ----------- ----------- Operating Activities: Net Income $ 4,126,553 $ 3,812,851 $ 3,505,495 Adjustments To Reconcile Net Income To Net Cash Used In Operating Activities: Equity In Earnings Of Security Federal Bank (4,246,503) (3,821,229) (3,512,277) Stock Compensation Expense 7,686 - - Increase In Accounts Receivable And Other Assets (40,363) (5,384) (4,409) Increase In Accounts Payable 12,859 - - ---------- ----------- ----------- Net Cash Used In Operating Activities (139,768) (13,762) (11,191) ---------- ----------- ----------- Investing Activities: Purchase Of Investment Securities - (102,938) - Investment in Security Federal Statutory Trust (155,000) - - Additional Investment in Security Federal Bank (4,597,319) - - Dividend Received From Security Federal Bank 1,000,000 - - ---------- ----------- ----------- Net Cash (Used In) Provided By Investing Activities (3,752,319) (102,938) - ---------- ----------- ----------- Financing Activities: Exercise Of Stock Options 438,465 222,450 168,235 Purchase Of Treasury Stock, At Cost (412,564) (73,567) (165,089) Proceeds From Junior Subordinated Debenture 5,155,000 - - Proceeds From Mandatorily Redeemable Financial Instrument 1,417,312 - - Dividends Paid (623,387) (406,749) (278,987) ---------- ----------- ----------- Net Cash Provided (Used) In Financing Activities 5,974,826 (257,866) (275,841) ---------- ----------- ----------- Net Increase (Decrease) In Cash 2,082,739 (374,566) (287,032) Cash At Beginning Of Year 294,984 669,550 956,582 ---------- ----------- ----------- Cash At End Of Year $2,377,723 $ 294,984 $ 669,550 ========== =========== =========== (19) Carrying Amounts and Fair Value of Financial Instruments -------------------------------------------------------- The carrying amounts and fair value of financial instruments are summarized below: At March 31, ------------------------------------------- 2007 2006 -------------------- -------------------- Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value -------- ---------- -------- ---------- (In Thousands) Financial Assets: Cash And Cash Equivalents $ 13,438 13,438 $ 14,351 14,351 Investment And Mortgage-Back Securities $249,750 249,053 $238,433 236,530 Loans Receivable, Net $436,038 439,785 $375,109 376,221 FHLB Stock $ 8,209 8,209 $ 7,150 7,150 Financial Liabilities: Deposits: Checking, Savings, And Money Market Accounts $268,466 268,466 $274,637 274,637 Certificate Accounts $255,272 255,068 $204,592 203,871 Advances From FHLB $153,049 152,595 $131,363 129,117 Other Borrowed Money $ 8,088 8,088 $ 7,290 7,290 Junior Subordinated Debentures $ 5,155 5,155 $ - - Mandatorily Redeemable Financial Instrument $ 1,417 1,403 $ - - 55 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (19) Carrying Amounts and Fair Value of Financial Instruments, Continued ------------------------------------------------------------------- At March 31, 2007, the Bank had $98.1 million of off-balance sheet financial commitments. These commitments are to originate loans and unused consumer lines of credit and credit card lines. Because these obligations are based on current market rates, if funded, the original principal is considered to be a reasonable estimate of fair 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. 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 values, loan servicing portfolios, 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. The values used are provided from the OTS interest rate risk model. The Company has used management's best estimate of fair value on the above assumptions. Thus, the fair values presented may not be the amounts, which could be realized, in an immediate sale or settlement of the instrument. In addition, any income taxes or other expenses that would be incurred in an actual sale or settlement are not taken into consideration in the fair value presented. 56 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES Notes To Consolidated Financial Statements (20) Quarterly Financial Data (Unaudited) ------------------------------------ Unaudited condensed financial data by quarter for fiscal year 2007 and 2006 is as follows (amounts, except per share data, in thousands): Quarter ended ------------------------------------------------- June 30, Sept. 30, Dec. 31, Mar. 31, 2006-2007 2006 2006 2006 2007 ---------- ---------- ---------- ---------- Interest Income $ 9,625 $ 10,283 $ 10,814 $ 11,376 Interest Expense 5,214 5,744 6,380 6,595 ---------- ---------- ---------- ---------- Net Interest Income 4,411 4,539 4,434 4,781 Provision For Loan Losses 150 150 150 150 ---------- ---------- ---------- ---------- Net Interest Income After Provision For Loan Losses 4,261 4,389 4,284 4,631 Non-interest Income 752 913 988 1,208 Non-interest Expense 3,443 3,729 3,817 4,168 ---------- ---------- ---------- ---------- Income Before Income Tax 1,569 1,573 1,455 1,671 Provision For Income taxes 547 546 478 571 ---------- ---------- ---------- ---------- Net Income $ 1,023 $ 1,027 $ 977 $ 1,100 ========== ========== ========== ========== Basic Net Income Per Common Share $ 0.40 $ 0.39 $ 0.37 $ 0.42 ========== ========== ========== ========== Diluted Net Income Per Common Share $ 0.40 $ 0.39 $ 0.37 $ 0.42 ========== ========== ========== ========== Basic Weighted Average Shares Outstanding 2,538,951 2,610,605 2,617,037 2,611,507 ========== ========== ========== ========== Diluted Weighted Average Shares Outstanding 2,564,893 2,622,996 2,625,945 2,620,375 ========== ========== ========== ========== Quarter ended ------------------------------------------------- June 30, Sept. 30, Dec. 31, Mar. 31, 2005-2006 2005 2005 2005 2006 ---------- ---------- ---------- ---------- Interest Income $ 7,461 $ 7,887 8,322 8,946 Interest Expense 3,489 3,784 4,112 4,584 ---------- ---------- ---------- ---------- Net Interest Income 3,972 4,103 4,210 4,362 Provision For Loan Losses 165 165 165 165 ---------- ---------- ---------- ---------- Net Interest Income After Provision For Loan Losses 3,807 3,938 4,045 4,197 Non-interest Income 641 697 662 630 Non-interest Expense 2,996 3,172 3,204 3,655 ---------- ---------- ---------- ---------- Income Before Income Tax 1,452 1,463 1,503 1,172 Provision For Income taxes 523 514 545 196 ---------- ---------- ---------- ---------- Net Income $ 929 $ 949 $ 958 $ 976 ========== ========== ========== ========== Basic Net Income Per Common Share $ 0.37 $ 0.38 $ 0.38 $ 0.38 ========== ========== ========== ========== Diluted Net Income Per Common Share $ 0.36 $ 0.37 $ 0.37 $ 0.38 ========== ========== ========== ========== Basic Weighted Average Shares Outstanding 2,530,389 2,527,533 2,536,304 2,537,771 ========== ========== ========== ========== Diluted Weighted Average Shares Outstanding 2,556,205 2,585,543 2,570,767 2,591,728 ========== ========== ========== ========== 57 SECURITY FEDERAL CORPORATION AND SUBSIDIARIES SHAREHOLDERS INFORMATION ANNUAL MEETING The annual meeting of shareholders will be held at 2:00 p.m., Thursday, July 19, 2007 at the City of Aiken Municipal Conference Center, 215 The Alley, Aiken, South Carolina. STOCK LISTING The Company's stock is traded on the Over-The-Counter-Bulletin Board under the symbol "SFDL.OB." The stock began trading on the Bulletin Board in October 2003. PRICE RANGE OF COMMON STOCK The table below shows the range of high and low bid prices. These prices represent actual transactions and do not include retail markups, markdowns or commissions. Market makers include Sterne, Agee, and Leach, Inc., Morgan Keegan and Company, Inc., A.G. Edwards and Sons, Inc., Hill, Thompson, and Magid, and Monroe Securities, Inc. Quarter Ending High Low -------------- ------ ------ 06-30-05 $21.75 $21.75 09-30-05 $29.00 $29.00 12-31-05 $23.50 $23.50 03-31-06 $24.25 $24.25 06-30-06 $25.50 $22.70 09-30-06 $23.50 $22.10 12-31-06 $24.00 $23.00 03-31-07 $25.00 $23.30 As of March 31, 2007, the Company had approximately 550 shareholders and 2,609,116 outstanding shares of common stock. DIVIDENDS The first quarterly dividend on the stock was paid to shareholders on March 15, 1991. Dividends will be paid upon the determination of the Board of Directors that such payment is consistent with the long-term interest 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 paid $0.02 per share cash dividends for each of the quarters during fiscal 2003-2004 and the first quarter of fiscal 2004-2005. The Company paid $0.03 per share cash dividend in each of the last three quarters of 2004-2005. The Company paid $0.04 per share cash dividends for each of the quarters during fiscal 2005-2006 and $0.06 per share cash dividends for each of the quarters during fiscal 2006-2007. The ability of the Company to pay dividends depends primarily on the ability of the Bank to pay dividends to the Company. The Bank may not declare or pay a cash dividend on its stock or repurchase shares of its stock if the offset thereof would be to cause its regulatory capital to be reduced below the amount required for the liquidation account or to meet applicable regulatory capital requirements. Pursuant to the OTS regulations, Tier 1 associations (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 capital year. However, a Tier 1 association deemed to be in need of more than normal supervision by the OTS may be downgraded to a Tier 2 or Tier 3 association as a result of such a determination. The Bank is also required to give the OTS 30 days notice prior to the declaration of a dividend. Unlike the Bank, there is no regulatory restriction on the payment of dividends by the Company; however, it is subject to the requirements of South Carolina. South Carolina generally prohibits the Company from paying dividends if, after giving effect to a proposed dividend: (1) the Company would be unable to pay its debts as they become due in the normal course of business, or (2) the Company's total assets would be less than its total liabilities plus the sum that would be needed to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the dividend. 58 [Picture Appears Here] Carol McCleskey Senior Vice President, Branch Administrator and A Familiar Face Security Officer Carol McCleskey is Senior Vice President, Branch Administrator and Security Officer for Security Federal. In her role as Branch Administrator, Carol has management responsibility for 11 branches located in Aiken and Lexington counties in addition to the Evans, Georgia and Columbia, South Carolina branches to open later this fall. Carol has over 40 years of banking experience and is a resident of Aiken. She is a graduate of Leadership Aiken County and is very active within the Aiken community. We are fortunate to have such an experienced and dedicated member on the Security Federal Bank team. Shareholders Information Annual and Other Reports The Company is required to file an annual report on Form 10-K for its fiscal year ended March 31, 2006 with the Securities and Exchange Commission. Copies of Form 10-K, Security Federal Corporation's annual report, and the Company's quarterly reports may be obtained from and inquiries may be addressed to Ms. Beverly Bradham of Security Federal Corporation. GENERAL TRANSFER SPECIAL INQUIRIES AGENT COUNSEL Ms. Beverly Bradham Security Federal Breyer & Associates, PC Security Federal Corp. Corporation Suite 785 238 Richland Ave., NW 238 Richland Ave., NW 8180 Greensboro Drive P.O. Box 810 P.O. Box 810 McLean, VA 22102 Aiken, SC 29802-0810 Aiken, SC 29802-0810 Phone: 803-641-3000 Toll free: 866-851-3000 INDEPENDENT AUDITORS Elliott Davis, LLC 1901 Main Street Suite 1650 P.O. Box 2227 Columbia, SC 29202-2227 59 BOARD OF DIRECTORS T. Clifton Weeks Sen. Thomas L. Moore Harry O. Weeks, Jr. Chairman President Business Dev. Executive Security Federal Corp. Boiler Efficiency, Inc. Hutson-Etherredge Co. Aiken, SC Clearwater, SC Aiken, SC Dr. Robert E. Alexander Timothy W. Simmons J. Chris Verenes Chancellor Emeritus President/CEO President Univ. of SC at Aiken Security Federal Corp. Security Federal Bank Aiken, SC Aiken, SC Aiken, SC Hon. William Clyburn G. L. Toole, III Roy G. Lindburg Member of the South Attorney-At-Law Executive Vice President Carolina Aiken, SC Treasurer/CFO House of Representatives Security Federal Corp. Aiken, SC Aiken, SC - ------------------------------------------------------------------------------ Directors Emeritus: Walter E. Brooker, Sr. President, Brooker's Inc. Denmark, SC 60 BANK ADVISORY BOARDS NORTH AUGUSTA----------------------------------------------------------------- P. Richard Borden Rev. G.L. Helen H. Butler Owner Brightharp Retired Banker Borden Pest Control Owner North Augusta, SC North Augusta, SC G.L. Brightharp & Sons Mortuary North Augusta, SC William M. Hixon Sen. Thomas L. John P. Potter Owner Moore Director of Finance Hixon Realty President City of North North Augusta, SC Boiler Efficiency, Inc. Augusta Clearwater, SC North Augusta, SC WAGENER----------------------------------------------------------------------- M. Judson Busbee Chad G. Ingram Mary T. Lybrand Owner President Retired Banker Busbee Hardware Garvin Oil Company Wagener, SC Wagener, SC Wagener, SC Dr. Michael L. Miller Richard H. Sumpter Anesthesiologist Retired Educator Palmetto Health Wagener, SC Richland Memorial Hosp. Columbia, SC MIDLAND VALLEY---------------------------------------------------------------- Charles A. Hilton Rev. Nathaniel Irvin, Sr. Rev. Stephen Phillips General Manager Pastor Pastor Breezy Hill Old Storm Branch Christian Heritage Water & Sewer Baptist Church Church Graniteville, SC Clearwater, SC Graniteville, SC Sen. Thomas L. Glenda K. Napier Carlton B. Shealy Moore Co-Owner Owner President Napier Funeral Home C. Shealy Realty Boiler Efficiency, Inc. Graniteville, SC Builders & Clearwater, SC Developers North Augusta, SC In Memory Gloria Busch Johnson [Picture Appears Here] 1942 - 2006 We were saddened to lose a member of the Security Federal family this year. Gloria Busch Johnson joined the Midland Valley Advisory Board in 1994. Gloria was an active board member and took great pride in her association with Security Federal. She was the Executive Director of the Midland Valley Chamber of Commerce and was named the 2006 Citizen of the Year by the Chamber of Commerce. Gloria was respected by all and will be missed. WESTCOLUMBIA - LEXINGTON------------------------------------------------------ Eleanor Powell Clark Sandra Dooley Parker L. Todd Sease Owner/Operator Attorney Partner B & E Enterprises Inc. Dooley, Dooley, Spence, Jumper, Carter, Sease dba McDonald's Parker & Hipp, PA Architects, PA Columbia, SC Lexington, SC West Columbia, SC G. Scott Middleton Sen. Nikki G. Setzler Dianne Light Owner Sr. Partner Owner Agape Assisted Living/ Setzler & Scott, PA Dianne's on Devine Nursing & Related Com. Law Firm & DiPrato's Deli West Columbia, SC West Columbia, SC Columbia, SC Jan Hook-Stamps Donald T. Martin Owner Controller, CPA Elante Day Spa Nexsen, Pruet, LLC West Columbia, SC Columbia, SC 61 MANAGEMENT TEAM & BRANCH LOCATIONS Management Team--------------------------------------------------------------- T. Clifton Weeks Chairman of Security Federal Corporation Timothy W. Simmons Chairman and Chief Executive Officer, Security Federal Bank G.L. Toole, III Vice President Robert E. Alexander Corporate Secretary J. Chris Verenes President, Security Federal Bank Roy G. Lindburg Executive Vice President, Treasurer and Chief Financial Officer Frank Thomas Executive Vice President - Aiken Area Executive Marian Shapiro Executive Vice President - Midlands Area Executive Lynn B. Shepard Senior Vice President - Senior Operations Officer Sandra M. Bartlett Senior Vice President - Human Resources Carol P. McCleskey Senior Vice President - Branch Administration H. Stanley Price Senior Vice President - Augusta Area Executive William O. Boyte, III Senior Vice President - Construction Lending - Midlands Area Audrey Varn President - Security Federal Trust and Investments Gerald Jennings President - Security Federal Insurance Margaret Hurt Controller Gabriele C. Dukes Vice President - Financial Counseling Janice S. Hauerwas Vice President - Mortgage Loan Originator Gregory D. Warfield Vice President - Mortgage Loan Originator Stan Carter Vice President - Mortgage Loan Originator Josie Quiller Vice President - Mortgage Lending James E. Bristow Vice President - Business Development/Commercial Loans Paul T. Rideout Vice President - Business Development/Commercial Loans Michael Strange Vice President - Business Development/Commercial Loans Elsie K. Dicks Vice President - Credit Administration Patricia B. Moseley Vice President - Loan Servicing Ronald R. Davis Vice President - Senior Auditor Laura B. Conway Vice President - Operations Auditor Rochelle D. Wright Vice President - Information Technology Branch Locations-------------------------------------------------------------- Whiskey Road, Aiken, SC Dana S. Hall, Assistant Vice President/Manager North Augusta, SC Kathy S. Williamson, Assistant Vice President/Manager Laurens Street, Aiken, SC Vicky W. Moseley, Assistant Vice President/Manager Richland Avenue, Aiken, SC Melanie Mackay, Assistant Vice President/Manager South Side, Aiken, SC Shane M. Bagby, Assistant Vice President/Manager Graniteville, SC Tonya Key, Assistant Vice President/Manager Langley, SC Pat W. Guglieri, Assistant Vice President/Manager Clearwater, SC Gail W. Dotson, Assistant Vice President/Manager Wagener, SC Scott Tindal, Assistant Vice President/Manager West Columbia, SC Mary B. Clark, Assistant Vice President/Manager Lexington, SC Sherrie Tanner, Assistant Vice President/Manager Opening Fall 2007 Assembly Street, Columbia, SC Marianne Poppacoda, Assistant Vice President/Manager Evans, GA Josh Booth, Assistant Vice President/Manager 62 OUR LOCATIONS [Map appears here] Exhibit 21 Subsidiaries of the Registrant State of Percentage Parent Subsidiary Incorporation of Ownership - ------ ---------- ------------- ------------ Security Federal Security Federal United States 100% Corporation Bank Security Federal Trust South Carolina 100% Security Federal Security Federal South Carolina 100% Bank Insurance, Inc. Security Federal South Carolina 100% Investments, Inc. Security Federal Trust, South Carolina 100% Inc. Security Financial South Carolina 100% Services Corporation Exhibit 23 Consent of Elliott Davis, LLC CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM -------------------------------------------------------- The Board of Directors Security Federal Corporation We consent to incorporation by reference in the Registration Statement No. 333-31500, 333-102337 and 333-136813 on Form S-8 of our report dated June 19, 2007, relating to the consolidated balance sheet of Security Federal Corporation and subsidiaries as of March 31, 2007 and the related consolidated statements of income, shareholders' equity and cash flows for the year then ended, which report appears in the March 31, 2007 Annual Report on Form 10-K. /s/ Elliott Davis, LLC Columbia South Carolina June 27, 2007 Exhibit 31.1 Certification Required by Rules 13a-15 and 15d-15 under the Securities Exchange Act of 1934 I, Timothy W. Simmons, certify that: 1. I have reviewed this annual report on Form 10-K of Security Federal Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: June 27, 2007 /s/Timothy W. Simmons ------------------------------------- Timothy W. Simmons President and Chief Executive Officer Exhibit 31.2 Certification Required by Rules 13a-15 and 15d-15 under the Securities Exchange Act of 1934 I, Roy G. Lindburg, certify that: 1. I have reviewed this annual report on Form 10-K of Security Federal Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: June 27, 2007 /s/Roy G. Lindburg ------------------------------------- Roy G. Lindburg Treasurer and Chief Financial Officer Exhibit 32 CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER OF SECURITY FEDERAL CORPORATION PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 The undersigned hereby certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and in connection with this Annual Report on Form 10-K, that: 1. the report fully complies with the requirements of Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, and 2. the information contained in the report fairly presents, in all material respects, the company's financial condition and results of operations. /s/Timothy W. Simmons /s/Roy G. Lindburg - ------------------------------------- ------------------------------------- Timothy W. Simmons Roy G. Lindburg President and Chief Executive Officer Treasurer and Chief Financial Officer Dated: June 27, 2007 -----END PRIVACY-ENHANCED MESSAGE-----