10-Q 1 ffb-604q.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Quarter Ended June 30, 2004 FIDELITY FEDERAL BANCORP ------------------------------------------------------ (Exact name of registrant as specified in its charter) Indiana 0-22880 35-1894432 ---------------------------- ---------- ------------- (State of other jurisdiction Commission (IRS Employer of Incorporation of File No. Identification No.) Organization) 18 NW Fourth Street Evansville, Indiana 47708 --------------------------------------------------- (Address of principal executive offices) (Zip Code) (812) 424-0921 -------------------------------------------------- Registrant's telephone number, including area code Indicate by checkmark 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 twelve months and (2) has been subject to such filing requirements for the past 90 days. YES X NO ----- ----- Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES NO X ----- ----- As of July 22, 2004, there were 10,999,871 shares of the Registrant's common stock, $1 stated value, issued and outstanding. FIDELITY FEDERAL BANCORP AND SUBSIDIARIES Index Page PART I - FINANCIAL INFORMATION ITEM 1- Financial Statements: Condensed Consolidated Balance Sheets................................ 3 Condensed Consolidated Statements of Income.......................... 4 Condensed Consolidated Statements of Changes in Stockholders' Equity. 5 Condensed Consolidated Statements of Cash Flows...................... 6 Notes to Condensed Consolidated Financial Statements................. 7 ITEM 2 - Management's Discussion and Analysis of Results of Operations and Financial Condition.............................................. 11-22 ITEM 3 - Quantitative and Qualitative Disclosures about Market Risk... 22 ITEM 4 - Controls and Procedures...................................... 22 PART II - OTHER INFORMATION............................................. 24 SIGNATURES.............................................................. 26 Index to Exhibits....................................................... 27 CERTIFICATIONS.......................................................... 28-31 2 Item 1 - Financial Statements Part I - Financial Information Fidelity Federal Bancorp And Subsidiaries Condensed Consolidated Balance Sheets (In thousands except share data)
June 30, December 31, 2004 2003 --------- --------- (Unaudited) Assets Cash and due from banks $ 1,656 $ 1,705 Interest-bearing demand deposits 1,163 1,263 --------- --------- Cash and cash equivalents 2,819 2,968 Investment securities available for sale 62,376 52,208 Loans, net of allowance for loan losses of $699 and $737 (Also includes loans to related parties, net of allowance for loan losses of $371 and $394) 107,104 100,437 Premises and equipment 4,529 4,620 Federal Home Loan Bank of Indianapolis stock 3,542 3,466 Deferred income tax 6,441 6,093 Foreclosed assets held for sale 110 30 Interest receivable and other assets 5,836 5,568 --------- --------- Total assets $ 192,757 $ 175,390 ========= ========= Liabilities Deposits: Non-interest bearing (includes related party deposits of $728 and $854) $ 6,119 $ 6,903 Interest bearing 114,282 113,777 --------- --------- Total deposits 120,401 120,680 Federal funds purchased 8,000 0 Federal Home Loan Bank advances 39,900 31,550 Borrowings (includes borrowings from a related party of $0 and $1,000) 7,367 8,077 Other liabilities 1,511 1,716 --------- --------- Total liabilities 177,179 162,023 --------- --------- Commitments and Contingencies -- -- Stockholders' Equity Preferred stock, no par or stated value Authorized and unissued--5,000,000 shares Common stock, $1 stated value - Authorized--15,000,000 shares Issued and outstanding--10,999,871 and 9,618,658 shares 11,000 9,619 Additional paid-in capital 17,728 16,634 Stock warrants 261 261 Retained earnings (12,763) (12,938) Accumulated other comprehensive income (648) (209) --------- --------- Total stockholders' equity 15,578 13,367 --------- --------- Total liabilities and stockholders' equity $ 192,757 $ 175,390 ========= =========
See notes to condensed consolidated financial statements. 3 FIDELITY FEDERAL BANCORP AND SUBSIDIARIES Condensed Consolidated Statements of Income (In Thousands, Except Share Data) (Unaudited)
Three Months Ended Six Months Ended June 30, June 30, 2004 2003 2004 2003 ------------ ------------ ------------ ------------ Interest Income Loans receivable $ 1,519 $ 1,181 $ 3,008 $ 2,360 Investment securities--taxable 492 364 997 689 Loans held for sale -- -- -- 39 Deposits with financial institutions 4 16 7 38 Other dividend income 35 35 79 73 ------------ ------------ ------------ ------------ Total interest income 2,050 1,596 4,091 3,199 ------------ ------------ ------------ ------------ Interest Expense Deposits 643 744 1,289 1,633 Federal funds purchased 17 -- 26 -- Federal Home Loan Bank advances 187 59 372 81 Borrowings 130 177 271 425 ------------ ------------ ------------ ------------ Total interest expense 977 980 1,958 2,139 ------------ ------------ ------------ ------------ Net Interest Income 1,073 616 2,133 1,060 Provision for loan losses 39 (18) 209 (122) ------------ ------------ ------------ ------------ Net Interest Income After Provision for Loan Losses 1,034 634 1,924 1,182 ------------ ------------ ------------ ------------ Other Income Service charges on deposit accounts 120 113 230 219 Net gains on loan sales 108 225 199 483 Net gains on sales of securities available for sale -- -- 47 320 Letter of credit fees 123 121 246 242 Servicing fees on loans sold 90 74 167 137 Income from interest only strip 17 54 36 114 Dealer interest recovery 52 79 103 162 Gain on sale of real estate owned -- 305 -- 317 Other income 149 135 333 331 ------------ ------------ ------------ ------------ Total non-interest income 659 1,106 1,361 2,325 ------------ ------------ ------------ ------------ Other Expenses Salaries and employee benefits 792 844 1,599 1,724 Occupancy 86 83 178 175 Equipment 95 99 190 199 Data processing 135 115 256 215 Deposit insurance 14 12 27 26 Legal and professional 66 64 124 115 Advertising 53 44 111 89 Promotions 35 47 64 102 Printing, postage, and office supplies expense 35 49 62 105 Insurance 46 73 104 135 Letter of credit valuation provision -- (170) -- (170) Correspondent bank charges 36 37 73 71 Other 209 361 401 634 ------------ ------------ ------------ ------------ Total non-interest expense 1,602 1,658 3,189 3,420 ------------ ------------ ------------ ------------ Income Before Income Tax 91 82 96 87 Income tax benefit (19) (21) (79) (71) ------------ ------------ ------------ ------------ Net Income $ 110 $ 103 $ 175 $ 158 ============ ============ ============ ============ Basic Earnings per Share $ 0.01 $ 0.01 $ 0.02 $ 0.02 Diluted Earnings per Share $ 0.01 $ 0.01 $ 0.02 $ 0.02 Average Common and Common Equivalent shares outstanding 10,335,466 9,618,659 9,979,430 8,234,129
See notes to condensed consolidated financial statements 4 FIDELITY FEDERAL BANCORP AND SUBSIDIARIES Condensed Consolidated Statements of Changes in Stockholders' Equity (In Thousands, Except Share Data)
Six Months Ended June 30, --------------------------------------------------- 2004 2003 --------- --------- Beginning Balance $13,367 $9,588 Comprehensive income (loss) Net income 175 158 Other comprehensive loss - net of tax (439) (152) --------- --------- Comprehensive income (loss) (264) 6 Issuance of stock 4,153 2,475 --------- --------- Balances, June 30 (unaudited) $15,578 $13,747 ========= =========
See notes to condensed consolidated financial statements. 5 Fidelity Federal Bancorp and Subsidiaries Condensed Consolidated Statements of Cash Flows (In thousands) (Unaudited)
Six Months Ended June 30, -------------------- 2004 2003 -------- -------- Operating Activities Net income $ 175 $ 158 Adjustments to reconcile net income to net cash provided (used) by operating activities Provision for loan losses 209 (122) Letter of credit valuation provision (170) Net gain on sales of securities available for sale (47) (320) Net gain on sale of loans (199) (483) Gain on sale of foreclosed assets (312) Depreciation and amortization 216 219 Mortgage loans originated for sale (5,582) (16,525) Proceeds from sale of mortgage loans 5,695 16,853 Consumer loan origination transferred to held for sale (14,230) (17,932) Proceeds from consumer loan sales 14,316 18,087 Changes in Interest payable and other liabilities (205) 382 Interest receivable and other assets (136) (615) Other (360) 47 -------- -------- Net cash used by operating activities (148) (733) -------- -------- Investing Activities Purchases of securities available for sale (23,222) (33,028) Proceeds from maturities of securities available for sale 10,199 8,966 Proceeds from sales of securities available for sale 2,555 12,098 Proceeds from the sale of foreclosed assets 2,666 Purchase of FHLB stock (76) (36) Net change in loans (7,168) (3,810) Purchase of premises and equipment (125) (40) -------- -------- Net cash used by investing activities (17,837) (13,184) -------- -------- Financing Activities Net change in Noninterest-bearing, interest-bearing demand and savings deposits (1,392) 454 Certificates of deposit 1,113 3,097 Net change in federal funds purchased 8,000 Proceeds from borrowings 2,465 Repayment of borrowings (2,175) (6,284) Repayment of borrowings to a related party (1,000) Proceeds from FHLB advances 64,500 14,000 Repayment of FHLB advances (56,150) Sale of stock 2,475 4,153 -------- -------- Net cash provided by financing activities 17,836 15,420 -------- -------- Net Change in Cash and Cash Equivalents (149) 1,503 Cash and Cash Equivalents, Beginning of Period 2,968 3,823 -------- -------- Cash and Cash Equivalents, End of Period $ 2,819 $ 5,326 ======== ======== Additional Cash Flows Information Interest paid $ 1,896 $ 2,127 Real estate acquired in settlement of loans 291 657
See notes to condensed consolidated financial statements 6 Fidelity Federal Bancorp and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) o Accounting Policies The significant accounting policies followed by Fidelity Federal Bancorp ("Fidelity") and its wholly owned subsidiaries for interim financial reporting are consistent with the accounting policies followed for annual financial reporting. All adjustments which are necessary for a fair presentation of the results for the periods reported, consist only of normal recurring adjustments, and have been included in the accompanying unaudited condensed consolidated financial statements. The results of operations for the six months ended June 30, 2004 are not necessarily indicative of those expected for the remainder of the year. The condensed consolidated balance sheet at December 31, 2003 has been derived from the audited financial statements. Certain information and note disclosures normally included in the company's annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the company's Form 10-K annual report for 2003 filed with the Securities and Exchange Commission. o Company Subsidiaries Fidelity's savings bank subsidiary, United Fidelity Bank, fsb ("United"), was organized in 1914, is a federally-chartered stock savings bank located in Evansville, Indiana, and is regulated by the Office of Thrift Supervision ("OTS"). Fidelity, through its savings bank subsidiary, is engaged in the business of obtaining funds in the form of savings deposits and other borrowings and investing such funds in consumer, commercial, and mortgage loans, and in investment and money market securities. o Stockholders' Equity In March 2004, Fidelity filed a registration statement for a stockholder rights offering with the Securities and Exchange Commission. A total of 1.4 million shares were registered in this filing. For every 6.9 shares of Fidelity held on the record date, shareholders could subscribe to purchase one share of Fidelity at $1.81. The rights offering was completed on May 14, 2004. Fidelity raised $2.5 million net of cost associated with the offering. The shares purchased by shareholders with these funds were issued in May 2004. In April 2003, Fidelity issued 2.8 million shares of common stock for $4.0 million in cash through the exercise of an option held by Pedcor Financial, LLC ("Pedcor Financial") and affiliates. The exercise price per share was $1.44, and was determined under a formula included in the shareholder-approved stock purchase agreement effective May 19, 2000. The proceeds of the option exercise were utilized to reduce Fidelity's long-term debt outstanding. The remaining options expired on May 19, 2003. Pedcor Financial is a member of a group of companies which is controlled by Bruce A. Cordingley, Gerald K. Pedigo and Phillip J. Stoffregen directors of Fidelity. Following the option exercise in April 2003, Pedcor Financial and group beneficially owned approximately 67.75% of Fidelity's issued and outstanding stock. o Cash Dividend Fidelity's dividend policy is to pay cash or distribute stock dividends when its Board of Directors deems it to be appropriate, taking into account Fidelity's financial condition and results of operations, economic and market conditions, industry standards, and other factors, including regulatory capital requirements of its savings bank subsidiary. Fidelity is not subject to any regulatory restrictions on payments to its stockholders. United has entered into a Supervisory Agreement ("Agreement") with the Office of Thrift Supervision ("OTS"). One of the 7 provisions of the Agreement requires prior approval from OTS for payments of dividends from United to Fidelity. Fidelity is uncertain when it will pay dividends in the future and the amount of such dividends, if any. o Other Restrictions United entered into a supervisory agreement with the OTS on February 3, 1999. The supervisory agreement, as amended on November 18, 2003, currently requires United to: o Refrain from paying dividends without OTS approval. o Continue to comply with its strategic plan, including its capital targets, as noted in the "Regulatory Capital" note, consistent with United's business plan as approved by the OTS. o Refrain from engaging in any transaction with or distribution of funds to Fidelity or its subsidiaries or selling any assets to an affiliate without OTS approval. o Not engage in new activities not included in its strategic plan without OTS approval. United believes that it currently is in compliance with all provisions of the supervisory agreement. o Earnings per share Earnings per share (EPS) were computed as follows:
Three Months Ended June 30, 2004 ---------------------------------------------- Income Weighted-Average Per Share Shares Amount ---------------------------------------------- Net income $ 110 ===== Basic earnings per share Income available to common stockholders $ 110 10,332,032 $ 0.01 ====== Effect of dilutive securities Stock options - 3,434 ----- ---------- Diluted earnings per share Income available to common stockholders and assumed conversions $ 110 10,335,466 $ 0.01 ====== ========== ====== Three Months Ended June 30, 2003 ---------------------------------------------- Income Weighted-Average Per Share Shares Amount ---------------------------------------------- Net income $ 103 ===== Basic earnings per share Income available to common stockholders $ 103 9,618,659 $0.01 ===== Effect of dilutive securities Stock options - - ----- --------- Diluted earnings per share Income available to common stockholders and assumed conversions $ 103 9,618,659 $0.01 ===== ========= =====
8 Earnings per share (EPS) were computed as follows:
Six Months Ended June 30, 2004 ---------------------------------------------- Income Weighted-Average Per Share Shares Amount ---------------------------------------------- Net income $ 175 ===== Basic earnings per share Income available to common stockholders $ 175 9,975,345 $ 0.02 ====== Effect of dilutive securities Stock options - 4,085 ----- --------- Diluted earnings per share Income available to common stockholders and assumed conversions $ 175 9,979,430 $ 0.02 ===== ========= ====== Six Months Ended June 30, 2003 ---------------------------------------------- Income Weighted-Average Per Share Shares Amount ---------------------------------------------- Net income $ 158 ===== Basic earnings per share Income available to common stockholders $ 158 8,234,129 $0.02 ===== Effect of dilutive securities Stock options - - ----- --------- Diluted earnings per share Income available to common stockholders and assumed conversions $ 158 8,234,129 $0.02 ===== ========= =====
Options to purchase 307,696 shares of common stock at prices ranging from $2.88 to $11.81 per share as well as stock warrants representing the right to purchase 509,471 share of common stock at prices ranging from $3.00 to $8.93 per share were outstanding at June 30, 2004, but were not included in the computation of diluted EPS because the options' exercise price was greater than the average market price of the common shares. o Automobile Loan Securitization United completed an automobile loan securitization transaction in 2002. A summary of the components of managed loans, which represents both owned and securitized loans, follows. The automobile loans presented represent the managed portfolio of indirect prime automobile loans. Loans Past Principal Due Over As of June 30, 2004 Balance 30 Days ----------------------------------------------------------------------------- Total managed automobile loans $ 96,486 $714 Less: Automobile loans securitized (16,705) (278) Automobile loans serviced for others (38,911) (146) ---------------------------- Total automobile loans held in portfolio $40,870 $290 ============================ United estimates the fair value of the retained interest at the date of the transfer and during the period of the transaction based on a discounted cash flow analysis. United receives annual servicing fees based on the loan 9 balances outstanding, the rights to future cash flows arising after investors in the securitization trust have received their contractual return and after certain administrative costs of operating the trust. These cash flows are estimated over the life of the loans using prepayment, default and interest rate assumptions that market participants would use for financial instruments subject to similar levels of prepayment, credit and interest rate risk. A summary of the fair values of the interest-only strip and servicing asset retained, key economic assumptions used to arrive at the fair values, and the sensitivity of the June 30, 2004 fair values to immediate 10% and 20% adverse changes in those assumptions follows. Actual credit losses experienced through year-end 2003 and thus far in 2004 on the pool of automobile loans securitized have been consistent with initial projections. As such, the expected static pool loss assumption would perform consistently with that disclosed in the sensitivity analysis. The sensitivities are hypothetical. Changes in fair value may not be linear. Also, the effect of a variation in a particular assumption on the fair value of the retained interests is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments and increased credit losses), which might either magnify or counteract the sensitivities.
Weighted- Monthly Expected Average Prepayment Cumulative Annual Weighted- Fair Life Speed Credit Discount Average Value (in months) (% ABS) Losses Rate Coupon --------------------------------------------------------------------------------- Interest-only strip As of the date of securitization $ 2,707 39 1.50% 1.50% 15.0% 9.09% As of June 30, 2004 1,258 12 1.19 1.50 15.0 8.49 Decline in fair value of 10% adverse change $ 9 $ 8 $ 15 Decline in fair value of 20% adverse change 27 15 30 Servicing asset As of the date of securitization 362 39 1.50% 1.50% 15.0% As of June 30, 2004 * 24 15 1.19 1.50 15.0 Decline in fair value of 10% adverse change $ 7 $ 0 $ 0 Decline in fair value of 20% adverse change 15 0 1
*Carrying value of the servicing asset approximated fair value at June 30, 2004. o Stock Option Stock options and Fidelity's stock-based incentive compensation plans are discussed more fully in the notes to Fidelity's December 31, 2003 audited financial statements contained in Fidelity's annual report. Fidelity accounts for these plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price that was equal to or greater than the market value of the underlying common stock on the grant date. The following table illustrates the effect on net income and earnings per share if Fidelity had applied the fair value provisions of FASB statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation. 10
Three Months Ended Six Months Ended June 30 June 30 ---------------------------------------------------------- 2004 2003 2004 2003 ---------------------------------------------------------- Net income as reported $ 110 $ 103 $ 175 $ 158 Less: Total stock-based compensation cost determined under the fair value based method, net of income (4) (8) (7) (16) taxes ---------------------------------------------------------- Pro forma net income $ 106 $ 95 $ 168 $ 142 ========================================================== Basic earnings per share - as reported $0.01 $0.01 $0.02 $0.02 Basic earnings per share - pro forma $0.01 $0.01 $0.02 $0.02 Diluted earnings per share - as reported $0.01 $0.01 $0.02 $0.02 Diluted earnings per share - pro forma $0.01 $0.01 $0.02 $0.02
o Reclassifications Reclassifications of certain amounts from the condensed consolidated income statements for the three and six month periods ended June 30, 2003 have been made to conform to the presentation of the three and six month periods ended June 30, 2004. These reclassifications had no effect on net income. Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations Management's discussion and analysis of financial condition and results of operations is intended to assist in understanding the financial condition and results of operations of Fidelity. The information contained in this section should be read in conjunction with the consolidated financial statements and accompanying notes contained in this report. Portions of this Management's Discussion and Analysis, as well as the notes to the consolidated financial statements contain certain forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995), which reflect management's current beliefs and expectations and are intended to benefit the reader. These forward-looking statements are inherently subject to various risks and uncertainties which may cause actual results to differ materially from expected results. Such risks and uncertainties include, but are not limited to, economic conditions, generally and in the market areas of the Company, increased competition in the financial services industry, actions by the Federal Reserve Board, changes in interest rates and governmental regulation and legislation. Comparison of Financial Condition at June 30, 2004 and December 31, 2003 Total assets at June 30, 2004 were $192.8 million, an increase of $17.4 million from $175.4 million at December 31, 2003. The increase in total assets was attributable to an $10.2 million increase in investment securities and $6.7 million increase in net loans. At June 30, 2004, the investment portfolio represented 32.4% of Fidelity's assets, compared to 29.8% at December 31, 2003 and is managed in a manner designed to meet the Board's investment policy objectives. Fidelity expects moderate investment activity in 2004, which includes new purchases to reinvest investments in maturities and paydowns in the mortgage-back portfolio. At June 30, 2004, the entire investment portfolio was classified as available for sale. The net unrealized loss at June 30, 2004, which is included as a component of stockholders' equity, was $648,000 and was comprised of gross unrealized gains of $31,000 and gross unrealized losses of $1.1 million and tax benefit of $396,000. The increase in unrealized loss from December 31, 2003 was caused primarily by market interest rate changes during the period. Net loans increased $6.7 million to $107.1 million at June 30, 2004. The increase is primarily attributable to a increase in commercial, commercial real estate and consumer loans. Total commercial real estate loans outstanding 11 have increased by $4.9 million, consumer loans have increased $3.5 million and total commercial and industrial loans have increased by approximately $1.5 million in 2004. Consumer loans increased by $3.5 million to $42.5 million at June 30, 2004. The portfolio is primarily composed of prime automobile loans generated through a network of automobile dealers in Indiana, Kentucky, Illinois and Missouri. In connection with United's strategic plan, United may increase its consumer loan portfolio up to 28% of total assets. At June 30, 2004, United's consumer loans to total assets was 22.4%. These increases were offset partially by a $3.6 million decrease in first mortgage loans. Fidelity continues to sell originated fixed-rated conventional mortgage loans, record the gain or loss at the time of sale and use the proceeds to fund future originations. Payments received during 2004 exceeded originations placed in the portfolio during 2004 resulting in a net decrease in first mortgage loans. Fidelity has no loans to foreign governments, foreign enterprises, foreign operations of domestic companies or highly leveraged transactions, nor any concentration to borrowers engaged in the same or similar industries that exceed ten percent of total loans. The allowance for loan losses decreased $38,000 to $699,000 at June 30, 2004 from $737,000 at December 31, 2003. During the first half of 2004 Fidelity provided an additional $323,000 in provision for loan losses which were offset by $323,000 in charge-offs for the first half of 2004. Recoveries of $76,000 were received during the first six months in addition to a $114,000 credit to the provision for consumer loans in connection with consumer loans transferred to held for sale which totaled $14.2 million during the first half of 2004. Fidelity completed consumer loan sales during the month the loans were identified for sale, therefore no consumer loans were identified as held for sale at June 30, 2004. Net charge offs for the quarter totaled $81,000 and were associated with consumer loans. An additional $63,000 charge-off was recorded in the first quarter of 2004 on a problem commercial loan with a remaining outstanding balance of $170,000 at June 30, 2004. The allowance for loan losses represented 0.65% of total loans at June 30, 2004, compared to 0.73% at December 31, 2003. Relative to non-performing loans, the allowance for loan losses was 77.2% compared to 43.3% at December 31, 2003. Multifamily letters of credit, an off-balance sheet item, carry the same risk characteristics as conventional loans and totaled $27.0 million at June 30, 2004 compared to $27.8 million at December 31, 2003. The valuation allowance for letters of credit to total letters of credit totaled 1.1% at June 30, 2004 compared to 1.0% at December 31, 2003. The valuation allowance for letters of credit is included in other liabilities and totaled $300,000 at June 30, 2004. The allowance for loan losses and letters of credit to total loans and letters of credit at June 30, 2004 and December 31, 2003 was 0.74% and 0.80%, respectively. Management considers the allowance for loan losses and valuation allowance for letters of credit adequate to meet losses inherent in the loan and letter of credit portfolios at June 30, 2004. The following table sets forth an analysis of the allowance for loan losses for the six months ended June 30, 2004 and the year ended December 31, 2003: Six months ended Year ended June 30, December 31, 2004 2003 ----------- ------------ (dollars in thousands) Allowance for loan losses at beginning of period $ 737 $ 837 Provision for losses 323 492 Provision transferred to held for sale (114) (479) Loans charged off (323) (236) Recoveries on loans 76 123 ----------- ------------ Allowance for loan losses at end of period $ 699 $ 737 =========== ============ 12 Average deposits increased $15.3 million to $127.2 million at June 30, 2004 compared to $111.9 million at December 31, 2003. United utilizes retail, public, and brokered deposits to assist in asset growth. Average non-interest bearing accounts at June 30, 2004 increased $1.7 million over December 31, 2003. Fidelity also utilized its various federal fund lines of credit to assist in asset growth. At June 30, 2004, Fidelity's federal funds purchased totaled $8.0 million compared to none at December 31, 2003. At June 30, 2004, Fidelity's borrowings consisted of FHLB advances, senior notes and junior notes. Of the $47.3 million outstanding at June 30, 2004, $39.9 million were FHLB advances. FHLB advances increased by $8.4 million over December 31, 2003 to assist in funding investment and loan growth. During the first half of 2004, Fidelity utilized funds received from its debt and equity offerings that were completed during the quarter to reduce the amount outstanding on its line of credit by $275,000 in addition to paying off a $1.0 million unsecured note to a related party. The remaining $1.8 million in 10% senior subordinated notes due June 2005 were retired in the second quarter of 2004. Total stockholders' equity increased $2.2 million to $15.6 million at June 30, 2004. The increase was attributable to net income of $175,000, and the issuance of $2.5 million in stock in connection with the equity offering that was completed on May 18, 2004. These increases were reduced $439,000 due to the change in unrealized losses on investment securities available for sale. Non-Performing Assets Non-performing assets decreased $716,000 from December 31, 2003 to $1.0 million or 0.53% of total assets at June 30, 2004 compared to $1.7 million or 0.99% of total assets at December 31, 2003. The decrease is primarily due to one large residential loan that paid off during the first quarter of 2004 and a reduction in non-accrual consumer loans. The following table provides information on Fidelity's non-performing assets as of June 30, 2004 and December 31, 2003: June 30, December 31, 2004 2003 ---------------------------------------------------------------------------- (Dollars in Thousands) Non-accrual loans Real estate mortgage $ 134 $ 788 Home equity 200 127 Consumer 100 233 Commercial 204 267 ------ ------ Total non-accrual loans 638 1,415 90 days or more past due and accruing Consumer 37 54 Commercial 231 233 ------ ------ Total 90 days or more past due and accruing 268 287 Other real estate owned and repossessed assets 110 30 ------ ------ Total non-performing assets $1,016 $1,732 ====== ====== Ratio of non-performing assets to total assets 0.53% 0.99% ====== ====== Classified Assets Classified assets totaled $1.1 million at June 30, 2004 compared to $1.8 million at December 31, 2003. Total classified assets were 6.9% and 12.2% of Fidelity's capital and reserves at June 30, 2004 and December 31, 2003, respectively. In addition to the classified assets and letters of credit, there are other assets and letters of credit 13 totaling $3.5 million at June 30, 2004, compared to $6.2 million at December 31, 2003, for which management was closely monitoring the borrower's abilities to comply with payment terms. Capital Resources United is subject to various regulatory capital requirements administered by the federal banking agencies and is assigned to a capital category. The assigned category is largely determined by three ratios that are calculated according to the regulations: total risk adjusted capital, Tier I capital, and Tier I leverage ratios. The ratios are intended to measure capital relative to assets and credit risk associated with those assets and off balance sheet exposures of the entity. The capital category assigned to an entity can also be affected by qualitative judgments made by regulatory agencies about the risk inherent in the entity's activities that are not part of the calculated ratios. There are five capital categories defined in the regulations, ranging from well capitalized to critically undercapitalized. Classification of a bank in any of the undercapitalized categories can result in actions by regulators that could have a material effect on a bank's operations. At June 30, 2004 and December 31, 2003, United is categorized as well capitalized and met all subject capital adequacy requirements.
Tangible Core Tier 1 Risk-based Dollars in thousands Capital Capital Capital Capital ------------------------------------------ ------------ ---------- ----------- -------------- Regulatory capital $13,192 $13,287 $12,100 $17,066 Minimum capital requirement 2,813 7,505 4,929 9,858 ------------ --------- ----------- -------------- Excess capital $10,379 $5,782 $ 7,171 $7,208 ============ ========= =========== ============== Regulatory capital 7.03% 7.08% 9.82% 13.85% Required capital requirements 1.50% 4.00% 4.00% 8.00% ------------ --------- ----------- -------------- Excess over minimum 5.53% 3.08% 5.82% 5.85% ============ ========= =========== ============== Regulatory capital 7.03% 7.08% 9.82% 13.85% Strategic plan capital requirement N/A 6.25% 8.25% 11.00% ------------ --------- ----------- -------------- Excess over minimum 7.03% 0.83% 1.57% 2.85% ============ ========= =========== ==============
United continues to evaluate and pursue opportunities to improve its capital ratios. There are no specific targets for capital levels included in the Supervisory Agreement between United and the OTS, only a requirement that United include capital minimums within its strategic plan. The strategic plan established minimum capital ratios of 6.25% for core capital 8.25% for Tier I and 11.0% for risk-based capital. United exceeded these minimums at June 30, 2004. Liquidity The primary sources of funds from operations are principal and interest payments on loans, deposits from customers, and sales and maturities of investment securities. Fidelity's entire investment portfolio is classified as "available for sale" and totaled $62.4 million at June 30, 2004 and could be utilized to assist in liquidity management. In addition, United is authorized to borrow money from the Federal Home Loan Bank (FHLB) or draw on $15.0 million in secured lines of credit with other financial institutions. At June 30, 2004, United's gross borrowing capacity at the FHLB is $75.0 million with approximately $3.7 million available to draw upon based on current assets pledged. United had approximately $5.1 million available to draw on its lines of credit at June 30, 2004. During the first half of 2004, Fidelity completed a debt and equity rights offering that raised approximately $4.9 million. Approximately $1.0 million of these proceeds was used to redeem a portion of the 10% senior subordinated notes on April 20, 2004 with an additional $800,000 redeemed on May 7, 2004. Approximately $275,000 was used to paydown a line of credit and $1.0 million was used to pay off an unsecured note to a related party. An additional $1.0 million was infused into United for additional capital to support asset growth. Fidelity believes that the above actions will assist it in meeting its future liquidity needs. 14 Fidelity is not subject to any regulatory restrictions on the payment of dividends to its stockholders. However, United is restricted from paying any dividends to Fidelity without prior approval of the OTS under the terms of the Supervisory Agreement. Fidelity has a $500,000 line of credit and can draw on this line until the expiration in September 2004. At June 30, 2004, $0 was outstanding on the line of credit. Fidelity's liquidity position may be further improved by the potential issuance of additional stock, additional debt or equity financing, or dividends from United to Fidelity. Comparison of Operating Results for the Three Months Ended June 30, 2004 and 2003 Net income for the three months ended June 30, 2004 was $110,000 compared to net income of $103,000 for the three months ended June 30, 2003. This change was primarily attributable to an increase in net interest income and a reduction in non-interest expense partially offset by an increase in the provision for loan losses and reduction in non-interest income. Net Interest Income The following table summarizes Fidelity's average interest-earning assets and average interest-bearing liabilities with the accompanying average rates for the first three months of 2004 and 2003:
Three months ended Average yield for June 30, Three months ended (dollars in thousands) June 30, -------------------------------- ----------------------------- 2004 2003 2004 2003 --------------- ------------ ------------ ------------ Interest-earning assets $178,380 $124,287 4.62% 5.15% Interest-bearing liabilities 170,525 122,457 2.30 3.21 -------- -------- ---- ---- Net interest bearing assets (liabilities) $ 7,855 $ 1,830 ======== ======== Net interest spread 2.32% 1.94% ===== ===== Net interest margin 2.42% 1.99% ===== =====
Net interest income for the quarter ended June 30, 2004 was $1.1 million compared to $616,000 earned during the same period in 2003. Total interest income increased $454,000 to $2.1 million for the quarter ended June 30, 2004 from $1.6 million for the same period in 2003. The increase in interest income was primarily attributable to an increase in average consumer loans of $23.5 million. The remaining increase in interest income from loans was a result of increased outstandings in commercial and commercial real estate loans of $8.4 million and a $5.3 million increase in real estate mortgage loans. Average investment securities increased by $22.9 million which attributed to additional interest income but was partially offset by a decrease in yield on the investment portfolio resulting in a net increase in interest income of $128,000 for the quarter ended June 30, 2004 when compared to the same period in 2003. Total interest expense decreased by $3,000 for the three months ended June 30, 2004 compared to the same period in 2003. Interest expense on deposits decreased by $101,000 due to a combination of an increase in outstandings in certificates of deposits offset by a decrease in their average rate. This decrease in expense was partially offset by an increase in outstandings for FHLB advances and borrowings that resulted in additional expense of $97,000 for the quarter ended June 30, 2004. Provision for Loan Losses and Letters of Credit Valuation Provision The provision for loan losses for the three months ended June 30, 2004 was $39,000 compared to a $18,000 credit for the three months ended June 30, 2003. Additional loan loss provisions were made during the second quarter of 2004 based on loan growth, delinquency and charge-off trends. 15 A provision for loan losses of $118,000 for the second quarter of 2004 was recognized but was partially offset by a $79,000 reduction due to a consumer loan sale, resulting in a net provision of $39,000. During the second quarter of 2003 the net $86,000 provision for loan losses was offset by a $104,000 reduction due to a consumer loan sale for a net credit to the provision for loan losses for the quarter of $18,000. Fidelity makes provisions for loan losses in amounts estimated to be sufficient to maintain the allowance for loan losses at a level considered necessary by management to absorb losses in the loan portfolios. Specific reserves are assigned to certain credits. The reserves are determined by management's evaluation of those credits, which include evaluations of borrower's ability to repay outstanding debt, as well as the value of supporting collateral. The results of internal loan reviews, previous regulatory reviews, and past events assist Fidelity in making that evaluation. The independent support for the allowance for loan losses and letter of credit valuation reserve includes documentation that supports the amount of recorded reserves for these credits. General reserves for loans and letters of credit not specifically reserved are also determined. Fidelity computes general reserves for the commercial, commercial mortgage, residential mortgage and consumer loan portfolios by utilizing historical information and information currently available about the loans within those portfolios that provides information as to the likelihood of loss. The potential effect of current economic conditions is also considered with respect to establishing general reserve amounts. United expects to increase the allowance for loan losses if loan growth and losses meets 2004 targets. As a result, the provision for loan losses may also increase on a quarter to quarter comparison in 2004. Non-interest income Non-interest income for the three months ended June 30, 2004 was $659,000 compared to $1.1 million for the same period in 2003, a decrease of $447,000. Net gains on loan sales decreased $117,000 from the prior year due to a decrease in volume of automobile and mortgage loans sold. Income of $17,000 was recognized on the retained interests in securitized assets compared to $54,000 in 2003. The sale of two foreclosed properties in the second quarter of 2003 generated gains totaling $305,000. There were no sales of foreclosed properties in the second quarter of 2004. Non-interest expense Non-interest expense decreased $56,000 to $1.6 million for the three months ended June 30, 2004 compared to $1.7 million for the same period in 2003. Excluding a $170,000 credit to the letter of credit valuation provision, non-interest expense would have decreased by $226,000. Salaries and employee benefits decreased $52,000 from the quarter ended June 30, 2003 due to a reduction in full-time equivalent employees. Data processing expense increased $20,000 over the prior year due to increased volume of mortgage and consumer loans serviced, and the introduction of internet banking late in 2003. Bond issuance expense decreased $45,000 from 2003 due to the retirement of subordinated notes in the prior year and the deferred cost associated with the retired debt. Insurance decreased $27,000 for the quarter ended June 30, 2004 when compared to the same period in 2003. Income tax benefit The income tax benefit was $19,000 for the three months ending June 30, 2004 compared to $21,000 for the same period last year. Included in the 2004 benefit are tax credits of $55,000. These credits are received from Fidelity's remaining investments in limited partnership interests in affordable housing properties and are a component of the overall return on these investments. 16 Comparison of Operating Results for the Six Months Ended June 30, 2004 and 2003 Net income for the six months ended June 30, 2004 was $175,000 compared to net income of $158,000 for the six months ended June 30, 2003. This change was primarily attributable to an increase in net interest income and a reduction in non-interest expense partially offset by an increase in the provision for loan losses and reduction in non-interest income. Net Interest Income The following table summarizes Fidelity's average interest-earning assets and average interest-bearing liabilities with the accompanying average rates for the first six months of 2004 and 2003:
Six months ended Average yield for June 30, Six months ended (dollars in thousands) June 30, -------------------------------- ----------------------------- 2004 2003 2004 2003 --------------- ------------ ------------ ------------ Interest-earning assets $173,193 $120,212 4.75% 5.37% Interest-bearing liabilities 166,909 120,756 2.36 3.57 -------- -------- ---- ---- Net interest bearing assets (liabilities) $ 6,284 $ (544) ======== ======== Net interest spread 2.39% 1.80% ===== ===== Net interest margin 2.48% 1.78% ===== =====
Net interest income for the first six months ended June 30, 2004 was $2.1 million compared to $1.1 million earned during the first six months ended June 30, 2003. Total interest income increased $892,000 to $4.1 million for the six months ended June 30, 2004 from $3.2 million for the same period in 2003. The increase in interest income was primarily attributable to an increase in average consumer loans of $23.5 million. The yield on consumer loans decreased from 7.49% at June 30, 2003 to 5.81% at June 30, 2004. This decrease in rate which impacted the margin negatively by $369,000 was offset by the increase in average balances which resulted in an increase in consumer loan income of $880,000 for a net effect of $511,000. The remaining increase in interest income from loans was a result of increased outstandings in commercial and commercial real estate loans. Average investment securities increased by $22.9 million which attributed to additional interest income of $426,000. However this interest income was partially offset by a decrease in yield on the investment portfolio resulting in $117,000 decrease in interest income for a net effect of additional interest income of $309,000. Total interest expense decreased by $181,000 for the six months ended June 30, 2004 compared to the same period in 2003. This decrease was due to a combination of a decrease in certificates of deposits and borrowings and their average rate of $681,000 and $207,000, respectively. This decrease in expense was partially offset by an increase in outstandings for certificates of deposit and borrowings (including FHLB advances) resulting in additional expense of $337,000 and $370,000, respectively. 17 The following table sets forth the details of the rate and volume change for the first six months of 2004 compared to the same period in 2003.
Six Months Ended June 30, 2004 vs 2003 Increase (Decrease) Due to change in ----------------------------------------------- Volume Rate Total ------------- ----------- --------------- Interest Income: Loans and mortgage-backed securities $ 1,574 $ (618) $ 956 Other interest-earning assets (47) (17) (64) ------- ------ ------- Total interest-earning assets 1,527 (635) 892 Interest Expense: Deposits 337 (681) (344) FHLB advances and other borrowings 370 (207) 163 ------- ------ ------- Total interest-bearing liabilities 707 (888) (181) ------- ------ ------- Change in net interest income $ 820 $ 253 $ 1,073 ======= ====== =======
Provision for Loan Losses and Letters of Credit Valuation Provision The provision for loan losses for the six months ended June 30, 2004 was $209,000 compared to a $122,000 credit for the six months ended June 30, 2003. Additional loan loss provisions were made during the first six months of 2004 based on loan growth, delinquency and charge-off trends. A provision of $323,000 for the first half of 2004 was recognized but partially offset by a $114,000 reduction due to a consumer loan sale in 2004, resulting in a net provision of $209,000. During the first half of 2003 the $161,000 provision was offset by a $283,000 reduction due to a consumer loan sale for a net credit of $122,000 for 2003. Fidelity makes provisions for loan losses in amounts estimated to be sufficient to maintain the allowance for loan losses at a level considered necessary by management to absorb losses in the loan portfolios. Specific reserves are assigned to certain credits. The reserves are determined by management's evaluation of those credits, which include evaluations of borrower's ability to repay outstanding debt, as well as the value of supporting collateral. The results of internal loan reviews, previous regulatory reviews, and past events assist Fidelity in making that evaluation. The independent support for the allowance for loan losses and letter of credit valuation reserve includes documentation that supports the amount of recorded reserves for these credits. General reserves for loans and letters of credit not specifically reserved are also determined. Fidelity computes general reserves for the commercial, commercial mortgage, residential mortgage and consumer loan portfolios by utilizing historical information and information currently available about the loans within those portfolios that provides information as to the likelihood of loss. The potential effect of current economic conditions is also considered with respect to establishing general reserve amounts. United expects to increase the allowance for loan losses if loan growth and losses meets 2004 targets. As a result, the provision for loan losses may also increase on a quarter to quarter comparison in 2004. Non-interest income Non-interest income for the six months ended June 30, 2004 was $1.4 million compared to $2.3 million for the same period in 2003, a decrease of $964,000. Net gains on loan sales decreased $284,000 from the prior year due to a decrease in volume of automobile and mortgage loans sold. A $320,000 gain on the sale of available for sale investments was recognized during the first half of 2003 compared to $47,000 in 2004 for the same time period. Increased prepayment speeds, remaining premiums, and pricing made it advantageous to sell the securities for a gain in 2003. Income of $36,000 was recognized on the retained interests in securitized assets compared to $114,000 in 2003. An increase in early payoffs on automobile loans due to the historically low interest rate environment in 2003 resulted in the 18 repayment of $162,000 in interest previously written off compared to $103,000 for the same period in 2004. The sale of two foreclosed properties generated gains totaling $317,000 during the first half of 2003 compared to none in 2004. Included in other income in 2003 were non-recurring items which Fidelity received during 2003 totaling approximately $125,000 from Fidelity's active participation in affordable housing activities, which ended late in 2002. This decrease in the current year was partially offset in 2004 by slower amortization of loan servicing rights which contributed to additional non-interest income of $106,000. Non-interest expense Non-interest expense decreased $231,000 to $3.2 million for the six months ended June 30, 2004 compared to $3.4 million for the same period in 2003. Excluding a $170,000 credit to the letter of credit provision, non-interest expense would have decreased by $401,000. Salaries and employee benefits decreased $125,000 from the first six months ended June 30, 2003 due to a reduction in full-time equivalent employees. Data processing expense increased $41,000 over the prior year due to increased volume of mortgage and consumer loans serviced, and the introduction of internet banking later in 2003. Promotion expense decreased $38,000 from 2003 due primarily to a decrease in automobile originations in the current year. Advertising increased $22,000 over 2003. Printing, postage and office supplies decreased $43,000 from 2003 due to cost cutting procedures implemented in 2004. Professional liability insurance decreased $31,000 from the prior year due to market rate decreases. Bond issuance expense decreased $54,000 from 2003 due to the retirement of subordinated notes in 2003 and the deferred cost associate with the retired debt. Credit bureau expense decreased $13,000 from the prior year due to lower automobile volume. Income tax benefit The income tax benefit was $79,000 for the six months ending June 30, 2004 compared to $71,000 for the same period last year. Included in the 2004 benefit are tax credits of $111,000. These credits are received from Fidelity's remaining investments in limited partnership interests in affordable housing properties and are a component of the overall return on these investments. Consideration of the need for a valuation allowance for the deferred tax asset was made at June 30, 2004 after projecting the reversal of the deferred items. These analyses were based on projected operating income in future years, action plans developed and partially implemented included in Fidelity's business plan and cost reductions. These analyses showed that not all carryforwards would be utilized within the carryforward periods (federal and state) and a valuation allowance would be necessary. The analyses assume that Fidelity will execute approximately 50% of the initiatives included within its current business plan and then achieve 10% growth in annual earnings thereafter. The conservative level of earnings contemplated by these analyses, if achieved, will constitute for the majority of the carryforward periods, earnings levels that are below other thrift holding companies included within Fidelity's peer group. Due to the level of projected profitability for 2002 being less than originally anticipated, Fidelity established a valuation allowance of $600,000 at December 31, 2002. Fidelity considers the current valuation allowance adequate at June 30, 2004 based upon the results of the above analysis and assumptions, but cannot assure that future income will be enough to support the current level of deferred taxes. The assumptions used to help consider the need for a valuation allowance for the deferred tax asset are subject to certain risks and uncertainties that could impact the final determination regarding the amount of the valuation allowance. These risks include the failure to implement the business plan targets for increased revenues, cost reductions, the potential loss of key employees, ability to maintain projected interest rate margins, and the potential disruption of activities in key income-producing areas. Sarbanes-Oxley Act On July 30, 2002, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act"). The Sarbanes-Oxley Act implements a broad range of corporate governance and accounting measures for public companies designed to promote honesty and transparency in corporate America and better protect investors from the type of corporate and accounting scandals that have occurred during the past years. We anticipate that 19 we will incur additional expense in complying with the provisions of the Sarbanes-Oxley Act and the resulting regulations. The financial impact on our results of operations or financial condition is not yet determinable. Fidelity's Board of Directors has discussed the desirability of taking steps to delist its shares of common stock from NASDAQ and to terminate its reporting obligations under the Securities Exchange Act of 1934. At this time, the Board has come to no conclusions regarding this matter and is not able to predict when it may do so. The Board is currently reviewing the additional costs expected to be incurred in connection with new requirements imposed by the Sarbanes-Oxley Act. Application of Critical Accounting Policies Fidelity's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and reporting practices followed within the banking industry. The application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Allowance for Loan Losses: Fidelity maintains a reserve to absorb probable loan losses inherent in the portfolio. The reserve for credit losses is maintained at a level Fidelity considers to be adequate to absorb probable loan losses inherent in the portfolio and is based on ongoing quarterly assessments and evaluations of the collectibility and historical loss experience of loans. Credit losses are charged and recoveries are credited to the reserve. Provisions for credit losses are based on Fidelity's review of the historical credit loss experience and such factors that, in management's judgment, deserve consideration under existing economic conditions in estimating probable credit losses. In determining the appropriate level of reserves, Fidelity estimates losses using a range derived from "base" and "conservative" estimates. Fidelity's methodology for assessing the appropriate reserve level consists of several key elements, as discussed below. Fidelity's strategy for credit risk management includes a combination of conservative exposure limits significantly below legal lending limits, and conservative underwriting, documentation and collection standards. The strategy also emphasizes diversification on a geographic, industry and customer level, regular credit examinations and quarterly management reviews of large credit exposures and loans experiencing deterioration of credit quality. Larger commercial loans that exhibit probable or observed credit weaknesses are subject to individual review. Where appropriate, reserves are allocated to individual loans based on management's estimate of the borrower's ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to Fidelity. Included in the review of individual loans are those that are impaired as provided in SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." Any reserves for impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or fair value of the underlying collateral. Fidelity evaluates the collectibility of both principal and interest when assessing the need for a loss accrual. Historical loss rates are applied to other commercial loans not subject to specific reserve allocations. Homogenous loans, such as consumer installment and residential mortgage loans, are not individually risk graded. Rather, standard credit scoring systems and delinquency monitoring are used to assess credit risks. Reserves are established for each pool of loans based on the expected net charge-offs for one year. Factors considered in establishing loss rates include expected future losses, historical loss rate, and adjustments in loan underwriting by category. Historical loss rates for commercial and consumer loans may be adjusted for significant factors that, in management's judgment, reflect the impact of any current conditions on loss recognition. Factors that management consider in the analysis include the effects of the national and local economies, trends in the nature and volume of loans (delinquencies, charge-offs and nonaccrual loans), changes in mix, credit score migration comparisons, asset quality trends, risk management and loan administration, changes in the internal lending policies and credit standards, collection practices and examination results from bank regulatory agencies and Fidelity's external credit examiners. An unallocated reserve is maintained to recognize the imprecision in estimating and measuring loss when evaluating reserves for individual loans or pools of loans. Reserves on individual loans and historical loss rates are reviewed 20 quarterly and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience. Fidelity, has not substantively changed any aspect of its overall approach in the determination of the reserve for loan and lease losses. There have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current year reserve for loan losses. Based on the procedures discussed above, management is of the opinion that the reserve of $699,000 was adequate, but not excessive, to absorb estimated credit losses associated with the loan portfolio at June 30, 2004. Valuation of Servicing Rights: When Fidelity sells loans through either securitizations or Freddie Mac, it may retain one or more subordinated tranches, servicing rights, interest-only strips, credit recourse, other residual interests, all of which are considered retained interests in the securitized or sold loans. Gain or loss on sale or securitization of the loans depends in part on the previous carrying amount of the financial assets sold or securitized, allocated between the assets sold and the retained interests based on their relative fair value at the date of sale or securitization. To obtain fair values, quoted market prices are used if available. If quotes are not available for retained interests, Fidelity calculates fair value based on the present value of future expected cash flows using both management's best estimates and third-party data sources for the key assumptions - credit losses, prepayment speeds, forward yield curves and discount rates commensurate with the risks involved. Gain or loss on sale or securitization of loans is reported as a component of other non-interest income in the Consolidated Statements of Income. Retained interests from securitized or sold loans, excluding servicing rights, are carried at fair value. Adjustments to fair value for retained interests are included in other non-interest expense in the Consolidated Statements of Income if the fair value has declined below the carrying amount and such decline has been determined to be other-than-temporary. See "Automobile Loan Securitization" in the footnotes to the consolidated financial statements for projected adverse changes in assumptions and the impact on the fair value. Servicing rights resulting from loan sales are amortized in proportion to and over the period of estimated net servicing revenues. Servicing rights are assessed for impairment quarterly, based on fair value, with temporary impairment recognized through a valuation allowance and permanent impairment recognized through a write-off of the servicing asset and related valuation reserve. Key economic assumptions used in measuring any potential impairment of the servicing rights include the prepayment speed of the underlying loans, the weighted-average life of the loan, the discount rate and the weighted-average default rate, as applicable. The primary risk of material changes to the value of the servicing rights resides in the potential volatility in the economic assumptions used, particularly the prepayment speed. Fidelity monitors this risk and adjusts its valuation allowance as necessary to adequately reserve for any probable impairment in the portfolio. For purposes of measuring impairment, the mortgage servicing rights are stratified based on financial asset type and interest rates. Fees received for servicing loans owned by investors are based on a percentage of the outstanding monthly principal balance of such loans and are included in non-interest income as loan payments are received. Costs of servicing loans are charged to expense as incurred. See "Loan Servicing" in the footnotes to the consolidated financial statements in Fidelity's 2003 Annual Report. Income Taxes: Fidelity accounts for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases. Such differences can relate to differences in accounting for credit losses, deprecation timing differences, unrealized gains and losses on investment securities, deferred compensation and leases, which are treated as operating leases for tax purposes and loans for financial statement purposes. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The determination of current and deferred income taxes is based on complex analyses of many factors including interpretation of Federal and state income tax laws, the difference between tax and financial reporting basis of assets and liabilities (temporary differences), estimates of amounts due or owed, the timing of reversals of temporary differences and current financial accounting interpretations used in determining the current and deferred income tax liabilities. 21 Fidelity has a net deferred tax asset of $6.4 million at June 30, 2004. The realization of the recorded deferred tax assets ultimately rests upon Fidelity's ability to generate taxable income to utilize the net operating loss carryforwards and low income housing tax credits that make up the majority of the recorded deferred tax asset. To determine that it is more likely than not that these carryforwards and tax credits will be utilized prior to their expiration, management utilizes a model that projects the utilization of the carryforwards and credits based upon the estimated future taxable income of Fidelity. The most significant assumption used in the model is pre-tax income estimated by management. The amount used for pre-tax income for 2004, 2005 and 2006 is estimated based on a percentage of the budgeted income in United's most recent strategic plan as approved by the OTS. Amounts used for pre-tax income for 2007 and into the future assumes 10% growth in earnings. Fidelity established a $600,000 valuation allowance at December 31, 2002. Additional details on Fidelity's deferred tax asset and model assumptions may be found under the heading "Income Tax" in the notes to the consolidated financial statements and under the heading "Income Tax Expense (Benefit)" in the Management Discussion and Analysis in Fidelity's 2003 Annual report. Additional accounting policies followed by Fidelity and United are presented in Note 1 to the financial statements in Fidelity's Annual Report. These policies, along with the disclosures presented in the other financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Item 3 - Asset/Liability Management--Quantitative and Qualitative Disclosures about Market Risk Fidelity is subject to interest rate risk to the degree that its interest bearing liabilities, primarily deposits with short and medium term maturities, mature or reprice at different rates than its interest-earning assets. Although having liabilities that mature or reprice less frequently will be beneficial in times of rising interest rates, such an asset/liability structure will result in lower net income during periods of declining interest rates, unless off-set by other factors. The OTS utilizes a model, the "Office of Thrift Supervision Net Portfolio Value" ("NPV") model, which uses a net market value methodology to measure the interest rate risk exposure of savings associations. Under this model, an institution's "normal" level of interest rate risk in the event of an assumed change in interest rates is a decrease in the institution's NPV in an amount not exceeding 2% of the present value of its assets. Savings associations with over $300 million in assets or less than 12% risk-based capital ratio are required to file the OTS Schedule CMR. Data from Schedule CMR is used by the OTS to calculate changes in NPV (and the related "normal" level of interest rate risk) based upon certain interest rate changes (discussed below). Associations which do not meet either of the filing requirements are not required to file OTS Schedule CMR, but may do so voluntarily. United voluntarily submits a CMR quarterly to the OTS. The data for June 30, 2004 is not required to be filed with the OTS until 45 days after quarter end, which coincides with the 10-Q filing. Management monitors its interest rate sensitivity during the quarter and will request the OTS to run scenarios on the NPV model to determine the change in interest rate sensitivity for management in an effort to assist management with its decision making regarding the maturities and pricing of its products. Although United has not yet submitted its CMR to the OTS for June 30, 2004, management anticipates there has been no material change from the information disclosed in Fidelity's annual report to shareholders at December 31, 2003. Item 4 - Controls and Procedures a. Evaluation of Disclosure Controls and Procedures. Fidelity's principal executive officer and principal financial officer have concluded that Fidelity's disclosure controls and procedures (as defined in Rule 13a-14(c) under the Securities Exchange Act of 1934, as amended), based on their evaluation of these controls and procedures by the end of the period covered by this Form 10-Q, are effective. 22 b. Changes in Internal Controls. There have been no significant changes in Fidelity's internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation thereof, including any corrective actions with regard to significant deficiencies and material weaknesses. c. Limitations on the Effectiveness of Controls. Fidelity's management, including its principal executive officer and principal financial officer, does not expect that Fidelity's disclosure controls and procedures and other internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can only be reasonable assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. d. CEO and CFO Certifications. Exhibits 31.1 and 31.2 contain the Certifications of Fidelity's principal executive officer and principal financial officer. The Certifications are required in accord with Section 302 of the Sarbanes-Oxley Act of 2002 (the "Section 302 Certifications"). This Item of this report which you are currently reading is the information concerning the Evaluation referred to in the Section 302 Certifications and this information should be read in conjunction with the Section 302 Certifications for a more complete understanding of the topics presented. 23 PART II -- OTHER INFORMATION ITEM 1 Legal Proceedings: ------------------ There are no material pending legal proceedings, other than ordinary routine litigation incidental to the Registrant's business, to which the Registrant or its subsidiaries are a party of or which any of their property is the subject. ITEM 2 None ITEM 3 Defaults Upon Senior Securities: -------------------------------- Not applicable. ITEM 4 Submission of Matters to a Vote of Security Holders: ---------------------------------------------------- At the annual meeting of shareholders held on April 28, 2004, in addition to the election of directors, the shareholders voted upon the one board proposal contained in Fidelity Federal Bancorp's Proxy Statement dated March 26, 2004. The Board nominees were elected as directors with the following vote: Nominee For Withheld ------- --- -------- Paul E. Becker 8,357,176 951,003 Bruce A. Cordingley 8,357,756 950,423 Jack Cunningham 8,366,823 941,356 Michael Elliott 8,357,176 951,003 Donald R. Neel 8,359,303 948,876 Gerald K. Pedigo 8,358,153 950,026 Barry A. Schnakenburg 8,364,087 944,092 Phillip J. Stoffregen 8,356,853 951,226 The Board proposal was approved with the following vote:
Abstentions (Other Than Broker Broker Proposal For Against Non-Votes) Non-Votes -------- --- ------- ---------- --------- Board proposal to ratify the appointment of BKD LLP as the Company's independent auditors 9,037,729 262,745 7,705 310,479
ITEM 5 Other Information: ------------------ 24 None ITEM 6 Exhibits and Reports on Form 8-K: --------------------------------- Exhibit Number Description a. 3(i) (a) Articles of Incorporation of Fidelity, filed as exhibit 3(a) to Fidelity's 1995 Annual Report on Form 10-K, are incorporated herein by reference 3(i) (b) Articles of Amendment of the Articles of Incorporation, filed as exhibit 4.1 with Fidelity's Registration Statement on Form S-3 (file no. 333-53668), are incorporated by reference 3(ii) By-Laws of Fidelity, filed as exhibit 4.2 with Fidelity's Registration Statement on Form S-3 (file no. 333-53668), are incorporated by reference 10 (a) The 1993 Director's Stock Option Plan, filed as exhibit 10(d) to Fidelity's 1995 Annual Report on Form 10-K, is incorporated herein by reference. (b) The 1995 Key Employee's Stock Option Plan, filed as exhibit 10(c) to Fidelity's 1996 Annual Report on Form 10-K, is incorporated herein by reference. (c) Employment agreement between Fidelity and Donald R. Neel, filed as exhibit 10(d) to Fidelity's 2000 Annual Report on Form 10-K, is incorporated herein by reference 31.1 Certification of CEO required pursuant to 15d-14(a) of the Securities Exchange Act of 1934 31.2 Certification of CFO required pursuant to 15d-14(a) of the Securities Exchange Act of 1934 32.1 Certification of Chief Executive Officer required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2 Certification of Chief Financial Officer required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 b. A form 8-K was filed on April 30, 2004 announcing that on April 26, 2004, Fidelity issued a press release in connection with Fidelity's first quarter 2004 earnings release. 25 SIGNATURES Pursuant to the requirements 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. FIDELITY FEDERAL BANCORP Date: August 12, 2004 By: /s/ DONALD R. NEEL -------------------------- ------------------------------------ Donald R. Neel President and CEO By: /s/ MARK A. ISAAC ------------------------------------ Mark A. Isaac Vice President and CFO (Principal Financial Officer) 26 Index to Exhibits Page Exhibit Number Exhibit -------------------------------------------------------------------------------- a. 3(i) (a) Articles of Incorporation of Fidelity, filed as exhibit 3(a) to Fidelity's 1995 Annual Report on Form 10-K, are incorporated herein by reference 3(i) (b) Articles of Amendment of the Articles of Incorporation, filed as exhibit 4.1 with Fidelity's Registration Statement on Form S-3 (file no. 333-53668), are incorporated by reference 3(ii) By-Laws of Fidelity, filed as exhibit 4.2 with Fidelity's Registration Statement on Form S-3 (file no. 333-53668), are incorporated by reference 10 (a) The 1993 Director's Stock Option Plan, filed as exhibit 10(d) to Fidelity's 1995 Annual Report on Form 10-K, is incorporated herein by reference. (b) The 1995 Key Employee's Stock Option Plan, filed as exhibit 10(c) to Fidelity's 1996 Annual Report on Form 10-K, is incorporated herein by reference. (c) Employment agreement between Fidelity and Donald R. Neel, filed as exhibit 10(d) to Fidelity's 2000 Annual Report on Form 10-K, is incorporated herein by reference 31.1 Certification of CEO required pursuant to 15d-14(a) of the Securities Exchange Act of 1934 31.2 Certification of CFO required pursuant to 15d-14(a) of the Securities Exchange Act of 1934 32.1 Certification of Chief Executive Officer required pursuant to Section 906 of the Sarbanes - Oxley Act of 2002 32.2 Certification of Chief Financial Officer required pursuant to Section 906 of the Sarbanes - Oxley Act of 2002 27