EX-13 3 ex13.txt Exhibit 13 2004 Annual Report to Shareholders [LOGO OF FIDELITY FEDERAL BANCORP] 2004 Annual Report Contents Page --------------------------------------------------------------------------- Financial Highlights 2 Market Summary 3 Selected Statistical Information 4 Management's Discussion and Analysis 5 Independent Auditor's Report 32 Consolidated Balance Sheets 33 Consolidated Statements of Income 34 Consolidated Statements of Changes in Stockholders' Equity 37 Consolidated Statements of Cash Flows 38 Notes to Consolidated Financial Statements 40 1 [LOGO OF FIDELITY FEDERAL BANCORP] Financial Highlights (Dollars in Thousands, Except Share and Per Share Data)
December 31, December 31, 2004 2003 Change ---------------------------------------------------------------------------------------------------- Per Share Basic net income $ 0.54 $ 0.29 86.21% Diluted net income 0.54 0.29 86.21 Book value at year end 17.74 16.68 6.35 Market price (bid) at year end 22.32 19.44 14.81 For the Year Net interest income $ 4,479 $ 2,823 58.66% Provision for loan losses 448 13 3,346.15 Non-interest income 2,495 3,878 (35.66) Non-interest expense 6,120 6,694 (8.57) Net income 472 214 120.56 At Year End Total assets $200,558 $175,390 14.35% Loans (net) 110,771 100,437 10.29 Total deposits 127,701 120,680 5.82 Total stockholders' equity 16,261 13,367 21.65 Averages Total assets $195,959 $149,577 31.01% Total earning assets 178,274 131,080 36.00 Total loans 109,050 82,553 32.10 Total deposits 128,238 111,888 14.61 Total stockholders' equity 15,274 12,668 20.57 Profitability Ratios Return on average assets 0.24% 0.14% Return on average stockholders' equity 3.09 1.69 Net interest margin 2.51 2.15 Loan Quality Ratios Net charge offs to average loans 0.39% 0.14% Allowance for loan losses to loans at end of period 0.68 0.73 Valuation allowance for letters of credit to total letters of credit 1.02 1.05 Savings Bank Capital Ratios Tangible capital to adjusted total assets 7.22% 6.87% Risk-based capital ratios Tier I capital 10.52 9.16 Total risk-based capital 14.48 13.62 Other Data Average common and common equivalent shares outstanding 874,432 744,340 Number of full-time equivalent employees at year end 52 62 Number of banking offices 5 5
2 [LOGO OF FIDELITY FEDERAL BANCORP] MARKET SUMMARY MARKET FOR COMMON STOCK AND RELATED STOCKHOLDER MATTERS Until March 1, 2005 Fidelity's common stock was traded on the NASDAQ System under the symbol FFED. The stock is not currently traded on any stock exchange or on the NASDAQ system, and there is no established public trading market for the stock. The following table sets forth, for the periods indicated, the high and low bid prices per share as reported by NASDAQ. The bid prices represent prices between dealers, do not include retail mark-up, mark-down, or commissions and may not represent actual transactions. The stock prices have been adjusted for the reverse and forward stock split on March 1, 2005. 2004 2003 ------------------------------------------------------ Common Stock Bid Prices Common Stock Bid Prices ------------------------------------------------------ Year Ended December 31 High Low High Low ------------------------------------------------------------------------------- First quarter $25.32 $18.60 $21.00 $14.52 Second quarter 24.60 16.44 18.36 13.44 Third quarter 21.24 16.92 21.00 15.00 Fourth quarter 24.96 17.16 22.56 18.00 We did not pay any cash dividends on our common stock in 2004 or 2003. Fidelity's dividend policy is to pay cash or distribute stock dividends when the 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. We do not anticipate paying cash dividends in the foreseeable future. As of February 28, 2005, shares were held of record by approximately 419 shareholders. 3 [LOGO OF FIDELITY FEDERAL BANCORP] Selected Statistical Information (Dollars in Thousands, Except Share and Per Share Data)
December 31, December 31, December 31, December 31, December 31, Selected Financial Data as of 2004 2003 2002 2001 2000 ----------------------------------------------------------------------------------------------------------------------- Total assets $ 200,558 $ 175,390 $ 132,290 $ 159,659 $ 166,466 Interest-bearing deposits 3,633 1,263 2,369 14,605 14,718 Investment securities available for sale 65,192 52,208 34,912 18,074 21,001 Loans, net 110,771 100,437 73,087 104,432 107,842 Deposits 127,701 120,680 106,791 120,155 126,944 Borrowings 10,460 8,077 10,586 12,317 13,939 Federal Home Loan Bank advances 44,090 31,550 3,000 12,333 9,903 Stockholders' equity 16,261 13,367 9,588 11,895 8,775 Selected Operations Data for Year Ended Interest income $ 8,483 $ 6,650 $ 9,034 $ 11,455 $ 12,100 Interest expense 4,004 3,827 6,022 8,501 8,457 --------------------------------------------------------------------- Net interest income 4,479 2,823 3,012 2,954 3,643 Provision for loan losses 448 13 (360) 1,349 670 --------------------------------------------------------------------- Net interest income after provision for loan losses 4,031 2,810 3,372 1,605 2,973 Non-interest income 2,495 3,878 3,507 3,933 1,816 Non-interest expense 6,120 6,694 9,927 5,698 7,314 --------------------------------------------------------------------- Income (loss) from continuing operations before tax 406 (6) (3,048) (160) (2,525) Income tax benefit (66) (220) (641) (384) (1,369) --------------------------------------------------------------------- Income (loss) from continuing operations 472 214 (2,407) 224 (1,156) --------------------------------------------------------------------- Loss from discontinued operations before tax -- -- (1,537) Income tax expense -- -- 451 --------------------------------------------------------------------- Loss from discontinued operations -- -- (1,988) --------------------------------------------------------------------- Net income (loss) $ 472 $ 214 $ (4,395) $ 224 $ (1,156) ===================================================================== Selected Financial Ratios Return on average assets 0.24% 0.14% (2.75)% 0.14% (0.71)% Return on stockholders' equity 3.09 1.69 (36.82) 2.18 (16.14) Net interest margin 2.51 2.15 2.18 2.03 2.49 Net interest spread 2.42 2.11 2.23 2.12 2.33 Tangible equity to assets at year end 7.22 6.87 8.52 8.48 8.42 Allowance for loan losses to loans 0.68 0.73 1.13 2.01 1.75 Allowance for loan losses to non-performing loans 74.48 49.33 91.48 55.90 222.27 Dividend payout ratio N/A N/A N/A N/A N/A Per Share Data Diluted net income (loss) from continuing operations $ 0.54 $ 0.29 $ (4.67) $ 0.52 $ (3.42) Diluted net income (loss) from discontinued operations (3.86) Diluted net income (loss) 0.54 0.29 (8.53) 0.52 (3.42) Basic net income (loss) from continuing operations 0.54 0.29 (4.67) 0.52 (3.42) Basic net income (loss) from discontinued operations (3.86) Basic net income (loss) 0.54 0.29 (8.53) 0.52 (3.42) Cash dividends declared Book value at year end 17.74 16.68 17.07 23.84 22.85 Closing market price (bid) at year end 22.32 19.44 17.64 27.60 15.72 Number of average common and common equivalent shares outstanding 874,432 744,340 515,272 428,894 338,097
4 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Termination of Registration Requirements On November 10, 2004, Fidelity announced a plan to terminate registration of its common stock. The Board of Directors unanimously approved a 1-for 30,000 reverse stock split in order to terminate the registration of its common stock with the Securities and Exchange Commission and result in the delisting of its shares on the NASDAQ. The reverse stock split was immediately followed by a 2,500-for-1 stock split. The effective dates for both the reverse and forward stock splits was February 28, 2005. On March 11, 2005, Fidelity filed Form 15 with the Securities and Exchange Commission notifying it of the completion of the reverse stock split and delisting of its shares on NASDAQ. Approximately $3.2 million will be paid out to fractional shareholders as a result of the reverse stock split in 2005 thus reducing shareholder's equity and cash. Additional details regarding this transaction may be found in the Schedule 13E-3 as filed with the Securities and Exchange Commission. SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS 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 Federal. 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 and the Letter To Our Shareholders, contains or incorporates by reference certain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, about our financial condition, results of operations and business that are based on our current and future expectations. You can find many of these statements by looking for words such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential," or "continue," or the negative of such terms and other comparable terminology. Such statements reflect our current views with respect to future events and are subject to risks and uncertainties, including those discussed in the Management Discussion and Analysis, notes to the consolidated financial statements and the Letter to Shareholders, that could cause actual results to differ materially from those contemplated in such forward-looking statements. A few uncertainties which could affect our future performance include, without limitation, the effects of competition, technological changes and regulatory developments; changes in fiscal, monetary and tax policies; market, economic conditions, either nationally or regionally, resulting in, among other things, credit quality deterioration; and changes in the securities markets. Investors should consider these risks, uncertainties, and other factors in addition to those mentioned by us in other filings from time to time when considering any forward-looking statement. We believe it is important to communicate our expectations to our investors. However, you are cautioned that no forward-looking statement is a guarantee of future performance and you should not place undue reliance on these forward-looking statements, which speak only as of the date of this annual report. There may be events in the future that we are not able to predict accurately or over which we have no control. We do not undertake any obligation to publicly release any revisions to these forward-looking statements to reflect events or circumstances after the date of this annual report or to reflect the occurrence of unanticipated events which may cause actual results to differ from those expressed or implied by the forward-looking statements contained in this annual report. General Fidelity Federal Bancorp ("Fidelity"), incorporated in 1993 under the laws of the State of Indiana, is a registered savings and loan holding company with its principal office in Evansville, Indiana. 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 securities. 5 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Operating Strategy Fidelity's strategy is to continue to operate as an independent, community-oriented financial institution dedicated to meeting the financial needs of consumers and businesses in its market area. Fidelity prides itself in meeting or exceeding customer expectations. Fidelity's emphasizes on mortgage and commercial lending activities, as well as increasing its portfolio of consumer loans. The strategy also includes continued management of its portfolio of mortgage-backed securities, and to increase core deposit growth to support growth in loans and investments. Performance Overview The primary source of Fidelity's revenue is net interest income from loans and deposits, fees generated from loan sales and fees from financial services provided to customers. Economic factors, such as interest rates, business spending and consumer confidence, in addition to competition, influences loan and deposit volume that is generated by Fidelity. Fidelity's earnings increased $258,000 over 2003. Net interest income increased $1.7 million and noninterest expense decreased $574,000 from the prior year. Offsetting a portion of these increases was a decrease of $1.4 million in noninterest income and a $435,000 increase in provision for loan losses. Net income per share was $0.54 compared to $0.29 in 2003. Return on assets and return on equity for 2004 were 0.24% and 3.09%, respectively, compared to 0.14% and 1.69% for 2003, respectively. Fidelity's balance sheet increased from $175.4 million at December 31, 2003 to $200.6 million at December 31, 2004. This increase was attributed to growth in the investment and loan portfolios. This growth was funded primarily by increases in certificate of deposits, and Federal Home Loan Bank advances. Fidelity also raised $2.5 million through a rights offering of equity in which 1.4 million shares were registered. A portion of these proceeds were used to increase regulatory capital during 2004 which supported balance sheet expansion. Fidelity increased its commercial real estate and commercial loans by 66% in 2004. The primary collateral sources on these loans have been income-producing residential properties, and owner-occupied commercial real estate. Fidelity's investment portfolio also increased 24.9% in 2004 primarily through purchases of mortgage-backed securities. Fidelity's classified assets have continued to decrease over the past several years. Total classified assets have declined from $6.0 million at December 31, 2002 to $1.5 million at December 31, 2004. Comparison of Financial Condition at December 31, 2004 and December 31, 2003 Total assets at December 31, 2004 increased $25.2 million to $200.6 million from $175.4 million in December 2003, primarily due to the increases in mortgage-backed securities available for sale of $13.0 million and an increase in net loans of $10.3 million. Average assets for the year ended December 31, 2004 increased by $46.4 million from $149.6 million at December 31, 2003 to $196.0 million at December 31, 2004. The increase in total average assets is primarily due to an increase in the automobile loan category of $16.8 million. Average investment securities grew $20.2 million in 2004 when compared to 2003 and total average commercial and commercial real estate loans grew by $7.4 million when compared to the prior year. Total assets at December 31, 2003 increased $43.1 million to $175.4 million from $132.3 million in December 2002, primarily due to the increases in mortgage-backed securities available for sale of $17.3 million and an increase in net loans of $27.4 million. Average assets for the year ended December 31, 2003 decreased by $10.0 million from $159.6 million at December 31, 2002 to $149.6 million at December 31, 2003. The decrease in total average assets is primarily due to decreases in the consumer loan category resulting from the $49.5 million loan securitization transaction completed in late 2002. As a result, average consumer loan outstandings for 2003 decreased $12.0 million from the prior year. In addition, loan workout activities reduced foreclosed assets held for sale from an average of $1.8 million in 2002 to $920,000 for December 31, 2003. 6 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Loans The following table shows the composition of Fidelity's loan portfolio:
December December December December December 2004 2003 2002 2001 2000 ------------------------------------------------------------------------------------------------------------------- (In Thousands) Real estate mortgage loans First mortgage loans Conventional $ 38,226 $ 41,754 $ 36,157 $ 43,929 $ 47,809 Construction 4,471 2,042 1,909 513 1,274 Commercial 16,251 9,144 5,645 6,114 6,873 Multi-family loans 594 213 3,083 3,856 4,350 Home equity loans 6,144 5,067 4,586 4,577 5,274 First mortgage real estate loans purchased 385 778 627 745 1,753 --------------------------------------------------------------------- 66,071 58,998 52,007 59,734 67,333 Commercial and industrial 4,136 3,138 2,210 1,848 2,305 Consumer loans 41,320 39,038 19,707 44,988 40,125 --------------------------------------------------------------------- Total loans 111,527 101,174 73,924 106,570 109,763 Allowance for loan losses (756) (737) (837) (2,138) (1,921) --------------------------------------------------------------------- Net loans $ 110,771 $ 100,437 $ 73,087 $ 104,432 $ 107,842 ===================================================================== Total assets $ 200,558 $ 175,390 $ 132,290 $ 159,659 $ 166,466 ===================================================================== Total loans to total assets 55.6% 57.7% 55.9% 66.7% 65.9%
Total conventional real estate mortgages decreased by $3.5 million in 2004, due to an overall decline in originations in 2004 as compared to 2003. Total commercial real estate loans outstanding have increased by approximately $7.1 million in 2004 and total commercial and industrial loans have increased by approximately $1.0 million as compared to 2003. Continued growth is expected in these two loan categories in 2005. Consumer loans increased by $2.3 million to $41.3 million at December 31, 2004. The portfolio is primarily composed of prime automobile loans previously generated through a network of automobile dealers in Indiana, Kentucky, Illinois and Missouri. During the third quarter of 2004, United exited the indirect automobile market and focused its resources on more traditional community bank products. The portfolio is expected to decline in 2005. 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. Loan Maturities The following table sets forth the remaining maturities for commercial loans as of December 31, 2004: Within One One to Five After Five Year Years Years Total --------------------------------------------------- (In Thousands) Predetermined interest rates $ 52 $1,240 $ 198 $1,490 Floating interest rates 1,055 202 1,389 2,646 --------------------------------------------------- $1,107 $1,442 $1,587 $4,136 =================================================== 7 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Non-Performing Loans Fidelity discontinues the accrual of interest income on loans when, in the opinion of management, there is reasonable doubt as to the timely collectibility of interest or principal. When a loan reaches a ninety day or more past due status, the asset is generally repossessed or sold, if applicable, or the foreclosure process is initiated and the loan is re-classified to other real estate owned to be sold. A loan could be placed in a nonaccrual status sooner than ninety days if management knows the customer has abandoned the collateral and has no intention of repaying the loan. Typically, when a loan reaches nonaccrual status, the accrued interest is reversed from income, unless strong evidence exists that the value of the collateral would support the collection of interest in a foreclosure situation. Nonaccrual loans are returned to an accrual status when, in the opinion of management, the financial position of the borrower indicates that there is no longer any reasonable doubt as to the timely payment of principal and interest. Income received on nonaccrual and restructured loans was $65,000 for the year ended December 31, 2004, $43,000 for the year ended December 31, 2003 and $23,000 for the year ended December 31, 2002. Additional interest income of approximately $53,000, $19,000 and $63,000 for the years ended December 31, 2004, 2003 and December 31, 2002, respectively, would have been recorded had income on nonaccruing and restructured loans been considered collectible and accounted for on an accrual basis. The following table provides information on Fidelity's non-performing loans.
December 31, December 31, December 31, December 31, December 31, 2004 2003 2002 2001 2000 ----------------------------------------------------------------------------- (Dollars In Thousands) Non-accrual loans Real estate mortgage $ 273 $ 788 $ 356 $ 130 Home equity 196 127 Consumer 108 233 131 116 Multi-family $ 148 Commercial 178 267 388 3,291 472 ---------------------------------------------------------------------- Total non-accrual loans 755 1,415 875 3,537 620 Restructured Consumer 39 190 115 Commercial 53 119 ---------------------------------------------------------------------- Total restructured loans 39 243 234 90 days or more past due and accruing Consumer 133 54 23 10 Commercial 126 233 22 Mortgage 1 ---------------------------------------------------------------------- Total 90 days or more past due and accruing 259 287 1 45 10 ---------------------------------------------------------------------- Total non-performing loans $1,014 $1,702 $ 915 $3,825 $ 864 ====================================================================== Ratio of non-performing loans to total loans 0.91% 1.68% 1.24% 3.59% 0.79% ======================================================================
The decrease in non-performing loans in 2004 is primarily due to one residential real estate loan totaling $451,000 on which accrual of interest income was ceased during the first quarter of 2003. The property was in the foreclosure process at the end of 2003 and sold during the first quarter of 2004. Proceeds were sufficient to repay principal, accrued interest, and other expenses. Approximately $170,000 of the $178,000 in commercial non-accrual loans is associated with one property that represents a small portion of a larger participated loan. Management believes that reserves for this loan are adequate. 8 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Analysis of Allowance for Loan Losses and Letter of Credit Valuation Allowance Fidelity establishes its provision for loan losses and letter of credit valuation provision and evaluates the adequacy of the allowance for loan losses and its letter of credit valuation reserve based on management's evaluation of the performance of its loan and letter of credit portfolios. United's review of all loans and letters of credit for which full collectibility may not be reasonably assured, considers among other matters, the present value of expected cash flows, the estimated fair value of the underlying collateral, economic conditions, historical loss experience, the composition of the portfolios and other factors that warrant recognition in providing for an adequate loan loss allowance and letters of credit valuation allowance. This evaluation is performed on a quarterly basis and is designed to ensure that all relevant matters affecting collectibility will consistently be identified in a detailed review and that the outcome of the review will be considered in a disciplined manner by management in determining the necessary allowances and related provisions. The amounts actually reported in each period will vary with the outcome of this detailed review. Classified Assets and Letters of Credit (in thousands) December 31, December 31, December 31, 2004 2003 2002 ---------------------------------------------- Classified assets $1,521 $1,757 $6,024 Classified letters of credit ---------------------------------------------- Total classified assets $1,521 $1,757 $6,024 ============================================== Classified assets and letters of credit of Fidelity totaled $1.5 million at December 31, 2004 compared to $1.8 million at December 31, 2003 and $6.0 million at December 31, 2002, a decrease of 74.8%. In addition to the classified assets and letters of credit, there are other assets and letters of credit totaling $6.1 million at December 31, 2004 for which management was closely monitoring the borrowers' abilities to comply with payment terms. Impaired loans are those that management believes will not perform in accordance with the original loan terms. At December 31, 2004 and December 31, 2003, Fidelity had impaired loans totaling $679,000 and $775,000 respectively. The allowances for loan losses on such impaired loans totaled $130,000 and $169,000, which were included in Fidelity's allowance for loan losses at December 31, 2004 and December 31, 2003 respectively. Using similar guidelines for impaired loans, impaired letters of credit at December 31, 2004 and December 31, 2003 totaled $0. Impaired loans do not include large groups of homogeneous loans that are collectively evaluated for impairment, such as residential mortgage and consumer installment loans. Foreclosed Assets Foreclosed assets owned, consisting of one-to-four family dwellings, totaled $316,000 at December 31, 2004, compared to zero at December 31, 2003. 9 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Allowance for Loan Losses The following table sets forth loan charge-offs and recoveries by the type of loan and an analysis of the allowance for loan losses for the years ended December 31, 2004, 2003, 2002 and 2001:
December 31, December 31, December 31, December 31, December 31, 2004 2003 2002 2001 2000 ----------------------------------------------------------------------------------------------------------------------- (In Thousands) Allowance for loan losses at beginning of period $ 737 $ 837 $ 2,138 $ 1,921 $ 2,021 ---------------------------------------------------------------------------- Loan charge offs Real estate mortgage 2 80 Multi-family 469 606 683 Commercial 71 1,158 354 12 Consumer 499 234 327 441 391 ---------------------------------------------------------------------------- Total loan charge offs 570 236 1,954 1,401 1,166 ---------------------------------------------------------------------------- Loan recoveries Real estate mortgage 7 Multi-family 24 937 200 317 Commercial 20 Consumer 141 99 76 62 59 ---------------------------------------------------------------------------- Total loan recoveries 141 123 1,013 269 396 ---------------------------------------------------------------------------- Net charge offs 429 113 941 1,132 770 Provision for loan losses transferred to held for sale (114) (479) (564) Provision for loan losses 562 492 204 1,349 670 ---------------------------------------------------------------------------- Total net provision for loan losses 448 13 (360) 1,349 670 ---------------------------------------------------------------------------- Allowance for loan losses at end of period $ 756 $ 737 $ 837 $ 2,138 $ 1,921 ============================================================================ Ratio of net charge offs to average loans outstanding during period 0.39% 0.14% 0.99% 1.02% 0.72% ============================================================================ Ratio of provision for loan losses to average loans outstanding during period 0.41% 0.02% (0.38)% 1.21% 0.63% ============================================================================ Ratio of allowance for loan losses to total loans outstanding at year end 0.68% 0.73% 1.13% 2.01% 1.75% ============================================================================ Average amount of loans outstanding for the period $ 109,050 $ 82,553 $ 94,821 $ 111,572 $ 106,599 ============================================================================ Amount of loans outstanding at end of period $ 111,527 $ 101,174 $ 73,924 $ 106,570 $ 109,763 ============================================================================
10 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition During the year ended December 31, 2004, 2003 and 2002 net charge-offs consisted primarily of consumer loans. Consumer loan charge-offs of $499,000 were recognized in 2004 compared to $234,000 in 2003 and $327,000 in 2002. Consumer loan recoveries of $141,000 were received in 2004 compared to $99,000 in 2003 and $76,000 in 2002. Charge-offs of $469,000 were recorded on multifamily loans in 2002 compared to zero in 2003 and 2004. During 2002 a subsidiary of United held general partnership interest in seventeen partnerships. Under the terms of the partnership agreement, the general partner was obligated to fund certain cash flow deficits of the particular partnership, or risk defaulting on loans. A default could have had a negative impact for the partners, including the company-owned general partner, such as causing recapture of tax credits. As such, funds would be loaned to the various partnerships to meet obligations. At the time the loans were made, they were fully reserved through additional provisions to the allowance for loan loss, due to the performance of the partnerships and the assessment of the quality of the credit. The loans were then charged-off. Recoveries of $937,000 were received on multifamily loans in 2002, compared to $24,000 in 2003 and none in 2004. Due to the poor performance of certain multifamily loans in prior periods and management's assessment of allowances necessary to reflect the credit quality of these loans, specific reserves were created and certain charge-offs recorded. Several of these loans were refinanced through third parties during the past three years. The refinancing activities generally created additional cash flow because of reduced interest rates. As these loans were paid off, the reserves previously established for these loans were reversed or recorded recoveries to the extent that the payments received exceeded the charged down balances. The provision for loan losses increased from $492,000 in 2003 to $562,000 in 2004 due to the $10.4 million increase in total loans outstanding. In 2002, operating deficit guarantees provided by Pedcor resulted in payments being made to Fidelity in the event that cash flows from properties were negative, based on a pre-determined computation. These guarantees and contingent liabilities were terminated upon the sale of the partnerships during the fourth quarter of 2002. Fidelity's letter of credit valuation allowance was $232,000 at December 31, 2004 compared to $291,000 at December 31, 2003. The decrease is primarily due to the reduction in classified letters of credit, primarily due to efforts to refinance the credits on a non-recourse basis since 2001. Multi-family letters of credit, an off-balance sheet item, carry the same risk characteristics as conventional loans and totaled $22.7 million at December 31, 2004 compared to $27.8 million at December 31, 2003 and $29.7 million at December 31, 2002. The valuation allowance for letters of credit totaled 1.02% of outstanding letters of credit at December 31, 2004 compared to 1.0% at December 31, 2003. The allowance for loan losses and letters of credit to total loans and letters of credit at December 31, 2004 and 2003 was 0.74% and 0.80%, respectively. Management is not currently aware of any additional letters of credit that are expected to be called or funded. 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 December 31, 2004. The provision for consumer loans was credited in connection with consumer loans transferred to held for sale for $114,000 for 2004 compared to a credit of $479,000 in 2003. The credit during 2004 and 2003 is primarily attributable to the reduction in allocated reserves previously set aside for consumer loans as a result of completing consumer loan sales during each year. Fidelity will generally complete consumer loan sales during the month the loans are identified for sale, therefore no consumer loans were identified as held for sale at December 31, 2004. Allocation of Allowance for Loan Losses The allocation for loan losses and the percentage of loans within each category to total loans at December 31, 2004, 2003, 2002, and 2001 are as follows:
Allocation of Amount ------------------------------------------------------------------------------------ December 31, December 31, December 31, December 31, December 31, 2004 2003 2002 2001 2000 ----------------------------------------------------------------------------------------------------------- (In Thousands) Real estate mortgage $ 62 $ 64 $ 91 $ 80 $ 49 Home equity 16 39 23 23 53 Multi-family 6 2 150 258 514 Consumer 414 363 247 505 628 Commercial 258 269 326 1,272 677 ------------------------------------------------------------------------------------ Total $ 756 $ 737 $ 837 $2,138 $1,921 ==================================================================================== Percentage of Loans to Total Loans ------------------------------------------------------------------------------------ December 31, December 31, December 31, December 31, December 31, 2004 2003 2002 2001 2000 ----------------------------------------------------------------------------------------------------------- Real estate mortgage 38.6% 43.0% 52.3% 42.4% 45.2% Home equity 5.5 5.0 6.2 4.3 4.8 Multi-family 0.5 0.2 4.2 3.6 3.4 Consumer 37.1 38.7 26.7 42.2 36.6 Commercial 18.3 13.1 10.6 7.5 10.0 ------------------------------------------------------------------------------------ Total 100.0% 100.0% 100.0% 100.0% 100.0% ====================================================================================
11 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Investment Securities United's investment policy is reviewed annually by its Board of Directors. Any significant changes to the policy must be approved by the Board. The Board has an interest rate risk management committee, which is responsible for keeping the investment policy current. At December 31, 2004, the investment portfolio represented 32.5% of Fidelity's assets, compared to 29.8% at December 31, 2003 and 26.4% at December 31, 2002, and is managed in a manner designed to meet the Board's investment policy objectives. The primary objectives, in order of priority, are to further the safety and soundness of Fidelity, to provide for the liquidity necessary to meet day to day, cyclical, and long-term changes in the mix of Fidelity's assets and liabilities and to provide for diversification of risk and management of interest rate and economic risk. At December 31, 2004, the entire investment portfolio was classified as available for sale. The net unrealized loss at December 31, 2004, which is included as a component of stockholders' equity, was $261,000 and was comprised of gross unrealized gains of $59,000 and gross unrealized losses of $480,000 and tax expense of $160,000. The change in the unrealized loss from December 31, 2003, was caused primarily by market interest rate changes during the period. Although the entire portfolio is classified as available for sale, management has not identified specific investments for sale in future periods. The following table sets forth the components of United's available-for-sale investment portfolio as of December 31, 2003, 2002, and 2001:
December 31, December 31, December 31, 2004 2003 2002 ----------------------------------------------------------------------------------------------------------------- (dollars in thousands) Federal Home Loan Mortgage Corporation mortgage-backed securities $11,075 $ 6,739 $17,148 Federal National Mortgage Association mortgage-backed securities 32,812 25,203 3,382 Government National Mortgage Association mortgage-backed securities 21,305 20,266 14,382 --------------------------------------------- Total securities available for sale $65,192 $52,208 $34,912 =============================================
The following table sets forth the contractual maturities of investment and mortgage-backed securities as of December 31, 2004, and the weighted average yields of such securities. The contractual maturities of mortgage-backed securities are not typically indicative of the actual holding period for such investments, as pre-payments on the underlying mortgage loans will reduce the average life of the investment, based on prevailing market interest rates.
----------------------------------------------------------------------------------------- After One But After Five But Within One Year Within Five Years Within Ten Years Over Ten Years Total -------------------------------------------------------------------------------------------------------------------- Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield -------------------------------------------------------------------------------------------------------------------- Federal Home Loan Mortgage Corporation 1,218 3.75% $ 9,857 3.96% $11,075 4.12% Federal National Mortgage Association $4,088 3.89% 28,724 4.15 32,812 3.94 Government National Mortgage Association 21,305 2.87 21,305 2.87 -------- -------- ------- --------- --------- Total $ 0 $0 $5,306 3.86% $59,886 3.66% $65,192 3.68% ======== ======== ======= ========= ========= Percent of total 0.00% 0.00% 8.14% 91.86% 100.00% ======== ======== ======= ========= =========
12 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Funding Sources Deposits Fidelity attracts both short-term and long-term deposits from the retail market by offering a wide assortment of accounts with different terms and different interest rates. These deposit alternatives include checking accounts, regular savings accounts, money market deposit accounts, fixed rate certificates with varying maturities, variable interest rate certificates, negotiable rate jumbo certificates ($99,000 or more), and variable rate IRA certificates. Average deposits increased by $16.4 million for the year ended December 31, 2004. The primary categories affecting the decrease are as follows: o Average retail certificate of deposits increased by $1.2 million, or 1.5% due to increased marketing efforts and rates offered during 2004. o Average money market accounts increased $778,000, or 11.5%. o Average demand deposits increased $1.8 million due to growth in commercial loan business accounts. o Average savings increased $321,000 or 5.9%. o Average agent-acquired certificates of deposit increased $13.0 million to assist Fidelity in funding balance sheet growth. The following table sets forth the average balances of and the average rate paid on deposits by deposit category for the years ended December 31, 2004, 2003 and 2002.
December 31, December 31, December 31, 2004 2003 2002 ---------------------------------------------------------------------------------- Average Deposits Amount Rate Amount Rate Amount Rate ------------------------------------------------------------------------------------------------------------ (In Thousands) Demand $ 7,379 $ 5,564 $ 4,964 NOW accounts 12,998 0.31% 13,793 0.49% 12,720 0.90% Money market accounts 7,521 0.73 6,743 0.86 9,664 1.42 Savings accounts 5,791 0.50 5,470 0.62 4,958 0.75 Certificates of deposit 81,364 2.59 80,121 3.39 86,531 4.71 Brokered deposits 13,185 2.34 197 3.55 248 6.05 --------------- --------------- ---------------- Totals $128,238 1.98% $111,888 2.58% $119,085 3.68% =============== =============== ================
The current interest rate environment and local market conditions presented significant repricing opportunities during 2004 and 2003, resulting in an overall average yield of 1.98% on the deposit portfolio compared to 2.58% in 2003 and 3.68% in 2002. Deposits at December 31, 2004 were $127.7 million compared to $120.7 million at December 31, 2003. This increase is primarily associated with the use of public and agent-acquired certificates of deposit to assist in balance sheet growth during 2004. 13 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition The following table summarizes certificates of deposit in amounts of $100,000 or more by maturity as of the following dates: December 31, December 31, December 31, 2004 2003 2002 ------------ ------------ ------------ (In Thousands) Three months or less $ 8,852 $18,168 $ 5,486 Three to six months 9,777 6,929 4,591 Six to twelve months 3,132 1,565 1,139 Over twelve months 3,491 2,727 3,955 ------- ------- ------- Total $25,252 $29,389 $15,171 ======= ======= ======= Federal Home Loan Bank advances Fidelity's investment and loan growth in 2004 was also facilitated by utilizing FHLB advances. FHLB advances outstanding increased from $31.6 million at December 31, 2003 to $44.1 million at December 31, 2004. To the extent that funding through deposits and other sources is not sufficient, United will continue to utilize FHLB advances to fund additional growth. Borrowings Fidelity's borrowings consisted primarily off FHLB advances, senior notes, junior notes and unsecured notes. Of the $54.6 million outstanding at December 31, 2004, $44.1 million were FHLB advances. Fidelity's borrowings, other than FHLB advances, increased $2.4 million to $10.5 million at December 31, 2004. o During the first half of 2004, Fidelity utilized funds received from its debt and equity offerings that were completed to repay a $1.0 million unsecured note to a related party and repay $1.8 million in 10% senior subordinated notes maturing in June 2005. o These decreases were offset by a rights offering which raised $2.4 million in senior subordinated notes bearing interest at 9.00%. Fidelity also raised $3.1 million in trust preferred securities in 2004. The proceeds are anticipated to service debt and cash out fractional shareholders upon the completion of the reverse stock split in connection with Fidelity going private. Capital Resources Fidelity's stockholders' equity increased $2.9 million to $16.3 million at December 31, 2004, compared to $13.4 million at December 31, 2003. The change in stockholders' equity was accounted for by net income of $472,000, an increase in the net unrealized loss on securities available for sale of $52,000, and $2.5 million attributable to the issuance of stock in connection with the equity offering that was completed on May 18, 2004. 14 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Total capital, as defined for regulatory purposes, for United consists of Tier I capital plus the allowance for loan losses. Minimum capital levels are 4% for the leverage ratio, which is, defined as Tier I capital as a percentage of total assets less goodwill and other identifiable intangible assets; 4% for Tier I to risk-weighted assets; and 8% for total capital to risk-weighted assets. Tangible Core Tier 1 Risk-based Capital Capital Capital Capital ----------------------------------------------- Regulatory capital $14,077 $14,122 $13,129 $18,079 Minimum capital requirement 2,925 7,801 4,992 9,985 ----------------------------------------------- Excess capital $11,152 $6,321 $8,137 $8,094 =============================================== Regulatory capital 7.22% 7.25% 10.52% 14.49% Required capital requirement 1.50 4.00 4.00 8.00 ----------------------------------------------- Excess over minimum 5.72% 3.25% 6.52% 6.49% =============================================== The capital rating 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. At December 31, 2004 and 2003, the Bank is categorized as well capitalized. 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 $65.2 million at December 31, 2004 and is available assist in liquidity management. In addition, United is authorized to borrow money from the Federal Home Loan Bank or draw on $12.4 million secured lines of credit with other financial institutions. At December 31, 2004, United's gross borrowing capacity is $75.0 million with the Federal Home Loan Bank with approximately $6.9 million available to draw upon based on current assets pledged. Fidelity has $500,000 available on a line of credit with another financial institution and can draw on this line until the expiration in November 2005. Fidelity's liquidity position may be further improved by the potential issuance of additional stock, additional trust preferred or debt financing, or dividends from United to Fidelity. Subsequent to year end, United obtained a $10.0 million secured line of credit and an additional $9.8 million in unsecured lines of credit with other financial institutions. These additional lines plus the above liquidity alternatives will assist Fidelity in meeting the future liquidity needs and growth. Contractual Obligations and Commitments The company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to originate loans, standby letters of credit and unadvanced loans and lines of credit. 15 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition The instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheets. The contract amounts of these instruments reflect the extent of involvement the company has in the particular classes of financial instruments. The following table summarizes the contractual obligations including interest and commitments at December 31, 2004.
Payments Due by Period Less than 2 - 3 4 - 5 After 5 ($ in thousands) Total 1 Year Years Years Years ------------------------------------ ------------ ------------- ----------- --------- ---------- Contractual Cash Obligations: FHLB advances $45,689 $28,862 $11,558 $5,269 Junior Subordinate notes 11,398 308 616 1,310 $9,164 Senior Subordinate notes 3,271 213 426 2,632 Other borrowings 7,464 146 292 292 6,734 ------------ ------------- ----------- --------- ---------- Total contractual obligations $67,822 $29,529 $ 12,892 $9,503 $15,898 ============ ============= =========== ========= ========== Payments Due by Period Other commitments: Less than 2 - 3 4 - 5 After 5 Total 1 Year Years Years Years ------------ ------------- ----------- --------- ---------- Unadvanced loans and lines $11,272 $4,309 $6,963 Standby letters of credit 22,724 22,724 - - Commitments to originate loans 6,678 6,678 - - - Commitments to sell loans 413 413 - - - ------------ ------------- ----------- --------- ---------- Total commitments $41,087 $34,124 $0 $0 $6,963 ============ ============= =========== ========= ==========
For additional information regarding Contractual Obligations and Commitments, see note, "Commitments and Contingent Liabilities", to the consolidated financial statements. Effect of Inflation and Changing Prices. Fidelity's Consolidated Financial Statements and related financial data presented have been prepared in accordance with accounting principles generally accepted in the United States of America, which require the measurement of financial position and operating results in terms of historical dollars, without considering the change in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of Fidelity's operations and in increased loan amounts and in increased interest rates (which must include a real rate of return and an additional amount to reflect expected inflation over the term of the loan). Unlike most industrial companies, virtually 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 do general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services. 16 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Off-Balance Sheet Arrangements In the normal course of business, to meet the financing needs of its customers, Fidelity is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. Fidelity's exposure to credit loss in the event of nonperformance by the other party to these financial instruments is represented by the contractual amount of the instruments. Fidelity uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Fidelity generally requires collateral or other security to support the financial instruments with credit risk. The amount of collateral or other security is determined based on management's credit evaluation of the counterparty. Fidelity evaluates each customer's creditworthiness on a case-by-case basis. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Letters of credit are conditional commitments issued by Fidelity to guarantee the performance of a customer to a third party. Letters of credit and other commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the letters of credit and commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. For further information about these arrangements, see Commitments and Contingent Liabilities of the Notes to Consolidated Financial Statements included elsewhere in this report. 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. Reserve for Credit Losses: Fidelity maintains a range of reserve estimates to absorb probable loan losses inherent in the portfolio. The reserve for credit losses is maintained between a minimum and maximum 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 range of reserves, Fidelity estimates losses using a range derived from "base" and "conservative" estimates. Fidelity's methodology for assessing the appropriate reserve range levels 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 cask 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. 17 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Homogenous loans, such as consumer installment, residential mortgage loans, and automobile leases are not individually risk graded. Rather, standard credit scoring systems and delinquency monitoring are used to assess credit risks. A minimum and maximum range of reserves are established for each pool of loans based on the expected net charge-offs for one year. Loss rates are based on the average net charge-off history by loan 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 range of estimates 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 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 $756,000 was adequate, but not excessive, to absorb estimated credit losses associated with the loan portfolio at December 31, 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 operating 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 operating income 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. 18 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition 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 operating income as loan payment are included in operating 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. 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. Fidelity has a net deferred tax asset of $6.2 million at December 31, 2004. The realization of the recorded deferred tax assets ultimately resets 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. Consideration of the need for a valuation allowance for the deferred tax asset was made at December 31, 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 capital gains generated as a result of the sale of two Company subsidiaries, and a level of projected profitability for 2002 being less than originally anticipated, Fidelity established a valuation allowance of $600,000 until such time that Fidelity meets its future period profitability forecasts. Fidelity has set forth reasonable plans, and exceeded its 2004 and 2003 strategic plan indicating that future period profitability will increase and be more in line with its recently approved strategic plan, the ultimate outcome of this uncertainty on net income or earnings per share, if any, is unknown. 19 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Additional details on Fidelity's deferred tax asset and model assumption 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. Additional accounting policies followed by Fidelity and United are presented in Note 1 to the financial statements. 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. New Accounting Pronouncements In December, 2004, the Financial Accounting Standards Board (FASB) issued an amendment to SFAS 123 Accounting for Stock-Based Compensation (SFAS 123R) which eliminates the ability to account for share-based compensation transactions using Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and generally requires that such transactions be accounted for using a fair value-based method. SFAS 123R will be effective for the Company beginning January 1, 2006. SFAS123R applies to all awards granted after the required effective date and to awards modified, repurchased, or cancelled after that date as well as for the unvested portion of awards existing as of the effective date. As of the required effective date, the Company will apply SFAS 123R using a modified version of prospective application. Under that transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for pro forma disclosures. For periods before the required effective date, a company may elect to apply a modified version of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by SFAS 123. Based on the awards outstanding at December 31, 2004, management has estimated that approximately $12,000 of compensation expense related to those awards will be recognized during the year ended December 31, 2006. In January 2003, the FASB issued Interpretation No. 46 (FIN 46), "Consolidation of Variable Interest Entities." This Interpretation clarifies the application of ARB No. 51, "Consolidated Financial Statements," for certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated support from other parties. This Interpretation requires variable interest entities (VIE's) to be consolidated by the primary beneficiary which represents the enterprise that will absorb the majority of the VIE's expected losses if they occur, receive a majority of the VIE's residual returns if they occur, or both. Qualifying Special Purpose Entities (QSPE) are exempt from the consolidation requirements of FIN 46. This Interpretation was effective for VIE's created after January 31, 2003 and for VIE's in which an enterprise obtains an interest after that date. In December 2003, the FASB issued Staff Interpretation No. 46R (FIN 46R), "Consolidation of Variable Interest Entities - an interpretation of ARB 51 (revised December 2003)," which replaces FIN 46. FIN 46R was primarily issued to clarify the required accounting for interests in VIE's. Additionally, this Interpretation exempts certain entities from its requirements and provides for special effective dates for enterprises that have fully or partially applied FIN 46 as of December 24, 2003. Application of FIN 46R is required in financial statements of public enterprises that have interests in structures that are commonly referred to as special-purpose entities, or SPE's, for periods ending after December 15, 2003. Application by public enterprises, other than small business issuers, for all other types of VIE's (i.e., non-SPE's) is required in financial statements for periods ending after March 15, 2004, with earIier adoption permitted. Adoption of this Interpretation did not have a material effect on Fidelity's Consolidated Financial Statements. 20 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Asset/Liability Management 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 than average assets 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 such as those experienced in 2003 and 2002, unless offset by other factors. Balance sheet growth and rising rates attributed to higher net interest income in 2004. 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 a 12% risk-based capital ratio are required to file 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 is not required to file a CMR since it exceeds the risk-based capital requirement and its assets are less than $300 million, but does so on a voluntary basis. Presented below, at December 31, 2004 and December 31, 2003, is an analysis performed by the OTS of United's interest ate risk as measured by changes in NPV for instantaneous and sustained parallel shifts in the yield curve, in 100 basis point increments, up 300 basis points and down 100 basis points. During the fourth quarter of 2004, the yield on the three month Treasury bill was below 2.00% and the information would not be meaningful. As a result, the NPV model did not produce results for the minus 200 or 300 basis points scenarios for the quarter ending December 31, 2004. The decrease in interest rate risk from December 31, 2003 to December 31, 2004 is due to interest rate changes and a change in United's balance sheet mix. Interest Rate Risk as of December 31, 2004
NPV as Percent of Present Net Portfolio Value Value of Assets -------------------------------------------------------------------------------- Change Dollar Dollar Percentage in Rates Amount Change Change NPV Ratio Change --------------------------------------------------------------------------------------------------- + 200 bp 18,172 (3,782) (17) 9.30 - 157 bp - 100 bp 22,668 714 3 11.11 24 bp Interest Rate Risk as of December 31, 2003 NPV as Percent of Present Net Portfolio Value Value of Assets -------------------------------------------------------------------------------- Change Dollar Dollar Percentage in Rates Amount Change Change NPV Ratio Change --------------------------------------------------------------------------------------------------- + 200 bp 12,006 (4,151) (26) 7.10 - 214 bp - 100 bp 17,114 958 6 9.68 44 bp
21 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition As with any method of measuring interest rate risk, certain shortcomings are inherent in the methods of analysis presented above. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as adjustable-rate loans, have features, which restrict changes in interest rates on a short-term basis and over the life of the assets. Further, in the event of a change in interest rates, expected rates of prepayments on loans and early withdrawals from certificates could likely deviate significantly from those assumptions used in calculating the table. Results of Operations General Fidelity recorded net income of $472,000 for the year ended December 31, 2004, an increase in net income of $258,000 over the previous year. Net interest income increased $1.7 million and the provision for loan losses increased $448,000. Noninterest income decreased $1.4 million while non-interest expense decreased $574,000. Overview Income Fidelity generates two sources of pre-tax income. The first is net interest income. Net interest income is the difference between interest income - which is the income that Fidelity earns on its loans and investments - and interest expense - which is the interest that Fidelity pays on its deposits and borrowings. Fidelity's second source of pre-tax income is noninterest income. This includes fee income - the compensation we receive from providing products and services - and gains on sales of loans. Most of Fidelity's fee income comes from loan sales, letter of credit fees, service charges and overdraft fees. Fidelity may occasionally recognize a gain or loss as a result of the sale of investment securities or foreclosed real estate. These gains and losses are not a regular part of Fidelity's income. Expenses The expenses Fidelity incurs in operating its business consist of salaries and employee benefits, occupancy and equipment expenses, deposit insurance premiums, data processing fees and other miscellaneous expenses. Salaries and employee benefits consist primarily of the salaries and wages paid to our employees, as well as expenses for retirement and other employee benefits. Occupancy and equipment expenses, the fixed and variable costs of building and equipment, consist primarily of depreciation of property and equipment, real estate taxes, maintenance and insurance. Deposit insurance premiums are calculated as a percentage of assessable deposits. Data processing fees depend on the number of accounts and transaction volume. Other expenses consist of professional fees, advertising and promotions, printing, supplies, postage and other miscellaneous operating expenses. 22 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition In addition to operating expenses noted above, Fidelity also occasionally recognizes expense that is not anticipated by management to be recurring. Such expenses that occurred in 2002 were changes in estimated useful lives of intangible assets, prepayment fees on FHLB advances, start up costs associated with United's first securitization transaction and other expenses incurred in connection with the sale of two of its subsidiaries. Net Interest Income Net interest income, Fidelity's largest component of income, represents the difference between interest and fees earned on loans, investments and other interest-earning assets, and interest paid on interest-bearing liabilities. It also measures how effectively management has balanced and allocated Fidelity's interest rate-sensitive assets and liabilities. In addition, certain external factors such as the overall condition of the economy, credit demand strength, Federal Reserve Board monetary policy, changes in tax laws, and the Supervisory Agreement that United currently operates under can also have significant effects on changes in net interest income from one period to another. The net interest margin is determined by dividing net interest income by average interest earning assets. The net interest spread is the difference between the average yield earned on interest earning assets and the average rate paid on interest-bearing liabilities. The following table details average balances, interest income/expense and average rates/yield for Fidelity's earning assets and interest bearing liabilities for the years ended December 31, 2004, 2003 and 2002. 23 [LOGO OF FIDELITY FEDERAL BANCORP]
Average Balance Sheet and Net Interest Analysis (Dollars In Thousands on Fully Taxable Equivalent Basis) December 2004 December 2003 December 2002 ------------------------------------------------------------------------------------------------ Average Average Average Average Average Average Year Ended: Balances Interest Rates Balances Interest Rates Balances Interest Rates ---------------------------------------------------------------------------------------------------------------------------- Assets Federal funds sold and other short-term investments $ 1,031 $ 14 1.36% $ 3,542 $ 47 1.33% $ 6,371 $ 114 1.79% Investment securities available for sale-taxable 61,871 2,089 3.38 41,658 1,421 3.41 32,191 1,427 4.43 Loans held for sale 2,769 171 6.18 572 39 6.82 2,016 137 6.80 Federal Home Loan Bank Stock 3,553 155 4.36 2,755 141 5.12 2,634 160 6.07 Loans (1) (2) Commercial loans 4,157 229 5.51 2,478 130 5.25 2,223 133 5.98 Multi-family loans 14,802 929 6.28 9,097 592 6.51 8,733 799 9.15 Home equity loans 5,490 259 4.72 4,795 224 4.67 4,563 245 5.37 Real estate mortgages 41,192 2,170 5.27 39,553 2,266 5.73 40,700 2,852 7.01 Consumer loans 43,409 2,467 5.68 26,630 1,790 6.72 38,602 3,167 8.20 ---------------------------------------------------------------------------------------------- Total loans 109,050 6,054 5.55 82,553 5,002 6.06 94,821 7,196 7.59 ---------------------------------------------------------------------------------------------- Total earning assets 178,274 8,483 4.76 131,080 6,650 5.07 138,033 9,034 6.54 ---------------- ----------------- ------------------- Allowance for loan losses (751) (775) (1,135) Cash and due from banks 2,028 2,191 2,435 Premises and equipment 4,565 4,774 5,810 Other assets 11,839 12,307 14,482 ----------- ----------- ----------- Total assets $195,955 $149,577 $159,625 =========== =========== =========== Liabilities Interest-bearing deposits Interest-bearing checking $ 12,998 $ 40 0.31 $ 13,792 $ 67 0.49 $ 12,720 $ 115 0.90 Money market accounts 7,521 55 0.73 6,743 58 0.86 9,664 137 1.42 Savings accounts 5,791 29 0.50 5,470 34 0.62 4,958 37 0.75 Certificates of deposit 94,549 2,414 2.55 80,319 2,727 3.40 86,779 4,096 4.72 -------------------- -------------------- -------------------- Total interest-bearing deposits 120,859 2,538 2.10 106,324 2,886 2.71 114,121 4,385 3.84 Federal funds purchased 5,148 87 1.69 156 3 1.92 Other borrowings 7,624 532 6.98 7,611 659 8.66 11,842 1,096 9.26 Federal Home Loan Bank advances 37,650 847 2.25 15,172 282 1.86 13,561 538 3.97 -------------------- -------------------- -------------------- Total interest-bearing liabilities 171,281 4,004 2.34 129,107 3,827 2.96 139,680 6,022 4.31 ------- ------- ------- Non-interest bearing demand deposits 7,379 5,564 4,964 Advances by borrowers for taxes and insurance 261 285 309 Other liabilities 1,760 1,953 2,736 ---------- ---------- ---------- Total liabilities 180,681 136,909 147,689 Stockholders' Equity 15,274 12,668 11,936 ---------- ---------- ---------- Total liabilities and stockholders' equity $195,955 $149,577 $159,625 ========== ========== ========== Recap: (3) Interest income 8,483 4.76 6,650 5.07 9,034 6.54% Interest expense 4,004 2.25 3,827 2.92 6,022 4.36 ----------------- ----------------- ------------------ Net interest Income/margin $4,479 2.51% $2,823 2.15% $3,012 2.18% ================= ================= ================== Interest rate spread 2.42% 2.11% 2.23% Average interest-bearing assets to average interest-bearing liabilities 104.08% 101.53% 98.82%
---------------------------- (1) Nonaccrual loans have been included in the average balances. (2) Loan income includes interest and fees on loans. (3) Interest rate spread is calculated by subtracting combined weighted average interest rate cost from combined weighted average interest rate earned for the period indicated. 24 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Net interest income increased $1.7 million for the year ended December 31, 2004, compared to December 31, 2003. The net interest margin increased from 2.15% at December 31, 2003 to 2.51% at December 31, 2004. Lower interest rates and an increase in earning assets in 2004 impacted the margin positively by approximately $111,000 and $1.5 million, respectively, resulting in a net increase of $1.7 million. o Consumer loan interest income increased $1.1 million in 2004 due to an increase in average loans but was partially offset by $451,000 decrease in rate. The yield on consumer loans decreased from 6.72% at December 31, 2003 to 5.68% due to lower rates. o The yield on average mortgage loans decreased from 5.73% to 5.27% during 2004 due to refinancing activity in the portfolio and growth of the adjustable-rate mortgage (ARM) portfolio, which carried a lower yield in 2004. This resulted in a $96,000 decrease in mortgage loan interest income, of which $190,000 was due to lower rates in 2004, but partially offset by a $94,000 increase due to higher outstandings. o Commercial and multifamily loans interest income increased $436,000 from the prior year primarily due the increase in average loans of $7.4 million. o Average investment securities increased $20.2 million during 2004 which attributed to additional interest income of $689,000. However this interest income was slightly offset by a decrease in the yield on the investment portfolio resulting in a $21,000 decrease in interest income. A lower interest rate environment contributed to a lower reinvestment yield in 2003 and early 2004. Interest expense increased $177,000 at December 31, 2004 when compared to December 31, 2003. Average interest-bearing liabilities increased $42.2 million from December 31, 2003 to $171.3 million at December 31, 2004. This increase accounted for $907,000 of increase in interest expense. The primary factors affecting the increase of interest expense were: o Average certificates of deposit increased $14.2 million and the corresponding interest expense associated with the volume change increased $483,000. o Average other borrowings and Federal Home Loan Bank advances increased $22.5 million during 2004 which accounted for $418,000 of the increase in other borrowings interest expense. The yield on interest bearing liabilities decreased from 2.96% in 2003 to 2.34% in 2004. The change in rate accounted for $730,000 decrease in interest expense. Other factors in the decrease of interest due to the yield on interest-bearing liabilities were: o The average rate on certificates of deposit decreased from 3.40% at December 31, 2003 to 2.55% at December 31, 2004. This decrease accounted for $796,000 of the decrease in interest expense. o The average yield on FHLB advances increased from 1.86% to 2.25% in 2004 due to repricing in a higher interest rate environment. This increase in yield accounted for approximately $147,000 increase in interest expense. Net interest income decreased $189,000 for the year ended December 31, 2003, compared to December 31, 2002. The net interest margin decreased slightly from 2.18% at December 31, 2002 to 2.15% at December 31, 2003. Lower interest rates in 2003 impacted the margin negatively by approximately $199,000, while the change in volume during 2003 impacted the margin favorably by approximately $10,000, resulting in a net decrease of $189,000. 25 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition United completed a $49.5 consumer loan securitization transaction at the end of the fourth quarter of 2002. The elimination of these higher earning assets and replacement with lower earning assets in 2003 negatively impacted interest income on a year-to-year comparison. Consumer loan interest income decreased $982,000 due to the decrease in average loans and an additional $395,000 due to a decrease in the overall yield on the consumer loan portfolio. The yield on consumer loans decreased from 8.20% at December 31, 2002 to 6.72% due to the completion of the securitization transaction and replacement of the sold loans with other loans at lower rates. The yield on average mortgage loans decreased from 7.01% to 5.73% during 2003 due to refinancing activity in the portfolio and growth of the adjustable-rate mortgage (ARM) portfolio, which carried a lower yield in 2003. This resulted in a $586,000 decrease in mortgage loan interest income, of which $506,000 was due to lower rates in 2003. During 2003, the Company sold $2.6 million in classified multifamily loans bearing an interest rate that was higher than market. These loans were effectively replaced with higher-quality, but lower yielding commercial real estate loans, resulting in a decrease in interest income of $207,000 from 2002. Average investment securities increased $9.5 million during 2003 which attributed to additional interest income of $420,000. However this interest income was offset by a decrease in the yield on the investment portfolio resulting in a $426,000 decrease in interest income. Sales and increased prepayment speeds on United's mortgage-backed portfolio and a lower interest rate environment contributed to a lower reinvestment yield in 2003. Interest expense decreased $2.2 million at December 31, 2003 when compared to December 31, 2002. Average interest-bearing liabilities decreased $10.6 million from December 31, 2002 to $129.1 million at December 31, 2003. This decrease accounted for $663,000 of the $2.2 million decrease in interest expense. Other factors in the decrease of interest expense were: o Average certificates of deposit decreased $6.5 million and the corresponding interest expense associated with the volume change decreased $305,000. o Average other borrowings decreased $4.2 million during 2003 which accounted for $392,000 of the $437,000 decrease in other borrowings interest expense. The yield on interest bearing liabilities decreased from 4.31% in 2002 to 2.96% in 2003. The change in rate accounted for $1.5 million of the $2.2 million decrease in interest expense. Other factors in the decrease of interest due to the yield on interest-bearing liabilities were: o The average rate on certificates of deposit decreased from 4.72% at December 31, 2002 to 3.40% at December 31, 2003. This decrease accounted for $1.1 million of the decrease in interest expense. o The average yield on FHLB advances decreased from 3.97% to 1.86% in 2003 due to repricing opportunities in a lower interest rate environment and the prepayment of higher interest bearing advances in 2002. This decrease in yield accounted for approximately $320,000 reduction in interest expense. 26 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Rate/Volume Analysis The following table sets forth an analysis of volume and rate changes in interest income and interest expense of Fidelity's average earning assets and average interest-bearing liabilities. The table distinguishes between the changes related to average outstanding balances of assets and liabilities (changes in volume holding the initial interest rate constant) and the changes related to average interest rates (changes in average rate holding the initial outstanding balance constant). The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
December 31, 2004 December 31, 2003 Compared to December 31, 2003 Compared to December 31, 2002 Increase (Decrease) Due To Increase (Decrease) Due To ---------------------------------------------------------------------------- Volume Rate Total Volume Rate Total ----------------------------------------------------------------------------------------------------------------------- (Dollars In Thousands) Interest income on average earning assets: Loans $1,605 $(553) $1,052 $(931) $(1,263) $(2,194) Investment securities 689 (21) 668 420 (426) (6) Loans held for sale 150 (18) 132 (98) - (98) Federal Home Loan Bank stock 41 (27) 14 7 (26) (19) Federal funds sold and other short-term investments (33) - (33) (51) (16) (67) --------------------------------------------------------------------------- Total interest income 2,452 (619) 1,833 (653) (1,731) (2,384) --------------------------------------------------------------------------- Interest expense on average interest-bearing liabilities: Now accounts (4) (23) (27) 10 (58) (48) Money market deposit accounts 7 (10) (3) (41) (38) (79) Savings accounts 2 (7) (5) 4 (7) (3) Certificates of deposit 483 (796) (313) (305) (1,064) (1,369) Federal funds purchased - 87 87 (3) - (3) Other borrowings 1 (128) (127) (392) (45) (437) Federal Home Loan Bank advances 418 147 565 64 (320) (256) --------------------------------------------------------------------------- Total interest expense 907 (730) 177 (663) (1,532) (2,195) --------------------------------------------------------------------------- Changes in net interest income $1,545 $ 111 $1,656 $ 10 $ (199) $ (189) ===========================================================================
Provision for Loan Losses and Letter of Credit Reserves 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. 27 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition 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. The provision for loan losses for the year ended December 31, 2003 was $448,000 compared to $13,000 for the year ended December 2003, an increase of $435,000. The increase was due to growth in United's loan portfolio. During 2002, Fidelity completed a securitization of automobile loans in addition to a loan sale which resulted in a net reversal of the provision for loan losses of $360,000. The ratio of allowance for loan losses to non-performing loans was 44.4% at December 31, 2004 compared to 49.3% at December 31, 2003. The primary reason for the increase in non-performing loans was due to one residential real estate loan totaling $451,000. This credit was paid off in full in the first quarter of 2004. The largest remaining non-accrual loan has a balance of $170,000 and is a purchased participation. Management believes that the reserves for the loan are adequate at December 31, 2004. Non-Interest Income Non-interest income for the year ended December 31, 2004 decreased by $1.4 million or 35.7% compared to December 31, 2003. Net gains on the sale of loans decreased $415,000 from the prior year due primarily to a decrease in the amount of mortgage loans sold. Fidelity recorded a $353,000 in gains on sales of available for sale securities in 2003 compared to $47,000 in 2004. During 2002, Fidelity liquidated a $500,000 senior note for $360,000 and recorded a gain of $140,000. A gain of $359,000 was recognized on the sale of three foreclosed properties during 2003, or substantially all of the real estate owned portfolio compared to zero in 2004. An increase in early payoffs on automobile loans previously sold resulted in the repayment of dealer interest totaling $203,000 from auto dealers, compared to $299,000 in 2003. Income of $118,000 was recognized on the retained interests in securitized assets compared to $182,000 in 2003. Non-interest income for the year ended December 31, 2003 increased by $371,000 or 10.6% compared to December 31, 2002. Net gains on the sale of loans decreased $558,000 from the prior year due primarily to a decrease in volume of automobile loans sold. Fidelity recorded a $353,000 in gains on sales of available for sale securities in 2003 compared to $73,000 in 2002. Declining interest rates and increased prepayment speeds made it advantageous to sell certain securities in 2003. Servicing fees on loans sold increased $131,000 over the prior year due to the increased size of the mortgage and consumer loan servicing portfolios. Gain on sales of assets was $15,000 for 2003 compared to $574,000 in 2002. A non recurring gain of $574,000 was recognized in the fourth quarter of 2002 in connection with the sale of certain affordable housing assets to a related party. During 2002, Fidelity liquidated a $500,000 senior note for $360,000 and recorded a gain of $140,000. A gain of $359,000 was recognized on the sale of three foreclosed properties during 2003, or substantially all of the real estate owned portfolio. An increase in early payoffs on automobile loans previously sold resulted in the repayment of dealer interest totaling $299,000 from auto dealers, compared to $66,000 in 2002. Income of $182,000 was recognized on the retained interests in securitized assets compared to $90,000 in 2002. 28 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Non-Interest Expense Non-interest expense decreased $574,000 or 8.6% for the year ended December 31, 2004, compared to December 31, 2003. Salaries and employee benefits decreased $269,000 during 2004 when compared to 2003, due to a reduction in full-time equivalent employees. Data processing expense increased $76,000 over 2003 due to increased volume of mortgage and consumer loans serviced when compared to the same period in 2003, in addition to the introduction of internet banking in 2003. Advertising increased $48,000 over 2003 due to increased product promotions. Printing, postage and office supplies decreased $69,000 in 2004 due to cost control measures and the termination of indirect lending late in the third quarter of 2004. Dealer promotional expenses decreased $63,000 in 2004 due primarily to a decrease in automobile originations in the current year and the termination of indirect lending. Professional liability insurance expense decreased $89,000 from the prior year due to market rate decreases and improvement in bank earnings. Non-interest expense decreased $3.2 million or 32.6% for the year ended December 31, 2003, compared to December 31, 2002. Salaries and employee benefits decreased $289,000 during 2003 when compared to 2002, due to a reduction in full-time equivalent employees. Data processing expense increased $100,000 over 2002 due to increased volume of mortgage and consumer loans serviced when compared to the same period in 2002, in addition to the introduction of internet banking in 2003. Legal and professional fees decreased $48,000 from the prior year due to a decrease in loan workout activities. Dealer promotional expenses decreased $60,000 in 2003 due primarily to a decrease in automobile originations in the current year. Professional liability insurance expense increased $108,000 over the prior year due to market rate increases. During 2003, the valuation allowance for letters of credit was reduced by $170,000 compared to none in 2002 and $1.5 million in 2001 to reflect a reduction in loss exposure achieved. The $170,000 in 2003 was effectively reclassified between the letter of credit valuation and allowance for loan losses offsetting the impact on net income. Fidelity records its percentage share of losses for its limited partner investments in various affordable housing partnerships under the equity method of accounting. These losses were $40,000, $160,000, and $304,000 for 2003, 2002 and 2001, respectively. During the fourth quarter of 2002, Fidelity completed the sale of a subsidiary that held general partnership interests in seventeen affordable housing projects. See "Related Party" footnote for additional details. Other real estate owned expenses of $247,000 were recognized in 2002 compared to only $34,000 in 2003 due to a foreclosure on one large commercial real estate loan in 2002. Non-recurring expenses were incurred during 2002 for various reasons, the following non-recurring items are included in non-interest expense: Changes in the estimated useful lives of intangible assets created additional expense of $864,000 and are discussed in the "Related Party" footnote. Prepayment fees on FHLB advances of $504,000 were recognized in 2002 compared to none in 2003 or 2001. United repaid long-term FHLB advances that had substantially higher interest rates than the current market. The completion of the securitization transaction created liquidity which was used to payoff these higher interest bearing liabilities. These higher cost borrowings were replaced with deposits and borrowings at a much lower rate. This is expected to result in a much lower overall cost of funds for Fidelity in the future. 29 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Income Tax Expense (Benefit) Fidelity reported a pretax income of $406,000 compared to the prior year pretax loss of $6,000. An income tax benefit of $66,000 was recorded on the pretax income which was primarily generated by the current year tax credits. In 2002, an income tax benefit of approximately $1.2 million was recorded on the $3.0 million pretax loss but was reduced by additional tax expense resulting from a capital gain, which reduced the benefit to $641,000. The additional tax expense was primarily the result of the capital gain for tax purposes on the sale of Fidelity's subsidiaries and the additional $600,000 tax valuation allowance established in connection with Fidelity's deferred tax asset. Included in the tax benefit are tax credits for 2004 and 2003 of $222,000. The 2004 and 2003 tax credits were received from Fidelity's remaining investment as a limited partner in affordable housing properties and are a component of the overall return on these investments. 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. Loss on Discontinued Operations During the fourth quarter of 2002, Fidelity completed the sale of the assets connected to their affordable housing activities that began in the mid-1990's to Pedcor Funding Corporation ("Pedcor"). The assets consisted of the stock of Village Housing Corporation (a wholly-owned subsidiary of United Fidelity Bank), the stock of Village Affordable Housing Corporation (a wholly-owned subsidiary of Fidelity Federal), an interest rate swap, and notes from affordable housing limited partnerships in which Village Housing Corporation is the general partner. The Company determined to pursue the sale of these assets in order to further focus on its community banking activities. It also determined that the elimination of the contingent liabilities associated with the ownership of the affordable housing general partnerships interests would improve its overall risk profile. The purchaser, Pedcor Funding Corporation ("Pedcor"), is a company controlled by Bruce A. Cordingley, Gerald K. Pedigo, and Phillip J. Stoffregen, directors of Fidelity Federal and members of a group which beneficially owns, including stock options and warrants at the time of the transaction, approximately 69.9% of Fidelity Federal's issued and outstanding stock. Because of the relationship between Pedcor and Fidelity Federal, Messrs. Cordingley, Pedigo, and Stoffregen did not participate in either the discussion or the vote by the boards of directors of Fidelity Federal and United Fidelity Bank regarding the sale. The sale was unanimously approved by all other members of the respective Boards of Directors of Fidelity Federal and United Fidelity Bank and was completed following receipt of all necessary regulatory approvals and a fairness opinion. The fairness opinion was rendered by Crowe Chizek & Co., an independent, non-affiliated entity which has never performed services for Messrs. Cordingley, Pedigo, or Stoffregen or any entity they control (other than Fidelity Federal or United Fidelity Bank), and has not performed services within the last five years for Fidelity Federal or United Fidelity Bank. The sale price for the all-cash transaction was approximately $1.7 million, thus the sale provided the Company with additional liquidity. Because a portion of the assets sold had been previously eliminated from regulatory capital, the sale resulted in an increase in the regulatory capital of United Fidelity Bank. Additional regulatory capital provides the Bank future capacity to increase earning assets, which could then increase net interest income. 30 [LOGO OF FIDELITY FEDERAL BANCORP] Management's Discussion and Analysis of Results of Operations and Financial Condition Net loss on operations from these subsidiaries totaled $2.0 million of which $1.5 million was associated with the completion of the sale and $451,000 associated with the income tax expense impact. Net income or loss from prior years were immaterial and not included as a separate component. See the "Discontinued Operations" footnote for additional details.
Quarterly Results of Operations (Dollars in thousands) March 31 June 30 September 30 December 31 Total ---------------------------------------------------------------------------------------------------------------------- December 31, 2004 Interest income $ 2,042 $ 2,050 $ 2,189 $ 2,202 $ 8,483 Interest expense 982 977 998 1,047 4,004 ---------------------------------------------------------------------------------- Net interest income 1,060 1,073 1,191 1,155 4,479 Provision for loan losses 170 39 134 105 448 Non-interest income 701 659 579 556 2,495 Non-interest expense 1,586 1,602 1,523 1,409 6,120 ---------------------------------------------------------------------------------- Income before income tax 5 91 113 197 406 Income tax expense (benefit) (60) (19) (8) 21 (66) ---------------------------------------------------------------------------------- Net income $ 65 $ 110 $ 121 $ 176 $ 472 ================================================================================== Net income (loss) per share Diluted net income $ 0.01 $ 0.01 $ 0.01 $ 0.02 $ 0.04 Basic net income 0.01 0.01 0.01 0.02 0.04 Cash dividends* December 31, 2003 Interest income $ 1,602 $ 1,596 $ 1,616 $ 1,836 $ 6,650 Interest expense 1,158 980 833 856 3,827 ---------------------------------------------------------------------------------- Net interest income 444 616 783 980 2,823 Provision for loan losses (104) (18) 99 36 13 Non-interest income 1,218 1,106 914 640 3,878 Non-interest expense 1,761 1,658 1,662 1,613 6,694 ---------------------------------------------------------------------------------- Income (loss) before income tax 5 82 (64) (29) (6) Income tax benefit (50) (21) (90) (59) (220) ---------------------------------------------------------------------------------- Net income $ 55 $ 103 $ 26 $ 30 $ 214 ================================================================================== Net income (loss) per share Diluted net income $ 0.10 $ 0.13 $ 0.03 $ 0.04 $ 0.29 Basic net income 0.10 0.13 0.03 0.04 0.29 Cash Dividends*
*No cash dividends were paid for the years ended December 31, 2004 and 2003. 31 [LOGO OF BKD LLP] Report of Independent Registered Public Accounting Firm Stockholders and Board of Directors Fidelity Federal Bancorp Evansville, Indiana We have audited the accompanying consolidated balance sheets of Fidelity Federal Bancorp as of December 31, 2004 and 2003, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with 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 financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Fidelity Federal Bancorp as of December 31, 2004 and 2003, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. /s/ BKD LLP Evansville, Indiana January 14, 2005 32 FIDELITY FEDERAL BANCORP Consolidated Balance Sheets (In Thousands, Except Share Data)
December 31 2004 2003 ------------------------------------------------------------------------------------------------------- Assets Cash and cash equivalents $ 989 $ 1,705 Interest-bearing demand deposits 3,633 1,263 -------------------------- Cash and cash equivalents 4,622 2,968 Investment securities available for sale 65,192 52,208 Loans, net of allowance for loan losses of $756 and $737 (also includes loans to related parties of $169 and $177 110,771 100,437 Premises and equipment 4,646 4,620 Federal Home Loan Bank of Indianapolis stock 3,627 3,466 Deferred income tax 6,192 6,093 Foreclosed assets held for sale, net of allowance of $20 and $0 316 Interest receivable and other assets 5,192 5,598 -------------------------- Total assets $ 200,558 $ 175,390 ========================== Liabilities Deposits Non-interest bearing (includes related party deposits of $2,179 and $854) $ 8,250 $ 6,903 Interest bearing (including related party time deposits of $364 and $0) 119,451 113,777 -------------------------- Total deposits 127,701 120,680 Federal Home Loan Bank advances 44,090 31,550 Borrowings (includes borrowings from a related party of $0 and $1,000) 10,460 8,077 Valuation allowance for letters of credit 232 291 Other liabilities 1,814 1,425 -------------------------- Total liabilities 184,297 162,023 -------------------------- Commitments and Contingent Liabilities Stockholders' Equity Preferred stock, no par or stated value Authorized and unissued--5,000,000 shares Common stock, $12 stated value Authorized--1,250,000 shares Issued and outstanding--916,656 and 801,555 shares 11,000 9,619 Additional paid-in capital 17,727 16,634 Stock warrants 261 261 Accumulated deficit (12,466) (12,938) Accumulated other comprehensive loss (261) (209) -------------------------- Total stockholders' equity 16,261 13,367 -------------------------- Total liabilities and stockholders' equity $ 200,558 $ 175,390 ==========================
See notes to consolidated financial statements. 33 FIDELITY FEDERAL BANCORP Consolidated Statements of Income (In Thousands, Except Share Data)
Year Ended December 31 2004 2003 2002 ----------------------------------------------------------------------------------------- Interest Income Loans receivable $ 6,054 $ 5,002 $ 7,196 Loans held for sale 171 39 137 Investment securities--taxable 2,089 1,421 1,427 Deposits with financial institutions 14 47 114 Other dividend income 155 141 160 ------------------------------- Total interest income 8,483 6,650 9,034 ------------------------------- Interest Expense Deposits 2,539 2,886 4,385 Short-term borrowings 96 18 64 Long-term debt 1,369 923 1,573 ------------------------------- Total interest expense 4,004 3,827 6,022 ------------------------------- Net Interest Income 4,479 2,823 3,012 Provision for loan losses 448 13 (360) ------------------------------- Net Interest Income After Provision for Loan Losses 4,031 2,810 3,372 ------------------------------- Other Income Service charges on deposit accounts 457 436 439 Net gains on loan sales (includes a $223 gain on sale to a related party in 2002) 310 725 1,283 Net gains on sales of securities available for sale 47 353 73 Letter of credit fees 491 491 501 Servicing fees on loans sold 351 292 161 Gain on sale of assets 15 574 Gain on early extinguishment of debt 140 Gain on sale of foreclosed assets 359 Dealer interest recovery 203 299 66 Income from I/O STRIP 118 182 90 Other income (includes a $72 gain on sale of interest rate swap to a related party in 2002) 518 726 180 ------------------------------- Total non-interest income 2,495 3,878 3,507 ===============================
34 FIDELITY FEDERAL BANCORP Consolidated Statements of Income (In Thousands, Except Share Data) (Continued)
Year Ended December 31 2004 2003 2002 ------------------------------------------------------------------------------------- Other Expenses Salaries and employee benefits $ 3,058 $ 3,327 $ 3,616 Net occupancy expenses 362 343 371 Equipment expenses 360 393 350 Data processing fees 513 437 337 Deposit insurance expense 55 51 57 Legal and professional fees 268 250 298 Advertising 204 156 142 Promotional expense 95 158 218 Printing, postage, and office supplies expenses 136 205 229 Professional liability insurance expense 195 284 176 Fee on prepayment of FHLB advances 504 Letter of credit valuation provision (77) (170) Loss on investment in partnerships 30 40 160 Amortization of intangible assets 917 Correspondent bank charges 145 147 132 Loss on securitization 976 Other real estate owned expenses 26 34 247 Bond issuance expense 36 110 63 Other expense 714 929 1,134 ---------------------------------- Total non-interest expense 6,120 6,694 9,927 ---------------------------------- Income (Loss) From Continuing Operations Before Income Tax 406 (6) (3,048) Income tax benefit (66) (220) (641) ---------------------------------- Income (Loss) From Continuing Operations 472 214 (2,407) ---------------------------------- Discontinued Operations Loss from operations of VHC and VAHC (including loss on sale of $1,517 to a related party) (1,537) Income tax expense 451 ---------------------------------- Loss on discontinued operations (1,988) ---------------------------------- Net Income (Loss) $ 472 $ 214 $(4,395) ==================================
35 FIDELITY FEDERAL BANCORP Consolidated Statements of Income (In Thousands, Except Share Data) (Continued)
Year Ended December 31 2004 2003 2002 ----------------------------------------------------------------------------------------------- Basic Earnings (Loss) Per Share From Continuing Operations $0.54 $0.29 $(4.67) Basic Loss Per Share from Discontinued Operations $(3.86) Basic Earnings (Loss) Per Share $0.54 $0.29 $(8.53) Diluted Earnings (Loss) Per Share From Continuing Operations $0.54 $0.29 $(4.67) Diluted Loss Per Share from Discontinued Operations $(3.86) Diluted Earnings (Loss) Per Share $0.54 $0.29 $(8.53)
See notes to consolidated financial statements. 36 FIDELITY FEDERAL BANCORP Consolidated Statements of Changes in Stockholders' Equity (In Thousands, Except Share Data)
Accumulated Common Stock Comprehensive Other -------------------- Paid-in Stock Income Accumulated Comprehensive Shares Amount Capital Warrants (Loss) Deficit Income (Loss) Total ---------------------------------------------------------------------------------------- Balances, January 1, 2002 498,917 $ 5,987 $14,692 $ 11 $ (8,757) $ (38) $11,895 Comprehensive loss Net loss $(4,395) (4,395) (4,395) Other comprehensive income, net of tax Unrealized gain on securities 417 417 417 ------------- Comprehensive loss $(3,978) ============= Sale of stock 62,823 754 667 1,421 Issuance of stock warrants 250 250 --------------------------------------- ------------------------------------ Balances, December 31, 2002 561,740 6,741 15,359 261 (13,152) 379 9,588 Comprehensive income Net income $ 214 214 214 Other comprehensive loss, net of tax Unrealized loss on securities (588) (588) (588) ------------- Comprehensive loss $(374) ============= Sale of stock 239,815 2,878 1,275 4,153 --------------------------------------- ------------------------------------ Balances, December 31, 2003 801,555 9,619 16,634 261 (12,938) (209) 13,367 Comprehensive income Net income $472 472 472 Other comprehensive loss, net of tax Unrealized loss on securities (52) (52) (52) ------------- Comprehensive income $420 ============= Sale of stock 115,101 1,381 1,093 2,474 --------------------------------------- ------------------------------------ Balances, December 31, 2004 916,656 $11,000 $17,727 $261 $(12,466) $(261) $16,261 ======================================= ====================================
See notes to consolidated financial statements. 37 FIDELITY FEDERAL BANCORP Consolidated Statements of Cash Flows (In Thousands)
Year Ended December 31 2004 2003 2002 --------------------------------------------------------------------------------------------------------- Operating Activities Net income (loss) $ 472 $ 214 $ (4,395) Adjustments to reconcile net income (loss) to net cash provided (used) by operating activities Provision for loan losses 448 13 (360) Provision for losses on foreclosed assets 20 Letter of credit valuation provision (77) (170) Gain on early extinguishment of debt (140) Net gain on sales of securities available for sale (47) (353) (73) Net gain on sale of loans (310) (725) Net gain on sale of foreclosed assets (359) Loss on impairment of assets held for sale and changes in estimated useful lives of intangible assets 1,769 Depreciation and amortization 418 438 1,334 Amortization of premiums and discounts, net 484 399 348 Valuation allowance--affordable housing investments 40 Mortgage loans originated for sale (9,557) (25,827) (22,954) Proceeds from sale of mortgage loans 9,760 26,349 23,129 Consumer loan originations transferred to held for sale (19,621) (36,829) (5,145) Proceeds from consumer loan sales 19,728 37,032 5,145 Deferred income tax (66) (220) (641) Changes in Interest payable and other liabilities 406 (439) (564) Interest receivable and other assets 389 (465) (617) ----------------------------------- Net cash provided (used) by operating activities 2,447 (942) (3,124) ----------------------------------- Investing Activities Purchases of securities available for sale (36,246) (60,298) (34,125) Proceeds from maturities of securities available for sale 20,185 19,455 12,607 Proceeds from sales of securities available for sale 2,555 22,530 5,053 Purchases of FHLB stock (161) (792) (54) Proceeds from sale of foreclosed assets 2,772 Proceeds from sale of note receivable to a related party (235) Net change in loans (11,126) (30,145) 29,510 Net change in loans to related parties 8 2,605 166 Purchase of premises and equipment (444) (123) (218) Proceeds from sales of premises and equipment 783 Funding on outstanding letters of credit 18 (239) ----------------------------------- Net cash provided (used) by investing activities (25,211) (43,996) 13,248 -----------------------------------
38 FIDELITY FEDERAL BANCORP Consolidated Statements of Cash Flows (In Thousands) (Continued)
Year Ended December 31 2004 2003 2002 --------------------------------------------------------------------------------------------------- Financing Activities Net change in Noninterest-bearing, interest-bearing demand and savings deposits (includes changes to related party of $1,325, $235 and $30) $ 2,876 $ 1,995 $ (3,753) Certificates of deposit (includes changes to related party of $364, $0 and $0) 4,145 11,894 (9,611) Proceeds from borrowings 5,558 4,275 4,858 Repayment of borrowings (2,175) (7,784) (6,449) Proceeds of borrowings from a related party 1,000 Repayment of borrowings from a related party (1,000) Proceeds of FHLB advances 123,235 68,500 60,300 Repayment of FHLB advances (110,695) (39,950) (69,633) Sale of stock 2,474 4,153 1,421 Sale of stock warrants 250 ---------------------------------------- Net cash provided (used) by financing activities 24,418 44,083 (22,617) ---------------------------------------- Net Change in Cash and Cash Equivalents 1,654 (855) (12,493) Cash and Cash Equivalents, Beginning of Period 2,968 3,823 16,316 ---------------------------------------- Cash and Cash Equivalents, End of Period $ 4,622 $ 2,968 $ 3,823 ======================================== Additional Cash Flows Information Interest paid $ 3,859 $ 3,754 $ 6,256 Real estate acquired in settlement of loans 752 192 2,123
See notes to consolidated financial statements. 39 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) >> Nature of Operations and Summary of Significant Accounting Policies The accounting and reporting policies of Fidelity Federal Bancorp (Fidelity) and its wholly-owned subsidiaries conform to accounting principles generally accepted in the United States of America and reporting practices followed by the thrift industry. The more significant of the policies are described below. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Fidelity is a registered thrift holding company whose principal activity is the ownership and management of United Fidelity Bank, fsb (United). United operates under a national thrift charter and provides full banking services. As a federally chartered thrift, United is subject to regulation by the Office of Thrift Supervision (OTS) and the Federal Deposit Insurance Corporation. United generates mortgage, consumer and commercial loans and receives deposits from customers located primarily in Vanderburgh County, Indiana and surrounding counties. Fidelity's loans are generally secured by specific items of collateral including real property, consumer assets and business assets. Village Capital Corporation previously earned fees by providing real estate mortgage banking services to unaffiliated borrowers. Village Capital has not provided any new banking services for the past three years, but records fee income on transactions previously completed. Another United subsidiary, Village Insurance Corporation, is engaged in the business of selling credit life and accident health insurance in conjunction with United's lending activities. Village Insurance was merged into Village Capital Corporation during 2003. United formed a new subsidiary, United Fidelity Finance, LLC, during the fourth quarter of 2001, which was utilized to complete an auto loan securitization transaction during 2002. Consolidation-- The consolidated financial statements include the accounts of Fidelity and its subsidiaries after elimination of all material intercompany transactions. Use of estimates-- The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowance for loan losses and the valuation of foreclosed assets held for sale, management obtains independent appraisals for significant properties. 40 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) Cash equivalents-- Fidelity considers all liquid investments with original maturities of three months or less to be cash equivalents. Securities available for sale are carried at fair value, with unrealized gains and losses reported separately in accumulated other comprehensive income, net of tax. Amortization of premiums and accretion of discounts are recorded as interest income from securities. Realized gains and losses are recorded as net security gains (losses). Gains and losses of securities are recorded on the specific-identification method. Loans held for sale are carried at the lower of aggregate cost or market value. Market is determined using the aggregate method. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income, based on the difference between estimated sales proceeds and aggregate cost. Loans held for sale at any point in time normally consist of blocks of consumer loans designated for sale to unrelated financial institutions or individual 1-4 family mortgage loans originated for sale into the secondary market. The amounts of loans held for sale at December 31, 2004 and 2003, were not significant and have been included with total loans on the consolidated balance sheets. Loans are carried at the principal amount outstanding. Interest income is accrued on the principal balances of loans. The accrual of interest on impaired loans is discontinued when, in management's opinion, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed when considered uncollectible. Interest income is subsequently recognized only to the extent cash payments are received. Certain loan fees and related direct costs are being deferred and amortized over the lives of the loans as an adjustment of yield on the loans. Allowance for loan losses is maintained for credit losses to absorb losses inherent in the loan portfolio. The valuation allowance for letters of credit is maintained for losses related to letters of credit, which are off-balance sheet instruments. The allowances are based on ongoing quarterly assessments of the probable estimated losses inherent in the loan and letter of credit portfolios. The allowance for loan losses is increased by the provision for credit losses, which is charged against current period operating results and decreased by the amount of chargeoffs, net of recoveries. The valuation allowance for letters of credit is maintained in a separate liability account and changes in the valuation allowance are included in current year operations. Fidelity's methodology for assessing the appropriateness of the allowance for loan losses consists of several key elements, which include the formula allowance, specific allowances for identified problem loans and the unallocated allowance. The formula allowance is calculated by applying loss factors to outstanding loans and certain unused commitments, in each case based on the internal risk grade of such loans, pools of loans or commitments. Changes in risk grades of both performing and nonperforming loans affect the amount of the formula allowance. Loss factors are based on historical loss experience and may be adjusted for significant factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. Specific loan and letter of credit valuation reserves are established in cases where management has identified significant conditions or circumstances related to a loan or letter of credit that management believes indicate the probability that a loss has been incurred in excess of the amount determined by the application of, in the case of the allowance for loan losses, the formula allowance. 41 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) The unallocated allowance for loan losses is based upon management's evaluation of various conditions, the effects of which are not directly measured in the determination of the formula and specific allowances. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific credits. The conditions evaluated in connection with the unallocated allowance for loan losses and the letter of credit valuation reserve may include existing general economic and business conditions affecting Fidelity's key lending areas, credit quality trends, collateral values, loan volumes and concentrations, seasoning of the loan and letter of credit portfolios, specific industry conditions within portfolio segments, recent loss experience in particular segments of the portfolios, duration of the current business cycle, regulatory examination results and findings of an independent third party conducting quarterly reviews of the loan and letter of credit portfolios. The allowance for loan losses also incorporates the results of measuring impaired loans as provided in SFAS No. 114 and SFAS No. 118. A loan is considered impaired when management determines that it is probable that the bank will be unable to collect all amounts due according to the original contractual terms of the loan agreement. Impairment is measured by the difference between the recorded investment in the loan and the estimated present value of total expected future cash flows, discounted at the loan's effective rate, or the fair value of the collateral of the loan, if collateral dependent. Impairment is recognized by adjusting an allocation of the existing allowance for loan losses. The determination of the adequacy of the allowance for loan losses and the letter of credit valuation allowance is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. Management believes that, as of December 31, 2004, the allowance for loan losses and the letter of credit valuation allowance were adequate based on information currently available. A worsening or protracted economic decline in the area within which Fidelity operates could affect the possibility of additional losses due to credit and market risks and could create the need for additional loss reserves. Automobile Loan Securitizations--In 2002, United used the securitization of automobile loans as a source of funding and as a mechanism to reduce its volume of automobile loans. Automobile loans were transferred into a qualifying special purpose entity (SPE) then to a trust in a transaction which is effective under applicable banking rules and regulations to legally isolate the assets from United. Where the transferor is a depository institution such as United, legal isolation is accomplished through compliance with specific rules and regulations of the relevant regulatory authorities. SFAS 140 requires, for certain transactions completed after the initial adoption date, a "true sale" analysis of the treatment of the transfer under state law as if United were a debtor under the bankruptcy code. A "true sale" legal analysis includes several legally relevant factors, such as the nature and level of recourse to United and the nature of retained servicing rights. The analytical conclusion as to a true sale is never absolute and unconditional, but contains qualifications based on the inherent equitable powers of a bankruptcy court, as well as the unsettled state of the common law. Once the legal isolation test has been met under SFAS 140, other factors concerning the nature and extent of United's control over the transferred assets are taken into account in order to determine whether derecognition of assets is warranted, including whether the SPE has complied with rules concerning qualifying special purpose entities. 42 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) A legal opinion was obtained for the automobile loan securitization transaction in 2002, which was structured as a two-step securitization. While noting the transaction fell within the meaning of a "securitization" under the FDIC regulation, "Treatment by the Federal Deposit Insurance Corporation as Conservator or Receiver of Financial Assets Transferred by an Insured Depository Institution in Connection with a Securitization or Participation" (the "Securitization Rule"), in accordance with accounting guidance, an analysis was also rendered under state law as if United was a debtor under the bankruptcy code. The "true sale" opinion provides reasonable assurance the purchased assets would not be characterized as the property of United's receivership or conservatorship estate in the event of insolvency and also states United would not be required to substantively consolidate the assets and liabilities of the purchaser SPE with those of United upon such event. In a securitization, the trust issues beneficial interests in the form of senior and subordinated asset-backed securities backed or collateralized by the assets sold to the trust. The senior classes of the asset-backed securities typically receive investment grade credit ratings at the time of issuance. These ratings are generally achieved through the acquisition of a financial guarantee policy, the creation of lower-rated subordinated classes of asset-backed securities, as well as subordinated interests retained by an affiliate of United. In all cases, United or its affiliate retains interests in the securitized assets, which may take the form of seller certificates, subordinated tranches, cash reserve balances, servicing assets and interest-only strips representing the cash flows generated by the assets in excess of the contractual cash flows required to be paid to the investors and for other obligations such as servicing fees. In accordance with SFAS 140, securitized automobile loans are removed from the balance sheet and a net gain or loss is recognized in income at the time of initial sale and each subsequent sale when the combined net sales proceeds and, if applicable, retained interests differ from the loans' allocated carrying amount. Net gains or losses resulting from securitizations are recorded in noninterest income or expense. Retained interests in the subordinated tranches and interest-only strips are recorded at their fair value and accounted for as available-for-sale securities with subsequent adjustments to fair value recorded through other comprehensive income within stockholders' equity or in other noninterest expense in the income statement if the fair value has declined below the carrying amount and such decline has been determined to be other than temporary. United uses assumptions and estimates in determining the fair value allocated to the retained interests at the time of sale and each subsequent sale in accordance with SFAS 140. These assumptions and estimates include projections concerning rates charged to customers, the expected life of the receivables, credit loss experience, loan repayment rates, the cost of funds and discount rates commensurate with the risks involved. On a quarterly basis, management reviews the historical performance of the retained interest and the assumptions used to project future cash flows. If past performance and future expectations dictate, assumptions are revised and the present value of future cash flows is recalculated. Refer to the automobile loan securitization footnote for further analysis of the assumptions used in the determination of fair value. The retained interest represents United's maximum loss exposure with respect to securitization vehicles. The investors in the debt securities issued by the SPEs have no further recourse against United if cash flows generated by the securitized automobile loans are inadequate to service the obligations of the SPEs. Transaction costs associated with the automobile loan securitization were recognized as a component of the gain or loss at the time of sale. 43 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) Premises and equipment are carried at cost, net of accumulated depreciation. Depreciation is computed using the straight-line method based principally on the estimated useful lives of the assets. Maintenance and repairs are expensed as incurred while major additions and improvements are capitalized. Gains and losses on dispositions are included in current operations. Federal Home Loan Bank (FHLB) stock is a required investment for institutions that are members of the FHLB system. The required investment in the common stock is based on a predetermined formula. Foreclosed assets held for sale-- Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net income or expense from foreclosed assets. Income tax in the consolidated statements of income includes deferred income tax provisions or benefits for all significant temporary differences in recognizing income and expenses for financial reporting and income tax purposes. Fidelity files consolidated income tax returns with its subsidiaries. Servicing rights on originated loans that have been sold, including those transferred as part of securitizations, are capitalized by allocating the total cost of the mortgage or consumer loans between the servicing rights and the loans based on their relative fair values. Capitalized servicing rights are amortized in proportion to and over the period of estimated servicing revenues. Impairment of mortgage and consumer loan-servicing rights is assessed based on the fair value of those rights. Fair values are estimated using discounted cash flows based on a current market interest rate. For purposes of measuring impairment, the rights are stratified based on the predominant risk characteristics of the underlying loans. The predominant characteristic currently used for stratification is type of loan. The amount of impairment recognized is the amount by which the capitalized servicing rights for a stratum exceed their fair value. Stock options and Fidelity's stock-based incentive compensation plans are discussed more fully in the Stock Option Plans footnote. The Company 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.
Year Ended December 31 2004 2003 2002 ---------------------------------------------------------------------------------------------- $472 $214 $(4,395) Net income (loss), as reported Less: Total stock-based compensation cost determined under the fair value based method, net of income taxes 18 31 73 ------------------------------ $454 $183 $(4,468) Pro forma net income (loss) ============================== $0.54 $0.29 $(8.54) Basic earnings (loss) per share - as reported Basic earnings (loss) per share - pro forma $0.52 $0.25 $(8.68) Diluted earnings (loss) per share - as reported $0.54 $0.29 $(8.54) Diluted earnings (loss) per share - pro forma $0.52 $0.25 $(8.68)
44 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) Earnings per share have been computed based upon the weighted-average common shares outstanding during the year. The effect of outstanding options and warrants are included in diluted earnings per share if they are not anti-dilutive. Reclassification of certain amounts in the 2003 and 2002 consolidated financial statements has been made to conform to the 2004 presentation. >> Restriction on Cash and Due From Banks United is required to maintain reserve funds in cash and/or on deposit with the Federal Reserve Bank. The reserve required at December 31, 2004 was $19. United maintains cash in bank deposit accounts, which at times, may exceed federally insured limits. United has not experienced any losses in such accounts. Management does not believe United is exposed to any significant risk. >> Investment Securities Available for Sale Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value ------------------------------------------------ December 31, 2004 Mortgage-backed securities $65,613 $59 $(480) $65,192 ================================================ December 31, 2003 Mortgage-backed securities $52,544 $50 $(386) $52,208 ================================================ Securities with a carrying value of $65,191 and $52,207 were pledged at December 31, 2004 and 2003, respectively, to secure certain deposits, outstanding Federal Home Loan Bank advances, secured federal funds purchased line of credit , repurchased lines of credit, and for other purposes as permitted or required by law. Gross gains of $47, $353 and $73 resulting from sales of available-for-sale securities were realized for 2004, 2003 and 2002, respectively. Taxes of $18, $134 and $28 were recorded on the gains, respectively. Certain investments in debt securities are reported in the financial statements at an amount less than their historical cost. Total fair value of these investments at December 31, 2004 and 2003, was $55,161 and $34,400, respectively, which is approximately 85% and 66% of Fidelity's available-for-sale investment portfolio. These declines primarily resulted from recent increases in market interest rates. Based on evaluation of available evidence, including recent changes in market interest rates and information obtained from regulatory filings, management believes the declines in fair value for these securities are temporary. 45 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) Should the impairment of any of these securities become other than temporary, the cost basis of the investment will be reduced and the resulting loss recognized in net income in the period the other-than-temporary impairment is identified. The following table shows our investments' gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position:
Less than 12 Months 12 Months or More Total ----------------------------------------------------------------------------------- Description of Securities Fair Value Unrealized Fair Value Unrealized Fair Value Unrealized Losses Losses Losses ------------------------------------------------------------------------------------------------------------------ December 31, 2004 Mortgage-backed securities $41,037 $(270) $14,124 $(210) $55,161 $(480) =================================================================================== December 31, 2003 Mortgage-backed securities $34,281 $(384) $ 119 $ (2) $34,400 $(386) ===================================================================================
>> Loans and Allowance
December 31 2004 2003 ------------------------------------------------------------------------------------------------------------------ Real estate mortgage loans First mortgage loans Conventional $ 38,226 $ 41,754 Construction 4,471 2,042 Commercial 16,251 9,144 Multi-family 594 213 Home equity loans 6,144 5,067 Purchased loans 385 778 Commercial loans--other than secured by real estate 4,136 3,138 Consumer loans 41,320 39,038 -------------------------- Total loans 111,527 101,174 Allowance for loan losses (756) (737) -------------------------- Total loans, net of the allowance for loan losses $110,771 $100,437 ==========================
46 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) Year Ended December 31 2004 2003 2002 ------------------------------------------------------------------------ Allowance for Loan Losses Balances, beginning of period $ 737 $ 837 $ 2,138 Provision for losses 562 492 204 Loans transferred to held for sale (114) (479) (564) Recoveries on loans 141 123 1,013 Loans charged off (570) (236) (1,954) --------------------------------- Balances, end of period $ 756 $ 737 $ 837 ================================= Information on impaired loans is summarized below: December 31 2004 2003 ----------------------------------------------------------- Impaired loans with an allowance $671 $765 Impaired loans without an allowance 8 10 --------------- Total impaired loans $679 $775 =============== Allowance for impaired loans (included in allowance for loan losses) $130 $169 =============== Year Ended December 31 2004 2003 2002 -------------------------------------------------------------------------- Average balance of impaired loans $ 725 $ 924 $3,656 Interest income recognized on impaired loans 26 13 312 Cash-basis interest included above 26 16 333 At December 31, 2004 and 2003, accruing loans delinquent 90 days or more totaled $259 and $287, respectively. Non-accruing loans at December 31, 2004 and 2003, were $755 and $1,415, respectively. >> Letter of Credit Valuation Allowance Reserves related to letters of credit issued by Fidelity and United relate to the permanent financing for certain affordable housing projects. Multi-family housing letters of credit, an off-balance sheet item, carry the same risk characteristics as conventional loans and totaled $22,724 and $27,774 at December 31, 2004 and 2003, respectively. 47 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) Year Ended December 31 2004 2003 2002 ------------------------------------------------------------------------- Letter of credit valuation allowance Balances, beginning of year $ 291 $ 445 $ 665 Provision (77) (170) Recoveries 18 16 19 Funding of outstanding letters of credit (239) -------------------------- Balances, end of year $ 232 $ 291 $ 445 ========================== >> Automobile Loan Securitization United completed an automobile loan securitization transaction in 2002. The transaction resulted in the sale of $49 million of rated class A notes. Financial Security Assurance (FSA) provided a financial guaranty policy on the class A notes. The transaction also resulted in the sale of $500,000 in non-rated class B notes. The transaction was effected through a wholly-owned subsidiary, United Fidelity Finance, LLC. A summary of the components of managed loans, which represents both owned and securitized loans, follow. The automobile loans presented represent the managed portfolio of indirect prime automobile loans. Loans Past Principal Due Over As of December 31, 2004 Balance 30 Days ------------------------------------------------------------------------------- Total managed automobile loans $ 86,240 $1,128 Less: Automobile loans securitized (11,493) (261) Automobile loans serviced for others (35,179) (222) -------------------------- Total automobile loans held in portfolio $ 39,568 $ 645 ========================== Certain cash flows received from the securitization trust follow: Year Ended December 31 2004 2003 2002 ------------------------------------------------------------------------ Proceeds from securitization $48,939 Servicing fees received $186 $329 138 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 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. 48 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) A summary of the fair values of the interest-only strips and servicing assets retained, key economic assumptions used to arrive at the fair values and the sensitivity of the December 31, 2004, fair values to immediate 10% and 20% adverse changes in those assumptions follows. Actual credit losses experienced through year end 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% 8.75% As of December 31, 2004 1,114 7 0.67 1.50 15.0 8.41 Decline in fair value of 10% adverse change $ 2 $3 $ 9 Decline in fair value of 20% adverse change 17 7 17 Servicing asset As of the date of securitization $ 362 39 1.50% 1.50% 15.0% As of December 31, 2004 0 7 0.67 1.50 15.0
>> Foreclosed Assets Held for Sale Activity in the allowance for losses on foreclosed assets was as follows: Year Ended December 31 2004 2003 ------------------------------------------------------------------------- Balance, beginning of year $ 0 $ 100 Provision charged to expense 20 Charge-offs, net of recoveries (100) ------------------------ Balance, end of year $20 $ 0 ======================== 49 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) >> Premises and Equipment December 31 2004 2003 --------------------- Land $ 935 $ 935 Building and land improvements 5,892 5,590 Furniture, fixtures and equipment 2,357 2,214 --------------------- Total cost 9,184 8,739 Accumulated depreciation (4,538) (4,119) --------------------- Net $ 4,646 $ 4,620 ===================== >> Other Assets and Investments in Limited Partnerships Included in other assets at December 31, 2004 and 2003, are investments of $327 and $358, respectively, in limited partnerships which are organized to build, own and operate apartment complexes. The carrying amounts of these investments approximate Fidelity's equity in the net assets of the partnerships. The investments at December 31, 2004 and 2003, were as follows: Amount of Number of Investment Partnerships Percentage and Type of ------------------------------------------ Partnership Interest 2004 2003 2004 2003 ------------------------------------------------------------------------------- 31%--Limited $ 0 $ 0 1 1 26%--Limited 45 45 1 1 10%--Limited 187 217 1 1 10%--Limited 95 95 1 1 Fidelity records income on the equity method in the income and losses of the limited partnerships, which resulted in losses of $0, $22 and $38 during the years ended December 31, 2004, 2003 and 2002, respectively. In addition to recording its equity in the losses of these projects, Fidelity has recorded the benefit of low-income housing tax credits of $222, $222 and $185 for the years ended December 31, 2004, 2003 and 2002, respectively. In certain cases, Fidelity could reduce the carrying value of its investments in and related loans to these partnerships, should its share of net losses materially exceed the net investments in and loans to these partnerships. Combined condensed financial statements as of December 31, 2004 and 2003, have not been presented because the investments in limited partnerships were not considered material at that date. Fidelity reduced the recorded value of its investment in limited partnerships, in addition to the losses recorded, by $30, $18 and $122 during the years ended December 31, 2004, 2003 and 2002, respectively, based on the performance of the underlying real estate operations. 50 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) Included in other assets is interest receivable as follows: December 31 2004 2003 ------------------------------------------------------------------------ Interest receivable on loans $336 $333 Interest receivable on investment securities and other 306 231 ---------------- Total interest receivable $642 $564 ================ >> Deposits December 31 2004 2003 ----------------------------------------------------------------------------- Non-interest bearing transaction accounts $ 8,250 $ 6,903 Interest-bearing transaction accounts 12,903 12,981 Money market deposit accounts 8,219 6,798 Savings accounts 5,720 5,533 Certificates of $100 or more 25,252 29,389 Other certificates and time deposits 67,357 59,076 -------------------- Total deposits $127,701 $120,680 ==================== Certificates maturing in years ending December 31: 2005 $61,746 2006 21,640 2007 8,587 2008 476 2009 104 Thereafter 56 ------- $92,609 ======= Time deposits at December 31, 2004 and 2003, included brokered deposits of approximately $14,438 and $2,873, respectively. 51 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) >> Federal Home Loan Bank Advances and Borrowings
December 31 2004 2003 ------------------------------------------------------------------------------------------------------- Subordinated Debenture- Trust Preferred Securities, 4.72%, interest paid quarterly, due December 2034, unsecured $ 3,093 Junior subordinated notes, 9.00%, interest paid semi-annually, due February 2009, unsecured 1,002 $ 1,002 Senior subordinated notes, 9.00%, interest paid semi-annually, due April 2009, unsecured 2,365 Senior subordinated notes, 10.00%, interest paid semi-annually, due June 2005, unsecured 1,800 Federal Home Loan Bank advances, due at various dates through 2008 (weighted-average rates of 2.37% and 2.08% at December 31, 2004 and 2003, respectively) 44,090 31,550 Note payable, 6.25%, interest paid monthly, due November 2005, secured by United guarantee 275 Junior subordinated notes, 5.41%, adjusted quarterly, interest paid quarterly, due September 2033, unsecured, with call option 4,000 4,000 Note payable, 9.00%, interest paid quarterly, due June 2004, unsecured 1,000 ------------------------- Total long-term debt $54,550 $39,627 =========================
Fidelity and Fidelity Federal Bancorp Statuary Trust I-2004 (Trust) entered into an agreement to issue and sell 3,000 of Floating Rate TruPS(R) of the Trust, having a stated liquidation amount of $1,000 per capital security and bearing a per annum rate of interest, reset quarterly, equal to the three month LIBOR plus 2.25%. The Junior Subordinated Debentures due in 2034 were issued by Fidelity to the Trust. Fidelity has fully and unconditionally guaranteed all of the Issuer's obligations under trust preferred securities issued by the Trust. The Junior Subordinated Debentures qualify as Tier 1 Capital for regulatory capital purposes. The terms of a security agreement with the FHLB require United to pledge as collateral qualifying first mortgage loans in an amount equal to at least 125% of these advances and all stock in the FHLB or eligible securities with a market value in an amount equal to at least 110% of these advances, in addition to first mortgage loans pledged of $30,964. Fidelity had $52,824 of investment securities pledged at December 31, 2004. Certain advances are subject to restrictions or penalties in the event of prepayment. All long-term debt, except for Federal Home Loan Bank advances and the $4,000 note payable noted above, are the debt of the parent company and totaled $6,460 at December 31, 2004, as compared to $4,077 at December 31, 2003. 52 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) The scheduled principal reduction of borrowings in years ended December 31 are: 2005 $28,090 2006 6,500 2007 4,500 2008 1,000 2009 7,367 Thereafter 7,093 -------- $54,550 ======== >> Loan Servicing Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of mortgage loans serviced for others totaled $54,658, $55,413 and $57,368 at December 31, 2004, 2003 and 2002, respectively. The aggregate fair value of capitalized mortgage servicing rights at December 31, 2004 and 2003, approximated $628 and $639, respectively. Comparable market values and a valuation model that calculates the present value of future cash flows were used to estimate fair value. For purposes of measuring impairment, risk characteristics including product type, investor type and interest rates, were used to stratify the originated mortgage servicing rights. Year Ended December 31 2004 2003 2002 ------------------------------------------------------------------- Mortgage servicing rights Balances, beginning of period $ 639 $ 514 $ 632 Servicing rights capitalized 95 258 232 Amortization of servicing rights (106) (285) (198) ------------------------------ 628 487 666 Change in valuation allowance 152 (152) ------------------------------ Balances, end of period $ 628 $ 639 $ 514 ============================== The entire valuation allowance of $152 at December 31, 2002, was added in the fourth quarter of 2002. The valuation allowance was reduced by $152 during 2003 leaving a balance of $0 in the valuation allowance at December 31, 2003 and 2004. Consumer loans are also serviced for others and are not included in the accompanying consolidated balance sheets. The unpaid principal balances of consumer loans serviced for others totaled $46,672 and $56,136 at December 31, 2004 and 2003, respectively. 53 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) The aggregate fair value of capitalized consumer loan servicing rights at December 31, 2004 and 2003, approximated $45 and $223, respectively. As with mortgage servicing rights, comparable market values and a valuation model that calculates the present value of future cash flows were used to estimate fair value. Year Ended December 31 2004 2003 --------------------------------------------------------- Consumer loan servicing rights Balances, beginning of period $ 223 $ 409 Servicing rights capitalized 26 96 Amortization of servicing rights (204) (282) ------------------- Balances, end of period $ 45 $ 223 =================== >> Income Tax
Year Ended December 31 2004 2003 2002 ------------------------------------------------------------------------------------------------ Income tax benefit Deferred Federal $ (99) $ (228) $(1,028) State 33 8 (213) Change in valuation allowance 600 ----------------------------------- Total income tax benefit $ (66) $ (220) $ (641) =================================== Reconciliation of federal statutory to actual tax benefit Federal statutory income tax at 34% $ 138 $ (2) $(1,036) Effect of state income taxes 22 5 (53) Nondeductible expenses 8 8 8 Changes in the deferred tax asset valuation allowance 600 Affordable housing tax credits and other (222) (211) (222) Other (12) (20) 62 ----------------------------------- Actual tax benefit $ (66) $ (220) $ (641) ===================================
54 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) The components of the deferred tax asset are as follows:
December 31 2004 2003 ------------------------------------------------------------------------------------- Assets Allowance for loan losses $ 751 $ 744 Valuation for letters of credit 88 111 Unrealized loss on available-for-sale securities 159 128 Alternative minimum tax credit 81 81 Low income housing credit carryforward 1,868 1,563 State net operating loss carryforward 972 974 Federal net operating loss carryforward 3,530 3,530 State income tax 20 14 Differences in accounting for certain accrued liabilities 4 Valuation for interest-only strip obligation 173 173 Other 13 8 ---------------------- Total assets 7,659 7,326 ---------------------- Liabilities Depreciation and amortization (8) (28) Differences in accounting for certain accrued liabilities (5) Differences in basis of FHLB stock (178) (117) Basis differential on certain partnership interests (245) (155) Differences in accounting for loan servicing rights (256) (328) ---------------------- Total liabilities (687) (633) ---------------------- Net deferred tax asset before valuation allowance 6,972 6,693 ---------------------- Valuation Allowance Beginning balance (600) (600) Increase during the period (180) ---------------------- Ending balance (780) (600) ---------------------- Net deferred tax asset $ 6,192 $ 6,093 ======================
At December 31, 2004, Fidelity has federal net operating loss carryforwards for tax purposes totaling $10,382. These loss carryforwards expire in varying amounts through the year 2022. Fidelity has state net operating loss carryforwards for tax purposes of $11,435. These loss carryforwards expire in varying amounts through the year 2016. Fidelity has affordable housing credit carryforwards of $1,868. These carryforwards expire in varying amounts through the year 2022. In addition, Fidelity has an alternative minimum tax credit carryforward of $81. 55 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) >> Other Comprehensive Income (Loss) Other comprehensive income components and related taxes were as follows:
Year Ended December 31 2004 2003 2002 ------------------------------------------------------------------------------------------ Unrealized gains (losses) on securities available for sale $ (38) $(602) $ 755 Reclassification for realized amount included in income (47) (353) (73) ----------------------------- Other comprehensive income (loss), before tax effect (85) (955) 682 Tax expense (benefit) (33) (367) 265 ----------------------------- Other comprehensive income (loss) $ (52) $(588) $ 417 =============================
>> Commitments and Contingent Liabilities In the normal course of business, there are outstanding commitments and contingent liabilities, such as commitments to extend credit and standby letters of credit, which are not included in the accompanying consolidated financial statements. Fidelity's exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. Fidelity uses the same credit policies in making such commitments as it does for instruments that are included on the consolidated balance sheets. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Fidelity evaluates each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by Fidelity upon extension of credit, is based on management's credit evaluation. Collateral held varies, but may include residential real estate, income-producing commercial properties or other assets of the borrower. At December 31, 2004 and 2003, commitments to extend credit, which represent financial instruments whose contract amount represents credit risk, were $6,678 and $12,099, respectively. Lines of credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Lines of credit generally have fixed expiration dates. Since a portion of the line may expire without being drawn upon, the total unused lines do not necessarily represent future cash requirements. Each customer's creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary, is based on management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, commercial real estate and residential real estate. Management uses the same credit policies in granting lines of credit as it does for on-balance-sheet instruments. At December 31, 2004 and 2003, Fidelity and United had granted unused lines of credit to borrowers aggregating approximately $11,272 and $12,839, respectively. Fidelity has issued standby letters of credit on affordable housing developments in which the borrowers are not affiliated with Fidelity. The letters of credit secure tax-exempt bond issues and other permanent financing of limited partnerships. The amount outstanding on the letters of credit at December 31, 2004 and 2003, was $22,724 and $27,774, respectively. 56 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) Fidelity, in its previous role as general partner on various affordable housing developments through its subsidiaries, was committed to advance certain amounts to limited partnerships. These previous commitments potentially included short-term loans to the limited partners or an increase in the general partner's equity investment. Upon the sale of Village Housing Corporation in the fourth quarter of 2002, these commitments were extinguished. Fidelity has entered into change in control agreements with one of its employees which provide for the continuation of a multiple of the employee's existing salary and certain benefits for a two-year period of time under certain conditions following a change in control. The agreement becomes effective if there is a change in control that is accompanied by a significant change in job responsibilities and/or compensation. Fidelity entered into an agreement with another institution in conjunction with a consumer loan sale that guaranteed to the purchaser that Fidelity would repurchase any consumer loans that exceeded a 60-day delinquency status. The original amount of the loans sold was $5.0 million and remaining amount outstanding totaled $745 at December 31, 2004. Over the past year, Fidelity has repurchased a total of $81 that exceeded the 60-day delinquency status. Fidelity and its subsidiaries are also subject to claims and lawsuits that arise primarily in the ordinary course of business. It is the opinion of management that the disposition or ultimate resolution of such claims and lawsuits will not have a material adverse effect on the consolidated financial position of Fidelity. >> Dividend and Capital Restrictions 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. Fidelity's primary source of income is dividends from United. United was previously under a Supervisory Agreement (Agreement) with the OTS which restricted the payments of dividends from United to Fidelity without prior written OTS approval. The Agreement and restriction were terminated on October 29, 2004. Fidelity is uncertain when it will pay dividends in the future and the amount of such dividends, if any. >> Regulatory Capital United is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on United's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, United must meet specific capital guidelines that involve quantitative measures of United's assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. United's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. 57 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) Quantitative measures established by regulation to ensure capital adequacy require United to maintain minimum amounts and ratios (set forth in the table below). Management believes, as of December 31, 2004 and 2003, that United meets all capital adequacy requirements to which it is subject. As of December 31, 2004, the most recent notification from United's federal regulators categorized United as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, United must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed United's category. United's actual and required capital amounts and ratios were as follows:
Required for To Be Well Required per Actual Adequate Capital Capitalized Strategic Plan --------------------------------------------------------------------------------- Amount Ratio Amount Ratio Amount Ratio Amount Ratio --------------------------------------------------------------------------------- As of December 31, 2004 Total risk-based capital (to risk- weighted assets) $18,079 14.5% $9,985 8.0% $12,481 10.0% N/A N/A Tier 1 capital (to risk-weighted assets) 13,129 10.5 4,992 4.0 7,489 6.0 N/A N/A Core capital (to adjusted total assets) 14,122 7.2 7,801 4.0 9,752 5.0 N/A N/A Core capital (to adjusted tangible assets) 14,122 7.2 3,901 2.0 N/A N/A N/A N/A Tangible capital (to adjusted total assets) 14,077 7.2 2,925 1.5 N/A N/A N/A N/A As of December 31, 2003 Total risk-based capital (to risk- weighted assets) $15,294 13.6% $8,984 8.0% $11,230 10.0% $12,353 11.0% Tier 1 capital (to risk-weighted assets) 10,292 9.2 4,492 4.0 6,738 6.0 9,265 8.3 Core capital (to adjusted total assets) 11,869 7.0 6,787 4.0 8,484 5.0 10,605 6.3 Core capital (to adjusted tangible assets) 11,869 7.0 3,394 2.0 N/A N/A N/A N/A Tangible capital (to adjusted total assets) 11,646 6.9 2,542 1.5 N/A N/A N/A N/A
>> Stockholders' Equity and Capital Infusion All information in this footnote agrees to information in registration statements previously filed by Fidelity. Therefore, share and per share data in this footnote has not been restated for the stock splits discussed in the footnote titled "Subsequent Events". 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 costs associated with the offering. The shares purchased by shareholders with these funds were issued in May 2004. 58 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) In April 2003, Fidelity issued 2.8 million shares of common stock for $4.0 million in cash through the exercise of an option help 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. In July 2002, Fidelity filed a registration statement for a stockholder rights offering with the Securities and Exchange Commission. A total of 750,000 shares were registered in this filing. For every 8.1 shares of Fidelity held on the record date, shareholders could subscribe to purchase one share of Fidelity at $2.00. The rights offering was completed in September 2002. Fidelity raised $770 net of costs associated with the offering. The shares purchased by shareholders with these funds were issued in September 2002. During the third quarter of 2002, Pedcor Investments, LLC (Investments) exercised a portion of its option that was granted under the stock purchase agreement in May 2000, and purchased $259 in common stock resulting in 137,765 shares being issued. In December 2001, Fidelity filed a registration statement for a debt and equity rights offering with the Securities and Exchange Commission. Subscription rights were distributed to persons who owned common stock as of the close of business on December 19, 2001, to purchase $1.5 million of 9.00% unsecured junior subordinated notes due February 28, 2009, and 500,000 warrants representing the right to purchase shares of common stock at $3.00 per share, less the purchase price of $0.50 per warrant. The offering was completed on February 28, 2002. Fidelity issued approximately $1.0 million in 9% notes and all of the 500,000 warrants, raising an additional $250. In connection with Fidelity's debt and equity offering completed on January 31, 1995, Fidelity reserved 346,500 shares of its common stock for issuance upon exercise of 1,500 outstanding warrants. Each warrant represents the right to purchase 231 shares of common stock. The warrants were valued at $100 per warrant, carrying an exercise price of $8.93 per share and expire on January 31, 2005. At December 31, 2004, a total of 337,029 of the shares originally reserved had been issued and 9,471 remained reserved and unissued. >> Discontinued Operations, Including Fourth Quarter Charges On September 30, 2002, Fidelity signed a definitive agreement to sell the stock of its wholly owned affordable housing subsidiary, Village Affordable Housing Corporation and the stock of United's wholly owned affordable housing subsidiary, Village Housing Corporation and certain other related affordable housing assets to Pedcor Funding Corporation (Funding). Funding is a company controlled by three directors of Fidelity and are members of a group that beneficially owns approximately 60.7% of Fidelity's issued and outstanding stock at time of transaction. 59 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) The sale price was approximately $1.7 million in cash and was consummated during the fourth quarter of 2002. The sale resulted in a consolidated pre-tax loss under generally accepted accounting principles of approximately $201, which consists of a gain from the sale of the affordable housing assets held by Fidelity and United of $574 offset by a loss from the sale of the subsidiaries of $775. The gain is recorded as gain on sale of assets in the other income section of the consolidated statements of income. The subsidiaries were sold as part of Fidelity's plan to end its active involvement in the affordable housing business. Accordingly, the results of operations for the two subsidiaries, which include impairment charges recorded upon signing the definitive agreement of $742, has been classified as discontinued operations in Fidelity's consolidated statement of income for December 31, 2002. The $742 combined with the $775 loss noted in the paragraph above total the $1,517 listed in the income statement as the loss on sale of discontinued operations. The results of operations of the two subsidiaries for the years ended December 31, 2001 and 2000, were not material and have, therefore, not been segregated. The sale was consummated in the fourth quarter of 2002. Certain charges were recorded in the third quarter because it was determined that some of the assets held for sale were impaired or their estimated useful lives had changed. Third quarter charges totaled approximately $1,000, net of tax, including approximately $860 in write-downs of intangible assets whose useful lives were reduced. In the fourth quarter, in addition to recording the amounts discussed in the second paragraph of this note, tax provisions of approximately $800 were recorded to account for the basis difference on the stock that was sold. >> Benefit Plans Fidelity is a participant in the Financial Institutions Retirement Fund (FIRF). This defined-benefit plan is a multi-employer plan; separate actuarial valuations are not made with respect to each participating employer. Effective January 1, 2004, the plan was frozen to reduce future cash outlay and expense. An estimated normal cost on an ongoing basis for a frozen plan is $14 per year. According to FIRF administrators, the market value of the fund's assets did not exceed the value of vested benefits in the aggregate as of June 30, 2004, the date of the latest actuarial valuation. Plan expense of $0 was recognized during 2004, and $0 in 2003 compared to $110 in 2002. The plan provides pension benefits for substantially all of Fidelity's employees. Fidelity has a retirement savings 401(k) plan in which substantially all employees may participate. Fidelity matches employees' contributions at the rate of 25% up to 6% of the participant's salary. Fidelity's expense for the plan was $19, $20 and $21 for the years ended December 31, 2004, 2003 and 2002, respectively. >> Related Party Transactions Fidelity has entered into transactions with certain directors, executive officers, significant stockholders and their affiliates and associates. Such transactions were made in the ordinary course of business on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in the opinion of management, involve more than normal credit risk or present other unfavorable features. 60 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) The aggregate amount of loans, as defined, to such related parties was as follows: December 31 2004 2003 ----------------------------------------------------------------------------- Balances, beginning of year $177 $ 2,782 Composition change (33) Loans charged off Recoveries New loans, including renewals Payments, etc., including renewals (8) (2,572) ------------------------ Balances, end of year $169 $ 177 ======================== Deposits from related parties held by Fidelity at December 31, 2004 and 2003, totaled $2.5 million and $854, respectively. During the second quarter of 2003, Fidelity sold two classified notes totaling $2.6 million in connection with two first mortgages held by Fidelity on certain multifamily housing partnerships to a related party. The instruments were acquired by Pedcor Bancorp at par and assisted Fidelity in reducing its classified assets. During the fourth quarter of 2003, Fidelity entered into a $1.0 million unsecured term loan note with Pedcor Bancorp which matures on June 30, 2004. These funds were contributed to United's capital prior to the end of the year. This note was paid off on March 11, 2004. During the first quarter of 2002, Fidelity sold two notes held in conjunction with advances made by Fidelity to certain multifamily housing partnerships to a related party. The advances were made to facilitate refinancing activities and resulted in loans subordinated to the first mortgage loans. The advances had been previously charged off and had no value on Fidelity's books. The gain on the note sale totaled $223. Fidelity also sold a position in an interest rate swap for a $72 gain. These gains are included in gains on sales of loans in the consolidated statements of income. The instruments were acquired by Pedcor Funding Corporation and the purchase price consisted of a 20% down payment with the remainder financed by a 10 year note totaling $235 at a rate of 5.25% for five years and 6.50% for the last five years with principal paid annually and interest paid quarterly. As noted in the discontinued operations footnote, Village Housing Corporation and Village Affordable Housing Corporation, along with certain affordable housing assets, were sold to Pedcor Funding Corporation in the fourth quarter of 2002. Pedcor had also been providing management services to the partnerships in which Fidelity was a general partner at no cost since May 2000, in accordance with the provisions of the sale of stock to Pedcor in May 2000. Upon completion of the Village Housing Corporation sale noted in the discontinued operations note, these services were no longer necessary. 61 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) >> Stock Option Plans Under Fidelity's stock option plans, Fidelity grants stock option awards which vest and become exercisable at various dates. During the years ended December 31, 2004 and 2002, Fidelity authorized the grant of options for up to 2,292 and 8,292 shares, respectively, of its common stock. No options were granted in 2003. The exercise price of each option, which has a 10-year life, was greater than the market price of Fidelity's stock on the date of grant; therefore, no compensation expense was recognized. Although Fidelity has elected to follow APB No. 25, SFAS No. 123 requires pro forma disclosures of net income and earnings per share as if Fidelity had accounted for its employee stock options under that Statement. The fair value of each option grant was estimated on the grant date using an option-pricing model with the following assumptions:
Year Ended December 31 2004 2003 2002 --------------------------------------------------------------------------------------------------- Risk-free interest rates 4.3% 4.2% 5.1% Dividend yields 0.0% 0.0% 0.0% Volatility factors of expected market price of common stock 39.1% 39.7% 40.3% Weighted-average expected life of the options 10 years 10 years 10 years
The following is a summary of the status of the Fidelity's stock option plans and changes in the plans as of and for the years ended December 31, 2004, 2003 and 2002. Directors' Plan Fidelity has a non-qualified stock option plan (Directors' Plan) which provides for the grant of non-qualified stock options to individuals who are directors of Fidelity, or any of its subsidiaries. The Directors' Plan provides for the grant of non-qualified stock options to acquire shares of common stock of Fidelity for the price of not less than $24 above the average of the high and low bid quotations, as reported by NASDAQ, for the common stock of Fidelity for the five trading days immediately preceding the date the option is granted. The plan has expired; however, as of December 31, 2004, there were options for 9,895 shares outstanding.
December 31 2004 2003 2002 -------------------------------------------------------------------------------------- Shares under option Outstanding at beginning of year 16,548 16,548 11,964 Granted 4,584 Forfeited/expired (6,653) ----------------------------------------------------- 9,895 16,548 16,548 Outstanding at end of year ===================================================== 9,895 16,548 16,548 Exercisable at end of year ===================================================== Weighted option price per share Exercisable $ 75.96 $ 75.48 $75.48 Granted 53.04 Weighted-average fair value of options granted during the year $12.60
62 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) The following table summarizes information about stock options under the Directors' Plan outstanding at December 31, 2004:
Options Outstanding Options Exercisable ---------------------------------------------------------------------------------- Weighted-Average Range of Exercise Number Remaining Weighted-Average Number Weighted-Average Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price ---------------------------------------------------------------------------------------------------------- $ 51.72 to $ 55.20 7,183 6.6 years $ 53.04 7,183 $ 53.04 $116.88 to $141.72 2,712 2.3 years $136.44 2,712 $136.44
1995 Key Employees' Stock Option Plan The 1995 Key Employees' Stock Option Plan (1995 Plan) provides for the granting of either incentive stock options (ISOs) pursuant to Section 422A of the Internal Revenue Code of 1986, as amended (Code), or stock options which do not qualify as ISOs, or any combination thereof. Options may be granted to key employees and officers of Fidelity and its subsidiaries. The option price per share for ISOs will not be less than the fair market value of a share on the date the option is granted. The option price per share for ISOs granted to an employee owning 10 percent or more of the common stock of Fidelity will be not less than 110 percent of the fair market value of a share on the date the option is granted. The option price per share for ISOs will be determined by the compensation committee, but may not be less than 100 percent of the fair market value on the date of grant. A total of 19,708 shares have been reserved for issuance under the 1995 Plan. At December 31, 2004, there were 5,431 options available for grant. A summary of the stock options activity for the 1995 Plan was as follows:
December 31 2004 2003 2002 --------------------------------------------------------------------------------------- Shares under option Outstanding at beginning of year 12,785 15,285 15,554 Granted 2,292 3,708 Forfeited/expired (833) (2,500) (3,810) Exercised (167) ------------------------------------- Outstanding at end of year 14,244 12,785 15,285 ===================================== Exercisable at end of year 11,677 10,702 128,423 ===================================== Weighted option price per share Exercisable $ 44.52 $ 46.08 $ 46.20 Granted 18.90 38.04 Weighted-average fair value of options granted during the year $ 10.68 $ 16.44
63 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) The following table summarizes information about stock options under the 1995 Plan outstanding at December 31, 2004:
Options Outstanding Options Exercisable --------------------------------------------------------------------------------- Weighted-Average Range of Exercise Number Remaining Weighted-Average Number Weighted-Average Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price ------------------------------------------------------------------------------------------------------ $ 18.36 to $ 48.00 13,535 6.4 years $ 38.76 10,968 $ 75.00 $129.72 709 2.8 years $129.72 709 $129.72
>> Earnings Per Share Earnings per share (EPS) were computed as follows:
Year Ended December 31 2004 2003 2002 ----------------------------------------------------------------------------------------------------------------------------- Weighted- Per Weighted- Per Weighted- Per Average Share Average Share Average Share Income Shares Amount Income Shares Amount Income Shares Amount ---------------------------------------------------------------------------------------------- Income from continuing operations $472 $214 $(2,407) =========== =========== =========== Basic earnings per share Income available to common stockholders $472 874,201 $0.54 $214 744,340 $0.29 $(2,407) 514,658 $(4.67) ====== ====== ======= Effect of dilutive securities Stock options 232 -------------------- ------------------- -------------------- Diluted earnings per share Income available to common stockholders and assumed conversions $472 874,433 $0.54 $214 744,340 $0.29 $(2,407) 514,658 $(4.67) ===============================================================================================
Options to purchase 21,572 shares of common stock at prices ranging from $21.48 to $141.72 per share, as well as stock warrants representing the right to purchase 42,456 shares of common stock at prices ranging from $36.00 to $107.16 per share were outstanding at December 31, 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. 64 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) Options to purchase 29,333 shares of common stock at prices ranging from $18.36 to $141.72 per share, as well as stock warrants representing the right to purchase 43,979 shares of common stock at prices ranging from $36.00 to $107.16 per share were outstanding at December 31, 2003, 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. Options to purchase 31,833 shares of common stock at prices ranging from $18.36 to $141.72 per share, as well as stock warrants representing the right to purchase 43,979 shares of common stock at prices ranging from $36.00 to $107.16 per share were outstanding at December 31 2002, 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. >> Fair Value of Financial Instruments The following methods and assumptions were used to estimate the fair value of each class of financial instrument: Cash and Cash Equivalents--The fair value of cash and cash equivalents approximates carrying value. Interest-Bearing Time Deposits--The fair value of interest-bearing time deposits approximates carrying value. Investment Securities--Fair values are based on quoted market prices. Loans--For both short-term loans and variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for certain mortgage loans, including one-to-four family residential, are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics. The fair value for other loans is estimated using discounted cash flow analyses using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Interest Receivable/Payable--The fair values of interest receivable/payable approximate carrying values. FHLB Stock--The fair value is estimated to be the carrying value, which is par. All transactions in the capital stock of the FHLB of Indianapolis are executed at par. Deposits--The fair values of non-interest-bearing, interest-bearing demand and savings accounts are equal to the amount payable on demand at the balance sheet date. The carrying amounts for variable rate, fixed-term certificates of deposit approximate their fair values at the balance sheet date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on such time deposits. Long-Term Debt--The fair value of these borrowings is estimated using a discounted cash flow calculation based on current rates for similar debt. Long-term debt consists of adjustable instruments tied to a variable market interest rate. 65 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) Off-Balance-Sheet Commitments--Commitments include commitments to purchase and originate mortgage loans, commitments to sell mortgage loans and standby letters of credit and are generally of a short-term nature. The fair value of the loan commitments is based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing. The carrying amounts of the commitments to purchase and originate mortgage loans and to sell mortgage loans, which are immaterial, are reasonable estimates of the fair value of these financial instruments. The carrying amount of the standby letters of credit, which consist of a letter of credit valuation allowance of $232 and $291 at December 31, 2004 and 2003, respectively, is a reasonable estimate of the fair value of those off-balance sheet items. The estimated fair values of Fidelity's financial instruments were as follows:
2004 2003 -------------------------------------------------------- Carrying Fair Carrying Fair December 31 Amount Value Amount Value -------------------------------------------------------------------------------------------------------- Assets Cash and cash equivalents $ 4,622 $ 4,622 $ 2,968 $ 2,968 Investment securities available for sale 65,192 65,192 52,208 52,208 Loans, net 110,771 112,275 100,437 102,462 Interest receivable 642 642 564 564 FHLB stock 3,627 3,627 3,466 3,466 Liabilities Deposits 127,701 127,457 120,680 121,782 FHLB advances and borrowings 54,550 53,991 39,627 39,723 Interest payable 485 485 339 339 Standby letters of credit 232 232 291 291
>> New Accounting Pronouncements In December, 2004, the Financial Accounting Standards Board (FASB) issued an amendment to SFAS 123 Accounting for Stock-Based Compensation, (SFAS 123R) which eliminates the ability to account for share-based compensation transactions using Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and generally requires that such transactions be accounted for using a fair value-based method. SFAS 123R will be effective for the Company beginning January 1, 2006. SFAS 123R applies to all awards granted after the required effective date and to awards modified, repurchased, or cancelled after that date as well as for the unvested portion of awards existing as of the effective date. As of the required effective date, the Company will apply SFAS 123R using a modified version of prospective application. Under that transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for pro forma disclosures. For periods before the required effective date, a company may elect to apply a modified version of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by SFAS 123. Based on the awards outstanding at December 31, 2004, management has estimated that approximately $12 of compensation expense related to those awards will be recognized during the year ended December 31, 2006. 66 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) >> Condensed Financial Information (Parent Company Only) Presented below is condensed financial information as to financial position, results of operations and cash flows of Fidelity: Condensed Balance Sheets December 31 2004 2003 ------------------------------------------------------------------------- Assets Cash and cash equivalents $ 3,265 $ 39 Investment in common stock of subsidiaries 16,681 14,889 Loans, net 381 421 Income tax receivable 2,291 2,063 Other assets 228 94 ----------------------- Total assets $22,846 $17,506 ======================= Liabilities Long-term debt $ 6,460 $ 4,077 Other liabilities 125 62 ----------------------- Total liabilities 6,585 4,139 Stockholders' Equity 16,261 13,367 ----------------------- Total liabilities and stockholders' equity $22,846 $17,506 ======================= 67 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) Condensed Statements of Income
Year Ended December 31 2004 2003 2002 ------------------------------------------------------------------------------------------------------ Income Interest income $ 19 $ 232 $ 560 Other income 15 102 614 ---------------------------------- Total income 34 334 1,174 ---------------------------------- Expense Interest expense 345 610 1,113 Provision for loan losses 25 (73) (400) Letter of credit valuation provision (61) Other expenses 264 350 1,526 ---------------------------------- Total expense 634 826 2,239 ---------------------------------- Loss Before Income Tax and Equity in Undistributed (Distributions in Excess of) Income of Subsidiaries (600) (492) (1,065) Income Taxes (Benefit) (228) (187) 976 ---------------------------------- Loss Before Equity in Undistributed (Distributions in Excess of) Income of Subsidiaries (372) (305) (2,041) Equity in Undistributed (Distributions in Excess of) Income of Subsidiaries 844 519 (2,354) ----------------------------------- Net Income (Loss) $ 472 $ 214 $(4,395) ===================================
68 FIDELITY FEDERAL BANCORP Notes to Consolidated Financial Statements (Dollar Amounts in Thousands, Except Share Data) Condensed Statements of Cash Flows
Year Ended December 31 2004 2003 2002 ---------------------------------------------------------------------------------------------------- Operating Activities Net income (loss) $ 472 $ 214 $(4,395) Adjustments to reconcile net income (loss) to net cash used by operating activities Depreciation and amortization 1 5 6 Provision for loan losses 25 (73) (400) Letter of credit valuation provision (61) Funding on outstanding letters of credit (239) Gain on early extinguishment of debt (140) Loss on impairment of assets held for sale and changes in estimated useful lives of intangible assets 1,096 Loss on sale of subsidiary 64 Undistributed net income (loss) of subsidiaries (844) (519) 2,374 (Increase) decrease in other assets (363) (87) 921 (Increase) decrease in other liabilities 64 (173) (498) ----------------------------------- Net cash used by operating activities (645) (694) (1,211) ----------------------------------- Investing Activities Capital contributions to subsidiaries (1,000) (1,000) (8) Proceeds from sale of subsidiary 461 Principal payments received on notes from subsidiaries 1,500 1,375 Net change in loans 14 2,466 (97) ----------------------------------- Net cash provided (used) by investing activities (986) 2,966 1,731 ----------------------------------- Financing Activities Repayment of long-term debt (3,075) (7,784) (3,928) Proceeds from issuance of long-term debt 5,458 1,275 1,858 Sale of common stock 2,474 4,153 1,421 Sale of stock warrants 250 ----------------------------------- Net cash provided (used) by financing activities 4,857 (2,356) (399) ----------------------------------- Change in Cash and Cash Equivalents 3,226 (84) 121 Cash and Cash Equivalents, Beginning of Period 39 123 2 ----------------------------------- Cash and Cash Equivalents, End of Period $ 3,265 $ 39 $ 123 ===================================
>> Subsequent Event On February 28, 2005, the board of directors unanimously approved and Fidelity executed a 1-for-30,000 reverse stock split. The reverse stock split was immediately followed by a 2,500-for-1 forward stock split. Fidelity then terminated the registration of its common stock by filing Form 15E with the Securities and Exchange Commission. This resulted in the delisting of its shares on the NASDAQ. All share and per share data in the accompanying financial statements has been adjusted for the above stock splits. 69