10QSB 1 form10qsb52212easttx.txt FORM 10-QSB SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the period ended March 31, 2003 OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______ to _______. Commission file number 0-24848 East Texas Financial Services, Inc. (Exact name of registrant as specified in its charter) Delaware 75-2559089 (State or other jurisdiction of (I.R.S. employer incorporation or organization identification number) 1200 South Beckham, Tyler, Texas 75701 (Address of principal executive offices) (Zip code) (903) 593-1767 (Registrant's telephone number, including area code) Check whether the issuer (1) filed all reports required to be filed by Section 13 of 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. |X| Yes |_| No The number of shares of the registrant's common stock ($.01 par value) outstanding as of March 31, 2003, was 1,163,887. EAST TEXAS FINANCIAL SERVICES, INC. AND SUBSIDIARY FORM 10-QSB March 31, 2003 INDEX Page No. Part I - Financial Information Item 1. Financial Statements Consolidated Statements of Financial Condition, March 31, 2003 (Unaudited) and September 30, 2002 ............................... 4 Consolidated Statements of Income, (Unaudited) six months ended March 31, 2003 and March 31, 2002 ................................ 5 Consolidated Statement of Changes in Stockholders' Equity, (Unaudited) six months ended March 31, 2003 ...................... 6 Consolidated Statements of Cash Flows, (Unaudited) six months ended March 31, 2003, and March 31, 2002 ............................... 7 Notes to (Unaudited) Consolidated Financial Statements, March 31, 2003 ................................................... 9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ......................................... 16 Item 3. Controls and Procedures ....................................... 25 Part II - Other Information Item 1. Legal Proceedings ............................................ 26 Item 2. Changes In Securities ........................................ 26 Item 3. Defaults Upon Senior Securities .............................. 26 Item 4. Submission of Matters To a Vote of Security Holders........... 26 Item 5. Other Information ............................................ 26 Item 6. Exhibits and Reports on Form 8-K ............................. 26 Certifications .............................................................. 27 2 of 29 EAST TEXAS FINANCIAL SERVICES, INC. AND SUBSIDIARY FORM 10-QSB March 31, 2003 PART I - FINANCIAL INFORMATION Item 1 - Financial Statements East Texas Financial Services, Inc. (the "Company") was formed in September of 1994 for the purpose of acquiring all of the common stock of First Federal Savings and Loan Association of Tyler (the "Association"), concurrent with its conversion from the mutual to stock form of ownership. The Company completed its initial public stock offering of 1,215,190 shares of $.01 par value common stock on January 10, 1995. The Company utilized approximately one half of the net stock sale proceeds to acquire all of the common stock issued by the Association. The financial statements presented in this Form 10-QSB reflect the consolidated financial condition and results of operations of the Company and its wholly owned subsidiary, First Federal Savings and Loan Association of Tyler. 3 of 29 EAST TEXAS FINANCIAL SERVICES, INC. CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
ASSETS March 31, 2003 September 30, 2002 -------------- ------------------ (Unaudited) Cash and due from banks $ 3,204,205 $ 2,561,615 Interest-bearing deposits with banks 5,568,825 2,883,189 Interest-earning time deposits with financial institutions 0 300,000 Federal funds sold 1,123,147 599,698 Investment securities available-for-sale 411,815 516,443 Investment securities held-to-maturity (estimated market value of $8,158,382 at March 31, 2003, and $10,134,910 at September 30, 2002) 7,702,687 9,723,716 Mortgage-backed securities available-for-sale 4,080,097 20,144,942 Mortgage-backed securities held-to-maturity (estimated market value of $56,964,203 at March 31, 2003 and $30,822,859 at September 30, 2002) 56,710,839 30,591,248 Loans receivable, net of allowance for credit losses of $822,572 at March 31, 2003 and $756,566 at September 30, 2002 121,843,592 137,182,965 Accrued interest receivable 1,149,251 1,324,440 Federal Home Loan Bank stock, at cost 4,648,700 4,588,500 Premises and equipment 2,807,033 2,868,435 Foreclosed assets, net 374,868 394,210 Goodwill, net 2,170,381 2,170,381 Mortgage servicing rights 386,800 255,269 Cash value of life insurance owned 3,677,046 0 Other assets 2,386,012 1,605,326 ------------- ------------- Total Assets $ 218,245,298 $ 217,710,377 ============= ============= LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Noninterest deposits $ 3,636,467 $ 3,900,913 Interest-bearing deposits 108,973,445 103,567,616 ------------- ------------- Total deposits 112,609,912 107,468,529 FHLB advances 82,416,020 86,312,294 Advances from borrowers for taxes and insurance 240,809 1,033,717 Federal income taxes Current (53,308) 847,781 Deferred 491,176 493,953 Accrued expenses and other liabilities 2,636,848 2,271,637 ------------- ------------- Total liabilities 198,341,457 198,427,911 ------------- ------------- Stockholders' equity: Preferred stock, $0.01 par value, 500,000 shares authorized, none outstanding Common stock, $0.01 par value, 5,500,000 shares authorized, 1,884,492 shares issued and 1,163,887 outstanding 18,845 18,845 Additional paid-in-capital 12,525,303 12,525,303 Unearned employee stock ownership plan shares (170,716) (170,716) Retained earnings (substantially restricted) 16,645,095 16,035,441 Accumulated other comprehensive income (264,516) (259,125) Treasury stock, 720,605 shares at cost (8,850,170) (8,867,282) ------------- ------------- Total stockholder's equity 19,903,841 19,282,466 ------------- ------------- Total liabilities and stockholders' equity $ 218,245,298 $ 217,710,377 ============= =============
The accompanying notes are an integral part of the consolidated financial statements. 4 of 29 EAST TEXAS FINANCIAL SERVICES, INC. CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
Three Months Six Months Ended March 31, Ended March 31, 2003 2002 2003 2002 ----------- ----------- ----------- ----------- INTEREST INCOME Loans receivable: First Mortgage $ 1,426,918 $ 1,597,670 $ 2,857,775 $ 3,157,844 Consumer and other loans 920,360 867,946 1,921,123 1,650,886 Securities available-for-sale: Investment securities 34,918 42,346 73,809 126,173 Mortgage-backed securities 14,340 104,106 68,613 372,668 Securities held-to-maturity: Investment securities 121,014 154,181 246,826 309,260 Mortgage-backed securities 456,844 496,414 850,305 1,023,377 Deposits with banks: 41,423 10,718 71,169 27,529 ----------- ----------- ----------- ----------- Total interest income 3,015,817 3,273,381 6,089,620 6,667,737 ----------- ----------- ----------- ----------- INTEREST EXPENSE Deposits 834,331 1,010,237 1,711,333 2,224,652 FHLB advances 609,526 649,423 1,262,543 1,332,433 ----------- ----------- ----------- ----------- Total interest expense 1,443,857 1,659,660 2,973,876 3,557,085 ----------- ----------- ----------- ----------- Net interest income before provision for 1,571,960 1,613,721 3,115,744 3,110,652 loan losses Provision for loan losses 276,253 101,438 399,896 111,197 ----------- ----------- ----------- ----------- Net interest income after provision for loan losses 1,295,707 1,512,283 2,715,848 2,999,455 ----------- ----------- ----------- ----------- NONINTEREST INCOME Gain (loss) on sale of interest-earning assets 146,012 43,639 357,534 452,173 Loan origination and commitment fees 23,622 33,506 43,487 82,995 Loan servicing fees 14,062 (23,197) 19,807 (59,318) Other 212,392 81,560 394,176 198,028 ----------- ----------- ----------- ----------- Total noninterest income 396,088 135,508 815,004 673,878 ----------- ----------- ----------- ----------- NONINTEREST EXPENSE Compensation and benefits 732,087 653,324 1,477,254 1,290,095 Occupancy and equipment 89,064 114,668 195,748 221,907 SAIF deposit insurance premium 5,173 5,279 9,696 10,473 Foreclosed assets, net 24,235 20,235 91,747 35,231 Other 379,673 274,267 614,544 531,374 ----------- ----------- ----------- ----------- Total noninterest expense 1,230,232 1,067,773 2,388,989 2,089,080 ----------- ----------- ----------- ----------- Income (loss) before provision for income taxes 461,563 580,018 1,141,863 1,584,253 Income tax expense (benefit) 166,559 210,277 413,626 561,346 ----------- ----------- ----------- ----------- NET INCOME (LOSS) $ 295,004 $ 369,741 $ 728,237 $ 1,022,907 =========== =========== =========== =========== Earnings per common share $ 0.26 $ 0.33 $ 0.64 $ 0.91 Earnings per common share - assuming dilution 0.25 0.32 0.62 0.90
The accompanying notes are an integral part of the consolidated financial statements. 5 of 29 EAST TEXAS FINANCIAL SERVICES, INC. CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (UNAUDITED)
Common Additional Retained Balance at September 30, 2002 Stock Paid-in Capital Earnings Treasury Stock -------------------------------------------------------------- $ 18,845 $ 12,525,303 $ 16,035,441 $ (8,867,282) Comprehensive income: Net Income $ 728,237 Net change in unrealized gain (loss) on securities available-for-sale net of deferred taxes Total comprehensive income Stock Options Exercised $ (2,350) $ 17,112 Cash dividends of $0.10 per share $ (116,233) ------------- ------------- ------------- ------------- Balance March 31, 2003 $ 18,845 $ 12,525,303 $ 16,645,095 $ (8,850,170) ============= ============= ============= ============= Net Unearned Employee Stock Other Accumulated Ownership Plan Comprehensive Balance at September 30, 2002 Shares Income Total --------------------------------------------------- $ (170,716) $ (259,125) $ 19,282,466 Comprehensive income: Net Income $ 728,237 Net change in unrealized gain (loss) on securities available-for-sale net of deferred taxes $ (5,391) $ (5,391) ------------- Total comprehensive income $ 722,846 Stock Options Exercised $ 14,762 Cash dividends of $0.10 per share $ (116,233) ------------- ------------- ------------- Balance March 31, 2003 $ (170,716) $ (264,516) $ 19,903,841 ============= ============= =============
The accompanying notes are an integral part of the consolidated financial statements. 6 of 29 EAST TEXAS FINANCIAL SERVICES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
For the Six Months Ended March 31, 2003 2002 ------------- ------------- Cash flows from operating activities: Net income $ 728,237 $ 1,022,907 Adjustments to reconcile net income to net cash provided by operating activities: Amortization of deferred loan origination fees (4,888) (1,808) Amortization of premiums and discounts on investment securities, mortgage-backed securities, and loans 245,875 (7,839) Amortization of mortgage servicing rights 52,558 121,324 Depreciation 85,225 79,427 Provision for loan losses 399,896 111,197 Stock dividends on FHLB stock (60,200) (64,800) Increase in cash value of life insurance (77,046) 0 Net (gain) loss on sale of: Loans held for sale (173,445) (56,327) Fixed assets (3,090) 8,287 Foreclosed assets 85,878 19,943 Interest earning assets 0 (325,503) Proceeds from loan sales 11,920,376 6,589,095 Originations of loans held for sale (11,746,931) (6,532,768) (Increase) decrease in Accrued interest receivable 175,189 (15,544) Other assets (780,686) 831,252 Increase (decrease) in: Accrued expenses and other liabilities 365,211 (8,851) Federal income tax payable (901,089) 510,580 ------------- ------------- Net cash provided (used) by operating activities 311,070 2,280,572 ------------- -------------
(Continued) 7 of 29 EAST TEXAS FINANCIAL SERVICES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
For the Six Months Ended March 31, 2003 2002 ------------- ------------- Cash flows from investing activities Net (increase) decrease in interest-earning time deposits 300,000 300,000 Net (increase) decrease in fed funds sold (523,449) (340,353) Activity in securities available-for-sale Proceeds from sales 0 6,308,899 Proceeds from maturities and calls 100,000 25,000 Purchases 0 (2,000,000) Activity in securities held-for-maturity Proceeds from maturities and calls 2,000,000 0 Activity in mortgage-backed securities available-for-sale Principal payments 15,982,580 11,177,578 Purchases 0 (6,522,879) Activity in mortgage-backed securities held-to-maturities Principal payments 22,130,222 12,842,999 Purchases (48,395,934) (7,627,398) Purchases of Bank Owned Life Insurance (3,600,000) 0 Net (increase)decrease in loans 14,487,410 (16,946,517) Proceeds from sale of foreclosed assets 391,882 182,240 Proceeds from the sale of fixed assets 3,090 0 Capitalized acquisition costs related to foreclosed assets (14,388) (2,974) Expenditures for premises and equipment (10,898) (37,553) Origination of mortgage servicing rights (184,089) (70,344) ------------- ------------- Net cash provided (used) by investing activities 2,666,426 (2,711,302) ------------- ------------- Cash flows from financing activities: Net increase (decrease) in: Deposits 5,141,382 (8,861,523) Advances from borrowers (792,908) (860,437) Proceeds from advances from Federal Home Loan Bank 222,000,000 354,000,000 Payment of advances from Federal Home Loan Bank (225,896,274) (345,347,301) Exercise of Stock Options 14,762 0 Dividends paid to stockholders (116,232) (116,232) ------------- ------------- Net cash provided (used) by financing activities 350,730 (1,185,493) ------------- ------------- Net increase (decrease) in cash and cash equivalents 3,328,226 (1,616,223) Cash and cash equivalents at beginning of the period 5,444,804 4,838,011 ------------- ------------- ============= ============= Cash and cash equivalents at end of the period $ 8,773,030 $ 3,221,788 ============= ============= Supplemental disclosure: Cash paid for: Interest on deposits $ 896,209 $ 1,499,090 Interest on FHLB advances and other borrowed funds 1,262,543 1,332,433 Income taxes 1,314,716 25,380 Transfers from loans to real estate and other assets acquired through foreclosures 1,023,077 415,923 Loans made to facilitate the sale of foreclosed assets 216,736 128,187 Transfer of foreclosed assets to fixed assets 12,925 0
The accompanying notes are an integral part of the financial statements. 8 of 29 EAST TEXAS FINANCIAL SERVICES, INC. AND SUBSIDIARY NOTES TO (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS March 31, 2003 NOTE 1 - BASIS OF PRESENTATION The financial statements presented in this report have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission for interim reporting and include all adjustments which are, in the opinion of management, necessary for fair presentation. These financial statements have not been audited by an independent accountant. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations for interim reporting. The Company believes that the disclosures are adequate to make the information not misleading. However, these financial statements should be read in conjunction with the financial statement and notes thereto included in the Company's Annual Report on Form 10-KSB for the year ended September 30, 2002. The financial data and results of operations for interim periods presented may not necessarily reflect the results to be anticipated for the complete year. NOTE 2 - EARNINGS PER SHARE Earnings per common share for the three months and the six months ended March 31, 2003 and 2002, has been computed based on net income divided by the weighted average number of common shares outstanding during the period. For the three months ended March 31, 2003 and 2002, the weighted average number of shares outstanding totaled 1,137,138 and 1,123,979 shares, respectively. For the six months ended March 31, 2003 and 2002, the weighted average number of shares outstanding totaled 1,136,970 and 1,123,979 shares respectively. Earnings per common share - assuming dilution, for the three months and six months ended March 31, 2003 and 2002, has been computed based on net income divided by the weighted average number of common shares outstanding. In addition, it includes the effects of all dilutive potential common shares that were outstanding during the period. For the three months ended March 31, 2003 and 2002, the weighted average number of shares outstanding for earnings per share - assuming dilution totaled 1,177,207 and 1,150,703 shares, respectively. For the six months ended March 31, 2003 and 2002, the weighted average number of share outstanding for earnings per share - dilution totaled 1,172,163 and 1,113,079 shares, respectively. For both earnings per share and earnings per common share - assuming dilution and as prescribed by the American Institute of Certified Public Accountants Statement of Position 93-6 ("SOP 93-6") Employer's Accounting for Employees Stock Ownership Plans, the weighted average number of shares outstanding does not include unallocated Employee Stock Ownership Plan ("ESOP") shares. See Part II, Item 6 - Exhibits for a detailed presentation of the earnings per share calculation for the three-month and six-month periods ended March 31, 2003 and 2002. 9 of 29 NOTE 3 - SECURITIES The carrying values and estimated market values of investment securities available-for-sale as of March 31, 2003, by type of security are as follows:
Principal Unamortized Unearned Unrealized Carrying Balance Premiums Discounts Gain/(Loss) Value ------------- ------------- ------------- ------------- ------------- Municipal bonds $ 390,000 -0- $ 1,774 $ 23,589 $ 411,815 ------------- ------------- ------------- ------------- ------------- $ 390,000 $ -0- $ 1,774 $ 23,589 $ 411,815 ------------- ------------- ------------- ------------- -------------
The amortized cost and estimated market values of investment securities held-to-maturity as of March 31, 2003, are as follows:
Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value ------------- ------------- ------------- ------------- Debt securities: U. S. government agency $ 1,490,069 $ 40,711 $ -0- $ 1,530,780 Corporate Debt 6,212,618 414,984 -0- 6,627,602 ------------- ------------- ------------- ------------- Total debt securities $ 7,702,687 $ 455,695 $ -0- 8,158,382 ------------- ------------- ------------- -------------
The amortized cost and estimated market values of investment securities held-to-maturity as of March 31, 2003, by contractual maturity are shown below: Estimated Amortized Market Cost Value ------------- ------------- Due in one year through two years $ 1,000,000 $ 1,006,562 Due in two years through three years 998,719 1,062,656 Due in three years through six years 2,557,554 2,683,125 Due after six years 3,146,414 3,406,039 ------------- ------------- Total debt securities $ 7,702,687 $ 8,158,382 ------------- ------------- 10 of 29 The carrying values and estimated market values of mortgage-backed and related securities available-for-sale as of March 31, 2003, by type of security are as follows:
Principal Unamortized Unearned Unrealized Carrying Balance Premiums Discounts Gain/(Loss) Value ------------- ------------- ------------- ------------- ------------- Fixed Rate $ 517,525 $ -0- $ 981 $ 22,145 $ 538,689 Adjustable Rate 3,486,122 6,139 918 50,065 3,541,408 ------------- ------------- ------------- ------------- ------------- $ 4,003,647 $ 6,139 $ 1,899 $ 72,210 $ 4,080,097 ------------- ------------- ------------- ------------- -------------
The carrying values and estimated market values of mortgage-backed and related securities held-to-maturity as of March 31, 2003, by type of security are as follows:
Estimated Principal Unamortized Unearned Unrealized Carrying Balance Premiums Discounts Gain/(Loss) Value ------------- ------------- ------------- ------------- ------------- Fixed Rate $ 27,849,724 $ 141,922 $ 3,487 $ 27,988,159 $ 28,293,840 Adjustable Rate 28,025,548 697,133 1 28,722,680 28,670,363 ------------- ------------- ------------- ------------- ------------- $ 55,875,272 $ 839,055 $ 3,488 $ 56,710,839 $ 56,964,203 ------------- ------------- ------------- ------------- -------------
11 of 29 NOTE 4 - STOCK OPTION AND INCENTIVE PLAN The 1995 Stock Option and Incentive Plan (the "Stock Option Plan") provides for awards in the form of stock options, stock appreciation rights, limited stock appreciation rights, and restricted stock. Options to purchase shares of common stock of the Company may be granted to selected directors, officers and key employees. The number of shares of common stock reserved for issuance under the stock option plan was equal to 182,278 or 10% of the total number of common shares issued pursuant to the conversion. The option exercise price cannot be less than the fair market value of the underlying common stock as of the date of the option grant, and the maximum option term cannot exceed ten years. Awards generally vest at a rate of 20% per year beginning at the date of the grant. The Company uses treasury stock for the exercise of options. The following is a summary of changes in options outstanding: Balance, September 30, 2001 151,776 Granted -0- Exercised -0- Forfeited and expired -0- ------- Balance, September 30, 2002 151,776 Granted -0- Exercised 1,567 Forfeited and expired -0- ------- Balance, March 31, 2003 150,209 ======= Options exercisable at March 31, 2003 under stock option plan 148,710 ======= Shares available for future grants 22,662 ======= 12 of 29 NOTE 5 - ADVANCES FROM FEDERAL HOME LOAN BANK The outstanding advances from the FHLB consisted of the following at March 31, 2003: Maturity Balance Rate ------------ --------------- ---------- 04/07/03 $ 2,000,000 1.21% 04/07/03 $ 22,000,000 1.30% 09/01/03 $ 276,669 6.25% 12/01/03 $ 1,000,000 3.12% 12/05/03 $ 5,000,000 3.57% 12/05/03 $ 2,000,000 1.66% 02/12/04 $ 5,000,000 2.09% 02/15/04 $ 100,000 6.01% 05/18/04 $ 5,000,000 1.95% 09/10/04 $ 2,000,000 1.40% 11/30/04 $ 1,000,000 3.93% 12/31/04 $ 224,070 6.09% 01/03/05 $ 42,538 6.03% 02/15/05 $ 100,000 6.04% 03/10/05 $ 2,000,000 1.58% 06/06/05 $ 3,000,000 2.83% 09/12/05 $ 2,000,000 1.95% 02/15/06 $ 150,000 6.05% 03/10/06 $ 2,000,000 2.20% 04/11/11 $ 5,000,000 3.73% 04/11/11 $ 5,000,000 3.91% 04/11/11 $ 5,000,000 4.25% 06/07/11 $ 5,000,000 4.38% 01/01/13 $ 376,052 6.09% 01/01/13 $ 357,526 6.13% 02/01/13 $ 354,451 5.91% 03/03/14 $ 613,016 5.45% 04/01/14 $ 595,385 5.97% 05/01/14 $ 809,355 5.66% 06/01/14 $ 619,045 5.90% 07/01/14 $ 576,018 6.38% 08/01/14 $ 418,816 6.37% 09/01/14 $ 531,525 6.59% 10/01/14 $ 467,062 6.86% 11/03/14 $ 1,152,450 6.77% 12/01/14 $ 393,747 6.57% 01/01/15 $ 258,294 6.73% -------------- $ 82,416,020 Pursuant to collateral agreements with the Federal Home Loan Bank (FHLB), advances are secured by all stock and deposit accounts in the FHLB, mortgage collateral, securities collateral, and other collateral. 13 of 29 NOTE 6 - ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES The following table sets forth an analysis of the Company's allowance for loan losses.
Six Months Ended Three Months Ended Three Months Ended March 31, 2003 March 31, 2003 December 31, 2002 ------------- ------------- ------------- (Dollars in (Dollars in (Dollars in Thousands) Thousands) Thousands) Balance at beginning of period $ 757 $ 775 $ 757 Charge-offs: One- to four-family 0 0 0 Consumer and other loans (411) (263) (148) ------------- ------------- ------------- Total charge-offs (411) (263) (148) ------------- ------------- ------------- Recoveries: One- to four-family 0 0 0 Consumer and other loans 77 35 42 ------------- ------------- ------------- Total recoveries 77 35 42 ------------- ------------- ------------- Net (charge-offs)/recoveries (334) (228) (106) Additions charged to income 400 276 124 ------------- ------------- ------------- Balance at end of period $ 823 $ 823 $ 775 ============= ============= ============= Ratio of net charge-offs/recoveries during the period to average loans outstanding during the period (0.26)% (0.18)% (0.08)% ============= ============= ============= Ratio of net charge-offs/recoveries during the period to average non-performing assets (14.76)% (8.85)% (5.33)% ============= ============= =============
The distribution of the Company's allowance for losses on loans at the dates indicated is summarized as follows:
March 31, 2003 September 30, 2002 ------------------------------------------- -------------------------------------------- Percent Percent Of Of Gross Loans In Gross Loans Loan Each Loan In Each Amount of Amounts Category Amount of Amounts Category Loan Loss by To Total Loan Loss by To Total Allowance Category Loans Allowance Category Loans ---------- ---------- ---------- ---------- ---------- ---------- (Dollars in Thousands) (Dollars in Thousands) One- to four-family $ 113 $ 48,124 38.41% $ 108 $ 61,396 43.07% Other residential 0 3,510 2.80 0 2,679 1.88 Home equity and Improvement 4 14,367 11.47 2 10,845 7.61 Non-residential 0 16,844 13.45 0 17,185 12.05 Construction 14 5,982 4.78 9 8,592 6.03 Commercial and Consumer 186 36,449 29.09 272 41,845 29.36 Unallocated 506 0 0 366 0 0.00 ---------- ---------- ---------- ---------- ---------- ---------- Total $ 823 $ 125,276 100.00% $ 757 $ 142,542 100.00% ========== ========== ========== ========== ========== ==========
14 of 29 NOTE 7 - BANK OWNED LIFE INSURANCE During the six months ended December 31, 2002, the Association elected to make an investment in Bank Owned Life Insurance ("BOLI"). The BOLI purchase was made with excess cash that was held by the Association that would have otherwise been invested in securities. The purpose of the BOLI investment is to increase earnings and thereby offset increased compensation and benefit expenses associated with the Association's defined benefit pension plan, medical insurance benefits, and other similar expenses. A total BOLI purchase of approximately $3.6 million in premiums was invested with two separate life insurance companies. The premiums are invested in the general assets of the life insurance companies. Crediting rates are set by the life insurance companies and are based on the overall performance of the assets under management by the insurance company. Earnings on the policies are tax deferred for the life of the insured under Internal Revenue Service guidelines. As part of the BOLI purchase, the Association identified 17 key employees that were given an opportunity to participate in the program. The $3.6 million in BOLI premiums were divided among the 17 participants and life insurance contracts were purchased on the 17 individual employees. All participants in the program were given an opportunity to decline to participate in the program. The Association is the owner and the beneficiary of the life insurance contracts. As part of the BOLI program, the Association expects to enter into separate death benefit agreements with the 17 employees. The death benefit agreements provide for a lump-sum payment to the participant's beneficiary in the event of the death of the participant while employed by the Association and, in certain instances, beyond the participant's employment with the Association. The Association worked in conjunction with the Meyer-Chatfield Company, a firm specializing in compensation and benefits consulting, to design and implement the BOLI program. Meyer-Chatfield assisted the Association in its due diligence efforts in analyzing prospective insurance carriers and in the Association's efforts to comply with all regulatory and legal aspects of the BOLI program. The Association also employed legal counsel with expertise in compensation and benefit planning and BOLI transactions to adopt board of director resolutions and draft the employee death benefit agreements. 15 of 29 EAST TEXAS FINANCIAL SERVICES, INC. AND SUBSIDIARY FORM 10-QSB March 31, 2003 Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations GENERAL The principle business of the Company is that of a holding company for a community-oriented financial institution attracting deposits from the general public and using such deposits to originate one- to four-family residential loans, commercial real estate, one- to four-family construction, multi-family, commercial and consumer loans. These funds have also been used to purchase mortgage-backed securities, U.S. government and agency obligations and other permissible investments. The Company also borrows funds from the Federal Home Loan Bank of Dallas ("FHLB") to fund loans and to purchase securities. The ability of the Company to attract deposits is influenced by a number of factors, including interest rates paid on competing investments, account maturities and levels of personal income and savings. The Company's cost of funds is influenced by interest rates on competing investments and general market rates of interest. Lending activities are influenced by the demand for real estate loans and other types of loans, which is in turn affected by the interest rates at which such loans are made, general economic conditions affecting loan demand, the availability of funds for lending activities, economic conditions and changes in real estate values. The Company's results of operations are dependent primarily on net interest income, which is the difference between the income earned on its loan and investment portfolios and the interest paid on deposits and borrowings. Results of operations are also affected by the Company's provision for loan losses and the net gain (loss) on sales of interest earning assets and loan fees. The Company's results of operations are also significantly affected by general economic and competitive conditions, particularly changes in interest rates, government policies and actions of regulatory authorities. As previously disclosed in the Company's Form 10-KSB for the fiscal year ended September 30, 2002, the Company has been notified by the OTS that the Association has been deemed to be in "troubled condition" as a result of a lack of compliance with regulatory requirements involving oversight of its interest rate risk program. The Association was required to take a number of steps to comply with the OTS directive. The Association is in the process of addressing each of the deficiencies. FINANCIAL CONDITION Total assets were $218.2 million at March 31, 2003, a $535,000 increase from the $217.7 million reported at September 30, 2002, the Company's most recent fiscal year end. The increase in total assets was the result of a $26.1 million increase in mortgage-backed securities held-to-maturity, a $3.7 million increase in cash value of life insurance owned, and a $2.7 million increase in interest bearing deposits with banks. [See Note 7 for a discussion of the cash value of life insurance owned.] The increases were partially offset by a $16.1 million decrease in mortgage-backed securities available-for-sale, a $15.3 million decrease in loans receivable, and a $2.0 million decrease in investment securities held-to-maturity. The changes in the composition of the balance sheet were primarily related to an increase in cash flow from the Company's mortgage loan portfolio and mortgage-backed securities portfolio. With continued lower interest rates, the Company continued to receive significant amounts of cash flow from these portfolios as customers refinanced existing mortgage loans. Also, the Company sold into the secondary market the majority of the loans it originated or refinanced. With the cash flow from its mortgage-backed securities portfolio increasing as the loans underlying those securities are refinanced, the Company expects to continue to receive significant amounts of cash to reinvest. 16 of 29 The overall result could be a continued reduction in the Company's loan portfolio balance outstanding and an increase in the investment portfolio or the mortgage-backed securities portfolio at rates that are lower than those currently in the portfolio. At March 31, 2003, loans receivable totaled $121.8 million, a decrease of $15.3 million or 11.2% from the $137.2 million at September 30, 2002. The decrease in loans receivable was primarily the result of the Company's decision to sell the majority of its one- to four-family loans into the secondary market. In addition, the Company elected to tighten the underwriting standards and loan-to-value limits on its indirect auto lending program which decreased the production of these type of loans. Interest bearing deposits with banks increased to $5.6 million at March 31, 2003, a $2.7 million increase from the $2.9 million reported at September 30, 2002. The increase was due to the additional cash flow from the Company's loans receivable and mortgage-backed securities portfolios as discussed above. The Company expects to systematically reinvest any excess cash flow into various investment and mortgage-backed securities. Investment securities held-to-maturity were reported as $7.7 million at March 31, 2003, a decrease of $2.0 million from the $9.7 million reported at September 30, 2002. The decrease was the result of the maturity of securities during the six months ended March 31, 2003. At March 31, 2003, this portfolio consisted of approximately $1.5 million of debt issued by governmental agencies such as Federal National Mortgage Corporation, Federal Home Loan Mortgage Corporation, and the Federal Home Loan Bank System, and approximately $6.2 million of corporate debt securities. All securities in the portfolio are fixed rate and term. Mortgage-backed securities available-for-sale totaled $4.1 million at March 31, 2003, a decrease of $16.1 million from the $20.1 million at September 30, 2002. The decrease was primarily the result of principle repayments on the securities during the six months ended March 31, 2003, due to the refinancing activity previously discussed. Mortgage-backed securities held-to-maturity portfolio totaled $56.7 million at March 31, 2003, an increase of $26.1 million from the $30.6 million reported at September 30, 2002. The increase was primarily due to additional securities added to the portfolio, during the six months ended March 31, 2003. Total deposits were $112.6 million at March 31, 2003, a $5.1 million increase from the $107.5 million reported at September 30, 2002. The increase was primarily the result of increases in certificate of deposit balances as the Company paid competitive interest rates on renewing certificates of deposit during the period. The Company reported $82.4 million in borrowed funds at March 31, 2003, a decrease of $3.9 million from the $86.3 million reported at September 30, 2002. The decrease was primarily due to the Company's decision to reduce its reliance on short term advances from the FHLB and to replace them with longer term certificates of deposits. Stockholder's equity totaled $19.9 million at March 31, 2003, an increase of $621,000 from the $19.3 million reported at September 30, 2002. The increase was primarily attributable to a net increase in retained earnings of $610,000. The increase in retained earnings was due to the $728,000 in net income less $116,000 in cash dividends paid during the six months ended March 31, 2003. RESULTS OF OPERATIONS The Company's net income is dependent primarily upon net interest income, the difference or spread between the average yield earned on loans and investments and the average rate paid on deposits, as well as the relative amounts of such assets and liabilities. The Company, like other financial intermediaries, is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different times, or on a different basis, than its interest earning assets. 17 of 29 COMPARISON OF THE THREE MONTHS ENDED MARCH 31, 2003 AND MARCH 31, 2002 General. Net income for the three months ended March 31, 2003 was $295,000 or $.26 per share and $.25 per share assuming - dilution, a decrease of $75,000 from the $370,000, or $.33 per share and $.32 per share - assuming dilution, reported for the three months ended March 31, 2002. The decrease in net income was attributable to a $217,000 decrease in net interest income after provision for loan losses. Approximately $175,000 of the decline in net interest income after provision for loan losses was attributable to additional provisions for loan losses and $42,000 was due to a decline in net interest income before provision for loan losses. The decrease in net income was also partially due to a $119,000 increase in noninterest expense. Noninterest income increased by $217,000 and income tax expense decreased by $44,000. Net Interest Income. For the quarter ended March 31, 2003, net interest income before provision for loan losses totaled $1.6 million, a decrease of $42,000 from the $1.6 million reported for the quarter ended March 31, 2002. On an annualized basis, the $1.6 million in net interest income for the current quarter was approximately 3.09% of average interest-earning assets and 2.88% of average total assets. For the quarter ended March 31, 2002, the $1.6 million in net interest income before provisions for loan losses was approximately 3.21% of average interest-earning assets and 3.07% of average total assets. Average interest-earning assets were approximately $203.3 million for the quarter ended March 31, 2003, compared to $200.8 million for the quarter ended March 31, 2002. Total interest income was $3.0 million for the quarter ended March 31, 2003, compared to $3.3 million for the quarter ended March 31, 2002. The decrease in total interest income was primarily due to a $171,000 decline in interest on first mortgage loans receivable. The decline in interest on first mortgage loans receivable was due to an overall decline in the balance in the portfolio as the Company elected to sell the majority of its mortgage loan production during the past year. Also, the decline in yields on the loans that were placed into the mortgage loan portfolio during the year contributed to the overall decrease in interest income on mortgage loans. However, interest on consumer and other loans increased by $52,000 to $920,000 for the three months ended March 31, 2003 from $868,000 for the three months ended March 31, 2002. The increase in interest income on consumer and other loans was due to the increased balances in the consumer and other loan portfolio during the past year. In addition, interest rates on these types of loans are not as sensitive to overall movements in the general level of interest rates, which allowed the Company to continue to originate and place into the loan portfolio loans with higher yields than those available on mortgage loans. The decrease in total interest income was also due to a $129,000 decrease in interest income on the Company's mortgage-backed securities portfolio. The decline in income was due to a decrease in the average yield in the portfolio. The Company placed excess cash flow into the portfolio at yields that were lower than maturing or prepaying securities ands loans. Interest income on loans receivable was $2.3 million for the quarter ended March 31, 2003, compared to $2.5 million for the quarter ended March 31, 2002. On an annualized basis, the $2.3 million was approximately 7.44% of average loans receivable balances outstanding for the quarter ended March 31, 2003, compared to approximately 7.73% for the quarter ended March 31, 2002. The decrease in total interest income on the loan portfolio was primarily the result of a decrease in one- to four-family real estate loan balances, as previously discussed. The overall decline in interest rates over the past 12 months and the refinance of mortgage loans held in portfolio contributed to the decline in overall yield on the loan portfolio. Interest income from mortgage-backed securities available-for-sale totaled $14,000 for the quarter ended March 31, 2003, compared to $104,000 for the quarter ended March 31, 2002. The decrease in income was due to a decline in the balance of the portfolio from $22.6 million at March 31, 2002 to $4.1 million at March 31, 2003, as the Company directed cash flow from this portfolio into other investments. Interest income from the investment securities held-to-maturity portfolio was $121,000 for the quarter ended March 31, 2003, compared to $154,000 for the quarter ended March 31, 2002. The decrease in income from the portfolio was primarily due to a decline in the balance of the portfolio. 18 of 29 Interest income on mortgage-backed securities held-to-maturity totaled $457,000 for the quarter ended March 31, 2003, a decrease of $39,000 from the $496,000 reported for the quarter ended March 31, 2002. The decrease was due primarily to a decline of the overall yield of the portfolio, despite an increase in the balance in the portfolio from $30.7 million at March 31, 2002 to $56.7 million at March 31, 2003. As previously discussed, the Company received excessive amounts of cash flow from its mortgage loans receivable and mortgage related securities portfolios during the past year. The Company chose to reinvest the majority of this excess cash flow into mortgage-backed securities held-to-maturity. The new securities were at substantially lower, primarily adjustable, rates than those previously held in the portfolio. The result was an overall decline in the yield and an overall decrease in interest income on the portfolio. Interest paid to depositors totaled $834,000 for the quarter ended March 31, 2003, a decrease of $176,000 from the $1.0 million reported for the quarter ended March 31, 2002. On an annualized basis, the $834,000 in interest expense on deposits was approximately 3.07% of interest bearing deposits for the quarter ended March 31, 2003. Interest on FHLB advances was $610,000 for the quarter ended March 31, 2003, compared to $649,000 for the quarter ended March 31, 2002. The decrease in interest expense was primarily the result of declining interest rates during the past year. At March 31, 2002, the Company had approximately $36.5 million in advances which re-priced approximately every 30 days. As short-term interest rates declined in 2002, the Company benefited from an overall lower cost of borrowing as the rate of interest on the advances declined substantially. For the three months ended March 31, 2003, the weighted average rate on FHLB advances was approximately 2.95%. Provision for Loan Losses. The Company made $276,000 in provision for loan losses for the quarter ended March 31, 2003, compared to $101,000 for the quarter ended March 31, 2002. The increase was directly related to the losses in the Company's indirect automobile lending program. [See "Asset Quality"] Noninterest Income. Non-interest income totaled $396,000 for the quarter ended March 31, 2003, compared to $136,000 for the quarter ended March 31, 2002. The increase was due to a $102,000 increase in gains on sales of interest earning assets from $44,000 for the quarter ended March 31, 2002 to $146,000 for the quarter ended March 31, 2003. The Company elected to sell the majority of its one- to four-family loan production into the secondary market during 2002 and 2003. The result was an increase in gains on the sale of loans for the quarter ended March 31, 2003, compared to the same period in 2002. Other noninterest income was reported as $212,000 for the three months ended March 31, 2003, an increase of $131,000 from the $82,000 reported for the three months ended March 31, 2002. Approximately $47,000 of the increase was from income earned on the Company's Bank Owned Life Insurance. [See "Note 7"] The remainder of the increase was from other increases in loan fee income and other miscellaneous fees. Noninterest Expense. Noninterest expense was $1.2 million for the quarter ended March 31, 2003, an increase of $119,000 from the $1.1 million for the quarter ended March 31, 2002. The increase in noninterest expense was primarily the result of a $79,000 increase in compensation and benefits expense, mainly associated with the Company's defined benefit pension plan and normal increases in employee compensation. The increase in defined benefit plan expense was due to the performance of plan assets in 2000 and 2001 and the additional employees gained in the Gilmer acquisition. Approximately two-thirds of the assets in the defined benefit plan trust are invested in various equity mutual funds. As the overall equity market declined in 2000 and 2001, the value of the assets in the plan decreased. The result was, on an actuarial basis, an increase in the pension plan expense to offset the decrease in the value of the plan assets. In addition, other noninterest expense increased by $105,000 to $380,000 for the three months ended March 31, 2003, compared to $274,000 for the three months ended March 31, 2002. The increase in other noninterest expense was due to a general increase for items such as legal expense, data processing expense, and other expenses. Provision for Income Taxes. The Company incurred federal income tax expense of $167,000 or 36.1% or pre-tax income for the quarter ended March 31, 2003, compared to $210,000 or 36.3% or pre-tax income for the quarter ended March 31, 2002. 19 of 29 COMPARISON OF THE SIX MONTHS ENDED MARCH 31, 2003 AND MARCH 31, 2002 General. For the six months ended March 31, 2003, the Company reported net income of $728,000 or $.64 per common share and $.62 per common share - assuming dilution, compared to $1.0 million or $.91 per common share and $.90 per common share - assuming dilution for the six months ended March 31, 2002. The decrease in net income was due to a $284,000 decrease in net interest income after provisions for loan losses and a $256,000 increase in noninterest expense. These were partially offset by a $148,000 decrease in income tax expense and a $97,000 increase in noninterest income. Net Interest Income. For the six months ended March 31, 2003, net interest income before provisions for loan losses totaled $3.1 million, unchanged from the $3.1 million reported for the six months ended March 31, 2002. On an annualized basis, the $3.1 million in net interest income before provisions for loan losses for the current period was approximately 3.05% of average interest earning assets and 2.86% of average total assets. For the six months ended March 31, 2002, the $3.1 million in net interest income before provisions for loan losses was, on an annualized basis, approximately 3.10% of average interest earning assets and 2.95% of average total assets. Average interest earning assets were approximately $204.4 million for the six months ended March 31, 2003, compared to $201.1 million for the six months ended March 31, 2002. Total interest income was $6.1 million or 5.96%, on an annualized basis, of average interest earning assets for the six months ended March 31, 2003, compared to $6.7 million or 6.63% of average interest earning assets for the six months ended March 31, 2002. The decrease was primarily due to a decline in interest on mortgage-backed securities available-for-sale of $304,000, and a decline in interest on mortgage loans of $300,000. The declines in interest income were partially offset by a $270,000 increase in interest income on consumer and other loans. Interest income on loans receivable totaled $4.8 million for the six months ended March 31, 2003 a decrease of $30,000 from the $4.8 million reported for the six months ended March 31, 2002. The decrease in interest income on loans receivable was due to a $300,000 decline in interest on first mortgage loans as the balance in the Company's one- to four-family portfolio declined. The balance in the one- to four-family portfolio declined as the Company elected to sell the majority of its new loans into the secondary market. Interest on consumer and other loans increased by $270,000 as the Company placed more of these loans into the loan portfolio Interest income from mortgage-backed securities available-for-sale totaled $69,000 for the six months ended March 31, 2003, compared to $373,000 for the six months ended March 31, 2002. The decrease in income was primarily attributable to a decrease in the balance in the portfolio. The Company elected to direct cash flow from this portfolio into its mortgage-backed securities held-to-maturity portfolio. Interest income on investment securities held-to-maturity totaled $247,000 for the six months ended March 31, 2003, compared to $309,000 for the six months ended March 31, 2002. The decrease was due primarily to a decline in the balance in the portfolio. Interest income on mortgage-backed securities held-to-maturity was $850,000 for the six months ended March 31, 2003, compared to $1.0 million for the six months ended March 31, 2002. The decrease in interest income on the portfolio was primarily the result of a decline in the overall yield of the portfolio as the Company redirected cash flow from its loan and other portfolios into this portfolio at lower yields, primarily adjustable rate securities. Interest expense was $3.0 million for the six months ended March 31, 2003, a decrease of $583,000 from the $3.6 million reported for the six-month period ended March 31, 2002. The decrease was due to a decline in the overall cost of interest bearing deposits, which resulted from continued low interest rates in 2002 and 2003. Noninterest Income. Noninterest income was $815,000 for the six months ended March 31, 2003, compared to $674,000 for the six months ended March 31, 2002. The increase was attributable to a $196,000 increase in other noninterest income. The increase in other noninterest income was primarily due to a $77,000 increase in Bank Owned Life Insurance income and increases in loan fee income. 20 of 29 Noninterest Expense. Noninterest expense was reported as $2.4 million for the six-month period ended March 31, 2003, a $300,000 increase from the $2.1 million reported for the six months ended March 31, 2002. The increase was primarily attributable to a $187,000 increase in compensation and benefits expense due to additional employees and normal compensation increases. A $56,000 increase in net expenses on foreclosed and repossessed assets accounted for a portion of the increase in noninterest expense. The increase in net expenses on foreclosed and repossessed assets was primarily due to expenses associated with the disposition of repossessed automobiles from the Company's consumer loan portfolio and other repossessed loans. Provision For Income Taxes. The Company incurred federal income tax expense of $414,000 or 36.2% of pre-tax income for the six months ended March 31, 2003, compared to $561,000 or 35.4% of pre-tax income for the six months ended March 31, 2002. ASSET QUALITY At March 31, 2003, the Company's non-performing assets (non-performing loans plus foreclosed assets) totaled $2.8 million or 1.27% of total assets, compared to $1.6 million or .75% of total assets at September 30, 2002. At March 31, 2003, non-performing assets were comprised primarily of non-accruing one- to four-family, consumer and other loans delinquent 90 days or more. It also included three one- to four-family interim construction loans and one commercial real estate loan that were past due 90 or more days and still accruing interest. It also includes foreclosed one- to four-family and foreclosed consumer and other loans. Non-performing loans at March 31, 2003 equaled $2.4 million or 1.95% of loans receivable, compared to $1.2 million or .90% of loans receivable at September 30, 2002. The increase in non-performing loans was primarily related to the Company's one- to four-family portfolio. The Company attributes the increased number of non-performing one- to four-family loans to a general decline in the economy in its market area. At March 31, 2003, the Company had $490,000 of loans that were contractually past due 90 days or more and for which it was still accruing interest. At March 31, 2003, the Company had no "troubled debt restructurings" as defined in Statement of Financial Accounting Standards No. 15 "Accounting by Debtors and Creditor for Troubled Debt Restructurings", or any other loans for which the Company has information about possible credit problems of borrowers that would cause management to have serious doubts as to the ability of such borrowers to comply with the preset loan repayment terms. Classified assets totaled $3.3 million or 1.5% of total assets at March 31, 2003, compared to $2.6 million or 1.2% of total assets at September 30, 2002. The increase in classified assets was also due to an increase in past due one- to four-family loans. Classified assets and non-performing assets differ in that classified assets may include loans less than 90 days delinquent. Also, assets guaranteed by government agencies such as the Veterans Administration and the Federal Housing Administration are not included in classified assets but are included in non-performing assets. At March 31, 2003, $3.1 million of classified assets were deemed to be substandard and $177,000 assets were classified as doubtful. The Company's allowance for loan and lease losses was $823,00 at March 31, 2003, which included $755,000 in general loan loss reserves, $57,000 in specific loan loss reserves, and $11,000 checking account loss reserves. The total allowance was $757,000 at September 30, 2002. The total allowance for loan losses as a percentage of loans receivable equaled 0.67% at March 31, 2003 and 0.55% at September 30, 2002. The Company uses a methodology for estimating the adequacy of its general allowance for loan losses that encompasses two separate components. The first component is an estimate of losses on the Company's list of currently classified assets. A percentage, generally ranging from 5% to 50% of each classified asset, is applied to the balance of the asset. The percentage for each asset is combined to determine the calculated allowance amount for this component. The second component is a combined inherent risk and historical loss component. This component recognizes the changes in the levels of loan balances and the historical loss levels of various classes of the loan portfolio. The loan portfolio is segregated into various classes of loans exhibiting similar risk characteristics. Each of the classes of loans is multiplied by a risk factor to determine the required allowance for the class of loans. The risk factor for each class of loans is determined by analyzing actual historical losses on the particular class of loans. 21 of 29 The historical loss analysis takes into account a period of time that is indicative of the current risks associated with the class of the loan portfolio being analyzed. The balance of loans in each class is reduced for any loans specifically reviewed by the Company and any classified assets, before applying the percentage amounts. The calculated allowance amount for each class is summed together to achieve the estimated allowance for the inherent risk and historical loss component. To determine a final estimate of the allowance for loan losses, the classified asset and inherent risk and historical loss component are summed together. The resulting calculated minimum allowance is compared to the actual balance in the allowance at the end of the period analyzed. A shortfall in the actual amount as compared to the calculated amount is charged against provision for loan losses in the period analyzed in order to bring the allowance up to the minimum calculated amount. Any excess in the actual allowance as compared to the calculated amount may remain in the allowance or may be reduced by applying the overage amount back against the provision for loan losses. At March 31, 2003, the classified asset component was calculated at $322,000 while the inherent risk and historical loss component was calculated at $438,000. At March 31, 2003, the Company had identified five separate components of the loan portfolio that it deemed necessary to analyze individually under the inherent risk and historical loss component. The five components were mortgage loans, indirect auto loans, sub-prime indirect auto loans, unsecured and miscellaneous collateral consumer loans, and all other non-mortgage loans. The classified asset component increased by $3,000 during the six months ended March 31, 2003 from approximately $319,000 at September 30, 2002 to $322,000 at March 31, 2003. The inherent risk and historical loss component increased from approximately $209,000 at September 30, 2002 to $438,000 at March 31, 2003. The increase in the inherent risk component was directly related to additional losses in the separate components, primarily associated with the Company's indirect auto lending program. During the six months ended March 31, 2003, the Company has experienced an increase in losses in the indirect lending program. The losses are equally spread between the sub-prime portion of the portfolio and the remainder of the indirect portfolio. The loss ratio for the sub-prime indirect portfolio and the remainder of the indirect portfolio was approximately 2.00% for both portfolios for the six months ended March 31, 2003. These loss rates were applied to the remaining balance in the indirect program to calculate that portion of the minimum allowance for loan and lease losses. The result was a significant increase in the calculated allowance for loan loss at March 31, 2003. The Company did not separate its loan portfolio for allowance for loan loss analysis at September 30, 2002 in the same manner as March 31, 2003. Therefore, no comparison of these specific components can be made at March 31, 2003. Nevertheless, the Company believes that the calculated allowance amounts for its sub-prime indirect auto loan balances and its unsecured and miscellaneous collateral loans have increased over the last six months as evidenced by the actual experience of losses in its loan portfolio. The Company believes that segregating its loan portfolio into specific categories of loan for allowance analysis will provide a more accurate method for estimating the adequacy of the allowance. Also, the Company has significantly decreased the volume of its indirect auto loan program by substantially tightening credit and loan to value limits on such loans. In addition, the Company has placed additional restrictions on the types of unsecured and miscellaneous collateral loans that its individual loan officers can make. The Company establishes a specific loan loss allowance of 100% of the outstanding balance of loans that are severely past due and deemed unlikely to be collected in a timely manner. Generally, the Company establishes a specific reserve when a real estate secured loan is 180 days or more past due and when a consumer loan is 120 days or more past due. The Company may establish a specific reserve sooner than these general guidelines in the case of a bankruptcy. Also, the Company may choose not to establish a specific reserve for loans that would otherwise warrant doing so, if there is sufficient value supporting the loan balance. At March 31, 2003, the Company had $57,000 in specific loan loss reserves established, compared to $71,000 at September 30, 2002. The Company believes that the overall quality of its loan portfolio remains good. However, the Company did record $400,000 in provision for loan losses during the six months ended March 31, 2003, compared to $111,000 for the same period in 2002. [See "Note 6".] 22 of 29 The Company anticipates that the general trend in the level of the allowance for loan loss will be to remain in a range that is close to the current balance in the allowance. By tightening loan-to-value and credit standards on its indirect auto loan program and its unsecured and miscellaneous collateral consumer loans, the Company believes that the balance in such loans will decline over time. The result should be a reduction in the calculated amount of the allowance for loan loss reserves for these specific components. However, the Company can not predict the affect that outside factors such as economic conditions in the Company's market and other factors may have on a borrower's ability to repay their loans. In general, the estimated allowance for loan losses could increase under the classified asset component if the Company experiences an increase in its classified assets. The allowance could increase under the inherent risk and historical loss component if the Company experiences additional losses on its loan portfolio that are charged against the allowance for loan loss account. LIQUIDITY AND CAPITAL RESOURCES The Company's principal sources of funds are deposits from customers, advances from the FHLB, amortization and prepayment of loan principal (including mortgage-backed securities), maturities of securities, sales of loans and operations. The Company uses its liquidity and capital resources principally to meet ongoing commitments to fund maturing certificates of deposit and loan commitments, maintain liquidity and pay operating expenses. At March 31, 2003, the Company had outstanding commitments to extend credit on approximately $5.7 million of loans. Management believes that present levels of liquid assets are sufficient to meet anticipated future loan commitments as well as deposit withdrawal demands. Total stockholders' equity equaled $19.9 million at March 31, 2003, an increase of $621,000 from the $19.3 million reported at September 30, 2002. The increase was primarily the result of a $610,000 increase in retained earnings that resulted from the $728,000 net income less $116,000 in cash dividends paid during the six months ended March 31, 2003. As of March 31, 2003, the Company's reported book value per share, using total stockholders' equity of $19.9 million (net of the cost of unearned ESOP shares) and 1,163,887 outstanding shares of common stock (the total issued shares including unearned ESOP shares, less treasury shares), equaled $17.10 per share. Subsequent to the quarter ended March 31, 2003, the Company announced its intention to pay a cash dividend of $.05 per share on May 7, 2003, to stockholders of record as of May 21, 2003. The Company paid $.10 per share in cash dividends in the six months ended March 31, 2003, which is approximately 19.2% of the $0.26 in reported earnings per share. The Company reported an equity to assets ratio of approximately 9.12% at March 31, 2003. Federally insured savings associations, such as First Federal, are required to maintain a minimum level of regulatory capital. The OTS has established capital standards, including a tangible capital requirement, a leverage ratio (or core capital) requirement and a risk-based capital requirement applicable to such savings associations. These capital requirements must be generally as stringent as the comparable capital requirements for national banks. The OTS is also authorized to impose capital requirements in excess of these standards on individual associations on a case-by-case basis. The capital regulations require tangible capital of at least 1.5% of adjusted total assets (as defined by regulation). Tangible capital generally includes common stockholders' equity and retained income, and certain non-cumulative perpetual preferred stock and related income. In addition, all intangible assets, other than a limited amount of purchased mortgage-servicing rights, must be deducted from total capital for calculating compliance with this requirement. At March 31, 2003, First Federal had approximately $2.2 million of intangible assets and other required regulatory adjustments that were required to be deducted from total capital. At March 31, 2003, First Federal had tangible capital of $17.3 million, or 8.02% of adjusted total assets, which is approximately $14.1 million above the minimum requirement of 1.5% of adjusted total assets in effect on that date. 23 of 29 The capital standards also require Tier 1 capital equal to at least 4.0% of adjusted total assets. Tier 1 capital generally consists of tangible capital plus certain intangible assets, including a limited amount of purchased credit card receivables. At March 31, 2003, First Federal had Tier 1 capital equal to $17.3 million, or 8.02% of adjusted total assets, which is $8.7 million above the minimum requirement for capital adequacy purposes of 4.0% as in effect on that date. The OTS risk-based requirement requires savings associations to have total capital of at least 8.0% of risk-weighted assets. Total risk-based capital consists of core capital, as defined above and supplementary capital. Supplementary capital consists of certain permanent and maturing capital instruments that do not qualify as core capital and general valuation loan and lease loss allowances up to a maximum of 1.25% of risk-weighted assets. Supplementary capital may be used to satisfy the risk-based requirement only to the extent of core capital. The OTS is also authorized to require a savings association to maintain an additional amount of total capital to account for concentration of credit risk and the risk of non-traditional activities. At March 31, 2003, First Federal had no capital instruments that qualify as supplementary capital and $760,000 of loss reserves, which was less than 1.25% of risk-weighted assets. Certain exclusions from capital and assets are required to be made for the purpose of calculating total risk-based capital. First Federal had no such exclusions from capital and assets at March 31, 2003. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet items, will be multiplied by a risk weight generally, ranging from 0% to 100%, based on the risk inherent in the type of asset. For example, the OTS has assigned a risk of 50% for prudently underwritten permanent one- to four-family first lien mortgage loans not more than 90 days delinquent and having a loan to value ratio of not more than 80% at origination unless insured to such ratio by a insurer approved by Fannie Mae or Freddie Mac. For certain assets, such as sub-prime indirect automobile lending, the OTS can require a risk-weighting of greater than 100%. The OTS has assigned a risk weighting of 200% to the Company's sub-prime indirect automobile lending program. At March 31, 2003, the Company reported approximately $7.7 million in indirect automobile loans that met the OTS definition of sub-prime. On March 31, 2003, First Federal had total risk based capital of $18.1 million (including $17.3 million in Tier 1 capital and $760,000 in loan loss reserves) and risk-weighted assets of $127.1 million, or total risk-based capital of 14.2% of risk-weighted assets. This amount was $7.9 million above the 8.0% requirement in effect on that date. At March 31, 2003, First Federal was also considered a "well capitalized" institution under the prompt corrective action requirements of the Federal Deposit Insurance Corporation Improvement Act of 1991. FORWARD-LOOKING STATEMENTS When used in this Form 10-QSB or future filings by the Company with the Securities and Exchange Commission, the Company's press releases or other public or shareholder communications or in oral statements made with the approval of an authorized executive officer, the words or phrases "will likely result", "are expected to", "will continue", "is anticipated", "estimate", "project", "believe" or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made, and to advise readers that various factors, including regional and national economic conditions, changes in levels of market interest rates, credit risks of lending activities, and competitive and regulatory factors, could affect the Company's financial performance and could cause the Company's actual results for future periods to differ materially from those anticipated or projected. The Company does not undertake, and specifically disclaims any obligation, to publicly release the result of any revisions, which may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. 24 of 29 Item 3. Controls and Procedures. (a) Evaluation of Disclosure Controls and Procedures: An evaluation of the Company's disclosure controls and procedures (as defined in Rule 13a-14(c) under the Securities Exchange Act of 1934 (the "Act")) was carried out under the supervision and with the participation of the Company's Chief Executive Officer, Chief Financial Officer and several other members of the Company's senior management within the 90-day period preceding the filing date of this quarterly report. The Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures as currently in effect are effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is (i) accumulated and communicated to the Company's management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. (b) Changes in Internal Controls: In the fiscal year ended September 30, 2002, there were no significant changes in the Company's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation. 25 of 29 EAST TEXAS FINANCIAL SERVICES, INC. AND SUBSIDIARY FORM 10-QSB MARCH 31, 2003 PART II - OTHER INFORMATION Item 1. Legal Proceedings There are no material legal proceedings to which the Company or the Association is a party or of which any of their property is subject. From time-to-time, the Association is a party to various legal proceedings incident to the conduct of its business. Item 2. Changes In Securities None Item 3. Defaults Upon Senior Securities None Item 4. Submissions Of Matters To A Vote Of Security Holders None Item 5. Other Information. None Item 6. Exhibits and Reports on Form 8-K (a) The following exhibits are filed herewith: Exhibit 11.0 - Computation of Earnings Per Share (b) Reports on Form 8-K During the quarter ended March 31, 2003, the Company filed a report on Form 8-K on January 31, 2003 to report the issuance of a press release dated January 31, 2003, announcing a cash dividend for the quarter ending December 31, 2002. 26 of 29 CERTIFICATIONS I, Gerald W. Free, certify that: 1. I have reviewed this quarterly report on Form 10-QSB of East Texas Financial Services, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 /s/ Gerald W. Free ------------------------------------- Gerald W. Free President and Chief Executive Officer 27 of 29 I, Derrell W. Chapman, certify that: 1. I have reviewed this quarterly report on Form 10-QSB of East Texas Financial Services, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 /s/ Derrell W. Chapman ------------------------------------------------- Derrell W. Chapman Executive Vice President, Chief Financial Officer and Chief Operating Officer 28 of 29 CERTIFICATION (Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) Each of the undersigned hereby certifies in his capacity as an officer of East Texas Financial Services, Inc. (the "Registrant") that the Quarterly Report of the Registrant on Form 10-QSB for the quarter ended March 31, 2003 fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934 and that the information contained in such report fairly presents, in all material respects, the consolidated financial condition of the Registrant at the end of such period and the results of operations of the Registrant for such period. Date: May 14, 2003 /s/ Gerald W. Free ------------------------------------------------- Gerald W. Free President and Chief Executive Officer Date: May 14, 2003 /s/ Derrell W. Chapman ------------------------------------------------- Derrell W. Chapman Executive Vice President, Chief Financial Officer and Chief Operating Officer 29 of 29