Item 1.
Business
Forward-Looking Statements
This report contains certain “forward-looking
statements” within the meaning of the federal securities laws. These statements are not historical facts, rather statements
based on Kentucky First Federal Bancorp’s current expectations regarding its business strategies, intended results and future
performance. Forward-looking statements are preceded by terms such as “expects,” “believes,” “anticipates,”
“intends” and similar expressions.
Management’s ability to predict
results or the effect of future plans or strategies is inherently uncertain. Factors which could affect actual results include
the following: interest rate trends; the general economic climate in the market areas in which Kentucky First Federal Bancorp operates,
as well as nationwide; Kentucky First Federal Bancorp’s ability to control costs and expenses; competitive products and pricing;
loan delinquency rates; and changes in federal and state legislation and regulation. These factors should be considered in evaluating
the forward-looking statements and undue reliance should not be placed on such statements. Kentucky First Federal Bancorp assumes
no obligation to update any forward-looking statements.
General
References in this
Annual Report on Form 10-K to “we,” “us” and “our” refer to Kentucky First, and where appropriate,
collectively to Kentucky First, First Federal of Hazard and First Federal of Kentucky.
Kentucky First Federal Bancorp.
Kentucky
First Federal Bancorp (“Kentucky First” or the “Company”) was incorporated as a mid-tier holding company
under the laws of the United States on March 2, 2005 upon the completion of the reorganization of First Federal Savings and Loan
Association of Hazard (“First Federal of Hazard”) into a federal mutual holding company form of organization (the “Reorganization”).
On that date, Kentucky First also completed its minority stock offering and its concurrent acquisition of Frankfort First Bancorp,
Inc. (“Frankfort First Bancorp”) and its wholly owned subsidiary First Federal Savings Bank of Kentucky, Frankfort,
Kentucky (“First Federal of Kentucky”) (the “Merger”). Following the Reorganization and Merger, the Company
has operated First Federal of Hazard and First Federal of Kentucky (collectively, the “Banks”) as two independent,
community-oriented savings institutions.
On December 31, 2012, Kentucky First acquired
CFK Bancorp, Inc., the savings and loan holding company for Central Kentucky Federal Savings Bank, a federally chartered savings
bank located in Danville, Kentucky. Central Kentucky Federal Savings Bank was merged into First Federal of Kentucky and now operates
as a division of First Federal of Kentucky under the name “Central Kentucky Federal Savings Bank” through its two offices
in Danville, Kentucky and its Lancaster, Kentucky branch. With the acquisition, the Company expanded its customer base in the central
Kentucky area with an institution that shared its community banking orientation and thrift heritage and enjoyed a favorable reputation
within the new Danville-Lancaster market area.
Kentucky First’s and First Federal
of Hazard’s executive offices are located at 655 Main Street, Hazard, Kentucky, 41702 and the telephone number for investor
relations is (888) 818-3372.
At June 30, 2016, Kentucky First had total
assets of $291.9 million, deposits of $188.6 million and stockholders’ equity of $67.5 million. The discussion in this Annual
Report on Form 10-K relates primarily to the businesses of First Federal of Hazard and First Federal of Kentucky, as Kentucky First’s
operations consist primarily of operating the Banks and investing funds retained in the Reorganization.
First Federal of Hazard and First Federal
of Kentucky are subject to examination and comprehensive regulation by the Office of the Comptroller of the Currency and their
savings deposits are insured up to applicable limits by the Deposit Insurance Fund, which is administered by the Federal Deposit
Insurance Corporation. Both of the Banks are members of the Federal Home Loan Bank of Cincinnati, which is one of the 12 regional
banks in the FHLB System. See “
Regulation and Supervision
.”
First Federal Savings and Loan Association
of Hazard.
First Federal of Hazard was formed as a federally chartered mutual savings and loan association in 1960. First
Federal of Hazard operates from a single office in Hazard, Kentucky as a community-oriented savings and loan association offering
traditional financial services to consumers in Perry and surrounding counties in eastern Kentucky. It engages primarily in the
business of attracting deposits from the general public and using such funds to originate, when available, loans secured by first
mortgages on owner-occupied, residential real estate and occasionally other loans secured by real estate. To the extent there is
insufficient loan demand in its market area, and where appropriate under its investment policies, First Federal of Hazard has historically
invested in mortgage-backed and investment securities, although since the reorganization, First Federal of Hazard has been purchasing
whole loans and participations in loans originated at First Federal of Kentucky. At June 30, 2016, First Federal of Hazard had
total assets of $72.3 million, net loans of $53.8 million, total mortgage-backed and other securities of $975,000, deposits of
$51.5 million and total capital of $18.0 million.
First Federal Savings Bank of Kentucky.
First Federal of Kentucky is a federally chartered savings bank, which is primarily engaged in the business of attracting
deposits from the general public and originating primarily adjustable-rate loans secured by first mortgages on owner-occupied and
nonowner-occupied one- to four-family residences in Franklin, Boyle, Garrard and other counties in Kentucky. First Federal of Kentucky
also originates, to a lesser extent, home equity loans and loans secured by churches, multi-family properties, professional office
buildings and other types of property. At June 30, 2016, First Federal of Kentucky had total assets of $228.7 million, net loans
of $184.7 million, total mortgage-backed and other securities of $3.2 million, deposits of $150.0 million and total capital of
$45.0 million.
First Federal of Kentucky’s main office
is located at 216 W. Main Street, Frankfort, Kentucky 40602 and its main telephone number is (502) 223-1638.
Market Areas
First Federal of Hazard and First Federal
of Kentucky operate in three distinct market areas.
First Federal of Hazard’s market area
consists of Perry County, where the business office is located, as well as the surrounding counties of Letcher, Knott, Breathitt,
Leslie and Clay Counties in eastern Kentucky. The economy in its market area has been distressed in recent years. The local economy
depends on the coal industry and other industries, such as health care and manufacturing. Still, the economy in First Federal of
Hazard’s market area continues to lag behind the economies of Kentucky and the United States. In the most recent available
data, using information from the Commonwealth of Kentucky Economic Development and the United States Bureau of Labor Statistics,
per capita personal income in Perry County averaged $34,578in 2014, compared to personal income of $39,000 in Kentucky and $47,669
in the United States. Total population in Perry County has remained stable over the last five years at approximately 29,000. However,
as a regional economic center, Hazard tends to draw consumers and workers who commute from surrounding counties. Employment in
the market area, particularly in Perry County, consists primarily of the trade, transportation and utilities industry (18.2%),
the mining industry (17.3%), and the services sector, including health care (15.4%). During the last five years, the unemployment
rate has been higher than most regions, and in June 2016, was 10.5%, compared to 5.4% in Kentucky and 4.9% in the United States.
First Federal of Kentucky’s primary
lending area includes the Kentucky counties of Franklin, Boyle, Garrard and surrounding counties, with the majority of lending
originated on properties located in Franklin and Boyle Counties.
Franklin County has a population of approximately
50,000, of which approximately 27,000 live within the city of Frankfort, which serves as the capital of Kentucky. The primary employer
in the area is government, which employs about 36.3% of the workforce followed by the services sector and the trade, transportation
and utilities sector, which employ about 29.4% and 10.7% of the workforce, respectively. Despite this large, relatively stable
source of employment, the unemployment rate was 4.3% for June 2016 after having experienced an unemployment rate which had ranged
from 4.5 to 9.0% in prior years. The per capita income in Franklin County for 2014 averaged $37,875.
Boyle County has a population of approximately
29,000. The service sector, which employs about 42.9% of the work force, is the largest employer, while the trade, transportation
and utilities sector is the next largest employer with approximately 20.3% of the workforce. Centre College is one of the larger
employers in the community. The unemployment rate was 5.5% in June 2016, while the per capita income in Boyle County for 2014 averaged
$33,163.
Lending Activities
General
.
Our loan portfolio
consists primarily of one- to four-family residential mortgage loans. As opportunities arise, we also offer loans secured by churches,
commercial real estate, and multi-family real estate. We also offer loans secured by deposit accounts and, through First Federal
of Kentucky, home equity loans. Substantially all of our loans are made within the Banks’ respective market areas.
Residential Mortgage Loans
.
Our primary lending activity is the origination of mortgage loans to enable borrowers to purchase or refinance existing homes in
the Banks’ respective market areas. At June 30, 2016, residential mortgage loans totaled $204.5 million, or 83.5%, of our
total loan portfolio. We offer a mix of adjustable-rate and fixed-rate mortgage loans with terms up to 30 years. Adjustable-rate
loans have an initial fixed term of one, three, five or seven years. After the initial term, the rate adjustments on most of First
Federal of Kentucky’s adjustable-rate loans are indexed to the National Average Contract Interest Rate for Major Lenders
on the Purchase of Previously Occupied Homes. The interest rates on these mortgages are adjusted once a year, with limitations
on adjustments generally of one percentage point per adjustment period, and a lifetime cap of five percentage points. We determine
loan fees charged, interest rates and other provisions of mortgage loans on the basis of our own pricing criteria and competitive
market conditions. Some loans originated by the Banks have an additional advance clause which allows the borrower to obtain additional
funds at prevailing interest rates, subject to managements’ approval.
At June 30, 2016, the Company’s loan
portfolio included $155.8 million in adjustable-rate residential mortgage loans, or 76.2%, of the Company’s residential mortgage
loan portfolio.
The retention of adjustable-rate loans in
the portfolio helps reduce our exposure to increases in prevailing market interest rates. However, there are unquantifiable credit
risks resulting from potential increases in costs to borrowers in the event of upward repricing of adjustable-rate loans. It is
possible that during periods of rising interest rates, the risk of default on adjustable-rate loans may increase due to increases
in interest costs to borrowers. However, despite their popularity in some parts of the country, neither bank has offered adjustable-rate
loans that contractually allow for negative amortization. Such loans, under some circumstances, can cause the balance of a closed-end
loan to exceed the original balance and perhaps surpass the value of the collateral. Further, although adjustable-rate loans allow
us to increase the sensitivity of our interest-earning assets to changes in interest rates, the extent of this interest sensitivity
is limited by the initial fixed-rate period before the first adjustment and the periodic and lifetime interest rate adjustment
limitations. Accordingly, there can be no assurance that yields on our adjustable-rate loans will fully adjust to compensate for
increases in our cost of funds. Finally, adjustable-rate loans may decrease at a pace faster than decreases in our cost of funds,
resulting in reduced net income.
While one- to four-family residential real
estate loans are normally originated with up to 30-year terms, such loans typically remain outstanding for substantially shorter
periods because borrowers often prepay their loans in full upon sale of the mortgaged property or upon refinancing the original
loan. Therefore, average loan maturity is a function of, among other factors, the level of purchase and sale activity in the real
estate market, prevailing interest rates and the interest rates payable on outstanding loans. As interest rates declined and remained
low over the past few years, we have experienced high levels of loan repayments and refinancings.
The Banks offer various programs for the
purchase and refinance of one- to four-family loans. Most of these loans have loan-to-value ratios of 80% or less, based on an
appraisal provided by a state licensed or certified appraiser. For owner-occupied properties, the borrower may be able to borrow
up to 95% of the value if they secure and pay for private mortgage insurance or they may be able to obtain a second mortgage (at
a higher interest rate) in which they borrow up to 90% of the value. On a rare case-by-case basis, the Boards of Directors of the
Banks may approve a loan above the 80% loan-to-value ratio without such enhancements.
Construction Loans
.
We originate
loans to individuals to finance the construction of residential dwellings for personal use or for use as rental property. On a
case-by-case basis we consider construction loans on other than owner-occupied, residential property. At June 30, 2016, construction
loans totaled $2.8 million, or 1.2%, of our total loan portfolio. Our construction loans generally provide for the payment of interest
only during the construction phase, which is usually less than one year. Loans generally can be made with a maximum loan to value
ratio of 80% of the appraised value. Funds are disbursed as progress is made toward completion of the construction based on site
inspections by qualified bank staff.
Construction financing is generally considered
to involve a higher degree of risk of loss than long-term financing on improved, occupied real estate. Risk of loss on a construction
loan depends largely upon the accuracy of the initial estimate of the property’s value at completion of construction or development
and the estimated cost (including interest) of construction. During the construction phase, a number of factors could result in
delays and cost overruns. If the estimate of construction costs proves to be inaccurate, we may be required to advance funds beyond
the amount originally committed to permit completion of the development. If the estimate of value proves to be inaccurate, we may
be confronted, at or before the maturity of the loan, with a project having a value which is insufficient to assure full repayment.
As a result of the foregoing, construction lending often involves the disbursement of substantial funds with repayment dependent,
in part, on the success of the ultimate project rather than the ability of the borrower or guarantor to repay principal and interest.
If we are forced to foreclose on a project before or at completion due to a default, there can be no assurance that we will be
able to recover the unpaid balance and accrued interest on the loan, as well as related foreclosure and holding costs.
Multi-Family Loans
.
We offer
mortgage loans secured by multi-family property (residential real estate comprised of five or more units.) At June 30, 2016, multi-family
loans totaled $15.6 million, or 6.3%, of our total loan portfolio. We originate multi-family real estate loans for terms of generally
25 years or less. Loan amounts generally do not exceed 80% of the appraised value and tend to range much lower.
Nonresidential Loans
.
As opportunities
arise, we offer mortgage loans secured by nonresidential real estate, which is generally secured by commercial office buildings,
churches, condominiums and properties used for other purposes. At June 30, 2016, nonresidential totaled $27.1 million, or 11.1%
of our total loan portfolio. We originate nonresidential real estate loans for terms of generally 25 years or less and loan amounts
generally do not exceed 80% of the appraised value and tend to range much lower.
Loans secured by multi-family and nonresidential
real estate generally have larger balances and involve a greater degree of risk than one- to four-family residential mortgage loans.
Of primary concern in multi-family and nonresidential real estate lending is the borrower’s creditworthiness and the feasibility
and cash flow potential of the project. Payments on loans secured by income properties often depend on successful operation and
management of the properties. As a result, repayment of such loans may be subject to a greater extent than residential real estate
loans to adverse conditions in the real estate market or the economy. To monitor cash flows on income properties, we require borrowers
and/or loan guarantors to provide annual financial statements on larger multi-family and commercial real estate loans. In reaching
a decision on whether to make a multi-family or nonresidential real estate loan, we consider the net cash flow of the project,
the borrower’s expertise, credit history and the value of the underlying property.
Commercial Non-mortgage Loans
.
At June 30, 2016, commercial non-mortgage loans totaled $1.8 million, or 0.7%, of our total loan portfolio. We do not emphasize
commercial non-mortgage loans, which may be secured by vehicles used in business or by inventory and equipment of the business
or may be unsecured, although we do originate such loans on a limited basis and generally require a pre-existing relationship with
the Bank. These loans are made only to businesses in our local market and we generally require personal guarantees of well-established
individuals for these loans. Commercial loans involve an even greater degree of risk than real estate loans.
Consumer Lending.
Our consumer
loans include home equity lines of credit, loans secured by savings deposits, automobile loans and unsecured or personal loans.
At June 30, 2016, our consumer loan balance totaled $8.6 million, or 3.5%, of our total loan portfolio. Of the consumer loan balance
at June 30, 2016, $6.2 million were home equity loans, $1.8 million were loans secured by savings deposits and $766,000 were automobile
or unsecured loans.
Our home equity loans are made at First
Federal of Kentucky and are made on the security of residential real estate and have terms of up to 15 years. Most of First Federal
of Kentucky’s home equity loans are second mortgages subordinate only to first mortgages also held by the bank and do not
exceed 80% of the estimated value of the property, less the outstanding principal of the first mortgage. First Federal of Kentucky
does offer home equity loans up to 90% of the value less the balance of the first mortgage at a premium rate to qualified borrowers.
These loans are not secured by private mortgage insurance. First Federal of Kentucky’s home equity loans require the monthly
payment of 1.0% to 2% of the unpaid principal until maturity, when the remaining unpaid principal, if any, is due. First Federal
of Kentucky’s home equity loans bear variable rates of interest indexed to the prime rate for loans with 80% or less loan-to-value
ratio, and 2% above the prime rate for loans with a loan-to-value ratio in excess of 80%. Interest rates on these loans can be
adjusted monthly. At June 30, 2016, the total outstanding home equity loans amounted to 2.5% of the Company’s total loan
portfolio.
Loans secured by savings are originated
for up to 90% of the depositor’s savings account balance. The interest rate is varying percentage points above the rate paid
on the savings account, and the account must be pledged as collateral to secure the loan. At June 30, 2016, loans on savings accounts
totaled 0.7% of the Company’s total loan portfolio.
Consumer loans generally entail greater
risk than do residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciable
assets. Automobile and unsecured loans at June 30, 2016, totaled 0.3% of the Company’s total loan portfolio.
Loan Originations, Purchases and Sales
.
Loan originations come from a number of sources. The primary source of loan originations are our in-house loan originators, and
to a lesser extent, advertising and referrals from customers and real estate agents. First Federal of Kentucky sells fixed-rate
loans with longer maturities to the Federal Home Loan Bank of Cincinnati (“FHLB-Cincinnati”). We earn income on the
loans sold through fees we charge on the origination, interest spread premiums earned when we sell the loans, and loan servicing
fees on an on-going basis, because servicing rights are retained on such loans. At June 30, 2016, $11.7 million in loans were being
serviced by First Federal of Kentucky for the FHLB-Cincinnati.
Loan Approval Procedures and Authority
.
Our lending activities follow written, nondiscriminatory, underwriting standards and loan origination procedures established by
each Bank’s Board of Directors and management. First Federal of Hazard’s loan committee, consisting of its two senior
officers, has authority to approve loans of up to $275,000. Loans above this amount and loans with non-standard terms such as longer
repayment terms or high loan-to-value ratios, must be approved by our Board of Directors. First Federal of Kentucky’s loan
approval process allows for various combinations of experienced bank officers to approve or deny loans which are one- to four-family
properties totaling $350,000 or less, church loans of under $150,000, home equity lines of credit of $100,000 or less and loans
to individuals whose aggregate borrowings with the Bank is less than $500,000. Loans that do not conform to these criteria must
be submitted to the Board of Directors or Executive Committee composed of at least three directors, for approval.
It is the Company’s practice to record
a lien on the real estate securing a loan. The Banks generally do not require title insurance, although it may be required for
loans made in certain programs. The Banks do require fire and casualty insurance on all security properties and flood insurance
when the collateral property is located in a designated flood hazard area.
Loans to One Borrower
.
The
maximum amount either Bank may lend to one borrower and the borrower’s related entities is limited, by regulation, to generally
15% of that Bank’s stated capital and the allowance for loan losses. At June 30, 2016, the regulatory limit on loans to one
borrower was $2.8 million for First Federal of Hazard and $4.7 million for First Federal of Kentucky. Neither of the banks had
lending relationships in excess of their respective lending limits. However, loans or participations in loans may be sold among
the Banks, which may allow a borrower’s total loans with the Company to exceed the limit of either individual bank.
Loan Commitments
.
The Banks
issue commitments for the funding of mortgage loans. Generally, these commitments exist from the time the underwriting of the loan
is completed and the closing of the loan. Generally, these commitments are for a maximum of 30 or 60 days but management routinely
extends the commitment if circumstances delay the closing. Management reserves the right to verify or re-evaluate the borrower’s
qualifications and to change the rates and terms of the loan at that time.
If conditions exist whereby either Bank
experiences a significant increase in loans outstanding or commits to originate loans that are riskier than a typical one- to four-family
mortgage, management and the boards will consider reflecting the anticipated loss exposure in a separate liability. As residential
loans are approved in the normal course of business, and those loans are underwritten to the standards of the Banks, management
does not believe alteration of the allowance for loan losses is warranted. At June 30, 2016, no commitment losses were reflected
in a separate liability.
First Federal of Kentucky offers construction
loans in which the borrower obtains the loan for a short term, less than one year, and simultaneously extends a commitment for
permanent financing. First Federal of Hazard offers a construction loan that is convertible to permanent financing, thus no additional
commitment is made.
Interest Rates and Loan Fees.
Interest
rates charged on mortgage loans are primarily determined by competitive loan rates offered in our market areas and our yield objectives.
Mortgage loan rates reflect factors such as prevailing market interest rate levels, the supply of money available to the savings
industry and the demand for such loans. These factors are in turn affected by general economic conditions, the monetary policies
of the federal government, including the Board of Governors of the Federal Reserve System, the general supply of money in the economy,
tax policies and governmental budget matters.
We receive fees in connection with late
payments on our loans. Depending on the type of loan and the competitive environment for mortgage loans, we may charge an origination
fee on all or some of the loans we originate. We may also offer a menu of loans whereby the borrower may pay a higher fee to receive
a lower rate or to pay a smaller or no fee for a higher rate.
Delinquencies
.
When a borrower
fails to make a required loan payment, we take a number of steps to have the borrower cure the delinquency and restore the loan
to current status. We make initial contact with the borrower when the loan becomes 15 days past due. Subsequently, bank staff under
the direct supervision of senior management and with consultation by the Banks’ attorneys, attempt to contact the borrower
and determine their status and plans for resolving the delinquency. However, once a delinquency reaches 90 days, management considers
foreclosure and, if the borrower has not provided a reasonable plan (such as selling the collateral, securing a commitment from
another lender to refinance the loan or submitting a plan to repay the delinquent principal, interest, escrow, and late charges)
the foreclosure suit may be initiated. In some cases, management may delay initiating the foreclosure suit if, in management’s
opinion, the Banks’ chance of loss is minimal (such as with loans where the estimated value of the property greatly exceeds
the amount of the loan) or if the original borrower is deceased or incapacitated. If a foreclosure action is initiated and the
loan is not brought current, paid in full, or refinanced with another lender before the foreclosure sale, the real property securing
the loan is sold at foreclosure. The Banks are represented at the foreclosure sale and in most cases will bid an amount equal to
the Banks’ investment (including interest, advances for taxes and insurance, foreclosure costs, and attorney’s fees).
If another bidder outbids the Bank, the Bank’s investment is received in full. If another bidder does not outbid the Banks,
the Banks acquire the property and attempt to sell it to recover their investment.
A borrower’s filing for bankruptcy
can alter the methods available to the Banks to seek collection. In such cases, the Banks work closely with legal counsel to resolve
the delinquency as quickly as possible.
We may consider loan workout arrangements
with certain borrowers under certain conditions. Management of each bank provides a report to its board of directors on a monthly
basis of all loans more than 60 days delinquent, including loans in foreclosure, and all property acquired through foreclosure.
Investment Activities
We have legal authority to invest in various
types of liquid assets, including U.S. Treasury obligations, securities of various federal agencies and state and municipal governments,
mortgage-backed securities and certificates of deposit of federally insured institutions. We also are required to maintain an investment
in FHLB-Cincinnati stock, the level of which is largely dependent on our level of borrowings from the FHLB.
At June 30, 2016, our investment portfolio
consisted of mortgage-backed securities issued and guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae with stated final maturities
of 30 years or less. The Company held no equity position with Fannie Mae, but acquired an equity position in Freddie Mac along
with the acquisition of CKF Bancorp. At June 30, 2016, the carrying amount of our Freddie Mac stock was $53,000, which was also
its estimated fair market value, while its cost basis was $8,000.
Our investment objectives are to provide
an alternate source of low-risk investments when loan demand is insufficient, to provide and maintain liquidity, to maintain a
balance of high quality, diversified investments to minimize risk, to provide collateral for pledging requirements, to establish
an acceptable level of interest rate risk, and to generate a favorable return. The Banks’ Board of Directors has the overall
responsibility for each institution’s investment portfolio, including approval of investment policies
.
The management
of each Bank may authorize investments as prescribed in each of the Bank’s investment policies.
Bank Owned Life Insurance
First Federal of Kentucky owns several Bank
Owned Life Insurance policies totaling $3.1 million at June 30, 2016. The purpose of these policies is to offset future escalation
of the costs of non-salary employee benefit plans such as First Federal of Kentucky’s defined benefit retirement plan and
First Federal of Kentucky’s health insurance plan. The lives of certain key Bank employees are insured, and First Federal
of Kentucky is the sole beneficiary and will receive any benefits upon the employee’s death. The policies were purchased
from four highly-rated life insurance companies. The design of the plan allows for the cash value of the policy to be designated
as an asset of First Federal of Kentucky. The asset’s value will increase by the crediting rate, which is a rate set by each
insurance company and is subject to change on an annual basis. The growth of the value of the asset will be recorded as other operating
income. Management does not foresee any expense associated with the plan. Because this is a life insurance product, current federal
tax laws exempt the income from federal income taxes.
Bank owned life insurance is not secured
by any government agency nor are the policies’ asset values or death benefits secured specifically by tangible property.
Great care was taken in selecting the insurance companies, and the bond ratings and financial condition of these companies are
monitored on a quarterly basis. The failure of one of these companies could result in a significant loss to First Federal of Kentucky.
Other risks include the possibility that the favorable tax treatment of the income could change, that the crediting rate will not
be increased in a manner comparable to market interest rates, or that this type of plan will no longer be permitted by First Federal
of Kentucky’s regulators. This asset is considered illiquid because, although First Federal of Kentucky may terminate the
policies and receive the original premium plus all earnings, such an action would require the payment of federal income taxes on
all earnings since the policies’ inception.
Deposit Activities and Other Sources of Funds
General
.
Deposits, loan repayments
and maturities, redemptions, sales and repayments of investment and mortgage-backed securities are the major sources of our funds
for lending and other investment purposes. Loan repayments are a relatively stable source of funds, while deposit inflows and outflows
and loan prepayments are significantly influenced by general interest rates and money market conditions.
Deposit Accounts
.
The vast
majority of our depositors are residents of the Banks’ respective market areas. Deposits are attracted from within our market
areas through the offering of passbook savings and certificate accounts, and, at First Federal of Kentucky, checking accounts and
individual retirement accounts (“IRAs”). We do not utilize brokered funds. Deposit account terms vary according to
the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. In
determining the terms of our deposit accounts, we consider the rates offered by our competition, profitability to us, asset liability
management and customer preferences and concerns. We review our deposit mix and pricing on an ongoing basis as needed
.
Borrowings
.
First Federal of Hazard and First Federal of Kentucky borrow from the FHLB-Cincinnati to supplement their supplies of investable
funds and to meet deposit withdrawal requirements. The Federal Home Loan Bank functions as a central reserve bank providing credit
for member financial institutions. As members, each Bank is required to own capital stock in the FHLB-Cincinnati and is authorized
to apply for advances on the security of such stock and certain of our mortgage loans and other assets (principally securities
which are obligations of, or guaranteed by, the United States), provided certain standards related to creditworthiness have been
met. Advances are made under several different programs, each having its own interest rate and range of maturities. Depending on
the program, limitations on the amount of advances are based either on a fixed percentage of an institution’s net worth or
on the Federal Home Loan Bank’s assessment of the institution’s creditworthiness.
Subsidiary Activities
The Company has no other wholly owned subsidiaries
other than First Federal of Hazard and Frankfort First Bancorp. Frankfort First Bancorp has one subsidiary, First Federal of Kentucky.
As federally chartered savings institutions,
the Banks are permitted to invest an amount equal to 2% of assets in subsidiaries, with an additional investment of 1% of assets
where such investment serves primarily community, inner-city and community-development purposes. Under such limitations, as of
June 30, 2016, First Federal of Hazard and First Federal of Kentucky were authorized to invest up to $2.2 million and $6.9 million,
respectively, in the stock of or loans to subsidiaries, including the additional 1% investment for community, inner-city and community
development purposes.
Competition
We face significant competition for the
attraction of deposits and origination of loans. Our most direct competition for deposits has historically come from the banks
and credit unions operating in our market areas and, to a lesser extent, from other financial services companies, such as investment
brokerage firms. We also face competition for depositors’ funds from money market funds and other corporate and government
securities. Several of our competitors are significantly larger than us and, therefore, have significantly greater resources. We
expect competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing
trend of consolidation in the financial services industry. Technological advances, for example, have lowered the barriers to enter
new market areas, allowed banks to expand their geographic reach by providing services over the Internet and made it possible for
non-depository institutions to offer products and services that traditionally have been provided by banks. Changes in federal law
permit affiliation among banks, securities firms and insurance companies, which promotes a competitive environment in the financial
services industry. Competition for deposits and the origination of loans could limit our growth in the future.
According to the Federal Deposit Insurance
Corporation (“FDIC”), at June 30, 2015 (the most recent period for which information is available,) First Federal of
Hazard had a deposit market share of 10.0% in Perry County. Its largest competitors, Hazard Bancorp (Peoples Bank & Trust Company
of Hazard,) Community Trust Bancorp, Inc. (Community Trust Bank, Inc.) and 1
st
Trust Bank, Inc. had Perry County deposit
market shares of 42.4%, 18.6% and 26.9%, respectively. First Federal of Hazard’s competition for loans comes primarily from
financial institutions in its market area and, to a lesser extent, from other financial services providers, such as mortgage companies
and mortgage brokers. Competition for loans also comes from the increasing number of non-depository financial services companies
entering the mortgage market, such as insurance companies, securities companies and specialty finance companies.
First Federal of Kentucky’s principal
competitors for deposits in its market area are other banking institutions, such as commercial banks and credit unions, as well
as mutual funds and other investments. First Federal of Kentucky principally competes for deposits by offering a variety of deposit
accounts, convenient business hours and branch locations, customer service and a well-trained staff. According to the FDIC, at
June 30, 2015, (the most recent period for which information is available,) First Federal of Kentucky had deposit market share
of 9.4%, 10.9% and 17.0% for the Kentucky counties of Franklin, Boyle and Garrard. Its largest competitors for depositors are the
Farmers Capital Bank Corporation (Farmers Bank and Capital Trust Company) at a 34.0% market share in the three-county area, Boyle
Bancorp, Inc. (The Farmers National Bank of Danville) at 17.8% and Whitaker Bank Corporation of Kentucky at 15.5%. Farmers Capital
Bank Corporation, Boyle Bancorp, Inc., and Whitaker Bank Corporation had assets at June 30, 2016, of $1.8 billion, $472.8 million
and $1.8 billion, respectively. The Bank also faces considerable competition from credit unions including the Commonwealth Credit
Union ($1.1 billion in assets) and the Kentucky Employees Credit Union ($74.4 million in assets). First Federal of Kentucky competes
for loans with other depository institutions, as well as specialty mortgage lenders and brokers and consumer finance companies.
First Federal of Kentucky principally competes for loans on the basis of interest rates and the loan fees it charges, the types
of loans it originates and the convenience and service it provides to borrowers. In addition, First Federal of Kentucky believes
it has developed strong relationships with the businesses, real estate agents, builders and general public in its market area.
Personnel
At June 30, 2016, we had 71 full-time employees
and two part-time employees, none of whom was represented by a collective bargaining unit. We believe our relationship with our
employees is good.
Regulation and Supervision
General.
First Federal of
Hazard and First Federal of Kentucky are subject to extensive regulation, examination and supervision by the Office of the Comptroller
of the Currency, as their primary federal regulator, and the Federal Deposit Insurance Corporation, as insurer of deposits. First
Federal of Hazard and First Federal of Kentucky are each members of the Federal Home Loan Bank System and their deposit accounts
are insured up to applicable limits by the Deposit Insurance Fund managed by the Federal Deposit Insurance Corporation. First Federal
of Hazard and First Federal of Kentucky must each file reports with the Office of the Comptroller of the Currency and the Federal
Deposit Insurance Corporation concerning their activities and financial condition in addition to obtaining regulatory approvals
before entering into certain transactions such as mergers with, or acquisitions of, other financial institutions. There are periodic
examinations by the Office of the Comptroller of the Currency and, under certain circumstances, the Federal Deposit Insurance Corporation
to evaluate First Federal of Hazard’s and First Federal of Kentucky’s safety and soundness and compliance with various
regulatory requirements. This regulatory structure is intended primarily for the protection of the insurance fund and depositors.
The Federal Reserve Board, the agency that regulates and supervises bank holding companies, now supervises and regulates Kentucky
First Federal MHC. Kentucky First and First Federal MHC, as savings and loan holding companies, are required to file certain reports
with, and are subject to examination by, and otherwise are required to comply with the rules and regulations of the Federal Reserve
Board.
The Dodd-Frank Act made extensive changes
in the regulation of federal savings banks such as First Federal of Hazard and First Federal of Kentucky. Under the Dodd-Frank
Act, the Office of Thrift Supervision was eliminated and responsibility for the supervision and regulation of federal savings banks
was transferred to the Office of the Comptroller of the Currency, the agency that is primarily responsible for the regulation and
supervision of national banks, on July 21, 2011. The Office of the Comptroller of the Currency assumed responsibility for implementing
and enforcing many of the laws and regulations applicable to federal savings banks. Additionally, the Dodd-Frank Act created a
new Consumer Financial Protection Bureau as an independent bureau of the Federal Reserve Board. The Consumer Financial Protection
Bureau assumed responsibility for the implementation of the federal financial consumer protection and fair lending laws and regulations
and has authority to impose new requirements. However, institutions of less than $10 billion in assets, such as First Federal of
Hazard and First Federal of Kentucky, will continue to be examined for compliance with consumer protection and fair lending laws
and regulations by, and be subject to the enforcement authority of, their prudential regulator. Many of the provisions of the Dodd-Frank
Act require the issuance of regulations before their impact on operations can be fully assessed by management. However, there is
a significant possibility that the Dodd-Frank Act will, at a minimum, result in increased regulatory burden and compliance for
First Federal MHC, Kentucky First and each of the Banks.
Certain of the regulatory requirements that
are applicable to First Federal of Hazard, First Federal of Kentucky, Kentucky First and First Federal MHC are described below.
This discussion does not purport to be a complete description of the laws and regulations involved, and is qualified in its entirety
by the actual laws and regulations. Moreover, laws and regulations are subject to changes by the U.S. Congress or the regulatory
agencies as applicable.
Regulation of Federal Savings Institutions
Business Activities.
Federal
law and regulations, primarily the Home Owners’ Loan Act and the regulations of the Office of the Comptroller of the Currency,
govern the activities of federal savings institutions, such as First Federal of Hazard and First Federal of Kentucky. These laws
and regulations delineate the nature and extent of the activities in which federal savings banks may engage. In particular, certain
lending authority for federal savings institutions,
e.g.
, commercial, nonresidential real property loans and consumer loans,
is limited to a specified percentage of the institution’s capital or assets.
Branching.
Federal savings
institutions are authorized to establish branch offices in any state or states of the United States and its territories, subject
to the approval of the Office of the Comptroller of the Currency.
Capital Requirements
.
In July
2013, the Federal Reserve Board and the OCC approved a new rule that implemented the Basel III regulatory capital reforms. The
capital regulations now require federal savings banks to meet four minimum capital standards: a 4.0% Tier 1 leverage ratio; a 4.5%
common equity Tier 1 ratio; a 6.0% Tier 1 capital ratio; and an 8% Total capital ratio. In addition, the prompt corrective action
standards discussed below also establish, in effect, a minimum 2% tangible capital standard. The rules eliminated the inclusion
of certain instruments, such as trust preferred securities, from Tier 1 capital. Instruments issued before May 19, 2010 are grandfathered
for companies with consolidated assets of $15 billion or less. The rules also established a “capital conservation buffer”
of 2.5% above the new regulatory minimum capital requirements, which must consist entirely of common equity Tier 1 capital and
would result in the following minimum ratios: (1) a common equity Tier 1 capital ratio of 7.0%, (2) a Tier 1 capital ratio of 8.5%,
and (3) a total capital ratio of 10.5%. The new capital conservation buffer requirement will be phased in beginning in January
2016 at 0.625% of risk-weighted assets and would increase by that amount each year until fully implemented in January 2019. An
institution will be subject to limitations on paying dividends, engaging in share repurchases and paying discretionary bonuses
if its capital level falls below the buffer amount. These limitations will establish a maximum percentage of eligible retained
income that could be utilized for such actions.
The risk-based capital standard requires
federal savings banks to maintain Tier 1 and total capital (which is defined as core capital and supplementary capital, less certain
specified deductions from total capital such as reciprocal holdings of depository institution capital, instruments and equity investments)
to risk-weighted assets of at least 6% and 8%, respectively. In determining the amount of risk-weighted assets, all assets, including
certain off-balance sheet assets, recourse obligations, residual interests and direct credit substitutes, are multiplied by a risk-weight
factor of 0% to 150%, as assigned by the capital regulation based on the risks believed inherent in the type of asset. Tier 1 capital
is generally defined as common stockholders’ equity (including retained earnings), certain non-cumulative perpetual preferred
stock and related surplus and minority interests in equity accounts of consolidated subsidiaries, less intangibles other than certain
mortgage servicing rights and credit card relationships. The components of Tier 2 capital currently include cumulative preferred
stock, long-term perpetual preferred stock, mandatory convertible securities, subordinated debt and intermediate preferred stock,
the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets and up to 45% of unrealized gains
on available-for-sale equity securities with readily determinable fair market values. Overall, the amount of Tier 2 capital included
as part of total capital cannot exceed 100% of core capital.
Savings and loan holding companies with
less than $1 billion in assets are not subject to specific regulatory capital requirements. The Dodd-Frank Act, however, requires
the Federal Reserve Board to promulgate consolidated capital requirements for depository institution holding companies, including
savings and loan holding companies that are no less stringent, both quantitatively and in terms of components of capital, than
those applicable to institutions themselves.
As of June 30, 2016, current capital levels
of First Federal of Hazard and First Federal of Kentucky exceed the required capital amounts to be considered “well capitalized”
and we believe they also meet the fully-phased in minimum capital requirements, including the related capital conservation buffers,
as required by the Basel III capital rules.
Prompt Corrective Regulatory Action
.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized,
significantly undercapitalized and critically undercapitalized, although these terms are not used to represent overall financial
condition. If adequately capitalized, regulatory approval is required to accept broker deposits. The OCC is required to take certain
supervisory actions against undercapitalized institutions, the severity of which depends upon the institution’s degree of
undercapitalization. In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution,
including, but not limited to, increased monitoring by regulators and restrictions on growth, capital distributions and expansion.
The OCC could also take any one of a number of discretionary supervisory actions, including the issuance of a capital directive
and the replacement of senior executive officers and directors. Significantly and undercapitalized institutions are subject to
additional mandatory and discretionary measures.
Loans to One Borrower.
Federal
law provides that savings institutions are generally subject to the limits on loans to one borrower applicable to national banks.
Generally, subject to certain exceptions, a savings institution may not make a loan or extend credit to a single or related group
of borrowers in excess of 15% of its unimpaired capital and surplus. An additional amount may be lent, equal to 10% of unimpaired
capital and surplus, if secured by specified readily-marketable collateral.
Standards for Safety and Soundness.
As required by statute, the federal banking agencies have adopted Interagency Guidelines prescribing Standards for Safety and Soundness.
The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems
at insured depository institutions before capital becomes impaired. If the Office of the Comptroller of the Currency determines
that a savings institution fails to meet any standard prescribed by the guidelines, the Office of the Comptroller of the Currency
may require the institution to submit an acceptable plan to achieve compliance with the standard.
Limitation on Capital Distributions.
Office of the Comptroller of the Currency regulations impose limitations upon all capital distributions by a savings institution,
including cash dividends, payments to repurchase its shares and payments to shareholders of another institution in a cash-out merger.
Under the regulations, an application to and the prior approval of the Office of the Comptroller of the Currency is required before
any capital distribution if the institution does not meet the criteria for “expedited treatment” of applications under
Office of the Comptroller of the Currency regulations (
i.e.
, generally, examination and Community Reinvestment Act ratings
in the two top categories), the total capital distributions for the calendar year exceed net income for that year plus the amount
of retained net income for the preceding two years, the institution would be undercapitalized following the distribution or the
distribution would otherwise be contrary to a statute, regulation or agreement with the Office of the Comptroller of the Currency.
If an application is not required, the institution must still provide prior notice to the Federal Reserve Board of the capital
distribution if, like First Federal of Hazard and First Federal of Kentucky, it is a subsidiary of a holding company as well as
an informational notice to the Office of the Comptroller of the Currency. If First Federal of Hazard’s or First Federal of
Kentucky’s capital were ever to fall below its regulatory requirements or the Office of the Comptroller of the Currency notified
it that it was in need of increased supervision, its ability to make capital distributions could be restricted. In addition, the
Office of the Comptroller of the Currency could prohibit a proposed capital distribution that would otherwise be permitted by the
regulation, if the agency determines that such distribution would constitute an unsafe or unsound practice.
Qualified Thrift Lender Test.
Federal law requires savings institutions to meet a qualified thrift lender test. Under the test, a savings institution is required
to either qualify as a “domestic building and loan association” under the Internal Revenue Code or maintain at least
65% of its “portfolio assets” (total assets less: (i) specified liquid assets up to 20% of total assets; (ii) intangibles,
including goodwill; and (iii) the value of property used to conduct business) in certain “qualified thrift investments”
(primarily residential mortgages and related investments, including certain mortgage-backed securities, education loans, credit
card loans and small business loans) in at least 9 months out of each 12-month period.
A savings institution that fails the qualified
thrift lender test is subject to certain operating restrictions. The Dodd-Frank Act also specifies that failing the qualified thrift
lender test is a violation of law that could result in an enforcement action and dividend limitations. At June 30, 2016, First
Federal of Hazard and First Federal of Kentucky each met the qualified thrift lender test.
Transactions with Related Parties.
Federal law limits the authority of First Federal of Hazard and First Federal of Kentucky to lend to, and engage in certain other
transactions with (collectively, “covered transactions”), “affiliates” (
e.g.
, any company that controls
or is under common control with an institution, including Kentucky First, First Federal MHC and their non-savings institution subsidiaries).
The aggregate amount of covered transactions with any individual affiliate is limited to 10% of the capital and surplus of the
savings institution. The aggregate amount of covered transactions with all affiliates is limited to 20% of the savings institution’s
capital and surplus. Loans and other specified transactions with affiliates are required to be secured by collateral in an amount
and of a type described in federal law. The purchase of low quality assets from affiliates is generally prohibited. Transactions
with affiliates must be on terms and under circumstances that are at least as favorable to the institution as those prevailing
at the time for comparable transactions with non-affiliated companies. In addition, savings institutions are prohibited from lending
to any affiliate that is engaged in activities that are not permissible for bank holding companies and no savings institution may
purchase the securities of any affiliate other than a subsidiary. Transactions between sister depository institutions that are
80% or more owned by the same holding company are exempt from the quantitative limits and collateral requirements.
The Sarbanes-Oxley Act of 2002 generally
prohibits a company from making loans to its executive officers and directors. However, that law contains a specific exception
for loans by a depository institution to its executive officers and directors in compliance with federal banking laws. Under such
laws, First Federal of Hazard’s and First Federal of Kentucky’s authority to extend credit to executive officers, directors
and 10% shareholders (“insiders”), as well as entities such persons control, is limited. The law restricts both the
individual and aggregate amount of loans First Federal of Hazard and First Federal of Kentucky may make to insiders based, in part,
on First Federal of Hazard’s and First Federal of Kentucky’s respective capital positions and requires certain board
approval procedures to be followed. Such loans must be made on terms, including rates and collateral, substantially the same as
those offered to unaffiliated individuals prevailing at the time for comparable loans with persons not related to the lender and
not involve more than the normal risk of repayment. There are additional restrictions applicable to loans to executive officers.
Enforcement.
The Office of
The Comptroller of the Currency has primary enforcement responsibility over federal savings institutions and has the authority
to bring actions against the institution and all institution-affiliated parties, including stockholders, and any attorneys, appraisers
and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution.
Formal enforcement action may range from the issuance of a capital directive or cease and desist order to removal of officers and/or
directors to appointment of a receiver or conservator or termination of deposit insurance. Civil penalties cover a wide range of
violations and can amount to $25,000 per day, or even $1 million per day in especially egregious cases. The Federal Deposit Insurance
Corporation has authority to recommend to the Director of the Office of the Comptroller of the Currency that enforcement action
to be taken with respect to a particular savings institution. If action is not taken by the Director, the Federal Deposit Insurance
Corporation has authority to take such action under certain circumstances. Federal law also establishes criminal penalties for
certain violations.
Assessments.
Federal savings
banks pay assessments to the Office of the Comptroller of the Currency to fund its operations. The general assessments, paid on
a semi-annual basis, are based upon the savings institution’s total assets, including consolidated subsidiaries, its financial
condition and the complexity of its portfolio.
Insurance of Deposit Accounts.
The deposits of both First Federal of Hazard and First Federal of Kentucky are insured up to applicable limits by the Deposit Insurance
Fund administered by the Federal Deposit Insurance Corporation. Deposit insurance per account owner is currently $250,000. Under
the Federal Deposit Insurance Corporation’s risk-based assessment system, insured institutions are assigned a risk category
based on supervisory evaluations, regulatory capital levels and certain other factors. An institution’s assessment rate depends
upon the category to which it is assigned, and certain adjustments specified by Federal Deposit Insurance Corporation regulations.
Institutions deemed less risky pay lower assessments. The Federal Deposit Insurance Corporation may adjust the scale uniformly,
except that no adjustment can deviate more than two basis points from the base scale without notice and comment. No institution
may pay a dividend if in default of the federal deposit insurance assessment.
The Dodd-Frank Act required the Federal
Deposit Insurance Corporation to revise its procedures to base its assessments upon each insured institution’s total assets
less tangible equity instead of deposits. The Federal Deposit Insurance Corporation finalized a rule, effective April 1, 2011,
that set the assessment range at 2.5 to 45 basis points of total assets less tangible equity.
The Federal Deposit Insurance Corporation
has authority to increase insurance assessments. A significant increase in insurance premiums would likely have an adverse effect
on the operating expenses and results of operations of the Banks. Management cannot predict what insurance assessment rates will
be in the future.
Federal Home Loan Bank System.
First Federal of Hazard and First Federal of Kentucky are members of the Federal Home Loan Bank System, which consists of 12 regional
Federal Home Loan Banks. The Federal Home Loan Bank provides a central credit facility primarily for member institutions. As members
of the Federal Home Loan Bank of Cincinnati, First Federal of Hazard and First Federal of Kentucky are each required to acquire
and hold shares of capital stock in that Federal Home Loan Bank. First Federal of Hazard and First Federal of Kentucky were in
compliance with this requirement with investments in Federal Home Loan Bank of Cincinnati stock at June 30, 2016, of $2.0 million
and $4.5 million, respectively.
Federal Reserve System.
Pursuant
to regulations of the Federal Reserve Board, a financial institution must maintain average daily reserves equal to 3% on transaction
accounts of between $15.2 million and $110.2 million, plus 10% on the remainder. The first $15.2 million of transaction accounts
are exempt. These percentages are subject to adjustment by the Federal Reserve Board. Because required reserves must be maintained
in the form of vault cash or in a noninterest-bearing account at the Federal Reserve Bank, the effect of the reserve requirement
is to reduce the amount of the institution’s interest-earning assets. As of June 30, 2016, the Banks met their reserve requirements.
Community Reinvestment Act.
All federal savings institutions have a continuing and affirmative obligation consistent with its safe and sound operation to help
meet the credit needs of its entire community, including low and moderate income neighborhoods. The Community Reinvestment Act
does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s
discretion to develop the types of products and services that it believes are best suited to its particular community, consistent
with the Community Reinvestment Act. The Community Reinvestment Act requires the Office of the Comptroller of the Currency, in
connection with its examination of a savings institution, to assess the institution’s record of meeting the credit needs
of its community and to take such record into account in its evaluation of certain applications by such institution.
The Community Reinvestment Act requires
public disclosure of an institution’s rating and requires the Office of the Comptroller of the Currency to provide a written
evaluation of an institution’s Community Reinvestment Act performance utilizing a four-tiered descriptive rating system.
First Federal of Hazard and First Federal of Kentucky each received a “Satisfactory” rating as a result of their most
recent Community Reinvestment Act assessments.
Holding Company Regulation
General.
Kentucky First and
First Federal MHC are savings and loan holding companies within the meaning of federal law. As such, they are registered with the
Federal Reserve Board and are subject to Federal Reserve Board regulations, examinations, supervision, reporting requirements and
regulations concerning corporate governance and activities. In addition, the Federal Reserve Board has enforcement authority over
Kentucky First and First Federal MHC and their non-savings institution subsidiaries. Among other things, this authority permits
the Federal Reserve Board to restrict or prohibit activities that are determined to be a serious risk to First Federal of Hazard
and/or First Federal of Kentucky.
Restrictions Applicable to Mutual
Holding Companies.
According to federal law and Federal Reserve Board regulations, a mutual holding company, such as First
Federal MHC, may generally engage in the following activities: (1) investing in the stock of insured depository institutions and
acquiring them by means of a merger or acquisition; (2) investing in a corporation the capital stock of which may be lawfully purchased
by a savings association under federal law; (3) furnishing or performing management services for a savings association subsidiary
of a savings and loan holding company; (4) conducting an insurance agency or escrow business; (5) holding, managing or liquidating
assets owned or acquired from a savings association subsidiary of the savings and loan holding company; (6) holding or managing
properties used or occupied by a savings association subsidiary of the savings and loan holding company; (7) acting as trustee
under deed of trust; (8) any activity permitted for multiple savings and loan holding companies by Federal Reserve Board regulations;
(9) any activity permitted by the Board of Governors of the Federal Reserve System for bank holding companies and financial holding
companies; and (10) any activity permissible for service corporations. Legislation, which authorized mutual holding companies to
engage in activities permitted for financial holding companies, expanded the authorized activities. Financial holding companies
may engage in a broad array of financial services activities, including insurance and securities.
Federal law prohibits a savings and loan
holding company, including a federal mutual holding company, from directly or indirectly, or through one or more subsidiaries,
acquiring more than 5% of the voting stock of another savings institution, or its holding company, without prior written approval
of the Federal Reserve Board. Federal law also prohibits a savings and loan holding company from acquiring or retaining control
of a depository institution that is not insured by the Federal Deposit Insurance Corporation. In evaluating applications by holding
companies to acquire savings institutions, the Federal Reserve Board must consider the financial and managerial resources and future
prospects of the company and institution involved, the effect of the acquisition on the risk to the insurance funds, the convenience
and needs of the community and competitive factors.
The Federal Reserve Board is prohibited
from approving any acquisition that would result in a multiple savings and loan holding company controlling savings institutions
in more than one state, except: (1) the approval of interstate supervisory acquisitions by savings and loan holding companies,
and (2) the acquisition of a savings institution in another state if the laws of the state of the target savings institution
specifically permit such acquisitions. The states vary in the extent to which they permit interstate savings and loan holding company
acquisitions.
Capital Requirements
.
Savings
and loan holding companies historically have not been subject to specific regulatory capital requirements. However, in July 2013,
the Federal Reserve Board approved a new rule that implements the “Basel III” regulatory capital reforms and changes
required by the Dodd-Frank Act. The final rule established consolidated capital requirements for many savings and loan holding
companies, including the Company. See
“Regulation and Supervision—Regulation of Federal Savings Institutions –
Capital Requirements,”
above.
Source of Strength.
The Dodd-Frank
Act also extends the “source of strength” doctrine to savings and loan holding companies. The regulatory agencies must
promulgate regulations implementing the “source of strength” policy that holding companies act as a source of strength
to their subsidiary depository institutions by providing capital, liquidity and other support in times of financial stress.
Dividends.
The Federal Reserve
Board has issued a policy statement on the payment of cash dividends by bank holding companies, which expressed the Federal Reserve
Board’s view that a bank holding company should pay cash dividends only to the extent that the company’s net income
for the past year is sufficient to cover both the cash dividends and a rate of earning retention that is consistent with the company’s
capital needs, asset quality and overall financial condition. The Federal Reserve Board also indicated that it would be inappropriate
for a company experiencing serious financial problems to borrow funds to pay dividends. Furthermore, under the prompt correction
action regulations, the Federal Reserve Board may prohibit a bank holding company from paying any dividends if the holding company’s
bank subsidiary is classified as “undercapitalized.” See
“Depository Institution Regulation – Prompt
Corrective Regulatory Action.”
Stock Holding Company Subsidiary Regulation.
Federal Reserve Board regulations govern the two-tier mutual holding company form of organization and subsidiary stock
holding companies that are controlled by mutual holding companies. Kentucky First is the stock holding company subsidiary of First
Federal MHC. Kentucky First is only permitted to engage in activities that are permitted for First Federal MHC subject to the same
restrictions and conditions.
Waivers of Dividends by First Federal
MHC
.
Federal Reserve Board regulations require First Federal MHC to notify the Federal Reserve Board if it proposes
to waive receipt of our dividends from Kentucky First. The Dodd-Frank Act addresses the issue of dividend waivers in the context
of the transfer of the supervision of savings and loan holding companies to the Federal Reserve Board. The Dodd-Frank Act specified
that dividends may be waived if certain conditions are met, including that the Federal Reserve Board does not object after being
given written notice of the dividend and proposed waiver. The Dodd-Frank Act indicates that the Federal Reserve Board may not object
to such a waiver (i) if the mutual holding company involved has, prior to December 1, 2009, reorganized into a mutual holding company
structure, engaged in a minority stock offering and waived dividends; (ii) the board of directors of the mutual holding company
expressly determines that a waiver of the dividend is consistent with its fiduciary duties to members and (iii) the waiver would
not be detrimental to the safe and sound operation of the savings association subsidiaries of the holding company. The Federal
Reserve Board will not consider the amount of dividends waived by the mutual holding company in determining an appropriate exchange
ratio in the event of a full conversion to stock form. Kentucky First was granted such a waiver and dividends were paid to the
Company’s shareholders on August 16 and November 22, 2011, as well as February 21, 2012. First Federal MHC was not allowed
to waive its dividend with respect to the dividend paid on May 21, 2012. First Federal MHC subsequently received Federal Reserve
Board approval to waive quarterly dividends totaling $0.40 per share annually beginning with the dividend paid on September 28,
2012 and continuing through the dividend payable in the 3rd quarter of 2014. In an effort to comply with Regulation MM and to be
able to continue to waive the dividend, First Federal MHC put the issue to a vote of the members on August 23, 2012, again on July
9, 2013, again on July 8, 2014, again on July 7, 2015, and again on July 7, 2016. Members of First Federal MHC voted in favor of
the dividend waiver on all four occasions. As a result, First Federal MHC will be permitted to waive the receipt of dividends for
quarterly dividends up to $0.10 per common share through the third quarter of 2017. It is expected that First Federal MHC will
continue to waive future dividends, except to the extent dividends are needed to fund First Federal MHC’s continuing operations,
subject to the ability of First Federal MHC to obtain regulatory approval of its requests to waive dividends and to its ability
to obtain member approval of dividend waivers. For more information, see Item 1A,
“Risk Factors – Our ability to
pay dividends is subject to the ability of First Federal of Hazard and First Federal of Kentucky to make capital distributions
to Kentucky First and the waiver of dividends by First Federal MHC.”
Conversion of First Federal MHC to
Stock Form.
Federal Reserve Board regulations permit First Federal MHC to convert from the mutual form of organization
to the capital stock form of organization. In a conversion transaction, a new holding company would be formed as successor to First
Federal MHC, its corporate existence would end, and certain depositors would receive the right to subscribe for additional shares
of the new holding company. In a conversion transaction, each share of common stock held by stockholders other than First Federal
MHC would be automatically converted into a number of shares of common stock of the new holding company based on an exchange ratio
determined at the time of conversion that ensures that stockholders other than First Federal MHC own the same percentage of common
stock in the new holding company as they owned in us immediately before conversion. Under Federal Reserve Board regulations, stockholders
other than First Federal MHC would not be diluted because of any dividends waived by First Federal MHC (and waived dividends would
not be considered in determining an appropriate exchange ratio, provided that the mutual holding company involved was formed, engaged
in a minority offering and waived dividends prior to December 1, 2009), in the event First Federal MHC converts to stock form.
First Federal MHC was formed, engaged in a minority stock offering and waived dividends prior to December 1, 2009. The total number
of shares held by stockholders other than First Federal MHC after a conversion transaction also would be increased by any purchases
by stockholders other than First Federal MHC in the stock offering conducted as part of the conversion transaction.
Acquisition of Control.
Under
the federal Change in Bank Control Act, a notice must be submitted to the Federal Reserve Board if any person (including a company),
or group acting in concert, seeks to acquire “control” of a savings and loan holding company or savings association.
An acquisition of “control” can occur upon the acquisition of 10% or more of the voting stock of a savings and loan
holding company or savings institution or as otherwise defined by the Federal rd. Under the Change in Bank Control Act, the Federal
Reserve Board has 60 days from the filing of a complete notice to act, taking into consideration certain factors, including the
financial and managerial resources of the acquirer and the anti-trust effects of the acquisition. Any company that so acquires
control would then be subject to regulation as a savings and loan holding company.
Federal and State Taxation
General.
We report our income
on a fiscal year basis using the accrual method of accounting.
Federal Taxation.
The federal
income tax laws apply to us in the same manner as to other corporations with some exceptions, including particularly the reserve
for bad debts discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be
a comprehensive description of the tax rules applicable to us. Our federal income tax returns are subject to examination for years
2012 and later. For the 2016 fiscal year, First Federal of Hazard’s and Frankfort First’s maximum federal income tax
rate was 34.0%.
For fiscal years beginning before June 30,
1996, thrift institutions that qualified under certain definitional tests and other conditions of the Internal Revenue Code were
permitted to use certain favorable provisions to calculate their deductions from taxable income for annual additions to their bad
debt reserve. A reserve could be established for bad debts on qualifying real property loans, generally secured by interests in
real property improved or to be improved, under the percentage of taxable income method or the experience method. The reserve for
nonqualifying loans was computed using the experience method. Federal legislation enacted in 1996 repealed the reserve method of
accounting for bad debts and the percentage of taxable income method for tax years beginning after 1995 and require savings institutions
to recapture or take into income certain portions of their accumulated bad debt reserves. First Federal of Hazard did not qualify
for such favorable tax treatment for any years through 1996. Approximately $5.2 million of First Federal of Kentucky First’s
accumulated bad debt reserves would not be recaptured into taxable income unless Frankfort First makes a “non-dividend distribution”
to Kentucky First as described below.
If First Federal of Hazard or First Federal
of Kentucky makes “non-dividend distributions” to us, the distributions will be considered to have been made from First
Federal of Hazard’s and First Federal of Kentucky’s unrecaptured tax bad debt reserves, including the balance of their
reserves as of December 31, 1987, to the extent of the “non-dividend distributions,” and then from First Federal
of Kentucky’s supplemental reserve for losses on loans, to the extent of those reserves, and an amount based on the amount
distributed, but not more than the amount of those reserves, will be included in First Federal of Kentucky’s taxable income.
Non-dividend distributions include distributions in excess of First Federal of Kentucky’s current and accumulated earnings
and profits, as calculated for federal income tax purposes, distributions in redemption of stock, and distributions in partial
or complete liquidation. Dividends paid out of First Federal of Kentucky’s current or accumulated earnings and profits will
not be so included in First Federal of Kentucky’s taxable income.
The amount of additional taxable income
triggered by a non-dividend distribution is an amount that, when reduced by the tax attributable to the income, is equal to the
amount of the distribution. Therefore, if First Federal of Kentucky makes a non-dividend distribution to us, approximately one
and one-half times the amount of the distribution not in excess of the amount of the reserves would be includable in income for
federal income tax purposes, assuming a 34% federal corporate income tax rate. First Federal of Kentucky does not intend to pay
dividends in the future that would result in a recapture of any portion of its bad debt reserves.
State Taxation.
Although First
Federal MHC and Kentucky First are subject to the Kentucky corporation income tax and state corporation license tax (franchise
tax), the corporation license tax is repealed effective for tax periods ending on or after December 31, 2005. Gross income of corporations
subject to Kentucky income tax is similar to income reported for federal income tax purposes except that dividend income, among
other income items, is exempt from taxation. For First Federal MHC and Kentucky First tax years beginning July 1, 2005, the corporations
are subject to an alternative minimum income tax. Corporations must pay the greater of the income tax, the alternative tax or $175.
The corporations can choose between two methods to calculate the alternative minimum; 9.5 cents per $100 of the corporation’s
gross receipts, or 75 cents per $100 of the corporation’s Kentucky gross profits. Kentucky gross profits means Kentucky gross
receipts reduced by returns and allowances attributable to Kentucky gross receipts, less Kentucky cost of goods sold. The corporations,
in their capacity as holding companies for financial institutions, do not have a material amount of cost of goods sold. Although
the corporate license tax rate is 0.21% of total capital employed in Kentucky, a bank holding company, as defined in Kentucky Revised
Statutes 287.900, is allowed to deduct from its taxable capital, the book value of its investment in the stock or securities of
subsidiaries that are subject to the bank franchise tax.
First Federal of Hazard and First Federal
of Kentucky are exempt from both the Kentucky corporation income tax and corporation license tax. However, both institutions are
instead subject to the bank franchise tax, an annual tax imposed on federally or state chartered savings and loan associations,
savings banks and other similar institutions operating in Kentucky. The tax is 0.1% of taxable capital stock held as of January 1
each year. Taxable capital stock includes an institution’s undivided profits, surplus and general reserves plus savings accounts
and paid-up stock less deductible items. Deductible items include certain exempt federal obligations and Kentucky municipal bonds.
Financial institutions which are subject to tax both within and without Kentucky must apportion their net capital.
Item 1A. Risk Factors
Rising interest rates may hurt our profits and asset values
.
If interest rates rise, our net interest
income would likely decline in the short term since, due to the generally shorter terms of interest-bearing liabilities, interest
expense paid on interest-bearing liabilities, increases more quickly than interest income earned on interest-earning assets, such
as loans and investments. In addition, a continuation of rising interest rates may hurt our income because of reduced demand for
new loans, the demand for refinancing loans and the interest and fee income earned on new loans and refinancings. While we believe
that modest interest rate increases will not significantly hurt our interest rate spread over the long term due to our high level
of liquidity and the presence of a significant amount of adjustable-rate mortgage loans in our loan portfolio, interest rate increases
may initially reduce our interest rate spread until such time as our loans and investments reprice to higher levels.
Changes in interest rates also affect the
value of our interest-earning assets, and in particular our securities portfolio. Generally, the value of fixed-rate securities
fluctuates inversely with changes in interest rates. Unrealized gains and losses on securities available for sale are reported
as separate components of equity. Decreases in the fair value of securities available for sale resulting from increases in interest
rates therefore could have an adverse effect on stockholders’ equity.
A larger percentage of our loans are collateralized by
real estate and further disruptions in the real estate market may result in losses and hurt our earnings.
Approximately 95.8% of our loan portfolio
at June 30, 2016 was comprised of loans collateralized by real estate. The declining economic conditions have caused a decrease
in demand for real estate, which has resulted in an erosion of some real estate values in our markets. Further disruptions in the
real estate market could significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure.
The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may
deteriorate in value during the time the credit is extended. If real estate values decline further, it will become more likely
that we would be required to increase our allowance for loan losses. If during a period of reduced real estate values, we are required
to liquidate the collateral securing a loan to satisfy the debt or to increase our allowance for loan losses, it could materially
reduce our profitability and adversely affect our financial condition.
Strong competition within our market areas could hurt
our profits and slow growth.
Although we consider ourselves competitive
in our market areas, we face intense competition both in making loans and attracting deposits. Price competition for loans and
deposits might result in our earning less on our loans and paying more on our deposits, which reduces net interest income. Some
of the institutions with which we compete have substantially greater resources than we have and may offer services that we do not
provide. We expect competition to increase in the future as a result of legislative, regulatory and technological changes and the
continuing trend of consolidation in the financial services industry. Our profitability will depend upon our continued ability
to compete successfully in our market areas.
The distressed economy in First Federal of Hazard’s
market area could hurt our profits and slow our growth.
First Federal of Hazard’s market area
consists of Perry and surrounding counties in eastern Kentucky. The economy in this market area has been distressed in recent years
due to the decline in the coal industry on which the economy has been dependent. While the region has seen improvement in the economy
from the influx of other industries, such as health care and manufacturing, and the competition provided by new methods of extracting
natural gas has recently hurt the coal industry. As a consequence, the economy in First Federal of Hazard’s market area continues
to lag behind the economies of Kentucky and the United States and First Federal of Hazard has experienced insufficient loan demand
in its market area. While First Federal of Hazard will seek to use excess funds to purchase loans from First Federal of Kentucky,
we expect the redeployment of funds from securities into loans to take several years. Moreover, the slow economy in First Federal
of Hazard’s market area will limit our ability to grow our asset base in that market.
Regulation of the financial services industry is undergoing
major changes, and we may be adversely affected by changes in laws and regulations.
We are subject to extensive government regulation,
supervision and examination. Such regulation, supervision and examination governs the activities in which we may engage, and is
intended primarily for the protection of the deposit insurance fund and our depositors.
In 2010 and 2011, in response to the financial
crisis and recession that began in 2008, significant regulatory and legislative changes resulted in broad reform and increased
regulation affecting financial institutions. The Dodd-Frank Act has created a significant shift in the way financial institutions
operate and has restructured the regulation of depository institutions by merging the Office of Thrift Supervision, which previously
regulated the Banks, into the Office of the Comptroller of the Currency, and assigning the regulation of savings and loan holding
companies, including the Company and the MHC, to the Federal Reserve Board. The Dodd-Frank Act also created the Consumer Financial
Protection Bureau to administer consumer protection and fair lending laws, a function that was formerly performed by the depository
institution regulators. As required by the Dodd-Frank Act, the federal banking regulators have proposed new consolidated capital
requirements that will limit our ability to borrow at the holding company level and invest the proceeds from such borrowings as
capital in the Banks that could be leveraged to support additional growth. The Dodd-Frank Act contains various other provisions
designed to enhance the regulation of depository institutions and prevent the recurrence of a financial crisis such as that which
occurred in 2008 and 2009. The full impact of the Dodd-Frank Act on our business and operations may not be known for years until
final regulations implementing the legislation are adopted. The Dodd-Frank Act may have a material impact on our operations, particularly
through increased regulatory burden and compliance costs. Any future legislative changes could have a material impact on our profitability,
the value of assets held for investment or the value of collateral for loans. Future legislative changes could also require changes
to business practices and potentially expose us to additional costs, liabilities, enforcement action and reputational risk.
In addition to the enactment of the Dodd-Frank
Act, the federal regulatory agencies recently have begun to take stronger supervisory actions against financial institutions that
have experienced increased loan losses and other weaknesses as a result of the recent economic crisis. These actions include the
entering into of written agreements and cease and desist orders that place certain limitations on their operations. Federal banking
regulators recently have also been using with more frequency their ability to impose individual minimal capital requirements on
banks, which requirements may be higher than those imposed under the Dodd-Frank Act or which would otherwise qualify the bank as
being “well capitalized” under the Office of the Comptroller of the Currency’s prompt corrective action regulations.
If we were to become subject to a supervisory agreement or higher individual capital requirements, such action may have a negative
impact on our ability to execute our business plans, as well as our ability to grow, pay dividends, repurchase stock or engage
in mergers and acquisitions and may result in restrictions in our operations. See
“Regulation and Supervision—Regulation
of Federal Savings Institutions—Capital Requirements”
for a discussion of regulatory capital requirements.
We expect that our return on equity will be low compared
to other companies as a result of our high level of capital.
Return on average equity, which equals net
income divided by average equity, is a ratio used by many investors to compare the performance of a particular company with other
companies. For the year ended June 30, 2016, our return on average equity was 2.2%. We also intend to continue managing excess
capital through our stock repurchase program, which has been successful, given relatively low market prices of the Company’s
common stock. However, this program could be curtailed or rendered less effective if the market price of our stock increases, or
if the Company’s liquid funds are deployed elsewhere. Our goal of generating a return on average equity that is competitive
with other publicly-held subsidiaries of mutual holding companies, by increasing earnings per share and book value per share, without
assuming undue risk, could take a number of years to achieve, and we cannot assure that our goal will be attained. Consequently,
you should not expect a competitive return on average equity in the near future. Failure to achieve a competitive return on average
equity might make an investment in our common stock unattractive to some investors and might cause our common stock to trade at
lower prices than comparable companies with higher returns on average equity.
We may be subject to more stringent
capital requirements.
In July 2013, the OCC and the Federal Reserve
Board approved a new rule that will substantially amend the regulatory risk-based capital rules applicable to First Federal of
Hazard, First Federal of Kentucky and Kentucky First. The final rule implements the “Basel III” regulatory capital
reforms and changes required by the Dodd-Frank Act. The final rule includes new minimum risk-based capital and leverage ratios,
which became effective for First Federal of Hazard, First Federal of Kentucky and Kentucky First on January 1, 2015, and refines
the definition of what constitutes “capital” for purposes of calculating these ratios. The new minimum capital requirements
are: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 to risk-based assets capital ratio of 6% (increased from
4%); (iii) a total capital ratio of 8% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 4%. The final rule also
establishes a “capital conservation” buffer of 2.5%, and will result in the following minimum ratios: (i) a common
equity Tier 1 capital ratio of 7%; (ii) a Tier 1 to risk-based assets capital ratio of 8.5%; and (iii) a total capital ratio of
10.5%. The new capital conservation buffer requirement will be phased in beginning in January 2016 at 0.625% of risk-weighted assets
and will increase each year until fully implemented in January 2019. An institution will be subject to limitations on paying dividends,
engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations
will establish a maximum percentage of eligible retained income that can be utilized for such actions.
The application of
more stringent capital requirements for us could among other things, result in lower returns on equity, require the raising of
additional capital, and result in regulatory actions constraining us from paying dividends or repurchasing shares if we were unable
to comply with such requirements. See
“Regulation and Supervision—Regulation of Federal Savings Institutions—Capital
Requirements.”
Additional annual employee compensation and benefit expenses
may reduce our profitability and stockholders’ equity
.
We will continue to recognize employee compensation
and benefit expenses for employees and executives under our benefit plans. With regard to the employee stock ownership plan, applicable
accounting practices require that the expense be based on the fair market value of the shares of common stock at specific points
in the future, therefore we will recognize expenses for our employee stock ownership plan when shares are committed to be released
to participants’ accounts. We will also recognize expenses for restricted stock awards and options over the vesting periods
of those awards. In addition, employees of both subsidiary Banks participate in a defined-benefit plan through Pentegra. Costs
associated with the defined-benefit plans could increase or legislation could be enacted that would increase the Banks’ obligations
under the plan or change the methods the Banks use in accounting for the plans. Those changes could adversely affect personnel
expense and the Company’s balance sheet.
First Federal MHC owns a majority of our common stock
and is able to exercise voting control over most matters put to a vote of stockholders, including preventing sale or merger transactions
you may like or a second-step conversion by First Federal MHC.
First Federal MHC owns a majority of our
common stock and, through its Board of Directors, is able to exercise voting control over most matters put to a vote of stockholders.
As a federally chartered mutual holding company, the board of directors of First Federal MHC must ensure that the interests of
depositors of First Federal of Hazard are represented and considered in matters put to a vote of stockholders of Kentucky First.
Therefore, the votes cast by First Federal MHC may not be in your personal best interests as a stockholder. For example, First
Federal MHC may exercise its voting control to prevent a sale or merger transaction in which stockholders could receive a premium
for their shares, prevent a second-step conversion transaction by First Federal MHC or defeat a stockholder nominee for election
to the Board of Directors of Kentucky First. However, implementation of a stock-based incentive plan will require approval of Kentucky
First’s stockholders other than First Federal MHC. Federal Reserve Board regulations would likely prevent an acquisition
of Kentucky First other than by another mutual holding company or a mutual institution.
There may be a limited market for our common stock which
may lower our stock price.
Although our shares of common stock are
listed on the Nasdaq Global Market, there is no guarantee that the shares will be regularly traded. If an active trading market
for our common stock does not develop, you may not be able to sell all of your shares of common stock on short notice and the sale
of a large number of shares at one time could temporarily depress the market price.
Our ability to pay dividends is subject to the ability
of First Federal of Hazard and First Federal of Kentucky to make capital distributions to Kentucky First and the waiver of dividends
by First Federal MHC.
Our long-term ability to pay dividends to
our stockholders is based primarily upon the ability of the Banks to make capital distributions to Kentucky First, and also on
the availability of cash at the holding company level in the event earnings are not sufficient to pay dividends according to the
cash dividend payout policy. Under Office of the Comptroller of the Currency safe harbor regulations, the Banks may each distribute
to Kentucky First capital not exceeding net retained income for the current calendar year and the prior two calendar years. First
Federal MHC owns a majority of Kentucky First’s outstanding stock. First Federal MHC has historically waived its right to
dividends on the Kentucky First common shares it owns, in which case the amount of dividends paid to public stockholders is significantly
higher than it would be if First Federal MHC accepted dividends. First Federal MHC is not required to waive dividends, but Kentucky
First expects this practice to continue, subject to member and regulatory approval annually. First Federal MHC is required to obtain
a waiver from the Federal Reserve Board allowing it to waive its right to dividends.
The Federal Reserve Board in 2011 issued
regulations that govern the activities of Kentucky First and First Federal MHC and the regulations were implemented in the fourth
quarter of 2011. Under Section 239.8(d) of the Federal Reserve Board’s Regulation MM governing dividend waivers, a mutual
holding company may waive its right to dividends on shares of its subsidiary if the mutual holding company gives written notice
of the waiver to the Federal Reserve Board and the Federal Reserve Board does not object. For a company such as First Federal MHC
that waived dividends prior to December 1, 2009, the Federal Reserve Board may not object to a dividend waiver if such waiver would
not be detrimental to the safety and soundness of the savings association subsidiary and the board of directors of the mutual holding
company expressly determines that such dividend waiver is consistent with the board’s fiduciary duties to the members of
the mutual holding company.
To address concerns with respect to the
conflict of interest created by dividend waivers, Regulation MM requires the board of directors of the mutual holding company to
adopt a resolution that describes the conflict of interest that exists because of a director’s ownership of stock in the
subsidiary declaring the dividends and any actions the mutual holding company board have taken to eliminate the conflict of interest,
such as the directors’ waiving their right to receive dividends. Also, the resolution must contain an affirmation that a
majority of the mutual members eligible to vote have, within the 12 months prior to the declaration date of the dividend, voted
to approve the waiver of dividends.
Federal MHC has received Federal Reserve
Board approval to waive quarterly dividends totaling $0.40 per share annually beginning with the dividend paid on September 28,
2012 and continuing through the dividend payable in the 3rd quarter of 2017. It is expected that First Federal MHC will continue
to waive future dividends, except to the extent dividends are needed to fund First Federal MHC’s continuing operations,
subject to the ability of First Federal MHC to obtain regulatory approval of its requests to waive dividends and to its ability
to obtain member approval of dividend waivers.
We cannot predict whether members will continue
to approve annual dividend waiver requests or whether the Federal Reserve Board will grant future dividend waiver requests and,
if granted, there can be no assurance as to the conditions, if any, the Federal Reserve Board will place on future dividend waiver
requests by grandfathered mutual holding companies such as First Federal MHC. If First Federal MHC is unable to waive the receipt
of dividends, our ability to pay dividends to our stockholders may be substantially impaired and the amounts of any such dividends
may be significantly reduced.
We are subject to certain risks in connection with our
use of technology.
Our security measures may not be sufficient
to mitigate the risk of a cyber attack.
Communications and information systems are essential to the conduct of our business,
as we use such systems to manage our customer relationships, our general ledger and virtually all other aspects of our business.
Our operations rely on the secure processing, storage, and transmission of confidential and other information in our computer systems
and networks. Although we take protective measures and endeavor to modify them as circumstances warrant, the security of our computer
systems, software, and networks may be vulnerable to breaches, unauthorized access, misuse, computer viruses, or other malicious
code and cyber attacks that could have a security impact. If one or more of these events occur, this could jeopardize our or our
customers’ confidential and other information processed and stored in, and transmitted through, our computer systems and
networks, or otherwise cause interruptions or malfunctions in our operations or the operations of our customers or counterparties.
We may be required to expend significant additional resources to modify our protective measures or to investigate and remediate
vulnerabilities or other exposures, and we may be subject to litigation and financial losses that are either not insured against
or not fully covered through any insurance maintained by us. We could also suffer significant reputational damage.
Security breaches in our Internet banking
activities could further expose us to possible liability and damage our reputation. Any compromise of our security also could deter
customers from using our Internet banking services that involve the transmission of confidential information. We rely on standard
Internet security systems to provide the security and authentication necessary to effect secure transmission of data. These precautions
may not protect our systems from compromises or breaches of our security measures, which could result in significant legal liability
and significant damage to our reputation and our business.
Our security measures may not protect
us from systems failures or interruptions.
While we have established policies and procedures to prevent or limit the impact
of systems failures and interruptions, there can be no assurance that such events will not occur or that they will be adequately
addressed if they do. In addition, we outsource certain aspects of our data processing and other operational functions to certain
third-party providers. If our third-party providers encounter difficulties, or if we have difficulty in communicating with them,
our ability to adequately process and account for transactions could be affected, and our business operations could be adversely
impacted. Threats to information security also exist in the processing of customer information through various other vendors and
their personnel.
The occurrence of any failures or interruptions
may require us to identify alternative sources of such services, and we cannot assure you that we could negotiate terms that are
as favorable to us, or could obtain services with similar functionality as found in our existing systems without the need to expend
substantial resources, if at all. Further, the occurrence of any systems failure or interruption could damage our reputation and
result in a loss of customers and business, could subject us to additional regulatory scrutiny, or could expose us to legal liability.
Any of these occurrences could have a material adverse effect on our financial condition and results of operations.