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IF BANCORP, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION(Edgar Glimpses Via Acquire Media NewsEdge) Overview We have grown our organization to $551.3 million in assets at June 30, 2014 from $377.2 million in assets at June 30, 2009. We have increased our assets primarily through increased investment securities and loan growth. Historically, we have operated as a traditional thrift institution. As recently as June 30, 2009, $163.6 million, or approximately 72.4% of our loan portfolio, consisted of longer-term, one- to four-family residential real estate loans. However, in recent years, we have increased our focus on the origination of commercial real estate loans, multi-family real estate loans and commercial business loans, which generally provide higher returns than one- to four-family residential mortgage loans, have shorter durations and are often originated with adjustable rates of interest. As a result, our net interest rate spread (the difference between the yield on average interest-earning assets and the cost of average interest-bearing liabilities) increased to 2.83% for the year ended June 30, 2014 from 2.53% for the year ended June 30, 2009. This contributed to a corresponding increase in net interest income (the difference between interest income and interest expense) to $15.8 million for the fiscal year ended June 30, 2014 from $9.5 million for the fiscal year ended June 30, 2009. Our emphasis on conservative loan underwriting has resulted in relatively low levels of non-performing assets at a time when many financial institutions are experiencing significant asset quality issues. Our non-performing assets totaled $3.2 million or 0.6% of total assets at June 30, 2014. Other than our loans for the construction of one- to four-family residential properties and the draw portion of our home equity lines of credit, we do not offer "interest only" mortgage loans on one- to four-family residential properties (where the borrower pays interest but no principal for an initial period, after which the loan converts to a fully amortizing loan). We also do not offer loans that provide for negative amortization of principal, such as "Option ARM" loans, where the borrower can pay less than the interest owed on their loan, resulting in an increased principal balance during the life of the loan. We do not offer "subprime loans" (loans that generally target borrowers with weakened credit histories typically characterized by payment delinquencies, previous charge-offs, judgments, bankruptcies, or borrowers with questionable repayment capacity as evidenced by low credit scores or high debt-burden ratios) or Alt-A loans (traditionally defined as loans having less than full documentation). We also do not own any private label mortgage-backed securities that are collateralized by Alt-A, low or no documentation or subprime mortgage loans. The Association's legal lending limit to any one borrower is 15% of unimpaired capital and surplus. On July 30, 2012 the Association received approval from the Office of the Comptroller of the Currency to participate in the Supplemental Lending Limits Program (SLLP). This program allows eligible savings associations to make additional residential real estate loans or extensions of credit to one borrower, small business loans or extensions of credit to one borrower, or small farm loans or extensions of credit to one borrower. For our association this additional limit (or "supplemental limit(s)") for one- to four-family residential real estate, small business, or small farm loans is 10% of our Association's capital and surplus. In addition, the total outstanding amount of the Association's loans or extensions of credit or parts of loans and extensions of credit made to all of its borrowers under the SLLP may not exceed 100% of the Association's capital and surplus. By Association policy, participation of any credit facilities in the SLLP is to be infrequent and all credit facilities are to be with prior Board approval. All of our mortgage-backed securities have been issued by Freddie Mac, Fannie Mae or Ginnie Mae, U.S. government-sponsored enterprises. These entities guarantee the payment of principal and interest on our mortgage-backed securities. On July 7, 2011 we completed our initial public offering of common stock in connection with Iroquois Federal's mutual-to-stock conversion, selling 4,496,500 shares of common stock at $10.00 per share, including 384,900 shares sold to Iroquois Federal's employee stock ownership plan, and raising approximately $45.0 million of gross proceeds. In addition, we issued 314,755 shares of our common stock to the Iroquois Federal Foundation. 45-------------------------------------------------------------------------------- Table of Contents In April, 2014 we opened a new branch office at 108 Arbours Drive, Savoy, Illinois, in Champaign County. Critical Accounting Policies We consider accounting policies that require management to exercise significant judgment or discretion or make significant assumptions that have, or could have, a material impact on the carrying value of certain assets or on income, to be critical accounting policies. We consider the following to be our critical accounting policies. Allowance for Loan Losses. We believe that the allowance for loan losses and related provision for loan losses are particularly susceptible to change in the near term, due to changes in credit quality which are evidenced by trends in charge-offs and in the volume and severity of past due loans. In addition, our portfolio is comprised of a substantial amount of commercial real estate loans which generally have greater credit risk than one- to four-family residential mortgage and consumer loans because these loans generally have larger principal balances and are non-homogenous. The allowance for loan losses is maintained at a level to cover probable credit losses inherent in the loan portfolio at the balance sheet date. Based on our estimate of the level of allowance for loan losses required, we record a provision for loan losses as a charge to earnings to maintain the allowance for loan losses at an appropriate level. The estimate of our credit losses is applied to two general categories of loans: • loans that we evaluate individually for impairment under ASC 310-10, "Receivables;" and • groups of loans with similar risk characteristics that we evaluate collectively for impairment under ASC 450-20, "Loss Contingencies." The allowance for loan losses is evaluated on a regular basis by management and reflects consideration of all significant factors that affect the collectability of the loan portfolio. The factors used to evaluate the collectability of the loan portfolio include, but are not limited to, current economic conditions, our historical loss experience, the nature and volume of the loan portfolio, the financial strength of the borrower, and estimated value of any underlying collateral. This evaluation is inherently subjective as it requires estimates that are subject to significant revision as more information becomes available. Actual loan losses may be significantly more than the allowance for loan losses we have established which could have a material negative effect on our financial results. See also "Business - Allowance for Loan Losses." Income Tax Accounting. The provision for income taxes is based upon income in our consolidated financial statements, rather than amounts reported on our income tax return. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on our deferred tax assets and liabilities is recognized as income or expense in the period that includes the enactment date. Under GAAP, a valuation allowance is required to be recognized if it is more likely than not that a deferred tax asset will not be realized. The determination as to whether we will be able to realize the deferred tax assets is highly subjective and dependent upon judgment concerning our evaluation of both positive and negative evidence, our forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions. Positive evidence includes the existence of taxes paid in available carryback years as well as the probability that taxable income will be generated in future periods, while negative evidence includes any cumulative losses in the current year and prior two years and general business and economic trends. Any reduction in estimated future taxable income may require us to record a valuation allowance against our deferred tax assets. Any required valuation allowance would result in additional income tax expense in the period and could have a significant impact on our future earnings. Positions taken in our tax returns may be subject to challenge by the taxing authorities upon examination. The benefit of an uncertain tax position is initially recognized in the financial statements only when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are both initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement with the tax authority, assuming full knowledge of the position and all relevant facts. Differences between our position and the position of tax authorities could result in a reduction of a tax benefit or an increase to a tax liability, which could adversely affect our future income tax expense. 46-------------------------------------------------------------------------------- Table of Contents We believe our tax policies and practices are critical accounting policies because the determination of our tax provision and current and deferred tax assets and liabilities have a material impact on our net income and the carrying value of our assets. We believe our tax liabilities and assets are properly recorded in the consolidated financial statements at June 30, 2014 and no valuation allowance was necessary. Comparison of Financial Condition at June 30, 2014 and June 30, 2013 Total assets increased $3.8 million, or 0.7%, to $551.3 million at June 30, 2014 from $547.5 million at June 30, 2013. The increase was primarily due to a $14.1 million increase in net loans and a $6.2 million increase in cash and cash equivalents, partially offset by a $16.2 million decrease in investment securities. Net loans receivable, including loans held for sale, increased by $14.1 million, or 4.5%, to $329.9 million at June 30, 2014 from $315.8 million at June 30, 2013. The increase in net loans receivable during this period was due primarily to an $8.5 million, or 11.3%, increase in commercial real estate loans, a $3.4 million, or 17.4%, increase in commercial business loans, a $3.2 million, or 5.4%, increase in multi-family loans, and a $2.3 million, or 1.6%, increase in one- to four-family loans. These increases were partially offset by a $1.2 million, or 11.9%, decrease in consumer loans, a $925,000, or 37.0%, decrease in construction loans, and a $404,000, or 4.9%, decrease in home equity lines of credit. Investment securities, consisting entirely of securities available for sale, decreased $16.2 million, or 8.1%, to $184.6 million at June 30, 2014 from $200.8 million at June 30, 2013. The decrease was primarily due to the sale of securities to reduce FHLB advances and to fund loan growth. We had no held-to-maturity securities at June 30, 2014 or June 30, 2013. As of June 30, 2014, other assets decreased $318,000 to $489,000 and the deferred income tax asset decreased $1.2 million to $2.1 million, while premises and equipment increased $831,000 to $5.1 million from their respective balances as of June 30, 2013. Federal Home Loan Bank stock was $5.4 million at both June 30, 2014 and 2013. The decrease in other assets resulted from a decrease in prepaid insurance due to the timing of multi-year premiums and also from a decrease in accounts receivable general due to the receipt of a receivable that was outstanding as of June 30, 2013. The decrease in deferred income taxes was mostly due to an increase in the unrealized gain on sale of available-for sale securities, and the increase in premises and equipment was due to the purchase of an office building, furniture, and equipment for our new branch in Savoy, Illinois. At June 30, 2014, our investment in bank-owned life insurance was $8.0 million, an increase of $268,000 from $7.8 million at June 30, 2013. We invest in bank-owned life insurance to provide us with a funding source for our benefit plan obligations. Bank-owned life insurance also generally provides us noninterest income that is non-taxable. Federal regulations generally limit our investment in bank-owned life insurance to 25% of the Association's Tier 1 capital plus our allowance for loan losses, which totaled $17.6 million at June 30, 2014. Deposits increased $33.4 million, or 9.0%, to $404.6 million at June 30, 2014 from $371.2 million at June 30, 2013. Certificates of deposit, excluding brokered certificates of deposit, increased $30.9 million, or 16.4%, to $219.7 million, savings, NOW, and money market accounts increased $859,000, or 0.7%, to $132.6 million, brokered certificates of deposit decreased $2.3 million, or 6.0%, to $35.6 million, and noninterest bearing demand accounts increased $3.9 million, or 30.3% to $16.7 million. Repurchase agreements increased $650,000 to $2.3 million. Advances from the Federal Home Loan Bank of Chicago decreased $30.8 million, or 35.1%, to $56.8 million at June 30, 2014 from $87.5 million at June 30, 2013. The reduction in advances was part of the Company's strategy to improve their interest rate risk position. We decreased our borrowings by using the proceeds from the sale of securities to pay down short term advances and fund new loans. Total equity increased $337,000, or 0.4%, to $82.1 million at June 30, 2014 from $81.7 million at June 30, 2013. Equity increased due to net income of $3.5 million and an increase in unrealized gains on securities available for sale of $1.5 million, partially offset by the repurchase of 278,535 shares of common stock at an aggregate cost of 47-------------------------------------------------------------------------------- Table of Contents approximately $4.6 million. Two stock repurchase programs were adopted during the year ended June 30, 2014, which authorized the Company to repurchase up to 228,535 and 221,383 shares of its common stock, respectively, or approximately 5% of then current outstanding shares in each program. The first repurchase plan was completed on January 27, 2014, and the 228,535 shares were repurchased at an average price of $16.61 per share. As of June 30, 2014, the Company had acquired 50,000 shares of the 221,383 shares of its outstanding common stock authorized in the second repurchase program at an average purchase price of approximately $16.50 per share. Comparison of Operating Results for the Years Ended June 30, 2014 and 2013 General. Net income decreased $233,000, or 6.3%, to $3.5 million net income for the year ended June 30, 2014 from $3.7 million net income for the year ended June 30, 2013. The decrease was primarily due to a decrease in noninterest income and an increase in noninterest expense, partially offset by an increase in net interest income and a decrease in provision for loan losses. Net Interest Income. Net interest income increased by $1.3 million, or 9.0%, to $15.8 million for the year ended June 30, 2014 from $14.5 million for the year ended June 30, 2013. The increase was due to an increase of $1.4 million in interest and dividend income, partially offset by an increase of $49,000 in interest expense. The increase in net interest income was primarily the result of an increase in the average balance of interest earning assets and lower rates paid on certificates of deposit and FHLB advances. We had a $31.3 million, or 6.2%, increase in the average balance of interest earning assets, partially offset by a $31.6 million, or 7.4%, increase in the average balance of interest bearing liabilities. Our interest rate spread increased 8 basis points to 2.83% for the year ended June 30, 2014 from 2.75% for the year ended June 30, 2013, and our net interest margin increased by 8 basis points to 2.94% for the year ended June 30, 2014 from 2.86% for the year ended June 30, 2013. Interest and Dividend Income. Interest and dividend income increased $1.4 million, or 7.7%, to $19.0 million for the year ended June 30, 2014 from $17.6 million for the year ended June 30, 2013. The increase in interest income was due to an increase in interest income on loans and an increase in interest income on securities. Interest on securities increased $24,000, or 0.5%, as a 12 basis point increase in the average yield on securities to 2.53% from 2.41%, was partially offset by a $8.8 million decrease in the average balance of securities to $204.2 million at June 30, 2014 from $213.0 million at June 30, 2013. An increase of $1.3 million, or 10.6%, in interest on loans resulted from a $41.9 million, or 14.7%, increase in the average balance of loans to $326.8 million for the year ended June 30, 2014, partially offset by a 16 basis point, or 3.7%, decrease in the average yield on loans to 4.21% from 4.37%. The decrease in the average yield on loans reflected a reduction in the current interest rates charged on loans originated during the period versus the average rates on loans in the portfolio in the prior period. Interest Expense. Interest expense increased $49,000, or 1.6%, and was $3.1 million for both the year ended June 30, 2014 and the year ended June 30, 2013. The increase was primarily due to increased average balances of deposits, partialy offset by lower market interest rates during the period. Interest expense on interest-bearing deposits increased $88,000, or 3.9%, to $2.3 million for the year ended June 30, 2014 from $2.2 million for the year ended June 30, 2013. This increase was primarily due to an increase in the average balance of interest-bearing deposits to $376.1 million for the year ended June 30, 2014, from $340.0 million for the year ended June 30, 2013. This increase in average balance of interest-bearing deposits was partially offset by a decrease of 4 basis points in the average cost of interest-bearing deposits to 0.62% for the year ended June 30, 2014 from 0.66% for the year ended June 30, 2013. We experienced decreases in the average cost across all categories of interest-bearing deposits for the year ended June 30, 2014, reflecting lower market interest rates as compared to the prior period. Interest expense on borrowings, including FHLB advances and repurchase agreements, decreased $39,000, or 4.5%, to $826,000 for the year ended June 30, 2014 from $865,000 for the year ended June 30, 2013. This decrease was due to a $4.5 million, or 5.1%, decrease in the average balance of borrowings to $83.4 million for the year ended June 30, 2014 from $87.9 million for the year ended June 30, 2013, partially offset by a 1 basis point increase in the average cost of such borrowings to 0.99% for the year ended June 30, 2014 from 0.98% for the year ended June 30, 2013. Provision for Loan Losses. We establish provisions for loan losses, which are charged to operations in order to maintain the allowance for loan losses at a level we consider necessary to absorb probable credit losses inherent in our loan portfolio. We recorded a provision for loan losses of $502,000 for the year ended June 30, 48 -------------------------------------------------------------------------------- Table of Contents 2014, compared to a provision for loan losses of $595,000 for the year ended June 30, 2013. The allowance for loan losses was $4.0 million, or 1.18% of total loans, at June 30, 2014, compared to $3.9 million, or 1.23% of total loans, at June 30, 2013. Non-performing loans decreased during the year ended June 30, 2014, to $2.8 million. During the year ended June 30, 2014 and 2013, $482,000 and $188,000 in net charge-offs were recorded. The following table sets forth information regarding the allowance for loan losses and nonperforming assets at the dates indicated: Year Ended Year Ended June 30, 2014 June 30, 2013 Allowance to non-performing loans 143.1 % 91.12 % Allowance to total loans outstanding at the end of the period 1.18 % 1.23 % Net charge-offs to average total loans outstanding during the period, annualized 0.15 % 0.07 % Total non-performing loans to total loans 0.82 % 1.35 % Total non-performing assets to total assets 0.58 % 0.87 % Noninterest Income. Noninterest income decreased $1.4 million, or 31.7%, to $3.1 million for the year ended June 30, 2014 from $4.5 million for the year ended June 30, 2013. The decrease was primarily due to decreases in net realized gains on the sale of available-for-sale securities, gains on sale of loans, mortgage banking income, and other service charges and fees, patially offset by an increase in brokerage commissions. For the year ended June 30, 2014, net realized gains on the sale of available-for-sale securities decreased to a loss of $123,000 from a gain of $724,000, gains on sale of loans decreased to $90,000 from $319,000, mortgage banking income decreased to $197,000 from $354,000, and other service charges and fees decreased to $109,000 from $271,000, while brokerage commissions increased to $704,000 from $616,000. The decrease in net realized gains on the sale of available-for-sale securities was due to the rate environment in the year ended June 30, 2013, that allowed for profits to be gained when repositioning the investment portfolio that were not available in the year ended June 30, 2014. The decrease in gains on sale of loans and the decrease in the mortgage banking income were primarily due to a decrease in the number of loans sold to the Federal Home Loan Bank of Chicago in the year ended June 30, 2014, and the decrease in other service charges and fees was due to a decrease in the number of fees. The increase in brokerage commissions reflects increased activity due to movement in market interest rates. Noninterest Expense. Noninterest expense increased $402,000, or 3.2%, to $13.0 million for the year ended June 30, 2014 from $12.6 million for the year ended June 30, 2013. The largest components of this increase were compensation and benefits, which increased $458,000, or 5.8%, and loss on foreclosed assets, net, which increased $147,000, or 267.3%. Increased medical insurance costs, normal salary increases, and stock equity plan expenses primarily accounted for the increase in compensation and benefits expense, while loss on foreclosed assets, net, increased due to gains taken in the year ended June 30, 2013. These increases were partially offset by decreases in equipment expense, professional services, and audit and accounting. The decrease in equipment expense was due to increased expenses in the year ended June 30, 2013, when we relocated our information technology department to a more secure and efficient location. Decreases in audit and accounting and professional services were due to additional services received in the year ended June 30, 2013. Income Tax Expense. We recorded a provision for income tax of $1.9 million for the year ended June 30, 2014, compared to a provision for income tax of $2.1 million for the year ended June 30, 2013, reflecting effective tax rates of 34.9% and 35.7%, respectively. Asset Quality and Allowance for Loan Losses For information regarding asset quality and allowance for loan loss activity, see "Item 1. Business-Non-performing and Problem Assets" and "Item 1. Business-Allowance for Loan Losses." 49-------------------------------------------------------------------------------- Table of Contents Average Balances and Yields The following tables set forth average balance sheets, average yields and costs, and certain other information for the periods indicated. Tax-equivalent yield adjustments have not been made for tax-exempt securities. All average balances are based on month-end balances, which management deems to be representative of the operations of Iroquois Federal. Non-accrual loans were included in the computation of average balances, but have been reflected in the table as loans carrying a zero yield. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense. For the Fiscal Years Ended June 30, 2014 2013 2012 Average Average Average Outstanding Yield/ Outstanding Yield/ Outstanding Yield/ Balance Interest Rate Balance Interest Rate Balance Interest Rate (Dollars in thousands)Interest-earning assets: Loans: Real estate loans: One- to four-family (1) $ 148,047 $ 6,215 4.20 % $ 146,005 $ 5,874 4.02 % $ 147,438 $ 6,668 4.52 % Multi-family 60,213 2,452 4.07 45,841 2,085 4.55 30,857 1,524 4.94 Commercial 78,695 3,185 4.05 54,193 2,511 4.63 30,667 1,723 5.62 Home equity lines of credit 7,827 328 4.19 8,579 357 4.16 9,408 400 4.25 Construction loans 1,835 67 3.65 4,133 146 3.53 5,240 231 4.41 Commercial business loans 21,124 993 4.70 15,109 744 4.92 12,679 688 5.43 Consumer loans 9,107 521 5.72 11,114 728 6.55 14,513 943 6.50 Total loans 326,848 13,761 4.21 284,974 12,445 4.37 250,802 12,177 4.86 Securities: U.S. government, federal agency and government-sponsored enterprises 124,809 3,069 2.46 137,848 3,206 2.33 160,472 4,179 2.60 U.S. government sponsored mortgage-backed securities 76,177 2,048 2.69 71,342 1,875 2.63 44,407 1,562 3.52 State and political subdivisions 3,184 46 1.44 3,807 59 1.55 2,776 52 1.87 Total securities 204,170 5,163 2.53 212,997 5,140 2.41 207,655 5,793 2.79 Other 7,703 37 0.48 9,495 25 0.26 8,665 31 0.36 Total interest-earning assets 538,721 18,961 3.52 507,466 17,610 3.47 467,122 18,001 3.85 Noninterest-earning assets 19,875 25,368 26,412 Total assets $ 558,596 $ 532,834 $ 493,534 Interest-bearing liabilities: Interest-bearing checking or NOW $ 34,342 35 0.10 $ 32,206 57 0.18 $ 28,649 58 0.20 Savings accounts 33,383 72 0.22 30,706 84 0.27 27,560 94 0.34 Money market accounts 59,035 140 0.24 65,335 161 0.25 68,619 202 0.29 Certificates of deposit 249,340 2,075 0.83 211,795 1,932 0.91 202,466 2,522 1.25 Total interest-bearing deposits 376,100 2,322 0.62 340,042 2,234 0.66 327,294 2,876 0.88 Federal Home Loan Bank advances and repurchase agreements 83,394 826 0.99 87,875 865 0.98 65,830 908 1.38 Total interest-bearing liabilities 459,494 3,148 0.69 427,917 3,099 0.72 393,124 3,784 0.96 Noninterest-bearing liabilities 17,493 19,490 16,088 Total liabilities 476,987 447,407 409,212 Equity 81,609 85,427 84,322 Total liabilities and equity 558,596 $ 532,834 $ 493,534 Net interest income $ 15,813 $ 14,511 $ 14,217 Net interest rate spread (2) 2.83 % 2.75 % 2.89 % Net interest-earning assets (3) $ 79,227 $ 79,549 $ 73,998 Net interest margin (4) 2.94 % 2.86 % 3.04 % Average interest-earning assets to interest-bearing liabilities 117 % 119 % 119 % (1) Includes home equity loans. (2) Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average interest-bearing liabilities. (3) Net interest-earning assets represents total interest-earning assets less total interest-bearing liabilities. (4) Net interest margin represents net interest income divided by average total interest-earning assets. 50 -------------------------------------------------------------------------------- Table of Contents Rate/Volume Analysis The following table presents the effects of changing rates and volumes on our net interest income for the periods indicated. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The net column represents the sum of the prior columns. For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated to the changes due to rate and the changes due to volume in proportion to the relationship of the absolute dollar amounts of change in each. Fiscal Years Ended June 30, Fiscal Years Ended June 30, 2014 vs. 2013 2013 vs. 2012 Increase (Decrease) Total Increase (Decrease) Total Due to Increase Due to Increase Volume Rate (Decrease) Volume Rate (Decrease) (In thousands) Interest-earning assets: Loans $ 1,784 $ (468 ) $ 1,316 $ 1,567 $ (1,299 ) $ 268 Securities (222 ) 245 23 147 (800 ) (653 ) Other (6 ) 18 12 3 (9 ) (6 ) Total interest-earning assets $ 1,556 $ (205 ) $ 1,351 $ 1,717 $ (2,108 ) $ (391 ) Interest-bearing liabilities: Interest-bearing checking or NOW $ 4 $ (26 ) $ (22 ) $ 6 $ (7 ) $ (1 ) Savings accounts 6 (18 ) (12 ) 10 (20 ) (10 ) Certificates of deposit 321 (178 ) 143 114 (704 ) (590 ) Money market accounts (12 ) (9 ) (21 ) (19 ) (22 ) (41 ) Total interest-bearing deposits 319 (231 ) 88 111 (753 ) (642 ) Federal Home Loan Bank advances (47 ) 8 (39 ) 259 (302 ) (43 ) Total interest-bearing liabilities $ 272 $ (223 ) $ 49 $ 370 $ (1,055 ) $ (685 ) Change in net interest income $ 1,284 $ 18 $ 1,302 $ 1,347 $ (1,053 ) $ 294 51 -------------------------------------------------------------------------------- Table of Contents Management of Market Risk General. Because the majority of our assets and liabilities are sensitive to changes in interest rates, our most significant form of market risk is interest rate risk. We are vulnerable to an increase in interest rates to the extent that our interest-bearing liabilities mature or reprice more quickly than our interest-earning assets. As a result, a principal part of our business strategy is to manage interest rate risk and limit the exposure of our net interest income to changes in market interest rates. Accordingly, our Board of Directors has established an Asset/Liability Management Committee pursuant to our Interest Rate Risk Management Policy that is responsible for evaluating the interest rate risk inherent in our assets and liabilities, for determining the level of risk that is appropriate, given our business strategy, operating environment, capital, liquidity and performance objectives, and for managing this risk consistent with the guidelines approved by the Board of Directors. As part of our ongoing asset-liability management, we currently use the following strategies to manage our interest rate risk: (i) sell the majority of our long-term, fixed-rate one- to four-family residential mortgage loans that we originate; (ii) lengthen the weighted average maturity of our liabilities through retail deposit pricing strategies and through longer-term wholesale funding sources such as fixed-rate advances from the Federal Home Loan Bank of Chicago; (iii) invest in shorter- to medium-term investment securities and interest-earning time deposits; (iv) originate commercial mortgage loans, including multi-family loans and land loans, commercial loans and consumer loans, which tend to have shorter terms and higher interest rates than one- to four-family residential mortgage loans, and which generate customer relationships that can result in larger noninterest-bearing demand deposit accounts; and (v) maintain adequate levels of capital. We currently do not engage in hedging activities, such as futures, options or swap transactions, or investing in high-risk mortgage derivatives, such as collateralized mortgage obligations, residual interests, real estate mortgage investment conduit residual interests or stripped mortgage backed securities. In addition, changes in interest rates can affect the fair values of our financial instruments. For additional information regarding the fair values of our assets and liabilities, see Note 17 to the Notes to our Consolidated Financial Statements. Interest Rate Risk Analysis We also perform our own internal interest rate risk analysis that assesses our earnings at risk, capital at risk and our net economic value of equity (NEVE) at risk. Our analysis involves shocking interest rates up to 400 basis points using a dynamic and realistic yield curve as well as "real world" simulation and timing. In addition to measuring net economic value of equity, our model also analyzes earnings at risk for both net interest income and net income, and capital at risk for tangible equity capital, tier 1 risk based capital, and total risk based capital in rate shock scenarios up to 400 basis points over a three-year period. Due to the current low interest rate environment, we do not analyze rate shock scenarios involving decreasing interest rates at this time. When interest rates increase, we will also analyze scenarios involving decreasing rates. Details of our general ledger along with key data from each deposit, loan, investment, and borrowing are downloaded into our forecasting model, which takes into account both market and internal trends. Historical testing is done internally on a regular basis to confirm the validity of the model, while third-party testing is done periodically. Details of our interest rate risk analysis are reviewed by the Asset/Liability Management Committee and presented to the Board on a quarterly basis. 52-------------------------------------------------------------------------------- Table of Contents The tables below illustrate the simulated impact of rate shock scenarios up to 400 basis points over a three-year period on our earnings at risk (for both net interest income and net income) and our capital at risk (for tangible equity capital, tier 1 risk-based capital, and total risk-based capital). The earnings at risk tables show net interest income and net income decreasing in a rising rate environment. The capital at risk tables show tangible equity capital, tier 1 risk-based capital, and total risk-based capital all remain well capitalized when shocked 400 basis points over a three year period. The net economic value of equity at risk table below sets forth our calculation of the estimated changes in our net economic value of equity at June 30, 2014 resulting from immediate rate shocks up to 400 basis points. Earnings at Risk Change in Interest % Change in Net Interest Income % Change in Net Income Rates (basis points) 6/30/15 6/30/16 6/30/17 6/30/15 6/30/16 6/30/17 +400 (1.36 ) (6.29 ) (1.98 ) (14.47 ) (24.97 ) (21.09 ) +300 (1.19 ) (3.28 ) 3.45 (14.00 ) (16.59 ) (5.94 ) +200 (1.22 ) (2.78 ) 7.00 (14.09 ) (15.19 ) 3.93 +100 0.27 1.56 10.86 (9.95 ) (3.20 ) 14.59 0 3.42 4.63 12.54 (1.21 ) 5.20 19.07 Capital at Risk Change in Interest Tangible Equity Capital Tier 1 Risk-Based Capital Total Risk-BasedCapital Rates (basis points) 6/30/15 6/30/16 6/30/17 6/30/15 6/30/16 6/30/17 6/30/15 6/30/16 6/30/17 +400 12.49 12.64 12.66 20.76 20.70 20.56 22.01 21.95 21.81 +300 12.49 12.68 12.76 20.76 20.76 20.71 22.01 22.01 21.96 +200 12.49 12.68 12.81 20.76 20.76 20.78 22.01 22.01 22.03 +100 12.51 12.76 12.96 20.79 20.88 21.00 22.04 22.13 22.25 0 12.56 12.88 13.13 20.85 21.03 21.22 22.10 22.28 22.47 Net Economic Value of Equity (NEVE) at Risk At June 30, 2014 Change in Interest Rates (basis points) Estimated NEVE % Change NEVE +400 37,363 51.98 +300 46,719 39.95 +200 57,507 26.08 +100 67,377 13.40 0 77,801 - Liquidity and Capital Resources Liquidity is the ability to meet current and future financial obligations of a short-term nature. Our primary sources of funds consist of deposit inflows, loan sales and repayments, advances from the Federal Home Loan Bank of Chicago, and maturities of securities. We also utilize brokered certificates of deposit, internet funding, borrowings from the Federal Reserve, and sales of securities, when appropriate. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. Our Asset/Liability Management Committee is responsible for establishing and monitoring our liquidity targets and strategies in order to ensure that sufficient liquidity exists for meeting the borrowing needs and deposit withdrawals of our customers as well as unanticipated contingencies. For the years ended June 30, 2014 and 2013, our liquidity ratio averaged 36.3% and 40.1% of our total assets, respectively. We believe that we have enough sources of liquidity to satisfy our short- and long-term liquidity needs as of June 30, 2014. We regularly monitor and adjust our investments in liquid assets based upon our assessment of: (i) expected loan demand; (ii) expected deposit flows; (iii) yields available on interest-earning deposits and securities; and (iv) the objectives of our asset/liability management program. Excess liquid assets are invested generally in interest-earning deposits and short- and medium-term securities. 53 -------------------------------------------------------------------------------- Table of Contents Our most liquid assets are cash and cash equivalents. The levels of these assets are affected by our operating, financing, lending and investing activities during any given period. At June 30, 2014, cash and cash equivalents totaled $12.7 million. Our cash flows are derived from operating activities, investing activities and financing activities as reported in our Statements of Cash Flows included in our financial statements. At June 30, 2014, we had $8.9 million in loan commitments outstanding, and $18.7 million in unused lines of credit to borrowers. Certificates of deposit due within one year of June 30, 2014 totaled $184.3 million, or 45.6% of total deposits. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on the certificates of deposit due on or before June 30, 2014. Additionally, it is our intention as we continue to grow our commercial real estate portfolio, to emphasize lower cost deposit relationships with these commercial loan customers and thereby replace the higher cost certificates with lower cost deposits. We have the ability to attract and retain deposits by adjusting the interest rates offered. Our primary investing activity is originating loans. During the years ended June 30, 2014 and 2013, we originated $81.8 million and $112.6 million of loans, respectively. Financing activities consist primarily of activity in deposit accounts and Federal Home Loan Bank advances. We had a net increase in total deposits of $33.4 million for the year ended June 30, 2014, and a net increase in total deposits of $26.7 million for the year ended June 30, 2013. Deposit flows are affected by the overall level of interest rates, the interest rates and products offered by us and our local competitors, and by other factors. Liquidity management is both a daily and long-term function of business management. If we require funds beyond our ability to generate them internally, borrowing agreements exist with the Federal Home Loan Bank of Chicago, which provides an additional source of funds. Federal Home Loan Bank advances were $56.8 million at June 30, 2014. At June 30, 2014, we had the ability to borrow up to an additional $76.4 million from the Federal Home Loan Bank of Chicago based on our collateral and had the ability to borrow an additional $22.7 million from the Federal Reserve based upon current collateral pledged. Iroquois Federal is subject to various regulatory capital requirements, including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories. At June 30, 2014, Iroquois Federal exceeded all regulatory capital requirements. Iroquois Federal is considered "well capitalized" under regulatory guidelines. See "Note 12- Regulatory Matters of the notes to the financial statements included in this Annual Report on Form 10-K. Off-Balance Sheet Arrangements and Aggregate Contractual Obligations Commitments. As a financial services provider, we routinely are a party to various financial instruments with off-balance-sheet risks, such as commitments to extend credit and unused lines of credit. While these contractual obligations represent our future cash requirements, a significant portion of commitments to extend credit may expire without being drawn upon. Such commitments are subject to the same credit policies and approval process accorded to loans we make. For additional information, see Note 19 - Commitments and Credit Risk of the notes to the financial statements included in this Annual Report on Form 10-K. Contractual Obligations. In the ordinary course of our operations, we enter into certain contractual obligations. Such obligations include data processing services, operating leases for premises and equipment, agreements with respect to borrowed funds and deposit liabilities. Recent Accounting Pronouncements For a discussion of the impact of recent and future accounting pronouncements, see Note 1 of the notes to our consolidated financial statements beginning on page F-1 of this Annual Report on Form 10-K. 54-------------------------------------------------------------------------------- Table of Contents Impact of Inflation and Changing Prices Our financial statements and related notes have been prepared in accordance with U.S. GAAP. U.S. GAAP generally requires the measurement of financial position and operating results in terms of historical dollars without consideration of changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial companies, our assets and liabilities are primarily monetary in nature. As a result, changes in market interest rates have a greater impact on our performance than the effects of inflation. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information required by this item is incorporated herein by reference to Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operation." |