q123108.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

[  Ö ]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 
For the quarterly period ended ……………………………………....................................................  December 31, 2008

[     ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 
For the transition period from ________________ to _________________

 
Commission File Number 000-28304            

 
PROVIDENT FINANCIAL HOLDINGS, INC.          
 
(Exact name of registrant as specified in its charter)       
 
 
Delaware
    33-0704889
(State or other jurisdiction of   (I.R.S.  Employer 
incorporation or organization)   Identification No.) 
 
3756 Central Avenue, Riverside, California 92506
(Address of principal executive offices and zip code)

(951) 686-6060
(Registrant’s telephone number, including area code)

                                                                                                                                          .
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes      X  .            No                  .

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  [   ]   Accelerated filer   [X]  Non-accelerated filer   [   ] 
Smaller reporting company  [   ]     
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes      .               No           X .

APPLICABLE ONLY TO CORPORATE ISSUERS

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
 
 
Title of class:  As of February 5, 2009  
   
Common stock, $ 0.01 par value, per share  6,208,519 shares 
 
 
 
 
 

PROVIDENT FINANCIAL HOLDINGS, INC.

Table of Contents

PART 1  -  
FINANCIAL INFORMATION
  
       
 ITEM 1  -  
Financial Statements.  The Unaudited Interim Condensed Consolidated Financial
Statements of Provident Financial Holdings, Inc. filed as a part of the report are as
follows:
  
       
 
Condensed Consolidated Statements of Financial Condition
  
   
as of December 31, 2008 and June 30, 2008
1
 
Condensed Consolidated Statements of Operations
  
   
for the Quarters and Six Months ended December 31, 2008 and 2007
2
 
Condensed Consolidated Statements of Stockholders’ Equity
  
   
for the Quarters and Six Months ended December 31, 2008 and 2007
3
 
Condensed Consolidated Statements of Cash Flows
  
   
for the Six Months ended December 31, 2008 and 2007
5
 
Notes to Unaudited Interim Condensed Consolidated Financial Statements
6
       
 ITEM 2  -  
Management’s Discussion and Analysis of Financial Condition and Results of
  
   
Operations:
  
       
 
General
  15
 
Safe Harbor Statement
   17
 
Critical Accounting Policies
17
 
Executive Summary and Operating Strategy
18
 
Off-Balance Sheet Financing Arrangements and Contractual Obligations
19
 
Comparison of Financial Condition at December 31, 2008 and June 30, 2008
19
 
Comparison of Operating Results
  
   
for the Quarters and Six Months ended December 31, 2008 and 2007
20
 
Asset Quality
32
 
Loan Volume Activities
36
 
Liquidity and Capital Resources
37
 
Commitments and Derivative Financial Instruments
38
 
Stockholders’ Equity
38
 
Incentive Plans
39
 
Supplemental Information
43
       
 ITEM 3  -  
Quantitative and Qualitative Disclosures about Market Risk
43
       
 ITEM 4  -  
Controls and Procedures
44
       
PART II  -  
OTHER INFORMATION
  
       
 ITEM 1  -  
Legal Proceedings
45
 ITEM 1A  
Risk Factors
45
 ITEM 2  -  
Unregistered Sales of Equity Securities and Use of Proceeds
49
 ITEM 3  -  
Defaults Upon Senior Securities
49
 ITEM 4  -  
Submission of Matters to a Vote of Security Holders
49
 ITEM 5  -  
Other Information
50
 ITEM 6  -  
Exhibits
50
       
SIGNATURES
52
   



 
 
 

PROVIDENT FINANCIAL HOLDINGS, INC.
Condensed Consolidated Statements of Financial Condition
(Unaudited)
Dollars in Thousands

   
December 31,
    
June 30,
  
   
2008
    
2008
  
Assets
            
     Cash and due from banks
  $ 17,514     $ 12,614  
     Federal funds sold
    -       2,500  
                Cash and cash equivalents
    17,514       15,114  
                 
     Investment securities – available for sale, at fair value
    144,931       153,102  
     Loans held for investment, net of allowance for loan losses of
                
          $34,953 and $19,898, respectively
    1,265,404       1,368,137  
     Loans held for sale, at lower of cost or market
    46,447       28,461  
     Accrued interest receivable
    6,712       7,273  
     Real estate owned, net
    11,115       9,355  
     Federal Home Loan Bank (“FHLB”) – San Francisco stock
    32,929       32,125  
     Premises and equipment, net
     6,687       6,513  
     Prepaid expenses and other assets
     19,409       12,367  
                 
               Total assets
   $ 1,551,148     $ 1,632,447  
                 
Liabilities and Stockholders’ Equity
                
Liabilities:
                
     Non interest-bearing deposits
   $ 40,297     $ 48,056  
     Interest-bearing deposits
     894,527       964,354  
               Total deposits
     934,824       1,012,410  
                 
     Borrowings
     480,714       479,335  
     Accounts payable, accrued interest and other liabilities
     17,756       16,722  
               Total liabilities
     1,433,294       1,508,467  
                 
Commitments and Contingencies
                
                 
Stockholders’ equity:
                
     Preferred stock, $.01 par value (2,000,000 shares authorized;
          none issued and outstanding)
                
    -       -  
     Common stock, $.01 par value (15,000,000 shares authorized;
          12,435,865 and 12,435,865 shares issued, respectively;
          6,208,519 and 6,207,719 shares outstanding, respectively)
                
               
    124       124  
     Additional paid-in capital
     74,943       75,164  
     Retained earnings
     136,251       143,053  
     Treasury stock at cost (6,227,346 and 6,228,146 shares,
          respectively)
                
    (93,930 )     (94,798 )
     Unearned stock compensation
     -       (102 )
     Accumulated other comprehensive income, net of tax
     466       539  
                 
               Total stockholders’ equity
     117,854       123,980  
                 
               Total liabilities and stockholders’ equity
   $ 1,551,148     $ 1,632,447  

The accompanying notes are an integral part of these condensed consolidated financial statements.

 
1
 


PROVIDENT FINANCIAL HOLDINGS, INC.
Condensed Consolidated Statements of Operations
(Unaudited)
In Thousands, Except Per Share Information
 
  
   
Quarter Ended
December 31,
    
Six Months Ended
December 31,
  
 
   
2008
    
2007
    
2008
    
2007
  
Interest income:
                        
     Loans receivable, net
  $ 19,648     $ 21,700     $ 40,306     $ 43,214  
     Investment securities
    1,804       1,902       3,709       3,646  
     FHLB – San Francisco stock
    (125 )     432       324       901  
     Interest-earning deposits
    9       5       10       14  
     Total interest income
    21,336       24,039       44,349       47,775  
                                 
Interest expense:
                                
     Checking and money market deposits
    302       499       632       924  
     Savings deposits
    535       804       1,104       1,591  
     Time deposits
    5,441       7,888       11,568       15,946  
     Borrowings
    4,817       5,280       9,511       10,373  
     Total interest expense
     11,095       14,471       22,815       28,834  
                                 
Net interest income, before provision for loan losses
    10,241       9,568       21,534       18,941  
Provision for loan losses
    16,536       2,140       22,268       3,659  
Net interest (expense) income, after provision for
    loan losses
    (6,295 )     7,428       (734 )     15,282  
                                 
Non-interest income:
                                
     Loan servicing and other fees
     266       513       514       1,004  
     Gain on sale of loans, net
     1,394       934       2,585       1,056  
     Deposit account fees
    777       785       1,535       1,443  
     Gain on sale of investment securities
    -       -       356       -  
     Loss on sale and operations of real estate owned
       acquired in the settlement of loans
    (496 )     (704 )     (886 )     (1,008 )
     Other
     383       419       696       827  
     Total non-interest income
     2,324       1,947       4,800       3,322  
                                 
Non-interest expense:
                                
     Salaries and employee benefits
     4,525       4,522       9,150       9,646  
     Premises and occupancy
     718       831       1,434       1,538  
     Equipment
     397       391       757       791  
     Professional expenses
     332       474       692       793  
     Sales and marketing expenses
     119       130       300       303  
     Deposit insurance premiums and regulatory
       assessments
    288       115       610       230  
     Other
     860       857       1,660       1,787  
     Total non-interest expense
     7,239       7,320       14,603       15,088  
                                 
(Loss) income before income taxes
     (11,210 )     2,055       (10,537 )     3,516  
(Benefit) provision for income taxes
     (4,699 )     1,011       (4,355 )     1,860  
     Net (loss) income
   $ (6,511 )   $ 1,044     $ (6,182 )   $ 1,656  
                                 
Basic (loss) earnings per share
  $ (1.05 )   $ 0.17     $ (1.00 )   $ 0.27  
Diluted (loss) earnings per share
  $ (1.05 )   $ 0.17     $ (1.00 )   $ 0.27  
Cash dividends per share
  $ 0.05     $ 0.18     $ 0.10     $ 0.36  

The accompanying notes are an integral part of these condensed consolidated financial statements.

 
2
 

PROVIDENT FINANCIAL HOLDINGS, INC.
Condensed Consolidated Statements of Stockholders' Equity
(Unaudited)
Dollars in Thousands
For the Quarters Ended December 31, 2008 and 2007

 
 
 
Common
Stock
 
 
Additional Paid-In
 
 
 
Retained
 
 
 
Treasury
 
 
Unearned
Stock
Accumulated
Other
Comprehensive
Income (Loss),
  
 
Shares
  
Amount
Capital
Earnings
Stock
Compensation
Net of Tax
Total
Balance at October 1, 2008
6,208,519
  
$ 124
$ 74,635
  
$ 143,072
  
$ (93,930
)
$ (22
)
$ 622
  
$ 124,501
  
                               
Comprehensive loss:
                              
   Net loss
         
(6,511
)
            
(6,511
)
   Unrealized holding loss on
      securities available for sale,
                              
      net of tax benefit of $113
                     
(156
)
(156
)
Total comprehensive loss
                         
(6,667
)
                               
Amortization of restricted stock
     
113
                  
113
  
Stock options expense
     
186
                  
186
  
Allocations of contribution to ESOP (1)
      
9
          
22
      
31
  
Cash dividends
         
(310
)
            
(310
)
                               
Balance at December 31, 2008
6,208,519
  
$ 124
$ 74,943
  
$ 136,251
  
$ (93,930
)
$     -
  
$ 466
  
$ 117,854
  

(1)  
Employee Stock Ownership Plan (“ESOP”).


 
 
 
Common
Stock
 
 
Additional Paid-In
 
 
 
Retained
 
 
 
Treasury
 
 
Unearned
Stock
Accumulated
Other
Comprehensive
Income,
  
 
Shares
  
Amount
Capital
Earnings
Stock
Compensation
Net of Tax
Total
Balance at October 1, 2007
6,232,803
  
$ 124
$ 73,627
  
$ 145,659
  
$ (94,097
)
$ (358
)
$ 1,017
  
$ 125,972
  
                               
Comprehensive income:
                              
   Net income
         
1,044
              
1,044
  
   Unrealized holding gain on
      securities available for sale,
                              
      net of tax expense of $197
                     
273
  
273
  
Total comprehensive income
                         
1,317
  
                               
Purchase of treasury stock
(36,369
)
          
(700
)
        
(700
)
Amortization of restricted stock
     
63
                  
63
  
Stock options expense
     
136
                  
136
  
Allocations of contribution to ESOP
     
354
          
97
      
451
  
Cash dividends
         
(1,116
)
            
(1,116
)
                               
Balance at December 31, 2007
6,196,434
  
$ 124
$ 74,180
  
$ 145,587
  
$ (94,797
)
$ (261
)
$ 1,290
  
$ 126,123
  


                The accompanying notes are an integral part of these condensed consolidated financial statements.

 
3
 


PROVIDENT FINANCIAL HOLDINGS, INC.
Condensed Consolidated Statements of Changes in Stockholders' Equity
(Unaudited)
Dollars in Thousands
For the Six Months Ended December 31, 2008 and 2007

 
 
 
Common
Stock
 
 
Additional Paid-In
 
 
 
Retained
 
 
 
Treasury
 
 
Unearned
Stock
Accumulated
Other
Comprehensive
Income (Loss),
  
 
Shares
  
Amount
Capital
Earnings
Stock
Compensation
Net of Tax
Total
Balance at July 1, 2008
6,207,719
  
$ 124
$ 75,164
  
$ 143,053
  
$ (94,798
)
$ ( 102
)
$ 539
  
$ 123,980
  
                               
Comprehensive loss:
                              
   Net loss
          
(6,182
)
            
(6,182
)
   Unrealized holding loss on
      securities available for sale,
                              
      net of tax benefit of $53
                     
(73
)
(73
)
Total comprehensive loss
                          
(6,255
)
                               
Distribution of restricted stock
800
                        
-
  
Amortization of restricted stock
     
208
                  
208
  
Awards of restricted stock
     
(868
)
    
868
          
-
  
Stock options expense
     
369
                  
369
  
Allocations of contribution to ESOP
      
70
          
102
      
172
  
Cash dividends
         
(620
)
            
(620
)
                               
Balance at December 31, 2008
6,208,519
  
$ 124
$ 74,943
  
$ 136,251
  
$ (93,930
)
$       -
  
$ 466
  
$ 117,854
  



 
 
 
Common
Stock
 
 
Additional Paid-In
 
 
 
Retained
 
 
 
Treasury
 
 
Unearned
Stock
Accumulated
Other
Comprehensive
 Income,
  
 
Shares
  
Amount
Capital
Earnings
Stock
Compensation
Net of Tax
Total
Balance at July 1, 2007
6,376,945
  
$ 124
$ 72,935
  
$ 146,194
  
$ (90,694
)
$ ( 455
)
$   693
  
$ 128,797
  
                               
Comprehensive income:
                              
   Net income
          
1,656
              
1,656
  
   Unrealized holding gain on
      securities available for sale,
                              
      net of tax expense of $432
                     
597
  
597
  
Total comprehensive income
                          
2,253
  
                               
Purchase of treasury stock (1)
(188,011
)
          
(4,096
)
        
(4,096
)
Exercise of stock options
7,500
  
-
69
                  
69
  
Amortization of restricted stock
     
131
                  
131
  
Awards of restricted stock
     
(45
)
    
45
          
-
  
Forfeiture of restricted stock
     
52
      
(52
)
        
-
  
Stock options expense
     
276
                  
276
  
Tax benefit from non-qualified
                              
  equity compensation
     
6
                  
6
  
Allocations of contribution to ESOP
     
756
          
194
      
950
  
Cash dividends
         
(2,263
)
            
(2,263
)
                               
Balance at December 31, 2007
6,196,434
  
$ 124
$ 74,180
  
$ 145,587
  
$ (94,797
)
$ (261
)
$ 1,290
  
$ 126,123
  

(1)  
Includes the repurchase of 930 shares of distributed restricted stock.

                The accompanying notes are an integral part of these condensed consolidated financial statements.

 
4
 

PROVIDENT FINANCIAL HOLDINGS, INC.
Condensed Consolidated Statements of Cash Flows
(Unaudited - In Thousands)
 
Six Months Ended
December 31,
  
 
 
2008
    
2007
  
Cash flows from operating activities:
          
   Net (loss) income
$     (6,182
)
  
$     1,656
  
   Adjustments to reconcile net (loss) income to net cash (used for) provided by
          
    operating activities:
          
       Depreciation and amortization
1,037
    
1,148
  
       Provision for loan losses
22,268
    
3,659
  
       Provision for losses on real estate owned
422
    
463
  
       Gain on sale of loans
(2,585
)
  
(1,056
)
       Net gain on sale of investment securities
(356
)
  
-
  
       Net (gain) loss on sale of real estate owned
(439
)
  
168
  
       Stock-based compensation
722
    
1,282
  
       FHLB – San Francisco stock dividend
(804
)
  
(1,023
)
   Tax benefit from non-qualified equity compensation
-
    
(6
)
   Decrease in accounts payable and other liabilities
(520
)
  
(2,876
)
   (Increase) decrease in prepaid expense and other assets
(6,063
)
  
2,465
  
   Loans originated for sale
(334,660
)
  
(197,912
)
   Proceeds from sale of loans and net change in receivable from sale of loans
320,071
    
240,317
  
Net cash (used for) provided by operating activities
(7,089
)
  
48,285
  
           
Cash flows from investing activities:
          
   Net decrease (increase) in loans held for investment
60,763
    
(53,766
)
   Maturity and call of investment securities held to maturity
-
    
14,000
  
   Maturity and call of investment securities available for sale
65
    
2,129
  
   Principal payments from mortgage-backed securities
15,860
    
23,382
  
   Purchase of investment securities available for sale
(8,135
)
  
(41,172
)
      Proceeds from sale of investment securities available for sale
480
    
-
  
      Purchase of FHLB – San Francisco stock
-
    
(39
)
      Redemption of FHLB – San Francisco stock
-
    
13,638
  
      Proceeds from sale of real estate owned
17,937
    
3,709
  
   Purchase of premises and equipment
(662
)
  
(144
)
Net cash provided by (used for) investing activities
86,308
    
(38,263
)
           
Cash flows from financing activities:
          
   Net (decrease) increase in deposits
(77,586
)
  
4,287
  
   (Repayments of) proceeds from short-term borrowings, net
(98,600
)
  
56,630
  
   Proceeds from long-term borrowings
115,000
    
20,000
  
   Repayments of long-term borrowings
(15,021
)
  
(85,020
)
   ESOP loan payment
8
    
52
  
   Exercise of stock options
-
    
69
  
   Tax benefit from non-qualified equity compensation
-
    
6
  
   Cash dividends
(620
)
  
(2,263
)
   Treasury stock purchases
-
    
(4,096
)
Net cash used for financing activities
(76,819
)
  
(10,335
)
           
Net increase (decrease) in cash and cash equivalents
2,400
    
(313)
  
Cash and cash equivalents at beginning of period
15,114
    
12,824
  
           
Cash and cash equivalents at end of period
$    17,514
    
$   12,511
  
Supplemental information:
          
  Cash paid for interest
$ 22,380
    
$ 29,250
  
  Cash paid for income taxes
$   2,489
    
$      100
  
  Transfer of loans held for sale to loans held for investment
$      707
    
$   8,467
  
  Real estate acquired in the settlement of loans
$ 26,151
    
$   8,393
  

The accompanying notes are an integral part of these condensed consolidated financial statements.

 
5
 


PROVIDENT FINANCIAL HOLDINGS, INC.
NOTES TO UNAUDITED INTERIM CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

December 31, 2008


Note 1: Basis of Presentation

The unaudited interim condensed consolidated financial statements included herein reflect all adjustments which are, in the opinion of management, necessary to present a fair statement of the results of operations for the interim periods presented.  All such adjustments are of a normal, recurring nature.  The condensed consolidated financial statements at June 30, 2008 are derived from the audited consolidated financial statements of Provident Financial Holdings, Inc. and its wholly owned subsidiary, Provident Savings Bank, F.S.B. (the “Bank”) (collectively, the “Corporation”).  Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) with respect to interim financial reporting.  It is recommended that these unaudited interim condensed consolidated financial statements be read in conjunction with the audited consolidated financial statements and notes thereto included in the Corporation’s Annual Report on Form 10-K for the year ended June 30, 2008.  Certain amounts in the prior periods’ financial statements have been reclassified to conform to the current period’s presentation.  The results of operations for the quarter and six months ended December 31, 2008 are not necessarily indicative of results that may be expected for the entire fiscal year ending June 30, 2009.


Note 2: Recent Accounting Pronouncements

Financial Accounting Standards Board (“FASB”) Staff Position (“FSP”) 133-1 and FASB Interpretation (“FIN”) 45-4:
In September 2008, the FASB issued FSP No. 133-1 and FIN 45-4, “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161.”  The FSP is intended to improve disclosures about credit derivatives by requiring more information about the potential adverse effects of changes in credit risk on the financial position, financial performance, and cash flows of the sellers of credit derivatives.  It amends SFAS No. 133 to require disclosures by sellers of credit derivatives, including credit derivatives embedded in hybrid instruments.  The FSP also amends FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others,” to require an additional disclosure about the current status of the payment/performance risk of a guarantee.  Finally, the FSP clarifies the Board’s intent about the effective date of SFAS No. 161.  Accordingly, the FSP clarifies that the disclosures required by SFAS No. 161 will be incorporated upon adoption of SFAS No. 161 on July 1, 2009.  The adoption of this FSP did not have material impact on the Corporation’s consolidated financial statements.

Statement of Financial Accounting Standards (“SFAS” or “Statement”) No. 162:
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles.”  The FASB believes the Generally Accepted Accounting Principal (“GAAP”) hierarchy should be directed to entities because it is the entity (not its auditor) that is responsible for selecting accounting principles for financial statements that are presented in conformity with GAAP.  Accordingly, the FASB concluded that the GAAP hierarchy should reside in the accounting literature established by the FASB and is issuing this Statement to achieve that result.  The adoption of this Statement did not have a material impact on our consolidated financial statements.

 
6
 
Note 3: Earnings (Loss) Per Share and Stock-Based Compensation

Earnings (Loss) Per Share:
Basic earnings per share (“EPS”) excludes dilution and is computed by dividing income or loss available to common shareholders by the weighted-average number of shares outstanding for the period.  Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that would then share in the earnings of the entity.  As of December 31, 2008 and 2007, there were outstanding options to purchase 907,700 shares and 734,700 shares of the Corporation common stock, respectively, of which 907,700 shares and 597,000 shares, respectively, were excluded from the diluted EPS computation as their effect was anti-dilutive.

The following table provides the basic and diluted EPS computations for the quarters and six months ended December 31, 2008 and 2007, respectively.

             
 
(In Thousands, Except Earnings (Loss) Per Share)
  
For the Quarter
Ended
December 31,
    
For the Six Months
Ended
December 31,
  
   
2008
    
2007
    
2008
    
2007
  
Numerator:
                        
     Net (loss) income – numerator for basic (loss)
        earnings per share and diluted (loss) earnings
        per share - available to common stockholders
   $ (6,511 )   $ 1,044     $ (6,182 )   $ 1,656  
                                 
Denominator:
                                
     Denominator for basic (loss) earnings per share:
         Weighted-average shares
                               
    6,204       6,134       6,195       6,187  
                                 
     Effect of dilutive securities:
                                
         Stock option dilution
    -       64       -       57  
         Restricted stock dilution
    -       -       -       1  
                                 
     Denominator for diluted (loss) earnings per share:
                                
         Adjusted weighted-average shares
         and assumed conversions
    6,204       6,198       6,195       6,245  
                                 
Basic (loss) earnings per share
  $ (1.05 )   $ 0.17     $ (1.00 )   $ 0.27  
Diluted (loss) earnings per share
  $ (1.05 )   $ 0.17     $ (1.00 )   $ 0.27  

SFAS No. 123R, “Share-Based Payment,” requires companies to recognize in the statement of operations the grant-date fair value of stock options and other equity-based compensation issued to employees and directors.  Effective July 1, 2005, the Corporation adopted SFAS No. 123R using the modified prospective method under which the provisions of SFAS No. 123R are applied to new awards and to awards modified, repurchased or cancelled after June 30, 2005 and to awards outstanding on June 30, 2005 for which requisite service has not yet been rendered.

The adoption of SFAS No. 123R resulted in incremental stock-based compensation expense and is solely related to issued and unvested stock option grants.  The incremental stock-based compensation expense for the quarters ended December 31, 2008 and 2007 was $186,000 and $136,000, respectively.  For the six months ended December 31, 2008 and 2007, the incremental stock-based compensation expense was $369,000 and $276,000, respectively.  For the first six months of fiscal 2009 and 2008, cash provided by operating activities decreased by $0 and $6,000, respectively, and cash provided by financing activities increased by an identical amount, respectively, related to excess tax benefits from stock-based payment arrangements.  These amounts are reflective of the tax benefit for stock options exercised and restricted stock distributions during the respective periods.
 
 
7
Note 4: Operating Segment Reports

The Corporation operates in two business segments: community banking through the Bank and mortgage banking through Provident Bank Mortgage (“PBM”), a division of the Bank.

The following tables set forth condensed statements of operations and total assets for the Corporation’s operating segments for the quarters ended December 31, 2008 and 2007, respectively (in thousands).

 
For the Quarter Ended December 31, 2008
   
Provident
  
 
Provident
Bank
Consolidated
 
Bank
Mortgage
Totals
             
Net interest income, before provision for loan
   losses
 
$ 10,195
  
 
$        46
  
 
$  10,241
  
Provision for loan losses
15,331
  
1,205
  
16,536
  
Net interest expense, after provision for
  loan losses
 
(5,136
 
)
 
(1,159
 
)
 
(6,295
 
)
             
Non-interest income:
            
     Loan servicing and other fees
238
  
28
  
266
  
     Gain on sale of loans, net
4
  
1,390
  
1,394
  
     Deposit account fees
777
  
-
  
777
  
     Loss on sale and operations of real estate owned
        acquired in the settlement of loans, net
 
(307
 
)
 
(189
 
)
 
(496
 
)
     Other
381
  
2
  
383
  
          Total non-interest income
1,093
  
1,231
  
2,324
  
             
Non-interest expense:
            
     Salaries and employee benefits
3,276
  
1,249
  
4,525
  
     Premises and occupancy
593
  
125
  
718
  
     Operating and administrative expenses
1,180
  
816
  
1,996
  
          Total non-interest expense
5,049
  
2,190
  
7,239
  
Loss before taxes
(9,092
)
(2,118
)
(11,210
)
Benefit for income taxes
(3,808
)
(891
)
(4,699
)
Net loss
$ (5,284
)
$  (1,227
)
$  (6,511
)
Total assets, end of period
$ 1,502,099
  
$ 49,049
  
$ 1,551,148
  


 
8
 



 
For the Quarter Ended December 31, 2007
   
Provident
  
 
Provident
Bank
Consolidated
 
Bank
Mortgage
Totals
             
Net interest income (expense), before provision for
   loan losses
 
$ 9,722
  
 
$    (154
 
)
 
$ 9,568
  
Provision for loan losses
1,098
  
1,042
  
2,140
  
Net interest income (expense), after provision for
  loan losses
 
8,624
  
 
(1,196
 
)
 
7,428
  
             
Non-interest income:
            
     Loan servicing and other fees (1)
63
  
450
  
513
  
     Gain on sale of loans, net
10
  
924
  
934
  
     Deposit account fees
785
  
-
  
785
  
     Loss on sale and operations of real estate owned
        acquired in the settlement of loans, net
 
(204
 
)
 
(500
 
)
 
(704
 
)
     Other
419
  
-
  
419
  
          Total non-interest income
1,073
  
874
  
1,947
  
             
Non-interest expense:
            
     Salaries and employee benefits
3,321
  
1,201
  
4,522
  
     Premises and occupancy
491
  
340
  
831
  
     Operating and administrative expenses
926
  
1,041
  
1,967
  
          Total non-interest expense
4,738
  
2,582
  
7,320
  
Income (loss) before taxes
4,959
  
(2,904
)
2,055
  
Provision (benefit) for income taxes
2,386
  
(1,375
)
1,011
  
Net income (loss)
$ 2,573
  
$ (1,529
)
$ 1,044
  
Total assets, end of period
$ 1,619,102
  
$ 21,389
  
$ 1,640,491
  

(1)  
Includes an inter-company charge of $352 credited to PBM by the Bank during the period to compensate PBM for originating loans held for investment.

 
9
 


The following tables set forth condensed statements of operations and total assets for the Corporation’s operating segments for the six months ended December 31, 2008 and 2007, respectively (in thousands).

 
For the Six Months Ended December 31, 2008
   
Provident
  
 
Provident
Bank
Consolidated
 
Bank
Mortgage
Totals
             
Net interest income, before provision for loan
  losses
 
$ 21,377
  
 
$      157
  
 
$  21,534
  
Provision for loan losses
20,209
  
2,059
  
22,268
  
Net interest income (expense), after provision for
  loan losses
 
1,168
  
 
(1,902
 
)
 
(734
 
)
             
Non-interest income:
            
     Loan servicing and other fees (1)
343
  
171
  
514
  
     Gain on sale of loans, net
7
  
2,578
  
2,585
  
     Deposit account fees
1,535
  
-
  
1,535
  
     Gain on sale of investment securities
356
  
-
  
356
  
     Loss on sale and operations of real estate owned
        acquired in the settlement of loans, net
 
(620
 
)
 
(266
 
)
 
(886
 
)
     Other
693
  
3
  
696
  
          Total non-interest income
2,314
  
2,486
  
4,800
  
             
Non-interest expense:
            
     Salaries and employee benefits
6,666
  
2,484
  
9,150
  
     Premises and occupancy
1,185
  
249
  
1,434
  
     Operating and administrative expenses
2,310
  
1,709
  
4,019
  
          Total non-interest expense
10,161
  
4,442
  
14,603
  
Loss before taxes
(6,679
)
(3,858
)
(10,537
)
Benefit for income taxes
(2,733
)
(1,622
)
(4,355
)
Net loss
$ (3,946
)
$ (2,236
)
$  (6,182
)
Total assets, end of period
$ 1,502,099
  
$ 49,049
  
$ 1,551,148
  

(1)  
Includes an inter-company charge of $102 credited to PBM by the Bank during the period to compensate PBM for originating loans held for investment.


 
10
 


 
For the Six Months Ended December 31, 2007
   
Provident
  
 
Provident
Bank
Consolidated
 
Bank
Mortgage
Totals
             
Net interest income (expense), before provision for
  loan losses
 
$ 19,106
  
 
$     (165
 
)
 
$ 18,941
  
Provision for loan losses
1,772
  
1,887
  
3,659
  
Net interest income (expense), after provision for
  loan losses
 
17,334
  
 
(2,052
 
)
 
15,282
  
             
Non-interest income:
            
     Loan servicing and other fees (1)
(1
)
1,005
  
1,004
  
     Gain on sale of loans, net
33
  
1,023
  
1,056
  
     Deposit account fees
1,443
  
-
  
1,443
  
     Loss on sale and operations of real estate owned
        acquired in the settlement of loans, net
 
(355
 
)
 
(653
 
)
 
(1,008
 
)
     Other
827
  
-
  
827
  
          Total non-interest income
1,947
  
1,375
  
3,322
  
             
Non-interest expense:
            
     Salaries and employee benefits
6,801
  
2,845
  
9,646
  
     Premises and occupancy
1,041
  
497
  
1,538
  
     Operating and administrative expenses
1,915
  
1,989
  
3,904
  
          Total non-interest expense
9,757
  
5,331
  
15,088
  
Income (loss) before taxes
9,524
  
(6,008
)
3,516
  
Provision (benefit) for income taxes
5,038
  
(3,178
)
1,860
  
Net income (loss)
$   4,486
  
$ (2,830
)
$  1,656
  
Total assets, end of period
$ 1,619,102
  
$ 21,389
  
$ 1,640,491
  

(1)  
Includes an inter-company charge of $695 credited to PBM by the Bank during the period to compensate PBM for originating loans held for investment.


Note 5: Derivative and Other Financial Instruments with Off-Balance Sheet Risks

The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit in the form of originating loans or providing funds under existing lines of credit, and forward loan sale agreements to third parties.  These instruments involve, to varying degrees, elements of credit and interest-rate risk in excess of the amount recognized in the accompanying Condensed Consolidated Statements of Financial Condition.  The Corporation’s exposure to credit loss, in the event of non-performance by the counterparty to these financial instruments, is represented by the contractual amount of these instruments.  The Corporation uses the same credit policies in entering into financial instruments with off-balance sheet risk as it does for on-balance sheet instruments.  As of December 31, 2008 and June 30, 2008, the Corporation had commitments to extend credit (on loans to be held for investment and loans to be held for sale) of $46.2 million and $29.4 million, respectively.  The following table provides information regarding undisbursed funds to borrowers on existing loans and lines of credit with the Bank as well as commitments to originate loans to be held for investment.

 
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December 31,
  
June 30,
Commitments
2008
  
2008
(In Thousands)
      
       
Undisbursed loan funds – Construction loans
$   3,242
  
$   7,864
Undisbursed lines of credit – Mortgage loans
4,344
  
4,880
Undisbursed lines of credit – Commercial business loans
6,349
  
6,833
Undisbursed lines of credit – Consumer loans
1,545
  
1,672
Commitments to extend credit on loans to be held for investment
650
  
6,232
Total
$ 16,130
  
$ 27,481

In accordance with SFAS No. 133 and interpretations of the Derivatives Implementation Group of the FASB, the fair value of the commitments to extend credit on loans to be held for sale, loan sale commitments, commitments to purchase mortgage-backed securities (“MBS”), put option contracts and call option contracts are recorded at fair value on the balance sheet, and are included in other assets or other liabilities.  The Corporation does not apply hedge accounting to its derivative financial instruments; therefore, all changes in fair value are recorded in earnings.  The net impact of derivative financial instruments on the Condensed Consolidated Statements of Operations during the quarters ended December 31, 2008 and 2007 were a gain of $748,000 and a gain of $30,000, respectively.  For the six months ended December 31, 2008 and 2007, the net impact of derivative financial instruments on the Condensed Consolidated Statements of Operations was a gain of $596,000 and a loss of $42,000, respectively.

 
 December 31, 2008
  
 June 30, 2008
  
December 31, 2007
  
     
Fair
      
Fair
      
Fair
  
Derivative Financial Instruments
Amount
  
Value
  
Amount
  
Value
  
Amount
  
Value
  
(In Thousands)
                        
                         
Commitments to extend credit
                        
  on loans to be held for sale (1)
$  45,573
  
$  540
  
$ 23,191
  
$ (304
)
$  9,995
  
$ (29
)
Best-efforts loan sale
   commitments
 
(77,848
 
)
 
-
  
 
(51,652
 
)
 
-
  
 
(9,995
 
)
 
-
  
Mandatory loan sale
   commitments
 
(34,712
 
)
 
(248
 
)
 
-
  
 
-
  
 
-
  
 
-
  
Total
$ (66,987
)
$  292
  
$ (28,461
)
$ (304
)
$         -
  
$ (29
)

(1)  
Net of 41.0 percent at December 31, 2008, 48.0 percent at June 30, 2008 and 57.0 percent at December 31, 2007 of commitments, which may not fund.


Note 6: Income Taxes

FASB Interpretation 48, “Accounting for Uncertainty in Income Taxes,” requires the affirmative evaluation that it is more likely than not, based on the technical merits of a tax position, that an enterprise is entitled to economic benefits resulting from positions taken in income tax returns. If a tax position does not meet the more-likely-than-not recognition threshold, the benefit of that position is not recognized in the financial statements. Management has determined that there are no unrecognized tax benefits to be reported in the Corporation’s financial statements, and none are anticipated during the fiscal year ending June 30, 2009.

SFAS No. 109, “Accounting for Income Taxes,” requires that when determining the need for a valuation allowance against a deferred tax asset, management must assess both positive and negative evidence with regard to the realizability of the tax losses represented by that asset. To the extent available sources of taxable income are insufficient to absorb tax losses, a valuation allowance is necessary. Sources of taxable income for this analysis include prior years’ tax returns, the expected reversals of taxable temporary differences between book and tax income, prudent and feasible tax-planning strategies, and future taxable income.   The Corporation’s tax asset has increased during the first six months of fiscal 2009 due to an increase in its loan loss allowances. The deferred tax asset related to loan loss allowances will be realized
 
12
when actual charge-offs are made against the loan loss allowances. Based on the availability of loss carry-backs and projected taxable income during the periods for which loss carry-forwards are available, management believes that no valuation allowance is necessary at this time.

The Corporation files income tax returns for the United States and state of California jurisdictions.  In September 2008, the Internal Revenue Service (“IRS”) completed its examination of the Corporation’s tax returns for 2006 and 2007. Tax years subsequent to 2007 remain subject to federal examination, while the California state tax returns for years subsequent to 2004 are subject to examination by taxing authorities.  It is the Corporation’s policy to record any penalties or interest arising from federal or state taxes as a component of income tax expense.  There were no penalties or interest included in the Condensed Consolidated Statements of Operations for the quarter and six months ended December 31, 2008.


Note 7: Fair Value of Financial Instruments

The Corporation adopted SFAS No. 157, “Fair Value Measurements,” and SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” on July 1, 2008.  SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements.  SFAS No. 159 permits entities to elect to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis (the Fair Value Option) at specified election dates.  At each subsequent reporting date, an entity is required to report unrealized gains and losses on items in earnings for which the fair value option has been elected at each subsequent reporting date.  The objective of the statement is to provide entities with the opportunity to mitigate volatility in earnings caused by measuring related assets and liabilities differently without having to apply complex accounting provisions.    The Corporation did not elect to measure any financial instruments at fair value under SFAS No. 159.  Under FSP 157-2, portions of SFAS No. 157 have been deferred until years beginning after November 15, 2008 for all nonfinancial assets and nonfinancial liabilities recognized or disclosed at fair value in the financial statement on a recurring basis. Therefore, the Corporation has partially adopted the provisions of SFAS No. 157.

In October 2008, the FASB issued FSP 157-3 – “Determining the Fair Value of a Financial Asset When the Market for that Asset is not Active.”  FSP 157-3 clarifies the application of SFAS No. 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active.

SFAS No. 157 establishes a three-level valuation hierarchy that prioritizes inputs to valuation techniques used in fair value calculations.  The three levels of inputs are defined as follows:

Level 1  
-
Unadjusted quoted prices in active markets for identical assets or liabilities that the Corporation has the ability to access at the measurement date.
 
Level 2  
-
Observable inputs other than Level 1 such as: quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated to observable market data for substantially the full term of the asset or liability.
 
Level 3  
-
Unobservable inputs for the asset or liability that use significant assumptions, including assumptions of risks.  These unobservable assumptions reflect our own estimate of assumptions that market participants would use in pricing the asset or liability.  Valuation techniques include use of pricing models, discounted cash flow models and similar techniques.

SFAS No. 157 requires the Corporation to maximize the use of observable inputs and minimize the use of unobservable inputs.  If a financial instrument uses inputs that fall in different levels of the hierarchy, the instrument will be categorized based upon the lowest level of input that is significant to the fair value calculation.

The Corporation’s financial assets and liabilities measured at fair value on a recurring basis consist of investment securities and derivative financial instruments, while loans held for sale and impaired loans are measured at fair value on a nonrecurring basis.  
 
 
13

Investment securities are primarily comprised of U.S. government sponsored enterprise debt securities, U.S. government agency mortgage-backed securities, U.S. government sponsored enterprise mortgage-backed securities and private issue collateralized mortgage obligations.  The Corporation utilizes unadjusted quoted prices in active markets for identical securities (Level 1) for its fair value measurement of debt securities, quoted prices in active and less than active markets for similar securities (Level 2) for its fair value measurement of mortgage-backed securities and broker price indications for similar securities in non-active markets (Level 3) for its fair value measurement of collateralized mortgage obligations (“CMO”).

Derivative financial instruments are comprised of commitments to extend credit on loans to be held for sale and mandatory loan sale commitments.  The fair value is determined, when possible, using quoted secondary-market prices.  If no such quoted price exists, the fair value of a commitment is determined by quoted prices for a similar commitment or commitments, adjusted for the specific attributes of each commitment.

Loans held for sale are primarily single-family loans.  The fair value is determined, when possible, using quoted secondary-market prices.  If no such quoted price exists, the fair value of a loan is determined by quoted prices for a similar loan or loans, adjusted for the specific attributes of each loan.

Impaired loans are loans which are inadequately protected by the current net worth and paying capacity of the borrowers or of the collateral pledged.  The impaired loans are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.  The fair value of an impaired loan is determined based on an observable market price or current appraised value of the underlying collateral.   Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the borrower.  Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above.  This loss is not recorded directly as an adjustment to current earnings or comprehensive income, but rather as a component in determining the overall adequacy of the allowance for losses on loans.  These adjustments to the estimated fair value of impaired loans may result in increases or decreases to the provision for losses on loans recorded in current earnings.

The Corporation’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values.  While management believes the Corporation’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

The following fair value hierarchy table presents information about the Corporation’s assets measured at fair value on a recurring basis:

 
Fair Value Measurement at December 31, 2008 Using:
(Dollars in Thousands)
Level 1
Level 2
  
Level 3
  
Total
  
Investment securities
$ 5,377
$ 137,798
  
$ 1,756
  
$ 144,931
  
Derivative financial instruments
-
-
  
292
  
292
  
Total
$ 5,377
$ 137,798
  
$ 2,048
  
$ 145,223
  


 
14
 


The following is a reconciliation of the beginning and ending balances of recurring fair value measurements recognized in the accompanying condensed consolidated statement of financial condition using Level 3 inputs:

 
Fair Value Measurement
Using Significant Other Unobservable Inputs
(Level 3)
 
 
(Dollars in Thousands)
 
 
CMO
  
Derivative
Financial
Instruments
  
 
 
Total
  
Beginning balance at October 1, 2008
$ 2,003
  
$ (456
)
$ 1,547
  
 
Total gains or losses (realized/unrealized):
            
 
Included in earnings (or changes in net assets)
-
  
456
  
456
  
 
Included in other comprehensive income
(176
)
-
  
(176
)
 
Purchases, issuances, and settlements
(71
)
292
  
221
  
 
Transfers in and/or out of Level 3
-
  
-
  
-
  
Ending balance at December 31, 2008
$ 1,756
  
$  292
  
$ 2,048
  

 
Fair Value Measurement
Using Significant Other Unobservable Inputs
(Level 3)
 
 
(Dollars in Thousands)
 
 
CMO
  
Derivative
Financial
Instruments
  
 
 
Total
  
Beginning balance at July 1, 2008
$ 2,225
  
$ (304
)
$ 1,921
  
 
Total gains or losses (realized/unrealized):
            
 
Included in earnings (or changes in net assets)
-
  
760
  
760
  
 
Included in other comprehensive income
(176
)
-
  
(176
)
 
Purchases, issuances, and settlements
(293
)
(164
)
(457
)
 
Transfers in and/or out of Level 3
-
  
-
  
-
  
Ending balance at December 31, 2008
$ 1,756
  
$  292
  
$ 2,048
  

The following fair value hierarchy table presents information about the Corporation’s assets measured at fair value on a nonrecurring basis:

 
Fair Value Measurement at December 31, 2008 Using:
(Dollars in Thousands)
Level 1
  
Level 2
  
Level 3
  
Total
  
Loans held for sale
$ -
  
$ 487
  
$           -
  
$      487
  
Impaired loans (1)
-
  
-
  
45,733
  
45,733
  
Total
$ -
  
$ 487
  
$ 45,733
  
$ 46,220
  

(1) The fair value of the impaired loans are derived from their respective collateral values.


Note 8: Subsequent Events

On January 20, 2009, the Corporation announced a cash dividend of $0.03 per share on the Corporation’s outstanding shares of common stock for shareholders of record as of the close of business on February 10, 2009, payable on March 6, 2009.


ITEM 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations

General

Provident Financial Holdings, Inc., a Delaware corporation, was organized in January 1996 for the purpose of becoming the holding company of Provident Savings Bank, F.S.B. upon the Bank’s conversion from a
 
 
15
federal mutual to a federal stock savings bank (“Conversion”).  The Conversion was completed on June 27, 1996.  At December 31, 2008, the Corporation had total assets of $1.55 billion, total deposits of $934.8 million and total stockholders’ equity of $117.9 million.  The Corporation has not engaged in any significant activity other than holding the stock of the Bank.  Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank and its subsidiaries.

The Bank, founded in 1956, is a federally chartered stock savings bank headquartered in Riverside, California.  The Bank is regulated by the Office of Thrift Supervision (“OTS”), its primary federal regulator, and the Federal Deposit Insurance Corporation (“FDIC”), the insurer of its deposits.  The Bank’s deposits are federally insured up to applicable limits by the FDIC.  The Bank has been a member of the Federal Home Loan Bank System since 1956.

The Bank’s business consists of community banking activities and mortgage banking activities.  Community banking activities primarily consist of accepting deposits from customers within the communities surrounding the Bank’s full service offices and investing those funds in single-family loans, multi-family loans, commercial real estate loans, construction loans, commercial business loans, consumer loans and other real estate loans.  The Bank also offers business checking accounts, other business banking services, and services loans for others.  Mortgage banking activities consist of the origination and sale of mortgage and consumer loans secured primarily by single-family residences.  The Bank currently operates 14 retail/business banking offices in Riverside County and San Bernardino County (commonly known as the Inland Empire), including the newly opened Iris Plaza office in Moreno Valley, California.  Provident Bank Mortgage operates wholesale loan production offices in Pleasanton and Rancho Cucamonga, California and retail loan production offices in Glendora and Riverside, California.  The Bank’s revenues are derived principally from interest on its loans and investment securities and fees generated through its community banking and mortgage banking activities.  There are various risks inherent in the Bank’s business including, among others, the general business environment, interest rates, the California real estate market, the demand for loans, the prepayment of loans, the repurchase of loans previously sold to investors, competitive conditions between banks and non-bank financial services providers, legislative and regulatory changes, fraud and other risks.

The Corporation, from time to time, may repurchase its common stock.  The Corporation evaluates the repurchase of its common stock when the market price of the stock is lower than its book value and/or the Corporation believes that the current market price is not commensurate with its current and future earnings potential.  Consideration is also given to the Corporation’s liquidity, regulatory capital requirements and future capital needs based on the Corporation’s current business plan.  The Corporation’s Board of Directors authorizes each stock repurchase program, the duration of which is typically one year.  Once the stock repurchase program is authorized, management may repurchase the Corporation’s common stock from time to time in the open market or in privately negotiated transactions, depending upon market conditions and the factors described above.  On June 26, 2008, the Corporation announced that its Board of Directors authorized the repurchase of up to five percent of its outstanding common stock, or approximately 310,385 shares, over a one-year period.  As a result of current economic conditions, the Corporation did not repurchase any of its shares during the quarter ended December 31, 2008.  See Part II, Item 2 – “Unregistered Sales of Equity Securities and Use of Proceeds” on page 49.

The Corporation began to distribute quarterly cash dividends in the quarter ended September 30, 2002.  On October 30, 2008, the Corporation declared a quarterly cash dividend of $0.05 per share for the Corporation’s shareholders of record at the close of business on November 21, 2008, which was paid on December 16, 2008.  On January 20, 2009, the Corporation declared a cash dividend of $0.03 per share on the Corporation’s outstanding shares of common stock for shareholders of record as of the close of business on February 10, 2009, payable on March 6, 2009.  Future declarations or payments of dividends will be subject to the consideration of the Corporation’s Board of Directors, which will take into account the Corporation’s financial condition, results of operations, tax considerations, capital requirements, industry standards, legal restrictions, economic conditions and other factors, including the regulatory restrictions which affect the payment of dividends by the Bank to the Corporation.  Under Delaware law, dividends may be paid either out of surplus or, if there is no surplus, out of net profits for the current fiscal year and/or the preceding fiscal year in which the dividend is declared.

Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding the financial condition and results of operations of the Corporation.  The
 
 
16
information contained in this section should be read in conjunction with the Unaudited Interim Condensed Consolidated Financial Statements and accompanying selected Notes to Unaudited Interim Condensed Consolidated Financial Statements.


Safe-Harbor Statement

This Form 10-Q contains statements that the Corporation believes are “forward-looking statements.”  These statements relate to the Corporation’s financial condition, results of operations, plans, objectives, future performance or business.  You should not place undue reliance on these statements, as they are subject to risks and uncertainties.  When considering these forward-looking statements, you should keep in mind these risks and uncertainties, as well as any cautionary statements the Corporation may make.  Moreover, you should treat these statements as speaking only as of the date they are made and based only on information then actually known to the Corporation.  There are a number of important factors that could cause future results to differ materially from historical performance and these forward-looking statements.  Factors which could cause actual results to differ materially include, but are not limited to, the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs; changes in general economic conditions, either nationally or in our market areas; changes in the levels of general interest rates, deposit interest rates, our net interest margin and funding sources; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; results of examinations of us by the Office of Thrift Supervision, Federal Deposit Insurance Corporation or other regulatory authorities, including the possibility that any such regulatory authority may, among other things, require us to increase our reserve for loan losses or to write-down assets;  our ability to control operating costs and expenses;  our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we have acquired or may in the future acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto; our ability to manage loan delinquency rates; our ability to retain key members of our senior management team; costs and effects of litigation, including settlements and judgments; increased competitive pressures among financial services companies; changes in consumer spending, borrowing and savings habits; legislative or regulatory changes that adversely affect our business; adverse changes in the securities markets; inability of key third-party providers to perform their obligations to us; changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board; war or terrorist activities; other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services and other risks detailed in the Corporation’s reports filed with the Securities and Exchange Commission, including its Annual Report on Form 10-K for the fiscal year ended June 30, 2008.


Critical Accounting Policies

The discussion and analysis of the Corporation’s financial condition and results of operations are based upon the Corporation’s condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America.  The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities at the date of the financial statements.  Actual results may differ from these estimates under different assumptions or conditions.

Allowance for loan losses involves significant judgment and assumptions by management, which have a material impact on the carrying value of net loans.  Management considers this accounting policy to be a critical accounting policy. The allowance is based on two principles of accounting:  (i) SFAS No. 5, “Accounting for Contingencies,” which requires that losses be accrued when they are probable of occurring and can be estimated; and (ii) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” and SFAS No. 118, “Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures,” which require that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.  The allowance has two components: a formula allowance for groups of homogeneous loans and a specific valuation allowance for identified problem loans.  Each of these components is based upon estimates that
 
 
17
 
can change over time.  The formula allowance is based primarily on historical experience and as a result can differ from actual losses incurred in the future.  The history is reviewed at least quarterly and adjustments are made as needed.  Various techniques are used to arrive at specific loss estimates, including historical loss information, discounted cash flows and the fair market value of collateral.  The use of these techniques is inherently subjective and the actual losses could be greater or less than the estimates.

Interest is not accrued on any loan when its contractual payments are more than 90 days delinquent or if the loan is deemed impaired.  In addition, interest is not recognized on any loan where management has determined that collection is not reasonably assured.  A non-accrual loan may be restored to accrual status when delinquent principal and interest payments are brought current and future monthly principal and interest payments are expected to be collected.

SFAS No. 133, “Accounting for Derivative Financial Instruments and Hedging Activities,” requires that derivatives of the Corporation be recorded in the consolidated financial statements at fair value.  Management considers this accounting policy to be a critical accounting policy.  The Bank’s derivatives are primarily the result of its mortgage banking activities in the form of commitments to extend credit, commitments to sell loans, commitments to purchase MBS and option contracts to mitigate the risk of the commitments to extend credit.  Estimates of the percentage of commitments to extend credit on loans to be held for sale that may not fund are based upon historical data and current market trends.  The fair value adjustments of the derivatives are recorded in the consolidated statements of operations with offsets to other assets or other liabilities in the consolidated statements of financial condition.

Management accounts for income taxes by estimating future tax effects of temporary differences between the tax and book basis of assets and liabilities considering the provisions of enacted tax laws.  These differences result in deferred tax assets and liabilities, which are included in the Corporation’s Condensed Consolidated Statements of Financial Condition.  Management’s judgment is required in determining the amount and timing of recognition of the resulting deferred tax assets and liabilities, including projections of future taxable income.  Therefore, management considers its accounting for income taxes a critical accounting policy.


Executive Summary and Operating Strategy

Provident Savings Bank, F.S.B., established in 1956, is a financial services company committed to serving consumers and small to mid-sized businesses in the Inland Empire region of Southern California.  The Bank conducts its business operations as Provident Bank, Provident Bank Mortgage, a division of the Bank, and through its subsidiary, Provident Financial Corp.  The business activities of the Corporation, primarily through the Bank and its subsidiary, consist of community banking, mortgage banking, and to a lesser degree, investment services for customers and trustee services on behalf of the Bank.

Community banking operations primarily consist of accepting deposits from customers within the communities surrounding the Bank’s full service offices and investing those funds in single-family, multi-family, commercial real estate, construction, commercial business, consumer and other loans.  Additionally, certain fees are collected from depositors, such as returned check fees, deposit account service charges, ATM fees, IRA/KEOGH fees, safe deposit box fees, travelers check fees, and wire transfer fees, among others.  The primary source of income in community banking is net interest income, which is the difference between the interest income earned on loans and investment securities, and the interest expense paid on interest-bearing deposits and borrowed funds.  During the next three years, although not immediately given the uncertain environment, the Corporation intends to improve the community banking business by moderately growing total assets; by decreasing the concentration of single-family mortgage loans within loans held for investment; and by increasing the concentration of higher yielding multi-family, commercial real estate, construction and commercial business loans (which are sometimes referred to in this report as “preferred loans”).  In addition, over time, the Corporation intends to decrease the percentage of time deposits in its deposit base and to increase the percentage of lower cost checking and savings accounts.  This strategy is intended to improve core revenue through a higher net interest margin and ultimately, coupled with the growth of the Corporation, an increase in net interest income.  While the Corporation’s long-term strategy described moderate growth, management may determine from time to time that shrinking the balance sheet is the most prudent short-term strategy in response to deteriorating general economic conditions.
 
 
18

Mortgage banking operations primarily consist of the origination and sale of mortgage loans secured by single-family residences.  The primary sources of income in mortgage banking are gain on sale of loans and certain fees collected from borrowers in connection with the loan origination process.  The Corporation will continue to restructure its operations in response to the rapidly changing mortgage banking environment.  Changes may include a different product mix, further tightening of underwriting standards, a further reduction in its operating expenses or a combination of these and other changes.

Investment services operations primarily consist of selling alternative investment products such as annuities and mutual funds to the Bank’s depositors.  Provident Financial Corp performs trustee services for the Bank’s real estate secured loan transactions and has in the past held, and may in the future hold, real estate for investment.  Investment services and trustee services contribute a very small percentage of gross revenue.

There are a number of risks associated with the business activities of the Corporation, many of which are beyond the Corporation’s control, including: changes in accounting principles, changes in regulation and changes in the economy, among others.  The Corporation attempts to mitigate many of these risks through prudent banking practices such as interest rate risk management, credit risk management, operational risk management, and liquidity management.  The current economic environment presents heightened risk for the Corporation primarily with respect to falling real estate values and higher loan delinquencies.  Declining real estate values may lead to higher loan losses since the majority of the Corporation’s loans are secured by real estate located within California.  Significant declines in the value of California real estate may inhibit the Corporation’s ability to recover on defaulted loans by selling the underlying real estate.  For further details on risk factors, see the Safe-Harbor Statement on page 17 and Item 1A – Risk Factors on page 45.


Off-Balance Sheet Financing Arrangements and Contractual Obligations

The following table summarizes the Corporation’s contractual obligations at December 31, 2008 and the effect these obligations are expected to have on the Corporation’s liquidity and cash flows in future periods (in thousands):

 
Payments Due by Period
 
   1 year
  
   Over 1 year
  
   Over 3 years
  
   Over
    
 
   or less
  
   to 3 years
  
   to 5 years
  
   5 years
  
   Total
Operating obligations
$        795
  
$     930
  
$        447
  
$           -
  
$        2,172
Time deposits
559,808
  
51,350
  
20,114
  
75
  
631,347
FHLB – San Francisco advances
146,127
  
229,954
  
130,918
  
19,268
  
526,267
FHLB – San Francisco letter of credit
2,500
  
-
  
-
  
-
  
2,500
Total
$ 709,230
  
$ 282,234
  
$ 151,479
  
$ 19,343
  
$ 1,162,286

The expected obligation for time deposits and FHLB – San Francisco advances include anticipated interest accruals based on the respective contractual terms.

In addition to the off-balance sheet financing arrangements and contractual obligations mentioned above, the Corporation has derivatives and other financial instruments with off-balance sheet risks as described in Note 5 of the Notes to Unaudited Interim Consolidated Financial Statements on page 11.


Comparison of Financial Condition at December 31, 2008 and June 30, 2008

Total assets decreased $81.3 million, or five percent, to $1.55 billion at December 31, 2008 from $1.63 billion at June 30, 2008.  The decrease was primarily attributable to a decrease in loans held for investment.

Loans held for investment decreased $102.7 million, or eight percent, to $1.27 billion at December 31, 2008 from $1.37 billion at June 30, 2008.  During the first six months of fiscal 2009, the Bank originated $17.2 million of loans held for investment, of which $7.4 million, or 43 percent, were “preferred loans”
 
 
 
19
(multi-family, commercial real estate, construction and commercial business loans).  The Bank did not purchase any loans for investment in the first six months of fiscal 2009, resulting from the Corporation’s decision to compete less aggressively for origination volume given the economic uncertainty of the current banking environment.  Total loan principal payments during the first six months of fiscal 2009 were $89.7 million, compared to $134.7 million during the comparable period in fiscal 2008.  The balance of preferred loans decreased to $528.5 million, or 41 percent of loans held for investment at December 31, 2008, as compared to $569.6 million, or 41 percent of loans held for investment at June 30, 2008.  Purchased loans serviced by others at December 31, 2008 were $132.7 million, or 10 percent of loans held for investment, compared to $146.5 million, or 11 percent of loans held for investment at June 30, 2008.

The table below describes the geographic dispersion of real estate secured loans held for investment at December 31, 2008, as a percentage of the total dollar amount outstanding:

 
Inland
Empire
Southern
California (1)
Other
California
Other
States
 
Total
Loan Category
  Balance
  %
  Balance
  %
  Balance
  %
  Balance
  %
  Balance
  %
Single-family
$231,011
31%
$413,528
54%
$105,945
14%
$10,605
1%
$761,089
100%
Multi-family
34,928
9%
267,744
70%
72,797
19%
6,119
2%
381,588
100%
Commercial real estate
60,045
47%
63,402
50%
2,387
2%
1,655
1%
127,489
100%
Construction
11,908
97%
400
3%
-
0%
-
0%
12,308
100%
Other
3,289
100%
-
0%
-
0%
-
0%
3,289
100%
Total
$341,181
27%
$745,074
58%
$181,129
14%
$18,379
1%
$1,285,763
100%

(1) Other than the Inland Empire.

Total loans held for sale increased $17.9 million, or 63 percent, to $46.4 million at December 31, 2008 from $28.5 million at June 30, 2008.  The increase was due primarily to the timing difference between loan originations and loan sale settlements.  See “Loan Volume Activities” on page 36.

Total investment securities decreased $8.2 million, or five percent, to $144.9 million at December 31, 2008 from $153.1 million at June 30, 2008.  The decrease was primarily the result of scheduled and accelerated principal payments on mortgage-backed securities.  The Bank evaluates individual investment securities quarterly for other-than-temporary declines in market value.  The Bank does not believe that there are any other-than-temporary impairments at December 31, 2008; therefore, no impairment losses have been recorded as of December 31, 2008.

Total deposits decreased $77.6 million, or eight percent, to $934.8 million at December 31, 2008 from $1.01 billion at June 30, 2008.  This decrease was primarily attributable to the strategic decision to compete less aggressively on time deposit interest rates, partly offset by the Bank’s marketing strategy to promote transaction accounts.

Borrowings, consisting of FHLB – San Francisco advances increased slightly to $480.7 million at December 31, 2008 from $479.3 million at June 30, 2008.  The increase in borrowings was primarily the result of the decrease in deposits and the increase in loans held for sale, partly offset by the decrease in loans held for investment.  The weighted-average maturity of the Bank’s FHLB – San Francisco advances was approximately 29 months (27 months, if put options are exercised by the FHLB – San Francisco) at December 31, 2008, as compared to the weighted-average maturity of 23 months (20 months, if put options were exercised by the FHLB – San Francisco) at June 30, 2008.

Total stockholders’ equity decreased $6.1 million, or five percent, to $117.9 million at December 31, 2008, from $124.0 million at June 30, 2008, primarily as a result of the net loss and the quarterly cash dividends paid during the first six months of fiscal 2009.  No stock options were exercised and no common stock was repurchased during the first six months of fiscal 2009.  The total cash dividend paid to the Corporation’s shareholders in the first six months of fiscal 2009 was $620,000.


 
20
 
Comparison of Operating Results for the Quarters and Six Months Ended December 31, 2008 and 2007

The Corporation’s net loss for the quarter ended December 31, 2008 was $6.5 million, compared to net income of $1.0 million during the same quarter of fiscal 2008.  For the six months ended December 31, 2008, the Corporation’s net loss was $6.2 million, compared to net income of $1.7 million during the same period of fiscal 2008.  The decrease for both periods was primarily a result of the increase in the provision for loan losses, partly offset by the increase in net interest income (before provision for loan losses), the increase in non-interest income and the decrease in operating expenses.

The Corporation’s efficiency ratio improved to 58 percent in the second quarter of fiscal 2009 from 64 percent in the same period of fiscal 2008.  For the six months ended December 31, 2008, the efficiency ratio improved to 55 percent from 68 percent in the six months ended December 31, 2007.  The improvement in the efficiency ratio for both these periods was a result of the increase in net interest income (before provision for loan losses), the increase in non-interest income and the decrease in non-interest expenses.

Return on average assets for the quarter ended December 31, 2008 decreased 193 basis points to (1.67) percent from 0.26 percent in the same period last year.  For the six months ended December 31, 2008 and 2007, the return on average assets was (0.78) percent and 0.21 percent, respectively, a decrease of 99 basis points.

Return on average equity for the quarter ended December 31, 2008 decreased to (21.44) percent from 3.30 percent for the same period last year.  For the six months ended December 31, 2008, the return on average equity decreased to (10.07) percent from 2.60 percent for the same period last year.

Diluted earnings per share for the quarter ended December 31, 2008 were $(1.05), compared to $0.17 for the quarter ended December 31, 2007.  For the six months ended December 31, 2008 and 2007, diluted earnings per share were $(1.00) and $0.27, respectively.

Net Interest Income:

For the Quarters Ended December 31, 2008 and 2007.  The Corporation’s net interest income (before the provision for loan losses) increased by $673,000, or seven percent, to $10.2 million for the quarter ended December 31, 2008 from $9.6 million in the comparable period in fiscal 2008.  This increase was the result of a higher net interest margin, partly offset by lower average earning assets.  The net interest margin increased to 2.70 percent in the second quarter of fiscal 2009, up 28 basis points from 2.42 percent for the same period of fiscal 2008.  The increase in the net interest margin during the second quarter of fiscal 2009 was primarily attributable to a decrease in the average cost of funds which declined more than the average yield on earning assets.  The average balance of earning assets decreased $66.3 million to $1.52 billion in the second quarter of fiscal 2009 from $1.58 billion in the comparable period of fiscal 2008.

For the Six Months Ended December 31, 2008 and 2007.  Net interest income (before the provision for loan losses) for the first six months of fiscal 2009 was $21.5 million, up $2.6 million or 14 percent from $18.9 million during the same period of fiscal 2008.  This increase was the result of a higher net interest margin, partly offset by lower average earning assets.  The net interest margin increased to 2.79 percent in the first six months of fiscal 2009, up 38 basis points from 2.41 percent during the same period of fiscal 2008.  The increase in the net interest margin during the first six months of fiscal 2009 was primarily attributable to a decrease in the average cost of funds which decreased more than the average yield on earning assets, which remained relatively stable, coupled with the lower average balance of interest earning assets.  The average balance of earning assets decreased $28.7 million, or two percent, to $1.54 billion in the first six months of fiscal 2009 from $1.57 billion in the comparable period of fiscal 2008.

Interest Income:

For the Quarters Ended December 31, 2008 and 2007.  Total interest income decreased by $2.7 million, or 11 percent, to $21.3 million for the second quarter of fiscal 2009 from $24.0 million in the same quarter of fiscal 2008.  This decrease was primarily the result of a lower average earning asset yield and a lower
 
 
21
average balance of earning assets.  The average yield on earning assets during the second quarter of fiscal 2009 was 5.62 percent, 45 basis points lower than the average yield of 6.07 percent during the same period of fiscal 2008.

Loans receivable interest income decreased $2.1 million, or 10 percent, to $19.6 million in the quarter ended December 31, 2008 from $21.7 million for the same quarter of fiscal 2008.  This decrease was attributable to a lower average loan yield and a lower average loan balance.  The average loan yield during the second quarter of fiscal 2009 decreased 28 basis points to 5.93 percent from 6.21 percent during the same quarter last year.  The decrease in the average loan yield was primarily attributable to accrued interest reversals from newly classified non-accrual loans and loan payoffs which carried a higher average yield than the average yield of loans receivable.  The average balance of loans outstanding, including loans held for sale, decreased $72.6 million, or five percent, to $1.33 billion during the second quarter of fiscal 2009 from $1.40 billion in the same quarter of fiscal 2008.

Interest income from investment securities decreased $98,000, or five percent, to $1.8 million during the quarter ended December 31, 2008 from $1.9 million in the same quarter of fiscal 2008.  The decrease was primarily a result of a decrease in average yield and a decrease in the average balance.  The average yield on investment securities decreased 12 basis points to 4.83 percent during the quarter ended December 31, 2008 from 4.95 percent during the quarter ended December 31, 2007.  The decrease in the average yield of investment securities was primarily attributable to the net premium amortization of $24,000 in the second quarter of fiscal 2009 as compared to the net discount amortization of $4,000 in the comparable quarter of fiscal 2008.  During the second quarter of fiscal 2009, the Bank did not purchase any investment securities, while $7.5 million of principal payments were received on mortgage-backed securities.  The average balance of investment securities decreased $4.5 million, or three percent, to $149.3 million in the second quarter of fiscal 2009 from $153.8 million in the same quarter of fiscal 2008.

FHLB – San Francisco stock dividends were $(125,000) in the second quarter of fiscal 2009, down from $432,000 in the same period of fiscal 2008.  The decline was primarily attributable to the FHLB announcement that they will not pay a dividend for the quarter ended December 31, 2008 and an accrual adjustment resulting from a lower actual dividend received in November 2008 than accrued for the relevant period.

For the Six Months Ended December 31, 2008 and 2007.  Total interest income decreased by $3.5 million, or seven percent, to $44.3 million for the first six months of fiscal 2009 from $47.8 million in the same period of fiscal 2008.  This decrease was primarily the result of a lower average balance of earning assets and a lower average earning asset yield.  The average yield on earning assets during the first six months of fiscal 2009 was 5.75 percent, 33 basis points lower than the average yield of 6.08 percent during the same period of fiscal 2008.

Loans receivable interest income decreased $2.9 million, or seven percent, to $40.3 million in the six months ended December 31, 2008 from $43.2 million for the same period of fiscal 2008.  This decrease was attributable to a lower average loan balance and a lower average loan yield.  The average balance of loans outstanding, including the receivable from sale of loans and loans held for sale, decreased $36.0 million, or three percent, to $1.35 billion during the first six months of fiscal 2009 from $1.39 billion during the same period of fiscal 2008.  The average loan yield during the first six months of fiscal 2009 decreased 26 basis points to 5.97 percent from 6.23 percent during the same period last year.  The decrease in the average loan yield was primarily attributable to accrued interest reversals from newly classified non-accrual loans and loan payoffs which carried a higher average yield than the average yield of loans receivable.

Interest income from investment securities increased $63,000 to $3.7 million during the six months ended December 31, 2008 from $3.6 million in the same period of fiscal 2008.  This increase was primarily a result of an increase in average yield and an increase in the average balance.  The average yield on the investment securities increased seven basis points to 4.88 percent during the six months ended December 31, 2008 from 4.81 percent during the six months ended December 31, 2007.  The average balance of investment securities increased $418,000, or less than one percent, to $152.0 million in the first six months of fiscal 2009 from $151.6 million in the same period of fiscal 2008.  During the first six months of fiscal 2009, $8.1 million of investment securities were purchased, while $15.9 million of principal payments were received on mortgage-backed securities.
 
 
22
FHLB – San Francisco stock dividends decreased by $577,000, or 64 percent, to $324,000 in the first six months of fiscal 2009 from $901,000 in the same period of fiscal 2008.  This decrease was attributable to a lower average yield and a lower average balance in the amount of FHLB – San Francisco stock.  The average yield on FHLB – San Francisco stock decreased 348 basis points to 1.99 percent during the first six months of fiscal 2009 from 5.47 percent during the same period last year.  The decrease in the average yield was primarily attributable to the FHLB – San Francisco announcement on January 8, 2009 that they would not pay a dividend for the quarter ended December 31, 2008.  The average balance of FHLB – San Francisco stock decreased $378,000 to $32.6 million during the first six months of fiscal 2009 from $33.0 million during the same period of fiscal 2008.  The average balance of FHLB – San Francisco stock was consistent with the borrowing requirements of the FHLB – San Francisco.

Interest Expense:

For the Quarters Ended December 31, 2008 and 2007.  Total interest expense for the quarter ended December 31, 2008 was $11.1 million as compared to $14.5 million for the same period of fiscal 2008, a decrease of $3.4 million, or 23 percent.  This decrease was primarily attributable to a lower average cost of interest-bearing liabilities and a lower average balance.  The average cost of interest-bearing liabilities was 3.12 percent during the quarter ended December 31, 2008, down 78 basis points from 3.90 percent during the same period of fiscal 2008.  The average balance of interest-bearing liabilities, principally deposits and borrowings, decreased $59.9 million, or four percent, to $1.41 billion during the second quarter of fiscal 2009 from $1.47 billion during the same period of fiscal 2008.

Interest expense on deposits for the quarter ended December 31, 2008 was $6.3 million as compared to $9.2 million for the same period of fiscal 2008, a decrease of $2.9 million, or 32 percent.  The decrease in interest expense on deposits was primarily attributable to a lower average cost and a lower average balance.  The average cost of deposits decreased to 2.66 percent during the quarter ended December 31, 2008 from 3.62 percent during the same quarter of fiscal 2008, a decrease of 96 basis points.  The decrease in the average cost of deposits was attributable primarily to new time deposits with a lower average cost, replacing maturing time deposits with a higher average cost, consistent with declining short-term interest rates.  The average balance of deposits decreased $70.8 million, or seven percent, to $937.5 million during the quarter ended December 31, 2008 from $1.01 billion during the same period of fiscal 2008.  The decline in the average balance was primarily in time deposits, the result of the Bank’s strategic decision to compete less aggressively for this product.  The average balance of transaction account deposits to total deposits in the second quarter of fiscal 2009 was unchanged at 34 percent, compared to the same period of fiscal 2008.

Interest expense on borrowings, consisting primarily of FHLB – San Francisco advances, for the quarter ended December 31, 2008 decreased $463,000, or nine percent, to $4.8 million from $5.3 million for the same period of fiscal 2008.  The decrease in interest expense on borrowings was primarily a result of a lower average cost, partly offset by a higher average balance.  The average cost of borrowings decreased to 4.02 percent for the quarter ended December 31, 2008 from 4.50 percent in the same quarter of fiscal 2008, a decrease of 48 basis points.  The decrease in the average cost of borrowings was primarily the result of maturing long-term advances which had a higher average cost than the average cost of new advances. Additionally, short-term advance interest rates have fallen as a result of U.S. Treasury and Federal Reserve Board actions. The average balance of borrowings increased $10.9 million, or two percent, to $476.4 million during the quarter ended December 31, 2008 from $465.5 million during the same period of fiscal 2008.

For the Six Months Ended December 31, 2008 and 2007.  Total interest expense was $22.8 million for the first six months of fiscal 2009 as compared to $28.8 million for the same period of fiscal 2008, a decrease of $6.0 million, or 21 percent.  This decrease was primarily attributable to a lower average balance of interest-bearing liabilities and a decrease in the average cost.  The average balance of interest-bearing liabilities, principally deposits and borrowings, decreased $25.3 million, or two percent, to $1.44 billion during the first six months of fiscal 2009 from $1.46 billion during the same period of fiscal 2008.  The average cost of interest-bearing liabilities was 3.16 percent during the six months ended December 31, 2008, down 75 basis points from 3.91 percent during the same period of fiscal 2008.
 
 
23
Interest expense on deposits for the six months ended December 31, 2008 was $13.3 million as compared to $18.5 million for the same period of fiscal 2008, a decrease of $5.2 million, or 28 percent.  The decrease in interest expense on deposits was primarily attributable to a lower average cost and a lower average balance.  The average cost of deposits decreased to 2.76 percent during the six months ended December 31, 2008 from 3.64 percent during the same period of fiscal 2008, a decrease of 88 basis points.  The decline in the average balance was primarily in time deposits, the result of the Bank’s strategic decision to compete less aggressively for this product.  The average balance of deposits decreased $47.9 million, or five percent, to $959.2 million during the six months ended December 31, 2008 from $1.01 billion during the same period of fiscal 2008.  The average balance of transaction accounts decreased by $15.4 million, or four percent, to $329.7 million in the six months ended December 31, 2008 from $345.1 million in the six months ended December 31, 2007.  The average balance of time deposits decreased by $32.4 million, or five percent, to $629.6 million in the six months ended December 31, 2008 as compared to $662.0 million in the six months ended December 31, 2007.  The average balance of transaction account deposits to total deposits in the first six months of fiscal 2009 was unchanged at 34 percent, compared to the same period of fiscal 2008.

Interest expense on borrowings, consisting primarily of FHLB – San Francisco advances, for the six months ended December 31, 2008 decreased $862,000, or eight percent, to $9.5 million from $10.4 million for the same period of fiscal 2008.  The decrease in interest expense on borrowings was primarily a result of a lower average cost, partly offset by a higher average balance.  The average cost of borrowings decreased to 3.96 percent for the six months ended December 31, 2008 from 4.52 percent in the same period ended December 31, 2007, a decrease of 56 basis points.  The decrease in the average cost of borrowings was primarily the result of maturing long-term advances which had a higher average cost than the average cost of new advances.  Additionally, short-term advance interest rates have fallen as a result of U.S. Treasury and Federal Reserve Board actions.  The average balance of borrowings increased $22.5 million, or five percent, to $477.6 million during the six months ended December 31, 2008 from $455.1 million during the same period of fiscal 2008.


 
24
 


The following table depicts the average balance sheets for the quarters and six months ended December 31, 2008 and 2007, respectively:

Average Balance Sheets
(Dollars in thousands)

   
Quarter Ended
    
Quarter Ended
  
   
December 31, 2008
    
December 31, 2007
  
   
Average
          
       Yield/
    
Average
          
       Yield/
  
   
Balance
    
Interest
    
       Cost
    
Balance
    
Interest
    
       Cost
  
Interest-earning assets:
                                    
Loans receivable, net (1)
  $ 1,325,675     $ 19,648       5.93 %   $ 1,398,321     $ 21,700       6.21 %
Investment securities
     149,314       1,804       4.83 %     153,816       1,902       4.95 %
FHLB – San Francisco stock
     32,769       (125 )     (1.53 )%     30,986       432       5.58 %
Interest-earning deposits
     9,595       9       0.38 %     532       5       3.76 %
                                                 
Total interest-earning assets
     1,517,353       21,336       5.62 %     1,583,655       24,039       6.07 %
                                                 
Non interest-earning assets
     38,676                       38,159                  
                                                 
Total assets
   $ 1,556,029                     $ 1,621,814                  
                                                 
Interest-bearing liabilities:
                                                
Checking and money market accounts (2)
   $ 184,196       302       0.65 %   $ 195,760       499       1.01 %
Savings accounts
    135,785       535       1.57 %     147,225       804       2.17 %
Time deposits
    617,554       5,441       3.51 %     665,333       7,888       4.70 %
                                                 
Total deposits
     937,535       6,278       2.66 %     1,008,318       9,191       3.62 %
                                                 
Borrowings
    476,376       4,817       4.02 %     465,452       5,280       4.50 %
                                                 
Total interest-bearing liabilities
    1,413,911       11,095       3.12 %     1,473,770       14,471       3.90 %
                                                 
Non interest-bearing liabilities
    20,635                       21,626                  
                                                 
Total liabilities
     1,434,546                       1,495,396                  
                                                 
Stockholders’ equity
     121,483                       126,418                  
Total liabilities and stockholders’
     equity
                                                
  $ 1,556,029     $ 1,621,814  
                                                 
Net interest income
           $ 10,241                     $ 9,568          
                                                 
Interest rate spread (3)
                     2.50 %                     2.17 %
Net interest margin (4)
                     2.70 %                     2.42 %
Ratio of average interest-earning
     assets to average interest-bearing
     liabilities
                                                
               
    107.32 %     107.46 %
(Loss) return on average assets
                     (1.67 )%                     0.26 %
(Loss) return on average equity
                     (21.44 )%                     3.30 %
                                                 
(1)  Includes the receivable from sale of loans, loans held for sale and non-accrual loans, as well as net deferred loan cost amortization of $167 and $210 for the quarters ended December 31, 2008 and 2007, respectively. 
(2)  Includes the average balance of non interest-bearing checking accounts of $40.1 million and $42.9 million during the quarters ended December 31, 2008 and 2007, respectively. 
(3)  Represents the difference between the weighted-average yield on all interest-earning assets and the weighted-average rate on all interest-bearing liabilities. 
(4)  Represents net interest income before provision for loan losses as a percentage of average interest-earning assets. 
 
 

 
25
 



   
Six Months Ended
    
Six Months Ended
  
   
December 31, 2008
    
December 31, 2007
  
   
Average
          
      Yield/
    
Average
          
       Yield/
  
   
Balance
    
Interest
    
     Cost
    
Balance
    
Interest
    
       Cost
  
Interest-earning assets:
                                    
Loans receivable, net (1)
  $ 1,350,464     $ 40,306       5.97 %   $ 1,386,524     $ 43,214       6.23 %
Investment securities
     152,036       3,709       4.88 %     151,618       3,646       4.81 %
FHLB – San Francisco stock
     32,573       324       1.99 %     32,951       901       5.47 %
Interest-earning deposits
     7,898       10       0.25 %     639       14       4.38 %
                                                 
Total interest-earning assets
     1,542,971       44,349       5.75 %     1,571,732       47,775       6.08 %
                                                 
Non interest-earning assets
     37,286                       37,441                  
                                                 
Total assets
   $ 1,580,257                     $ 1,609,173                  
                                                 
Interest-bearing liabilities:
                                                
Checking and money market accounts (2)
   $ 191,250       632       0.66 %   $ 196,851       924       0.93 %
Savings accounts
    138,441       1,104       1.59 %     148,232       1,591       2.13 %
Time deposits
    629,558       11,568       3.65 %     662,049       15,946       4.78 %
                                                 
Total deposits
     959,249       13,304       2.76 %     1,007,132       18,461       3.64 %
                                                 
Borrowings
    477,642       9,511       3.96 %     455,075       10,373       4.52 %
                                                 
Total interest-bearing liabilities
    1,436,891       22,815       3.16 %     1,462,207       28,834       3.91 %
                                                 
Non interest-bearing liabilities
    20,575                       19,555                  
                                                 
Total liabilities
     1,457,466                       1,481,762                  
                                                 
Stockholders’ equity
     122,791                       127,411                  
Total liabilities and stockholders’
     equity
                                                
  $ 1,580,257     $ 1,609,173  
                                                 
Net interest income
           $ 21,534                     $ 18,941          
                                                 
Interest rate spread (3)
                     2.59 %                     2.17 %
Net interest margin (4)
                     2.79 %                     2.41 %
Ratio of average interest-earning
     assets to average interest-bearing
     liabilities
                                                
               
    107.38 %     107.49 %
(Loss) return on average assets
                     (0.78 )%                     0.21 %
(Loss) return on average equity
                     (10.07 )%                     2.60 %
 
(1)  Includes the receivable from sale of loans, loans held for sale and non-accrual loans, as well as net deferred loan cost amortization of $288 and $390 for the six months ended December 31, 2008 and 2007, respectively. 
(2)  Includes the average balance of non interest-bearing checking accounts of $42.6 million and $42.7 million during the six months ended December 31, 2008 and 2007, respectively. 
(3)  Represents the difference between the weighted-average yield on all interest-earning assets and the weighted-average rate on all interest-bearing liabilities. 
(4)  Represents net interest income before provision for loan losses as a percentage of average interest-earning assets. 
 
 

 
26
 
The following table provides the rate/volume variances for the quarters and six months ended December 31, 2008 and 2007, respectively:

Rate/Volume Variance
(In Thousands)

   
Quarter Ended December 31, 2008 Compared
  
   
To Quarter Ended December 31, 2007
  
   
Increase (Decrease) Due to
  
             
       Rate/
        
   
       Rate
  
       Volume
    
       Volume
    
       Net
  
Interest-earning assets:
                        
     Loans receivable (1)
  $ (975 )   $ (1,128 )   $ 51     $ (2,052 )
     Investment securities
    (43 )     (56 )     1       (98 )
     FHLB – San Francisco stock
    (550 )     25       (32 )     (557 )
     Interest-bearing deposits
    (4 )     85       (77 )     4  
Total net change in income
     on interest-earning assets
                               
    (1,572 )     (1,074 )     (57 )     (2,703 )
                                 
Interest-bearing liabilities:
                                
     Checking and money market accounts
     (178 )     (29 )     10       (197 )
     Savings accounts
    (223 )     (63 )     17       (269 )
     Time deposits
    (2,024 )     (566 )     143       (2,447 )
     Borrowings
    (574 )     124       (13 )     (463 )
Total net change in expense on
     interest-bearing liabilities
                               
    (2,999 )     (534 )     157       (3,376 )
Net increase (decrease) in net interest
     income
                                
  $ 1,427     $ (540 )   $ (214 )   $ 673  
                                 
(1)  Includes the receivable from sale of loans, loans held for sale and non-accrual loans. For purposes of calculating volume, rate and rate/volume variances, non-accrual loans were included in the weighted-average balance outstanding. 
 

   
Six Months Ended December 31, 2008 Compared
  
   
To Six Months Ended December 31, 2007
  
   
Increase (Decrease) Due to
  
             
       Rate/
        
   
       Rate
  
       Volume
    
       Volume
    
       Net
  
Interest-earning assets:
                        
     Loans receivable (1)
  $ (1,832 )   $ (1,123 )   $ 47     $ (2,908 )
     Investment securities
    53       10       -       63  
     FHLB – San Francisco stock
    (574 )     (10 )     7       (577 )
     Interest-bearing deposits
    (13 )     159       (150 )     (4 )
Total net change in income
     on interest-earning assets
                               
    (2,366 )     (964 )     (96 )     (3,426 )
                                 
Interest-bearing liabilities:
                                
     Checking and money market accounts
    (274 )     (26 )     8       (292 )
     Savings accounts
    (409 )     (105 )     27       (487 )
     Time deposits
    (3,780 )     (783 )     185       (4,378 )
     Borrowings
    (1,312 )     514       (64 )     (862 )
Total net change in expense on
     interest-bearing liabilities
                               
    (5,775 )     (400 )     156       (6,019 )
Net increase (decrease) in net interest
     income
                               
  $ 3,409     $ (564 )   $ (252 )   $ 2,593  
 
(1)  Includes the receivable from sale of loans, loans held for sale and non-accrual loans. For purposes of calculating volume, rate and rate/volume variances, non-accrual loans were included in the weighted-average balance outstanding. 
 
27
Provision for Loan Losses:

For the Quarters Ended December 31, 2008 and 2007.  During the second quarter of fiscal 2009, the Corporation recorded a provision for loan losses of $16.5 million, compared to a loan loss provision of $2.1 million during the same period of fiscal 2008.  The loan loss provision in the second quarter of fiscal 2009 was primarily attributable to loan classification downgrades ($11.4 million) and an increase in the general loan loss provision for loans held for investment ($5.9 million), partly offset by a decrease in loans held for investment ($805,000).  The general loan loss allowance was augmented to reflect the impact on loans held for investment resulting from the deteriorating general economic conditions of the U.S. economy such as the higher unemployment rates, negative gross domestic product indicators and lower retail sales.  See related discussion on asset quality on page 32.

For the Six Months Ended December 31, 2008 and 2007.  The Corporation recorded a loan loss provision of $22.3 million for the first six months of fiscal 2009, compared to a loan loss provision of $3.7 million during the same period of fiscal 2008.  The loan loss provision in the first six months of fiscal 2009 was primarily attributable to loan classification downgrades ($17.5 million) and an increase in the general loan loss provision for loans held for investment ($5.9 million), partly offset by a decrease in loans held for investment ($1.1 million).

At December 31, 2008, the allowance for loan losses was $35.0 million, comprised of $17.0 million of general loan loss reserves and $18.0 million of specific loan loss reserves, in comparison to the allowance for loan losses of $19.9 million at June 30, 2008, comprised of $13.4 million of general loan loss reserves and $6.5 million of specific loan loss reserves.  The allowance for loan losses as a percentage of gross loans held for investment was 2.69 percent at December 31, 2008 compared to 1.43 percent at June 30, 2008.  Management considers the allowance for loan losses sufficient to absorb potential losses inherent in loans held for investment.

The allowance for loan losses is maintained at a level sufficient to provide for estimated losses based on evaluating known and inherent risks in the loans held for investment and upon management’s continuing analysis of the factors underlying the quality of the loans held for investment.  These factors include changes in the size and composition of the loans held for investment, actual loan loss experience, current economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the realizable value of the collateral securing the loans.  Provisions for loan losses are charged against operations on a monthly basis, as necessary, to maintain the allowance at appropriate levels.  Management believes that the amount maintained in the allowance will be adequate to absorb losses inherent in the loans held for investment.  Although management believes it uses the best information available to make such determinations, there can be no assurance that regulators, in reviewing the Bank’s loans held for investment, will not request that the Bank significantly increase its allowance for loan losses.  Future adjustments to the allowance for loan losses may be necessary and results of operations could be significantly and adversely affected as a result of economic, operating, regulatory, and other conditions beyond the control of the Bank.

 
28
 


The following table is provided to disclose additional details on the Corporation’s allowance for loan losses:

   
For the Quarter Ended
    
For the Six Months Ended
  
   
December 31,
    
December 31,
  
(Dollars in Thousands)
  
        2008
    
        2007
    
        2008
    
         2007
  
                         
Allowance at beginning of period
  $ 22,519     $ 15,599     $ 19,898     $ 14,845  
                                 
Provision for loan losses
    16,536       2,140       22,268       3,659  
                                 
Recoveries:
                                
Mortgage loans:
                                
Single-family
    111       -       111       -  
Construction
    50       -       50       -  
Consumer loans
    -       1       1       1  
     Total recoveries
    161       1       162       1  
                                 
Charge-offs:
                                
Mortgage loans:
                                
Single-family
    (4,223 )     (568 )     (7,260 )     (1,332 )
Construction
    -       -       (73 )     -  
Consumer loans
     (2 )     (1 )     (4 )     (2 )
Other loans
    (38 )     -       (38 )     -  
     Total charge-offs
    (4,263 )     (569 )     (7,375 )     (1,334 )
                                 
     Net charge-offs
    (4,102 )     (568 )     (7,213 )     (1,333 )
          Balance at end of period
  $ 34,953     $ 17,171     $ 34,953     $ 17,171  
                                 
Allowance for loan losses as a
     percentage of gross loans held for
     investment
                                
    2.69 %     1.22 %     2.69 %     1.22 %
                                 
Net charge-offs as a percentage of
     average loans outstanding during
     the period
                                
    1.24 %     0.16 %     1.07 %     0.19 %
                                 
Allowance for loan losses as a
     percentage of non-performing loans
     at the end of the period
                                
    76.24 %     97.44 %     76.24 %     97.44 %

Non-Interest Income:

For the Quarters Ended December 31, 2008 and 2007.  Total non-interest income increased $377,000, or 19 percent, to $2.3 million during the quarter ended December 31, 2008 from $1.9 million during the same period of fiscal 2008.  The increase was primarily attributable to an increase in the gain on sale of loans and a lower loss on sale and operations of real estate owned acquired in the settlement of loans, partly offset by a decrease in loan servicing and other fees.

Loan servicing and other fees decreased $247,000, or 48 percent, to $266,000 in the second quarter of fiscal 2009 from $513,000 in the same quarter of fiscal 2008.  The decrease was primarily attributable to a decrease in other loan fees, primarily related to loan payoffs.  Total loan payoffs declined $23.4 million, or 38 percent, to $38.9 million in the second quarter of fiscal 2009 from $62.3 million in the same quarter last year.

The gain on sale of loans increased $460,000, or 49 percent, to $1.4 million for the quarter ended December 31, 2008 from $934,000 in the same quarter of fiscal 2008.  The average loan sale margin for
 
29
 
PBM during the second quarter of fiscal 2009 was 0.80 percent, down 29 basis points from 1.09 percent in the same period of fiscal 2008.  The gain on sale of loans for the second quarter of fiscal 2009 includes a $1.5 million recourse provision on loans sold that are subject to repurchase, compared to a $38,000 recourse provision recovery in the comparable quarter last year.  The gain on sale of loans also includes a favorable fair-value adjustment on derivative financial instruments pursuant to the SFAS No. 133 (a gain of $748,000 versus a gain of $30,000).  As of December 31, 2008, the fair value of derivative financial instruments was a gain of $292,000 as compared to a loss of $304,000 at June 30, 2008 and a loss of $29,000 at December 31, 2007.  As of December 31, 2008, the total recourse reserve for loans sold that are subject to repurchase was $3.5 million, compared to $2.1 million at June 30, 2008 and $403,000 at December 31, 2007.  Total loans sold for the quarter ended December 31, 2008 were $161.1 million, up 57 percent from $102.4 million for the same quarter last year.  The mortgage banking environment remains highly volatile as a result of the well-publicized deterioration of the single-family real estate market.

The volume of loans originated for sale increased to $168.7 million in the second quarter of fiscal 2009 as compared to $98.4 million during the same period last year.  The increase in loan originations was primarily attributable to better liquidity in the secondary mortgage market particularly in FHA/VA loan products and an increase in activity resulting from lower mortgage interest rates.

The net loss on sale and operations of real estate owned acquired in the settlement of loans was $496,000 in the second quarter of fiscal 2009 compared to a net loss of $704,000 in the same quarter last year.  Twenty-two real estate owned properties were sold in the quarter ended December 31, 2008 as compared to six properties in the quarter ended December 31, 2007.  See related discussion on asset quality on page 32.

For the Six Months Ended December 31, 2008 and 2007.  Total non-interest income increased $1.5 million, or 45 percent, to $4.8 million for the first six months of fiscal 2009 from $3.3 million during the same period of fiscal 2008.  The increase was primarily attributable to an increase in the gain on sale of loans, an increase in deposit account fees, the gain on sale of investment securities and a lower loss on sale and operations of real estate owned acquired in the settlement of loans, partly offset by a decrease in loan servicing and other fees.

Loan servicing and other fees decreased $490,000, or 49 percent, to $514,000 in the first six months of fiscal 2009 from $1.0 million in the same period of fiscal 2008.  The decrease was primarily attributable to a decrease in other loan fees, primarily related to loan payoffs.  Total loan payoffs declined $45.0 million, or 33 percent, to $89.7 million in the first six months of fiscal 2009 from $134.7 million in the same period last year.

The gain on sale of loans increased $1.5 million, or 136 percent, to $2.6 million for the six months ended December 31, 2008 from $1.1 million in the same period of fiscal 2008.  The increase was a result of a higher volume of loans sold and a higher average loan sale margin in the first six months of fiscal 2009.  Total loans sold for the first six months of fiscal 2009 was $316.4 million, up 59 percent from $199.2 million in the comparable period last year.  The volume of loans originated for sale increased by $136.8 million, or 69 percent, to $334.7 million in the first six months of fiscal 2009 as compared to $197.9 million during the same period of fiscal 2008.  The average loan sale margin for PBM during the first six months of fiscal 2009 was 0.76 percent, up 16 basis points from 0.60 percent in the same period of fiscal 2008.  The increase in the average loan sale margin was primarily attributable to an increase in the fair-value adjustment on derivative financial instruments pursuant to the SFAS No. 133 (a gain of $596,000 versus a loss of $42,000), partly offset by an increase to the recourse reserve for loans sold that are subject to repurchase (a provision of $2.3 million versus a recovery of $81,000).

Deposit account fees increased $92,000, or six percent, to $1.5 million in the first six months of fiscal 2009 from $1.4 million in the same period of fiscal 2008.  The increase was primarily attributable to an increase in returned check fees.

The gain on sale of investment securities for the six months ended December 31, 2008 was $356,000, resulting from the sale of equity investments.

The net loss on sale and operations of real estate owned acquired in the settlement of loans was $886,000 for the six months ended December 31, 2008 as compared to a net loss of $1.0 million in the same period ended December 31, 2007.  A total of 47 real estate owned properties were sold during the six months
 
30
ended December 31, 2008 as compared to 10 real estate owned properties in the comparable period in fiscal 2008.

Other non-interest income in the first six months of fiscal 2009 was $696,000 as compared to $827,000 in the same period of fiscal 2008.  The decrease was primarily attributable to a decrease in investment service fees.

Non-Interest Expense:

For the Quarters Ended December 31, 2008 and 2007.  Total non-interest expense in the quarter ended December 31, 2008 was $7.2 million, a decrease of $81,000 or one percent, as compared to $7.3 million in the same quarter of fiscal 2008.  The decrease in non-interest expense was primarily the result of a decrease in premises and occupancy and professional expenses, partly offset by higher deposit insurance premiums and regulatory assessments.

Total premises and occupancy decreased $113,000, or 14 percent, to $718,000 in the second quarter of fiscal 2009 from $831,000 in the same period of fiscal 2008.  The decrease was primarily attributable to the cost savings generated from closing five mortgage banking loan production offices in the second quarter of fiscal 2008.

Total professional expenses decreased $142,000, or 30 percent, to $332,000 in the second quarter of fiscal 2009 from $474,000 in the same period of fiscal 2008.  The decrease was primarily attributable to lower legal expenses related to the 23 fraudulent, individual construction loans located in Coachella, California.

Total deposit insurance premiums and regulatory assessments increased $173,000, or 150 percent, to $288,000 in the second quarter of fiscal 2009 from $115,000 in the same period of fiscal 2008.  The increase was primarily attributable to higher FDIC deposit insurance premiums, which are expected to continue to increase during fiscal 2009.

For the Six Months Ended December 31, 2008 and 2007.  Total non-interest expense was $14.6 million for the first six months of fiscal 2009, a decrease of $485,000 or three percent, as compared to $15.1 million in the same period of fiscal 2008.  The decrease in non-interest expense was primarily the result of decreases in compensation, premises and occupancy, professional and other operating expenses, partly offset by higher deposit insurance premiums and regulatory assessments.

Total compensation expense in the first six months of fiscal 2009 was $9.2 million, down $496,000 or five percent, from $9.6 million in the same period of fiscal 2008.  The decrease in compensation expense was primarily attributable to lower ESOP expenses, partly offset by higher stock-based compensation costs.  Total ESOP expenses in the first six months of fiscal 2009 decreased $735,000, or 82 percent, to $164,000 from $899,000 in the same period of fiscal 2008.  This decrease was primarily due to fewer shares allocated and a lower average share price.

Total premises and occupancy expense decreased $104,000, or seven percent, to $1.4 million in the first six months of fiscal 2009 from $1.5 million in the same period of fiscal 2008.  The decrease was primarily attributable to the cost savings generated from closing five mortgage banking loan production offices in the second quarter of fiscal 2008.

Total professional expenses decreased $101,000, or 13 percent, to $692,000 in the first six months of fiscal 2009 from $793,000 in the same period of fiscal 2008.  The decrease was primarily attributable to lower legal expenses related to the 23 fraudulent, individual construction loans located in Coachella, California.

Total deposit insurance premiums and regulatory assessments increased $380,000, or 165 percent, to $610,000 in the first six months of fiscal 2009 from $230,000 in the same period of fiscal 2008.  The increase was primarily attributable to higher FDIC deposit insurance premiums, which are expected to continue to increase during fiscal 2009.

Total other operating expenses decreased $127,000, or seven percent, to $1.7 million in the first six months of fiscal 2009 from $1.8 million in the same period of fiscal 2008.

 
31
 
Provision (benefit) for income taxes:

For the Quarters Ended December 31, 2008 and 2007.  The income tax benefit was $4.7 million for the quarter ended December 31, 2008 as compared to an income tax provision of $1.0 million during the same period of fiscal 2008.  The effective income tax rate for the quarter ended December 31, 2008 decreased to 41.9 percent as compared to 49.2 percent for the same quarter last year.  The decrease in the effective income tax rate was primarily the result of a lower percentage of permanent tax differences relative to income or loss before taxes.  The Corporation believes that the effective income tax rate applied in the second quarter of fiscal 2009 reflects its current income tax obligations.

For the Six Months Ended December 31, 2008 and 2007.  The income tax benefit was $4.4 million for the first six months of fiscal 2009 as compared to an income tax provision of $1.9 million during the same period of fiscal 2008.  The effective income tax rate for the six months ended December 31, 2008 decreased to 41.3 percent as compared to 52.9 percent for the same period last year.  The decrease in the effective income tax rate was primarily the result of a lower percentage of permanent tax differences relative to income or loss before taxes.  The Corporation believes that the effective income tax rate applied in the first six months of fiscal 2009 reflects its current income tax obligations.


Asset Quality

Non-performing loans, consisting solely of non-accrual loans, increased to $45.8 million at December 31, 2008 from $23.2 million at June 30, 2008.  The non-accrual loans at December 31, 2008 were primarily comprised of 136 single-family loans held for investment ($38.9 million), three multi-family loans held for investment ($1.1 million), two commercial real estate loans ($1.5 million), 10 construction loans held for investment ($2.3 million, of which nine are associated with the Coachella, California construction loan fraud), six commercial business loans held for investment ($115,000), two land loans held for investment ($1.0 million), and eight single-family loans repurchased from, or unable to sell to investors ($901,000).  No interest accruals were made for loans that were past due 90 days or more or if the loans were deemed impaired.

The non-accrual loans as a percentage of net loans held for investment increased to 3.62 percent at December 31, 2008 from 1.70 percent at June 30, 2008.  Real estate owned was $11.1 million (61 properties) at December 31, 2008, up 18 percent from $9.4 million (45 properties) at June 30, 2008.  Non-performing assets, which includes non-performing loans and real estate owned, as a percentage of total assets increased to 3.67 percent at December 31, 2008 from 1.99 percent at June 30, 2008.

The Bank remains entangled in litigation on the 23 individual construction loans in a single-family construction project located in Coachella, California.  The Bank believes that significant misrepresentations were made to secure the Bank’s involvement in the project and as a result the Bank is vigorously pursuing legal remedies to protect the Bank’s interests.  The Bank has delivered demands to the individual borrowers, mortgage loan broker and builder who knowingly misled the Bank on certain key aspects of the loans and the project, which were ignored by the respective parties.  Therefore, the Bank has filed lawsuits alleging loan fraud by the 23 individual borrowers, misrepresentation fraud by the mortgage loan broker and misuse of funds fraud by the contractor.  The establishment of the specific loan loss reserve is consistent with the improved land value based on an appraisal.  Given the number of parties involved or soon to be involved, the complexity of the transaction and probable fraud, this matter may take an extended period of time to resolve.  As of December 31, 2008, the Bank foreclosed on 14 of these loans which were converted to real estate owned with a total fair value of $409,000, while the remaining nine loans are classified as substandard with a total fair value of $263,000.

During the second quarter of fiscal 2009, the Bank repurchased $692,000 of loans from investors, fulfilling certain recourse/repurchase covenants in the respective loan sale agreements, and originated $96,000 of loans that could not be sold to investors.  This compares to $2.1 million of repurchased loans in the same period of fiscal 2008.  For the first six months of fiscal 2009, the Bank repurchased $1.5 million of loans from investors and originated $96,000 of loans that could not be sold to investors.  This compares to $3.8 million of repurchased loans and $4.2 million of loans that could not be sold to investors in the same period
 
 
32
of fiscal 2008.  Many of the repurchases and loans that could not be sold were the result of fraud.  The Bank has implemented tighter underwriting standards to reduce this problem.

The Bank reviews loans individually to identify when impairment has occurred.  A loan is identified as impaired when it is deemed probable that the borrower will be unable to meet the scheduled principal and interest payments under the terms of the loan agreement.  Impairment is based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except that as a practical expedient, the Bank may measure impairment based on a loan’s observable market price or the fair value of the collateral if the loan is collateral dependent.

The following table describes certain credit risk characteristics of the Corporation’s single-family, first trust deed, mortgage loans held for investment as of December 31, 2008, which totaled $755.3 million at December 31, 2008 compared to $802.2 million at June 30, 2008:

   
Weighted-
Weighted-
Weighted-
 
Outstanding
Average
Average
Average
(Dollars in Thousands)
Balance (1)
FICO (2)
LTV (3)
Seasoning (4)
Interest only
$ 549,246
734
74%
2.80 years
Stated income (5)
$ 397,336
732
73%
3.00 years
FICO less than or equal to 660
$   20,887
641
71%
3.78 years
Over 30-year amortization
$   24,308
740
68%
3.30 years

(1)  
The outstanding balance presented on this table may overlap more than one category.  Of the outstanding balance, $45.6 million of “Interest Only,” $35.2 million of “Stated Income,” $5.2 million of “FICO Less Than or Equal to 660,” and $353,000 of “Over 30-Year Amortization” balances were non-performing.
(2)  
The FICO score represents the creditworthiness of a borrower based on the borrower’s credit history, as reported by an independent third party.  A higher FICO score indicates a greater degree of creditworthiness.  Bank regulators have issued guidance stating that a FICO score of 660 and below is indicative of a “subprime” borrower.
(3)  
LTV (loan-to-value) is the ratio calculated by dividing the current loan balance by the original appraised value of the real estate collateral.
(4)  
Seasoning describes the number of years since the funding date of the loan.
(5)  
Stated income is defined as borrower provided income which is not subject to verification during the loan origination process.

 
33
 


The following table sets forth information with respect to the Bank’s non-performing assets and restructured loans, net of specific loan loss reserves, within the meaning of SFAS No. 15, “Accounting by Debtors and Creditors for Troubled Debt Restructurings,” at the dates indicated:

 
 At December 31,
  
        At June 30,
(Dollars In Thousands)
       2008
  
          2008
Loans accounted for on a non-accrual basis:
      
Mortgage loans:
      
     Single-family
$ 39,769
  
$ 17,330
     Multi-family
1,112
  
-
     Commercial real estate
1,520
  
572
     Construction
2,300
  
4,716
Commercial business loans
115
  
-
Other loans
1,032
  
575
       
     Total
45,848
  
23,193
       
Accruing loans which are contractually past due
     90 days or more
 
-
  
 
-
       
Total of non-performing loans
45,848
  
23,193
       
Real estate owned, net
11,115
  
9,355
       
     Total non-performing assets
$ 56,963
  
$ 32,548
       
Restructured loans (1)
$ 19,598
  
$ 10,484
       
Non-performing loans as a percentage of loans held for
     investment, net
 
3.62%
  
 
1.70%
       
Non-performing loans as a percentage of total assets
2.96%
  
1.42%
       
Non-performing assets as a percentage of
     total assets
 
3.67%
  
 
1.99%

(1)  
The amount included in non-performing loans at December 31, 2008 and June 30, 2008 was $11.8 million and $1.4 million, respectively.

All of the loans set forth in the table above have been classified in accordance with OTS regulations.  Total classified loans (including loans designated as special mention) were $61.7 million at December 31, 2008, an increase of $2.5 million or four percent, from $59.2 million at June 30, 2008.  The classified loans at December 31, 2008 consist of 39 loans in the special mention category (25 single-family loans of $9.1 million, five multi-family loans of $2.9 million, four commercial real estate loans of $1.4 million, four commercial business loans of $548,000 and one construction loan of $400,000) and 176 loans in the substandard category (151 single-family loans of $41.0 million, 10 construction loans of $2.3 million, two commercial real estate loans of $1.5 million, three land loans of $1.3 million, three multi-family loans of $1.1 million and seven commercial business loans of $116,000).

The classified loans at June 30, 2008 consisted of 46 loans in the special mention category (33 single-family loans of $11.8 million, two construction loans of $8.1 million, six multi-family loans of $8.0 million, two commercial real estate loans of $1.4 million, one commercial business loans of $100,000, one land loan of $28,000 and one consumer loan of $20,000) and 97 loans in the substandard category (79 single-family loans of $23.6 million, 12 construction loans of $4.7 million, two land loans of $575,000, one commercial real estate loan of $572,000, one multi-family loan of $367,000 and two fully reserved commercial business loans).
 
 
34
As of December 31, 2008, real estate owned was comprised of 61 properties (11 from loan repurchases and loans which could not be sold and 50 from loans held for investment), primarily located in Southern California, with a net fair value of $11.1 million.  A new appraisal was obtained on each of the properties and fair value was calculated by using the lower of appraised value or the listing price of the property, net of selling costs.  Any initial loss is recorded as a charge to the allowance for loan losses before being transferred to real estate owned.  Subsequently, if there is further deterioration in real estate values, specific real estate loss reserves are established and charged to the statement of operations.  In addition, the Corporation reflects costs to carry real estate owned as real estate operating expenses when incurred.  As of June 30, 2008, real estate owned was comprised of 45 properties (nine from loan repurchases and 36 from loans held for investment), primarily located in Southern California, with a net fair value of $9.4 million.  For the quarter ended December 31, 2008, thirty-five real estate owned properties were acquired in the settlement of loans, while 22 real estate owned properties were sold for a net gain of $572,000.  For the six months ended December 31, 2008, sixty-three real estate owned properties were acquired in the settlement of loans, while 47 real estate owned properties were sold for a net gain of $439,000.


For the quarter ended December 31, 2008, 20 loans for $7.4 million were modified from their original terms, were re-underwritten and were identified in the Corporation’s asset quality reports as restructured loans.  For the six months ended December 31, 2008, 30 loans for $14.1 million were modified from their original terms, were re-underwritten and were identified in the Corporation’s asset quality reports as restructured loans.  As of December 31, 2008, the outstanding balance of modified loans was $19.6 million:  22 are classified as pass and remain on accrual status ($7.6 million); one is classified as substandard and remains on accrual status ($240,000); 34 are classified as substandard on non-accrual status ($11.8 million); and one is classified as loss on non-accrual status ($120,000).  To qualify for restructuring, a borrower must provide evidence of their creditworthiness such as, current financial statements, their most recent income tax returns, current paystubs, current W-2s, and most recent bank statements, among other documents, which are then verified by the Bank.  The Bank re-underwrites the loan with the borrower’s updated financial information, new credit report, current loan balance, new interest rate, remaining loan term, updated property value and modified payment schedule, among other considerations, to determine if the borrower qualifies.

 
35
 
Loan Volume Activities

The following table is provided to disclose details related to the volume of loans originated, purchased and sold (in thousands):

 
For the Quarter Ended
  
For the Six Months Ended
 
December 31,
  
December 31,
 
2008
  
2007
  
2008
  
2007
Loans originated for sale:
                      
     Retail originations
$    48,269
    
$    30,075
    
$    99,827
    
$   64,634
  
     Wholesale originations
120,389
    
68,324
    
234,833
    
133,278
  
        Total loans originated for sale (1)
168,658
    
98,399
    
334,660
    
197,912
  
                       
Loans sold:
                      
     Servicing released
(161,104
)
  
(102,009
)
  
(316,162
)
  
(196,648
)
     Servicing retained
-
    
(395
)
  
(193
)
  
(2,534
)
        Total loans sold (2)
(161,104
)
  
(102,404
)
  
(316,355
)
  
(199,182
)
                       
Loans originated for investment:
                      
     Mortgage loans:
                      
          Single-family
-
    
32,738
    
7,476
    
63,033
  
          Multi-family
3,300
    
18,914
    
4,500
    
26,428
  
          Commercial real estate
-
    
9,252
    
2,073
    
10,758
  
          Construction
-
    
1,984
    
265
    
11,662
  
     Commercial business loans
500
    
196
    
580
    
361
  
     Consumer loans
-
    
212
    
531
    
212
  
     Other loans
-
    
1,680
    
1,740
    
1,680
  
        Total loans originated for investment (3)
3,800
    
64,976
    
17,165
    
114,134
  
                       
Loans purchased for investment:
                      
     Mortgage loans:
                      
          Multi-family
-
    
25,921
    
-
    
68,130
  
          Commercial real estate
-
    
1,996
    
-
    
1,996
  
          Construction
-
    
400
    
-
    
400
  
     Other loans
-
    
1,000
    
-
    
1,000
  
        Total loans purchased for investment
-
    
29,317
    
-
    
71,526
  
                       
Mortgage loan principal payments
(38,877
)
  
(62,341
)
  
(89,731
)
  
(134,682
)
Real estate acquired in settlement of loans
(15,678
)
  
(4,711
)
  
(26,151
)
  
(8,393
)
(Decrease) increase in other items, net (4)
(6,028
)
  
1,334
    
(4,335
)
  
2,056
  
Net (decrease) increase in loans held for
                      
    investment and loans held for sale
$   (49,229
)
  
$    24,570
    
$ (84,747
)
  
$   43,371
  

(1)  
Primarily comprised of PBM loans originated for sale, totaling $168.7 million, $98.4 million, $334.7 million and $195.5 million for the quarters and six months ended December 31, 2008 and 2007, respectively.
(2)  
Primarily comprised of PBM loans sold, totaling $161.1 million, $101.6 million, $316.4 million and $196.7 million for the quarters and six months ended December 31, 2008 and 2007, respectively.
(3)  
Primarily comprised of PBM loans originated for investment, totaling $0, $32.8 million, $8.0 million and $66.4 million for the quarters and six months ended December 31, 2008 and 2007, respectively.
(4)  
Includes net changes in undisbursed loan funds, deferred loan fees or costs, escrow accounts and allowance for loan losses.


 
36
 
Liquidity and Capital Resources

The Corporation’s primary sources of funds are deposits, proceeds from the sale of loans originated for sale, proceeds from principal and interest payments on loans, proceeds from the maturity of investment securities and FHLB – San Francisco advances. While maturities and scheduled amortization of loans and investment securities are a relatively predictable source of funds, deposit flows, mortgage prepayments and loan sales are greatly influenced by general interest rates, economic conditions and competition.

The primary investing activity of the Bank is the origination and purchase of loans held for investment.  During the first six months of fiscal 2009 and 2008, the Bank originated loans in the amounts of $351.8 million and $312.0 million, respectively.  In addition, the Bank did not purchase any loans from other financial institution in the first six months of fiscal 2009 compared to purchases of $71.5 million in the first six months of fiscal 2008.  The total loans sold in the first six months of fiscal 2009 and 2008 were $316.4 million and $199.2 million, respectively.  At December 31, 2008, the Bank had loan origination commitments totaling $46.2 million and undisbursed loans in process and lines of credit totaling $15.5 million.  The Bank anticipates that it will have sufficient funds available to meet its current loan commitments.

The Bank’s primary financing activity is gathering deposits.  During the first six months of fiscal 2009, the net decrease in deposits was $77.6 million in comparison to a net increase in deposits of $4.3 million during the same period in fiscal 2008.  On December 31, 2008, time deposits that are scheduled to mature in one year or less were $550.1 million.  Historically, the Bank has been able to retain a significant amount of its time deposits as they mature by adjusting deposit rates to the current interest rate environment.

The Bank must maintain an adequate level of liquidity to ensure the availability of sufficient funds to support loan growth and deposit withdrawals, to satisfy financial commitments and to take advantage of investment opportunities.  The Bank generally maintains sufficient cash and cash equivalents to meet short-term liquidity needs.  At December 31, 2008, total cash and cash equivalents were $17.5 million, or 1.13 percent of total assets.  Depending on market conditions and the pricing of deposit products and FHLB – San Francisco advances, the Bank may continue to rely on FHLB – San Francisco advances for part of its liquidity needs.  As of December 31, 2008, the financing availability at FHLB – San Francisco is limited to 45 percent of total assets and the remaining borrowing capacity was $259.4 million.

On December 3, 2008, the Bank elected to participate in the FDIC Temporary Liquidity Guarantee Program (“TLGP”), which consists of the Transaction Account Guarantee Program (“TAGP”) and Debt Guarantee Program (“DGP”).  Through the TAGP, the FDIC will provide unlimited deposit insurance coverage for all noninterest-bearing transaction accounts through December 31, 2009.  This includes traditional non-interest bearing checking accounts, certain types of attorney trust accounts and NOW accounts as long as the interest rate does not exceed 0.50 percent.  The program is designed to enhance depositor confidence in the safety of the United States banking system.  Through the DGP, the Bank has an option to issue senior unsecured debt (fully guaranteed by the FDIC) on or before June 30, 2009 with a maturity of June 30, 2012 or sooner.  If the Bank chooses to issue debt under the DGP program it will be limited to two percent of its liabilities as of September 30, 2008, or approximately $29.4 million.

Although the OTS eliminated the minimum liquidity requirement for savings institutions in April 2002, the regulation still requires thrifts to maintain adequate liquidity to assure safe and sound operations. The Bank’s average liquidity ratio (defined as the ratio of average qualifying liquid assets to average deposits and borrowings) for the quarter ended December 31, 2008 increased to 7.2 percent from 4.6 percent during the quarter ended June 30, 2008.  During the first six months of fiscal 2009, the United States (“the U.S.”) and international banking systems were under a considerable strain as a result of large financial losses experienced by many financial institutions worldwide.  As a result, the U.S. government has taken many actions designed to alleviate liquidity concerns in the U.S. banking system.  Those well publicized actions seem to have stabilized the U.S. banking system.  The Bank did not experience any specific liquidity problems during the course of the second quarter of fiscal 2009 although it is probable that interest rates paid for deposits and borrowings were elevated as a result of the market turmoil.

The Bank is required to maintain specific amounts of capital pursuant to OTS requirements.  Under the OTS prompt corrective action provisions, a minimum ratio of 1.5 percent for Tangible Capital is required
 
 
37
to be deemed other than “critically undercapitalized,” while a minimum of 5.0 percent for Core Capital, 10.0 percent for Total Risk-Based Capital and 6.0 percent for Tier 1 Risk-Based Capital is required to be deemed “well capitalized.”  As of December 31, 2008, the Bank exceeded all regulatory capital requirements.  The Bank’s actual and required capital amounts and ratios as of December 31, 2008 are as follows (dollars in thousands):

 
        Amount
  
 Percent
       
Tangible capital
$ 112,412
  
7.25%
Requirement
31,007
  
   2.00    
       
Excess over requirement
$   81,405
  
5.25%
       
Core capital
$ 112,412
  
7.25%
Requirement to be “Well Capitalized”
 77,518
  
   5.00    
             
Excess over requirement
 $   34,894
  
2.25%
       
Total risk-based capital
$ 121,254
  
12.88%
Requirement to be “Well Capitalized”
 94,123
  
10.00    
       
Excess over requirement
$   27,131
  
2.88%
       
Tier 1 risk-based capital
$ 109,424
  
11.63%
Requirement to be “Well Capitalized”
 56,474
  
  6.00    
       
Excess over requirement
$   52,950
  
5.63%

Commitments and Derivative Financial Instruments

The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit, in the form of originating loans or providing funds under existing lines of credit, and mandatory loan sale agreements to third parties.  These instruments involve, to varying degrees, elements of credit and interest-rate risk in excess of the amount recognized in the accompanying condensed consolidated statements of financial condition.  The Corporation’s exposure to credit loss, in the event of non-performance by the counterparty to these financial instruments, is represented by the contractual amount of these instruments.  The Corporation uses the same credit policies in entering into financial instruments with off-balance sheet risk as it does for on-balance sheet instruments.  For a discussion on commitments and derivative financial instruments, see Note 5 of the Notes to Unaudited Interim Consolidated Financial Statements on page 11.


Stockholders’ Equity

The ability of the Corporation to pay dividends to stockholders depends primarily on the ability of the Bank to pay dividends to the Corporation.  The Bank may not declare or pay a cash dividend if the effect thereof would cause its net worth to be reduced below the regulatory capital requirements imposed by federal and state regulation.  The Corporation paid $620,000 of cash dividends to its shareholders in the first six months of fiscal 2009.

In June 2008, the Corporation’s Board of Directors authorized a stock repurchase program; however, in order to preserve capital during this difficult banking environment, the Corporation has not repurchased any of its stock under this program during the six months ended December 31, 2008.  As of December 31, 2008, all of the 310,385 authorized shares from the June 2008 stock repurchase program are available for future repurchase.
 
 
38
Incentive Plans

As of December 31, 2008, the Corporation had three share-based compensation plans, which are described below.  These plans include the 2006 Equity Incentive Plan, 2003 Stock Option Plan and 1996 Stock Option Plan.  The compensation cost that has been charged against income for these plans was $299,000 and $199,000 for the quarters ended December 31, 2008 and 2007, respectively, and there was no tax benefit from these plans during either quarter.  For the six months ended December 31, 2008 and 2007, the compensation cost for these plans was $558,000 and $385,000, respectively, and the tax benefit from these plans was $0 and $6,000, respectively.

Equity Incentive Plan.  The Corporation established and the shareholders approved the 2006 Equity Incentive Plan (“2006 Plan”) for directors, advisory directors, directors emeriti, officers and employees of the Corporation and its subsidiary.  The 2006 Plan authorizes 365,000 stock options and 185,000 shares of restricted stock.  The 2006 Plan also provides that no person may be granted more than 73,000 shares of stock options or 27,750 shares of restricted stock in any one year.

Equity Incentive Plan - Stock Options.  Under the 2006 Plan, options may not be granted at a price less than the fair market value at the date of the grant.  Options typically vest over a five-year or shorter period as long as the director, advisory director, director emeriti, officer or employee remains in service to the Corporation.  The options are exercisable after vesting for up to the remaining term of the original grant.  The maximum term of the options granted is 10 years.

The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option valuation model with the assumptions noted in the following table.  The expected volatility is based on implied volatility from historical common stock closing prices for the last 84 months.  The expected dividend yield is based on the most recent quarterly dividend on an annualized basis.  The expected term is based on the historical experience of all fully vested stock option grants and is reviewed annually.  The risk-free interest rate is based on the U.S. Treasury note rate with a term similar to the underlying stock option on the particular grant date.

 
Quarter
Quarter
Six Months
Six Months
 
Ended
Ended
Ended
Ended
 
December 31,
December 31,
December 31,
December 31,
 
2008
2007
2008
2007
Expected volatility
-
  
-
  
35%
  
22%
  
Weighted-average volatility
-
  
-
  
           35%
  
22%
  
Expected dividend yield
-
  
-
  
2.8%
  
3.6%
  
Expected term (in years)
-
  
-
  
7.0
  
7.4
  
Risk-free interest rate
-
  
-
  
3.5%
  
4.8%
  

There was no stock option activity in the second quarter of fiscal 2009.  This compares to a total of 13,500 options forfeited and no other activity in the second quarter of fiscal 2008.  For the first six months of fiscal 2009, a total of 182,000 options were granted, while no options were exercised or forfeited. This compares to a total of 12,000 options forfeited, while no options were granted or exercised during the first six months of fiscal 2008.  As of December 31, 2008 and 2007, there were 7,700 options and 189,700 options available for future grants under the 2006 Plan, respectively.

 
39
 


The following table summarizes the stock option activity in the 2006 Plan for the quarter and six months ended December 31, 2008.
Options
Shares
Weighted-
Average
Exercise
Price
Weighted-
Average
Remaining
Contractual
Term (Years)
Aggregate
Intrinsic
Value
($000)
Outstanding at October 1, 2008
357,300
  
$ 17.47
          
Granted
-
  
-
          
Exercised
-
  
-
          
Forfeited
-
  
-
          
Outstanding at December 31, 2008
357,300
  
 $ 17.47
  
5.30
  
    $ -
  
Vested and expected to vest at December 31, 2008
292,852
  
$ 17.73
  
5.37
  
    $ -
  
Exercisable at December 31, 2008
35,060
  
$ 28.31
  
8.11
  
     $ -
  


Options
Shares
Weighted-
Average
Exercise
Price
Weighted-
Average
Remaining
Contractual
Term (Years)
Aggregate
Intrinsic
Value
($000)
Outstanding at July 1, 2008
175,300
  
$ 28.31
          
Granted
182,000
  
$   7.03
          
Exercised
-
  
-
          
Forfeited
-
  
-
          
Outstanding at December 31, 2008
357,300
  
 $ 17.47
  
5.30
  
    $ -
  
Vested and expected to vest at December 31, 2008
292,852
  
$ 17.73
  
5.37
  
    $ -
  
Exercisable at December 31, 2008
35,060
  
$ 28.31
  
8.11
  
     $ -
  

As of December 31, 2008 and 2007, there was $873,000 and $747,000 of unrecognized compensation expense, respectively, related to unvested share-based compensation arrangements granted under the stock options in the 2006 Plan.  The expense is expected to be recognized over a weighted-average period of 2.8 years and 4.1 years, respectively.  The forfeiture rate during the first six months of fiscal 2009 was 20 percent and was calculated by using the historical forfeiture experience of all fully vested stock option grants and is reviewed annually.

Equity Incentive Plan – Restricted Stock.  The Corporation will use 185,000 shares of its treasury stock to fund the 2006 Plan.  Awarded shares typically vest over a five-year or shorter period as long as the director, advisory director, director emeriti, officer or employee remains in service to the Corporation.  Once vested, a recipient of restricted stock will have all rights of a shareholder, including the power to vote and the right to receive dividends.  The Corporation recognizes compensation expense for the restricted stock awards based on the fair value of the shares at the award date.

There was no restricted stock activity in the second quarter of fiscal 2009 and 2008.  For the first six months of fiscal 2009, a total of 100,300 shares of restricted stock were awarded, while 800 shares were vested and distributed, and no restricted stock was forfeited.  This compares to a total of 4,000 shares of restricted stock awarded, 6,000 shares forfeited, and no restricted stock vested or distributed during the first six months of fiscal 2008.  As of December 31, 2008 and 2007, there were 23,950 shares and 124,250 shares of restricted stock available for future awards, respectively.
 
 
40

The following table summarizes the unvested restricted stock activity in the quarter and six months ended December 31, 2008.

Unvested Shares
Shares
Weighted-Average
Award Date
Fair Value
Unvested at October 1, 2008
148,900
  
$ 14.84
  
Granted
-
  
-
  
Vested
-
  
-
  
Forfeited
-
  
-
  
Unvested at December 31, 2008
148,900
  
$ 14.84
  
Expected to vest at December 31, 2008
119,120
  
$ 14.84
  

Unvested Shares
Shares
Weighted-Average
Award Date
Fair Value
Unvested at July 1, 2008
49,400
  
$ 25.81
  
Granted
100,300
  
$   6.46
  
Vested
(800
)
$ 18.09
  
Forfeited
-
  
-
  
Unvested at December 31, 2008
148,900
  
$ 14.84
  
Expected to vest at December 31, 2008
119,120
  
$ 14.84
  

As of December 31, 2008 and 2007, there was $1.8 million and $1.4 million of unrecognized compensation expense, respectively, related to unvested share-based compensation arrangements awarded under the restricted stock in the 2006 Plan, and reported as a reduction to stockholders’ equity.  This expense is expected to be recognized over a weighted-average period of 3.0 years and 4.1 years, respectively.  Similar to options, a forfeiture rate of 20 percent is used for the restricted stock compensation expense calculations.

Stock Option Plans.  The Corporation established the 1996 Stock Option Plan and the 2003 Stock Option Plan (collectively, the “Stock Option Plans”) for key employees and eligible directors under which options to acquire up to 1.15 million shares and 352,500 shares of common stock, respectively, may be granted.  Under the Stock Option Plans, options may not be granted at a price less than the fair market value at the date of the grant.  Options vest over a five-year period on a pro-rata basis as long as the employee or director remains in service to the Corporation.  The options are exercisable after vesting for up to the remaining term of the original grant.  The maximum term of the options granted is 10 years.

On April 28, 2005, the Board of Directors accelerated the vesting of 136,950 unvested stock options, which were previously granted to directors, officers and key employees who had three or more continuous years of service with the Corporation or an affiliate of the Corporation.  The Board believed that it was in the best interest of the shareholders to accelerate the vesting of these options which were granted prior to January 1, 2004, since it had a positive impact on the future earnings of the Corporation.  This action was taken as a result of SFAS No. 123R which the Corporation adopted on July 1, 2005.

As a result of accelerating the vesting of these options, the Corporation recorded a $320,000 charge to compensation expense during the quarter ended June 30, 2005.  This charge represents a new measurement of compensation cost for these options as of the modification date.  The modification introduced the potential for an effective renewal of the awards as some of these options may have been forfeited by the holders.  This charge requires quarterly adjustment in future periods for actual forfeiture experience.  A final recovery of $19,000 was realized in the first quarter of fiscal 2009; and since inception, all of the original costs have been recovered.  The Corporation estimates that the compensation expense related to these options that would have been recognized over their remaining vesting period pursuant to the transition provisions of SFAS No. 123R is $1.7 million.

The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option valuation model with the assumptions noted in the following table.  The expected volatility is based on implied volatility from historical common stock closing prices for the last 84 months.  The expected dividend yield is based on the most recent quarterly dividend on an annualized basis.  The expected term is
 
 
41
based on the historical experience of all fully vested stock option grants and is reviewed annually.  The risk-free interest rate is based on the U.S. Treasury note rate with a term similar to the underlying stock option on the particular grant date.


 
Quarter
Quarter
Six Months
Six Months
 
Ended
Ended
Ended
Ended
 
December 31,
December 31,
December 31,
December 31,
 
2008
2007
2008
2007
Expected volatility
-
  
-
  
-
  
22%
  
Weighted-average volatility
-
  
-
  
-
  
22%
  
Expected dividend yield
-
  
-
  
-
  
3.6%
  
Expected term (in years)
-
  
-
  
-
  
7.4
  
Risk-free interest rate
-
  
-
  
-
  
4.8%
  

There was no activity in the second quarter of fiscal 2009 and 2008.  For the first six months of fiscal 2009, there was no stock option activity.  This compares to a total of 50,000 options that were granted, 7,500 options that were exercised, and 48,700 options forfeited in the first six months of fiscal 2008.  As of December 31, 2008 and 2007, the number of options available for future grants under the Stock Option Plans were 14,900 and 14,900 options, respectively.

The following is a summary of the activity in the Stock Option Plans for the quarter and six months ended December 31, 2008.

Options
Shares
Weighted-
Average
Exercise
Price
Weighted-
Average
Remaining
Contractual
Term (Years)
Aggregate
Intrinsic
Value
($000)
Outstanding at October 1, 2008
550,400
  
 $ 20.52
          
Granted
-
  
-
          
Exercised
-
  
-
          
Forfeited
-
  
-
          
Outstanding at December 31, 2008
550,400
  
 $ 20.52
  
5.10
  
$ -
  
Vested and expected to vest at December 31, 2008
524,960
  
$ 20.30
  
5.01
  
$ -
  
Exercisable at December 31, 2008
423,200
  
$ 19.16
  
4.50
  
$ -
  

Options
Shares
Weighted-
Average
Exercise
Price
Weighted-
Average
Remaining
Contractual
Term (Years)
Aggregate
Intrinsic
Value
($000)
Outstanding at July 1, 2008
550,400
  
 $ 20.52
          
Granted
-
  
-
          
Exercised
-
  
-
          
Forfeited
-
  
-
          
Outstanding at December 31, 2008
550,400
  
 $ 20.52
  
5.10
  
$ -
  
Vested and expected to vest at December 31, 2008
524,960
  
$ 20.30
  
5.01
  
$ -
  
Exercisable at December 31, 2008
423,200
  
$ 19.16
  
4.50
  
$ -
  

The weighted-average grant-date fair value of options granted during the six months ended December 31, 2008 and 2007 was $2.14 and $3.94 per share, respectively.  The total intrinsic value of options exercised during the six months ended December 31, 2008 and 2007 was $0 and $104,000, respectively.

As of December 31, 2008 and 2007, there was $1.2 million and $1.3 million of unrecognized compensation expense, respectively, related to unvested share-based compensation arrangements granted under the Stock Option Plans.  The expense is expected to be recognized over a weighted-average period of 2.1 years and
 
 
42
2.8 years, respectively.  The forfeiture rate during the first six months of fiscal 2009 was 20% and was calculated by using the historical forfeiture experience of all fully vested stock option grants and is reviewed annually.


Supplemental Information

 
     At
  
     At
  
     At
 
     December 31,
  
     June 30,
  
     December 31,
 
     2008
  
     2008
  
     2007
           
Loans serviced for others (in thousands)
$ 173,288
  
$ 181,032
  
$ 195,645
           
Book value per share
$ 18.98
  
$ 19.97
  
$     20.35


ITEM 3 – Quantitative and Qualitative Disclosures about Market Risk.

The principal financial objective of the Corporation’s interest rate risk management function is to achieve long-term profitability while limiting exposure to the fluctuation of interest rates.  The Bank, through its Asset Liability Committee seeks to reduce the exposure of its earnings to changes in market interest rates by managing the mismatch between asset and liability maturities.  The principal element in achieving this objective is to manage the interest-rate sensitivity of the Bank’s assets by holding loans with interest rates subject to periodic market adjustments.  In addition, the Bank maintains a liquid investment securities portfolio comprised of government agency securities and mortgage-backed securities.  The Bank relies on retail deposits as its primary source of funding while utilizing FHLB – San Francisco advances as a secondary source of funding.  As part of its interest rate risk management strategy, the Bank promotes transaction accounts and time deposits with terms up to five years.

Through the use of an internal interest rate risk model and the OTS interest rate risk model, the Bank is able to analyze its interest rate risk exposure by measuring the change in net portfolio value (“NPV”) over a variety of interest rate scenarios.  NPV is defined as the net present value of expected future cash flows from assets, liabilities and off-balance sheet contracts.  The calculation is intended to illustrate the change in NPV that would occur in the event of an immediate change in interest rates of at least 100 basis points with no effect given to steps that management might take to counter the effect of the interest rate movement.  The results of the internal interest rate risk model are reconciled with the results provided by the OTS on a quarterly basis.  Significant deviations are researched and adjusted where applicable.

The following table is derived from the OTS interest rate risk model and represents the NPV based on the indicated changes in interest rates as of December 31, 2008 (dollars in thousands).

               
NPV as Percentage
    
   
Net
  
NPV
  
Portfolio
  
of Portfolio Value
  
Sensitivity
Basis Points ("bp")
  
Portfolio
  
Change
  
Value of
  
Assets
  
Measure
Change in Rates
  
Value
  
(1)
  
Assets
  
(2)    
 
(3)
                     
+300 bp
    
 $ 119,073
  
$   4,722
  
 $ 1,543,338
  
             7.72%           
 
        50 bp
+200 bp
    
$ 124,526
  
$ 10,175
  
 $ 1,564,454
  
             7.96%            
 
        74 bp
+100 bp
    
$ 119,904
  
$   5,553
  
 $ 1,575,942
  
             7.61%            
 
        39 bp
0 bp
    
$ 114,351
  
$           -
  
 $ 1,584,820
  
             7.22%            
 
           -
-100 bp
    
$ 105,655
  
$  (8,696
)
 $ 1,589,117
  
             6.65%           
 
       -57 bp
                     

(1)  
Represents the increase (decrease) of the NPV at the indicated interest rate change in comparison to the NPV at December 31, 2008 (“base case”).
(2)  
Calculated as the NPV divided by the portfolio value of total assets.
(3)  
Calculated as the change in the NPV ratio from the base case amount assuming the indicated change in interest rates (expressed in basis points).  
 
43
 
The following table is derived from the OTS interest rate risk model and represents the change in the NPV at a -100 basis point rate shock at December 31, 2008 and a +200 basis point rate shock at June 30, 2008.

 
At December 31, 2008
  
       At June 30, 2008
  
 
(-100 bp rate shock)
  
        (+200 bp rate shock)
  
Pre-shock NPV ratio: NPV as a % of PV Assets
 7.22
%
9.01
%
Post-shock NPV ratio: NPV as a % of PV Assets
6.65
%
8.07
%
Sensitivity measure: Change in NPV Ratio
57
bp
95
bp
TB 13a Level of Risk
Minimal                                   
Minimal                                  

As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing tables.  For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates.  Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates.  Additionally, certain assets, such as adjustable rate mortgage (“ARM”) loans, have features that restrict changes in interest rates on a short-term basis and over the life of the asset.  Further, in the event of a change in interest rates, expected rates of prepayments on loans and early withdrawals from time deposits could likely deviate significantly from those assumed when calculating the tables above.  It is also possible that, as a result of an interest rate increase, the higher mortgage payments required from ARM borrowers could result in an increase in delinquencies and defaults.  Changes in market interest rates may also affect the volume and profitability of the Corporation’s mortgage banking operations.  Accordingly, the data presented in the tables above should not be relied upon as indicative of actual results in the event of changes in interest rates.  Furthermore, the NPV presented in the foregoing tables is not intended to present the fair market value of the Bank, nor does it represent amounts that would be available for distribution to shareholders in the event of the liquidation of the Corporation.

The Bank also models the sensitivity of net interest income for the 12-month period subsequent to any given month-end assuming a dynamic balance sheet (accounting for the Bank’s current balance sheet, 12-month business plan, embedded options, rate floors, periodic caps, lifetime caps, and loan, investment, deposit and borrowing cash flows, among others), and immediate, permanent and parallel movements in interest rates of plus 100, plus 200, minus 100 and minus 200 basis points.  The following table describes the results of the analysis at December 31, 2008 and June 30, 2008.

At December 31, 2008
  
At June 30, 2008
Basis Point (bp)
  
Change in
Basis Point (bp)
  
Change in
Change in Rates
  
Net Interest Income
Change in Rates
  
Net Interest Income
+200 bp
  
           -1.87%
+200 bp
  
             -9.78%
+100 bp
  
          +0.88%
+100 bp
  
  -5.29%
-100 bp
  
           -3.17%
-100 bp
  
 +3.62%
-200 bp
  
           -2.12%
-200 bp
  
 +8.58%

Management believes that the assumptions used to complete the analysis described in the table above are reasonable.  However, past experience has shown that immediate, permanent and parallel movements in interest rates will not necessarily occur.  Additionally, while the analysis provides a tool to evaluate the projected net interest income to changes in interest rates, actual results may be substantially different if actual experience differs from the assumptions used to complete the analysis, particularly with respect to the 12-month business plan when asset growth is forecast.  Therefore, the model results that we disclose should be thought of as a risk management tool to compare the trends of the Corporation’s current disclosure to previous disclosures, over time, within the context of the actual performance of the treasury yield curve.
 
ITEM 4 – Controls and Procedures.

a) An evaluation of the Corporation’s disclosure controls and procedure (as defined in Section 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was carried out under the supervision and
 
 
44
with the participation of the Corporation’s Chief Executive Officer, Chief Financial Officer and the Corporation’s Disclosure Committee as of the end of the period covered by this quarterly report.  In designing and evaluating the Corporation’s disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met.  Additionally, in designing disclosure controls and procedures, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.  Based on their evaluation, the Corporation’s Chief Executive Officer and Chief Financial Officer concluded that the Corporation’s disclosure controls and procedures as of December 31, 2008 are effective in ensuring that the information required to be disclosed by the Corporation in the reports it files or submits under the Act is (i) accumulated and communicated to the Corporation’s management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

b) There have been no changes in the Corporation’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Act) that occurred during the quarter ended December 31, 2008, that has materially affected, or is reasonably likely to materially affect, the Corporation’s internal control over financial reporting.  The Corporation does not expect that its internal control over financial reporting will prevent all error and all fraud.  A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met.  Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Corporation have been detected.  These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake.  Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control.  The design of any control procedure also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.  Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.


PART II – OTHER INFORMATION

Item 1.  Legal Proceedings.

From time to time, the Corporation or its subsidiaries are engaged in legal proceedings in the ordinary course of business, none of which are currently considered to have a material impact on the Corporation’s financial position or results of operations.


Item 1A.  Risk Factors.

There have been no material changes in the risk factors previously disclosed in Part I, Item IA of our Annual Report of Form 10-K for the year ended June 30, 2008, except that the following risk factors are added to those previously contained in the Form 10-K.

If external funds were not available, this could adversely impact our growth and prospects.
We rely on retail deposits, advances from the FHLB - San Francisco and other borrowings to fund our operations.  Although we have historically been able to replace maturing deposits and advances as necessary, we might not be able to replace such funds in the future if, among other things, our results of operations or financial condition, or the results of operations or financial condition of the FHLB - San Francisco, or market conditions were to change. In addition, if we fall below the FDIC’s thresholds to be considered “well capitalized” we will be unable to continue with uninterrupted access to the brokered funds markets.
 
 
45
 
Although we consider these sources of funds adequate for our liquidity needs, we may be compelled or elect to seek additional sources of financing in the future.  Likewise, we may seek additional debt in the future to achieve our long-term business objectives, in connection with future acquisitions or for other reasons.  Additional borrowings, if sought, may not be available to us or, if available, may not be on reasonable terms.  If additional financing sources are unavailable or not available on reasonable terms, our financial condition, results of operations and future prospects could be materially adversely affected.

Difficult market conditions have adversely affected our industry.
We are particularly exposed to downturns in the U.S. housing market. Dramatic declines in the housing market over the past year, with falling home prices and increasing foreclosures, unemployment and under-employment, have negatively impacted the credit performance of mortgage loans and resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities, major commercial and investment banks, and regional financial institutions such as our Corporation.  Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced or ceased providing funding to borrowers, including to other financial institutions. This market turmoil and tightening of credit have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressure on consumers and lack of confidence in the financial markets have adversely affected our business, financial condition and results of operations. We do not expect that the difficult conditions in the financial markets are likely to improve in the near future. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry.  In particular, we may face the following risks in connection with these events:

·      
Increased regulation of our industry. Compliance with such regulation may increase our costs and limit our ability to pursue business opportunities.

·      
The process we use to estimate losses inherent in our credit exposure requires difficult, subjective and complex judgments, including forecasts of economic conditions and how these economic conditions might impair the ability of our borrowers to repay their loans.  The level of uncertainty concerning economic conditions may adversely affect the accuracy of our estimates which may, in turn, impact the reliability of the process.


·      
We may be required to pay significantly higher FDIC deposit premiums because market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits.

Recently enacted legislation and other measures undertaken by the Treasury, the Federal Reserve and other governmental agencies may not help stabilize the U.S. financial system or improve the housing market.
On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008 (the “EESA”), which, among other measures, authorized the Treasury Secretary to establish the Troubled Asset Relief Program (“TARP”).  EESA gives broad authority to Treasury to purchase, manage, modify, sell and insure the troubled mortgage related assets that triggered the current economic crisis as well as other “troubled assets.”  EESA includes additional provisions directed at bolstering the economy, including:

·      
Authority for the Federal Reserve to pay interest on depository institution balances;

·      
Mortgage loss mitigation and homeowner protection;
   
·      
Temporary increase in Federal Deposit Insurance Corporation (“FDIC”) insurance coverage from $100,000 to $250,000 through December 31, 2009; and

·      
Authority to the Securities and Exchange Commission (the “SEC”) to suspend mark-to-market accounting requirements for any issuer or class of category of transactions.

46

Pursuant to the TARP, the Treasury has the authority to, among other things, purchase up to $700 billion (of which $250 billion is currently available) of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.  Under the TARP, the Treasury has created a capital purchase program, pursuant to which it is providing access to capital to financial institutions through a standardized program to acquire preferred stock (accompanied by warrants) from eligible financial institutions that will serve as Tier 1 capital.

EESA also contains a number of significant employee benefit and executive compensation provisions, some of which apply to employee benefit plans generally, and others which impose on financial institutions that participate in the TARP program restrictions on executive compensation.

EESA followed, and has been followed by, numerous actions by the Federal Reserve, Congress, Treasury, the SEC and others to address the liquidity and credit crisis that has followed the sub-prime meltdown that commenced in 2007.  These measures include homeowner relief that encourage loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial institutions and investment banks; the lowering of the federal funds rate; emergency action against short selling practices; a temporary guaranty program for money market funds; the establishment of a commercial paper funding facility to provide back-stop liquidity to commercial paper issuers; coordinated international efforts to address illiquidity and other weaknesses in the banking sector.

In addition, the Internal Revenue Service has issued an unprecedented wave of guidance in response to the credit crisis, including a relaxation of limits on the ability of financial institutions that undergo an “ownership change” to utilize their pre-change net operating losses and net unrealized built-in losses.  The relaxation of these limits may make it significantly more attractive to acquire financial institutions whose tax basis in their loan portfolios significantly exceeds the fair market value of those portfolios.

On October 14, 2008, the FDIC announced the establishment of a temporary liquidity guarantee program to provide insurance for all non-interest bearing transaction accounts and guarantees of certain newly issued senior unsecured debt  issued by financial institutions (such as the Bank), bank holding companies and savings and loan holding companies (such as the Corporation).  Financial institutions are automatically covered by this program for the 30-day period commencing October 14, 2008 and will continue to be covered as long as they do not affirmatively opt out of the program.  Under the program, newly issued senior unsecured debt issued on or before June 30, 2009 will be insured in the event the issuing institution subsequently fails, or its holding company files for bankruptcy.  The debt includes all newly issued unsecured senior debt (e.g., promissory notes, commercial paper and inter-bank funding). The aggregate coverage for an institution may not exceed 125% of its debt outstanding on December 31, 2008 that was scheduled to mature before June 30, 2009.  The guarantee will extend to June 30, 2012 even if the maturity of the debt is after that date.

The actual impact that EESA and such related measures undertaken to alleviate the credit crisis will have generally on the financial markets, including the extreme levels of volatility and limited credit availability currently being experienced, is unknown.   The failure of such measures to help stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely affect our business, financial condition, results of operations, access to credit or the trading price of our common stock.

Continued capital and credit market volatility may adversely affect our ability to access capital and may have a material adverse effect on our business, financial condition and results of operations.
The capital and credit markets have been experiencing volatility and disruption for more than a year. In recent months, the volatility and disruption has reached unprecedented levels. In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength. If current levels of market disruption and volatility continue or worsen, there can be no assurance that we will not experience an adverse effect, which may be material, on our ability to access capital and on our business, financial condition and results of operations may be adversely affected.
 
 
47

Our deposit insurance assessments will increase substantially, which will adversely affect our profits.
Our Federal Deposit Insurance Corporation deposit insurance expense for the year ended December 31, 2008 was $440,000.  Deposit insurance assessments will increase in 2009 due to recent strains on the Federal Deposit Insurance Corporation deposit insurance fund resulting from the cost of recent bank failures and an increase in the number of banks likely to fail over the next few years.  The current rates for Federal Deposit Insurance Corporation assessments range from five to 43 basis points, depending on the financial health of the insured institution.  On December 16, 2008, the Federal Deposit Insurance Corporation issued a final rule increasing that assessment range to 12 to 50 basis points for the first quarter of 2009.  For the remainder of 2009, the Federal Deposit Insurance Corporation has proposed a range of 10 to 45 basis points for institutions that do not trigger the brokered deposits adjustment, the secured liability adjustment, or the unsecured debt adjustment.  For institutions that are subject to those adjustments, the Federal Deposit Insurance Corporation proposes rate assessments in the range of eight to 77.5 basis points.  In this regard, the brokered deposit adjustment can range from 0 to 10 basis points, the secured liability adjustment (which includes, among others, Federal Home Loan Bank advances, securities sold under repurchase agreements, secured federal funds purchased, and certain other secured borrowings) can range from 0 to 22.5 basis points, and the unsecured debt adjustment can range from minus two to 0 basis points.  The Federal Deposit Insurance Corporation has stated that it may need to set a higher base rate schedule at the time of the issuance of its final assessment rate rule, depending upon the information available at that time including, without limitation, on its updated bank failure and loss projections.  The Federal Deposit Insurance Corporation’s proposal would continue to allow it to adopt actual assessment rates that are higher or lower than the total base assessment rates without the necessity of further notice and comment rulemaking, although this power is subject to several limitations.  The Federal Deposit Insurance Corporation has announced that it intends to issue a final rule in early 2009, to be effective on April 1, 2009, to set new assessment rates beginning with the second quarter of 2009 and to make other changes to its assessment rule.

Liquidity risk could impair our ability to fund operations and jeopardize our financial condition.
Liquidity is essential to our business.  An inability to raise funds through deposits, borrowings, the sale of investments or loans, and other sources could have a substantial negative effect on our liquidity.  Our access to funding sources in amounts adequate to finance our activities or the terms of which are acceptable to us could be impaired by factors that affect us specifically or the financial services industry or economy in general.  Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity as a result of a downturn in the markets in which our loans are concentrated or adverse regulatory action against us.  Our ability to borrow could also be impaired by factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations and the continued deterioration in credit markets.

Provident Bank can borrow up to 45% of its assets from the Federal Home Loan Bank of San Francisco, subject to the amount of qualifying collateral it holds.  At December 31, 2008, we held $745.8 million in qualifying collateral with the Federal Home Loan Bank of San Francisco and had borrowed $486.4 million, compared to $499.5 million at December 31, 2007.  The unused borrowing capacity available from the Federal Home Loan Bank of San Francisco at December 31, 2008 was $230.9 million.  If our funding needs were greater than the remaining $230.9 million available from the Federal Home Loan Bank of San Francisco, we would have to raise deposits or sell assets to provide additional funding.  If the Bank had to quickly raise deposits or sell assets, we may have to pay above market rates to raise those deposits or sell assets at a loss, both of which would adversely affect our financial condition and results of operations, perhaps materially.  At December 31, 2008 and 2007, we have no brokered deposits.

We may elect or be compelled to seek additional capital in the future, but that capital may not be available when it is needed.
We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations.  In addition, we may elect to raise additional capital to support our business or to finance acquisitions, if any, or we may otherwise elect to raise additional capital.  In that regard, a number of financial institutions have recently raised considerable amounts of capital as a result of a deterioration in their results of operations and financial condition arising from the turmoil in the mortgage loan market, deteriorating economic conditions, declines in real estate values and other factors.  Should we be required
 
 
48
by regulatory authorities to raise additional capital, we may seek to do so through the issuance of, among other things, our common stock or preferred stock.

Our ability to raise additional capital, if needed, will depend on conditions in the capital markets, economic conditions and a number of other factors, many of which are outside our control, and on our financial performance. Accordingly, we cannot assure you of our ability to raise additional capital if needed or on terms acceptable to us. If we cannot raise additional capital when needed, it may have a material adverse effect on our financial condition, results of operations and prospects.


Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds.

The table below represents the Corporation’s purchases of equity securities for the second quarter of fiscal 2009.

 
 
 
 
Period
 
 
        (a)    Total
Number of
Shares Purchased
 
 
       (b)   Average
Price Paid
per Share
 
(c) Total Number of
Shares Purchased as
Part of Publicly
Announced Plan
(d) Maximum
Number of Shares
that May Yet Be
Purchased Under the
Plan (1)
October 1 – 31, 2008
-
  
$ -
-
310,385
November 1 – 30, 2008
-
  
   -
-
310,385
December 1 – 31, 2008
-
  
   -
-
310,385
Total
-
  
 $ -
-
310,385

(1)  
On June 26, 2008, the Corporation announced a new repurchase plan of 310,385 shares, which expires on June 26, 2009.

During the quarter ended December 31, 2008, the Corporation did not sell any securities that were not registered under the Securities Act of 1933.


Item 3.  Defaults Upon Senior Securities.

Not applicable.


Item 4.  Submission of Matters to a Vote of Security Holders.

The Corporation’s 2008 Annual Meeting of Shareholders was held on November 25, 2008 at the Riverside Art Museum, 3425 Mission Inn Avenue, Riverside, California.  The results of the two items presented at the meeting were as follows:

1.  
Election of Directors:
Shareholders elected the following nominees to the Board of Directors for a three-year term ending 2011 by the following vote:

 
FOR
  
AGAINST
 
Number
of Votes
 
Percentage
  
Number
of Votes
 
Percentage
Craig G. Blunden
5,902,620
98.5%
  
86,986
1.5%
Roy H. Taylor
5,904,692
98.6%
  
84,914
1.4%

The following directors, who were not up for election at the Annual Meeting of Shareholders, will continue to serve as directors: Joseph P. Barr, Bruce W. Bennett, Debbi H. Guthrie, Robert G. Schrader, and William E. Thomas.

2.  
Ratification of Appointment of Independent Auditor:
 
 
49
Shareholders ratified the appointment of Deloitte & Touche LLP as the Corporation’s independent auditor for the fiscal year ending June 30, 2009 by the following vote:

    
                 
     
Number
of Votes 
      
Percentage 
  
FOR
    5,974,160       99.7 %
AGAINST
    13,702       0.2 %
ABSTAIN
    1,744       0.1 %
BROKER NON-VOTES
    -       -  


Item 5.  Other Information.

Not applicable.


Item 6.  Exhibits.

Exhibits:

3.1   
Certificate of Incorporation of Provident Financial Holdings, Inc. (Incorporated by reference to Exhibit 3.1 to the Corporation’s Registration Statement on Form S-1 (File No. 333-02230))
   
3.2   
Bylaws of Provident Financial Holdings, Inc. (Incorporated by reference to Exhibit 3.2 to the Corporation’s Form 8-K dated October 25, 2007). 
   
10.1  
Employment Agreement with Craig G. Blunden (Incorporated by reference to Exhibit 10.1 to the Corporation’s Form 8-K dated December 19, 2005)

10.2  
Post-Retirement Compensation Agreement with Craig G. Blunden (Incorporated by reference to Exhibit 10.2 to the Corporation’s Form 8-K dated December 19, 2005)

10.3  
1996 Stock Option Plan (incorporated by reference to Exhibit A to the Corporation’s proxy statement dated December 12, 1996)

10.4  
1996 Management Recognition Plan (incorporated by reference to Exhibit B to the Corporation’s proxy statement dated December 12, 1996)

10.5  
Severance Agreement with Richard L. Gale, Kathryn R. Gonzales, Lilian Salter,  Donavon P. Ternes and David S. Weiant (incorporated by reference to Exhibit 10.1 in the Corporation’s Form 8-K dated July 3, 2006)
 
10.6  
2003 Stock Option Plan (incorporated by reference to Exhibit A to the Corporation’s proxy statement dated October 21, 2003)
 
10.7  
Form of Incentive Stock Option Agreement for options granted under the 2003 Stock Option Plan (incorporated by reference to Exhibit 10.13 to the Corporation’s Annual Report on Form 10-K for the year ended June 30, 2005)
 
10.8  
Form of Non-Qualified Stock Option Agreement for options granted under the 2003 Stock Option Plan (incorporated by reference to Exhibit 10.14 to the Corporation’s Annual Report on Form 10-K for the year ended June 30, 2005)
 
10.9  
2006 Equity Incentive Plan (incorporated by reference to Exhibit A to the Corporation’s proxy statement dated October 12, 2006)
 
10.10  
Form of Incentive Stock Option Agreement for options granted under the 2006 Equity Incentive Plan (incorporated by reference to Exhibit 10.10 in the Corporation’s Form 10-Q ended December 31, 2006)
 
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10.11  
Form of Non-Qualified Stock Option Agreement for options granted under the 2006 Equity Incentive Plan (incorporated by reference to Exhibit 10.11 in the Corporation’s Form 10-Q ended December 31, 2006)
 
10.12  
Form of Restricted Stock Agreement for restricted shares awarded under the 2006 Equity Incentive Plan (incorporated by reference to Exhibit 10.12 in the Corporation’s Form 10-Q ended December 31, 2006)
 
14     
Code of Ethics for the Corporation’s directors, officers and employees (incorporated by reference to Exhibit 14 in the Corporation’s Annual Report on Form 10-K for the year ended June 30, 2007)  
   
31.1  
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2  
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1  
Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2  
Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 
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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
  Provident Financial Holdings, Inc. 
   
   
   
February 9, 2009  /s/Craig G. Blunden                                                      
  Craig G. Blunden 
  Chairman, President and Chief Executive Officer 
  (Principal Executive Officer) 
   
   
   
February 9, 2009     /s/ Donavon P. Ternes                                                  
   Donavon P. Ternes
   Chief Operating Officer and Chief Financial Officer
   (Principal Financial and Accounting Officer)
   
 

                         
 
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Exhibit Index


31.1  
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2  
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1  
Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2  
Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.