10-Q 1 c73186e10vq.txt QUARTERLY REPORT ================================================================================ U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002 COMMISSION FILE NUMBER 0-19829 UMBRELLA BANCORP, INC. ------------------------- (Exact name of registrant as specified in its charter) Maryland 36-3620612 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.} 5818 South Archer Road, Summit, Illinois 60501-1830 (Address of principal executive offices) (708) 458-2002 (Issuer's telephone number) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such report(s), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- The Registrant had 1,695,986 shares outstanding as of November 7, 2002. Transitional Small Business Disclosure Format (check one): Yes No X ----- ----- ================================================================================ UMBRELLA BANCORP, INC. AND SUBSIDIARIES FORM 10-Q SEPTEMBER 30, 2002 INDEX PAGE NO. -------- PART I - FINANCIAL INFORMATION ------------------------------ Item 1 Financial Statements Consolidated Statements of Financial Condition as of September 30, 2002 and December 31, 2001 (unaudited)....... 4 Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2002 and 2001 (unaudited)............. 5 Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2002 and 2001 (unaudited).... 6 Consolidated Statements of Stockholders' Equity for the Nine Months Ended September 30, 2002 and 2001 (unaudited) ............ 7 Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2002 and 2001 (unaudited) ................... 8 Notes to Consolidated Financial Statements ...................... 9 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations ....................................... 16 Item 3 Quantitative and Qualitative Disclosures about Market Risk....... 30 Item 4 Controls and Procedures.......................................... 31 PART II - OTHER INFORMATION --------------------------- Item 1 Legal Proceedings .............................................. 32 Item 2 Changes in Securities .......................................... 32 Item 3 Default Upon Senior Securities ................................. 32 Item 4 Submission of Matters to a Vote of Security Holders ............ 32 Item 5 Other Information .............................................. 32 Item 6 Exhibits and Reports on Form 8-K ............................... 32 Form 10-Q Signature Page ................................................. 34 2 UMBRELLA BANCORP, INC. AND SUBSIDIARIES FORM 10-Q SEPTEMBER 30, 2002 INDEX (CONTINUED) Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.................................................... 35 Exhibit 99.1 - Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002..................................... Exhibit 99.2 - Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002..................................... 3 PART 1 - FINANCIAL INFORMATION UMBRELLA BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Unaudited) (Dollars in Thousands)

See notes to accompanying unaudited consolidated financial statements. 4 UMBRELLA BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in Thousands, Except Per Share Data)

See notes to accompanying consolidated unaudited financial statements. 5 UMBRELLA BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Dollars in Thousands)

See notes to accompanying consolidated unaudited financial statements. 6 UMBRELLA BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Dollars in Thousands) (Unaudited)

See notes to accompanying consolidated unaudited financial statements. 7 UMBRELLA BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in Thousands)

See accompanying notes to unaudited consolidated financial statements. 8 UMBRELLA BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A - BASIS OF PRESENTATION AND NEW ACCOUNTING POLICIES The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and with the instructions to Form 10-Q and Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments, including normal recurring accruals considered necessary for fair presentation, have been included. The results of operations for the three and nine months ended September 30, 2002, are not necessarily indicative of the results that may be expected for the year ending December 31, 2002. Certain reclassifications have been made to prior period amounts in the financial statements in order to conform to the current period presentation. The unaudited consolidated financial statements include Umbrella Bancorp, Inc. (the "Bancorp" or the "Company") and its wholly owned subsidiaries, UmbrellaBank, fsb, (the "Savings Bank"), Argo Redemption Corp., Inc. ("Argo Redemption" or "ARC"), and the Savings Bank's wholly owned subsidiary, Dolton-Riverdale Savings Service Corporation (Dolton-Riverdale). The Bancorp, through its subsidiaries, provides a full range of financial services through its Internet banking delivery channel at http://www.umbrellabank.com and two retail banking facilities in Cook County, Illinois. As discussed more fully in the Accounting Developments section of the Management Discussion and Analysis ("MDE&A") the Company adopted Statement of Financial Accounting Standards (SFAS) No. 145 "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections" and SFAS No. 146 "Accounting for Costs Associated with Exit or Disposal Activities", effective September 30, 2002 and July 1, 2002, respectively. NOTE B - PREMISES AND EQUIPMENT HELD FOR SALE During June 2002, the Savings Bank classified its investment in an office building as held for sale and, as such, it is being carried at the lower of cost or fair value. This building was purchased in April 2001 as a branch location for the Savings Bank. As of September 30, 2002, the net book value of this office building was $4.6 million. During the nine month period ended September 30, 2002, occupancy and equipment expense was reduced by approximately $477,000 related to rental income from the building and included approximately $191,000 of expenses from the building. In addition, as of September 30, 2002, the Savings Bank classified $300,000 of leasehold improvements and furniture fixtures and equipment located in its two branch locations and corporate office as held for sale. As described further in Note K - Business Plan, the Savings Bank is pursuing the sale of its branch deposits and operations and is exploring the consolidation of its corporate locations which would result in the sale of certain leasehold improvements and furniture fixtures and equipment at these locations. The Company currently leases the facilities it utilizes for its branch and corporate locations from third parties. Management anticipates that the acquirer of its branch deposits and operations and the new tenants for its corporate locations would also acquire the leasehold improvements and furniture and fixtures at these locations. Management also anticipates that the third party owners of these facilities will allow the Company to assign its lease obligations to these parties. NOTE C - LOANS HELD FOR SALE As of September 30, 2002 loans held for sale consisted of loans under the purchase repurchase program and loans held for sale-other as described further following. Loans held for sale-purchase repurchase as of September 30, 2002 and December 31, 2001 were $17.8 million and $65.1 million, respectively. During the third quarter, the Company decided to cease its lending activity under the purchase repurchase program as a result of regulatory dissatisfaction with, and criticisms of, the program and considering the profitability of the program, as described 9 further in Note K - Business Plan. Subsequent to September 30, 2002 the loans held for sale under the purchase repurchase program have declined to $3.1 million and it is anticipated that by December 31, 2002 the termination of the purchase repurchase loan program will be complete. Based on the bid prices received and anticipated the actual and anticipated gains on these sales is not expected to be significant to future operations. Loans held for sale-other, which totaled $108.1 million as of September 30, 2002, consists of both single family mortgage loans and commercial loans which the Company has identified as held for sale in conjunction with the Company's Business Plan as described further in Note - K Business Plan. As of September 30, 2002 and through November 14, 2002, the Savings Bank had entered into firm commitments to sell $42.5 million of the $108.1 million of the loans held for sale-other. Based on the bid prices received and anticipated the actual and anticipated gains on these sales is not expected to be significant to future operations. As of September 30, 2002 loans held for sale-other were transferred from the loans receivable portfolio and were recorded at the lower of cost or fair value with no resulting loss on transfer. NOTE D - ALLOWANCE FOR LOAN AND LEASE LOSSES During the three and nine month periods ended September 30, 2002, the Company recorded provisions for loan and lease losses of approximately $1.7 million and $10.3 million as compared to $37,000 and $143,000 during the three and nine months periods ended September 30, 2001. As of September 30, 2002 and December 31, 2001, the allowance for loan and lease losses ("ALLL") recorded in the consolidated statement of condition was $5.0 million and $3.0 million, respectively. An analysis of the ALLL for the nine month period ended September 30, 2002 is as follows: Savings Bank Bancorp Total -------------------------------------------- ALLL as of December 31, 2001 $ 2,484,000 $ 500,000 $ 2,984,000 Provisions 8,494,000 1,814,000 10,308,000 Charge-offs (6,507,000) (1,814,000) (8,321,000) ------------ ------------ ------------ ALLL as of September 30, 2002 $ 4,471,000 $ 500,000 $ 4,971,000 ============ ============ ============ ALLL as a percentage of Gross Loans (including loans held for sale and discounted loans): December 31, 2001 .79% 15.73% .95% September 30, 2002 2.07% 94.58% 2.29% The significant provisions recorded during the second and third quarters 2002 can be attributable to several internal and external factors, as described below: During the second quarter 2002, the Savings Bank started and completed the conversion of its commercial loan portfolio, which totaled $126.6 million as of March 31, 2002, to a new loan software subsidiary ledger system. As part of that conversion, the Savings Bank performed an extensive review of its loan files, payment histories, delinquency reporting and its loan classification reporting (e.g. special mention, substandard, doubtful and loss). The results of these procedures indicated that the Savings Bank's loan files related to certain loans were missing required documentation in accordance with the Savings Bank's underwriting standards. Although management continues to investigate the existence of such supporting documentation, including contacting lead banks on participation loans and contacting borrowers directly, management downgraded any loans where documentation was not currently in the loan file. In addition, certain payment histories did not accurately reflect the loan's current 10 payment status, and as such, the Savings Bank's delinquency reporting and loan classification reporting excluded certain loans. Accordingly, these loans were either classified for the first time or downgraded during the quarter ended June 30, 2002. In addition, during the second quarter of 2002, commercial loan borrowers with loans totaling approximately $3.6 million either declared, or it is anticipated that they will likely declare bankruptcy. Although some of these loans had been previously classified, management downgraded these loans in the second quarter of 2002 due to the actual and likely bankruptcy filings and recorded a provision related to these loans totaling $1.9 million, of which $1.6 million was subsequently charged-off. The remaining $2.0 million of loans that were not charged off consist of two loans. The first is a loan with a remaining balance of $1.6 million, with an allowance allocation of $240,000. This loan is secured by leases on consumer "photo center" equipment deployed in a national retailer. The second is a loan with a remaining balance of $364,000, with an allowance allocation of $55,000, and is secured by single family real estate. The Company also provided for and charged off $2.5 million related to one loan relationship during the second quarter of 2002. Based upon financial information received during the second quarter 2002 related to this borrower, updated information received related to the collateral for certain of these loans, and updated information related to the borrower's business as a whole, the Company charged off the entire relationship balance in question and is pursuing recovery. Management intends to actively seek recovery of charged off loan assets through legal proceedings. Management also increased its allowance factors within all commercial loan classifications, based on current economic factors. During the third quarter 2002, the Savings Bank charged-off $2.5 million related to loans or pools of loans which it had previously provided an allowance of $1.0 million. The most significant was a $3.0 million commercial non-residential loan in which $1.9 million was charged-off, $900,000 of which had previously been reserved. During the third quarter, the principal of the company which was developing the property was indicted for bank fraud related to his financial dealings with another financial institution. The Company intends to pursue all avenues against the principal of the development company and his professional service firms to recover its investment in this loan, however, as of September 30, 2002 the loan was written down to its fair value based on recent appraisals of the land collateralizing the loan. Finally, during the second and third quarters 2002, delinquencies increased in the single-family mortgage loan portfolio. The total amount of single-family mortgage loans ninety (90) days or more past due at December 31, 2001, March 31, 2002, June 30, 2002 and September 30, 2002 were $7.6 million, $10.6 million, $14.6 million and $16.6 million, respectively. Management believes these increases are attributable to a declining economy and higher unemployment levels. To address this situation, the Savings Bank lowered the classification on certain pools of loans and also increased its allowance factors within certain single-family loan classifications. As discussed more fully in the Regulatory Compliance section of the MD&A, during May 2002, the Office of Thrift Supervision ("OTS") and the Federal Deposit Insurance Corporation ("FDIC") began a joint Field Visit examination in preparation for a joint risk-focused examination of the Savings Bank and the Bancorp, which commenced on July 1, 2002, and is nearing completion. This examination follows the safety and soundness examinations by the OTS of the Savings Bank and Bancorp completed January 2002, for which the Reports of Examinations were delivered, as appropriate to the Savings Bank and Bancorp in March 2002 and in which no loans were classified as "loss" assets. During the current joint OTS/FDIC safety and soundness examination, management has met with the OTS/FDIC representatives numerous times. Based on these meetings, management believes that all loans have been properly graded by management and the Company's analysis of its ALLL, as of September 30, 2002, has properly considered all the concerns conveyed by the OTS/FDIC representatives related to the status of the Savings Bank's loan files, delinquency reporting, and loan classification reporting. Based on these factors, management believes that the ALLL as of September 30, 2002 is adequate. 11 Management has taken the following steps to improve its ALLL reporting, delinquent loan reporting and its loan classification reporting: 1) as previously discussed, the Savings Bank completed the conversion of its commercial loan portfolio to a new loan software subsidiary ledger system; as part of that conversion, all commercial loans were re-amortized to determine that the principal and accrued interest balances were accurate (requiring minimal adjustment to either the principal or accrued interest), and all other significant information (such as origination date, interest rate, maturity date, payment dates, etc.) was re-verified to source documents such as the original note or payment tickets; and 2) during the period July 2002 to October 2002, the Savings Bank has expanded its commercial loan department by hiring new senior loan credit administrators and several mid-level managers to effectively monitor and evaluate the commercial loan portfolio. NOTE E - INVESTMENT IN LIMITED PARTNERSHIP The balance of investment in limited partnership of $1.2 million and $3.7 million at September 30, 2002 and December 31, 2001 represents the Savings Bank's investment in two divisions of a single limited partnership. The investment at September 30, 2002 includes a $900,000 equity interest in a division of a limited partnership whose business activities are to purchase mortgage servicing rights ("PMSRs"), and a $300,000 investment in subordinated debentures of another division of the limited partnership. The debentures have an interest rate of 30%. As of December 31, 2001, the investment included $3.0 million in equity interests and $700,000 in subordinated debentures. During the second quarter 2002 the Company recorded a $2.5 million valuation allowance against its interest in the limited partnership due to the impact of the recent declines in interest rates and the adverse effect of increased loan prepayment speeds on the value of PMSRs, and a change in accounting for the value of a $5.0 million escrow deposit of the PMSR servicer associated with the PMSR. Management estimates the value of the escrow deposit to be approximately $750,000 at September 30, 2002. Management is awaiting a ruling from the OTS regarding whether the value of this escrow can be utilized in the PMSR valuation, and management may reverse this $750,000 valuation allowance upon receipt of that ruling from the OTS. NOTE F - BORROWINGS On September 30, 2002 the Bancorp's $4.8 million note payable to a third party matured. The note payable is secured by all the common stock of the Savings Bank. The Bancorp is currently in negotiations with the third party to extend the maturity date of the note payable until approximately December 2003, consisting of a $2.0 million principal reduction by March 2003, quarterly $1.0 million principal reductions in the second and third quarters of 2003, with the remainder due at maturity. In addition, the principal shareholders of the Company will likely be required to pledge additional personal assets as collateral for the note payable. The ultimate repayment of this note payable is contingent upon the Bancorp receiving future capital infusions, refinancing the note payable through another third party or a future dividend from the Savings Bank, subject to OTS approval, based on its future profitability. NOTE G - EMPLOYEE STOCK OWNERSHIP PLAN The Savings Bank maintained an ERISA qualified employee stock ownership plan ("ESOP") for eligible employees. In previous years the ESOP borrowed funds from the Bancorp in order to purchase shares for the ESOP. Effective September 30, 2002 the ESOP was terminated and the Bancorp accepted the unallocated shares in full satisfaction of the outstanding loan balance of $289,000. The unallocated shares were accounted for as a treasury stock transaction by the Bancorp. NOTE H - EARNINGS (LOSS) PER SHARE The following table sets forth the components of basic and diluted earnings (loss) per share. Basic and diluted loss per share are the same for 2002, as diluted loss per share would be anti-dilutive. 12

NOTE I - CAPITAL TRANSACTIONS On September 29, 2002, the Board of Directors of the Bancorp authorized the issuance of up to 10,000 shares of Series A 8.0% Perpetual Preferred Convertible Preferred Stock ("Series A Stock"). The Series A Stock has a par and face value of $1,000. After March 31, 2003, the holders of record of the Series A Stock on the dates specified below shall be entitled to receive, as and when declared by the Board of Directors and out of assets of the Bancorp which are by law available for payment of dividends, cumulative preferential cash dividends, at the rate of $80.00 per share per annum, payable quarterly on the first day of July, October, January and April in each year. Dividends on the Series A Stock shall be cumulative, whether or not in any dividend period or periods after March 31, 2003 there shall be surplus or net profits of the Company legally available for the payment of such dividends. Dividends on the Series A Stock shall be junior and subordinate to the payment of the Bancorp's obligations for dividends or payments under the Company's 11% Junior Subordinate Deferrable Interest Debentures. After March 31, 2004, the Bancorp, at the option of the Board of Directors, may at any time or from time to time redeem the whole or any part of the Series A Stock by paying therefore in cash $1,000 per share plus an amount equal to all dividends thereon declared but unpaid on the date fixed for redemption (the "Redemption Price"). Until March 31, 2008, each holder of Series A Stock may at any time upon surrender of the certificates therefore, convert any or all of such holder's Series A Stock into fully paid and nonassessable shares of Common Stock of the Bancorp, at the rate of 166 shares of Common Stock for each share of Series A Stock so surrendered for conversion. On September 30, 2002 the Company issued 900 shares of the Series A stock to the Company's two principal shareholders in exchange for cash of $900,000. The form of consideration to be paid by the Company for additional cash contributions of $175,000 and $1.0 million, received from the Company's two principal shareholders on October 15 and November 7, 2002, respectively, has not yet been finalized. The Company anticipates additional Series A stock may be issued, that the shareholders may accept Common Stock pursuant to exercise of currently exercisable options, illiquid assets may be transferred at book value, or a combination of the foregoing options will be agreed upon. On September 30, 2002, the Bancorp made a $2 million cash contribution the Savings Bank in order to increase the Savings Bank's capital ratios. 13 NOTE J - REGULATORY CAPITAL REQUIREMENTS Pursuant to the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), savings institutions must meet three separate minimum capital requirements. There are no similar minimum capital requirements for thrift holding companies. The following tables summarize, as of September 30, 2002 and December 31, 2001, the Savings Bank's actual capital amounts and ratios. As of September 30, 2002, the Savings Bank was well capitalized under the regulatory framework for prompt corrective action as compared to adequately capitalized as of June 30, 2002 and well capitalized as of December 31, 2001. Requirements for the well capitalized and adequately capitalized categories, with respect to the ratio of total risk-based, Tier I risk-based, Tier I leverage, and tangible capital ratios, are set forth in the following table. Additionally, as a result of regulatory actions arising from the October 29, 2001 OTS Report of Examination of the Savings Bank, as described further in the Regulatory Compliance section of the MD&A, the Savings Bank is restricted from increasing assets during any quarter in excess of an amount equal to net interest credited on deposit liabilities during the quarter, in the absence of the prior written approval of the OTS. On November 28, 2001, the Savings Bank issued and sold $3.0 million subordinated debentures in a pooled security offering. On December 5, 2001, the Savings Bank filed an application with the OTS seeking inclusion of the proceeds of the sale of the debentures in regulatory "Tier II" (risk weighted) capital. As of June 28, 2002, the OTS approved the application. Thus, the Savings Bank's "Tier II" ratios below reflect the $3.0 million of subordinated debentures as of September 30, 2002 and the "Tier II" ratios do not reflect the subordinated debentures as of December 31, 2001.

NOTE K - BUSINESS PLAN As described further in the Regulatory Compliance section of the MD&A the Bancorp and Savings Bank have provided to the OTS their plans for increasing the capital levels at both the Bancorp and Savings Bank as well as a business plan at the Savings Bank level which outlines the future operating strategies of the Savings Bank to achieve the targeted capital levels along with providing the framework for achieving profitability. In November 2002, these plans were approved by the respective Boards of Directors of the Bancorp and the Savings Bank and were delivered to the OTS for their review and approval. To achieve the targeted capital levels and profitability levels the business plan of the Savings Bank highlights the following actions; 1) reduction of total assets to $250 million by March 31, 2003, to be achieved through the reduction of deposits by selling the Savings Bank's branch deposits and operations, rate reductions and the early redemption of brokered deposits with corresponding decreases in loans and investments; 2) the elimination of certain lending programs; 3) a restructuring of the Savings Bank's statement of financial condition to achieve the desired mix of interest earning assets and interest bearing liabilities; 4) staff and management reductions; 5) consolidation of personnel into one facility to achieve overhead reductions; 6) general reductions in general and administrative expenses; and 7) capital infusions from the Bancorp. The increase in capital levels at the Bancorp is to be achieved through capital infusions from current principal shareholders and potential third party investors. During the fourth quarter 2002 and the first quarter 2003 the Company anticipates it may experience significant one time charges, which could total as much as $1.2 million before tax effects, related to the business plan discussed above that were not accrued at September 30, 2002, in accordance with accounting principles generally accepted in the United States. In addition, one time gains, which could total as much as $2.6 million before tax effects, are expected as the action plans described above are implemented to achieve the desired capital and profitability levels management anticipates. In addition, in future quarters the Company may identify additional assets to be held for sale or remove current assets identified as held for sale. NOTE L - COMMITMENTS AND CONTINGENCIES At September 30, 2002, the Savings Bank had funding commitments relating to loans, lines of credit and letters of credit totaling $43.5 million. Included in this amount is $21.3 million related to the Savings Bank's purchase repurchase program which the Savings Bank does not anticipate funding due to the termination of this program. Commitments to fund loans, lines of credit and letters of credit have credit risk essentially the same as that involved in extending loans to customers and are subject to the Savings Bank's normal credit policies. The Savings Bank also had Community Reinvestment Act ("CRA") investment commitments outstanding of $923,000. The Savings Bank also had commitments to sell and purchase $6.1 million and $6.3 million of mortgage backed securities, respectively. As of September 30, 2002 and through November 14, 2002 the Savings Bank had entered into firm commitments to sell $42.5 million of $108.1 million classified as loans held for sale-other. 15 ITEM 2. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS PRIVATE SECURITIES LITIGATION REFORM ACT SAFE HARBOR STATEMENT This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The Company intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995, and is including this statement for purposes of these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are generally identifiable by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project" or similar expressions. The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse affect on the operations and future prospects of the Company and its subsidiary include, but are not limited to, changes in: interest rates, general economic conditions, legislative/regulatory changes, monetary and fiscal policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan and securities portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Company's market area, the Company's implementation of new technologies, the Company's ability to develop and maintain secure and reliable information systems and accounting principles, policies and guidelines and limitations imposed on the Savings Bank's operations as a result of the agreed upon enforcement action described in the Regulatory Compliance section following. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Further information concerning the Company and its business, including additional factors that could materially affect the Company's financial results, is included in the Company's filings with the Securities and Exchange Commission. Further description of the risks and uncertainties to the business are included in detail in Item 1, "Business" of the Company's 2001 Form 10-K. OVERVIEW Umbrella Bancorp, Inc. (the "Bancorp" or the "Company") is a unitary savings and loan holding company and is registered as such with the Office of Thrift Supervision ("OTS"). The Company is an active holding company with assets consisting of investments in UmbrellaBank, fsb (the "Savings Bank"), marketable securities, loans receivable, and interest-earning deposits. The Company is a Federal Housing Authority ("FHA") approved originator and servicer and an approved Federal National Mortgage Association ("Fannie Mae") servicer. The Savings Bank's principal business consists of attracting deposits from the public through its Internet banking delivery channel at http://www.umbrellabank.com and its two traditional branch locations and investing these deposits primarily in residential and commercial real estate secured loans. The Savings Bank also invests, to a lesser extent, in purchase repurchase loan facilities, for which it offers for sale to a number of mortgage banking firms. During the third quarter, the Company decided to cease its lending activity under the purchase repurchase program as a result of regulatory dissatisfaction with, and criticisms of the program and considering the profitability of the program. Management anticipates that the termination of the purchase repurchase loan program will be complete by December 31, 2002. These purchase repurchase loans are, and historically have been, classified as held for sale on the consolidated statement of financial condition. Additionally, the Savings Bank maintains a portfolio of bank qualified securities and operates a network of more than 1,900 ATM machines. The Savings Bank's deposit accounts are insured to the maximum allowable by the Federal Deposit Insurance Corporation (the "FDIC"). The Savings Bank's results of operations are dependent primarily on net interest income, which is the difference between the interest earned on its loans and securities portfolios, and the interest paid on deposits and borrowed funds. The Savings Bank's operating results are also affected by provisions for loan and lease losses, loan 16 servicing fees, customer service charges and fees, fees from ATM operations, gains (losses) on the sale of securities and other assets and other income. Operating expenses of the Savings Bank include employee compensation and benefits, equipment and occupancy costs, outsourced servicing expenses, federal deposit insurance premiums and other administrative expenses. The Savings Bank's results of operations are further affected by economic and competitive conditions, particularly changes in market interest rates. Results are also affected by monetary and fiscal policies of federal agencies, and actions of regulatory authorities. REGULATORY COMPLIANCE The OTS commenced risk-focused safety and soundness examinations of the Savings Bank and the Bancorp on October 29, 2001 and November 14, 2001, respectively. The OTS Reports of Examinations, which were primarily based on financial information as of September 30, 2001, were transmitted to the Savings Bank and Bancorp in March 2002. The November 14, 2001 Holding Company Report of Examination ("Bancorp ROE") was not limited to any one area, but focused on the risk factors of Transactions with Affiliates, Funds Distribution, Financial Effect and Management Quality. During the course of the OTS examination, the Bancorp addressed the specific regulatory violations identified and developed and implemented policies and procedures to ensure future regulatory compliance. The OTS commented in the Bancorp ROE on the Bancorp's level of operating losses, debt service requirements and capital position. As a result of the findings contained in the Bancorp ROE, the Bancorp was required to provide OTS with a quarterly financial cash flow projection report and quarterly monitoring reports. The Bancorp was also required to take actions to ensure future regulatory compliance, and take actions sufficient to ensure safe and sound operations. In addition, the Bancorp was placed under various operating restrictions, including a requirement that the Bancorp file notice with the OTS prior to adding or replacing a director or hiring a senior executive officer. The Bancorp was also restricted in making "golden parachute" payments to any institution-affiliated party unless authorized by regulation. The Bancorp has been, and is currently in compliance with the requirements set forth by the OTS, as a result of the findings contained in the Bancorp ROE. The October 29, 2001, Report of Examination of the Savings Bank ("Savings Bank ROE") focused on Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Sensitivity to Market Risk. The OTS identified various regulatory deficiencies resulting, in part, in supervisory imposed operating restrictions on growth and lending activities, as well as restrictions on capital distributions, contracts, "golden parachute" payments and changes in senior executive positions. In addition, the Savings Bank was required to provide reports to the OTS detailing corrective actions taken, identification of policies and procedures adopted and implemented to remedy areas of criticism and ensure future regulatory compliance. Management and the Board of Directors have responded to the Savings Bank ROE, and have provided OTS with either assurance of compliance with the material exceptions noted in the Savings Bank ROE or the current status of efforts to correct matters requiring on-going remediation. On May 20, 2002, the OTS and FDIC began a joint Field Visit examination in preparation for a joint risk-focused examination of the Savings Bank. According to the OTS/FDIC regulators, the purpose of the Field Visit was, in part, to obtain an initial assessment of the asset quality and capital levels of the Savings Bank to determine the effectiveness of corrective actions taken by the Board of Directors and management since the issuance of the Savings Bank ROE, and establish the scope for the full joint risk-focused examination of the Savings Bank, which commenced on July 1, 2002, and is nearing completion. Since completion of the Bancorp ROE and Savings Bank ROE, management officials and the Boards of Directors of both the Bancorp and the Savings Bank have engaged in active discussions with the OTS to develop a mutually agreeable business framework that will strengthen the regulatory foundation of the Bancorp and the Saving Bank. As a result, in the spirit of regulatory cooperation, the Board of Directors of both the Bancorp and the Savings Bank, without admitting or denying that such grounds exist, or the accuracy of the OTS findings, opinions and/or 17 conclusions, separately agreed to enforcement actions that became effective on August 16, 2002. The provisions of the enforcement action between the Bancorp and OTS establish, in principal part, that the Bancorp will provide the OTS with a plan for raising additional common equity capital and restructuring outstanding debt at the Bancorp, recognizing that economic and market conditions are outside of the control of the Bancorp. In addition to the operating restrictions previously placed on the Bancorp by the OTS, pursuant to the Bancorp ROE, the agreed upon action requires the Bancorp to provide OTS with quarterly cash flow projections for the purpose of identifying the Bancorp's sources and uses of funds for the remainder of fiscal 2002, fiscal 2003 and fiscal 2004. The subject enforcement action also provides assurance that Bancorp will maintain documentation sufficient to evidence that all transactions with affiliates and insiders are in compliance with statutory and regulatory requirements. To date, the Bancorp is in full compliance with the provisions of the agreed upon enforcement action. The agreed upon language in the enforcement action between the Savings Bank and the OTS provides, in principal part, for a plan addressing the level of the Savings Bank's fixed assets, as well as the adoption and implementation of a capital plan for the establishment and maintenance of acceptable capital levels. In conjunction with the capital plan, the Savings Bank has developed a business plan that details the Savings Bank's overall operating strategies, in light of current economic conditions. The agreed upon language also (without prior written approval of the OTS): prohibits any increase in the Savings Bank's total assets during any quarter in excess of an amount equal to net interest credited on deposit liabilities during the quarter; and prohibits the purchase or origination of new loans other than single-family residential mortgage loans, credit card loans and over draft lines of credit. The Board of Directors has already taken action to alleviate many of the issues raised by the OTS and, has formalized plans, policies and procedures concerning the Savings Bank's staffing levels, internal audit function, overall lending programs, including loan administration, and refined its Allowance for Loan and Lease Losses ("ALLL") policy and practices. In addition to the operating restrictions previously imposed on the Savings Bank, as a result of the findings contained in the Savings Bank ROE, the Savings Bank has developed and implemented policies and procedures to: i) ensure compliance with its loans to one borrower limitation; ii) address its classified assets; iii) monitor its interest rate risk; and iv) ensure continued accurate thrift financial reports. Furthermore, the Savings Bank has agreed not to accept, renew or roll over any brokered deposits without the prior consent of the OTS. Beginning no later than fourth quarter 2001, management of the Savings Bank had already initiated a plan not to renew maturing brokered deposits. Additionally, the agreed upon action provides for an independent loan review of the Saving Bank's construction, commercial real estate, commercial, direct lease financing and broker purchase/repurchase lending programs. Of additional note, the Savings Bank will continue to utilize its recently formed Board of Directors Oversight Committee for the purpose of reviewing and approving new lending and investment initiatives. To date, the Savings Bank is in full compliance with the provisions of the agreed upon enforcement action. As part of the regulatory spirit of cooperation and the mutual desire for future success, both the Bancorp and the Savings Bank will report to, and consult with, the OTS on all matters addressed under the agreed upon enforcement actions. On September 17, 2002 the OTS issued a letter to the Savings Bank requiring, in part, the Savings Bank to i) establish position and loss limits for its available for sale investment portfolio; ii) reduce its borrowings under reverse repurchase agreements and margin debt to $0 and discontinue their use other than the permitted use of reverse repurchase agreements up to $10 million for liquidity purposes; iii) reduce its investment in a pass through investment mutual fund to a predetermined percentage; iv) suspend its trading portfolio; and v) revise its Investment Policy accordingly. In management's opinion it has complied with the provisions of the subject OTS letter. 18 BUSINESS PLAN As described above, the Bancorp and Savings Bank have to provided the OTS their plans for increasing the capital levels at both the Bancorp and Savings Bank as well as a business plan at the Savings Bank level which outlines the future operating strategies of the Savings Bank to achieve the desired capital levels along with providing the framework for achieving profitability. In November 2002, these plans were approved by the respective Boards of Directors of the Bancorp and the Savings Bank and were delivered to the OTS for their review and approval. To achieve the desired capital levels and profitability levels the business plan of the Savings Bank highlights the following actions: 1) reduction of total assets to $250 million by March 31, 2003 to be achieved through the reduction of deposits by selling the Savings Bank's branch deposits and operations, rate reductions and the early redemption of brokered deposits with corresponding decreases in loans and investments; 2) the elimination of certain lending programs; 3) a restructuring of the Savings Bank's statement of financial condition to achieve the desired mix of interest earning assets and interest bearing liabilities; 4) staff and management reductions; 5) consolidation of personnel into one facility to achieve overhead reductions; 6) general reductions in general and administrative expenses; and 7) capital infusions from the Bancorp. The increase in capital levels at the Bancorp is to be achieved through capital infusions from current principal shareholders and potential third party investors. During the fourth quarter 2002 and the first quarter 2003, the Company anticipates it may experience significant one time charges, which could total as much as $1.2 million before tax effects, related to the business plan discussed above that were not accrued at September 30, 2002, in accordance with accounting principles generally accepted in the United States. In addition, one time gains, which could total as much as $2.6 million before tax effects, are expected as the action plans described above are implemented to achieve the desired capital and profitability levels management anticipates. In addition, in future quarters the Company may identify additional assets to be held for sale or remove current assets identified as held for sale. Although management believes the successful implementation of the action plans described above will allow the Bancorp and Savings Bank to achieve the desired capital and profitability levels there can be no assurances of such or that the OTS will approve the plans submitted to it. FINANCIAL CONDITION Total assets decreased by $139.2 million to $397.4 million at September 30, 2002, from $536.6 million at December 31, 2001. Proceeds from the sale of securities available-for-sale and principal repayments on loans receivable as well as proceeds from loan sales were used to fund the $124.2 million decrease in deposits, consisting primarily of a $94.5 million decrease in brokered certificates of deposit ("CDs") and a $30.7 million decrease in money market accounts. Of the $94.5 million decrease in high yielding/costing brokered CDs $52.2 million is attributable to the Savings Bank's effort not to renew maturing brokered certificates of deposit CDs yielding higher interest rates and the Savings Bank's early redemption of $43.4 million of brokered CDs during September 2002. In addition, the Company recorded an $10.3 million provision for loan and lease losses and a $2.5 million valuation reserve on its purchased mortgage servicing rights ("PMSRs") during the nine month period ended September 30, 2002, as described in the Results of Operations section following. Borrowed money also decreased by $5.3 million at September 30, 2002, as compared to December 31, 2001. Interest-earning deposits increased $16.0 million during the nine months ended September 30, 2002 to $53.0 million as the Savings Bank invested the proceeds from the sale of securities available-for-sale and loans held for sale into interest-earning deposits. Interest-earning deposits at September 30, 2002 includes $26.4 million of ATM cash, on which the Savings Bank earns a return of 200 basis points over the overnight FHLB rate, and $26.6 million of other interest earning deposits with an annualized yield of 5.38% at September 30, 2002. Securities available-for-sale decreased by $47.5 million to $75.6 million at September 30, 2002 from $123.1 million at December 31, 2001, as the Company utilized the proceeds of sales of such securities to fund its initiatives to reduce high yielding/costing brokered CDs at the Savings Bank and to payoff borrowings at the Bancorp, as described below. In addition, during the first quarter 2002, the Company sold approximately $27.0 million of its Trust Preferred Securities ("TPS"), for regulatory compliance purposes in conjunction with the Savings Bank's ROE described in the preceding Regulatory Compliance section. During September 2002, the 19 Savings Bank reclassified trading account securities with a market value of $878,000 to its securities available for sale based on the direction of the OTS discussed in the previous Regulatory Compliance section. As of September 30, 2002 loans held for sale consisted of loans under the purchase repurchase program and loans held for sale-other as described further following. Loans held for sale-purchase repurchase decreased by $47.2 million to $17.8 million at September 30, 2002 from $65.1 million at December 31, 2001 as the Savings Bank implemented a planned approach to reduce its purchase repurchase loan program. During the third quarter, the Company decided to cease its lending activity under the purchase repurchase program as a result of regulatory dissatisfaction with, and criticisms of, the program and considering the profitability of the program. Subsequent to September 30, 2002 the loans held for sale under the purchase repurchase program have declined to $3.1 million and it is anticipated that by December 31, 2002 the termination of the purchase repurchase loan program will be complete. Based on the bid prices received and anticipated the actual and anticipated gains on these sales is not expected to be significant to future operations. Loans held for sale-other was $108.1 million as of September 30, 2002 with no corresponding amount as of December 31, 2001. Loans held for sale-other consists of both single family mortgage loans and commercial loans which the Company has identified as held for sale in conjunction with the Company's business plan as described in the preceding Business Plan section. As of September 30, 2002 and through November 14, 2002, the Savings Bank had entered into firm commitments to sell $42.5 million of the $108.1 million of the loans held for sale-other. Based on the bid prices received and anticipated the actual and anticipated gains on these sales is not expected to be significant to future operations. As of September 30, 2002 loans held for sale-other were transferred from the loans receivable portfolio and were recorded at the lower of cost or fair value with no resulting loss on transfer. Net loans receivable decreased by $164.3 million to $86.0 million at September 30, 2002, from $250.3 million at December 31, 2001, primarily due to the transfer of $108.1 of loans to the loans held for sale category, the recording of a $10.3 million provision for loan and leases losses consisting of a $2.0 million increase in the allowance for loan and lease losses and $8.3 million in loan and lease charge-offs and finally during the third quarter the Company experienced minimal loan originations or purchases of loan pools as the funds received from loan repayments were utilized to fund the deposit reductions. Premises and equipment decreased by $5.7 to $14.9 million at September 30, 2002 from $20.6 million at December 31, 2001. The decrease is attributable to $2.6 million in gross depreciation expense for the nine months ended September 30, 2002, offset by additions of $1.7 million. Additions include an investment of $1.4 million in 217 ATMs during May 2002. Net depreciation expense reflected in the statement of operations is $900,000, which reflects gross depreciation of $2.6 million less $1.7 million reimbursed to the Company through its ATM partnership activities. In addition, during June 2002, the Savings Bank classified its investment in an office building as held for sale and, as such, the office building is being carried at the lower of cost or fair value. This building was purchased in April 2001 as a branch location for the Savings Bank. As of September 30, 2002, the net book value of this office building was $4.6 million. During the nine month period ended September 30, 2002, occupancy and equipment expense was reduced by approximately $477,000 related to rental income from the building and included approximately $191,000 of expenses from the building. In addition, as of September 30, 2002, the Savings Bank classified $300,000 of leasehold improvements and furniture fixtures and equipment located in its two branch locations and corporate office as held for sale. As previously described in the Business Plan section, the Savings Bank is pursuing the sale of its branch deposits and operations and is exploring the consolidation of its corporate locations which would result in the sale of certain leasehold improvements and furniture fixtures and equipment at these locations. The Company currently leases the facilities it utilizes for its branch and corporate locations from third parties. Management anticipates that the acquirer of its branch deposits and operations and the new tenants for its corporate locations would also acquire the leasehold improvements and furniture and fixtures at these locations. Management also anticipates that the third party owners of these facilities will allow the Company to assign its lease obligations to these parties. 20 Prepaid expenses and other assets increased by $4.0 million to $16.7 million at September 30, 2002 from $12.7 million at December 31, 2001. This increase was primarily the result of a $6.3 million increase in current and deferred tax assets, offset by a $2.3 million decrease in prepaid and other expenses. The current tax asset at September 30, 2002 was approximately $3.2 million, and related to tax refunds due from the Internal Revenue Service and Illinois Department of Revenue for previously filed tax returns and amounts previously paid on prior tax returns that were claimed when the December 31, 2001 tax returns were filed and will be claimed when the December 31, 2002 tax returns are filed. The deferred tax asset at September 30, 2002 totaled approximately $8.3 million, of which $32,000 related to securities available-for-sale. The remaining deferred tax asset primarily consists of the tax effects of bad debt deductions, partnership interests, Federal Home Loan Bank stock dividends, the deferred gain on a prior sales of facilities, and federal and state net operating loss carry-forwards. Based upon the Company's prior history of paying taxes and management's projections of future taxable income, no valuation allowance is recorded against the deferred tax asset. Deposits decreased $124.2 million to $333.9 million at September 30, 2002, from $458.1 million at December 31, 2001. The decrease consists primarily of a $94.5 million decrease in high yielding/costing brokered CDs and a $30.7 million decrease in money market accounts. Of the $94.5 million decrease brokered CDs $52.2 million is attributable to the Savings Bank's effort not to renew maturing brokered certificates of deposit CDs yielding higher interest rates and the Savings Bank's early redemption of $43.4 million of brokered CDs during September 2002. The Savings Bank's deposit composition at September 30, 2002 includes approximately 45% personal/business CDs, 3% brokered CDs, 38% money market and savings accounts and 14% demand deposit and NOW accounts. In addition, deposits include $289.0 million, or 87%, of deposits attracted via its Internet delivery channel, as compared to $296.3 million, or 64.7%, at December 31, 2001. All deposits attracted via the Internet are consumer deposits. As discussed in the preceding Business Plan section to achieve the desired capital levels and profitability levels the business plan of the Savings Bank anticipates the reduction of total assets to $250 million by March 31, 2003 to be achieved through the reduction of deposits by selling the Savings Bank's branch deposits and operations, rate reductions and the early redemption of the remaining brokered deposits. All three initiatives are anticipated to reduce total deposits by an additional $143.0 million by March 31, 2003. Borrowings decreased by $5.2 million to $23.1 million at September 30, 2002, from $28.3 million at December 31, 2001, primarily due to the repayment of $2.4 million in federal funds purchased using the proceeds from the sale of securities available-for-sale and loans held for sale at the Savings Bank and the repayment of $1.7 million in notes payable and $1.4 million in margin account open lines using the proceeds from the sale of securities available-for-sale offset by an increase of $300,000 in short term debt at the Bancorp. Stockholders' equity declined $9.0 million to $8.6 million at September 30, 2002, from $17.6 million at December 31, 2001 primarily as a result of the $10.9 million after-tax net loss for the nine months ended September 30, 2002, which includes the pre-tax $10.3 million provision for loan and lease losses and $2.5 million valuation allowance for PMSRs. On September 30, 2002 the Company received a capital infusion of $900,000 from the Company's two principal shareholders through the issuance of 900 shares of preferred stock as described below. In addition, the Company paid dividends of $264,000, received $118,000 through the exercise of stock options and had other comprehensive income of $1,060,000 through decreased unrealized losses on its securities available-for-sale portfolio. Also, effective September 30, 2002 the ESOP was terminated and the Bancorp accepted the unallocated shares in full satisfaction of the outstanding loan balance of $289,000. The unallocated shares were accounted for as a treasury stock transaction by the Bancorp. On October 15 and November 7, 2002 the Company received additional cash contributions of $175,000 and $1.0 million, respectively from the Company's two principle shareholders. The form of consideration to be paid by the Company for these contributions has not yet been finalized. The Company anticipates additional Series A stock may be issued, that the shareholders may accept Common Stock pursuant to exercise of currently exercisable options, illiquid assets may be transferred at book value, or a combination of the foregoing options will be agreed upon. On September 29, 2002, the Board of Directors of the Bancorp authorized the issuance of up to 10,000 shares of Series A 8.0% Perpetual Preferred Convertible Preferred Stock ("Series A Stock"). The Series A Stock has a par and face value of $1,000. After March 31, 2003, the holders of record of the Series A Stock on the dates specified 21 below shall be entitled to receive, as and when declared by the Board of Directors and out of assets of the Bancorp which are by law available for payment of dividends, cumulative preferential cash dividends, at the rate of $80.00 per share per annum, payable quarterly on the first day of July, October, January and April in each year. Dividends on the Series A Stock shall be cumulative, whether or not in any dividend period or periods after March 31, 2003 there shall be surplus or net profits of the Company legally available for the payment of such dividends. Dividends on the Series A Stock shall be junior and subordinate to the payment of the Bancorp's obligations for dividends or payments under the Company's 11% Junior Subordinate Deferrable Interest Debentures. After March 31, 2004, the Bancorp, at the option of the Board of Directors, may at any time or from time to time redeem the whole or any part of the Series A Stock by paying therefore in cash $1,000 per share plus an amount equal to all dividends thereon declared but unpaid on the date fixed for redemption (the "Redemption Price"). Until March 31, 2008, each holder of Series A Stock may at any time upon surrender of the certificates therefore, convert any or all of such holder's Series A Stock into fully paid and nonassessable shares of Common Stock of the Bancorp, at the rate of 166 shares of Common Stock for each share of Series A Stock so surrendered for conversion. LIQUIDITY The Savings Bank's primary sources of funds are deposits, proceeds from principal and interest payments on the loan and securities available-for-sale portfolios, custodial deposit accounts related to loans serviced for others, and the sale of discounted loans receivable and newly originated fixed rate long-term mortgage loans. The most liquid assets are cash and short-term investments. The levels of these assets are dependent on the operating, financing and investing activities during any given period. Cash and interest-earning deposits totaled $57.4 million at September 30, 2002. Recent legislation repealed the OTS minimum liquidity ratio requirements. OTS regulations now require the Savings Bank to maintain sufficient liquidity to ensure the Savings Bank's safe and sound operation. Liquidity management for the Savings Bank is both a daily and long-term function of the Savings Bank's senior management. Management meets on a daily basis and monitors interest rates, current and projected commitments to purchase loans and the likelihood of funding such commitments, and projected cash flows. Excess funds are generally invested in short-term investments such as federal funds. Cash flow projections are updated regularly to assure necessary liquidity. On September 30, 2002 the Bancorp's $4.8 million note payable to a third party matured. The note payable is secured by all the common stock of the Savings Bank. The Bancorp is currently in negotiations with the third party to extend the maturity date of the note payable until approximately December 2003, consisting of a $2.0 million principal reduction by March 2003, quarterly $1.0 million principal reductions in the second and third quarters of 2003, with the remainder due at maturity. In addition, the principal shareholders of the Company will likely be required to pledge additional personal assets as collateral for the note payable. The ultimate repayment of this note payable is contingent upon the Bancorp receiving future capital infusions, refinancing the note payable through another third party or a future dividend from the Savings Bank, subject to OTS approval, based on its future profitability. ASSET QUALITY The Bancorp and the Savings Bank regularly review assets to determine proper valuation. Loans are reviewed on a regular basis and an allowance for loan losses is established when, in the opinion of management, the net realizable value of the property collateralizing the loan is less than the outstanding principal and interest and the collectibility of the loan's principal and interest becomes doubtful. See further discussion in Provision and Allowance for Loan and Lease Losses section following. At September 30, 2002, the Company had fifty-six (56) properties, totaling $3.1 million classified as foreclosed real estate, as compared to twenty-seven (27) properties totaling $730,000 at December 31, 2001. As of September 30, 22 2002, thirteen (13) of the properties totaling $1.3 million were related to the Company's purchase of a distressed loan portfolio during 2002. The portfolio was purchased at a substantial discount with one portion of the exit strategy being converting the properties to foreclosed real estate and realizing a return on the ultimate sale. Based on this strategy it is likely that the Company's investment in foreclosed real estate will increase in future. The underlying properties at September 30, 2002 consisted primarily of single-family residences. The foreclosed real estate has been written down to estimated fair value at September 30, 2002. The total amount of loans receivable ninety (90) days or more past due at September 30, 2002, was $20.6 million or 9.50% of total loans receivable compared to $20.1 million or 7.44% of total loans at June 30, 2002, $11.0 million or 3.90% of total loans at March 31, 2002 and $9.0 million or 2.82% of total loans at December 31, 2001. The $11.6 million increase is comprised of a $9.0 million increase in delinquent one-to-four family loans and a $2.7 million increase in commercial delinquent loans offset by a $100,000 decrease in other types of loans. Loans ninety (90) days or more past due are primarily secured by one-to-four family residences and, for commercial loans, single and multi-family unit residential property and commercial business assets. Total non-performing assets at September 30, 2002, totaled $23.7 million or 5.96% of total assets compared to $9.7 million or 1.81% of total assets at December 31, 2001. Excluded from these totals are $464,000 of discounted loans ninety (90) days or more contractually past due at September 30, 2002, and $901,000 at December 31, 2001. Along with other financial institutions, management shares a concern for the outlook of the economy during the remainder of 2002. A slow down in economic activity beginning in 2002 severely impacted several major industries, as well as the economy as a whole. Even though there are numerous indications of emerging strength, it is not certain that this strength is sustainable. In addition, consumer confidence may be negatively impacted by the recent volatility in equity prices. These events could still adversely affect cash flows for both commercial and individual borrowers, as a result of which, the Savings Bank could experience increases in problem assets, delinquencies and losses on loans. RESULTS OF OPERATIONS - COMPARISON OF OPERATING RESULTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001. GENERAL Net loss for the three months ended September 30, 2002 was $2.0 million or ($1.14) per diluted share as compared to net loss of $301,000 or ($.18) per diluted share for the corresponding period in 2001. The operating results were significantly impacted by the $1.7 million provision for loan and lease losses and the early redemption of $43.3 million of brokered deposits resulting in additional interest expense of $657,000 during the quarter. In addition, non-interest income, exclusive of the $1.1 million valuation allowance on investment in partnership recorded in 2001, for the three month period ended September 30, 2002 declined to $693,000 as compared to $1.6 million during the three month period ended September 30, 2001. Non-interest expense remained constant at $3.5 million for the three month periods ended September 30, 2002 and 2001. Net loss for the nine months ended September 30, 2002 was $10.9 million or ($6.34) per diluted share as compared to net income of $286,000 or $.15 per diluted share for the corresponding period in 2001. The operating results were significantly impacted by the $10.3 million provision for loan and lease losses, the $2.5 million valuation allowance on the investment in limited partnership related to the partnership's investment in PMSRs and the early redemption of $43.3 million of brokered deposits resulting in additional interest expense of $657,000 during the third quarter. In addition, non-interest income, exclusive of the valuation allowance on investment in partnership in both the nine month periods ended September 30, 2002 and 2001, declined to $521,000 during the nine month period ended September 30, 2002 as compared to $1.8 million during the nine month period ended September 30, 2001. Non-interest expense increased to $11.1 million for the nine month period ended September 30, 2002 as compared to $8.9 million for the nine month period ended September 30, 2001. 23 The average outstanding diluted shares increased by 37,000 shares for the three months ended September 30, 2002 and declined by 236,000 shares for the nine months ended September 30, 2002, as compared to shares for the same period last year. The increase in average shares for the three months ended September 30, 2002 is primarily the result of the exercise of options during 2002. The decline in average shares for the nine months ended September 30, 2002 is primarily the result of the Company repurchasing 365,796 of its shares from Deltec Banking Corporation Limited ("Deltec") in April 2001 and the effect of dilutive stock options outstanding in the prior periods. INTEREST INCOME Interest income for the three months ended September 30, 2002 totaled $6.6 million, as compared to $9.9 million for the comparable 2001 period. The $3.3 million decrease was primarily the result of an 89 basis point decrease in the tax equivalent yield on earning assets to 6.27% from 7.16%. Earning asset yields have declined as a result of re-pricing Prime rate based loans with each change in the Prime lending rate, as well as a result of the Company's affirmative actions to reduce the amount of assets of the Savings Bank and Bancorp. In addition, the increase in non-performing loans during 2002 had a negative impact on interest income. The average yield on earning assets was 6.19% at the Savings Bank and 12.35% at the Bancorp, with a consolidated Company average yield of 6.27% for the three months ended September 30, 2002. For the nine months ended September 30, 2002, interest income decreased by $6.5 million to $21.8 million from $28.3 million for the same period last year. The $6.5 million decrease was primarily the result of a 150 basis point decrease in the tax equivalent yield on earning assets to 6.46% from 7.96%. Earning asset yields have declined as a result of re-pricing Prime rate based loans with each change in the Prime lending rate, as well as a result of the Company's affirmative actions to reduce the amount of assets of the Savings Bank and Bancorp. In addition, the increase in non-performing loans during 2002 had a negative impact on interest income. The average yield on earning assets was 6.38% at the Savings Bank and 10.89% at the Bancorp, with a consolidated Company average yield of 6.46% for the nine months ended September 30, 2002. INTEREST EXPENSE Interest expense for the three months ended September 30, 2002, totaled $5.7 million as compared to $7.5 million for the comparable 2001 period. The $1.8 million decrease was primarily the result of a 52 basis point decline in the average cost of interest-bearing liabilities to 5.07% for the three months ended September 30, 2002 as compared to 5.59% for the same period last year. The average cost of interest-bearing liabilities was 4.79% at the Savings Bank and 10.06% at the Bancorp, with a consolidated Company average cost of 5.07% for the three months ended September 30, 2002. The Savings Bank and the consolidated Company average cost of funds was increased by 59 basis points due to the additional interest expense of $657,000 incurred in September 2002 related to the early redemption of $43.4 million of high yielding/costing brokered CDs. This will have a positive effect on the cost of funds in future periods. For the nine month period ended September 30, 2002 interest expense decreased by $5.5 million to $17.1 million from $22.6 million for the same period last year. The $5.5 million decrease was primarily the result of a 125 basis point decline in the average cost of interest-bearing liabilities to 4.80% for the nine months ended September 30, 2002 as compared to 6.05% for the same period last year. The average cost of interest-bearing liabilities was 4.50% at the Savings Bank and 10.06% at the Bancorp, with a consolidated Company average cost of 4.80% for the nine months ended September 30, 2002. The Savings Bank and the consolidated Company average cost of funds was increased by 18 basis points due to the additional interest expense of $657,000 incurred in September 2002 related to the early redemption of $43.4 million of high yielding/costing brokered CDs. This will have a positive effect on the cost of funds in future periods. Interest-bearing liabilities include $17.0 million of 11.0% junior subordinated debt, which the Bancorp issued in 24 November, 1998. Interest-bearing liabilities also include $3.0 million of subordinated debentures issued by the Savings Bank in November 2001 with an annualized cost of 6.19% for the three months ended September 30, 2002 and an annualized cost of 6.62% for nine months ended September 30, 2002. NET INTEREST INCOME Net interest income for the three months ended September 30, 2002 totaled $955,000 as compared to $2.4 million for the comparable 2001 period. The $1.4 million decrease was primarily due to a 37 basis point decrease in the net interest spread to 1.20% as compared to 1.57%. The net interest spread has decreased as earning asset yields have declined as a result of re-pricing Prime rate based loans with each change in the Prime lending rate, as well as a result of the Company's affirmative actions to reduce the amount of assets of the Savings Bank and Bancorp. In addition, the increase in non-performing loans during 2002 had a negative impact on the net interest spread. The net interest spread was 1.40% at the Savings Bank and 2.29% at the Bancorp, with a consolidated Company net interest spread of 1.20%. The Savings Bank and the consolidated Company net interest spread was decreased by 59 basis points due to the additional interest expense of $657,000 incurred in September 2002 related to the early redemption of $43.4 million of high yielding/costing brokered CDs. This will have a positive effect on the net interest spread in future periods. For the nine month period ended September 30, 2002 net interest income decreased by $1.0 to $4.7 million from $5.7 million for the same period last year. The $1.0 million decrease was primarily due to a 24 basis point decrease in the net interest spread to 1.67% as compared to 1.91%. The net interest spread has decreased as earning asset yields have declined as a result of re-pricing Prime rate based loans with each change in the Prime lending rate, as well as a result of the Company's affirmative actions to reduce the amount of assets of the Savings Bank and Bancorp. In addition, the increase in non-performing loans during 2002 had a negative impact on the net interest spread. The net interest spread was 1.88% at the Savings Bank and 0.84% at the Bancorp, with a consolidated Company net interest spread of 1.67%. The Savings Bank and the consolidated Company net interest spread was decreased by 18 basis points due to the additional interest expense of $657,000 incurred in September 2002 related to the early redemption of $43.4 million of high yielding/costing brokered CDs. This will have a positive effect on the net interest spread in future periods. PROVISION AND ALLOWANCE FOR LOAN AND LEASE LOSSES During the three and nine month periods ended September 30, 2002, the Company recorded provisions for loan and lease losses of approximately $1.7 million and $10.3 million as compared to $37,000 and $143,000 during the three and nine months periods ended September 30, 2001. As of September 30, 2002 and December 31, 2001, the allowance for loan and lease losses (ALLL) recorded in the consolidated statement of condition was $5.0 million and $3.0 million, respectively. An analysis of the ALLL for the nine month period ended September 30, 2002 is as follows: Savings Bank Bancorp Total ----------------------------------------------- ALLL as of December 31, 2001 $ 2,484,000 $ 500,000 $ 2,984,000 Provisions 8,494,000 1,814,000 10,308,000 Charge-offs (6,507,000) (1,814,000) (8,321,000) ------------ ------------ ------------ ALLL as of September 30, 2002 $ 4,471,000 $ 500,000 $ 4,971,000 ============ ============ ============ 25 ALLL as a percentage of Gross Loans (including loans held for sale and discounted loans): December 31, 2001 .79% 15.73% .95% September 30, 2002 2.07% 94.58% 2.29% The significant provisions recorded during the second and third quarters 2002 can be attributable to several internal and external factors, as described below: During the second quarter 2002, the Savings Bank started and completed the conversion of its commercial loan portfolio, which totaled $126.6 million as of March 31, 2002, to a new loan software subsidiary ledger system. As part of that conversion, the Savings Bank performed an extensive review of its loan files, payment histories, delinquency reporting and its loan classification reporting (e.g. special mention, substandard, doubtful and loss). The results of these procedures indicated that the Savings Bank's loan files related to certain loans were missing required documentation in accordance with the Savings Bank's underwriting standards. Although management continues to investigate the existence of such supporting documentation, including contacting lead banks on participation loans and contacting borrowers directly, management downgraded any loans where documentation was not currently in the loan file. In addition, certain payment histories did not accurately reflect the loan's current payment status, and as such, the Savings Bank's delinquency reporting and loan classification reporting excluded certain loans. Accordingly, these loans were either classified for the first time or downgraded during the quarter ended June 30, 2002. In addition, during the second quarter of 2002, commercial loan borrowers with loans totaling approximately $3.6 million either declared, or it is anticipated that they will likely declare bankruptcy. Although some of these loans had been previously classified, management downgraded these loans in the second quarter of 2002 due to the actual and likely bankruptcy filings and recorded a provision related to these loans totaling $1.9 million, of which $1.6 million was subsequently charged-off. The remaining $2.0 million of loans that were not charged off consist of two loans. The first is a loan with a remaining balance of $1.6 million, with an allowance allocation of $240,000. This loan is secured by leases on consumer "photo center" equipment deployed in a national retailer. The second is a loan with a remaining balance of $364,000, with an allowance allocation of $55,000, and is secured by single family real estate. The Company also provided for and charged off $2.5 million related to one loan relationship during the second quarter of 2002. Based upon financial information received during the second quarter 2002 related to this borrower, updated information received related to the collateral for certain of these loans, and updated information related to the borrower's business as a whole, the Company charged off the entire relationship balance in question and is pursuing recovery. Management intends to actively seek recovery of charged off loan assets through legal proceedings. Management also increased its allowance factors within all commercial loan classifications, based on current economic factors. During the third quarter 2002, the Savings Bank charged-off $2.5 million related to loans or pools of loans which it had previously provided an allowance of $1.0 million. The most significant was a $3.0 million commercial non-residential loan in which $1.9 million was charged-off and $900,000 had previously been reserved for. During the third quarter, the principal of the company which was developing the property was indicted for bank fraud related to his financial dealings with another financial institution. The Company intends to pursue all avenues against the principal of the development company and his professional service firms to recover its investment in this loan, however, as of September 30, 2002 the loan was written down to its fair value based on recent appraisals of the land collateralizing the loan. Finally, during the second and third quarters 2002, delinquencies increased in single-family mortgage loan portfolio. The total amount of single-family mortgage loans ninety (90) days or more past due at December 31, 2001, March 31, 2002, June 30, 2002 and September 30, 2002 were $7.6 million, $10.6 million, $14.6 million and $16.6 million, respectively. Management believes these increases are attributable to a declining economy and 26 higher unemployment levels. To address this situation, the Savings Bank lowered the classification on certain pools of loans and also increased its allowance factors within certain single-family loan classifications. As discussed more fully in the Regulatory Compliance section of the MD&A, during May 2002, the OTS and the FDIC began a joint Field Visit examination in preparation for a joint risk-focused examination of the Savings Bank and the Bancorp, which commenced on July 1, 2002, and is nearing completion. This examination follows the safety and soundness examinations by the OTS of the Savings Bank and Bancorp completed January 2002, for which the Reports of Examinations were delivered, as appropriate to the Savings Bank and Bancorp in March 2002 and in which no loans were classified as "loss" assets. During the current joint OTS/FDIC safety and soundness examination, management has met with the OTS/FDIC representatives numerous times. Based on these meetings, management believes that all loans have been properly graded by management and the Company's analysis of its ALLL, as of September 30, 2002, has properly considered all the concerns conveyed by the OTS/FDIC representatives related to the status of the Savings Bank's loan files, delinquency reporting, and loan classification reporting. Based on these factors, management believes that the ALLL as of September 30, 2002 is adequate. Management has taken the following steps to improve its ALLL reporting, delinquent loan reporting and its loan classification reporting: 1) as previously discussed, the Savings Bank completed the conversion of its commercial loan portfolio to a new loan software subsidiary ledger system; as part of that conversion, all commercial loans were re-amortized to determine that the principal and accrued interest balances were accurate (requiring minimal adjustment to either the principal or accrued interest), and all other significant information (such as origination date, interest rate, maturity date, payment dates, etc.) was re-verified to source documents such as the original note or payment tickets; and 2) during the period July 2002 to October 2002, the Savings Bank has expanded its commercial loan department by hiring new senior loan credit administrators and several mid-level managers to effectively monitor and evaluate the commercial loan portfolio. NON-INTEREST INCOME Total non-interest income increased $200,000 to $700,000 for the three months ended September 30, 2002, as compared to $500,000 of income for the three months ended September 30, 2001. The increase was primarily due to the recording of a $1.1 million valuation allowance during the third quarter 2001, taken against the Company's interest in limited partnership that invests in PMSRs. This was offset in 2002 due to net gains on the sale of assets declined $800,000, to a net gain of $300,000 as compared to a net gain of $1.2 million for the comparable period in 2001. Included in the $800,000 decrease in gain on sale of assets is a decrease of $700,000 related to securities available for sale and $200,000 related to trading securities. Due to declining market conditions in the third quarter, the Company's equity securities in its trading portfolio declined in value and securities sold from the available for sale portfolio also had declines. Total non-interest income (expense) decreased $5.0 million to an expense of $2.0 million for the nine months ended September 30, 2002, as compared to $3.0 million of income for the nine months ended September 30, 2001. The decline was primarily the result of recording a $2.5 million valuation allowance during 2002 compared to $1.1 million in 2001, taken against the Company's interest in the limited partnership and resulting from recent declines in interest rates and the negative adverse effect of increased loan prepayment speeds on the value of PMSRs. In addition, net gains on the sale of assets declined by $2.5 million to a net loss of $500,000 as compared to a net gain of $2.0 million for the comparable period in 2001. Included in the $2.5 million decline in gain on sale of assets is a decline of $2.0 million related to securities available-for-sale and $500,000 related to trading account securities. Of the $2.0 million pre-tax loss on the sale of securities available-for-sale, $770,000 was related to the Company selling its excess investment in TPS, for regulatory compliance purposes, and in conjunction with the Savings Bank's ROE that is described in the preceding Regulatory Compliance section. Due to declining market conditions in 2002, the Company's equity securities in its trading portfolio declined in value and securities sold 27 from the available for sale portfolio also had declines. In addition, fees and service charges decreased approximately $300,000 primarily due to a decrease of approximately $300,000 of income related to the Savings Bank's ATM network during first quarter 2002. NON-INTEREST EXPENSE Non-interest expense remained constant at $3.5 million for the three months ended September 30, 2002 and 2001 and represented 2.75% and 2.79% of average assets, respectively. During the three months ended September 30, 2002, a $100,000 increase in federal deposit insurance premiums was offset by a $100,000 decline in occupancy and equipment expenses. Non-interest expense increased by $2.2 million to $11.1 million or 2.18% of average assets for the nine months ended September 30, 2002 from $8.9 million or 2.32% of average assets for the same period last year. The $2.2 million increase in operating expenses was primarily the result of increases in: (i) professional fees of approximately $800,000, consisting of legal, consulting and audit related fees, and resulting, in part, from the Bancorp ROE and Savings Bank ROE discussed in the preceding Regulatory Compliance section; (ii) data processing expense of approximately $200,000 due to the Savings Bank's increased volume of Internet transaction processing; (iii) loan servicing expense of approximately $200,000 due to the Savings Bank's increase in non-performing assets; (iv) compensation expense of approximately $400,000; (v) net ATM overages / shortages of approximately $200,000; and (vi) general administrative expenses of approximately $700,000 including $200,000 for insurance, consisting of a $100,000 increase in federal deposit insurance premiums and $100,000 increase in general business insurance. All of which were offset by a $300,000 decline in occupancy expenses. INCOME TAX EXPENSE The Company recorded a tax benefit of $1.6 million for the three months ended September 30, 2002 compared to a tax benefit of $374,000 for the same period last year. The 2002 benefit is based on a tax rate of approximately 39% calculated on the pre-tax loss of $3.6 million, plus tax benefits derived from tax-exempt municipal securities and tax-exempt charter school loans, plus utilization of affordable housing tax credits. The Company recorded a tax benefit of $7.8 million for the nine months ended September 30, 2002 compared to a tax benefit of $634,000 for the same period last year. The 2002 benefit is based on a tax rate of approximately 39% calculated on the pre-tax loss of $18.7 million, plus tax benefits derived from tax-exempt municipal securities and tax-exempt charter school loans, plus the utilization of affordable housing tax credits. Management's analysis of the deferred tax asset at September 30, 2002 is discussed in the preceding Financial Condition section. ACCOUNTING DEVELOPMENTS The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 141 "Business Combinations" in June 2001. SFAS No. 141 requires all business combinations within its scope to be accounted for using the purchase method, rather than the pooling-of-interest method. The provisions of SFAS No. 141 apply to all business combinations initiated after June 30, 2001. The adoption of SFAS No. 141 will only impact the Company's financial statements if it enters into a business combination. The FASB also issued SFAS No. 142, "Goodwill and Other Intangible Assets", which addresses the accounting for such assets arising from prior and future business combinations, in June 2001. Under SFAS No. 142, goodwill arising from business combinations will no longer be amortized, but rather will be assessed regularly for impairment, with any such impairment recognized as a reduction of earnings in the period identified. Other identified intangible assets, such as core deposit intangible assets, will continue to be amortized over their estimated useful lives. The Company adopted SFAS No. 142 on January 1, 2002. The adoption of SFAS No. 142 28 did not have any impact on the Company's financial statements at that date as the Company had no recorded goodwill at December 31, 2001. Effective January 1, 2003, SFAS 143, "Accounting for Asset Retirement Obligations" will apply. This statement requires that the fair value of a liability for an asset retirement obligation be recognized in the period incurred. The effect of this statement on the financial position and operations of the Company is not anticipated to have a material affect. The Company adopted SFAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" on January 1, 2002. The statement requires that the Company recognize an impairment loss on long-lived assets when the carrying amount is not recoverable and the measurement of the impairment loss is the difference between the carrying amount and the fair value of the asset. This pronouncement did not have a material effect on the Company's financial statements. On April 1, 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." SFAS No. 145 is effective for financial statements issued on or after May 15, 2002. SFAS 145 requires that any gains or losses on extinguishment of debt that were classified as an extraordinary item in prior periods that are not unusual in nature and infrequent in occurrence be reclassified to other income or expense. SFAS No. 145 also amends SFAS No. 13 to require certain modifications to capital leases be treated as a sale-leaseback and modifies the accounting for sub-leases when the original lessee remains a secondary obligor or guarantor. Adoption of SFAS No. 145 on September 30, 2002 resulted in the Company recording $657,000 of additional interest expense on deposits in the statement of operations. The additional interest expense was the result of an early redemption of brokered CDs. Prior to adoption of this pronouncement, the expense would have been recorded as an extraordinary event. On June 1, 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS No. 146 is effective for exit or disposal activities initiated after December 31, 2002, and may be early applied. SFAS No. 146 supersedes EITF 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)". SFAS No. 146 provides guidance on the accounting for the recognition of liabilities associated with exit and disposal activities. Under SFAS No. 146, "a liability for a cost associated with an exit or disposal activity should be recognized when the liability is incurred." The FASB concluded that an entity's commitment to a plan, by itself, does not create a present obligation to others that meet the definition of a liability. The Company has adopted SFAS No. 146 effective July 1, 2002 and the adoption of this standard did not have a material effect on the Company's consolidated financial position or results of operations. However as the Company exits certain business activities and reduces personnel it is anticipated the Company will recognize liabilities in accordance with SFAS No. 146. On October 1, 2002, the FASB issued SFAS No. 147, "Acquisitions of Certain Financial Institutions." SFAS No. 147 is effective October 1, 2002, and may be early applied. SFAS No. 147 supersedes SFAS No. 72, "Accounting for Certain Acquisitions of Banking or Thrift Institutions." SFAS No. 147 provides guidance on the accounting for the acquisition of a financial institution, and applies to all such acquisitions except those between two or more mutual enterprises. Under SFAS No. 147, the excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired in a financial institution business combination represents goodwill that should be accounted for under SFAS No. 142, "Goodwill and Other Intangible Assets." If certain criteria are met, the amount of the unidentifiable intangible asset resulting from prior financial institutions acquisitions is to be reclassified to goodwill upon adoption of this Statement. Financial institutions meeting conditions outlined in SFAS No. 147 are required to restate previously issued financial statements. The objective of the restatement is to present the balance sheet and income statement as if the amount accounted for under SFAS No. 72 as an unidentifiable intangible asset had been reclassified to goodwill as of the date the Company adopted SFAS No. 142. Adoption of SFAS No. 147 on October 1, 2002 did not have a material effect on the Company's consolidated financial position or results of operations. The adoption of SFAS No. 147 did not have any impact on the Company's financial statements at that date as the Company had not previously acquired any financial institutions branches. 29 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK As part of its normal operations, the Savings Bank is subject to interest-rate risk on the interest-sensitive assets it invests in and the interest-sensitive liabilities it borrows. The Investment Committee, which includes members of senior management and directors, monitors and determines the strategy of managing the rate and sensitivity re-pricing characteristics of the individual asset and liability portfolios the Savings Bank maintains. The overall goal is to manage this interest rate risk to most efficiently utilize the Savings Bank's capital, as well as to maintain an acceptable level of change to its net portfolio value ("NPV") and net interest income. The Savings Bank's strategy is to minimize the impact of sudden and sustained changes in interest rates and NPV and its net interest margin. Interest rate risk exposure is measured using interest rate sensitivity analysis to determine the Savings Bank's change in NPV in the event of hypothetical changes in interest rates, as well as interest rate sensitivity gap analysis, which monitors the re-pricing characteristics of the Saving Bank's interest-earning assets and interest-bearing liabilities. The Board of Directors has established limits to changes in NPV and net interest income across a range of hypothetical interest rate changes. If estimated changes to NPV and net interest income are not within these limits, the Board may direct management to adjust its asset/liability mix to bring its interest rate risk within Board limits. In an effort to reduce its interest rate risk, the Savings Bank has focused on strategies limiting the average maturity of its assets by emphasizing the origination of adjustable-rate mortgage loans and the purchase of adjustable rate/floating rate U.S. agency issued mortgage backed securities and collateralized mortgage obligations. The Savings Bank, from time to time, also invests in long-term, fixed-rate mortgages provided it is compensated with an acceptable spread. None of these strategies are prohibited or otherwise restricted by the Savings Bank ROE discussed previously. Interest rate sensitivity analysis is used to measure the Savings Bank's interest rate risk by calculating the estimated change in the NPV of its cash flows from interest sensitive assets and liabilities, as well as certain off-balance-sheet items, in the event of a series of sudden and sustained changes in interest rates ranging from 100 to 300 basis points. Management assumes that a 200 basis point movement up or down is considered reasonable and plausible for purposes of managing its interest-rate risk on a day to day basis. NPV is the market value of portfolio equity and is computed as the difference between market value of assets and the market value of liabilities, adjusted for the value of off-balance-sheet items. The following table presents the Saving Bank's projected change in NPV for the various rate shocks as of June 30, 2002 which is the most recent available. Estimated Increase (Decrease) in NPV Change in Estimated ----------------- Interest Rate NPV Amount Percent ------------- --- ------ ------- (Dollars in thousands) 300 basis point rise $ 31,941 $ (724) (2)% 200 basis point rise 33,248 583 2 100 basis point rise 34,448 1,783 5 Base scenario 32,665 -- -- 100 basis point decline 30,811 (1,854) (6) Due to the level of interest rates at June 30, 2002, the Company is not able to model an additional 200 or 300 basis point decrease in rates. 30 The NPV is calculated by the Savings Bank using guidelines established by the OTS related to interest rates, loan prepayment rates, deposit decay rates, and market values of certain assets under the various interest rate scenarios. These assumptions should not be relied upon as indicative of actual results due to the inherent shortcomings of the NPV analysis. These shortcomings include: (i) the possibility that actual market conditions could vary from the assumptions used in the computation of NPV; (ii) certain assets, including adjustable-rate loans, have features which affect the potential re-pricing of such instruments, which may very from the assumptions used; and (iii) the likelihood that as interest rates are changing, the Investment Committee would likely be changing strategies to limit the indicated changes in NPV as part of its management process. The Savings bank does not use derivative instruments to control interest rate risk. In addition, interest rate risk is the most significant market risk affecting the Savings Bank. Other types of market risk, such as foreign currency exchange risk and commodity price risk, do not arise in the normal course of the Company's business activities and operations. ITEM 4. CONTROLS AND PROCEDURES Within the 90 days prior to the date of this report, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer along with the Company's Principal Accounting and Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to the Securities Exchange Act of 1934 ("Exchange Act") Rule 13a-14. Based upon that evaluation, the Company's Chief Executive Officer along with the Company's Principal Accounting and Financial Officer concluded that the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic Securities and Exchange Commission ("SEC") filings. There have been no significant changes in the Company's internal controls or in other factors which could have a significant adverse effect on these controls subsequent to the date the Company carried out its evaluation. Disclosure controls and procedures are those controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Principal Accounting and Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. 31 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Bancorp and the Savings Bank are not engaged in any legal proceedings of a material nature at the present time. ITEM 2. CHANGES IN SECURITIES On September 29, 2002, the Board of Directors of the Bancorp authorized the issuance of up to 10,000 shares of Series A 8.0% Perpetual Preferred Convertible Preferred Stock ("Series A Stock"). The Series A Stock has a par and face value of $1,000. After March 31, 2003, the holders of record of the Series A Stock on the dates specified below shall be entitled to receive, as and when declared by the Board of Directors and out of assets of the Bancorp which are by law available for payment of dividends, cumulative preferential cash dividends, at the rate of $80.00 per share per annum, payable quarterly on the first day of July, October, January and April in each year. Dividends on the Series A Stock shall be cumulative, whether or not in any dividend period or periods after March 31, 2003 there shall be surplus or net profits of the Company legally available for the payment of such dividends. Dividends on the Series A Stock shall be junior and subordinate to the payment of the Bancorp's obligations for dividends or payments under the Company's 11% Junior Subordinate Deferrable Interest Debentures. After March 31, 2004, the Bancorp, at the option of the Board of Directors, may at any time or from time to time redeem the whole or any part of the Series A Stock by paying therefore in cash $1,000 per share plus an amount equal to all dividends thereon declared but unpaid on the date fixed for redemption (the "Redemption Price"). Until March 31, 2008, each holder of Series A Stock may at any time upon surrender of the certificates therefore, convert any or all of such holder's Series A Stock into fully paid and nonassessable shares of Common Stock of the Bancorp, at the rate of 166 shares of Common Stock for each share of Series A Stock so surrendered for conversion. ITEM 3. DEFAULT UPON SENIOR SECURITIES Not applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ITEM 5. OTHER INFORMATION Not Applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K A. Exhibits Exhibit 99.1 Certificate of Chief Executive Officer Exhibit 99.2 Certificate of Principal Accounting and Financial Officer The following exhibits are incorporated herein by reference: (3) The Certificate of Incorporation and By-Laws. 32 3.1 Amended Certificate of Incorporation of Umbrella Bancorp, Inc.* 3.2 By-Laws of Umbrella Bancorp, Inc.* 4.0 Stock Certificate of Umbrella Bancorp, Inc.* 11.0 Statement Regarding Computation of Earnings Per Share (See Note D) B. Reports of Form 8-K None. * Incorporated herein by reference into this document from the Exhibits to Form S-1, Registration Statement, and filed on January 28, 1992, any amendments thereto, Registration No. 33-45222. 33 SIGNATURES Pursuant to the requirement of the Securities and Exchange Act of 1934, the Registrant had duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. UMBRELLA BANCORP, INC. Date: November 19, 2002 /S/ John G. Yedinak ------------------------- --------------------------------------- John G. Yedinak, Chairman, President and Chief Executive Officer Date: November 19, 2002 /S/ Frank J. Shinnick ------------------------- --------------------------------------- Frank J. Shinnick, Principal Accounting and Financial Officer 34 CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, John G. Yedinak., certify that: 1. I have reviewed this quarterly report on Form 10-Q of Umbrella Bancorp, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in the quarterly report, fairly present in all material respects the financial condition, results of operations and cash flow of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 35 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 19, 2002 /S/ John G. Yedinak ------------------------- ---------------------------------------- John G. Yedinak, Chairman, President and Chief Executive Officer 36 CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Frank J. Shinnick, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Umbrella Bancorp, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in the quarterly report, fairly present in all material respects the financial condition, results of operations and cash flow of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 37 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 19, 2002 /S/ Frank J. Shinnick ------------------------ --------------------------------------- Frank J. Shinnick, Principal Accounting and Financial Officer 38

UMBRELLA BANCORP INC 10-Q