Overview

Magyar Bancorp, Inc. (the "Company") is a Delaware-chartered mid-tier stock holding company whose most significant business activity is ownership of 100% of the common stock of Magyar Bank. Magyar Bank's principal business is attracting retail deposits from the general public and investing those deposits, together with funds generated from operations, principal repayments on loans and securities and borrowed funds, into one-to four-family residential mortgage loans, multi-family and commercial real estate mortgage loans, home equity loans and lines of credit, commercial business loans and construction loans. Our results of operations depend primarily on our net interest income which is the difference between the interest we earn on our interest-earning assets and the interest we pay on our interest-bearing liabilities. Our net interest income is primarily affected by the market interest rate environment, the shape of the U.S. Treasury yield curve, the timing of the placement of interest-earning assets and interest-bearing liabilities, and the prepayment rate on our mortgage-related assets. Other factors that may affect our results of operations are general and local economic and competitive conditions, government policies and actions of regulatory authorities.

On April 22, 2010, the Bank entered into agreements with the Federal Deposit Insurance Corporation and the New Jersey Department of Banking and Insurance which required the Bank to take certain measures to improve its safety and soundness. In connection with these agreements, the Bank stipulated to the issuance of consent orders against the Bank (the "Consent Orders") relating to certain findings from a recent examination of the Bank. In entering into the stipulation and consenting to entry of the Consent Orders, the Bank did not concede the findings or admit to any of the assertions therein. The Consent Orders imposed no fines or penalties upon the Bank.

Among the corrective actions required were for the Bank to develop, within 30 days of the April 22, 2010 effective date of the Consent Orders, a written capital plan that detailed the manner in which the Bank would achieve a Tier 1 capital as a percentage of the Bank's total assets of at least 8%, and total qualifying capital as a percentage of risk-weighted assets of at least 12%. On March 2, 2012 the Bank was informed in writing by the Federal Deposit Insurance Corporation and the New Jersey Department of Banking and Insurance, that the Consent Order had been terminated. The Bank is required to maintain Tier 1 capital as a percentage of the Bank's total assets of at least 8%, and total qualifying capital as a percentage of risk-weighted assets of at least 12%. At September 30, 2012, Magyar Bank's Tier 1 capital as a percentage of the Bank's total assets was 8.40% and the total qualifying capital as a percentage of risk-weighted assets was 13.21%.

During the year ended September 30, 2012, net loans increased $4.0 million, or 1.1%, despite a $16.2 million, or 47.4%, decrease in construction loans. The contraction in the construction loan portfolio was due to the decision to cease originations of new construction loans in 2008 based on the adverse economic environment and its impact on this type of lending. Due to the difficult economic environment and the need to increase capital ratios, the repayments of these loans were used to shrink the Bank's balance sheet by reducing higher-cost borrowings and deposits.

Borrowing decreased $8.4 million, or 16.9%, and deposits decreased $8.4 million, or 2.0%, during the year ended September 30, 2012. Balances of certificates of deposit (including individual retirement accounts) declined $17.1 million, or 9.7%, reflecting the Bank's continued strategy of shifting funding sources from higher cost certificates of deposit and borrowings to lower cost checking accounts, which increased $13.4 million, or 43.2%, during the year. The shift in funding helped contribute to a $1.6 million, or 21.6%, decrease in the Company's interest expense on its interest bearing liabilities from $7.4 million for the year ended September 30, 2011 to $5.8 million for the year ended September 30, 2012. We attribute the decrease in the average interest expense to the expansion of our commercial relationships, which tend to hold larger deposit balances, successful business development efforts by our retail branch managers, and the continued growth of the Bank's two newest branch facilities.

The Company reported net income of $509,000 for the year ended September 30, 2012. Net income increased $758,000 for the year ended September 30, 2012 compared with a net loss of $249,000 for the year ended September 30, 2011, attributable to a $169,000 increase in net interest income and a $714,000 decrease in other expenses.

Loan loss provisions decreased $287,000 to $1.5 million during the year ended September 30, 2012 compared with $1.7 million for the year ended September 30, 2011 due to lower level of loan charge-offs and the decrease in the total loan receivables during the current period, specifically construction loan balances, which required higher levels of reserves.

Throughout 2013, we expect to continue the resolution of non-performing assets, diversifying our balance sheet with higher concentrations in commercial real estate and commercial business loans, and managing non-interest expenses in order to increase profitability of the Company.

Critical Accounting Policies

Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. Critical accounting policies may involve complex subjective decisions or assessments. We consider the following to be our critical accounting policies.

Allowance for Loan Loss. The allowance for loan losses is the amount estimated by management as necessary to cover credit losses in the loan portfolio both probable and reasonably estimable at the balance sheet date. The allowance is established through the provision for loan losses which is charged against income. In determining the allowance for loan losses, management makes significant estimates and has identified this policy as one of our most critical. Due to the high degree of judgment involved, the subjectivity of the assumptions utilized and the potential for changes in the economic environment that could result in changes to the amount of the recorded allowance for loan losses, the methodology for determining the allowance for loan losses is considered a critical accounting policy by management.

As a substantial amount of our loan portfolio is collateralized by real estate, appraisals of the underlying value of property securing loans and discounted cash flow valuations of properties are critical in determining the amount of the allowance required for specific loans. Assumptions for appraisals and discounted cash flow valuations are instrumental in determining the value of properties. Overly optimistic assumptions or negative changes to assumptions could significantly affect the valuation of a property securing a loan and the related allowance determined. The assumptions supporting such appraisals and discounted cash flow valuations are carefully reviewed by management to determine that the resulting values reasonably reflect amounts realizable on the related loans.

Management performs a quarterly evaluation of the adequacy of the allowance for loan losses. We consider a variety of factors in establishing this estimate including, but not limited to, current economic conditions, delinquency statistics, geographic and industry concentrations, the adequacy of the underlying collateral, the financial strength of the borrower, results of internal loan reviews and other relevant factors. This evaluation is inherently subjective as it requires material estimates by management that may be susceptible to significant change based on changes in economic and real estate market conditions.

The evaluation has a specific and general component. The specific component relates to loans that are delinquent or otherwise identified as impaired through the application of our loan review process and our loan grading system. All such loans are evaluated individually, with principal consideration given to the value of the collateral securing the loan and discounted cash flows. Specific impairment allowances are established as required by this analysis. However, the Bank's Federal and State regulators generally require that the specific reserve against impaired loans be charged-off, reducing the carrying balance of the loan and allowance for loan loss. The general component is determined by segregating the remaining loans by type of loan, risk weighting (if applicable) and payment history. We analyze historical loss experience, delinquency trends, general economic conditions and geographic and industry concentrations in establishing the general portion of the reserve. This analysis establishes factors that are applied to the loan groups to determine the amount of the general component of the allowance for loan losses.

Actual loan losses may be significantly greater than the allowances we have established, which could have a material negative effect on our financial results.

Deferred Income Taxes. The Company records income taxes using the asset and liability method. Accordingly, deferred tax assets and liabilities: (i) are recognized for the expected future tax consequences of events that have been recognized in the financial statements or tax returns; (ii) are attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases; and (iii) are measured using enacted tax rates expected to apply in the years when those temporary differences are expected to be recovered or settled.

Deferred tax assets have been reduced by a valuation allowance for all portions determined not likely to be realized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period of enactment. The valuation allowance is adjusted, by a charge or credit to income tax expense, as changes in facts and circumstances warrant.

Comparison of Financial Condition at September 30, 2012 and September 30, 2011

Total Assets. Total assets decreased $15.2 million, or 2.9%, to $508.8 million at September 30, 2012 from $524.0 million at September 30, 2011, due to reductions in investment securities, cash and cash equivalents and other real estate owned, partially offset by an increase in net loan receivables.

Loans Receivable. Net loans receivable increased $4.0 million, or 1.1%, to $385.3 million at September 30, 2012 from $381.3 million at September 30, 2011. During the year ended September 30, 2012, construction loans decreased $16.2 million, or 47.4%, to $18.0 million at September 30, 2012 from $34.1 million at September 30, 2011. In addition, commercial business loans decreased $6.3 million, or 17.3%, to $29.9 million from $36.2 million, and one-to four-family residential mortgage loans decreased $1.7 million, or 1.1%, to $157.5 million from $159.2 million. Offsetting the decreases was a $27.8 million, or 23.0%, increase in commercial real estate loans to $148.8 million from $121.0 million and a $403,000, or 1.2%, increase in home equity lines of credit and other loans to $34.7 million from $34.3 million.

At September 30, 2012, the significant loan categories in terms of the percent of total loans were 40.5% in one-to four-family residential mortgage loans and 38.3% in commercial real estate loans. The remaining categories were comprised of 7.7% in commercial business loans, and 8.9% in home equity lines of credit and other loans, which consisted primarily of stock-secured consumer loans and 4.6% in construction loans.

Total non-performing and restructured loans decreased $10.2 million to $22.7 million at September 30, 2012 from $32.9 million at September 30, 2011. Excluding troubled debt restructurings, non-performing loans decreased $8.1 million, or 28.7%, to $20.1 million. Non-performing loans consisted of six construction loan relationships totaling $5.1 million, twenty-four mortgage loans secured by one-to-four family residential properties totaling $7.6 million, eight commercial real estate loans totaling $6.4 million, eight home equity lines of credit and other consumer loans totaling $875,000, and two commercial business loan totaling $57,000.

Adverse economic conditions have led to high levels of non-performing loans, particularly in the Company's construction loan portfolio. The repayment of construction loans is typically dependent upon the sale of the collateral securing the loan, which has been negatively impacted by significant deterioration in the housing market and decreased buyer demand. As a result, construction projects have slowed and reached their maturity dates. In order for the Company to extend the loans beyond the original maturity date, the value of the collateral securing the loan must be assessed, which is typically done by obtaining an updated third-party appraisal. Given the deterioration in the economy and, specifically, the housing market, updated valuations of the collateral reflect depreciation from earlier assessments. To the extent that the current appraised value of collateral is insufficient to cover a collateral-dependent loan, the Company reduces the balance of the loan via a charge to the allowance for loan loss.

Non-performing loans secured by one-to four-family residential properties, including home equity lines of credit and other consumer loans, increased $3.6 million to $8.4 million at September 30, 2012 from $4.8 million at September 30, 2011. Magyar Bank had begun foreclosure proceedings on the majority of the properties as of September 30, 2012. During the year ended September 30, 2012, Magyar Bank charged off $407,000 from these loans through a reduction of its allowance for loan loss. There were six troubled debt restructurings of loans secured by a one-to four-family residential property totaling $2.3 million that were performing at their restructured terms at September 30, 2012.

Non-performing construction loans decreased $10.3 million, or 66.8%, to $5.1 million at September 30, 2012 from $15.5 million at September 30, 2011. The real estate securing these loans consists of vacant and partially completed residential lots in various locations in the State of New Jersey. Magyar Bank is determining the proper course of action to collect the principal outstanding on these loans including foreclosure of collateral and pursuit of personal guarantors on the loans. During the year ended September 30, 2012, Magyar Bank charged off $880,000 in non-performing construction loan balances through a reduction of its allowance for loan loss. There were no troubled debt restructurings of construction loans during the year ended September 30, 2012.

Construction loans may contain interest reserves on which the interest is capitalized. At September 30, 2012, there were two performing construction loans with interest reserves representing outstanding balances of $893,000, an original interest reserve of $169,000, an advanced interest reserve of $9,000, and a remaining interest reserve balance of $160,000.

Underwriting for construction loans with and without interest reserves has followed a uniform process. Construction loan progress is monitored by loan on a monthly basis by management of the Bank as well as by the Board of Directors. Each time an advance is requested, an inspection is made of the project by an outside engineer or appraiser, depending on the size and complexity of the project, to determine the amount of work completed and if the costs to date are supported adequately. The Bank's construction loan operations personnel compare the advance request with the original budget and remaining loan funds available to ensure the project is in balance and that at all times the amount remaining on the loan is sufficient to complete the project.

A number of the Bank's construction loans have been extended due to slower sales as a result of worsening economic conditions. In cases where updated appraisals reflect collateral values insufficient to cover the loan, additional collateral and/or a principal reduction is required to extend the loan. Some of the Bank's loans that originally had interest reserves are non-performing. The Bank does not currently have any non-performing loans with active interest reserves. Once a loan is deemed impaired, any interest reserve is frozen and the loan is placed on non-accrual so that no future interest income is recorded on these loans. The Bank ceased originating new non-owner occupied construction loans in October 2008.

Non-performing commercial real estate loans decreased $1.2 million, or 15.4%, to $6.4 million at September 30, 2012 from $7.6 million at September 30, 2011. Magyar Bank had begun foreclosure proceedings on the properties securing these loans at September 30, 2012. During the year ended September 30, 2012, Magyar Bank had charged off $110,000 in non-performing commercial real estate loan balances through a reduction of its allowance for loan loss. There was one troubled debt restructurings of commercial real estate loan totaling $245,000 that was performing at its restructured term during the year ended September 30, 2012.

Non-performing commercial business loans decreased $198,000, or 77.6%, to $57,000 at September 30, 2012 from $255,000 at September 30, 2011. Magyar Bank is determining the proper course of action to collect the principal outstanding on these loans which will include foreclosure proceedings for those loans secured by real estate. During the year ended September 30, 2012, Magyar Bank had charged off $69,000 in non-performing commercial business loans for the year ended September 30, 2012. There were no troubled debt restructurings of commercial business loans during the year ended September 30, 2012.

The ratio of non-performing loans and troubled debt restructurings to total loans receivable decreased to 5.83% at September 30, 2012 from 8.55% at September 30, 2011. The allowance for loan losses increased $46,000 to $3.9 million, or 19.2% of non-performing loans, at September 30, 2012 compared with $3.8 million, or 13.5% of non-performing loans, at September 30, 2011. Provisions for loan loss during the year ended September 30, 2012 were $1.5 million while net charge-offs were $1.4 million, compared with a provision of $1.7 million and net charge-offs of $2.7 million for the prior year period. The allowance for loan losses was 0.99% of gross loans outstanding at September 30, 2012 and 2011.

Investment Securities.Investment securities decreased $12.5 million, or 17.7%, to $57.9 million at September 30, 2012 from $70.3 million at September 30, 2011.

Securities available-for-sale decreased $8.5 million, or 33.7%, to $16.8 million at September 30, 2012 from $25.3 million at September 30, 2011. The decrease was the result of $14.9 million in sales and maturities and $3.7 million in principal amortization, partially offset by $10.2 million in purchases of mortgage-backed securities and U.S. government-sponsored enterprise obligations. In addition, the unrealized gain on the available-for-sale portfolio decreased $10,000 to $484,000 at September 30, 2012 compared with $494,000 at the prior year end.

Securities held-to-maturity decreased $3.9 million, or 8.7%, to $41.1 million at September 30, 2012 from $45.0 million at September 30, 2011. The decrease was the result of $12.6 million in maturities and calls and $8.4 million in principal amortization, offset by $17.2 million in security purchases,

Bank-Owned Life Insurance.The cash surrender value of life insurance held for directors and executive officers of Magyar Bank increased $350,000, or 3.6%, to $10.0 million at September 30, 2012 from $9.7 million at September 30, 2011. The increase in bank-owned life insurance was due to the increase in the cash surrender value of the existing policies.

Other Real Estate Owned. Other real estate owned decreased $3.2 million to $13.4 million at September 30, 2012 from $16.6 million at September 30, 2011.

During the year ended September 30, 2012, the Company was able to successfully dispose of six properties totaling $8.5 million at a net loss of $22,000, invested $1.2 million and was able to obtain title for seven other properties totaling $5.8 million previously securing non-performing loans. Other real estate owned at September 30, 2012 consisted of ten completed residential properties, three partially completed residential properties, thirteen real estate lots approved for the construction of residential homes, and two commercial real estate buildings.The Bank is determining the proper course of action for its other real estate owned, which may include holding the properties until the real estate market improves, selling the properties to a developer and completing partially completed homes for either rental or sale.

Deposits.Total deposits decreased $8.4 million, or 2.0%, to $416.5 million at September 30, 2012 from $424.9 million at September 30, 2011.

The Company's deposit strategy during the year ended September 30, 2012 was focused on increasing and expanding customer relationships with Magyar Bank, including higher balance commercial deposit accounts. As a result of this strategy, the Bank was able to continue replacing higher-cost, single service time deposit account holders with lower-cost checking account balances.

The contraction in deposits during the twelve months ended September 30, 2012 occurred in certificates of deposit (including individual retirement accounts), which decreased $17.1 million, or 9.7%, to $158.5 million from $175.6 for the same period of last year. Savings decreased $5.2 million, or 8.7%, to $55.3 million compared to $60.5 million for the same period of last year. Partially offsetting this decrease was a $13.9 million, or 7.4%, increase in checking accounts (including money market accounts) to $202.8 million from $188.9 for the same period of last year. Deposits accounted for 81.9% of assets and 108.1% of net loans at September 30, 2012.

At September 30, 2012, the Company held $7.5 million in brokered certificates of deposit and no Certificate of Deposit Account Registry Service (CDARS) Reciprocal certificates of deposit. At September 30, 2011, the Company held $1.8 million in CDARS Reciprocal certificates of deposit and $10.0 million in brokered certificates of deposit.

Borrowed Funds. Borrowings decreased $8.4 million, or 16.9% to $41.5 million at September 30, 2012 from $49.9 million at September 30, 2011.

Securities sold under agreements to repurchase decreased $10.0 million as maturing borrowings were paid off with excess cash. Borrowings and securities sold under agreements to repurchase decreased to 8.2% of assets at September 30, 2012 from 9.5% at September 30, 2011.

Stockholders' Equity. Stockholders' equity increased $496,000, or 1.1%, to $45.0 million at September 30, 2012 from $44.5 million at September 30, 2011. The increase in stockholders' equity was attributable to the Company's results from operations for the year ended September 30, 2012.

During the year ended September 30, 2012, the Company repurchased 14,030 shares of its common stock. Under the current stock repurchase program, 48,924 shares of the 129,924 shares authorized remained available for repurchase at September 30, 2012.

Comparison of Operating Results for the Years Ended September 30, 2012 and 2011

Net Income (Loss). The Company's net income was $509,000 for the year ended September 30, 2012, reflecting a $758,000 increase from a net loss of $249,000 for the year ended September 30, 2011.

Net Interest and Dividend Income. Net interest and dividend income increased $169,000, or 1.1%, to $15.0 million during the year ended September 30, 2012 from $14.8 million during the year ended September 30, 2011. Interest and dividend income decreased $1.4 million, or 6.4%, to $20.8 million for the year ended September 30, 2012 from $22.2 million for the year ended September 30, 2011 while interest expense decreased $1.6 million, or 21.6%, to $5.8 million for the year ended September 30, 2012 from $7.4 million for the year ended September 30, 2011.

Average Balance Sheet. The following table presents certain information regarding our financial condition and net interest income for the years ended September 30, 2012 and 2011. The table presents the annualized average yield on interest-earning assets and the annualized average cost of interest-bearing liabilities. We derived the yields and costs by dividing annualized income or expense by the average balance of interest-earning assets and interest-bearing liabilities, respectively, for the periods shown. We derived average balances from daily balances over the periods indicated. Interest income includes fees that we consider adjustments to yields.

                                                                                              For the Year Ended September 30,
                                                             2012                                           2011                                           2010
                                                        Interest                                       Interest                                       Interest
                                           Average       Income/        Yield/Cost        Average       Income/        Yield/Cost        Average       Income/        Yield/Cost
                                           Balance       Expense       (Annualized)       Balance       Expense       (Annualized)       Balance       Expense       (Annualized)
                                                                                                   (Dollars In Thousands)
Interest-earning assets:
Interest-earning deposits                 $  12,419     $      38               0.30 %   $  11,699     $      25               0.22 %   $   2,598     $       8               0.30 %
Loans receivable, net                       383,493        18,730               4.88 %     393,907        20,033               5.09 %     424,554        22,521               5.30 %
Securities
Taxable                                      68,580         1,930               2.81 %      68,538         2,021               2.95 %      64,439         2,431               3.77 %
Tax-exempt (1)                                   50             4               8.81 %          80             7               8.93 %         105             6               5.94 %
FHLB of NY stock                              2,342           104               4.46 %       2,656           149               5.60 %       3,083           159               5.16 %
Total interest-earning assets               466,884        20,806               4.46 %     476,880        22,235               4.66 %     494,779        25,125               5.08 %
Noninterest-earning assets                   55,404                                         54,503                                         54,192
Total assets                              $ 522,288                                      $ 531,383                                      $ 548,971

Interest-bearing liabilities:
Savings accounts (2)                      $  58,125     $     222               0.38 %   $  61,367     $     373               0.61 %   $  61,639     $     599               0.97 %
NOW accounts (3)                            145,313           631               0.43 %     137,877         1,006               0.73 %     134,667         1,384               1.03 %
Time deposits (4)                           167,584         3,087               1.84 %     181,128         3,724               2.06 %     201,124         4,600               2.29 %
Total interest-bearing deposits             371,022         3,940               1.06 %     380,372         5,103               1.34 %     397,430         6,583               1.66 %
Borrowings                                   49,023         1,869               3.81 %      58,080         2,303               3.96 %      67,800         2,728               4.02 %
. . .