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TFSL > SEC Filings for TFSL > Form 10-Q on 9-May-2013All Recent SEC Filings

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Form 10-Q for TFS FINANCIAL CORP


9-May-2013

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Forward Looking Statements
This report contains forward-looking statements, which can be identified by the use of such words as estimate, project, believe, intend, anticipate, plan, seek, expect and similar expressions. These forward-looking statements include:
statements of our goals, intentions and expectations;

statements regarding our business plans and prospects and growth and operating strategies;

statements concerning trends in our provision for loan losses and charge-offs;

statements regarding the asset quality of our loan and investment portfolios; and

estimates of our risks and future costs and benefits.

These forward-looking statements are subject to significant risks, assumptions and uncertainties, including, among other things, the following important factors that could affect the actual outcome of future events:
significantly increased competition among depository and other financial institutions;

inflation and changes in the interest rate environment that reduce our interest margins or reduce the fair value of financial instruments;

general economic conditions, either nationally or in our market areas, including employment prospects, real estate values and conditions that are worse than expected;

decreased demand for our products and services and lower revenue and earnings because of a recession or other events;

adverse changes and volatility in the securities markets;

adverse changes and volatility in credit markets;

legislative or regulatory changes that adversely affect our business, including changes in regulatory costs and capital requirements and changes related to our ability to pay dividends and the ability of Third Federal Savings and Loan Association of Cleveland, MHC to waive dividends;

our ability to enter new markets successfully and take advantage of growth opportunities, and the possible short-term dilutive effect of potential acquisitions or de novo branches, if any;

changes in consumer spending, borrowing and savings habits;

changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the Financial Accounting Standards Board and the Public Company Accounting Oversight Board;

future adverse developments concerning Fannie Mae or Freddie Mac;

changes in monetary and fiscal policy of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board and changes in the level of government support of housing finance;

changes in policy and/or assessment rates of taxing authorities that adversely affect us;

changes in expense trends (including, but not limited to trends affecting non-performing assets, charge-offs and provisions for loan losses);

the impact of the current governmental effort to restructure the U.S. financial and regulatory system;

inability of third-party providers to perform their obligations to us;

adverse changes and volatility in real estate markets;

a slowing or failure of the moderate economic recovery;

the extensive reforms enacted in the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act"), which will continue to impact us;

the adoption of implementing regulations by a number of different regulatory bodies under the Dodd-Frank Act, and uncertainty in the exact nature, extent and timing of such regulations and the impact they will have on us;

the continuing impact of our coming under the jurisdiction of new federal regulators;

changes in our organization, or compensation and benefit plans;

the strength or weakness of the real estate markets and of the consumer and commercial credit sectors and its impact on the credit quality of our loans and other assets;

the ability of the U.S. Federal government to manage federal debt limits;

the uncertainty regarding the timing and final substance of any capital or liquidity standards, including final Basel III requirements and their implementation; and

the uncertainty regarding the timing and probability of the termination of the current restrictions imposed pursuant to a February 7, 2011 Memorandum of Understanding, now administered by the Federal Reserve Bank, with respect to our ability to repurchase stock and pay dividends.


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Because of these and other uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements.
Overview
Our business strategy is to operate as a well-capitalized and profitable financial institution dedicated to providing exceptional personal service to our customers. We cannot assure you that we will successfully implement our business strategy.
Since being organized in 1938, we grew to become, at the time of our initial public offering of stock in April 2007, the nation's largest mutually-owned savings and loan association based on total assets. We credit our success to our continued emphasis on our primary values: "Love, Trust, Respect, and a Commitment to Excellence, along with some Fun." Our values are reflected in our pricing of loan and deposit products, and historically, in our Home Today program, as described below. Our values are further reflected in the Broadway Redevelopment Initiative (a long-term revitalization program encompassing the three-mile corridor of the Broadway-Slavic Village neighborhood in Cleveland, Ohio where our main office is located) and the educational programs we have established and/or supported. We intend to continue to adhere to our primary values and to support our customers.
During the last several years, regionally high unemployment, weak residential real estate values, less than robust capital and credit markets, and a general lack of confidence in the financial service sector of the economy presented significant challenges for us. More recently, improving regional employment levels, more stabilized residential real estate values, recovering capital and credit markets and greater confidence in the financial services sector have resulted in better credit metrics for us.
Management believes that the following matters are those most critical to our success: (1) controlling our interest rate risk exposure; (2) monitoring and limiting our credit risk; (3) maintaining access to adequate liquidity and alternative funding sources; and (4) monitoring and controlling operating expenses.
Controlling Our Interest Rate Risk Exposure. Although housing and credit quality issues have had and continue to have a negative effect on our operating results and, as described below, are certainly a matter of significant concern for us, historically our greatest risk has been interest rate risk exposure. When we hold long-term, fixed-rate assets, funded by liabilities with shorter re-pricing characteristics, we are exposed to potentially adverse impact from rising interest rates. Generally, and particularly over extended periods of time that encompass full economic cycles, interest rates associated with longer term assets, like fixed rate mortgages, have been higher than interest rates associated with shorter term funding sources, like deposits. This difference has been an important component of our net interest income and is fundamental to our operations. We manage the risk of holding long-term, fixed-rate mortgage assets primarily by maintaining high levels of tangible capital. Additionally, by promoting adjustable-rate and shorter-term, fixed-rate loans, and, prior to June 30, 2010, by actively selling long-term, fixed-rate mortgage loans in the secondary market, we are able to modulate the amount of long-term, fixed-rate loans held in our portfolio. The total balance of loans sold subsequent to June 30, 2010 has been nominal in relation to the total balance of our owned fixed-rate portfolio. During the six months ended March 31, 2013 we sold $94.1 million of long-term, fixed-rate first mortgage loans and $128.1 million of long-term adjustable-rate first mortgage loans. No loans were sold during the six months ended March 31, 2012. As described in the following paragraphs, the low volume of loan sales since June 30, 2010 reflects the impact of changes by Fannie Mae related to requirements for loans that it accepts and a reduced level of fixed-rate loan originations.
Effective July 1, 2010, Fannie Mae, historically the Association's primary loan investor, implemented certain loan origination requirement changes affecting loan eligibility that, to date, we have not adopted. However, we are currently in the process of implementing the required changes and prospectively, upon review and approval by Fannie Mae, we expect that the portion of our future first mortgage loan originations that is processed and closed using the revised procedures, will thereafter be eligible for securitization and sale in Fannie Mae mortgage backed security form. Fannies Mae's review and approval is targeted for completion by late summer 2013. Previously, our decision against implementing the changes necessary to comply with Fannie Mae's revised requirements, was based on our consideration that since 1991, the Association, employing only non-commissioned loan originators and utilizing a centralized underwriting process, had sold loans to Fannie Mae under a series of proprietary variances, or contractual waivers, that were negotiated between us and Fannie Mae during the term of our relationship. Those proprietary concessions related to certain loan file documentation and quality control procedures the lack of which, in our opinion, did not diminish in any way the excellent credit quality of the loans that we delivered to Fannie Mae, but facilitated the efficiency and effectiveness of our operations and the quality and value of the loan products that we were able to offer to our borrowers. The credit quality of the loans that we delivered to Fannie Mae was consistently evidenced by the superior delinquency profile of our portfolio in peer performance comparisons prepared by Fannie Mae throughout the term of our relationship. In response to the housing crisis that commenced in 2008, and with the objective of improving the credit profile of its overall loan portfolio, Fannie Mae enacted many credit tightening measures, culminating in the effective


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elimination of proprietary variances and waivers, accompanied by the imposition of additional file documentation requirements and expanded quality control procedures. In addition to substantively changing Fannie Mae's operating procedures, effects of the housing crisis spread throughout the secondary residential mortgage market and resulted in a significantly altered operating framework for all secondary market participants. We believed that this dramatically altered operating framework offered opportunities for business process innovators to create new secondary market solutions especially as such opportunities would be expected to target high credit quality residential loans similar to those that we have traditionally originated. However, while we have been successful in completing several non-agency backed whole loan sales during the six months ended March 31, 2013, in our opinion the breadth of, and the transaction pricing in, the non-agency market has not developed in the manner. or with the speed that we believe justifies the continuing delay in adopting Fannie Mae's requirements. Accordingly, while we continue to evaluate available opportunities in the secondary market, we have concluded that in addition to our efforts to originate high credit quality residential loans using our proprietary underwriting and processing operation, as described above, we will develop a parallel operation that fully complies with current Fannie Mae loan eligibility standards. In the short-term, future sales of fixed-rate mortgage loans will be predominantly limited to those loans that have established payment histories, strong borrower credit profiles and are supported by adequate collateral values. In that regard, during the six months ended March 31, 2013 we sold, on a servicing retained basis, a total of $186.4 million of long-term, fixed- and adjustable-rate first mortgage loans to three private investors in separate transactions. Additionally, during the quarter ended June 30, 2012, the Association implemented procedures necessary for participation in Fannie Mae's HARP II (Home Affordable Refinance Program) initiative and during the six months ended March 31, 2013, we sold $35.8 million of long-term, fixed-rate first mortgage loans under HARP II. We continue to explore various loan sales opportunities. During the six months ended March 31, 2013 there were $323.0 million in loans transferred from the held for investment portfolio to the held for sale portfolio and as specific loans were excluded from sales discussions, $144.8 million in loans were transferred from the held for sale portfolio back to the held for investment portfolio. At March 31, 2013 and September 30, 2012, mortgage loans held for sale, all of which were long-term, fixed-rate first mortgage loans, totaled $96.9 million and $124.5 million, respectively, and were comprised of the following components:

                                     March 31,      September 30,
                                        2013             2012
                                        (Dollars in thousands)
Loans held for sale:
Held for sales to private investors $    90,170    $       114,678
Held for sales to Fannie Mae              6,712              9,850
Total                               $    96,882    $       124,528

No loan sales commitments were outstanding at March 31, 2013.
In response to the agencies' loan eligibility changes, in July 2010 we began marketing an adjustable-rate mortgage loan product that provides us with improved interest rate risk characteristics when compared to a long-term, fixed-rate mortgage. Since its introduction, the "SmartRate" adjustable rate mortgage has offered borrowers an interest rate lower than that of a fixed-rate loan. The rate is locked for three or five years then resets annually after that. It contains a feature to relock the rate an unlimited number of times at our then, current rate and fee schedule, for another three or five years (dependent on the original reset period) without having to complete a full refinance transaction. Relock eligibility is subject to satisfactory payment performance history by the borrower (never 60 days late, no 30-day delinquencies during the last twelve months, current at the time of relock, and no foreclosures or bankruptcies since the SmartRate application was taken). In addition to a satisfactory payment history, relock eligibility requires that the property continue to be the borrower's primary residence. The loan term cannot be extended in connection with a relock nor can new funds be advanced. All interest rate caps and floors remain as originated. During the six months ended March 31, 2013 and 2012, adjustable-rate mortgage loan production totaled $451.0 million and $773.1 million, respectively, while during the same time periods, fixed-rate mortgage loan production totaled $436.5 million and $564.4 million, respectively. By comparison, during the three months ended June 30, 2010, the last quarter of operations prior to the introduction of our SmartRate product, adjustable-rate mortgage loan production totaled $28.7 million while fixed rate production totaled $1.15 billion. The amount of origination and refinancing volumes along with the portion of that activity that pertains to loans that we previously sold (but for which we retained the right to provide mortgage servicing so as to maintain our relationship with our customer) when coupled with the level of loan sales, if any, determines the balance of loans held on our balance sheet. The amount of adjustable-rate loan activity described above resulted in $3.00 billion of long-term adjustable-rate loans in our residential mortgage loans held for investment portfolio at March 31, 2013, as compared to $2.93 billion at September 30, 2012 and $2.45 billion at March 31, 2012. At March 31, 2013, the amount of adjustable-rate residential mortgage loans represented 38% of the total residential mortgage loans held for investment portfolio. Fixed-rate mortgage loan activity described above resulted in $4.94 billion of long-term fixed rate loans in our residential mortgage loans held for investment portfolio (excluding loans held for sale) at March 31, 2013, as compared to $5.23 billion at September 30,


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2012 and $5.19 billion at March 31, 2012. The March 31, 2013, September 30, 2012 and March 31, 2012 measurements exclude $96.9 million, $124.5 million and $245.9 million, respectively, of long-term, fixed-rate loans reported as "held for sale". No long-term adjustable-rate loans were designated as "held for sale" at any of these reported measurement dates.
In addition to actively marketing our SmartRate product, beginning in the latter portion of fiscal 2012, we also began to feature our ten-year, fully amortizing fixed-rate first mortgage loans in our product promotions. The ten-year fixed-rate loan has a less severe interest rate risk profile when compared to fixed-rate terms of 15 to 30 years and helps us to more effectively manage our interest rate risk exposure, yet provides our borrowers with the certainty of a fixed interest rate throughout the life of the obligation. During the six months ended March 31, 2013, ten-year fixed-rate first mortgage loan originations totaled $203.0 million, or 47% of our fixed-rate originations and 23% of our total originations.
In the past, we have also managed interest rate risk by promoting home equity lines of credit, which have a variable interest rate. As described below, this product carries an incremental credit risk component and has been adversely impacted by the housing market downturn. Between June 28, 2010 and March 20, 2012, we suspended the acceptance of new home equity credit applications with the exception of bridge loans. In accordance with a reduction plan that was accepted by our primary federal banking regulator in December 2010, we actively pursued strategies to decrease the outstanding balance of our home equity lending portfolio as well as our exposure to undrawn home equity lines of credit. During the quarter ended June 30, 2011, we achieved the balance and exposure reduction targets included in the reduction plan. Beginning in March 2012, we offered redesigned home equity lines of credit to qualifying existing home equity customers. In February 2013 we further modified the product design and in April 2013 we extended the offer to both existing home equity customers and new consumers in Ohio, Florida and selected counties in Kentucky. These offers were, and are, subject to certain property and credit performance conditions which include:
lower combined loan to value ("CLTV") maximum ratios (80% in Ohio/Kentucky and 70% in Florida; for programs in place prior to 2012 the CLTV extended to as high as 89.99%);

limited geographic offering (only Ohio, Kentucky and Florida; programs in place prior to 2012, were offered nationwide);

borrower income is fully verified (in prior programs income was not always fully verified);

beginning in February 2013, the borrower is qualified using a principal and interest payment based on the current rate plus 2.00%, amortized over 30 years; for applications taken between March 2012 and February 2013, the borrower is qualified using a principal and interest payment based on the current rate plus 2.00%, amortized over 20 years (for programs in place prior to 2012, borrowers were qualified using the current rate);

the minimum credit score to qualify for the re-introduced home equity line of credit is 700 in Ohio and Kentucky and 720 in Florida (our prior home equity line of credit offering in 2010 required a minimum credit score of 680 in all markets); and

beginning in February 2013, the term for new home equity line of credit applications is a five year draw period, during which monthly principal and interest payments are made based on the portion of the original term of 30 years that remains, followed by a 25 year repayment only period, during which payments will be comprised of both principal and interest; for applications taken between March 2012 and February 2013, the term for new home equity line of credit applications was a five year draw period during which interest only payments are made, followed by a 20 year repayment period, during which payments are comprised of both principal and interest (for programs in place prior to 2012, terms generally offered a 10 year draw period, interest only payment, followed by a 10 year repayment period, principal and interest).

Notwithstanding achievement of the reduction plan target and recent limited offers to extend new revolving lines of credit to qualifying borrowers, promotion of home equity lines of credit is not a current, meaningful strategy used to manage our interest rate risk profile.
Should a rapid and substantial increase occur in general market interest rates, it is probable that, prospectively and particularly over a multi-year time horizon, the level of our net interest income would be adversely impacted. Monitoring and Limiting Our Credit Risk. While, historically, we had been successful in limiting our credit risk exposure by generally imposing high credit standards with respect to lending, the confluence of unfavorable regional and macro-economic events since 2008, coupled with our pre-2010 expanded participation in the second lien mortgage lending markets, has significantly refocused our attention with respect to credit risk. In response to the evolving economic landscape, we have continuously revised and updated our quarterly analysis and evaluation procedures, as needed, for each category of our lending


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with the objective of identifying and recognizing all appropriate credit impairments. At March 31, 2013, 90% of our assets consisted of residential real estate loans (both "held for sale" and "held for investment") and home equity loans and lines of credit, the overwhelming majority of which were originated to borrowers in the states of Ohio and Florida. Our analytic procedures and evaluations include specific reviews of all home equity loans and lines of credit that become 90 or more days past due, as well as specific reviews of all first mortgage loans that become 180 or more days past due. We also expanded our analysis of current performing home equity lines of credit to better mitigate future risk of loss. In accordance with regulatory guidance issued in January 2012, performing home equity lines of credit subordinate to first mortgages delinquent greater than 90 days are transferred to non-accrual status. At March 31, 2013, the recorded investment of such performing home equity lines of credit, not otherwise classified as non-accrual, was $4.9 million. Also, the Office of the Comptroller of the Currency ("OCC") issued guidance in July 2012 that requires loans, where at least one borrower had been discharged of their obligation in Chapter 7 bankruptcy, to be classified as troubled debt restructurings. Also required pursuant to this guidance is the charge off of performing loans to collateral value and non-accrual classification when all borrowers have had their obligations discharged in Chapter 7 bankruptcy, regardless of how long the loans have been performing. At March 31, 2013, $62.8 million of loans in Chapter 7 bankruptcy status were included in total troubled debt restructurings. At March 31, 2013, the recorded investment in non-accrual status loans included $30.9 million of performing loans in Chapter 7 bankruptcy status where at least one borrower had been discharged of their obligation. Based on the OCC interpretive guidance, $15.8 million of net charge-offs related to those loans were recognized during the fiscal quarter ended September 30, 2012.
In response to the unfavorable regional and macro economic environment that arose in 2008 and that has generally persisted, and in an effort to limit our credit risk exposure and improve the credit performance of new customers, we have tightened our credit criteria in evaluating a borrower's ability to successfully fulfill his or her repayment obligation and we have revised the design of many of our loan products to require higher borrower down-payments, limited the products available for condominiums, and eliminated certain product features (such as interest-only adjustable-rate loans, loans above certain loan-to-value ratios, and prior to March 2012, home equity lending products with the exception of bridge loans).
Prior to its July 21, 2011 merger into the OCC, the Office of Thrift Supervision ("OTS") issued,effective February 7, 2011, memoranda of understanding (the "MOU") covering the Association, Third Federal Savings, MHC and the Company. On December 22, 2012, the Association's primary regulator terminated the MOU applicable to the Association. However, the MOU applicable to Third Federal, MHC and the Company, which comes under the regulation of the Federal Reserve, has not been terminated. The items in the MOU applicable to Third Federal, MHC and the Company include the required non-objection 45 days in advance of any plans for new debt, dividends or stock repurchases and the further refinement and enhancement of our enterprise risk management process. The requirements of the MOU carry costs to complete which has increased our non-interest expense. The Company does not intend to declare or pay a cash dividend, or to repurchase any of its outstanding common stock, until the remaining concerns of our regulator are resolved. The requirements of the MOU which are applicable to the Company and Third Federal Savings, MHC will remain in effect until our regulator decides to terminate, suspend or modify them.
One aspect of our credit risk concern relates to the high percentage of our loans that are secured by residential real estate in the states of Ohio and Florida, particularly in light of the difficulties that have arisen with respect to the real estate markets in those states. At March 31, 2013, approximately 76% and 18% of the combined total of our residential, non-Home Today and construction loans held for investment were secured by properties in Ohio and Florida, respectively. Our 30 or more days delinquency ratios on those loans in Ohio and Florida at March 31, 2013 were 0.9% and 2.2%, respectively. Our 30 or more days delinquency ratio for the non-Home Today portfolio as a whole was 1.1%. Also, at March 31, 2013, approximately 39% and 29% of our home equity loans and lines of credit were secured by properties in Ohio and Florida, respectively. Our 30 days or more delinquency ratios on those loans in Ohio and Florida at March 31, 2013 were 1.1% and 1.7%, respectively. Our 30 or more days delinquency ratio for the home equity loans and lines of credit portfolio as a whole was 1.3%. While we focus our attention on, and are concerned with respect to the resolution of all loan delinquencies, as these ratios illustrate, our highest concern is centered on loans that are secured by properties in Florida. The "Allowance for Loan Losses" portion of the Critical Accounting Policies section provides extensive details regarding our loan portfolio composition, delinquency statistics, our methodology in evaluating our loan loss provisions and the adequacy of our allowance for loan losses. In spite of recent improving credit metrics, as long as unemployment levels remain high, particularly in Ohio and Florida, and Florida housing values remain depressed, due to prior overbuilding and speculation which has resulted in considerable inventory on the market, we expect that we will continue to experience elevated levels of . . .

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