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TFSL > SEC Filings for TFSL > Form 10-Q on 7-Feb-2014All Recent SEC Filings

Show all filings for TFS FINANCIAL CORP

Form 10-Q for TFS FINANCIAL CORP


7-Feb-2014

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, among other things:
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 trends in factors affecting our financial condition and results of operations, including 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, 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 FNMA or Freddie Mac;

changes in monetary and fiscal policy of the U.S. Government, including policies of the U.S. Treasury and the FRS 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 governmental effort to restructure the U.S. financial and regulatory system;

the 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 DFA, which will continue to impact us;

the adoption of implementing regulations by a number of different regulatory bodies under the DFA, 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. Government to manage federal debt limits; and

the uncertainty regarding the timing and probability of the termination of the current restrictions imposed pursuant to a February 7, 2011 MOU, now administered by the FRS, 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 any forward-looking statements. Any forward-looking statement made by us in this report speaks only as of the date on which it is made. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future developments or otherwise, except as may be required by law. Please see Item 1A. Risk Factors for a discussion of certain risks related to our business. Overview
Our business strategy is to operate as a well-capitalized and profitable financial institution dedicated to providing exceptional personal service to our customers.
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 Having Fun." Our values are reflected in the design and pricing of our 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 was established and continues to be 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 and the communities in which we operate.
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 services sector of the economy presented significant challenges for us. More recently, improving regional employment levels, recovering residential real estate values, recovering capital and credit markets and greater confidence in the financial services sector have resulted in better credit metrics and improved operating results 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, to a lesser extent, 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 our exposure to interest rate risk. When we hold long-term, fixed-rate assets, funded by liabilities with shorter re-pricing characteristics, we are exposed to potentially adverse impacts 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 and by promoting adjustable-rate loans and shorter-term, fixed-rate loans. Additionally, in years prior to fiscal 2010, we also managed this risk by actively selling long-term, fixed-rate mortgage loans in the secondary market, a strategy pursuant to which we were able to modulate the amount of long-term, fixed-rate loans held in our portfolio. As described in greater detail below, during fiscal 2013 we adopted the necessary procedural changes that, subsequent thereto, we believe result in certain of our long-term, fixed-rate loan originations being eligible for delivery and sale to FNMA, and will prospectively provide us with additional options in managing our interest rate risk profile. The total balance of loans sold subsequent to June 30, 2010 has not been significant when measured in relation to the total balance of our owned fixed-rate portfolio. During the fiscal year ended September 30, 2013, we sold $221.1 million of long-term, fixed-rate first mortgage loans compared to $11.4 million and $33.6 million during the fiscal years ended September 30, 2012 and 2011, respectively, and as further compared to sales of $1.03 billion during the fiscal year ended September 30, 2010. Also, during fiscal 2013 we sold $128.1 million of long-term, adjustable-rate first mortgage loans to a private investor. The adjustable-rate transaction demonstrated our ability to further manage interest rate risk and liquidity by selling Smart Rate loans in the secondary market. No long-term, adjustable-rate first mortgage loans were sold during any of the fiscal years ended September 30, 2012, 2011 or 2010. During the three months ended December 31, 2013 and 2012, we sold $20.9 million and $77.2 million, respectively of fixed-rate, first mortgage loans. As described in the following paragraphs, the relatively low volume of long-term, fixed-rate first mortgage loan sales since June 30, 2010 reflects the impact of changes by FNMA related to requirements for loans that it accepts and our reduced level of longer-term, fixed-rate loan originations.
FNMA, historically the Association's primary loan investor, implemented, effective July 1, 2010, certain loan origination requirement changes affecting loan eligibility that we chose not to adopt until May 2013. Subsequent to the May 2013 implementation date of our revised loan origination procedures, and upon review and validation by FNMA which was received on November 15, 2013, we expect that those fixed-rate, first mortgage loans that are originated under the revised procedures,


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will thereafter be eligible for sale to FNMA in either whole loan or mortgage-backed security form. During the three months ended December 31, 2013, we delivered and sold to FNMA $11.1 million of fixed-rate, first mortgage loans that had been originated under the revised procedures. Previously, our decision not to implement the changes necessary to comply with FNMA's revised requirements, was based on our consideration that between 1991 and 2010, the Association, employing only non-commissioned loan originators and utilizing a centralized underwriting process, had sold loans to FNMA under a series of proprietary variances, or contractual waivers, that were negotiated between us and FNMA throughout the term of that 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 FNMA, 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 high credit quality of the loans that we delivered to FNMA was consistently evidenced by the superior delinquency profile of our portfolio in peer performance comparisons prepared by FNMA. In response to the housing crisis that commenced in 2008, and with the objective of improving the credit profile of its overall loan portfolio, FNMA enacted many credit tightening measures, culminating in the effective 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 FNMA'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. During the fiscal year ended September 30, 2011, $20.3 million of non-agency eligible, fixed-rate mortgage loans were sold (on a servicing retained basis) to a private investor. No loan sales to private investors were completed during the fiscal year ended September 30, 2012, while during the fiscal year ended September 30, 2013, $276.9 million of non-agency eligible, whole loan sales, all on a servicing retained basis, were completed. During the three months ended December 31, 2013, there were no non-agency eligible, whole loan sales, nor were any non-agency eligible, whole loans classified as mortgage loans held for sale at December 31, 2013. Additionally, there were no loan sale commitments outstanding with respect to such loans at December 31, 2013. While we were successful in completing several non-agency backed whole loan sales during the fiscal year ended September 30, 2013, in our opinion, the breadth of, and the transaction pricing in, the non-agency market did not develop in the manner, or with the speed that we believe justified the continuing delay in our adoption of FNMA's loan origination requirements. Accordingly, while we continue to evaluate available opportunities in the secondary market, we have developed a parallel operation, approved by FNMA on November 15, 2013, that fully complies with current FNMA loan eligibility standards. Previously, during the quarter ended June 30, 2012, the Association implemented procedures necessary for participation in FNMA's HARP II initiative. The balances of mortgage loans held for sale at December 31, 2013 and September 30, 2013, were $1.5 million and $4.2 million, respectively, and were comprised entirely of agency-compliant HARP II loans. HARP II loan sales during the three months ended December 31, 2013 and the fiscal year ended September 30, 2013, totaled $9.8 million and $72.3 million, respectively. HARP II loan sales during the three months ended December 31, 2012 totaled $18.9 million. At September 30, 2013, outstanding loan sales commitments, all of which were agency-compliant HARP II loans, totaled $3.3 million. At December 31, 2013, there were no outstanding loan sales commitments.
In response to the changes made in FNMA's loan eligibility requirements, 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 loan. Since its introduction, the "Smart Rate" adjustable rate mortgage has offered borrowers an interest rate lower than that of a long-term fixed-rate loan. The rate is locked for three or five years then resets annually after that. It contains a feature to re-lock 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. Re-lock eligibility is subject to a 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 re-lock, and no foreclosures or bankruptcies since the Smart Rate application was taken). In addition to a satisfactory payment history, re-lock eligibility requires that the property continues to be the borrower's primary residence. The loan term cannot be extended in connection with a re-lock nor can new funds be advanced. All interest rate caps and floors remain as originated. During the three month periods ended December 31, 2013 and 2012, adjustable-rate mortgage loan originations totaled $192.0 million and $236.8 million, respectively, while during the same time periods, fixed-rate mortgage loan originations totaled $279.1 million and $210.7 million, respectively. By comparison, during the nine months ended June 30, 2010, the last nine months of operations prior to the introduction of our Smart Rate product, adjustable-rate mortgage loan originations totaled $28.7 million while fixed-rate originations totaled $1.15 billion. The amount of origination volumes, including refinances by our existing customers, 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 $3.23 billion of long-term adjustable-rate loans in our residential mortgage loans held for investment portfolio at December 31, 2013, as compared to $3.19 billion at September 30, 2013. At December 31, 2013, the amount of adjustable-rate residential mortgage loans represented 38% of the total residential


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mortgage loans held for investment portfolio. Primarily as a result of changes in the balance of 10-year fixed-rate loans as described in the next paragraph, the fixed-rate mortgage loan activity described above resulted in $5.18 billion of long-term fixed rate loans in our residential mortgage loans held for investment portfolio, as compared to $5.11 billion at September 30, 2013, and $4.98 billion at December 31, 2012. The December 31, 2013, September 30, 2013 and December 31, 2012 measurements excluded $1.5 million, $4.2 million and $155.3 million, respectively, of long-term, fixed-rate loans reported as mortgage loans held for sale. The December 31, 2012 measurement also excluded $169.1 million of adjustable-rate loans that were designated as mortgage loans held for sale. No adjustable-rate loans were designated as mortgage loans held for sale at either December 31, 2013 or September 30, 2013.
In addition to actively marketing our Smart Rate product, beginning in the latter portion of fiscal 2012, we also began to feature our ten-year, fully amortizing fixed-rate first mortgage loan in our product promotions. The ten-year, fixed-rate loan has a less severe interest rate risk profile when compared to loans with 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. While the total balance of fixed-rate mortgage loans increased between December 31, 2012 and December 31, 2013, as described in the preceding paragraph, changes in the composition of the fixed-rate portion of the portfolio followed divergent paths. Between December 31, 2012 and December 31, 2013 the total fixed-rate portion of our first mortgage loan portfolio increased $195.8 million and was comprised of an increase of $547.7 million in the balance of fixed-rate loans with original terms of 10 years or less, and a decrease of $351.9 million in the balance of fixed-rate loans with original terms greater than 10 years. Also, between September 30, 2013 and December 31, 2013 the total fixed-rate portion of our first mortgage loan portfolio increased $66.4 million and was comprised of an increase of $124.9 million in the balance of fixed-rate loans with original terms of 10 years or less, and a decrease of $58.6 million in the balance of fixed-rate loans with original terms greater than 10 years. During the three months ended December 31, 2013, ten-year fixed-rate first mortgage loan originations totaled $157.7 million, or 57% of our fixed-rate originations and 33% 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, due to the deterioration in overall housing conditions including concerns for loans and credit lines in a second lien position, home equity lines of credit and home equity loans were not offered by the Association. Beginning in March 2012, the Association offered redesigned home equity lines of credit to qualifying existing home equity customers, subject to certain property and credit performance conditions. In February 2013 the Association further modified the product design and the terms included monthly principal and interest payments throughout the entire term. 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 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, borrowers are qualified using a principal and interest payment based on the interest rate offered to the borrower, plus 2.00%, amortized over 30 years; for applications taken between March 2012 and February 2013, borrowers were qualified using a principal and interest payment based on the interest rate offered to the borrower plus 2.00%, amortized over 20 years (for programs in place prior to 2012, borrowers were qualified using only the interest rate offered to the borrower);

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, with interest only payments, followed by a 10-year repayment period, with payments of principal and interest).


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The existing home equity lines of credit portfolio, with a principal balance of $1.64 billion at December 31, 2013, favorably impacts our interest rate risk profile. The efforts described above are intended to prudently stem the portfolio attrition/reduction that has been experienced during the last three years and to ultimately re-establish home equity line of credit lending as a 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 with the objective of identifying and recognizing all appropriate credit impairments. At December 31, 2013, 89% 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 December 31, 2013, the recorded investment of such performing home equity lines of credit, not otherwise classified as non-accrual, was $3.8 million. Also, the OCC issued guidance in July 2012 that requires loans, where at least one borrower has 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 December 31, 2013, $58.9 million of loans in Chapter 7 bankruptcy status were included in total troubled debt restructurings. At December 31, 2013, the recorded investment in non-accrual status loans included $33.7 million of performing loans in Chapter 7 bankruptcy status where at least one borrower had been discharged of their obligation.
In response to the unfavorable regional and macro-economic environment that arose beginning in 2008, 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). 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 December 31, 2013, approximately 72.6% and 17.8% 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 December 31, 2013 were 0.7% and 1.6%, respectively. Our 30 or more days delinquency ratio for the non-Home Today portfolio as a whole was 0.8% at December 31, 2013. Also, at December 31, 2013, approximately 38.9% and 29.0% 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 December 31, 2013 were each 1.3%. Our 30 or more days delinquency ratio for the home equity loans and lines of credit portfolio as a whole at December 31, 2013 was 1.3%. While we focus our attention on, and . . .

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