UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

Commission File Number: 1-13605

EFC BANCORP, INC.

(Exact name of registrant as specified in its charter)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý    No o

Indicate by check mark if disclosure of delinquent filers in response to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Park III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes o  No ý

The aggregate market value of voting stock held by non-affiliates of the registrant, i.e., persons other than directors and executive officers of the registrant was $73,300,000 based upon the average bid and asked price of such common equity as of the last business day of registrant’s most recently completed second fiscal quarter.

The number of shares of Common Stock outstanding as of March 7, 2005 is 4,759,513.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Annual Report and Proxy Statement for the 2005 Annual Meeting of Stockholders are incorporated by reference into Part II and III of this Form 10-K.

INDEX

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PART I

Item 1. Business.

General

EFC Bancorp, Inc. (also referred to as the “Company” or “Registrant”), was incorporated under Delaware law in October 1997.  The Registrant was formed to acquire Elgin Financial Savings Bank and subsidiaries, Elgin, Illinois, (the “Bank”) as part of the Bank’s conversion from a mutual to a stock form of organization (the “Conversion”).  In connection with the Conversion, the Company issued an aggregate of 7,491,434 shares of its common stock, par value $0.01 per share (“Common Stock”) at a purchase price of $10 per share, of which 6,936,513 shares were issued in a subscription offering and 554,921 shares were issued to the Elgin Financial Foundation (the “Foundation”), now known as EFS Foundation, a charitable foundation established by the Bank.  The Company received approval to become a savings and loan holding company and is subject to regulation by the Office of Thrift Supervision (“OTS”) and the Securities and Exchange Commission (“SEC”).  The Company’s acquisition of the Bank occurred on April 3, 1998.

The Bank is a community-oriented savings institution that was originally organized in 1924 as a federally-chartered mutual savings and loan association.  The Bank reorganized in the 1980s to become Elgin Federal Financial Center, a federally-chartered mutual savings association, and again in 1996 to become Elgin Financial Center, S.B., an Illinois state-chartered mutual savings bank.  In 1998, the Bank changed its name to Elgin Financial Savings Bank.  Most recently, in October 2002 the Bank changed its name to EFS Bank.  The Bank’s principal business consists of the acceptance of retail deposits from the general public in the areas surrounding its full-service branch offices and the investment of those deposits, together with funds generated from operations and borrowings, primarily in one- to four-family residential mortgage loans and, to a lesser extent, multi-family and commercial real estate loans, construction and land loans, commercial business loans, home equity loans, and automobile and passbook savings loans.  The Bank generally originates all of its loans for investment.  The Bank also invests primarily in government insured or guaranteed mortgage-backed securities, U.S. Government obligations and municipal securities.  The Bank’s revenues are derived principally from the interest on its mortgage, consumer and commercial business loans and securities and from servicing fees.  The Bank’s primary sources of funds are retail savings deposits and, to a lesser extent, advances from the Federal Home Loan Bank of Chicago (the “FHLB-Chicago”).

Market Area

Headquartered in largely suburban Kane County, Illinois, the Bank has been, and intends to continue to be, a community-oriented financial institution offering a variety of financial services to meet the needs of the communities it serves.  The Bank currently operates four full-service banking facilities in Elgin and five full service facilities located in West Dundee, East Dundee, Huntley, Carpentersville and St. Charles, Illinois.  The Bank’s primary lending and deposit gathering area is concentrated around the areas where its full-service banking facilities are located which the Bank generally considers to be its primary market area.

Elgin is located on U.S. Interstate 90 (the Northwest tollway) in the Fox River Valley approximately 38 miles northwest of downtown Chicago and 25 miles west of O’Hare International Airport.  Interstate 90 provides easy access to the City of Chicago and is a major corridor of suburban growth for Chicago.  The economy in the Bank’s primary market area has historically benefited from the growth of the Chicago suburbs into Kane, Western Cook and McHenry Counties with an influx of new residents and employers.  Other employment and economic activity is provided by a variety of wholesale and retail trade, hospitals and a riverboat gambling facility located on the Fox River in Elgin.

Competition

The Bank faces significant competition both in making loans and in attracting deposits.  The State of Illinois has a high density of financial institutions, many of which are branches of significantly larger institutions, which have greater financial resources than the Bank, all of which are competitors of the Bank to varying degrees.  The Bank’s competition for loans comes principally from savings banks, savings and loan associations, commercial banks, mortgage banking companies, credit unions, insurance companies and other financial service companies.  Its most direct competition for deposits has historically come from

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savings and loan associations, savings banks, commercial banks and credit unions.  The Bank faces additional competition for deposits from non-depository competitors such as the mutual fund industry, securities and brokerage firms and insurance companies.  Competition may also increase as a result of the lifting of restrictions on the interstate operations of financial institutions.  There are approximately 21 financial institutions with operations in Elgin and approximately 51 financial institutions with operations in the Bank’s primary market area.

Lending Activities

Loan Portfolio Composition.  The types of loans that the Bank may originate are subject to federal and state laws and regulations.  Interest rates charged by the Bank on loans are affected principally by the demand for such loans, the supply of money available for lending purposes and the rates offered by its competitors.  These factors are, in turn, affected by general and economic conditions, monetary policies of the federal government, including the Federal Reserve Board (“FRB”), legislative tax policies and governmental budgetary matters.

The Bank’s loan portfolio primarily consists of first mortgage loans secured by one- to four-family residences most of which are located in its primary market area.  At December 31, 2004, the Bank’s gross loan portfolio totaled $812.5 million, of which $503.8 million were one- to four-family residential mortgage loans, or 62.0% of total loans.  At such date, the remainder of the loan portfolio consisted of $55.3 million of multi-family loans, or 6.8% of total loans; $131.0 million of commercial real estate loans, or 16.1% of total loans; $44.1 million of construction and land loans, or 5.4% of total loans; $39.4 million of commercial loans, or 4.9% of total loans; and $39.0 million of consumer loans, or 4.8% of total loans, consisting of $31.7 million of home equity lines of credit, $5.6 million of secured and unsecured personal loans and $1.7 million of automobile loans.  The Bank sold loans totaling $42.7 million and $20.8 million during the years ended December 31, 2004 and December 31, 2003, respectively.  At December 31, 2004, 53.0% of the Bank’s mortgage loans had adjustable interest rates, most of which were indexed to the one year Constant Maturity Treasury (“CMT”) Index.

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The following table sets forth the composition of the Bank’s loan portfolio in dollar amounts and in percentages of the respective portfolios at the dates indicated.

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Loan Originations.  The Bank’s mortgage lending activities are conducted by its loan personnel operating at its nine branch offices as well as through participation and loan acquisition programs.  All loans originated by the Bank are underwritten by the Bank pursuant to the Bank’s policies and procedures.  The Bank originates both adjustable-rate and fixed-rate mortgage loans, commercial loans, and consumer loans.  The Bank’s ability to originate fixed- or adjustable-rate loans is dependent upon the relative customer demand for such loans, which is affected by the current and expected future level of interest rates.  It is the general policy of the Bank to retain loans originated in its portfolio.

During the years ended December 31, 2004 and 2003, the Bank originated $12.0 million and $93.6 million of fixed-rate one- to four-family residential mortgage loans, respectively, and for the years ended December 31, 2004 and 2003, the Bank originated $84.2 million and $62.5 million of adjustable-rate one- to four-family residential mortgage loans, respectively, all of which were retained by the Bank.  Based upon the Bank’s investment needs and market opportunities, the Bank participates and purchases loans, consisting of one-to-four family, multi-family and commercial real estate mortgage loans, and construction loans secured by property located in Illinois, southern Wisconsin and, to a lesser extent, in Minnesota, and had $192.2 million of purchased loan participation interests at December 31, 2004.

The following tables set forth the Bank’s loan originations, purchases and principal repayments for the periods indicated.  All loans originated by the Bank are generally held for investment.

(1)   Gross loans exclude unearned discounts, deferred loan fees and the allowance for loan losses.

(2)   Amounts for each period include loans in process at period end.

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Loan Maturity and Repricing.  The following table shows the contractual maturity of the Bank’s loan portfolio at December 31, 2004.  The table does not include prepayments, scheduled principal amortization or repricing of adjustable rate loans.  Prepayments and scheduled principal amortization on mortgage loans totaled $240.7 million, $268.4 million and $178.0 million for the years ended December 31, 2004, 2003 and 2002, respectively.

 The following table sets forth at December 31, 2004, the dollar amount of gross loans receivable contractually due after December 31, 2005, and whether such loans have fixed interest rates or adjustable interest rates.

One- to Four-Family Lending.  The Bank currently offers both fixed-rate and adjustable-rate mortgage (“ARM”) loans with maturities up to 30 years secured by one- to four-family residences which are generally located in the Bank’s primary market area. One- to four-family mortgage loan originations are generally obtained from the Bank’s in-house loan representatives,

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mortgage brokers, from existing or past customers, through advertising, and through referrals from local builders, real estate brokers and attorneys.  At December 31, 2004, the Bank’s one- to four-family mortgage loans totaled $503.8 million, or 62.0%, of total loans.  Of the one- to four-family mortgage loans outstanding at that date, 47.1% were fixed-rate mortgage loans and 52.9% were ARM loans.

The Bank currently offers fixed-rate mortgage loans with terms from 10 to 30 years.  These loans have generally been priced at current market rates for such loans.  The Bank currently offers a number of ARM loans with terms of up to 30 years and interest rates which adjust every one, two or three years from the outset of the loan or which adjust annually after a two, three or five year initial fixed period.  The interest rates for the Bank’s ARM loans are indexed to the one-year CMT Index.  The Bank originates ARM loans with initially discounted rates, often known as “teaser rates.”  The Bank’s ARM loans generally provide for periodic (not more than 2%) and overall (not more than 6%) caps on the increase or decrease in the interest rate at any adjustment date and over the life of the loan.  However, interest rates on the Bank’s residential ARM loans may never adjust to be less than the initial rate of interest charged on any such loan.

The origination of adjustable-rate residential mortgage loans, as opposed to fixed-rate residential mortgage loans, helps reduce the Bank’s exposure to increases in interest rates.  However, adjustable-rate loans generally pose credit risks not inherent in fixed-rate loans, primarily because as interest rates rise, the underlying payments of the borrower rise, thereby increasing the potential for default.  Periodic and lifetime caps on interest rate increases help to reduce the risks associated with adjustable-rate loans but also limit the interest rate sensitivity of such loans.

The Bank has also purchased one-to-four family first mortgage loans generally out of our primary market area.  As of December 31, 2004, the Bank had $123.1 million of these loans.  In addition, the Bank sold loans totaling $42.7 million and $20.8 million for the years ended December 31, 2004 and 2003, respectively.

Multi-Family and Commercial Real Estate Lending.  The Bank originates multi-family and commercial real estate loans that are generally secured by five or more unit apartment buildings and properties used for business purposes such as small office buildings or retail facilities located in the Bank’s primary market area.  The Bank’s multi-family and commercial real estate underwriting policies provide that such real estate loans may be made in amounts up to 80% of the appraised value of the property, subject to the Bank’s current loans-to-one-borrower limit, which at December 31, 2004 was $20.9 million.  The Bank’s multi-family and commercial real estate loans may be made with terms up to 25 years and are offered with interest rates that adjust periodically.  In reaching its decision on whether to make a multi-family or commercial real estate loan, the Bank considers the net operating income of the property, the borrower’s expertise, credit history and profitability and the value of the underlying property. The Bank has generally required that the properties securing these real estate loans have debt service coverage ratios (the ratio of earnings before debt service to debt service) of at least 1.20x.  Environmental impact surveys are generally required for all commercial real estate loans.  Generally, all multi-family and commercial real estate loans made to corporations, partnerships and other business entities require personal guarantees by the principals.  On an exception basis, the Bank may not require a personal guarantee on such loans depending on the creditworthiness of the borrower and the amount of the down payment and other mitigating circumstances.  The Bank continues to emphasize commercial real estate lending.  The Bank’s multi-family real estate loan portfolio at December 31, 2004 was $55.3 million, or 6.8% of total loans, and the Bank’s commercial real estate loan portfolio at such date was $131.0 million, or 16.1% of total loans.  This compares to $52.2 million and $109.4 million at December 31, 2003, respectively.  The largest multi-family or commercial real estate loan in the Bank’s portfolio (excluding loan participation interests) at December 31, 2004 was a $6.4 million performing commercial real estate loan secured by commercial type property located in Elgin, Illinois.

The Bank also purchases up to 90% participation interests in multi-family, commercial real estate and construction loans secured by real estate, most of which is located outside of the Bank’s primary market area in southern Wisconsin and Minnesota.  When determining whether to participate in such loans, the Bank will underwrite its participation interest according to its own underwriting standards. The Bank will generally hedge against participating in problematic loans by participating in those loans that have been in existence for at least one to two years and, accordingly, possess an established payment history.  At December 31, 2004, the Bank had $25.0 million in multi-family real estate loan participation interests, or 45.2% of multi-family loans and 3.1% of total loans.  In addition, the Bank had $43.9 million in commercial real estate loan participation interests as of the same date.

Loans secured by multi-family and commercial real estate properties generally involve larger principal amounts and a greater degree of risk than one- to four-family residential mortgage loans. Because payments on loans secured by multi-family and

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commercial real estate properties are often dependent on successful operation or management of the properties, repayment of such loans may be subject to adverse conditions in the real estate market or the economy.  The Bank seeks to minimize these risks through its underwriting standards.

Construction and Land Lending.  The Bank originates fixed-rate construction loans for the development of residential property primarily located in the Bank’s market area.  Construction loans are offered primarily to experienced local developers operating in the Bank’s primary market area and, to a lesser extent, to individuals for the construction of their residence.  The majority of the Bank’s construction loans are originated or participation interests purchased primarily to finance the construction of one- to four-family, owner-occupied residential real estate and multi-family real estate properties located in the Bank’s primary market area as well as southern Wisconsin and Minnesota.  Construction loans are generally offered with terms up to 12 months and may be made in amounts up to 80% of the appraised value of the property, as improved.  Construction loan proceeds are disbursed periodically in increments as construction progresses and as inspections by the Bank’s lending personnel warrant.

The Bank also originates fixed-rate land loans to local developers for the purpose of developing the land for sale.  Such loans are secured by a lien on the property, are limited to 75% of the appraised value of the secured property and have terms of up to three years.  The principal of the loan is reduced as lots are sold and released.  The Bank’s land loans are generally secured by properties located in its primary market area.  Generally, if the borrower is a corporation, partnership or other business entity, personal guarantees by the principals are required.

The Bank originated $59.5 million, $19.4 million and $31.0 million of construction and land loans for the years ended December 31, 2004, 2003 and 2002, respectively.  At December 31, 2004, the Bank’s largest construction or land loan was a performing loan with a $8.8 million balance secured by 36 acres of vacant land for development in Algonquin, Illinois.  This loan was granted to a joint venture, of which the Bank’s wholly-owned subsidiary, EFS Service Corporation, is involved.  For more information see the Subsidiary Activities section of this report.  At December 31, 2004, the Bank had $44.1 million of construction and land loans, which amounted to 5.4% of the Bank’s total loans.

Construction and land financing is generally considered to involve a higher degree of credit risk than long-term financing on improved, owner-occupied real estate.  Risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property’s value at completion of construction or development compared to the estimated cost (including interest) of construction and other assumptions, including the estimated time to sell residential properties.  If the estimate of value proves to be inaccurate, the Bank may be confronted with a project, when completed, having a value that is insufficient to assure full repayment.

Commercial Business Lending.  The Bank also originates commercial business loans in the forms of term loans and lines of credit to small- and medium-sized businesses operating in the Bank’s primary market area.  Equipment, leases, inventory, accounts receivable, and marketable securities generally secure such loans; however, the Bank also makes unsecured commercial business loans.  The maximum amount of a commercial business loan is limited by the Bank’s loans-to-one-borrower limit which, at December 31, 2004, was $20.9 million.  Depending on the collateral used to secure the loans, commercial loans are made in amounts up to 80% of the value of the property securing the loan.  Term loans are generally offered with fixed rates of interest and terms of up to 10 years.  All term loans fully amortize during the term of such loan.  Business lines of credit have adjustable rates of interest and terms of up to one year.  Business lines of credit adjust on a daily basis and are indexed to the prime rate as published in The Wall Street Journal.  The Bank also issues both secured and unsecured letters of credit to business customers of the Bank.  Acceptable collateral includes an assigned deposit account with the Bank, real estate or marketable securities.  Letters of credit have a maximum term of 36 months.

In making commercial business loans, the Bank considers primarily the financial resources of the borrower, the borrower’s ability to repay the loan out of net operating income, the Bank’s lending history with the borrower and the value of the collateral.  Generally, if the borrower is a corporation, partnership or other business entity, personal guarantees by the principals are required.  However, personal guarantees may not be required on such loans depending on the creditworthiness of the borrower and other mitigating circumstances.  The Bank continues to emphasize commercial business loans.  The Bank’s largest commercial loan at December 31, 2004 was $5.2 million.  At such date, the Bank had $61.4 million of unadvanced commercial lines of credit.  At December 31, 2004, the Bank had $39.4 million of commercial business loans, which amounted to 4.9% of the Bank’s total loans.  The Bank originated $50.0 million, $8.9 million and $9.1 million in commercial business loans for the years ended December 31, 2004, 2003 and 2002, respectively.

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Unlike mortgage loans, which generally are made on the basis of the borrower’s ability to make repayment from his or her employment or other income, and are secured by real property which value tends to be more easily ascertainable, commercial loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business.  As a result, the availability of funds for the repayment of commercial loans may be substantially dependent on the success of the business itself.  Further, any collateral securing such loans may depreciate over time, may be difficult to appraise and may fluctuate in value.

Consumer Lending. Consumer loans at December 31, 2004 amounted to $39.0 million, or 4.8% of the Bank’s total loans, and consisted primarily of home equity lines of credit and, to a significantly lesser extent, secured and unsecured personal loans and new and used automobile loans.  Such loans are generally originated in the Bank’s primary market area and generally are secured by real estate, deposit accounts, personal property and automobiles.

Substantially all of the Bank’s home equity lines of credit are secured by second mortgages on owner-occupied single-family residences located in the Bank’s primary market area.  At December 31, 2004, these loans totaled $31.7 million, or 3.9% of the Bank’s total loans and 80.1% of consumer loans.  Home equity lines of credit generally have adjustable-rates of interest, which adjust on a monthly basis.  The unused home equity lines of credit totaled $34.5 million at December 31, 2004.  The adjustable-rate of interest charged on such loans is indexed to the prime rate as reported in The Wall Street Journal.  Home equity lines of credit generally have an 18% lifetime limit on interest rates.  Generally, the maximum combined LTV ratio on home equity lines of credit is 89.9%.  The underwriting standards employed by the Bank for home equity lines of credit include a determination of the applicant’s credit history and an assessment of the applicant’s ability to meet existing obligations and payments on the proposed loan and the value of the collateral securing the loan.  The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment and, additionally, from any verifiable secondary income.  Creditworthiness of the applicant is of primary consideration.

The Bank also originates other types of consumer loans consisting of secured and unsecured personal loans and new and used automobile loans.  Secured personal loans are generally secured by deposit accounts.  Unsecured personal loans generally have a maximum borrowing limitation of $25,000 and generally require a debt ratio of 38%.  Automobile loans have a maximum borrowing limitation of 80% of the sale price of the automobile, except that existing customers of the Bank who meet certain underwriting criteria may borrow up to 100% of the sale price of the automobile.  At December 31, 2004, personal loans (both secured and unsecured) totaled $5.6 million or 0.7% of the Bank’s total loans and 14.3% of consumer loans; and automobile loans totaled $1.7 million, or 0.2% of total loans and 4.4% of consumer loans.

With respect to automobile loans, full-time employees of the Bank, other than executive officers and directors, who satisfy certain lending criteria and the general underwriting standards of the Bank receive an interest rate 1% less than that which is offered to the general public; provided, however, that the discounted interest rate is at no time less than 75 basis points above the Bank’s overall cost of funds, rounded to the highest quarter percentage point.

Loans secured by rapidly depreciable assets such as automobiles or that are unsecured entail greater risks than one- to four-family residential mortgage loans.  In such cases, repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance, since there is a greater likelihood of damage, loss or depreciation of the underlying collateral.  Further, consumer loan collections on these loans are dependent on the borrower’s continuing financial stability and, therefore, are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.  Finally, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans in the event of a default.

Loans-to-One Borrower Limitations.  The Illinois Savings Bank Act imposes limitations on the aggregate amount of loans that an Illinois chartered savings bank can make to any one borrower.  Under the Illinois Savings Bank Act the permissible amount of loans-to-one borrower is the greater of $500,000 (for a savings bank meeting its minimum capital requirements) or 25% of a savings bank’s total capital plus general loan loss reserves.  In addition, a savings bank may make loans in an amount equal to an additional 10% of the savings bank’s capital plus general loan loss reserves if the loans are 100% secured by readily marketable collateral.  Under Illinois law, a savings bank’s capital consists of capital stock and noncumulative perpetual preferred stock, related paid-in capital, retained earnings and other forms of capital deemed to be qualifying capital by the Federal Deposit Insurance Corporation (the “FDIC”).  Illinois law also permits an institution with capital in excess of 6% of assets to request permission of the Illinois Commissioner of Banks and Real Estate (the “Commissioner”) to lend up to 30% of the institution’s total capital and general loan loss reserves to one borrower for the development of residential housing properties within Illinois.  At

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December 31, 2004, the Bank’s ordinary limit on loans-to-one borrower under the Illinois Savings Bank Act was $20.9 million.  The 30% limitation equaled $25.1 million at that date.  At December 31, 2004, the Bank’s five largest groups of loans-to-one borrower ranged from $9.6 million to $14.9 million, with the largest single loan in such groups being a $6.2 million loan for the construction of town homes located in Elgin, Illinois.  At December 31, 2004, there were no loans exceeding the 25% limitation.  A substantial portion of each large group of loans is secured by real estate.

Loan Approval Procedures and Authority.  The Board of Directors establishes the lending policies and loan approval limits of the Bank.  The Board of Directors has established the Loan Committee (the “Committee”) of the Board, which considers and approves all loans within its designated authority as established by the Board.  In addition, the Board of Directors has authorized certain officers of the Bank (the “designated officers”) to consider and approve all loans within their designated authority as established by the Board.

Underwriting.  With respect to loans originated by the Bank, it is the general policy of the Bank to retain such loans in its portfolio.  The Bank does not have a policy of underwriting its loans in conformance with the Fannie Mae or Federal Home Loan Mortgage Corporation (“FHLMC”) guidelines.  Upon receipt of a completed loan application from a prospective borrower, a credit report is ordered and certain other information is verified by an independent credit agency.  If necessary, additional financial information may be required.  An appraisal of real estate intended to secure a proposed loan generally is required to be performed by the Bank’s “in-house” appraisers or outside appraisers approved by the Bank.  For proposed mortgage loans, the Board annually approves independent appraisers used by the Bank and approves the Bank’s appraisal policy.  The Bank’s policy is to obtain title and hazard insurance on all mortgage loans and flood insurance when necessary and the Bank may require borrowers to make payments to a mortgage escrow account for the payment of property taxes.

At December 31, 2004, the Bank’s ratio of nonperforming loans to total loans was 0.36%, and its ratio of nonperforming assets to total assets was 0.29%.  The Bank did not have any real estate owned at December 31, 2004.  Net charge-offs amounted to $18,000 in 2004.  There were no net charge-offs in 2003 and net charge-offs in 2002 totaled $14,000.  See “Delinquent Loans, Classified Assets and Real Estate Owned.”

The Bank’s one- to four-family lending policy permits the investment in mortgage loans where the borrower’s monthly mortgage and prorated real estate tax payments were less than 32% of the borrower’s gross income, and where the borrower’s total monthly obligations did not exceed 43% of the borrower’s gross income.  It is also the general practice of the Bank not to require private mortgage insurance, though the Bank retains the right to require such insurance on any loan with a loan to value ratio in excess of 80.0%.  All loans with loan to value ratios in excess of 89.9% must have private mortgage insurance, with the exception of its “First-Time Home Buyer” and “American Dream Loan” programs.  In addition, the Bank had historically priced its one- to four- family loans with loan to value ratios of between 80.0% and 89.9% at 25 basis points higher than loans with loan to value ratios of less than 80.0%, again in an effort to control the origination of such loans.  The Bank believes that its underwriting standards are sufficient to allow it to adequately assess the creditworthiness of prospective borrowers.  There can be no assurances, however, that increasing the permissible debt coverage ratios and loan-to-value ratios permitted for borrowers will not result in the Bank experiencing increased delinquencies and defaults on loans.

Delinquent Loans, Classified Assets and Real Estate Owned

Delinquencies, Classified Assets and Real Estate Owned.  Reports listing all delinquent accounts are generated and reviewed by management on a monthly basis and the Board of Directors performs a monthly review of all loans or lending relationships delinquent 45 days or more.  The procedures taken by the Bank with respect to delinquencies vary depending on the nature of the loan, period and cause of delinquency and whether the borrower is habitually delinquent.  When a borrower fails to make a required payment on a loan, the Bank takes a number of steps to have the borrower cure the delinquency and restore the loan to current status.  The Bank generally sends the borrower a written notice of non-payment after the loan is first past due.  The Bank’s guidelines provide that telephone, written correspondence and/or face-to-face contact will be attempted to ascertain the reasons for delinquency and the prospects of repayment.  When contact is made with the borrower at any time prior to foreclosure, the Bank will attempt to obtain full payment, offer to work out a repayment schedule with the borrower to avoid foreclosure or, in some instances, accept a deed in lieu of foreclosure.  In the event payment is not then received or the loan not otherwise satisfied, additional letters and telephone calls generally are made.  If the loan is still not brought current or satisfied and it becomes necessary for the Bank to take legal action, which typically occurs after a loan is 90 days or more delinquent, the Bank will commence foreclosure proceedings against any real property that secured the loan.  If a foreclosure action is instituted and the loan is not brought current, paid in full, or refinanced before the foreclosure sale, the property securing the loan generally is sold at

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foreclosure and, if purchased by the Bank, becomes real estate owned.

Federal regulations and the Bank’s internal policies require that the Bank utilize an internal asset classification system as a means of reporting problem and potential problem assets.  The Bank currently classifies problem and potential problem assets as “Substandard,” “Doubtful” or “Loss” assets.  An asset is considered Substandard if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any.  Substandard assets include those characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.  Assets classified as Doubtful have all of the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Assets classified as Loss are those considered uncollectible and of such little value that their continuance as assets, without the establishment of a specific loss reserve, is not warranted.  Assets which do not currently expose the Bank to a sufficient degree of risk to warrant classification in one of the aforementioned categories but possess weaknesses are required to be designated “Special Mention.”  Loans classified Special Mention may have been delinquent in the past or had other weaknesses, however, in management’s judgment risk of loss is not probable.  This classification represents a watch list of loans for management to closely monitor.

When the Bank classifies one or more assets, or portions thereof, as Substandard or Doubtful, it establishes a specific allowance for probable loan losses in an amount deemed appropriate by management.  When the Bank classifies one or more assets, or portions thereof, as Loss, it either establishes a specific allowance for losses equal to 100% of the amount of the assets so classified or charges off such amount.

The Bank’s determination as to the classification of its assets and the amount of its allowances for loan losses is subject to review by the FDIC and Commissioner, which can order the establishment of additional general or specific loss allowances.  The FDIC, in conjunction with the other federal banking agencies, adopted an interagency policy statement on the allowance for loan and lease losses.  The policy statement provides guidance for financial institutions on both the responsibilities of management for the assessment and establishment of adequate allowances and guidance for banking agency examiners to use in determining the adequacy of general valuation guidelines.  Generally, the policy statement recommends that institutions have effective systems and controls to identify, monitor and address asset quality problems; that management has analyzed all significant factors that affect the collectibility of the portfolio in a reasonable manner; and that management has established acceptable allowance evaluation processes that meet the objectives set forth in the policy statement.  While the Bank believes that it has established an adequate allowance for loan losses, there can be no assurance that regulators, in reviewing the Bank’s loan portfolio, will not request the Bank to increase at that time its allowance for loan losses, thereby negatively affecting the Bank’s financial condition and earnings at that time.  Although management believes that adequate specific and general loan loss allowances have been established, future provisions are dependent upon future events such as loan growth and portfolio diversification and, as such, further additions to the level of the allowance for loan losses may become necessary.

The Bank reviews and classifies its assets on a quarterly basis and the Board of Directors reviews the results of the reports on a quarterly basis.  The Bank classifies its assets in accordance with the management guidelines described above.  At December 31, 2004, the Bank had $2.9 million of assets, representing 0.36% of loans receivable, or 0.29%, of assets, designated as Substandard.  No loans were classified as Doubtful, Loss, or Special Mention.

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The following tables set forth delinquencies in the Bank’s loan portfolio past due 60 days or more:

(1)   Total loans represent gross loans receivable less deferred loan fees and unearned discounts.

Nonperforming Assets.  The following table sets forth information regarding nonperforming loans and REO.  It is the general policy of the Bank to cease accruing interest on loans 90 days or more past due and to fully reserve for all previously accrued interest.  For each of the five years ended December 31, 2004, the amount of additional interest income that would have been recognized on non-accrual loans if such loans had continued to perform in accordance with their contractual terms was $99,000 $82,000, $198,000, $187,000, and $89,000, respectively.

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(1)   Loans receivable, gross.

(2)   Nonperforming assets consist of nonperforming loans and REO.

Nonperforming loans totaled $2.9 million as of December 31, 2004, and included eight one- to four-family loans, with an aggregate balance of $1.1 million, one commercial real estate loan totaling $500,000, seven commercial business loans totaling $1.3 million, two automobile loans totaling $7,000, one consumer loan totaling $16,000 and one home equity line of credit totaling $20,000.

Allowance for Loan Losses – Critical Accounting Policy

The allowance for loan losses is considered by management to be a critical accounting policy.  The allowance for loan losses is maintained through provisions for loan losses based on management’s on-going evaluation of the risks inherent in its loan portfolio in consideration of the trends in its loan portfolio, the national and regional economies and the real estate market in the Bank’s primary lending area. The allowance for loan losses is maintained at an amount management considers adequate to cover probable losses in its loan portfolio, based on information currently known to management. The Bank’s loan loss allowance determinations also incorporate factors and analyses which consider the probable principal loss associated with the loan, costs of acquiring the property securing the loan through foreclosure or deed in lieu of foreclosure.  While management estimates loan losses using the best available information, no assurance can be given that future additions to the allowance will not be necessary based on changes in economic and real estate market conditions, further information obtained regarding problem loans, identification of additional problem loans and other factors, both within and outside of management’s control.

Management calculates a loan loss allowance sufficiency analysis quarterly based upon the loan portfolio composition, asset classifications, loan-to-value ratios, impairments in the loan portfolio and other factors.  The analysis is compared to actual losses, peer group comparisons and economic conditions.  As of December 31, 2004, the Bank’s allowance for loan losses was $4.5 million, or 0.56%, of total loans and 153.4% of nonperforming loans as compared to $3.8 million, or 0.52%, of total loans and 135.7% of nonperforming loans as of December 31, 2003.  The Bank had total nonperforming loans of $2.9 million at December 31, 2004 as compared to $2.8 million at December 31, 2003 and nonperforming loans to total loans of 0.36% and 0.39% at December 31, 2004 and 2003, respectively.  The Bank will continue to monitor and modify its allowance for loan losses as conditions dictate.  Management believes that, based on information available at December 31, 2004, the Bank’s allowance for loan losses was adequate to cover probable losses inherent in its loan portfolio at that time.  Based upon the Bank’s plan to increase its emphasis on non-one- to four-family mortgage lending which consist of secured commercial loans which are generally considered to involve a higher degree of risk than one- to four-family mortgage lending, the Bank has and may continue to further

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increase its allowance for loan losses over future periods depending upon the then current conditions.  The percentage of one- to four-family loans to total loans decreased to 62.0% at December 31, 2004 from 64.8% at December 31, 2003.  At the same time, the percentage of commercial real estate loans to total loans increased to 16.1% at December 31, 2004 from 15.2% at December 31, 2003.  However, no assurances can be given that the Bank’s level of allowance for loan losses will be sufficient to cover loan losses incurred by the Bank or that future adjustments to the allowance for loan losses will not be necessary if economic and other conditions differ substantially from the economic and other conditions used by management to determine the current level of the allowance for loan losses.  In addition, the FDIC and the Commissioner, as an integral part of their examination processes, periodically review the Bank’s allowance for loan losses.  Such agencies may require the Bank to make additional provisions for estimated loan losses based upon judgments different from those of management.

The following table sets forth activity in the Bank’s allowance for loan losses for the periods set forth in the table.

(1)   Loans receivable, gross.

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The following tables set forth the Bank’s percent of allowance for loan losses to total allowance and the percent of loans to total loans in each of the categories listed at the dates indicated.