UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

Form 10-Q

T            Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2016

OR

      Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934


Commission File Number 001-36271

WATERSTONE FINANCIAL, INC.
(Exact name of registrant as specified in its charter)

Maryland
90-1026709
(State or other jurisdiction of incorporation or organization)
(IRS Employer Identification No.)
   
11200 W. Plank Court Wauwatosa, Wisconsin
53226
(Address of principal executive offices)
(Zip Code)

(414) 761-1000
(Registrant's telephone number, including area code)

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 of 1934 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      T            No      

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes      T            No      

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.

Large accelerated filer 
Accelerated filer T
Non-accelerated filer 
Smaller reporting company 
 
(Do not check if smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes                  No      T

The number of shares outstanding of the issuer's common stock, $0.01 par value per share, was 29,385,903 at October 28, 2016.


WATERSTONE FINANCIAL, INC.

10-Q INDEX

 
Page No.
   
 3
   
 3
 3
 4
 6
 7
 8 - 29
   
 30 - 46
 47
 48
   
 48
   
 48
 48
48
49
49
49
 49
 49
   

 
 
 
 
 
 
 
 
 
- 2 -

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements


WATERSTONE FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

   
(Unaudited)
       
   
September 30, 2016
   
December 31, 2015
 
Assets
 
(Dollars In Thousands, except share and per share data)
 
Cash
 
$
22,388
   
$
57,419
 
Federal funds sold
   
21,914
     
20,297
 
Interest-earning deposits in other financial institutions and other short term investments
   
10,018
     
22,755
 
Cash and cash equivalents
   
54,320
     
100,471
 
Securities available for sale (at fair value)
   
245,396
     
269,658
 
Loans held for sale (at fair value)
   
227,765
     
166,516
 
Loans receivable
   
1,151,696
     
1,114,934
 
Less: Allowance for loan losses
   
15,633
     
16,185
 
Loans receivable, net
   
1,136,063
     
1,098,749
 
                 
Office properties and equipment, net
   
24,044
     
25,328
 
Federal Home Loan Bank stock (at cost)
   
12,600
     
19,500
 
Cash surrender value of life insurance
   
61,188
     
49,562
 
Real estate owned, net
   
7,454
     
9,190
 
Prepaid expenses and other assets
   
26,205
     
23,755
 
Total assets
 
$
1,795,035
   
$
1,762,729
 
                 
Liabilities and Shareholders' Equity
               
Liabilities:
               
Demand deposits
 
$
110,872
   
$
102,673
 
Money market and savings deposits
   
157,472
     
140,631
 
Time deposits
   
687,304
     
650,057
 
Total deposits
   
955,648
     
893,361
 
                 
Borrowings
   
377,983
     
441,203
 
Advance payments by borrowers for taxes
   
25,268
     
3,661
 
Other liabilities
   
26,579
     
32,574
 
Total liabilities
   
1,385,478
     
1,370,799
 
                 
Shareholders' equity:
               
Preferred stock (par value $.01 per share)
               
Authorized -  50,000,000 shares in 2016 and in 2015, no shares issued
   
-
     
-
 
Common stock (par value $.01 per share)
               
Authorized - 100,000,000 shares in 2016 and in 2015
               
Issued - 29,385,903 in 2016 and 29,407,455 in 2015
               
Outstanding - 29,385,903 in 2016 and 29,407,455 in 2015
   
294
     
294
 
Additional paid-in capital
   
322,164
     
317,022
 
Retained earnings
   
181,460
     
168,089
 
Unearned ESOP shares
   
(20,475
)
   
(21,365
)
Accumulated other comprehensive income, net of taxes
   
2,661
     
582
 
Cost of shares repurchased (5,908,150 shares at September 30, 2016 and 5,624,415 shares at December 31, 2015)
   
(76,547
)
   
(72,692
)
Total shareholders' equity
   
409,557
     
391,930
 
Total liabilities and shareholders' equity
 
$
1,795,035
   
$
1,762,729
 

See Accompanying Notes to Unaudited Consolidated Financial Statements.

- 3 -

WATERSTONE FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)

   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2016
   
2015
   
2016
   
2015
 
   
(In Thousands, except per share amounts)
 
                         
Interest income:
                       
Loans
 
$
14,754
   
$
14,117
   
$
42,611
   
$
41,495
 
Mortgage-related securities
   
743
     
792
     
2,371
     
2,451
 
Debt securities, federal funds sold and short-term investments
   
833
     
886
     
2,692
     
2,609
 
Total interest income
   
16,330
     
15,795
     
47,674
     
46,555
 
Interest expense:
                               
Deposits
   
1,923
     
1,540
     
5,477
     
4,251
 
Borrowings
   
3,082
     
4,345
     
10,724
     
12,898
 
Total interest expense
   
5,005
     
5,885
     
16,201
     
17,149
 
Net interest income
   
11,325
     
9,910
     
31,473
     
29,406
 
Provision for loan losses
   
135
     
580
     
340
     
1,720
 
Net interest income after provision for loan losses
   
11,190
     
9,330
     
31,133
     
27,686
 
Noninterest income:
                               
Service charges on loans and deposits
   
789
     
364
     
1,742
     
1,213
 
Increase in cash surrender value of life insurance
   
734
     
636
     
1,446
     
1,195
 
Mortgage banking income
   
35,552
     
26,708
     
91,146
     
77,324
 
Gain on sale of available for sale securities
   
-
     
-
     
-
     
44
 
Other
   
337
     
843
     
874
     
1,848
 
Total noninterest income
   
37,412
     
28,551
     
95,208
     
81,624
 
Noninterest expenses:
                               
Compensation, payroll taxes, and other employee benefits
   
27,573
     
21,234
     
70,968
     
62,584
 
Occupancy, office furniture, and equipment
   
2,319
     
2,292
     
7,074
     
7,004
 
Advertising
   
661
     
755
     
1,974
     
2,120
 
Data processing
   
616
     
592
     
1,897
     
1,797
 
Communications
   
374
     
332
     
1,088
     
1,053
 
Professional fees
   
474
     
642
     
1,486
     
1,771
 
Real estate owned
   
37
     
646
     
344
     
1,875
 
FDIC insurance premiums
   
140
     
243
     
500
     
851
 
Other
   
3,347
     
3,050
     
9,663
     
9,106
 
Total noninterest expenses
   
35,541
     
29,786
     
94,994
     
88,161
 
Income before income taxes
   
13,061
     
8,095
     
31,347
     
21,149
 
Income tax expense
   
5,556
     
2,896
     
12,214
     
7,651
 
Net income
 
$
7,505
   
$
5,199
   
$
19,133
   
$
13,498
 
Income per share:
                               
Basic
 
$
0.28
   
$
0.19
   
$
0.71
   
$
0.45
 
Diluted
 
$
0.27
   
$
0.19
   
$
0.70
   
$
0.45
 
Weighted average shares outstanding:
                               
Basic
   
27,043
     
27,490
     
26,976
     
29,882
 
Diluted
   
27,429
     
27,795
     
27,283
     
30,145
 

See Accompanying Notes to Unaudited Consolidated Financial Statements.

- 4 -

WATERSTONE FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)

   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2016
   
2015
   
2016
   
2015
 
   
(In Thousands)
 
Net income
 
$
7,505
   
$
5,199
   
$
19,133
   
$
13,498
 
                                 
Other comprehensive (loss) income, net of tax:
                               
Net unrealized holding (loss) gain on available for sale securities:
                               
Net unrealized holding (loss) gain arising during the period, net of tax benefit (expense) of $385, ($718), ($1,341), ($4), respectively
   
(596
)
   
1,114
     
2,079
     
8
 
                                 
Reclassification adjustment for net gain included in net income during the period, net of tax expense of $0, $0, $0, $17, respectively
   
-
     
-
     
-
     
(27
)
                                 
Total other comprehensive (loss) income
   
(596
)
   
1,114
     
2,079
     
(19
)
Comprehensive income
 
$
6,909
   
$
6,313
   
$
21,212
   
$
13,479
 

See Accompanying Notes to Unaudited Consolidated Financial Statements.


 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
- 5 -

WATERSTONE FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(Unaudited)


   
Common Stock
   
Additional
Paid-In
Capital
   
Retained
Earnings
   
Unearned
ESOP
Shares
   
Accumulated
Other
Comprehensive Income
   
Cost of
Shares
Repurchased
   
Total
Shareholders'
Equity
 
   
Shares
   
Amount
                                     
Balances at December 31, 2014
   
34,420
   
$
$344
   
$
313,894
   
$
157,304
   
$
(22,552
)
 
$
1,247
   
$
-
   
$
450,237
 
                                                                 
Comprehensive income:
                                                               
Net income
   
-
     
-
     
-
     
13,498
     
-
     
-
     
-
     
13,498
 
Other comprehensive loss
   
-
     
-
     
-
     
-
     
-
     
(19
)
   
-
     
(19
)
Total comprehensive income
                                                           
13,479
 
                                                                 
ESOP shares committed to be released to Plan participants
   
-
     
-
     
136
     
-
     
891
     
-
     
-
     
1,027
 
Cash dividend, $0.15 per share
   
-
     
-
     
-
     
(4,404
)
   
-
     
-
     
-
     
(4,404
)
Stock compensation activity, net of tax
   
599
     
6
     
96
     
-
     
-
     
-
     
-
     
102
 
Stock compensation expense
   
-
     
-
     
2,334
     
-
     
-
     
-
     
-
     
2,334
 
Repurchase of common stock returned to authorized but unissued
   
(5,582
)
   
(56
)
   
-
     
-
     
-
     
-
     
(72,125
)
   
(72,181
)
Balances at September 30, 2015
   
29,437
   
$
$294
   
$
316,460
   
$
166,398
   
$
(21,661
)
 
$
1,228
   
$
(72,125
)
 
$
390,594
 
                                                                 
                                                                 
Balances at December 31, 2015
   
29,407
   
$
$294
   
$
317,022
   
$
168,089
   
$
(21,365
)
 
$
582
   
$
(72,692
)
 
$
391,930
 
                                                                 
Comprehensive income:
                                                               
Net income
   
-
     
-
     
-
     
19,133
     
-
     
-
     
-
     
19,133
 
Other comprehensive income
   
-
     
-
     
-
     
-
     
-
     
2,079
     
-
     
2,079
 
Total comprehensive income
                                                           
21,212
 
                                                                 
ESOP shares committed to be released to Plan participants
   
-
     
-
     
278
     
-
     
890
     
-
     
-
     
1,168
 
Cash dividend, $0.21 per share
   
-
     
-
     
-
     
(5,762
)
   
-
     
-
     
-
     
(5,762
)
Stock based compensation activity
   
263
     
3
     
3,434
     
-
     
-
     
-
     
-
     
3,437
 
Stock compensation expense
   
-
     
-
     
1,430
     
-
     
-
     
-
     
-
     
1,430
 
Repurchase of common stock returned to authorized but unissued
   
(284
)
   
(3
)
   
-
     
-
     
-
     
-
     
(3,855
)
   
(3,858
)
Balances at September 30, 2016
   
29,386
   
$
$294
   
$
322,164
   
$
181,460
   
$
(20,475
)
 
$
2,661
   
$
(76,547
)
 
$
409,557
 

See Accompanying Notes to Unaudited Consolidated Financial Statements.

- 6 -

WATERSTONE FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

   
Nine months ended September 30,
 
   
2016
   
2015
 
   
(In Thousands)
 
             
Operating activities:
           
Net income
 
$
19,133
   
$
13,498
 
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
               
Provision for loan losses
   
340
     
1,720
 
Provision for depreciation
   
2,061
     
2,337
 
Stock based compensation
   
1,430
     
2,334
 
Net amortization of premium/discount on debt and mortgage related securities
   
749
     
1,011
 
Amortization of unearned ESOP shares
   
1,168
     
1,027
 
Amortization and impairment of mortgage servicing rights
   
513
     
422
 
Gain on sale of loans held for sale
   
(93,481
)
   
(75,935
)
Loans originated for sale
   
(1,756,454
)
   
(1,545,098
)
Proceeds on sales of loans originated for sale
   
1,788,685
     
1,604,297
 
Increase in accrued interest receivable
   
(204
)
   
(218
)
Increase in cash surrender value of life insurance
   
(1,446
)
   
(1,195
)
Decrease in accrued interest on deposits and borrowings
   
(615
)
   
(34
)
Increase in other liabilities
   
5,893
     
2,846
 
(Increase) decrease in accrued tax receivable
   
(172
)
   
2,591
 
Gain on sale of available for sale securities
   
-
     
(44
)
Net (gain) loss related to real estate owned
   
(123
)
   
427
 
Gain on sale of mortgage servicing rights
   
-
     
(807
)
Other
   
(3,784
)
   
(1,426
)
Net cash (used in) provided by operating activities
   
(36,307
)
   
7,753
 
                 
Investing activities:
               
Net increase in loans receivable
   
(41,096
)
   
(20,868
)
Purchases of:
               
Debt securities
   
(4,140
)
   
(10,000
)
Mortgage related securities
   
(5,236
)
   
(15,933
)
Premises and equipment, net
   
(925
)
   
(2,042
)
Bank owned life insurance
   
(10,180
)
   
(180
)
FHLB stock
   
(4,500
)
   
(2,000
)
Proceeds from:
               
Principal repayments on mortgage-related securities
   
29,689
     
31,647
 
Maturities of debt securities
   
6,620
     
8,160
 
Sales of debt securities
   
-
     
1,034
 
Sales of FHLB stock
   
11,400
     
-
 
Sales of real estate owned
   
5,304
     
18,332
 
Net cash (used in) provided by investing activities
   
(13,064
)
   
8,150
 
                 
Financing activities:
               
Net increase in deposits
   
62,288
     
9,195
 
Net change in short term borrowings
   
56,780
     
-
 
Repayment of long term debt
   
(220,000
)
   
-
 
Proceeds from long term debt
   
100,000
     
-
 
Net change in advance payments by borrowers for taxes
   
9,405
     
9,070
 
Cash dividends on common stock
   
(4,832
)
   
(4,509
)
Purchase of common stock returned to authorized but unissued
   
(3,858
)
   
(72,181
)
Proceeds from stock option exercises
   
3,437
     
102
 
Net cash provided by (used in) financing activities
   
3,220
     
(58,323
)
Decrease in cash and cash equivalents
   
(46,151
)
   
(42,420
)
Cash and cash equivalents at beginning of period
   
100,471
     
172,820
 
Cash and cash equivalents at end of period
 
$
54,320
   
$
130,400
 
                 
Supplemental information:
               
Cash paid or credited during the period for:
               
Income tax payments
 
$
11,009
   
$
10,234
 
Interest payments
   
16,816
     
17,183
 
Noncash activities:
               
Loans receivable transferred to real estate owned
   
3,442
     
11,719
 
Dividends declared but not paid in other liabilities
   
2,322
     
1,516
 

See Accompanying Notes to Unaudited Consolidated Financial Statements.

- 7 -

Note 1 — Basis of Presentation

The unaudited interim consolidated financial statements include the accounts of Waterstone Financial, Inc. (the "Company") and the Company's subsidiaries.

WaterStone Bank (the "Bank") is a community bank that has served the banking needs of its customers since 1921. WaterStone Bank also has an active mortgage banking segment, Waterstone Mortgage Corporation.

WaterStone Bank conducts its community banking business from 11 banking offices located in Milwaukee, Washington and Waukesha Counties, Wisconsin, as well as a loan production office in Minneapolis, Minnesota. WaterStone Bank's principal lending activity is originating one- to four-family and multi-family residential real estate loans for retention in its portfolio. WaterStone Bank also offers home equity loans and lines of credit, construction and land loans, commercial real estate and commercial business loans, and consumer loans. WaterStone Bank funds its loan production primarily with retail deposits and Federal Home Loan Bank advances. Our deposit offerings include: certificates of deposit, money market savings accounts, transaction deposit accounts, non-interest bearing demand accounts and individual retirement accounts. Our investment securities portfolio is comprised principally of mortgage-backed securities, government-sponsored enterprise bonds and municipal obligations.

WaterStone Bank's mortgage banking operations are conducted through its wholly-owned subsidiary, Waterstone Mortgage Corporation.  Waterstone Mortgage Corporation originates single-family residential real estate loans for sale into the secondary market.  Waterstone Mortgage Corporation utilizes lines of credit provided by WaterStone Bank as a primary source of funds, and also utilizes a line of credit with another financial institution as needed.

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles ("GAAP") for interim financial information, Rule 10-01 of Regulation S-X and the instructions to Form 10-Q. The financial statements do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of normal recurring accruals) necessary to present fairly the financial position, results of operations, changes in shareholders' equity, and cash flows of the Company for the periods presented.

The accompanying unaudited consolidated financial statements and related notes should be read in conjunction with the Company's December 31, 2015 Annual Report on Form 10-K. Operating results for the nine months ended September 30, 2016 are not necessarily indicative of the results that may be expected for the year ending December 31, 2016 or for any other period.

The preparation of the unaudited consolidated financial statements requires management of the Company to make a number of estimates and assumptions relating to the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period. Significant items subject to such estimates and assumptions include the allowance for loan losses, deferred income taxes and real estate owned. Actual results could differ from those estimates.

Certain prior period amounts have been reclassified to conform to current period presentation. These reclassifications did not result in any changes to previously reported net income or shareholders' equity.

Impact of Recent Accounting Pronouncements

ASU 2016-13 "Financial Instruments - Credit Losses (Topic 326)" ("ASU 2016-13") requires an entity to utilize a new impairment model known as the current expected credit loss ("CECL") model to estimate its lifetime "expected credit loss" and record an allowance that, when deducted from the amortized cost basis of the financial asset, presents the net amount expected to be collected on the financial asset. The CECL model is expected to result in more timely recognition of credit losses. ASU 2016-13 also requires new disclosures for financial assets measured at amortized cost, loans and available-for-sale debt securities. ASU 2016-13 is effective for public companies for annual periods beginning after December 15, 2019, including interim periods within those fiscal years. Entities will apply the standard's provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. We are in the process of evaluating the impact adoption of ASU 2016-13 will have on our consolidated financial statements and disclosures.

ASU 2016-02 "Lease (Topic 842)" ("ASU 2016-02") requires that lessees and lessors recognize lease assets and lease liabilities on the balance sheet and disclose key information about leasing arrangements. ASU 2016-02 is effective for public companies for annual periods beginning after December 15, 2018, including interim periods within those fiscal years. We are in the process of evaluating the impact adoption of ASU 2016-13 will have on our consolidated financial statements and disclosures.

 
 
 
 
- 8 -

Note 2— Securities Available for Sale

The amortized cost and fair values of the Company's investment in securities available for sale follow:

   
September 30, 2016
 
   
Amortized cost
   
Gross unrealized gains
   
Gross unrealized losses
   
Fair value
 
   
(In Thousands)
 
Mortgage-backed securities
 
$
78,582
   
$
2,201
   
$
(1
)
 
$
80,782
 
Collateralized mortgage obligations:
                               
Government sponsored enterprise issued
   
62,993
     
770
     
-
     
63,763
 
Mortgage-related securities
   
141,575
     
2,971
     
(1
)
   
144,545
 
                                 
Government sponsored enterprise bonds
   
3,750
     
15
     
-
     
3,765
 
Municipal securities
   
75,750
     
2,721
     
(6
)
   
78,465
 
Other debt securities
   
17,399
     
216
     
(723
)
   
16,892
 
Debt securities
   
96,899
     
2,952
     
(729
)
   
99,122
 
Certificates of deposit
   
1,715
     
14
     
-
     
1,729
 
   
$
240,189
   
$
5,937
   
$
(730
)
 
$
245,396
 


   
December 31, 2015
 
   
Amortized cost
   
Gross unrealized gains
   
Gross unrealized losses
   
Fair value
 
   
(In Thousands)
 
Mortgage-backed securities
 
$
95,911
   
$
1,004
   
$
(248
)
 
$
96,667
 
Collateralized mortgage obligations:
                               
Government sponsored enterprise issued
   
70,605
     
123
     
(300
)
   
70,428
 
Mortgage-related securities
   
166,516
     
1,127
     
(548
)
   
167,095
 
                                 
Government sponsored enterprise bonds
   
3,750
     
-
     
(4
)
   
3,746
 
Municipal securities
   
77,509
     
1,730
     
(80
)
   
79,159
 
Other debt securities
   
17,401
     
209
     
(647
)
   
16,963
 
Debt securities
   
98,660
     
1,939
     
(731
)
   
99,868
 
Certificates of deposit
   
2,695
     
4
     
(4
)
   
2,695
 
   
$
267,871
   
$
3,070
   
$
(1,283
)
 
$
269,658
 


The Company's mortgage-backed securities and collateralized mortgage obligations issued by government sponsored enterprises are guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. At September 30, 2016, $91.7 million of the Company's mortgage related securities were pledged as collateral to secure repurchase agreement obligations of the Company.  As of September 30, 2016, $2.0 million of the Company's mortgage related securities were pledged as collateral to secure mortgage banking related activities. At December 31, 2015, $94.1 million of the Company's government sponsored enterprise bonds and $2.5 million of the Company's mortgage related securities were pledged as collateral to secure mortgage banking related activities, respectively.

The amortized cost and fair values of investment securities by contractual maturity at September 30, 2016 are shown below. Actual maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

   
Amortized
Cost
   
Fair
Value
 
   
(In Thousands)
 
Debt and other securities
           
Due within one year
 
$
13,145
   
$
13,207
 
Due after one year through five years
   
21,265
     
21,521
 
Due after five years through ten years
   
41,448
     
43,262
 
Due after ten years
   
22,756
     
22,861
 
Mortgage-related securities
   
141,575
     
144,545
 
   
$
240,189
   
$
245,396
 

- 9 -

Gross unrealized losses on securities available for sale and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position were as follows:

   
September 30, 2016
 
   
Less than 12 months
   
12 months or longer
   
Total
 
   
Fair value
   
Unrealized loss
   
Fair value
   
Unrealized loss
   
Fair value
   
Unrealized loss
 
   
(In Thousands)
 
Mortgage-backed securities
 
$
-
   
$
-
   
$
1,342
   
$
(1
)
 
$
1,342
   
$
(1
)
Collateralized mortgage obligations:
                                               
  Government sponsored enterprise issued
   
-
     
-
     
-
     
-
     
-
     
-
 
Municipal securities
   
6,456
     
(5
)
   
2,999
     
(1
)
   
9,455
     
(6
)
Other debt securities
   
-
     
-
     
9,277
     
(723
)
   
9,277
     
(723
)
Certificates of deposit
   
-
     
-
     
-
     
-
     
-
     
-
 
   
$
6,456
   
$
(5
)
 
$
13,618
   
$
(725
)
 
$
20,074
   
$
(730
)


   
December 31, 2015
 
   
Less than 12 months
   
12 months or longer
   
Total
 
   
Fair value
   
Unrealized loss
   
Fair value
   
Unrealized loss
   
Fair value
   
Unrealized loss
 
   
(In Thousands)
 
Mortgage-backed securities
 
$
18,488
   
$
(163
)
 
$
5,577
   
$
(85
)
 
$
24,065
   
$
(248
)
Collateralized mortgage obligations:
                                               
Government sponsored enterprise issued
   
48,281
     
(300
)
   
-
     
-
     
48,281
     
(300
)
Government sponsored enterprise bonds
   
3,246
     
(4
)
   
-
     
-
     
3,246
     
(4
)
Municipal securities
   
9,409
     
(18
)
   
5,555
     
(62
)
   
14,964
     
(80
)
Other debt securities
   
14,363
     
(647
)
   
-
     
-
     
14,363
     
(647
)
Certificates of deposit
   
976
     
(4
)
   
-
     
-
     
976
     
(4
)
   
$
94,763
   
$
(1,136
)
 
$
11,132
   
$
(147
)
 
$
105,895
   
$
(1,283
)

The Company reviews the investment securities portfolio on a quarterly basis to monitor its exposure to other-than-temporary impairment. In evaluating whether a security's decline in market value is other-than-temporary, management considers the length of time and extent to which the fair value has been less than cost, the financial condition of the issuer and the underlying obligors, quality of credit enhancements, volatility of the fair value of the security, the expected recovery period of the security and ratings agency evaluations. In addition, the Company may also evaluate payment structure, whether there are defaulted payments or expected defaults, prepayment speeds and the value of any underlying collateral.

As of September 30, 2016, the Company held two municipal securities that had previously been deemed to be other-than-temporarily impaired. Both securities were issued by a tax incremental district in a municipality located in Wisconsin. During the year ended December 31, 2012, the Company received audited financial statements with respect to the municipal issuer that called into question the ability of the underlying taxing district that issued the securities to operate as a going concern. During the year ended December 31, 2012, the Company's analysis of these securities resulted in $100,000 in credit losses charged to earnings with respect to these two municipal securities. During the year ended December 31, 2014, there were sales in the market of municipal issuer bonds at a discounted price that resulted in the Company recording additional credit losses. An additional $17,000 credit loss was charged to earnings during the year ended December 31, 2014 for these municipal bonds.  As of September 30, 2016, these securities had a combined amortized cost of $198,000 and total life-to-date impairment of $117,000.

As of September 30, 2016, the Company had one mortgage-backed security, one municipal security, and one other debt security which had been in an unrealized loss position for twelve months or longer. These securities were determined not to be other-than-temporarily impaired as of September 30, 2016. The Company has determined that the decline in fair value of these securities is primarily attributable to an increase in market interest rates compared to the stated rates on these securities and is not attributable to credit deterioration. As the Company does not intend to sell nor is it more likely than not that it will be required to sell these securities before recovery of the amortized cost basis, these securities are not considered other-than-temporarily impaired.

Deterioration of general economic market conditions could result in the recognition of future other than temporary impairment losses within the investment portfolio and such amounts could be material to our consolidated financial statements.

There were no sales of securities during the nine months ended September 30, 2016.  During the nine months ended September 30, 2015, proceeds from the sale of securities totaled $1.0 million and resulted in gains totaling $44,000. The $44,000 included in gain on sale of available for sale securities in the consolidated statements of income during the nine months ended September 30, 2015 was reclassified from accumulated other comprehensive income.

- 10 -

Note 3 - Loans Receivable

Loans receivable at September 30, 2016 and December 31, 2015 are summarized as follows:

   
September 30, 2016
   
December 31, 2015
 
   
(In Thousands)
 
Mortgage loans:
           
Residential real estate:
           
One- to four-family
 
$
389,267
   
$
381,992
 
Multi-family
   
551,487
     
547,250
 
Home equity
   
22,394
     
24,326
 
Construction and land
   
21,571
     
19,148
 
Commercial real estate
   
137,298
     
118,820
 
Consumer
   
339
     
361
 
Commercial loans
   
29,340
     
23,037
 
   
$
1,151,696
   
$
1,114,934
 

The Company provides several types of loans to its customers, including residential, construction, commercial and consumer loans. Significant loan concentrations are considered to exist for a financial institution when there are amounts loaned to one borrower or to multiple borrowers engaged in similar activities that would cause them to be similarly impacted by economic or other conditions. While the Company's credit risks are geographically concentrated in the Milwaukee metropolitan area, there are no concentrations with individual or groups of related borrowers.

Qualifying loans receivable totaling $896.4 million and $872.8 million at September 30, 2016 and December 31, 2015, respectively, are pledged as collateral against $280.0 million in outstanding Federal Home Loan Bank of Chicago (FHLBC) advances under a blanket security agreement.

As of September 30, 2016 and December 31, 2015, there were no loans 90 or more days past due and still accruing interest.

An analysis of past due loans receivable as of September 30, 2016 and December 31, 2015 follows:

 
As of September 30, 2016
 
 
1-59 Days Past Due (1)
   
60-89 Days Past Due (2)
   
90 Days or Greater
   
Total Past Due
   
Current (3)
   
Total Loans
 
 
(In Thousands)
 
Mortgage loans:
                                 
Residential real estate:
                                 
One- to four-family
 
$
1,546
   
$
1,303
   
$
4,999
   
$
7,848
   
$
381,419
   
$
389,267
 
Multi-family
   
130
     
-
     
404
     
534
     
550,953
     
551,487
 
Home equity
   
37
     
35
     
58
     
130
     
22,264
     
22,394
 
Construction and land
   
-
     
-
     
-
     
-
     
21,571
     
21,571
 
Commercial real estate
   
10
     
-
     
207
     
217
     
137,081
     
137,298
 
Consumer
   
-
     
-
     
-
     
-
     
339
     
339
 
Commercial loans
   
-
     
1
     
26
     
27
     
29,313
     
29,340
 
Total
 
$
1,723
   
$
1,339
   
$
5,694
   
$
8,756
   
$
1,142,940
   
$
1,151,696
 

 
As of December 31, 2015
 
 
1-59 Days Past Due (1)
   
60-89 Days Past Due (2)
   
90 Days or Greater
   
Total Past Due
   
Current (3)
   
Total Loans
 
 
(In Thousands)
 
Mortgage loans:
                                 
Residential real estate:
                                 
One- to four-family
 
$
851
   
$
1,133
   
$
6,503
   
$
8,487
   
$
373,505
   
$
381,992
 
Multi-family
   
-
     
207
     
1,858
     
2,065
     
545,185
     
547,250
 
Home equity
   
255
     
96
     
110
     
461
     
23,865
     
24,326
 
Construction and land
   
-
     
-
     
238
     
238
     
18,910
     
19,148
 
Commercial real estate
   
57
     
-
     
223
     
280
     
118,540
     
118,820
 
Consumer
   
-
     
-
     
-
     
-
     
361
     
361
 
Commercial loans
   
-
     
-
     
-
     
-
     
23,037
     
23,037
 
Total
 
$
1,163
   
$
1,436
   
$
8,932
   
$
11,531
   
$
1,103,403
   
$
1,114,934
 

(1)
Includes $187,000 and $315,000 at September 30, 2016 and December 31, 2015, respectively, which are on non-accrual status.
(2)
Includes $48,000 and $467,000 at September 30, 2016 and December 31, 2015, respectively, which are on non-accrual status.
(3)
Includes $4.7 million and $7.9 million at September 30, 2016 and December 31, 2015, respectively, which are on non-accrual status.

- 11 -

A summary of the activity for the nine months ended September 30, 2016 and 2015 in the allowance for loan losses follows:

   
One- to
Four- Family
   
Multi-Family
   
Home Equity
   
Construction and Land
   
Commercial Real Estate
   
Consumer
   
Commercial
   
Total
 
   
(In Thousands)
 
Nine months ended September 30, 2016
                                           
Balance at beginning of period
 
$
7,763
   
$
5,000
   
$
433
   
$
904
   
$
1,680
   
$
9
   
$
396
   
$
16,185
 
Provision (credit) for loan losses
   
141
     
23
     
(25
)
   
(123
)
   
33
     
3
     
288
     
340
 
Charge-offs
   
(801
)
   
(488
)
   
(62
)
   
(3
)
   
-
     
-
     
-
     
(1,354
)
Recoveries
   
246
     
134
     
24
     
58
     
-
     
-
     
-
     
462
 
Balance at end of period
 
$
7,349
   
$
4,669
   
$
370
   
$
836
   
$
1,713
   
$
12
   
$
684
   
$
15,633
 

Nine months ended September 30, 2015
                                           
Balance at beginning of period
 
$
9,877
   
$
5,358
   
$
422
   
$
687
   
$
1,951
   
$
8
   
$
403
   
$
18,706
 
Provision (credit) for loan losses
   
1,032
     
615
     
(5
)
   
157
     
(204
)
   
(2
)
   
127
     
1,720
 
Charge-offs
   
(3,212
)
   
(1,501
)
   
(72
)
   
(84
)
   
(45
)
   
-
     
-
     
(4,914
)
Recoveries
   
436
     
789
     
101
     
45
     
40
     
5
     
-
     
1,416
 
Balance at end of period
 
$
8,133
   
$
5,261
   
$
446
   
$
805
   
$
1,742
   
$
11
   
$
530
   
$
16,928
 

A summary of the allowance for loan loss for loans evaluated individually and collectively for impairment by collateral class as of September 30, 2016 follows:

   
One- to
Four- Family
   
Multi-
Family
   
Home
Equity
   
Construction
and Land
   
Commercial
Real Estate
   
Consumer
   
Commercial
   
Total
 
   
(In Thousands)
 
Allowance related to loans individually evaluated for impairment
 
$
532
   
$
-
   
$
73
   
$
-
   
$
77
   
$
-
   
$
1
   
$
683
 
Allowance related to loans collectively evaluated for impairment
   
6,817
     
4,669
     
297
     
836
     
1,636
     
12
     
683
     
14,950
 
Balance at end of period
 
$
7,349
   
$
4,669
   
$
370
   
$
836
   
$
1,713
   
$
12
   
$
684
   
$
15,633
 
                                                                 
Loans individually evaluated for impairment
 
$
12,021
   
$
3,967
   
$
373
   
$
437
   
$
726
   
$
-
   
$
44
   
$
17,568
 
Loans collectively evaluated for impairment
   
377,246
     
547,520
     
22,021
     
21,134
     
136,572
     
339
     
29,296
     
1,134,128
 
Total gross loans
 
$
389,267
   
$
551,487
   
$
22,394
   
$
21,571
   
$
137,298
   
$
339
   
$
29,340
   
$
1,151,696
 

A summary of the allowance for loan loss for loans evaluated individually and collectively for impairment by collateral class as of December 31, 2015 follows:

   
One- to
Four-Family
   
Multi-
Family
   
Home
Equity
   
Construction
and Land
   
Commercial
Real Estate
   
Consumer
   
Commercial
   
Total
 
   
(In Thousands)
 
Allowance related to loans individually evaluated for impairment
 
$
1,114
   
$
242
   
$
108
   
$
3
   
$
106
   
$
-
   
$
3
   
$
1,576
 
Allowance related to loans collectively evaluated for impairment
   
6,649
     
4,758
     
325
     
901
     
1,574
     
9
     
393
     
14,609
 
Balance at end of period
 
$
7,763
   
$
5,000
   
$
433
   
$
904
   
$
1,680
   
$
9
   
$
396
   
$
16,185
 
                                                                 
Loans individually evaluated for impairment
 
$
18,385
   
$
5,100
   
$
472
   
$
1,795
   
$
1,766
   
$
-
   
$
27
   
$
27,545
 
Loans collectively evaluated for impairment
   
363,607
     
542,150
     
23,854
     
17,353
     
117,054
     
361
     
23,010
     
1,087,389
 
Total gross loans
 
$
381,992
   
$
547,250
   
$
24,326
   
$
19,148
   
$
118,820
   
$
361
   
$
23,037
   
$
1,114,934
 
 
The following table presents information relating to the Company's internal risk ratings of its loans receivable as of September 30, 2016 and December 31, 2015:

   
One
to Four- Family
   
Multi-Family
   
Home
Equity
   
Construction
and Land
   
Commercial
Real Estate
   
Consumer
   
Commercial
   
Total
 
   
(In Thousands)
 
At September 30, 2016
                                               
Substandard
 
$
14,415
   
$
1,445
   
$
406
   
$
   
$
725
   
$
-
   
$
44
   
$
17,035
 
Watch
   
9,923
     
2,920
     
194
     
873
     
1,053
     
-
     
2,896
     
17,859
 
Pass
   
364,929
     
547,122
     
21,794
     
20,698
     
135,520
     
339
     
26,400
     
1,116,802
 
   
$
389,267
   
$
551,487
   
$
22,394
   
$
21,571
   
$
137,298
   
$
339
   
$
29,340
   
$
1,151,696
 
                                                                 
At December 31, 2015
                                                               
Substandard
 
$
19,148
   
$
2,553
   
$
684
   
$
1,794
   
$
1,766
   
$
-
   
$
55
   
$
26,000
 
Watch
   
11,352
     
3,634
     
128
     
-
     
1,161
     
-
     
402
     
16,677
 
Pass
   
351,492
     
541,063
     
23,514
     
17,354
     
115,893
     
361
     
22,580
     
1,072,257
 
   
$
381,992
   
$
547,250
   
$
24,326
   
$
19,148
   
$
118,820
   
$
361
   
$
23,037
   
$
1,114,934
 

- 12 -

Factors that are important to managing overall credit quality include sound loan underwriting and administration, systematic monitoring of existing loans and commitments, effective loan review on an ongoing basis, early identification of potential problems, an allowance for loan losses, and sound non-accrual and charge-off policies.  Our underwriting policies require an officers' loan committee review and approval of all loans in excess of $500,000.  In addition, we utilize an independent loan review function for all loans. Our ability to manage credit risk depends in large part on our ability to properly identify and manage problem loans. To do so, we maintain a loan review system under which our credit management personnel review non-owner occupied one- to four-family, multi-family, construction and land, commercial real estate and commercial loans that individually, or as part of an overall borrower relationship exceed $1.0 million  in potential exposure.  Loans meeting these criteria are reviewed on an annual basis, or more frequently, if the loan renewal is less than one year.  With respect to this review process, management has determined that pass loans include loans that exhibit acceptable financial statements, cash flow and leverage. Watch loans have potential weaknesses that deserve management's attention, and if left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the credit. Substandard loans are considered inadequately protected by the current net worth and paying capacity of the obligor or the collateral pledged. These loans generally have a well-defined weakness that may jeopardize liquidation of the debt and are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.  Finally, a loan is considered to be impaired when it is probable that the Bank will not be able to collect all amounts due according to the contractual terms of the loan agreement. Management has determined that all non-accrual loans and loans modified under troubled debt restructurings meet the definition of an impaired loan.

The Company's procedures dictate that an updated valuation must be obtained with respect to underlying collateral at the time a loan is deemed impaired. Updated valuations may also be obtained upon transfer from loans receivable to real estate owned based upon the age of the prior appraisal, changes in market conditions or known changes to the physical condition of the property.

Estimated fair values are reduced to account for sales commissions, broker fees, unpaid property taxes and additional selling expenses to arrive at an estimated net realizable value.  The adjustment factor is based upon the Company's actual experience with respect to sales of real estate owned over the prior two years.  In situations in which we are placing reliance on an appraisal that is more than one year old, an additional adjustment factor is applied to account for downward market pressure since the date of appraisal. The additional adjustment factor is based upon relevant sales data available for our general operating market as well as company-specific historical net realizable values as compared to the most recent appraisal prior to disposition.

With respect to multi-family income-producing real estate, appraisals are reviewed and estimated collateral values are adjusted by updating significant appraisal assumptions to reflect current real estate market conditions. Significant assumptions reviewed and updated include the capitalization rate, rental income and operating expenses. These adjusted assumptions are based upon recent appraisals received on similar properties as well as on actual experience related to real estate owned and currently under Company management.

The following tables present data on impaired loans at September 30, 2016 and December 31, 2015.

   
As of or for the Nine Months Ended September 30, 2016
 
   
Recorded
Investment
   
Unpaid
Principal
   
Reserve
   
Cumulative
Charge-Offs
   
Average
Recorded
Investment
   
Interest
Paid
 
   
(In Thousands)
 
Total Impaired with Reserve
                                   
One- to four-family
 
$
3,249
   
$
3,289
   
$
532
   
$
40
   
$
3,307
   
$
113
 
Multi-family
   
-
     
-
     
-
     
-
     
-
     
-
 
Home equity
   
158
     
158
     
73
     
-
     
165
     
10
 
Construction and land
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial real estate
   
286
     
695
     
77
     
409
     
299
     
11
 
Consumer
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial
   
1
     
1
     
1
     
-
     
2
     
-
 
     
3,694
     
4,143
     
683
     
449
     
3,773
     
134
 
Total Impaired with no Reserve
                                               
One- to four-family
   
8,772
     
10,087
     
-
     
1,315
     
8,944
     
262
 
Multi-family
   
3,967
     
4,986
     
-
     
1,019
     
4,008
     
174
 
Home equity
   
215
     
215
     
-
     
-
     
224
     
6
 
Construction and land
   
437
     
437
     
-
     
-
     
615
     
15
 
Commercial real estate
   
440
     
440
     
-
     
-
     
440
     
10
 
Consumer
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial
   
43
     
43
     
-
     
-
     
47
     
1
 
     
13,874
     
16,208
     
-
     
2,334
     
14,278
     
468
 
Total Impaired
                                               
One- to four-family
   
12,021
     
13,376
     
532
     
1,355
     
12,251
     
375
 
Multi-family
   
3,967
     
4,986
     
-
     
1,019
     
4,008
     
174
 
Home equity
   
373
     
373
     
73
     
-
     
389
     
16
 
Construction and land
   
437
     
437
     
-
     
-
     
615
     
15
 
Commercial real estate
   
726
     
1,135
     
77
     
409
     
739
     
21
 
Consumer
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial
   
44
     
44
     
1
     
-
     
49
     
1
 
   
$
17,568
   
$
20,351
   
$
683
   
$
2,783
   
$
18,051
   
$
602
 

- 13 -

   
As of or for the Year Ended December 31, 2015
 
   
Recorded
Investment
   
Unpaid
Principal
   
Reserve
   
Cumulative
Charge-Offs
   
Average
Recorded
Investment
   
Interest
Paid
 
   
(In Thousands)
 
Total Impaired with Reserve
                                   
One- to four-family
 
$
7,903
   
$
8,923
   
$
1,114
   
$
1,020
   
$
8,113
   
$
393
 
Multi-family
   
1,055
     
1,055
     
242
     
-
     
1,044
     
42
 
Home equity
   
169
     
169
     
108
     
-
     
174
     
10
 
Construction and land
   
156
     
269
     
3
     
113
     
155
     
-
 
Commercial real estate
   
314
     
723
     
106
     
409
     
367
     
23
 
Consumer
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial
   
3
     
3
     
3
     
-
     
5
     
1
 
     
9,600
     
11,142
     
1,576
     
1,542
     
9,858
     
469
 
Total Impaired with no Reserve
                                               
One- to four-family
   
10,482
     
11,991
     
-
     
1,509
     
10,676
     
500
 
Multi-family
   
4,045
     
5,090
     
-
     
1,045
     
4,106
     
245
 
Home equity
   
303
     
303
     
-
     
-
     
307
     
13
 
Construction and land
   
1,639
     
1,639
     
-
     
-
     
1,827
     
62
 
Commercial real estate
   
1,452
     
1,452
     
-
     
-
     
1,458
     
72
 
Consumer
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial
   
24
     
24
     
-
     
-
     
29
     
2
 
     
17,945
     
20,499
     
-
     
2,554
     
18,403
     
894
 
Total Impaired
                                               
One- to four-family
   
18,385
     
20,914
     
1,114
     
2,529
     
18,789
     
893
 
Multi-family
   
5,100
     
6,145
     
242
     
1,045
     
5,150
     
287
 
Home equity
   
472
     
472
     
108
     
-
     
481
     
23
 
Construction and land
   
1,795
     
1,908
     
3
     
113
     
1,982
     
62
 
Commercial real estate
   
1,766
     
2,175
     
106
     
409
     
1,825
     
95
 
Consumer
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial
   
27
     
27
     
3
     
-
     
34
     
3
 
   
$
27,545
   
$
31,641
   
$
1,576
   
$
4,096
   
$
28,261
   
$
1,363
 

The difference between a loan's recorded investment and the unpaid principal balance represents a partial charge-off resulting from a confirmed loss when the value of the collateral securing the loan is below the loan balance and management's assessment that the full collection of the loan balance is not likely.

When a loan is considered impaired, interest payments received are treated as interest income on a cash basis as long as the remaining book value of the loan (i.e., after charge-off of all identified losses) is deemed to be fully collectible. If the remaining book value is not deemed to be fully collectible, all payments received are applied to unpaid principal. Determination as to the ultimate collectability of the remaining book value is supported by an updated credit department evaluation of the borrower's financial condition and prospects for repayment, including consideration of the borrower's sustained historical repayment performance and other relevant factors.

The determination as to whether an allowance is required with respect to impaired loans is based upon an analysis of the value of the underlying collateral and/or the borrower's intent and ability to make all principal and interest payments in accordance with contractual terms. The evaluation process is subject to the use of significant estimates and actual results could differ from estimates. This analysis is primarily based upon third party appraisals and/or a discounted cash flow analysis. In those cases in which no allowance has been provided for an impaired loan, the Company has determined that the estimated value of the underlying collateral exceeds the remaining outstanding balance of the loan. Of the total $13.9 million of impaired loans as of September 30, 2016 for which no allowance has been provided, $2.3 million in charge-offs have been recorded to reduce the unpaid principal balance to an amount that is commensurate with the loans' net realizable value, using the estimated fair value of the underlying collateral. To the extent that further deterioration in property values continues, the Company may have to reevaluate the sufficiency of the collateral servicing these impaired loans resulting in additional provisions to the allowance for loans losses or charge-offs.

- 14 -

At September 30, 2016, total impaired loans included $10.7 million of troubled debt restructurings. Troubled debt restructurings involve granting concessions to a borrower experiencing financial difficulty by modifying the terms of the loan in an effort to avoid foreclosure. The vast majority of debt restructurings include a modification of terms to allow for an interest only payment and/or reduction in interest rate. The restructured terms are typically in place for six to twelve months. At December 31, 2015, total impaired loans included $17.5 million of troubled debt restructurings.

The following presents data on troubled debt restructurings:

   
As of September 30, 2016
 
   
Accruing
 
Non-accruing
 
Total
 
   
Amount
   
Number
 
Amount
   
Number
 
Amount
   
Number
 
 
(Dollars in Thousands)
 
                               
One- to four-family
 
$
3,298
     
3
   
$
2,448
     
34
   
$
5,746
     
37
 
Multi-family
   
2,522
     
1
     
1,445
     
5
     
3,967
     
6
 
Home equity
   
54
     
1
     
98
     
1
     
152
     
2
 
Construction and land
   
438
     
1
     
-
     
-
     
438
     
1
 
Commercial real estate
   
296
     
1
     
63
     
1
     
359
     
2
 
   
$
6,608
     
7
   
$
4,054
     
41
   
$
10,662
     
48
 

   
As of December 31, 2015
 
   
Accruing
 
Non-accruing
 
Total
 
   
Amount
   
Number
 
Amount
   
Number
 
Amount
   
Number
 
 
(Dollars in Thousands)
 
                               
One- to four-family
 
$
3,900
     
4
   
$
5,739
     
45
   
$
9,639
     
49
 
Multi-family
   
2,546
     
1
     
2,317
     
7
     
4,863
     
8
 
Home equity
   
-
     
-
     
98
     
1
     
98
     
1
 
Construction and land
   
1,556
     
2
     
-
     
-
     
1,556
     
2
 
Commercial real estate
   
1,306
     
1
     
77
     
1
     
1,383
     
2
 
   
$
9,308
     
8
   
$
8,231
     
54
   
$
17,539
     
62
 


At September 30, 2016, $10.7 million in loans had been modified in troubled debt restructurings and $4.1 million of these loans were included in the non-accrual loan total. The remaining $6.6 million, while meeting the internal requirements for modification in a troubled debt restructuring, were current with respect to payments under their original loan terms at the time of the restructuring and, therefore, continued to be included with accruing loans. Provided these loans perform in accordance with the modified terms, they will continue to be accounted for on an accrual basis.

All loans that have been modified in a troubled debt restructuring are considered to be impaired. As such, an analysis has been performed with respect to all of these loans to determine the need for a valuation reserve. When a loan is expected to perform in accordance with the restructured terms and ultimately return to and perform under contract terms, a valuation allowance is established for an amount equal to the excess of the present value of the expected future cash flows under the original contract terms as compared with the modified terms, including an estimated default rate. When there is doubt as to the borrower's ability to perform under the restructured terms or ultimately return to and perform under market terms, a valuation allowance is established equal to the impairment when the carrying amount exceeds fair value of the underlying collateral. As a result of the impairment analysis, a $336,000 valuation allowance has been established as of September 30, 2016 with respect to the $10.7 million in troubled debt restructurings. As of December 31, 2015, a $996,000 valuation allowance had been established with respect to the $17.5 million in troubled debt restructurings.

After a troubled debt restructuring reverts to market terms, a minimum of six consecutive contractual payments must be received prior to consideration for a return to accrual status. If an updated credit department review indicates no other evidence of elevated credit risk, the loan is returned to accrual status at that time.

The following presents troubled debt restructurings by concession type:

   
As of September 30, 2016
 
 
Performing in
accordance with
modified terms
   
In Default
   
Total
 
 
Amount
   
Number
   
Amount
   
Number
   
Amount
   
Number
 
 
(dollars in thousands)
 
Interest reduction and principal forbearance
 
$
1,114
     
22
   
$
-
     
-
   
$
1,114
     
22
 
Principal forbearance
   
54
     
1
     
-
     
-
     
54
     
1
 
Interest reduction
   
8,710
     
23
     
784
     
2
     
9,494
     
25
 
   
$
9,878
     
46
   
$
784
     
2
   
$
10,662
     
48
 

   
As of December 31, 2015
 
 
Performing in
accordance with
modified terms
   
In Default
   
Total
 
 
Amount
   
Number
   
Amount
   
Number
   
Amount
   
Number
 
 
(dollars in thousands)
 
Interest reduction and principal forbearance
 
$
13,971
     
30
   
$
1,012
     
5
   
$
14,983
     
35
 
Principal forbearance
   
97
     
1
     
-
     
-
     
97
     
1
 
Interest reduction
   
2,459
     
26
     
-
     
-
     
2,459
     
26
 
   
$
16,527
     
57
   
$
1,012
     
5
   
$
17,539
     
62
 


- 15 -

The following table presents data on non-accrual loans as of September 30, 2016 and December 31, 2015:

   
September 30, 2016
   
December 31, 2015
 
   
(Dollars in Thousands)
 
Non-accrual loans:
           
Residential
           
One- to four-family
 
$
8,444
   
$
13,888
 
Multi-family
   
1,445
     
2,553
 
Home equity
   
305
     
437
 
Construction and land
   
-
     
239
 
Commercial real estate
   
429
     
460
 
Commercial
   
44
     
27
 
Consumer
   
-
     
-
 
Total non-accrual loans
 
$
10,667
   
$
17,604
 
Total non-accrual loans to total loans receivable
   
0.93
%
   
1.58
%
Total non-accrual loans to total assets
   
0.59
%
   
1.00
%

Note 4— Real Estate Owned

Real estate owned is summarized as follows:

   
September 30, 2016
   
December 31, 2015
 
   
(In Thousands)
 
             
One- to four-family
 
$
2,735
   
$
4,610
 
Multi-family
   
315
     
209
 
Construction and land
   
5,291
     
5,262
 
Commercial real estate
   
300
     
300
 
    Total real estate owned
   
8,641
     
10,381
 
Valuation allowance at end of period
   
(1,187
)
   
(1,191
)
    Total real estate owned, net
 
$
7,454
   
$
9,190
 

The following table presents the activity in the Company's real estate owned:

   
Nine months ended September 30,
 
   
2016
   
2015
 
   
(In Thousands)
 
Real estate owned at beginning of the period
 
$
9,190
     
18,706
 
Transferred from loans receivable
   
3,442
     
11,719
 
Sales (net of gains / losses)
   
(4,762
)
   
(17,265
)
Write downs
   
(416
)
   
(1,522
)
Other
   
-
     
518
 
    Real estate owned at the end of the period
 
$
7,454
     
12,156
 

Residential one- to four-family mortgage loans that were in the process of foreclosure were $3.0 million and $5.1 million at September 30, 2016 and December 31, 2015, respectively.

- 16 -

Note 5— Mortgage Servicing Rights

The following table presents the activity in the Company's mortgage servicing rights:

   
Nine months ended September 30,
 
   
2016
   
2015
 
   
(In Thousands)
 
Mortgage servicing rights at beginning of the period
 
$
1,422
   
$
2,521
 
Additions
   
1,486
     
3,149
 
Amortization
   
(412
)
   
(412
)
Sales
   
-
     
(4,260
)
Mortgage servicing rights at end of the period
   
2,496
     
998
 
Valuation allowance at end of period
   
(100
)
   
(20
)
Mortgage servicing rights at end of the period, net
 
$
2,396
   
$
978
 


During the nine months ended September 30, 2016, $1.8 billion in residential loans were originated for sale. During the same period, sales of loans held for sale totaled $1.8 billion, generating mortgage banking income of $91.1 million. The unpaid principal balance of loans serviced for others was $371.3 million and $176.4 million at September 30, 2016 and December 31, 2015, respectively. These loans are not reflected in the consolidated statements of financial condition.

During the nine months ended September 30, 2016, the Company did not sell any mortgage servicing rights. During the nine months ended September 30, 2015, the Company sold mortgage servicing rights related to $552.4 million in loans receivable with a book value of $4.3 million for $5.1 million resulting in a gain on sale of $807,000.

The following table shows the estimated future amortization expense for mortgage servicing rights for the periods indicated:

Estimate for the period ended December 31:
 
(In Thousands)
 
2016
 
$
115
 
2017
   
414
 
2018
   
366
 
2019
   
364
 
2020
   
363
 
Thereafter
   
774
 
Total
 
$
2,396
 

Note 6— Deposits

At September 30, 2016 and December 31, 2015, time deposits with balances greater than $250,000 amounted to $46.3 million and $37.7 million, respectively.

A summary of the contractual maturities of time deposits at September 30, 2016 is as follows:

   
(In Thousands)
 
       
Within one year
 
$
481,068
 
More than one to two years
   
194,598
 
More than two to three years
   
6,304
 
More than three to four years
   
4,037
 
More than four through five years
   
1,297
 
   
$
687,304
 

- 17 -

Note 7— Borrowings

Borrowings consist of the following:

     
September 30, 2016
   
December 31, 2015
 
     
Balance
   
Weighted Average Rate
   
Balance
   
Weighted Average Rate
 
     
(Dollars in Thousands)
 
Short term:
                         
Repurchase agreement
   
$
13,983
     
3.27
%
 
$
7,203
     
3.19
%
Federal Home Loan Bank, Chicago advances
     
50,000
     
0.29
%
   
-
     
0.00
%
                                   
Long term:
                                 
  Federal Home Loan Bank, Chicago advances maturing:
                                 
 2016
   
-
     
0.00
%
   
220,000
     
4.34
%
 2017
   
65,000
     
3.19
%
   
65,000
     
3.19
%
 2018
   
65,000
     
2.97
%
   
65,000
     
2.97
%
 2021
   
100,000
     
0.78
%
   
-
     
0.00
%
Repurchase agreements maturing
2017
   
84,000
     
3.96
%
   
84,000
     
3.96
%
      
$
377,983
     
2.31
%
 
$
441,203
     
3.88
%

The short-term repurchase agreement represents the outstanding portion of a total $35.0 million commitment with one unrelated bank.  The short-term repurchase agreement is utilized by Waterstone Mortgage Corporation to finance loans originated for sale.  This agreement is secured by the underlying loans being financed.  Related interest rates are based upon the note rate associated with the loans being financed. The short-term repurchase agreement had a $14.0 balance at September 30, 2016 and a $7.2 million balance at December 31, 2015.

The $50.0 million short-term advance has a maturity date of October 27, 2016. The short-term advance has a fixed rate of 0.29%.

The $65.0 million in advances due in 2017 consists of three advances with fixed rates ranging from 3.09% to 3.46% callable quarterly until maturity.

The $65.0 million in advances due in 2018 consists of three advances with fixed rates ranging from 2.73% to 3.11% callable quarterly until maturity.

The $100.0 million in advances due in 2021 consists of two advances totaling $50.0 million with fixed rates ranging from 0.67% to 0.73% with a FHLB quarterly call option beginning in June 2018 and one advance for $50.0 million with a fixed rate of 0.85% with a FHLB quarterly call option beginning in September 2018.

The $84.0 million in repurchase agreements have fixed rates ranging from 2.89% to 4.31% callable quarterly until their maturity in 2017. The repurchase agreements are collateralized by securities available for sale with an estimated fair value of $91.7 million at September 30, 2016 and $94.1 million at December 31, 2015.

The Company selects loans that meet underwriting criteria established by the FHLBC as collateral for outstanding advances. The Company's borrowings from the FHLBC are limited to 80% of the carrying value of unencumbered one- to four-family mortgage loans, 51% of the carrying value of home equity loans and 75% of the carrying value of multi-family loans. In addition, these advances are collateralized by FHLBC stock of $12.6 million at September 30, 2016 and $19.5 million at December 31, 2015. In the event of prepayment, the Company is obligated to pay all remaining contractual interest on the advance.


 
 
 
- 18 -

Note 8 – Regulatory Capital

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements, or overall financial performance deemed by the regulators to be inadequate, can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Company's and Bank's assets, liabilities, and certain off-balance-sheet items, as calculated under regulatory accounting practices. The Company's and Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

The Federal Reserve Board and the FDIC issued final rules implementing the Basel III regulatory capital framework and related Dodd-Frank Wall Street Reform and Consumer Protection Act changes. The rules revise minimum capital requirements and adjust prompt corrective action thresholds. The final rules revise the regulatory capital elements, add a new common equity Tier I capital ratio, increase the minimum Tier 1 capital ratio requirements and implement a new capital conservation buffer. The rules also permit certain banking organizations to retain, through a one-time election, the existing treatment for accumulated other comprehensive income. The Company and the Bank have made the election to retain the existing treatment for accumulated other comprehensive income. The final rules took effect for the Company and the Bank on January 1, 2015, subject to a transition period for certain parts of the rules.

The table below includes the new regulatory capital ratio requirements that became effective on January 1, 2015. Beginning in 2016, an additional capital conservation buffer was added to the minimum requirements for capital adequacy purposes, subject to a three year phase-in period. The capital conservation buffer will be fully phased-in on January 1, 2019 at 2.5 percent. A banking organization with a conservation buffer of less than 2.5 percent (or the required phase-in amount in years prior to 2019) will be subject to limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers. At the present time, the ratios for the Company and the Bank are sufficient to meet the fully phased-in conservation buffer.

The actual and required capital amounts and ratios for the Bank as of September 30, 2016 and December 31, 2015 are presented in the table below:

   
September 30, 2016
 
   
Actual
   
For Capital
Adequacy
Purposes
   
Minimum Capital
Adequacy with
Capital Buffer
   
To Be Well
Capitalized Under
Prompt Corrective
Action Provisions
 
   
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
   
(Dollars In Thousands)
 
Total Capital (to risk-weighted assets)
                                               
Consolidated Waterstone Financial, Inc.
 
$
421,928
     
32.25
%
 
$
104,659
     
8.00
%
 
$
112,836
     
8.625
%
 
$
N/A
     
N/A
 
WaterStone Bank
   
386,208
     
29.59
%
   
104,409
     
8.00
%
   
112,566
     
8.625
%
   
130,511
     
10.00
%
Tier 1 Capital (to risk-weighted assets)
                                                               
Consolidated Waterstone Financial, Inc.
   
406,295
     
31.06
%
   
78,495
     
6.00
%
   
86,671
     
6.625
%
   
N/A
     
N/A
 
WaterStone Bank
   
370,575
     
28.39
%
   
78,307
     
6.00
%
   
86,464
     
6.625
%
   
104,409
     
8.00
%
Common Equity Tier 1 Capital (to risk-weighted assets)
                                                               
Consolidated Waterstone Financial, Inc.
   
406,295
     
31.06
%
   
58,871
     
4.50
%
   
67,047
     
5.125
%
   
N/A
     
N/A
 
WaterStone Bank
   
370,575
     
28.39
%
   
58,730
     
4.50
%
   
66,887
     
5.125
%
   
84,832
     
6.50
%
Tier 1 Capital (to average assets)
                                                               
Consolidated Waterstone Financial, Inc.
   
406,295
     
22.66
%
   
71,735
     
4.00
%
   
N/A
     
N/A
     
N/A
     
N/A
 
WaterStone Bank
   
370,575
     
20.71
%
   
71,561
     
4.00
%
   
N/A
     
N/A
     
89,452
     
5.00
%
State of Wisconsin (to total assets)
                                                               
WaterStone Bank
   
370,575
     
20.69
%
   
107,442
     
6.00
%
   
N/A
     
N/A
     
N/A
     
N/A
 

   
December 31, 2015
 
   
(Dollars In Thousands)
 
Total Capital (to risk-weighted assets)
                                               
Consolidated Waterstone Financial, Inc.
 
$
405,947
     
33.41
%
 
$
97,207
     
8.00
%
 
$
N/A
     
N/A
   
$
N/A
     
N/A
 
WaterStone Bank
   
374,435
     
30.92
%
   
96,885
     
8.00
%
   
N/A
     
N/A
     
121,106
     
10.00
%
Tier 1 Capital (to risk-weighted assets)
                                                               
Consolidated Waterstone Financial, Inc.
   
390,747
     
32.16
%
   
72,905
     
6.00
%
   
N/A
     
N/A
     
N/A
     
N/A
 
WaterStone Bank
   
359,284
     
29.67
%
   
72,664
     
6.00
%
   
N/A
     
N/A
     
96,885
     
8.00
%
Common Equity Tier 1 Capital (to risk-weighted assets)
                                                               
Consolidated Waterstone Financial, Inc.
   
390,747
     
32.16
%
   
54,679
     
4.50
%
   
N/A
     
N/A
     
N/A
     
N/A
 
WaterStone Bank
   
359,284
     
29.67
%
   
54,498
     
4.50
%
   
N/A
     
N/A
     
78,719
     
6.50
%
Tier 1 Capital (to average assets)
                                                               
Consolidated Waterstone Financial, Inc.
   
390,747
     
22.20
%
   
70,417
     
4.00
%
   
N/A
     
N/A
     
N/A
     
N/A
 
WaterStone Bank
   
359,284
     
20.45
%
   
70,286
     
4.00
%
   
N/A
     
N/A
     
87,857
     
5.00
%
State of Wisconsin (to total assets)
                                                               
WaterStone Bank
   
359,284
     
20.43
%
   
105,493
     
6.00
%
   
N/A
     
N/A
     
N/A
     
N/A
 

- 19 -

Note 9 – Income Taxes

Income tax expense increased from $7.7 million during the nine months ended September 30, 2015 to $12.2 million for the nine months ended September 30, 2016. This increase was primarily due to the increase in our income before income taxes, which increased from $21.1 million during the nine months ended September 30, 2015 to $31.3 million during the nine months ended September 30, 2016.  Income tax expense is recognized on the statement of income during the nine months ended September 30, 2016 at an effective rate of 39.0% of pretax income compared to 36.2% during the nine months ended September 30, 2015.

During the quarter ended September 30, 2016, the Company incurred a charge related to stock options awarded in 2007.  The deferred tax asset established for the stock options was not fully utilized upon exercise, as the deductible compensation recognized was less than the value of the asset established at the time the award vested.  A net expense of $564,000 was charged to income tax for the quarter.

The Company still has a deferred tax asset of $193,000 related to stock options awarded in 2007 that have not yet been exercised.  The stock options awarded in 2007 expire in January 2017.  If these awards are not exercised, the Company will have to recognize additional tax expense equal to the amount of the deferred tax asset upon expiration.  In the event that these options are exercised, the Company's tax deduction would be limited to the amount by which the fair market value of the stock, on the exercise date, exceeds the options strike price.  Per ASC 718, the determination of a need for a valuation allowance against stock-based compensation awards by a company should not consider the current fair market value of its stock.  Therefore, no valuation allowance has been recorded against these awards, even though these awards are currently out-of-the-money and may not be exercised.


Note 10 – Offsetting of Assets and Liabilities

The Company enters into agreements under which it sells securities subject to an obligation to repurchase the same or similar securities. In addition, the Company enters into agreements under which it sells loans held for sale subject to an obligation to repurchase the same loans. Under these arrangements, the Company may transfer legal control over the assets but still retain effective control through an agreement that both entitles and obligates the Company to repurchase the assets. As a result, these repurchase agreements are accounted for as collateralized financing arrangements (i.e., secured borrowings) and not as a sale and subsequent repurchase of assets. The obligation to repurchase the assets is reflected as a liability in the Company's consolidated statements of condition, while the securities and loans held for sale underlying the repurchase agreements remain in the respective investment securities and loans held for sale asset accounts. In other words, there is no offsetting or netting of the investment securities or loans held for sale assets with the repurchase agreement liabilities. One of the Company's two short-term repurchase agreements and all of the Company's long-term repurchase agreements are subject to master netting agreements, which set forth the rights and obligations for repurchase and offset. Under the master netting agreement, the Company is entitled to set off the collateral placed with a single counterparty against obligations owed to that counterparty.

The following table presents the liabilities subject to an enforceable master netting agreement as of September 30, 2016 and December 31, 2015.

   
Gross
Recognized
Liabilities
   
Gross
Amounts
Offset
   
Net
Amounts
Presented
   
Gross
Amounts Not
Offset
   
Net
Amount
 
   
(In Thousands)
 
September 30, 2016
                             
Repurchase Agreements
                             
Short-term
 
$
13,983
   
$
-
   
$
13,983
   
$
13,983
   
$
-
 
Long-term
   
84,000
     
-
     
84,000
     
84,000
     
-
 
   
$
97,983
   
$
-
   
$
97,983
   
$
97,983
   
$
-
 
                                         
December 31, 2015
                                       
Repurchase Agreements
                                       
Short-term
 
$
7,203
   
$
-
   
$
7,203
   
$
7,203
   
$
-
 
Long-term
   
84,000
     
-
     
84,000
     
84,000
     
-
 
   
$
91,203
   
$
-
   
$
91,203
   
$
91,203
   
$
-
 

- 20 -

Note 11– Commitments, Off-Balance Sheet Arrangements, and Contingent Liabilities

The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

   
September 30, 2016
   
December 31, 2015
 
   
(In Thousands)
 
Financial instruments whose contract amounts represent potential credit risk:
           
Commitments to extend credit under amortizing loans (1)
 
$
35,463
   
$
10,307
 
Commitments to extend credit under home equity lines of credit (2)
   
13,969
     
14,173
 
Unused portion of construction loans (3)
   
28,507
     
25,545
 
Unused portion of business lines of credit
   
13,345
     
16,392
 
Standby letters of credit
   
392
     
566
 

(1) Commitments for loans are extended to customers for up to 90 days after which they expire. Excludes commitments to originate loans held for sale, which are discussed in the following footnote.
(2)  Unused portions of home equity loans are available to the borrower for up to 10 years.
(3)  Unused portions of construction loans are available to the borrower for up to one year.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements of the Company. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management's credit evaluation of the counter-party. Collateral obtained generally consists of mortgages on the underlying real estate.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds mortgages on the underlying real estate as collateral supporting those commitments for which collateral is deemed necessary.

The Company has determined that there are no probable losses related to commitments to extend credit or the standby letters of credit as of September 30, 2016 and December 31, 2015.

In the normal course of business, the Company, or it's subsidiaries, are involved in various legal proceedings.  In the opinion of management, any liability resulting from pending proceedings would not be expected to have a material adverse effect on the Company's consolidated financial statements.

Herrington, et al. v. Waterstone Mortgage Corporation

Waterstone Mortgage Corporation is a defendant in a lawsuit that was filed in the Federal District Court for the Western District of Wisconsin and has been transferred to arbitration, alleging that Waterstone Mortgage Corporation violated the Fair Labor Standards Act and failed to pay loan officers consistent with their various contracts.  Waterstone Mortgage Corporation is and will continue to vigorously defend its interests in this matter. 


 
 
 
 
 
 
 
 
 
- 21 -

Note 12 – Derivative Financial Instruments

In connection with its mortgage banking activities, the Company enters into derivative financial instruments as part of its strategy to manage its exposure to changes in interest rates. Mortgage banking derivatives include interest rate lock commitments provided to customers to fund mortgage loans to be sold in the secondary market and forward commitments for the future delivery of such loans to third party investors. It is the Company's practice to enter into forward commitments for the future delivery of residential mortgage loans when interest rate lock commitments are entered into in order to economically hedge the effect of future changes in interest rates on its commitments to fund the loans as well as on its portfolio of mortgage loans held for sale. The Company's mortgage banking derivatives have not been designated as hedge relationships. These instruments are used to manage the Company's exposure to interest rate movements and other identified risks but do not meet the strict hedge accounting requirements of ASC 815. Changes in the fair value of derivatives not designated in hedging relationships are recorded as a component of mortgage banking income in the Company's consolidated statements of operations. The Company does not use derivatives for speculative purposes.

Forward commitments to sell mortgage loans represent commitments obtained by the Company from a secondary market agency to purchase mortgages from the Company at specified interest rates and within specified periods of time. Commitments to sell loans are made to mitigate interest rate risk on interest rate lock commitments to originate loans and loans held for sale. At September 30, 2016, the Company had forward commitments to sell mortgage loans with an aggregate notional amount of approximately $454.6 million and interest rate lock commitments with an aggregate notional amount of approximately $262.0 million.  The fair value of the forward commitments to sell mortgage loans at September 30, 2016 included a loss of $859,000 that is reported as a component of other liabilities on the Company's consolidated statement of financial condition.  The fair value of the interest rate locks at September 30, 2016 included a gain of $4.2 million that is reported as a component of other assets on the Company's consolidated statements of financial condition.

In determining the fair value of its derivative loan commitments, the Company considers the value that would be generated by the loan arising from exercise of the loan commitment when sold in the secondary mortgage market. That value includes the price that the loan is expected to be sold for in the secondary mortgage market. The fair value of these commitments is recorded on the consolidated statements of financial condition with the changes in fair value recorded as a component of mortgage banking income.

Residential mortgage loans sold to others are predominantly conventional residential first lien mortgages. The Company's agreements to sell residential mortgage loans in the normal course of business usually require certain representations and warranties on the underlying loans sold related to credit information, loan documentation and collateral, which if subsequently are untrue or breached, could require the Company to repurchase certain loans affected. The Company has only been required to make insignificant repurchases as a result of breaches of these representations and warranties. The Company's agreements to sell residential mortgage loans also contain limited recourse provisions. The recourse provisions are limited in that the recourse provision ends after certain payment criteria have been met. With respect to these loans, repurchase could be required if defined delinquency issues arose during the limited recourse period. Given that the underlying loans delivered to buyers are predominantly conventional first lien mortgages and that historical experience shows negligible losses and insignificant repurchase activity, management believes that losses and repurchases under the limited recourse provisions will continue to be insignificant.


Note 13 – Earnings Per Share

Earnings per share are computed using the two-class method. Basic earnings per share is computed by dividing net income allocated to common shares by the weighted average number of common shares outstanding during the applicable period, excluding outstanding participating securities. Participating securities include unvested restricted stock awards. Unvested restricted stock awards issued in 2012 are considered participating securities because holders of these securities have the right to receive dividends at the same rate as holders of the Company's common stock. Diluted earnings per share is computed by dividing net income by the weighted average number of common shares outstanding adjusted for the dilutive effect of all potential common shares.

Presented below are the calculations for basic and diluted earnings per share:

   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2016
   
2015
   
2016
   
2015
 
   
(In Thousands, except per share amounts)
 
                         
Net income
 
$
7,505
   
$
5,199
   
$
19,133
   
$
13,498
 
Net income available to unvested restricted shares
   
5
     
6
     
12
     
15
 
Net income available to common stockholders
 
$
7,500
   
$
5,193
   
$
19,121
   
$
13,483
 
                                 
Weighted average shares outstanding
   
27,043
     
27,490
     
26,976
     
29,882
 
Effect of dilutive potential common shares
   
386
     
305
     
307
     
263
 
Diluted weighted average shares outstanding
   
27,429
     
27,795
     
27,283
     
30,145
 
                                 
Basic earnings per share
 
$
0.28
   
$
0.19
   
$
0.71
   
$
0.45
 
Diluted earnings per share
 
$
0.27
   
$
0.19
   
$
0.70
   
$
0.45
 

- 22 -

Note 14 – Fair Value Measurements

ASC Topic 820, "Fair Value Measurements and Disclosures" defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This accounting standard applies to reported balances that are required or permitted to be measured at fair value under existing accounting pronouncements. The standard also emphasizes that fair value (i.e., the price that would be received in an orderly transaction that is not a forced liquidation or distressed sale at the measurement date), among other things, is based on exit price versus entry price, should include assumptions about risk such as nonperformance risk in liability fair values, and is a market-based measurement, not an entity-specific measurement. When considering the assumptions that market participants would use in pricing the asset or liability, this accounting standard establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity's own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).

The fair value hierarchy prioritizes inputs used to measure fair value into three broad levels.

Level 1 inputs - In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities that we have the ability to access.

Level 2 inputs - Fair values determined by Level 2 inputs use inputs other than quoted prices included in Level 1 inputs that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets where there are few transactions and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs - Level 3 inputs are unobservable inputs for the asset or liability and include situations where there is little, if any, market activity for the asset or liability.

In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company's assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

The following table presents information about our assets recorded in our consolidated statement of financial position at their fair value on a recurring basis as of September 30, 2016 and December 31, 2015, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value.

         
Fair Value Measurements Using
 
   
September 30, 2016
   
Level 1
   
Level 2
   
Level 3
 
   
(In Thousands)
 
                         
Available for sale securities
                       
Mortgage-backed securities
 
$
80,782
   
$
-
   
$
80,782
   
$
-
 
Collateralized mortgage obligations
                               
Government sponsored enterprise issued
   
63,763
     
-
     
63,763
     
-
 
Government sponsored enterprise bonds
   
3,765
     
-
     
3,765
     
-
 
Municipal securities
   
78,465
     
-
     
78,465
     
-
 
Other debt securities
   
16,892
     
2,516
     
14,376
     
-
 
Certificates of deposit
   
1,729
     
-
     
1,729
     
-
 
Loans held for sale
   
227,765
     
-
     
227,765
     
-
 
Mortgage banking derivative assets
   
4,160
     
-
     
-
     
4,160
 
Mortgage banking derivative liabilities
   
859
     
-
     
-
     
859
 

         
Fair Value Measurements Using
 
   
December 31, 2015
   
Level 1
   
Level 2
   
Level 3
 
   
(In Thousands)
 
                         
Available for sale securities
                       
Mortgage-backed securities
 
$
96,667
   
$
-
   
$
96,667
   
$
-
 
Collateralized mortgage obligations
                               
Government sponsored enterprise issued
   
70,428
     
-
     
70,428
     
-
 
Government sponsored enterprise bonds
   
3,746
     
-
     
3,746
     
-
 
Municipal securities
   
79,159
     
-
     
79,159
     
-
 
Other debt securities
   
16,963
     
2,600
     
14,363
     
-
 
Certificates of deposit
   
2,695
     
-
     
2,695
     
-
 
Loans held for sale
   
166,516
     
-
     
166,516
     
-
 
Mortgage banking derivative assets
   
2,313
     
-
     
-
     
2,313
 
Mortgage banking derivative liabilities
   
125
     
-
     
-
     
125
 

- 23 -

The following summarizes the valuation techniques for assets recorded in our consolidated statements of financial condition at their fair value on a recurring basis:

Available for sale securities – The Company's investment securities classified as available for sale include: mortgage-backed securities, collateralized mortgage obligations, government sponsored enterprise bonds, municipal securities and other debt securities. The fair value of mortgage-backed securities, collateralized mortgage obligations and government sponsored enterprise bonds are determined by a third party valuation source using observable market data utilizing a matrix or multi-dimensional relational pricing model. Standard inputs to these models include observable market data such as benchmark yields, reported trades, broker quotes, issuer spreads, benchmark securities, prepayment models and bid/offer market data. For securities with an early redemption feature, an option adjusted spread model is utilized to adjust the issuer spread. These model and matrix measurements are classified as Level 2 in the fair value hierarchy. The fair value of municipal securities is determined by a third party valuation source using observable market data utilizing a multi-dimensional relational pricing model. Standard inputs to this model include observable market data such as benchmark yields, reported trades, broker quotes, rating updates and issuer spreads. These model measurements are classified as Level 2 in the fair value hierarchy. The fair value of other debt securities, which includes a trust preferred security issued by a financial institution, is determined through quoted prices in active markets and is classified as Level 1 in the fair value hierarchy.

Loans held for sale – The Company carries loans held for sale at fair value under the fair value option model. Fair value is generally determined by estimating a gross premium or discount, which is derived from pricing currently observable in the secondary market, principally from observable prices for forward sale commitments. Loans held-for-sale are considered to be Level 2 in the fair value hierarchy of valuation techniques.

Mortgage banking derivatives - Mortgage banking derivatives include interest rate lock commitments to originate residential loans held for sale to individual customers and forward commitments to sell residential mortgage loans to various investors. The Company utilizes a valuation model to estimate the fair value of its interest rate lock commitments to originate residential mortgage loans held for sale, which includes applying a pull through rate based upon historical experience and the current interest rate environment and then multiplying by quoted investor prices. The Company also utilizes a valuation model to estimate the fair value of its forward commitments to sell residential loans, which includes matching specific terms and maturities of the forward commitments against applicable investor pricing available. While there are Level 2 and 3 inputs used in the valuation models, the Company has determined that one or more of the inputs significant in the valuation of both of the mortgage banking derivatives fall within Level 3 of the fair value hierarchy.

The table below presents reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during 2016 and 2015.

   
Mortgage banking
derivatives, net
 
   
(In Thousands)
 
       
Balance at December 31, 2014
 
$
999
 
         
Mortgage derivative gain, net
   
1,189
 
Balance at December 31, 2015
 
$
2,188
 
         
Mortgage derivative gain, net
   
1,113
 
Balance at September 30, 2016
 
$
3,301
 


There were no transfers in or out of Level 1, 2 or 3 measurements during the periods.

Assets Recorded at Fair Value on a Non-recurring Basis

The following tables present information about our assets recorded in our consolidated statement of financial position at their fair value on a non-recurring basis as of September 30, 2016 and December 31, 2015, and indicate the fair value hierarchy of the valuation techniques utilized to determine such fair value.

         
Fair Value Measurements Using
 
   
September 30, 2016
   
Level 1
   
Level 2
   
Level 3
 
   
(In Thousands)
 
Impaired loans, net (1)
 
$
3,011
   
$
-
   
$
-
   
$
3,011
 
Real estate owned
   
7,454
     
-
     
-
     
7,454
 
Impaired mortgage servicing rights
   
1,149
     
-
     
-
     
1,149
 

         
Fair Value Measurements Using
 
   
December 31, 2015
   
Level 1
   
Level 2
   
Level 3
 
   
(In Thousands)
 
Impaired loans, net (1)
 
$
8,024
   
$
-
   
$
-
   
$
8,024
 
Real estate owned
   
9,190
     
-
     
-
     
9,190
 

(1) Represents collateral-dependent impaired loans, net, which are included in loans.

- 24 -

Loans – We do not record loans at fair value on a recurring basis. On a non-recurring basis, loans determined to be impaired are analyzed to determine whether a collateral shortfall exists, and if such a shortfall exists, are recorded on our consolidated statements of financial condition at net realizable value of the underlying collateral. Fair value is determined based on third party appraisals. Appraised values are adjusted to consider disposition costs and also to take into consideration the age of the most recent appraisal. Given the significance of the adjustments made to appraised values necessary to estimate the fair value of impaired loans, loans that have been deemed to be impaired are considered to be Level 3 in the fair value hierarchy of valuation techniques. At September 30, 2016, loans determined to be impaired with an outstanding balance of $3.7 million were carried net of specific reserves of $683,000 for a fair value of $3.0 million. At December 31, 2015, loans determined to be impaired with an outstanding balance of $9.6 million were carried net of specific reserves of $1.6 million for a fair value of $8.0 million. Impaired loans collateralized by assets which are valued in excess of the net investment in the loan do not require any specific reserves.

Real estate owned – On a non-recurring basis, real estate owned, is recorded in our consolidated statements of financial condition at the lower of cost or fair value. Fair value is determined based on third party appraisals and, if less than the carrying value of the foreclosed loan, the carrying value of the real estate owned is adjusted to the fair value. Appraised values are adjusted to consider disposition costs and also to take into consideration the age of the most recent appraisal. Given the significance of the adjustments made to appraised values necessary to estimate the fair value of the properties, real estate owned is considered to be Level 3 in the fair value hierarchy of valuation techniques. Changes in the value of real estate owned totaled $416,000 and $1.5 million during the nine months ended September 30, 2016 and 2015, respectively and are recorded in real estate owned expense. At September 30, 2016 and December 31, 2015, real estate owned totaled $7.5 million and $9.2 million, respectively.

Mortgage servicing rights - The Company utilizes an independent valuation from a third party which uses a discounted cash flow model to estimate the fair value of mortgage servicing rights.  The model utilizes prepayment assumptions to project cash flows related to the mortgage servicing rights based upon the current interest rate environment, which is then discounted to estimate an expected fair value of the mortgage servicing rights. The model considers characteristics specific to the underlying mortgage portfolio, such as: contractually specified servicing fees, prepayment assumptions, delinquency rates, late charges and costs to service.  Given the significance of the unobservable inputs utilized in the estimation process, mortgage servicing rights are classified as Level 3 within the fair value hierarchy.  The Company records the mortgage servicing rights at the lower of amortized cost or fair value.  At September 30, 2016, the Company determined that $1.1 million of mortgage servicing rights were temporarily impaired, and as a result, recorded an impairment valuation allowance of $100,000.  At December 31, 2015, there was no impairment identified for mortgage servicing rights.

For Level 3 assets and liabilities measured at fair value on a recurring or non-recurring basis as of September 30, 2016, the significant unobservable inputs used in the fair value measurements were as follows:

             
Significant Unobservable
Input Value
 
   
Fair Value at
September 30, 2016
 
Valuation
Technique
Significant
Unobservable
Inputs
 
Minimum
Value
   
Maximum
Value
 
                       
Mortgage banking derivatives
 
$
3,301
 
Pricing models
Pull through rate
   
52.2
%
   
99.9
%
Impaired loans
   
3,011
 
Market approach
Discount rates applied to appraisals
   
15.0
%
   
30.0
%
Real estate owned
   
7,454
 
Market approach
Discount rates applied to appraisals
   
5.6
%
   
85.7
%
Impaired mortgage servicing rights
   
1,149
 
Pricing models
Prepayment rate
   
7.0
%
   
36.7
%
              
Discount rate
   
10.0
%
   
12.0
%
              
Cost to service
 
$
75.93
   
$
571.61
 

The significant unobservable input used in the fair value measurement of the Company's mortgage banking derivatives, including interest rate lock commitments, is the loan pull through rate. This represents the percentage of loans currently in a lock position which the Company estimates will ultimately close. Generally, the fair value of an interest rate lock commitment will be positively (negatively) impacted when the prevailing interest rate is lower (higher) than the interest rate lock commitment. Generally, an increase in the pull through rate will result in the fair value of the interest rate lock increasing when in a gain position, or decreasing when in a loss position. The pull through rate is largely dependent on the loan processing stage that a loan is currently in and the change in prevailing interest rates from the time of the rate lock. The pull through rate is computed using historical data and the ratio is periodically reviewed by the Company.

The significant unobservable inputs used in the fair value measurement of collateral for collateral-dependent impaired loans and real estate owned included in the above table primarily relate to discounting criteria applied to independent appraisals received with respect to the collateral. Discounts applied to the appraisals are dependent on the vintage of the appraisal as well as the marketability of the property. The discount factor is computed using actual realization rates on properties that have been foreclosed upon and liquidated in the open market.

The significant unobservable inputs used in the fair value measurement of mortgage servicing rights include the prepayment rate, discount rate and cost to service.  The prepayment rate represents the assumed rate of prepayment of the outstanding principal balance of the underlying mortgage notes. Significant increases (decreases) in any of those inputs in isolation could result in a significantly lower (higher) fair value measurement. Although the prepayment rate and discount rate are not directly interrelated, they will generally move in opposite directions.

- 25 -

Fair value information about financial instruments follows, whether or not recognized in the consolidated statements of financial condition, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. Certain financial instruments and all nonfinancial instruments are excluded from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.
The carrying amounts and fair values of the Company's financial instruments consist of the following:

   
September 30, 2016
   
December 31, 2015
 
   
Carrying
amount
   
Fair Value
   
Carrying
amount
   
Fair Value
 
   
Total
   
Level 1
   
Level 2
   
Level 3
   
Total
   
Level 1
   
Level 2
   
Level 3
 
   
(In Thousands)
 
Financial Assets
                                                           
Cash and cash equivalents
 
$
54,320
   
$
54,320
   
$
44,570
   
$
9,750
   
$
-
   
$
100,471
   
$
100,471
   
$
100,471
   
$
-
   
$
-
 
Securities available-for-sale
   
245,396
     
245,396
     
2,516
     
242,880
     
-
     
269,658
     
269,658
     
2,600
     
267,058
     
-
 
Loans held for sale
   
227,765
     
227,765
     
-
     
227,765
     
-
     
166,516
     
166,516
     
-
     
166,516
     
-
 
Loans receivable
   
1,151,696
     
1,191,520
     
-
     
-
     
1,191,520
     
1,114,934
     
1,165,370
     
-
     
-
     
1,165,370
 
FHLB stock
   
12,600
     
12,600
     
-
     
12,600
     
-
     
19,500
     
19,500
     
-
     
19,500
     
-
 
Accrued interest receivable
   
4,312
     
4,312
     
4,312
     
-
     
-
     
4,108
     
4,108
     
4,108
     
-
     
-
 
Mortgage servicing rights
   
2,396
     
2,414
     
-
     
-
     
2,414
     
1,422
     
1,658
     
-
     
-
     
1,658
 
Mortgage banking derivative assets
   
4,160
     
4,160
     
-
     
-
     
4,160
     
2,313
     
2,313
     
-
     
-
     
2,313
 
                                                                                 
Financial Liabilities
                                                                               
Deposits
   
955,648
     
956,041
     
268,344
     
687,697
     
-
     
893,361
     
894,015
     
243,304
     
650,711
     
-
 
Advance payments by borrowers for taxes
   
25,268
     
25,268
     
25,268
     
-
     
-
     
3,661
     
3,661
     
3,661
     
-
     
-
 
Borrowings
   
377,983
     
383,180
     
-
     
383,180
     
-
     
441,203
     
463,238
     
-
     
463,238
     
-
 
Accrued interest payable
   
1,027
     
1,027
     
1,027
     
-
     
-
     
1,642
     
1,642
     
1,642
     
-
     
-
 
Mortgage banking derivative liabilities
   
859
     
859
     
-
     
-
     
859
     
125
     
125
     
-
     
-
     
125
 

The following methods and assumptions were used by the Company in determining its fair value disclosures for financial instruments.

Cash and Cash Equivalents

The carrying amount reported in the consolidated statements of financial condition for cash and cash equivalents is a reasonable estimate of fair value.

Securities

The fair value of securities is generally determined by a third party valuation source using observable market data utilizing a matrix or multi-dimensional relational pricing model. Standard inputs to these models include observable market data such as benchmark yields, reported trades, broker quotes, issuer spreads, benchmark securities and bid/offer market data. For securities with an early redemption feature, an option adjusted spread model is utilized to adjust the issuer spread. Prepayment models are used for mortgage related securities with prepayment features.

Loans Held for Sale

Fair value is estimated using the prices of the Company's existing commitments to sell such loans and/or the quoted market price for commitments to sell similar loans.

Loans Receivable

Loans determined to be impaired are analyzed to determine whether a collateral shortfall exists, and if such a shortfall exists, are recorded on our consolidated statements of financial condition at fair value. Fair value is determined based on third party appraisals. Appraised values are adjusted to consider disposition costs and also to take into consideration the age of the most recent appraisal. With respect to loans that are not considered to be impaired, fair value is estimated by discounting the future contractual cash flows using discount rates that reflect a current rate offered to borrowers of similar credit standing for the remaining term to maturity. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC 820-10 and generally produces a higher fair value.

- 26 -

FHLB Stock

For FHLB stock, the carrying amount is the amount at which shares can be redeemed with the FHLB and is a reasonable estimate of fair value.

Deposits and Advance Payments by Borrowers for Taxes

The fair values for interest-bearing and noninterest-bearing negotiable order of withdrawal accounts, savings accounts, and money market accounts are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates of similar remaining maturities to a schedule of aggregated expected monthly maturities of the outstanding certificates of deposit. The advance payments by borrowers for taxes are equal to their carrying amounts at the reporting date.

Borrowings

Fair values for borrowings are estimated using a discounted cash flow calculation that applies current interest rates to estimated future cash flows of the borrowings.

Accrued Interest Payable and Accrued Interest Receivable

For accrued interest payable and accrued interest receivable, the carrying amount is a reasonable estimate of fair value.

Commitments to Extend Credit and Standby Letters of Credit

Commitments to extend credit and standby letters of credit are generally not marketable. Furthermore, interest rates on any amounts drawn under such commitments would be generally established at market rates at the time of the draw. Fair values for the Company's commitments to extend credit and standby letters of credit are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the counterparty's credit standing, and discounted cash flow analyses. The fair value of the Company's commitments to extend credit was not material at September 30, 2016 and December 31, 2015.

Mortgage Banking Derivative Assets and Liabilities

Mortgage banking derivatives include interest rate lock commitments to originate residential loans held for sale to individual customers and forward commitments to sell residential mortgage loans to various investors. The Company relies on a valuation model to estimate the fair value of its interest rate lock commitments to originate residential mortgage loans held for sale, which includes applying a pull through rate based upon historical experience and the current interest rate environment, and then multiplying by quoted investor prices. The Company also relies on a valuation model to estimate the fair value of its forward commitments to sell residential loans, which includes matching specific terms and maturities of the forward commitments against applicable investor pricing available. On the Company's Consolidated Statements of Condition, instruments that have a positive fair value are included in prepaid expenses and other assets, and those instruments that have a negative fair value are included in other liabilities.

 
 
 
 
 
 
- 27 -

Note 15 – Segment Reporting

Selected financial and descriptive information is required to be provided about reportable operating segments, considering a "management approach" concept as the basis for identifying reportable segments. The management approach is based on the way that management organizes the segments within the enterprise for making operating decisions, allocating resources, and assessing performance. Consequently, the segments are evident from the structure of the enterprise's internal organization, focusing on financial information that an enterprise's chief operating decision-makers use to make decisions about the enterprise's operating matters.

The Company has determined that it has two reportable segments: community banking and mortgage banking. The Company's operating segments are presented based on its management structure and management accounting practices. The structure and practices are specific to the Company and therefore, the financial results of the Company's business segments are not necessarily comparable with similar information for other financial institutions.

Community Banking

The community banking segment provides consumer and business banking products and services to customers primarily within Southeastern Wisconsin along with a loan production office in Minneapolis, Minnesota.  Within this segment, the following products and services are provided:  (1) lending solutions such as residential mortgages, home equity loans and lines of credit, personal and installment loans, real estate financing, business loans, and business lines of credit; (2) deposit and transactional solutions such as checking, credit, debit and pre-paid cards, online banking and bill pay, and money transfer services; (3) investable funds solutions such as savings, money market deposit accounts, IRA accounts, certificates of deposit, and (4) fixed and variable annuities, insurance as well as trust and investment management accounts.

Consumer products include loan and deposit products: mortgage, home equity loans and lines, personal term loans, demand deposit accounts, interest bearing transaction accounts and time deposits. Consumer products also include personal investment services. Business banking products include secured and unsecured lines and term loans for working capital, inventory and general corporate use, commercial real estate construction loans, demand deposit accounts, interest bearing transaction accounts and time deposits.

Mortgage Banking

The mortgage banking segment provides residential mortgage loans for the primary purpose of sale on the secondary market. Mortgage banking products and services are provided by offices in 23 states.



   
As of or for the three months ended September 30, 2016
 
   
Community
Banking
   
Mortgage
Banking
   
Holding Company and
Other
   
Consolidated
 
   
(In Thousands)
 
                         
Net interest income
 
$
11,244
   
$
10
   
$
71
   
$
11,325
 
Provision for loan losses
   
100
     
35
     
-
     
135
 
Net interest income after provision for loan losses
   
11,144
     
(25
)
   
71
     
11,190
 
                                 
Noninterest income
   
1,658
     
36,124
     
(370
)
   
37,412
 
                                 
Noninterest expenses:
                               
Compensation, payroll taxes, and other employee benefits
   
4,392
     
23,295
     
(114
)
   
27,573
 
Occupancy, office furniture and equipment
   
740
     
1,579
     
-
     
2,319
 
FDIC insurance premiums
   
140
     
-
     
-
     
140
 
Real estate owned
   
37
     
-
     
-
     
37
 
Other
   
1,252
     
4,453
     
(233
)
   
5,472
 
Total noninterest expenses
   
6,561
     
29,327
     
(347
)
   
35,541
 
Income before income taxes
   
6,241
     
6,772
     
48
     
13,061
 
Income tax expense
   
2,107
     
2,767
     
682
     
5,556
 
Net income (loss)
 
$
4,134
   
$
4,005
   
$
(634
)
 
$
7,505
 
                                 
Total assets
 
$
1,777,014
   
$
259,636
   
$
(241,615
)
 
$
1,795,035
 


- 28 -

   
As of or for the three months ended September 30, 2015
 
   
Community
Banking
   
Mortgage
Banking
   
Holding Company and
Other
   
Consolidated
 
   
(In Thousands)
 
                         
Net interest income
 
$
9,566
   
$
265
   
$
79
   
$
9,910
 
Provision for loan losses
   
500
     
80
     
-
     
580
 
Net interest income after provision for loan losses
   
9,066
     
185
     
79
     
9,330
 
                                 
Noninterest income
   
1,146
     
27,636
     
(231
)
   
28,551
 
                                 
Noninterest expenses:
                               
Compensation, payroll taxes, and other employee benefits
   
3,927
     
17,411
     
(104
)
   
21,234
 
Occupancy, office furniture and equipment
   
800
     
1,492
     
-
     
2,292
 
FDIC insurance premiums
   
243
     
-
     
-
     
243
 
Real estate owned
   
646
     
-
     
-
     
646
 
Other
   
1,171
     
4,235
     
(35
)
   
5,371
 
Total noninterest expenses
   
6,787
     
23,138
     
(139
)
   
29,786
 
Income (loss) before income taxes
   
3,425
     
4,683
     
(13
)
   
8,095
 
Income tax expense
   
962
     
1,917
     
17
     
2,896
 
Net income (loss)
 
$
2,463
   
$
2,766
   
$
(30
)
 
$
5,199
 
                                 
Total assets
 
$
1,724,714
   
$
176,341
   
$
(156,346
)
 
$
1,744,709
 


   
As of or for the nine months ended September 30, 2016
 
   
Community
Banking
   
Mortgage
Banking
   
Holding Company and
Other
   
Consolidated
 
   
(In Thousands)
 
                         
Net interest income
 
$
30,977
   
$
287
   
$
209
   
$
31,473
 
Provision for loan losses
   
200
     
140
     
-
     
340
 
Net interest income after provision for loan losses
   
30,777
     
147
     
209
     
31,133
 
                                 
Noninterest income
   
3,583
     
92,457
     
(832
)
   
95,208
 
                                 
Noninterest expenses:
                               
Compensation, payroll taxes, and other employee benefits
   
12,784
     
58,526
     
(342
)
   
70,968
 
Occupancy, office furniture and equipment
   
2,388
     
4,686
     
-
     
7,074
 
FDIC insurance premiums
   
500
     
-
     
-
     
500
 
Real estate owned
   
344
     
-
     
-
     
344
 
Other
   
3,705
     
12,790
     
(387
)
   
16,108
 
Total noninterest expenses
   
19,721
     
76,002
     
(729
)
   
94,994
 
Income before income taxes
   
14,639
     
16,602
     
106
     
31,347
 
Income tax expense
   
4,711
     
6,797
     
706
     
12,214
 
Net income (loss)
 
$
9,928
   
$
9,805
   
$
(600
)
 
$
19,133
 

   
As of or for the nine months ended September 30, 2015
 
   
Community
Banking
   
Mortgage
Banking
   
Holding Company and
Other
   
Consolidated
 
         
(In Thousands)
       
                         
Net interest income
 
$
28,541
   
$
615
   
$
250
   
$
29,406
 
Provision for loan losses
   
1,450
     
270
     
-
     
1,720
 
Net interest income after provision for loan losses
   
27,091
     
345
     
250
     
27,686
 
                                 
Noninterest income
   
2,824
     
79,193
     
(393
)
   
81,624
 
                                 
Noninterest expenses:
                               
Compensation, payroll taxes, and other employee benefits
   
12,462
     
50,438
     
(316
)
   
62,584
 
Occupancy, office furniture and equipment
   
2,447
     
4,557
     
-
     
7,004
 
FDIC insurance premiums
   
851
     
-
     
-
     
851
 
Real estate owned
   
1,860
     
15
     
-
     
1,875
 
Other
   
3,275
     
12,434
     
138
     
15,847
 
Total noninterest expenses
   
20,895
     
67,444
     
(178
)
   
88,161
 
Income before income taxes
   
9,020
     
12,094
     
35
     
21,149
 
Income tax expense
   
2,544
     
5,018
     
89
     
7,651
 
Net income (loss)
 
$
6,476
   
$
7,076
   
$
(54
)
 
$
13,498
 


- 29 -

Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Information

This Form 10-Q may contain various forward-looking statements, which can be identified by the use of words such as "estimate," "project," "believe," "intend," "anticipate," "plan," "seek," "expect" and similar expressions and verbs in the future tense. These forward-looking statements include, but are not limited to:


 
Statements of our goals, intentions and expectations;
 
Statements regarding our business plans, prospects, growth and operating strategies;
 
Statements regarding the quality of our loan and investment portfolio;
 
Estimates of our risks and future costs and benefits.


These forward-looking statements are based on current beliefs and expectations of our management and are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change.

The following factors, among others, could cause actual results to differ materially from the anticipated results or other expectations expressed in the forward-looking statements:


 
general economic conditions, either nationally or in our market area, that are worse than expected;
 
competition among depository and other financial institutions;
 
inflation and changes in the interest rate environment that reduce our margins and yields, our mortgage banking revenues, the fair value of financial instruments or the origination levels in our lending business, or increase the level of defaults, losses or prepayments on loans we have made and make whether held in portfolio or sold in the secondary markets;
 
adverse changes in the securities or secondary mortgage markets;
 
changes in laws or government regulations or policies affecting financial institutions, including changes in regulatory fees and capital requirements;
 
our ability to manage market risk, credit risk and operational risk in the current economic conditions;
 
our ability to enter new markets successfully and capitalize on growth opportunities;
 
our ability to successfully integrate acquired entities;
 
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, the Securities and Exchange Commission or the Public Company Accounting Oversight Board;
 
our ability to retain key employees;
 
significant increases in our loan losses; and
 
changes in the financial condition, results of operations or future prospects of issuers of securities that we own.


See also the factors referred to in reports filed by the Company with the Securities and Exchange Commission (particularly those under the caption "Risk Factors" in Item 1A of the Company's Annual Report on Form 10-K for the year ended December 31, 2015).


Overview

The following discussion and analysis is presented to assist the reader in understanding and evaluating of the Company's financial condition and results of operations. It is intended to complement the unaudited consolidated financial statements, footnotes, and supplemental financial data appearing elsewhere in this Form 10-Q and should be read in conjunction therewith. The detailed discussion in the sections below focuses on the results of operations for the three and nine months ended September 30, 2016 and 2015 and the financial condition as of September 30, 2016 compared to the financial condition as of December 31, 2015.
As described in the notes to consolidated financial statements, we have two reportable segments: community banking and mortgage banking. The community banking segment provides consumer and business banking products and services to customers. Consumer products include loan products, deposit products, and personal investment services. Business banking products include loans for working capital, inventory and general corporate use, commercial real estate construction loans, and deposit accounts.  The mortgage banking segment, which is conducted through Waterstone Mortgage Corporation, consists of originating residential mortgage loans primarily for sale in the secondary market.

- 30 -

Our community banking segment generates the significant majority of our consolidated net interest income and requires the significant majority of our provision for loan losses. Our mortgage banking segment generates the significant majority of our noninterest income and a majority of our noninterest expenses. We have provided below a discussion of the material results of operations for each segment on a separate basis for the three and nine months ended September 30, 2016 and 2015, which focuses on noninterest income and noninterest expenses. We have also provided a discussion of the consolidated operations of Waterstone Financial, which includes the consolidated operations of the Bank and Waterstone Mortgage Corporation, for the same periods.

Comparison of Community Banking Segment Results of Operations for the Three Months Ended September 30, 2016 and 2015

Net income for the three months ended September 30, 2016 totaled $4.1 million compared to net income of $2.5 million for the three months ended September 30, 2015. Net interest income increased $1.7 million to $11.2 million for the three months ended September 30, 2016 compared to $9.6 million for the three months ended September 30, 2015. The provision for loan losses decreased $400,000 compared to the prior year comparable period. Noninterest income increased $512,000 as loan prepayment fees increased.  Compensation, payroll taxes, and other employee benefits expense increased due primarily to increases in health insurance costs and ESOP expense. The Bank also reported an increase in other noninterest expense for the three months ended September 30, 2016 compared to the three months ended September 30, 2015.  Occupancy, office furniture, and equipment expense, FDIC insurance premiums, and real estate owned expense decreased for the third quarter of 2016 compared to the previous year period. FDIC insurance premiums and real estate owned expense decreased as a direct result of improved asset quality metrics.

Comparison of Mortgage Banking Segment Results of Operations for the Three Months Ended September 30, 2016 and 2015

Net income totaled $4.0 million for the three months ended September 30, 2016 compared to net income of $2.8 million for the three months ended September 30, 2015. Mortgage banking segment revenue increased $8.5 million, or 30.7%, to $36.1 million for the three months ended September 30, 2016 compared to $27.6 million for the three months ended September 30, 2015. The increase in revenue was attributable to an increase in origination volume and an increase in margin. While mortgage segment revenue increased 30.7%, total noninterest expenses increased $6.2 million, or 26.7%, to $29.3 million for the three months ended September 30, 2016 compared to $23.1 million for the three months ended September 30, 2015. The increase in noninterest expenses resulted from an increase in commissions paid, which correlates to the increase in origination volume, resulting in $5.9 million additional compensation, payroll taxes, and other employee benefits expense.

Loans originated by the mortgage banking segment for the purpose of sale in the secondary market increased $160.1 million, or 29.1%, to $710.1 million during the three months ended September 30, 2016, compared to $550.0 million for the three months ended September 30, 2015. The increase in originations was driven by an increase in the origination of loans made for the purpose of residential purchases, which yield a higher margin than refinance loans, along with an increase in the origination of mortgage refinance loans. Our origination efforts continue to be focused on loans made for the purpose of residential purchases, as opposed to mortgage refinance. The percentage of origination volume related to purchase activity decreased slightly to 82% from 88% of total originations for the three months ended September 30, 2016 and 2015, respectively.  However, origination volume related to purchase activity still increased for the three months ended September 30, 2016 and 2015, respectively, as overall volumes increased.



Consolidated Waterstone Financial, Inc. Results of Operations

   
Three months ended September 30,
 
   
2016
   
2015
 
   
(Dollars in Thousands, except per share amounts)
 
             
Net income
 
$
7,505
     
5,199
 
Earnings per share - basic
   
0.28
     
0.19
 
Earnings per share - diluted
   
0.27
     
0.19
 
Annualized return on average assets
   
1.66
%
   
1.18
%
Annualized return on average equity
   
7.36
%
   
5.21
%
                 


- 31 -

Net Interest Income

Average Balance Sheets, Interest and Yields/Costs
The following tables set forth average balance sheets, annualized average yields and costs, and certain other information for the periods indicated. Non-accrual loans are included in the computation of the average balances of loans receivable and held for sale. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense. Yields on interest-earning assets are computed on a fully tax-equivalent yield, where applicable.

   
Three months ended September 30,
 
   
2016
   
2015
 
   
Average Balance
   
Interest
   
Yield/Cost
   
Average Balance
   
Interest
   
Yield/Cost
 
   
(Dollars in Thousands)
 
Assets
                                   
Interest-earning assets:
                                   
Loans receivable and held for sale (1)
 
$
1,333,666
   
$
14,754
     
4.40
%
 
$
1,243,879
   
$
14,117
     
4.50
%
Mortgage related securities (2)
   
150,790
     
743
     
1.96
%
   
165,839
     
792
     
1.89
%
Debt securities, federal funds sold and short-term investments (2)(3)
   
186,201
     
1,034
     
2.21
%
   
234,102
     
1,115
     
1.89
%
Total interest-earning assets
   
1,670,657
     
16,531
     
3.94
%
   
1,643,820
     
16,024
     
3.87
%
                                                 
Noninterest-earning assets
   
123,318
                     
98,224
                 
Total assets
 
$
1,793,975
                   
$
1,742,044
                 
                                                 
Liabilities and equity
                                               
Interest-bearing liabilities:
                                               
Demand accounts
 
$
35,066
     
5
     
0.06
%
 
$
31,980
     
5
     
0.06
%
Money market and savings accounts
   
176,582
     
97
     
0.22
%
   
152,346
     
59
     
0.15
%
Time deposits
   
685,969
     
1,821
     
1.06
%
   
641,064
     
1,476
     
0.91
%
Total interest-bearing deposits
   
897,617
     
1,923
     
0.85
%
   
825,390
     
1,540
     
0.74
%
Borrowings
   
374,730
     
3,082
     
3.27
%
   
434,943
     
4,345
     
3.96
%
Total interest-bearing liabilities
   
1,272,347
     
5,005
     
1.56
%
   
1,260,333
     
5,885
     
1.85
%
                                                 
Noninterest-bearing liabilities
                                               
Noninterest-bearing deposits
   
80,407
                     
65,016
                 
Other noninterest-bearing liabilities
   
35,331
                     
21,099
                 
Total noninterest-bearing liabilities
   
115,738
                     
86,115
                 
Total liabilities
   
1,388,085
                     
1,346,448
                 
Equity
   
405,890
                     
395,596
                 
Total liabilities and equity
 
$
1,793,975
                   
$
1,742,044
                 
                                                 
Net interest income / Net interest rate spread (4)
           
11,526
     
2.38
%
           
10,139
     
2.02
%
Less: taxable equivalent adjustment
           
201
     
0.05
%
           
229
     
0.06
%
Net interest income / Net interest rate spread, as reported
         
$
11,325
     
2.33
%
         
$
9,910
     
1.96
%
Net interest-earning assets (5)
 
$
398,310
                   
$
383,487
                 
Net interest margin (6)
                   
2.70
%
                   
2.39
%
Tax equivalent effect
                   
0.04
%
                   
0.06
%
Net interest margin on a fully tax equivalent basis (6)
                   
2.74
%
                   
2.45
%
Average interest-earning assets to average interest-bearing liabilities
                   
131.31
%
                   
130.43
%
__________
(1) Interest income includes net deferred loan fee amortization income of $229,000 and $139,000 for the three months ended September 30, 2016 and 2015, respectively.
(2) Average balance of mortgage related and debt securities are based on amortized historical cost.
(3) Interest income from tax exempt securities is computed on a taxable equivalent basis using a tax rate of 35% for all periods presented. The yields on debt securities, federal funds sold and short-term investments before tax-equivalent adjustments were 1.78% and 1.50% for the three months ended September 30, 2016 and 2015, respectively.
(4) Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average interest-bearing liabilities and is presented on a fully tax equivalent basis.
(5) Net interest-earning assets represent total interest-earning assets less total interest-bearing liabilities.
(6) Net interest margin represents net interest income divided by average total interest-earning assets.


- 32 -

Rate/Volume Analysis

The following table sets forth the effects of changing rates and volumes on our net interest income for the periods indicated.  The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume).  The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The net column represents the sum of the prior columns. For purposes of this table, changes attributable to changes in both rate and volume that cannot be segregated have been allocated proportionately based on the changes due to rate and the changes due to volume.

   
Three months ended September 30,
 
   
2016 versus 2015
 
   
Increase (Decrease) due to
 
   
Volume
   
Rate
   
Net
 
   
(In Thousands)
 
Interest income:
                 
Loans receivable and held for sale (1)(2)
 
$
967
   
$
(330
)
 
$
637
 
Mortgage related securities (3)
   
(75
)
   
26
     
(49
)
Other earning assets (3)(4)
   
(249
)
   
168
     
(81
)
Total interest-earning assets
   
643
     
(136
)
   
507
 
                         
Interest expense:
                       
Demand accounts
   
-
     
-
     
-
 
Money market and savings accounts
   
10
     
28
     
38
 
Time deposits
   
107
     
238
     
345
 
Total interest-earning deposits
   
117
     
266
     
383
 
Borrowings
   
(559
)
   
(704
)
   
(1,263
)
Total interest-bearing liabilities
   
(442
)
   
(438
)
   
(880
)
Net change in net interest income
 
$
1,085
   
$
302
   
$
1,387
 
______________
(1)
Interest income includes net deferred loan fee amortization income of $229,000 and $139,000 for the three months ended September 30, 2016 and 2015, respectively.
(2)   Non-accrual loans have been included in average loans receivable balance.
(3)   Includes available for sale securities. Average balance of available for sale securities is based on amortized historical cost.
(4)   Interest income from tax exempt securities is computed on a taxable equivalent basis using a tax rate of 35% for all periods presented.

Net interest income increased $1.4 million, or 14.3%, to $11.3 million during the three months ended September 30, 2016 compared to $9.9 million during the three months ended September 30, 2015.

·
Interest income on loans increased $637,000 due primarily to an increase of $89.8 million in average loans offset by a 10 basis point decrease in average yield on loans. The increase in average loan balance was driven by a $34.3 million increase in the average balance of loans held in portfolio along with a $55.5 million increase in the average balance of loans held for sale.
·
Interest income from mortgage-related securities decreased $49,000 year over year as the average balance decreased $15.0 million as securities have paid down in 2015 and 2016 and less purchases have occurred to replace those securities due to current market conditions, which was offset by an increase in rate.
·
Interest income from other interest earning assets (comprised of debt securities, federal funds sold and short-term investments) decreased $53,000 due to a decrease of $47.9 million in average balance, as municipal securities matured and were not replaced due to market conditions. Also, liquid funds were utilized to fund loan growth and pay off maturing FHLB advances. The decrease in interest income due to an decrease in average balance was partially offset by 28 basis point increase in the average yield. The increase in average yield was driven by a 25 basis point increase in the Federal Funds rate in December 2015, as well as an increase in the cash dividend paid by the FHLB on its stock.
·
Interest expense on time deposits increased $345,000 primarily due to a 15 basis point increase in the average cost of time deposits, as maturing time deposits have repriced or have been replaced at a higher rate in the current competitive market. In addition, to an increase in rate, the average balance of time deposits increased compared to the prior year, which reflects the Company's decision to raise funds through its retail delivery channels to pay off FHLB advances that matured during the first nine months of 2016.
·
Interest expense on money market and savings accounts increased $38,000 due to an increase in both rate and average balance. Increases in both rate and volume reflect the Company's strategy to target this segment of retail funds for more aggressive growth.
·
Interest expense on borrowings decreased $1.3 million due to the maturity of $220.0 million of fixed rate borrowings that were paid off during the current year with lower rate long term fixed borrowings and funds raised through our retail delivery channels.  A total of $220.0 million FHLB borrowings at a weighted average rate of 4.34% matured during 2016. The Company borrowed $100.0 million of long-term FHLB borrowings replaced the maturities in 2016 at a weighted average rate of 0.78%.  In addition to the long-term borrowings, a total of $50.0 million in short-term FHLB were utilized throughout and at the end of the three months ended September 30, 2016.


Provision for Loan Losses

Our provision for loan losses decreased $445,000 as a $135,000 provision was necessary during the three months ended September 30, 2016, compared to $580,000 during the three months ended September 30, 2015, as asset quality metrics continued to improve.  The provision for loan losses for the three months ended September 30, 2016 was primarily driven by growth in the loan portfolio.

The provision is primarily a function of the Company's reserving methodology and assessments of certain quantitative and qualitative factors which are used to determine an appropriate allowance for loan losses for the period.  See further discussion regarding the allowance for loan losses in the "Asset Quality" section for an analysis of charge-offs, nonperforming assets, specific reserves and additional provisions and the "Allowance for Loan Losses" section.

- 33 -

Noninterest Income
   
Three months ended September 30,
 
   
2016
   
2015
   
$ Change
   
% Change
 
   
(Dollars in Thousands)
 
                         
Service charges on loans and deposits
 
$
789
   
$
364
   
$
425
     
116.8
%
Increase in cash surrender value of life insurance
   
734
     
636
     
98
     
15.4
%
Mortgage banking income
   
35,552
     
26,708
     
8,844
     
33.1
%
Gain on sale of available for sale securities
   
-
     
-
     
-
     
N/
M
Other
   
337
     
843
     
(506
)
   
(60.0
)%
    Total noninterest income
 
$
37,412
   
$
28,551
   
$
8,861
     
31.0
%
                                 
N/M - Not meaningful
                               
                                 

Total noninterest income increased $8.9 million, or 31.0%, to $37.4 million during the three months ended September 30, 2016 compared to $28.6 million during the three months ended September 30, 2015. The increase resulted primarily from an increase in mortgage banking income.

·
Service charges on loans and deposits increased primarily due to a $407,000 increase in loan prepayment fees. This increase was driven by one significant relationship that paid off during the quarter.
·
The increase in cash surrender value of life insurance was due to the purchase of a $10.0 million policy in March 2016.
·
The increase in mortgage banking income was the result of an increase in origination volumes. The volume increased $160.1 million, or 29.1%, to $710.1 million during the three months ended September 30, 2016 compared to $550.0 million during the three months ended September 30, 2015. Along with the increase in origination volume, margin increased as higher margin purchase products performed well.
·
The $506,000 decrease in other noninterest income was due primarily to a decrease in gain on mortgage servicing rights sold.  There was a bulk sale of mortgage servicing rights which occurred during the three months ended September 30, 2015 and no sales occurred during the three months ended September 30, 2016.  In addition, certain loan products were sold and treated as a gain on mortgage servicing rights sold and included in other noninterest income in the prior year has been treated as mortgage banking income in the current year.


Noninterest Expenses
   
Three months ended September 30,
 
   
2016
   
2015
   
$ Change
   
% Change
 
   
(Dollars in Thousands)
 
                         
Compensation, payroll taxes, and other employee benefits
 
$
27,573
   
$
21,234
   
$
6,339
     
29.9
%
Occupancy, office furniture and equipment
   
2,319
     
2,292
     
27
     
1.2
%
Advertising
   
661
     
755
     
(94
)
   
(12.5
)%
Data processing
   
616
     
592
     
24
     
4.1
%
Communications
   
374
     
332
     
42
     
12.7
%
Professional fees
   
474
     
642
     
(168
)
   
(26.2
)%
Real estate owned
   
37
     
646
     
(609
)
   
(94.3
)%
FDIC insurance premiums
   
140
     
243
     
(103
)
   
(42.4
)%
Other
   
3,347
     
3,050
     
297
     
9.7
%
     Total noninterest expenses
 
$
35,541
   
$
29,786
   
$
5,755
     
19.3
%
                                 
                                 

Total noninterest expenses increased $5.8 million, or 19.3%, to $35.5 million during the three months ended September 30, 2016 compared to $29.8 million during the three months ended September 30, 2015.

·
Compensation, payroll taxes and other employee benefit expense increased $465,000, or 11.8%, at the community banking segment during the three months ended September 30, 2016. This was primarily due to health insurance being higher in 2016 from an increase in health claims and ESOP expense increasing with the increased stock price of the vested shares in the third quarter of 2016.
·
Compensation, payroll taxes and other employee benefit expense increased $5.9 million, or 33.8%, at our mortgage banking segment. An increase in loan origination activity resulted in more commission-based compensation for the quarter. Total compensation, payroll taxes and other employee benefits also increased at our mortgage banking segment as branch managers earned more with increased profitability and new branches were added. In addition to those increases, health insurance expense increased as a reimbursement for a significant claim was paid during the three months ended September 30, 2015.
·
Net real estate owned expense decreased $609,000, to $37,000 of expense during the three months ended September 30, 2016 compared to the three months ended September 30, 2015. Property management expense (other than gains/losses) decreased $435,000 during the three months ended September 30, 2016 compared to the three months ended September 30, 2015 due to a reduction in the number of properties under management during 2016. Net gains on sales of REO decreased $40,000 to $191,000 for the three months ended September 30, 2016 compared to $231,000 for the three months ended September 30, 2015. Real estate owned writedowns decreased $213,000 to $65,000 for the three months ended September 30, 2016 compared to $278,000 for the three months ended September 30, 2015.
·
FDIC insurance expense decreased during the three month period ended September 30, 2016. This was driven by a decrease in the FDIC assessment rate.
·
Other noninterest expense increased primarily due to increased expense at our mortgage banking segment associated with the increase of loan origination activity.


- 34 -

Income Taxes

Driven by an increase in pre-tax income, income tax expense increased $2.7 million, or 91.9%, to $5.6 million during the three months ended September 30, 2016, compared to $2.9 million during the three months ended September 30, 2015. Income tax expense was recognized during the three months ended September 30, 2016 at an effective rate of 42.5% compared to an effective rate of 35.8% during the three months ended September 30, 2015.  The increase in the effective rate was due to both an increase in pretax income, which minimizes the impact of tax deductions and tax-exempt income and the write off of a deferred tax asset.

Comparison of Community Banking Segment for the Nine Months Ended September 30, 2016 and 2015

Net income for the nine months ended September 30, 2016 totaled $9.9 million compared to net income of $6.5 million for the nine months ended September 30, 2015.  Net interest income increased $2.4 million to $31.0 million for the nine months ended September 30, 2016 compared to $28.5 million for the nine months ended September 30, 2015.  Provision for loan loss decreased $1.3 million as asset quality metrics continued to improve. Noninterest income increased $759,000 as loan prepayment fees increased.  Compensation, payroll taxes, and other employee benefits expense increased $322,000 primarily due to increases in health insurance and additional salary expense due to the two additional branches added in late 2015, offset by reduction in stock compensation expense that immediately vested the grant of stock awards during 2015. FDIC premiums and real estate owned expense decreased as asset quality improved and we experienced a reduction of foreclosured properties.  Those decreases were partially offset by an increase in other noninterest expense for the nine months ended September 30, 2016 compared to the nine months ended September 30, 2015.

Comparison of Mortgage Banking Segment Operations for the Nine Months Ended September 30, 2016 and 2015

Net income totaled $9.8 million for the nine months ended September 30, 2016, compared to $7.1 million during the nine months ended September 30, 2015.  Mortgage banking segment revenues increased $13.3 million, or 16.7%, to $92.5 million for the nine months ended September 30, 2016 compared to $79.2 million for the nine months ended September 30, 2015.  The increase in revenue was attributable to a 13.7% increase in volume origination to $1.76 billion during the nine months ended September 30, 2016 compared to $1.55 billion during the nine months ended September 30, 2015. While revenue increased 16.7%, noninterest expenses increased $8.6 million, or 12.7%, to $76.0 million for the nine months ended September 30, 2016 compared to $67.4 million for the nine months ended September 30, 2015.

Loans originated by the mortgage banking segment for the purpose of sale in the secondary market increased $211.4 million, or 13.7%, to $1.76 billion during the nine months ended September 30, 2016, compared to $1.55 billion for the nine months ended September 30, 2015.  The increase in originations was driven by an increase in the origination of loans made for the purpose of residential purchases, which yield a higher margin than refinance loans, along with an increase in the origination of mortgage refinance products.  Our origination efforts continue to be focused on loans made for the purpose of residential purchases, as opposed to mortgage refinance.  The percentage of origination volume related to purchase activity increased slightly to 85% from 84% of total originations for the nine months ended September 30, 2016 and 2015, respectively.

Consolidated Waterstone Financial, Inc. Results of Operations
   
Nine months ended September 30,
 
   
2016
   
2015
 
   
(Dollars in Thousands, except per share amounts)
 
             
Net income
 
$
19,133
   
$
13,498
 
Earnings per share - basic
   
0.71
     
0.45
 
Earnings per share - diluted
   
0.70
     
0.45
 
Annualized return on average assets
   
1.45
%
   
1.03
%
Annualized return on average equity
   
6.38
%
   
4.26
%
                 



 
 
 
 
- 35 -

Average Balance Sheets, Interest and Yields/Costs
The following tables set forth average balance sheets, annualized average yields and costs, and certain other information for the periods indicated.  Non-accrual loans are included in the computation of the average balances of loans receivable and held for sale.  The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense.  Yields on interest-earning assets are computed on a fully tax-equivalent yield, where applicable.

   
Nine months ended September 30,
 
   
2016
   
2015
 
   
Average Balance
   
Interest
   
Yield/Cost
   
Average Balance
   
Interest
   
Yield/Cost
 
   
(Dollars in Thousands)
 
Assets
                                   
Interest-earning assets:
                                   
Loans receivable and held for sale (1)
 
$
1,274,369
   
$
42,611
     
4.47
%
 
$
1,223,971
   
$
41,495
     
4.53
%
Mortgage related securities (2)
   
158,854
     
2,371
     
1.99
%
   
172,548
     
2,451
     
1.90
%
Debt securities, federal funds sold and short-term investments (2)(3)
   
208,241
     
3,309
     
2.12
%
   
255,284
     
3,306
     
1.73
%
Total interest-earning assets
   
1,641,464
     
48,291
     
3.93
%
   
1,651,803
     
47,252
     
3.82
%
                                                 
Noninterest-earning assets
   
116,863
                     
102,558
                 
Total assets
 
$
1,758,327
                   
$
1,754,361
                 
                                                 
Liabilities and equity
                                               
Interest-bearing liabilities:
                                               
Demand accounts
 
$
33,679
     
14
     
0.06
%
 
$
30,804
     
15
     
0.07
%
Money market and savings accounts
   
163,550
     
294
     
0.24
%
   
137,016
     
116
     
0.11
%
Time deposits
   
673,343
     
5,169
     
1.03
%
   
639,049
     
4,120
     
0.86
%
Total interest-bearing deposits
   
870,572
     
5,477
     
0.84
%
   
806,869
     
4,251
     
0.70
%
Borrowings
   
387,867
     
10,724
     
3.69
%
   
438,767
     
12,898
     
3.93
%
Total interest-bearing liabilities
   
1,258,439
     
16,201
     
1.72
%
   
1,245,636
     
17,149
     
1.84
%
                                                 
Noninterest-bearing liabilities
                                               
Noninterest-bearing deposits
   
73,828
                     
64,945
                 
Other noninterest-bearing liabilities
   
25,537
                     
20,532
                 
Total noninterest-bearing liabilities
   
99,365
                     
85,477
                 
Total liabilities
   
1,357,804
                     
1,331,113
                 
Equity
   
400,523
                     
423,248
                 
Total liabilities and equity
 
$
1,758,327
                   
$
1,754,361
                 
                                                 
Net interest income / Net interest rate spread (4)
           
32,090
     
2.21
%
           
30,103
     
1.98
%
Less: taxable equivalent adjustment
           
617
     
0.05
%
           
697
     
0.05
%
Net interest income / Net interest rate spread, as reported
         
$
31,473
     
2.16
%
         
$
29,406
     
1.93
%
Net interest-earning assets (5)
 
$
383,025
                   
$
406,167
                 
Net interest margin (6)
                   
2.56
%
                   
2.38
%
Tax equivalent effect
                   
0.05
%
                   
0.06
%
Net interest margin on a fully tax equivalent basis (6)
                   
2.61
%
                   
2.44
%
Average interest-earning assets to average interest-bearing liabilities
                   
130.44
%
                   
132.61
%
__________
(1)  Interest income includes net deferred loan fee amortization income of $596,000 and $420,000 for the nine months ended September 30, 2016 and 2015, respectively.
(2) Average balance of mortgage related and debt securities are based on amortized historical cost.
(3) Interest income from tax exempt securities is computed on a taxable equivalent basis using a tax rate of 35% for all periods presented. The yields on debt securities, federal funds sold and short-term investments before tax-equivalent adjustments were 1.73% and 1.37% for the nine months ended September 30, 2016 and 2015, respectively.
(4) Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average interest-bearing liabilities and is presented on a fully tax equivalent basis.
(5) Net interest-earning assets represent total interest-earning assets less total interest-bearing liabilities.
(6) Net interest margin represents net interest income divided by average total interest-earning assets.


- 36 -

Rate/Volume Analysis

The following table sets forth the effects of changing rates and volumes on our net interest income for the periods indicated. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The net column represents the sum of the prior columns. For purposes of this table, changes attributable to changes in both rate and volume that cannot be segregated have been allocated proportionately based on the changes due to rate and the changes due to volume.


   
Nine months ended September 30,
 
   
2016 versus 2015
 
   
Increase (Decrease) due to
 
   
Volume
   
Rate
   
Net
 
   
(In Thousands)
 
Interest income:
                 
Loans receivable and held for sale (1)(2)
 
$
1,721
   
$
(605
)
 
$
1,116
 
Mortgage related securities (3)
   
(199
)
   
119
     
(80
)
Other earning assets (3) (4)
   
(672
)
   
675
     
3
 
Total interest-earning assets
   
850
     
189
     
1,039
 
                         
Interest expense:
                       
Demand accounts
   
1
     
(2
)
   
(1
)
Money market and savings accounts
   
18
     
160
     
178
 
Time deposits
   
232
     
817
     
1,049
 
Total interest-earning deposits
   
251
     
975
     
1,226
 
Borrowings
   
(1,430
)
   
(744
)
   
(2,174
)
Total interest-bearing liabilities
   
(1,179
)
   
231
     
(948
)
Net change in net interest income
 
$
2,029
   
$
(42
)
 
$
1,987
 
______________
(1)
Interest income includes net deferred loan fee amortization income of  $596,000 and $420,000 for the nine months ended September 30, 2016 and 2015, respectively.
(2)    Non-accrual loans have been included in average loans receivable balance.
(3)    Includes available for sale securities. Average balance of available for sale securities is based on amortized historical cost.
(4)    Interest income from tax exempt securities is computed on a taxable equivalent basis using a tax rate of 35% for all periods presented.


Net interest income increased $2.1 million, or 7.0%, to $31.5 million during the nine months ended September 30, 2016 compared to $29.4 million during the nine months ended September 30, 2015.

·
Interest income on loans increased due to an increase in average balance of $50.4 million offset by a six basis point decrease in average yield on loans.  The increase in average loan balance was driven by a $27.5 million increase in the average balance of loans held in portfolio and the average balance of loans held for sale increased $22.9 million.
·
Interest income from mortgage related securities decreased as securities have paid down in 2015 and 2016, and less purchases have occurred to replace those securities due to current market conditions.
·
Interest income from other interest earning assets (comprised of debt securities, federal funds sold and short-term investments) increased due to a 36 basis point increase in the average yield due to an increase in higher yielding corporate securities balance, a 25 basis points increase in the federal funds rate and an increase in FHLB stock dividend rate, offset by a $47.0 million decrease in the total other earning assets average balance.
·
Interest expense on time deposits increased $1.0 million primarily due to a 17 basis point increase in the average cost of funds, as maturing time deposits have repriced, or have been replaced at a higher rate in the current competitive market.  In addition to an increase in rate, the average balance of time deposits increased compared to the prior year, which reflects the Company's decision to raise funds through its retail delivery channels to pay off FHLB advances that matured during the first nine months of 2016.
·
Interest expense on money market and savings accounts increased $178,000 due to an increase in both rate and average balance.  Increases in both rate and volume reflect the Company's strategy to aggressively grow this segment of retail funds.
·
Interest expense on borrowings decreased $2.2 million due to the maturity of $220.0 million of fixed rate borrowings that were paid off during the current year with lower rate long term fixed borrowings and funds raised through our retail delivery channels.
·
A total of $220.0 million FHLB borrowings at a weighted average rate of 4.34% matured during the 2016 year. The Company borrowed $100.0 million of long-term FHLB borrowings replacing the maturities in 2016 at a weighted average rate of 0.78%.  In addition to the long-term borrowings, a total of $50.0 million in short-term FHLB were utilized throughout and at the three months ended September 30, 2016.

Provision for Loan Losses

Our provision for loan losses decreased $1.4 million, or 80.2%, to $340,000 during the nine months ended September 30, 2016, from $1.7 million during the nine months ended September 30, 2015 as asset quality metrics continued to improve.

The provision is primarily a function of the Company's reserving methodology and assessments of certain quantitative and qualitative factors which are used to determine an appropriate allowance for loan losses for the period.  See further discussion regarding the allowance for loan losses in the "Asset Quality" section for an analysis of charge-offs, nonperforming assets, specific reserves and additional provisions and the "Allowance for Loan Losses" section.

- 37 -

Noninterest Income

   
Nine months ended September 30,
 
   
2016
   
2015
   
$ Change
   
% Change
 
   
(Dollars in Thousands)
 
                         
Service charges on loans and deposits
 
$
1,742
   
$
1,213
   
$
529
     
43.6
%
Increase in cash surrender value of life insurance
   
1,446
     
1,195
     
251
     
21.0
%
Mortgage banking income
   
91,146
     
77,324
     
13,822
     
17.9
%
Gain on sale of available for sale securities
   
-
     
44
     
(44
)
   
N/
M
Other
   
874
     
1,848
     
(974
)
   
(52.7
)%
    Total noninterest income
 
$
95,208
   
$
81,624
   
$
13,584
     
16.6
%
                                 
N/M - Not meaningful
                               
                                 
Total noninterest income increased $13.6 million, or 16.6%, to $95.2 million during the nine months ended September 30, 2016 compared to $81.6 million during the nine months ended September 30, 2015. The increase resulted primarily from an increase in mortgage banking income and service charges on loans and deposits offset by a decrease in other noninterest income.

·
The $13.8 million increase in mortgage banking income was the result of an increase in origination volumes and margins.  The volume increased $211.4 million, or 13.7%, to $1.76 billion during the nine months ended September 30, 2016 compared to $1.55 billion during the nine months ended September 30, 2015.
·
The increase in service charges on loans and deposits was related to an increase in loan prepayment fees.
·
The increase in cash surrender value of life insurance was due to the purchase of a $10.0 million policy in March 2016.
·
The Company sold one municipal security at a gain in the prior period compared to none in the current year.
·
The $974,000 decrease in other noninterest income was primarily due to a decrease in gain on mortgage servicing rights as there were no sales of mortgage servicing rights during the nine months ended September 30, 2016 compared to a $807,000 gain on sales of mortgage servicing rights during the nine months ended September 30, 2015.   There was a bulk sale of mortgage servicing rights which occurred during the nine months ended September 30, 2015 and no sales occurred during the nine months ended September 30, 2016.  In addition, certain loan products were sold and treated as again, which was treated as a sale and included in other noninterest income in the prior year has been treated as mortgage banking income in the current year. Also, other noninterest income decreased due to a decrease in the servicing fees earned on loans sold with mortgage servicing rights retained.


Noninterest Expenses

   
Nine months ended September 30,
 
   
2016
   
2015
   
$ Change
   
% Change
 
   
(Dollars in Thousands)
 
                         
Compensation, payroll taxes, and other employee benefits
 
$
70,968
   
$
62,584
   
$
8,384
     
13.4
%
Occupancy, office furniture and equipment
   
7,074
     
7,004
     
70
     
1.0
%
Advertising
   
1,974
     
2,120
     
(146
)
   
(6.9
)%
Data processing
   
1,897
     
1,797
     
100
     
5.6
%
Communications
   
1,088
     
1,053
     
35
     
3.3
%
Professional fees
   
1,486
     
1,771
     
(285
)
   
(16.1
)%
Real estate owned
   
344
     
1,875
     
(1,531
)
   
(81.7
)%
FDIC insurance premiums
   
500
     
851
     
(351
)
   
(41.2
)%
Other
   
9,663
     
9,106
     
557
     
6.1
%
     Total noninterest expenses
 
$
94,994
   
$
88,161
   
$
6,833
     
7.8
%
                                 
                                 

Total noninterest expenses increased $6.8 million, or 7.8%, to $95.0 million during the nine months ended September 30, 2016 compared to $88.2 million during the nine months ended September 30, 2015.

·
Compensation, payroll taxes and other employee benefit expense increased $8.4 million primarily due to an $8.1 million increase in compensation, payroll taxes and other benefits within our mortgage banking segment.  The increase in compensation within our mortgage banking segment correlates to the increase in mortgage banking income due to the commission-based compensation structure in place for our mortgage banking loan officers.
·
Compensation, payroll taxes and other employee benefit expense increased $322,000 within the community banking segment primarily due to salary increases due to adding two branches in the second half of 2015 and annual raises and health insurance costs, offset by reduction in stock compensation expense that immediately vested the grant of stock awards during 2015.
·
Occupancy, office furniture and equipment expense increased resulting from additional rent expense in the current year compared to prior year due to the addition of mortgage banking segment branches during 2016. Offsetting the rent increase, there was less depreciation expense at the mortgage banking segment in the nine months ended September 30, 2016 compared to the same period during the prior year.  Additionally, the community banking segment had lower expense year over year.
·
Advertising expense decreased as a result of mortgage banking segment branches advertising less with mortgage demand remaining high.
·
Data processing increased as the mortgage banking segment brought its hedging operations inhouse.
·
Professional fees expense decreased as a result of a decrease in legal fees at the mortgage banking segment.
·
Net real estate owned expense decreased $1.5 million, to $344,000 of expense during the nine months ended September 30, 2016 compared to the nine months ended September 30, 2015. Property management expense (other than gains/losses) decreased $965,000 to $468,000 during the nine months ended September 30, 2016 compared to the nine months ended September 30, 2015 due to a reduction in the number of properties under management during 2016. Net gains on sales of real estate owned decreased $556,000 to $539,000 for the nine months ended September 30, 2016  compared to $1.1 million for the nine months ended September 30, 2015. Real estate owned writedowns decreased $1.1 million to $461,000 for the nine months ended September 30, 2016 compared to $1.5 million for the nine months ended September 30, 2015.
·
FDIC insurance expense decreased during the nine  month period ended September 30, 2016. This was driven by a decrease in the FDIC assessment rate.
·
Other noninterest expense increased primarily due to increased expense at both the community banking and mortgage banking segments.  The community banking increase was related to commissions paid relative to loans purchased from the mortgage banking segment.  The mortgage banking segment increase was associated with the increase of loan origination activity.


- 38 -


Income Taxes

Driven by an increase in pre-tax income, income tax expense increased $4.6 million, or 59.6%, to $12.2 million during the nine months ended September 30, 2016, compared to $7.7 million during the nine months ended September 30, 2015.  Income tax expense was recognized during the nine months ended September 30, 2016 at an effective rate of 39.0% compared to 36.2% for the nine months ended September 30, 2015.  The increase in the effective rate was due to an increase in pretax income, which minimizes the impact of tax deductions and tax-exempt income, and the write off of a deferred tax asset.



Comparison of Financial Condition at September 30, 2016 and December 31, 2015

Total Assets - Total assets increased by $32.3 million, or 1.8%, to $1.80 billion at September 30, 2016 from $1.76 billion at December 31, 2015. The increase in total assets primarily reflects an increase in loans and loans held for sale offset by a reduction in cash and cash equivalents. Funding needed for the loans receivable and loans held for sale was provided by a reduction of cash and cash equivalents.

Cash and Cash EquivalentsCash and cash equivalents decreased $46.2 million, or 45.9%, to $54.3 million at September 30, 2016, compared to $100.5 million at December 31, 2015.  The decrease in cash and cash equivalents primarily reflects the increase in loans receivable and loans held for sale. In addition, cash was used to pay down borrowings and other liabilities, purchase bank owned life insurance, and repurchase shares since December 31, 2015.  Offsetting those uses, cash was raised through deposit growth and income from operations.

Securities Available for Sale – Securities available for sale decreased $24.3 million at September 30, 2016 compared to December 31, 2015. The decrease was due to paydowns in mortgage related securities and maturities of debt securities exceeding security purchases for the year.

Loans Held for Sale - Loans held for sale increased at September 30, 2016 due to increased funding volumes in the third quarter of 2016 at our mortgage subsidiary compared to the fourth quarter of 2015.  The total fundings were $710.1 million for the third quarter of 2016 compared to $441.0 for the fourth quarter of 2015.

Loans Receivable - Loans receivable held for investment increased $36.8 million to $1.15 billion at September 30, 2016 from $1.11 billion at December 31, 2015.  The increase in total loans receivable was primarily attributable to increases in the one- to four-family, multi-family, construction and land, commercial real estate, and commercial loan categories.   Offsetting those increases, the home equity and consumer categories decreased.

The following table shows loan origination, loan purchases, principal repayment activity, transfers to real estate owned, charge-offs and sales during the periods indicated.

   
As of or for the
   
As of or for the
 
   
Nine months ended September 30,
   
Year Ended
 
   
2016
   
2015
   
December 31, 2015
 
   
(In Thousands)
 
Total gross loans receivable and held for sale at beginning of period
 
$
1,281,450
   
$
1,220,063
   
$
1,220,063
 
Real estate loans originated for investment:
                       
Residential
                       
One- to four-family
   
57,080
     
32,286
     
41,835
 
Multi-family
   
93,724
     
76,695
     
117,657
 
Home equity
   
3,305
     
5,441
     
7,265
 
Construction and land
   
5,648
     
11,085
     
11,085
 
Commercial real estate
   
21,822
     
35,365
     
43,138
 
Total real estate loans originated for investment
   
181,579
     
160,872
     
220,980
 
Consumer loans originated for investment
   
-
     
688
     
688
 
Commercial business loans originated for investment
   
6,920
     
14,662
     
23,467
 
Total loans originated for investment
   
188,499
     
176,222
     
245,135
 
                         
Principal repayments
   
(146,941
)
   
(153,938
)
   
(203,271
)
Transfers to real estate owned
   
(3,442
)
   
(11,719
)
   
(15,580
)
Loan principal charged-off
   
(1,354
)
   
(4,914
)
   
(6,340
)
Net activity in loans held for investment
   
36,762
     
5,651
     
19,944
 
                         
Loans originated for sale
   
1,756,454
     
1,545,098
     
1,986,147
 
Loans sold
   
(1,695,205
)
   
(1,528,363
)
   
(1,944,704
)
Net activity in loans held for sale
   
61,249
     
16,735
     
41,443
 
Total gross loans receivable and held for sale at end of period
 
$
1,379,461
   
$
1,242,449
   
$
1,281,450
 


Allowance for Loan Losses - The allowance for loan losses decreased at September 30, 2016 from December 31, 2015. The decrease resulted from the charge-off of specific reserves and improvement of key loan quality metrics decreasing the allowance related to the loans collectively reviewed. The overall decrease was primarily related to the one- to four-family and multi-family categories.  Offsetting those decreases, amounts for the commercial loan category increased as more commercial loans entered the watch risk rating.  The other remaining categories were relatively consistent with the amounts at December 31, 2015.

- 39 -

Cash surrender value of life insurance – Total cash surrender value of life insurance increased $11.6 million from December 31, 2015.  During the nine months ended September 30, 2016, the Company purchased a $10 million bank owned life insurance policy.  Continued earnings aided in increasing the policy values.

Federal Home Loan Bank stock – Total Federal Home Loan Bank stock decreased $6.9 million from December 31, 2015.  During the nine months ended September 30, 2016, $11.4 million of stock was sold as $220.0 million of Federal Home Loan Bank borrowings matured. A total of $4.5 million of stock was purchased when $100.0 million of new long-term borrowings were entered into with the Federal Home Loan Bank.

Real Estate Owned – Total real estate owned decreased $1.7 million from December 31, 2015.  During the nine months ended September 30, 2016, $3.4 million was transferred from loans receivable to real estate owned upon completion of foreclosure.  During the same period, sales of real estate owned totaled $4.8 million and writedowns were $416,000.

Deposits – Total deposits increased $62.3 million to $955.6 million at September 30, 2016 from December 31, 2015.  The increase was driven by an increase in more cost effective transaction accounts along with an increase in time deposits to help fund loan and loans held for sale growth and reduce our reliance on wholesale funding.

Borrowings – Total borrowings decreased $63.2 million to $378.0 million at September 30, 2016 from December 31, 2015. A total of $220.0 million of fixed rate borrowings matured and were paid off during the current year.  These were replaced with $100.0 million of new fixed rate long-term borrowings with the Federal Home Loan Bank and with funds raised through our retail delivery channels.  Short term borrowings increased a total of $56.8 million at September 30, 2016 from December 31, 2015 for both the community banking and mortgage banking segment to fund loans held for sale .

Advance Payments by Borrowers for Taxes - Advance payments by borrowers for taxes increased $21.6 million.  The increase was the result of payments received from borrowers for their real estate taxes and is seasonally normal, as balances increase during the course of the calendar year until real estate tax obligations are paid out in the fourth quarter.

Other Liabilities - Other liabilities decreased $6.0 million at September 30, 2016 compared to December 31, 2015. A total decrease of $12.2 million related to a seasonal decrease in outstanding checks related to advance payments by borrowers for taxes.  The Company receives payments from borrowers for their real estate taxes during the course of the calendar year until real estate tax obligations are paid out in the fourth quarter.  At the time at which the disbursements are made, the outstanding checks are classified as other liabilities.  These amounts remain classified as other liabilities until settled.  Offsetting the decrease, the accrued expenses, accrued compensation, dividend payable, and hedging liability increased .

Shareholders' Equity – Shareholders' equity increased by $17.6 million to $409.6 million at September 30, 2016 from December 31, 2015.  The increase in shareholders' equity was primarily due to net income, additional paid in capital as stock options were exercised, along with accumulated other comprehensive income increasing as the fair value of the security portfolio increased. These increases were offset by the repurchase of stock and dividends declared.


ASSET QUALITY

NONPERFORMING ASSETS


   
At September 30,
   
At December 31,
 
   
2016
   
2015
 
   
(Dollars in Thousands)
 
Non-accrual loans:
           
Residential
           
One- to four-family
 
$
8,444
   
$
13,888
 
Multi-family
   
1,445
     
2,553
 
Home equity
   
305
     
437
 
Construction and land
   
-
     
239
 
Commercial real estate
   
429
     
460
 
Commercial
   
44
     
27
 
Consumer
   
-
     
-
 
Total non-accrual loans
   
10,667
     
17,604
 
                 
Real estate owned
               
One- to four-family
   
2,735
     
4,610
 
Multi-family
   
315
     
209
 
Construction and land
   
5,291
     
5,262
 
Commercial real estate
   
300
     
300
 
Total real estate owned
   
8,641
     
10,381
 
   Valuation allowance at end of period
   
(1,187
)
   
(1,191
)
Total real estate owned, net
   
7,454
     
9,190
 
Total nonperforming assets
 
$
18,121
   
$
26,794
 
                 
Total non-accrual loans to total loans, net
   
0.93
%
   
1.58
%
Total non-accrual loans to total assets
   
0.59
%
   
1.00
%
Total nonperforming assets to total assets
   
1.01
%
   
1.52
%

All loans that exceed 90 days past due with respect to principal and interest are recognized as non-accrual. Troubled debt restructurings that are non-accrual either due to being past due greater than 90 days or which have not yet performed under the modified terms for a reasonable period of time, are included in the table above. In addition, loans that are past due less than 90 days are evaluated to determine the likelihood of collectability given other credit risk factors such as early stage delinquency, the nature of the collateral or the results of a borrower review. When the collection of all contractual principal and interest is determined to be unlikely, the loan is moved to non-accrual status and an updated appraisal of the underlying collateral is ordered.  This process generally takes place when a loan is contractually past due between 60 and 90 days.  Upon determining the updated estimated value of the collateral, a loan loss provision is recorded to establish a specific reserve to the extent that the outstanding principal balance exceeds the updated estimated net realizable value of the collateral.  When a loan is determined to be uncollectible, typically coinciding with the initiation of foreclosure action, the specific reserve is reviewed for adequacy, adjusted if necessary, and charged-off.

- 40 -

The following table sets forth activity in our non-accrual loans for the periods indicated.

   
At or for the Nine Months
 
   
Ended September 30,
 
   
2016
   
2015
 
   
(In Thousands)
 
             
Balance at beginning of period
 
$
17,604
     
38,011
 
Additions
   
1,990
     
8,710
 
Transfers to real estate owned
   
(3,442
)
   
(11,719
)
Charge-offs
   
(662
)
   
(3,161
)
Returned to accrual status
   
(3,661
)
   
(5,242
)
Principal paydowns and other
   
(1,162
)
   
(4,748
)
Balance at end of period
 
$
10,667
     
21,851
 

Total non-accrual loans decreased by $6.9 million, or 39.4%, to $10.7 million as of September 30, 2016 compared to $17.6 million as of December 31, 2015.  The ratio of non-accrual loans to total loans receivable was 0.93% at September 30, 2016 compared to 1.58% at December 31, 2015.  During the nine months ended September 30, 2016, $3.4 million in non-accrual loans were transferred to real estate owned, $662,000 in loan principal was charged off, $3.7 million in loans were returned to accrual status and approximately $1.2 million in principal payments were received.  Offsetting this activity, $2.0 million in loans were placed on non-accrual status during the nine months ended September 30, 2016.

Of the $10.7 million in total non-accrual loans as of September 30, 2016, $10.0 million in loans have been specifically reviewed to assess whether a specific valuation allowance is necessary.  A specific valuation allowance is established for an amount equal to the impairment when the carrying value of the loan exceeds the present value of expected future cash flows, discounted at the loan's original effective interest rate or the fair value of the underlying collateral with an adjustment made for costs to dispose of the asset.  Based upon these specific reviews, a total of $2.1 million in cumulative partial charge-offs have been recorded over the life of these loans as of September 30, 2016.  Partially charged-off loans measured for impairment based upon net realizable collateral value are maintained in a "non-performing" status and are disclosed as impaired loans.  In addition, specific reserves totaling $505,000 have been recorded as of September 30, 2016.  The remaining $658,000 of non-accrual loans were reviewed on an aggregate basis and $132,000 in general valuation allowance was deemed necessary related to those loans as of September 30, 2016.   The $132,000 in valuation allowance is based upon a migration analysis performed with respect to similar non-accrual loans in prior periods.

The outstanding principal balance of our five largest non-accrual loans as of September 30, 2016 totaled $2.7 million, which represents 25.3% of total non-accrual loans as of that date.  These five loans are carried net of cumulative life-to-date charge-offs of $17,000.  Aggregate specific valuation allowances with respect to these five loans total $130,000 as of September 30, 2016.

For the nine months ended September 30, 2016, gross interest income that would have been recorded had our non-accruing loans been current in accordance with their original terms was $554,000.  We received $398,000 of interest payments on such loans during the nine months ended September 30, 2016.   Interest payments received are treated as interest income on a cash basis as long as the remaining book value of the loan (i.e., after charge-off of all identified losses) is deemed to be fully collectible. If the remaining book value is not deemed to be fully collectible, all payments received are applied to unpaid principal. Determination as to the ultimate collectability of the remaining book value is supported by an updated credit department evaluation of the borrower's financial condition and prospects for repayment, including consideration of the borrower's sustained historical repayment performance and other relevant factors.

There were no accruing loans past due 90 days or more at September 30, 2016 or December 31, 2015.


 
 
 
 
 
 
 
 
 
 
 
- 41 -

TROUBLED DEBT RESTRUCTURINGS

The following table summarizes information with respect to the accrual status of our troubled debt restructurings:


   
As of September 30, 2016
 
   
Accruing
   
Non-accruing
   
Total
 
   
(In Thousands)
 
                   
One- to four-family
 
$
3,298
   
$
2,448
     
5,746
 
Multi-family
   
2,522
     
1,445
     
3,967
 
Home equity
   
54
     
98
     
152
 
Construction and land
   
438
     
-
     
438
 
Commercial real estate
   
296
     
63
     
359
 
   
$
6,608
   
$
4,054
     
10,662
 
                         
   
As of December 31, 2015
 
   
Accruing
   
Non-accruing
   
Total
 
       
                         
One- to four-family
 
$
3,900
   
$
5,739
     
9,639
 
Multi-family
   
2,546
     
2,317
     
4,863
 
Home equity
   
-
     
98
     
98
 
Construction and land
   
1,556
     
-
     
1,556
 
Commercial real estate
   
1,306
     
77
     
1,383
 
   
$
9,308
   
$
8,231
     
17,539
 

All troubled debt restructurings are considered to be impaired, are risk rated as either substandard or watch and are included in the internal risk rating tables disclosed in the notes to the financial statements. Specific reserves have been established to the extent that collateral-based impairment analyses indicate that a collateral shortfall exists.

We do not participate in government-sponsored troubled debt restructuring programs.  Our troubled debt restructurings are short-term modifications.  Typical initial restructured terms include six to twelve months of principal forbearance, a reduction in interest rate or both.  Restructured terms do not include a reduction of the outstanding principal balance unless mandated by a bankruptcy court. Troubled debt restructuring terms may be renewed or further modified at the end of the initial term for an additional period if performance has been acceptable and the short-term borrower difficulty persists.
If a restructured loan is current in all respects and a minimum of six consecutive restructured payments have been received, it can be considered for return to accrual status. After a restructured loan that is current in all respects reverts to contractual/market terms, if a credit department review indicates no evidence of elevated market risk, the loan is removed from the troubled debt restructuring classification.


LOAN DELINQUENCY

The following table summarizes loan delinquency in total dollars and as a percentage of the total loan portfolio:


   
At September 30,
   
At December 31,
 
   
2016
   
2015
 
   
(Dollars in Thousands)
 
             
Loans past due less than 90 days
 
$
3,062
   
$
2,599
 
Loans past due 90 days or more
   
5,694
     
8,932
 
Total loans past due
 
$
8,756
   
$
11,531
 
                 
Total loans past due to total loans receivable
   
0.76
%
   
1.03
%


Past due loans decreased by $2.8 million, or 24.1%, to $8.8 million at September 30, 2016 from $11.5 million at December 31, 2015.  Loans past due 90 days or more decreased by $3.2 million, or 36.3%, during the nine months ended September 30, 2016.  Loans past due less than 90 days increased by $463,000, or 17.8%.  The $3.2 million decrease in loans past due 90 days or more was primarily due to $3.4 million in loans transferred to real estate owned along with charge-offs during the nine months ended September 30, 2016 offset by additional loans which were included in the less than 90 day group in the previous period.  The $463,000 increase in loans past due less than 90 days was primarily attributable to an increase in loans entering the 1-59 day past due category.


- 42 -

REAL ESTATE OWNED

Total real estate owned decreased by $1.7 million, or 18.9%, to $7.5 million at September 30, 2016, compared to $9.2 million at December 31, 2015.  During the nine months ended September 30, 2016, $3.4 million was transferred from loans to real estate owned upon completion of foreclosure.  During the same period, sales of real estate owned totaled $4.8 million.  A total of $416,000 in write downs occurred during the nine months ended September 30, 2016. New appraisals received on real estate owned and collateral dependent impaired loans are based upon an "as is value" assumption. During the period of time in which we are awaiting receipt of an updated appraisal, loans evaluated for impairment based upon collateral value are measured by the following:

·
Applying an updated adjustment factor (as described previously) to an existing appraisal;
·
Confirming that the physical condition of the real estate has not significantly changed since the last valuation date;
·
Comparing the estimated current value of the collateral to that of updated sales values experienced on similar collateral;
·
Comparing the estimated current value of the collateral to that of updated values seen on current appraisals of similar collateral; and
·
Comparing the estimated current value to that of updated listed sales prices on our real estate owned and that of similar properties (not owned by the Company).


Virtually all habitable real estate owned (both residential and commercial properties) is managed with the intent of attracting a lessee to generate revenue.  Foreclosed properties are recorded at the lower of carrying value or fair value, less costs to sell, with charge-offs, if any, charged to the allowance for loan losses upon transfer to real estate owned.  The fair value is primarily based upon updated appraisals in addition to an analysis of current real estate market conditions.



ALLOWANCE FOR LOAN LOSSES



   
At or for the Nine Months
 
   
Ended September 30,
 
   
2016
   
2015
 
   
(Dollars in Thousands)
 
             
Balance at beginning of period
 
$
16,185
   
$
18,706
 
Provision for loan losses
   
340
     
1,720
 
Charge-offs:
               
Mortgage
               
One- to four-family
   
801
     
3,212
 
Multi-family
   
488
     
1,501
 
Home equity
   
62
     
72
 
Commercial real estate
   
-
     
45
 
Construction and land
   
3
     
84
 
Consumer
   
-
     
-
 
Commercial
   
-
     
-
 
Total charge-offs
   
1,354
     
4,914
 
Recoveries:
               
Mortgage
               
One- to four-family
   
246
     
436
 
Multi-family
   
134
     
789
 
Home equity
   
24
     
101
 
Commercial real estate
   
-
     
40
 
Construction and land
   
58
     
45
 
Consumer
   
-
     
5
 
Commercial
   
-
     
-
 
Total recoveries
   
462
     
1,416
 
Net charge-offs
   
892
     
3,498
 
Allowance at end of period
 
$
15,633
   
$
16,928
 
                 
Ratios:
               
Allowance for loan losses to non-accrual loans at end of period
   
146.55
%
   
77.47
%
Allowance for loan losses to loans receivable at end of period
   
1.36
%
   
1.54
%
Net charge-offs to average loans outstanding (annualized)
   
0.11
%
   
0.43
%
Current period provision for loan losses to net charge-offs
   
38.12
%
   
49.17
%
Net charge-offs (annualized) to beginning of the period allowance
   
7.36
%
   
25.00
%



- 43 -

At September 30, 2016, the allowance for loan losses was $15.6 million compared to $16.2 million at December 31, 2015.  The decrease in allowance for loan losses reflects improvement in both the quality of the loan portfolio as well as stabilization in the overall local real estate market during the nine months ended September 30, 2016.  The Company has experienced improvement in a number of key loan-related loan quality metrics compared to December 31, 2015, including impaired loans, substandard loans, loans contractually past due and non-accrual loans.

Net charge-offs totaled $892,000, or an annualized 0.11% of average loans for the nine months ended September 30, 2016, compared to $3.5 million, or an annualized 0.43% of average loans for the nine months ended September 30, 2015. Of the $892,000 in charge-offs during the nine months ended September 30, 2016, a majority of the activity related to loans secured by multi-family and single-family residential loans.

Our underwriting policies and procedures emphasize that credit decisions must rely on both the credit quality of the borrower and the estimated value of the underlying collateral.  Credit quality is assured only when the estimated value of the collateral is objectively determined and is not subject to significant fluctuation.

The allowance for loan losses has been determined in accordance with GAAP. We are responsible for the timely and periodic determination of the amount of the allowance required. Any future provisions for loan losses will continue to be based upon our assessment of the overall loan portfolio and the underlying collateral, trends in non-performing loans, current economic conditions and other relevant factors. To the best of management's knowledge, all probable losses have been provided for in the allowance for loan losses.

The establishment of the amount of the loan loss allowance inherently involves judgments by management as to the appropriateness of the allowance, which ultimately may or may not be correct. Higher than anticipated rates of loan default would likely result in a need to increase provisions in future years.

Liquidity and Capital Resources
We maintain liquid assets at levels we consider adequate to meet our liquidity needs. We adjust our liquidity levels to fund loan commitments, repay our borrowings, fund deposit outflows and pay real estate taxes on mortgage loans. We also adjust liquidity as appropriate to meet asset and liability management objectives.  The level of our liquidity position at any point in time is dependent upon the judgment of the senior management as supported by the Asset/Liability Committee.  Liquidity is monitored on a daily, weekly and monthly basis using a variety of measurement tools and indicators.

Our primary sources of liquidity are deposits, amortization and repayment of loans, sales of loans held for sale, maturities of investment securities and other short-term investments, and earnings and funds provided from operations. While scheduled principal repayments on loans are a relatively predictable source of funds, deposit flows and loan repayments are greatly influenced by market interest rates, economic conditions, and rates offered by our competitors. We set the interest rates on our deposits to maintain a desired level of total deposits. In addition, we invest excess funds in short-term, interest-earning assets, which provide liquidity to meet lending requirements. Additional sources of liquidity used for the purpose of managing long- and short-term cash flows include advances from the FHLB.

During the nine months ended September 30, 2016 primary uses of cash and cash equivalents included: $1.76 billion funding loans held for sale, $220.0 million in the payment of long term debt, $41.1 million increase in loans receivable, purchase of $10.0 million in bank owned life insurance, $3.9 million for the repurchase of common stock, $5.2 million in purchases of mortgage related securities, $4.5 million in purchases of FHLB stock, $4.1 million in purchases of debt securities, and $4.8 million in dividends paid.

During the nine months ended September 30, 2016, primary sources of cash and cash equivalents included: $1.79 billion in proceeds from the sale of loans held for sale, $62.3 million increase in deposits, $100.0 million from long term borrowings, $56.8 million from short term borrowings, $29.7 million in principal repayments on mortgage related securities, $6.6 from maturities of debt securities, $19.1 million in net income, $11.4 from sales of FHLB stock, and $5.3 million from real estate owned sales.

During the nine months ended September 30, 2015 primary uses of cash and cash equivalents included: $1.55 billion funding loans held for sale, $72.2 million for the repurchase of common stock, $15.9 million in purchases of mortgage related securities, $20.9 million increase in net fundings of loans receivable (irrespective of loans transferred to real estate owned), $10.0 million in purchases of debt securities, and $4.5 million in dividends paid.

During the nine months ended September 30, 2015, primary sources of cash and cash equivalents included: $1.60 billion in proceeds from the sale of loans held for sale, $31.6 million in principal repayments on mortgage related securities, $8.2 million from maturities and calls of debt securities, $9.2 million increase in deposits, $9.1 million in advanced payments by borrowers for taxes, and $18.3 million from real estate owned sales.

A portion of our liquidity consists of cash and cash equivalents, which are a product of our operating, investing and financing activities.  At September 30, 2016 and 2015, respectively, $54.3 million and $130.4 million of our assets were invested in cash and cash equivalents.  At September 30, 2016, cash and cash equivalents are comprised of the following: $22.4 million in cash held at the Federal Reserve Bank and other depository institutions and $31.9 million in federal funds sold and short-term investments.  Our primary sources of cash are principal repayments on loans, proceeds from the calls and maturities of debt and mortgage-related securities, increases in deposit accounts and advances from the FHLBC.

- 44 -

Liquidity management is both a daily and longer-term function of business management.  If we require funds beyond our ability to generate them internally, borrowing agreements exist with the FHLBC which provide an additional source of funds.  At September 30, 2016, we had $50.0 million in short-term advances from the FHLBC with a contractual maturity date of October 27, 2016. At September 30, 2016, we had $230.0 million in long term advances from the FHLBC with contractual maturity dates in 2017, 2018, and 2021.  The advances with maturity dates in 2017 and 2018 are callable quarterly until maturity.  The 2021 advance maturities has quarterly call options beginning in June 2018 and September 2018.  As an additional source of funds, we also enter into repurchase agreements.  At September 30, 2016, we had $84.0 million in repurchase agreements.  The repurchase agreements mature at various times in 2017, however, all are callable quarterly until maturity.

At September 30, 2016, we had outstanding commitments to originate loans receivable of 35.5 million.  In addition, at September 30, 2016, we had unfunded commitments under construction loans of $28.5 million, unfunded commitments under business lines of credit of $13.3 million and unfunded commitments under home equity lines of credit and standby letters of credit of $14.4 million  At September 30, 2016, certificates of deposit scheduled to mature in one year or less totaled $481.1 million.  Based on prior experience, management believes that, subject to the Bank's funding needs, a significant portion of such deposits will remain with us, although there can be no assurance that this will be the case.  In the event a significant portion of our deposits is not retained by us, we will have to utilize other funding sources, such as FHLBC advances, in order to maintain our level of assets. However, we cannot assure that such borrowings would be available on attractive terms, or at all, if and when needed. Alternatively, we could reduce our level of liquid assets, such as our cash and cash equivalents and securities available-for-sale in order to meet funding needs. In addition, the cost of such deposits may be significantly higher if market interest rates are higher or there is an increased amount of competition for deposits in our market area at the time of renewal.

Waterstone Financial, Inc. is a separate legal entity from WaterStone Bank and must provide for its own liquidity to pay dividends to its shareholders, repurchase shares of its common stock, and for other corporate purposes.  The primary source of liquidity for Waterstone Financial, Inc. is dividend payments from WaterStone Bank.  The ability of WaterStone Bank to pay dividends is subject to regulatory restrcitions. At September 30, 2016, Waterstone Financial, Inc. (on an unconsolidated basis) had liquid assets totalling $29.8 million.

Capital

Shareholders' equity increased by $17.6 million to $409.6 million at September 30, 2016 from December 31, 2015.  The increase in shareholders' equity was primarily due to net income, additional paid in capital as stock options were exercised, along with accumulated other comprehensive income increasing as the fair value of the security portfolio increased. These increases were offset by the repurchase of stock and dividends declared.

The Company's Board of Directors authorized a stock repurchase program in the first quarter of 2015.  The Company authorized two stock repurchase programs in the second quarter of 2015.  The first three programs have been either fulfilled or cancelled. The Company's Board of Directors authorized a fourth stock repurchase program in the third quarter of 2015.  The timing of the repurchases will depend on certain factors, including but not limited to, market conditions and prices, available funds and alternative uses of capital. The stock repurchase program may be carried out through open-market purchases, block trades, negotiated private transactions and pursuant to a trading plan that will be adopted in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934.  Repurchased shares are held by the Company as authorized but unissued shares.

As of September 30, 2016, the Company repurchased 5,847,153 shares at an average price of $12.96 under previously approved stock repurchase plans. As of September 30, 2016, the Company is authorized to purchase up to 989,500 additional shares under the current approved stock repurchase program.

WaterStone Bank is subject to various regulatory capital requirements, including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning assets and off-balance sheet items to broad risk categories.  At September 30, 2016, WaterStone Bank exceeded all regulatory capital requirements and is considered "well capitalized" under regulatory guidelines. See "Notes to Consolidated Financial Statements - Regulatory Capital."

The net proceeds from the stock offering significantly increased our liquidity and capital resources. Over time, the initial level of liquidity will be reduced as net proceeds from the stock offering are used for general corporate purposes. Our financial condition and results of operations will be enhanced by the net proceeds from the stock offering, resulting in increased net interest-earning assets and net interest income. However, due to the increase in equity resulting from the net proceeds from the stock offering, our return on equity will continue to be adversely affected following the stock offering.

Contractual Obligations, Commitments, Contingent Liabilities, and Off-balance Sheet Arrangements

The following tables present information indicating various contractual obligations and commitments of the Company as of September 30, 2016 and the respective maturity dates.
               
More than
   
More than
       
               
One Year
   
Three Years
   
Over
 
         
One Year
   
Through
   
Through
   
Five
 
   
Total
   
or Less
   
Three Years
   
Five Years
   
Years
 
   
(In Thousands)
 
Demand deposits (4)
 
$
110,872
   
$
110,872
   
$
-
   
$
-
   
$
-
 
Money market and savings deposits (4)
   
157,472
     
157,472
     
-
     
-
     
-
 
Time deposit (4)
   
687,304
     
481,068
     
200,902
     
5,334
     
-
 
Bank lines of credit (4)
   
13,983
     
13,983
     
-
     
-
     
-
 
Federal Home Loan Bank advances (1)
   
280,000
     
50,000
     
130,000
     
100,000
     
-
 
Repurchase agreements (2)(4)
   
84,000
     
69,000
     
15,000
     
-
     
-
 
Operating leases (3)
   
10,160
     
2,766
     
3,797
     
1,794
     
1,803
 
Salary continuation agreements
   
128
     
128
     
-
     
-
     
-
 
   
$
1,343,919
   
$
885,289
   
$
349,699
   
$
107,128
   
$
1,803
 

(1)  Secured under a blanket security agreement on qualifying assets, principally, mortgage loans.  Excludes interest which will accrue on the advances.
     All Federal Home Loan Bank advances with maturities exceeding one year are callable on a quarterly basis.
(2)  The repurchase agreements are callable on a quarterly basis until maturity.
(3)  Represents non-cancelable operating leases for offices and equipment.
(4)  Excludes interest.

- 45 -


Herrington, et al. v. Waterstone Mortgage Corporation

Waterstone Mortgage Corporation is a defendant in a lawsuit that was filed in the Federal District Court for the Western District of Wisconsin and has been transferred to arbitration alleging that Waterstone Mortgage Corporation violated the Fair Labor Standards Act and failed to pay loan officers consistent with their various contracts. Waterstone Mortgage Corporation is and will continue to vigorously defend its interests in this matter.


Off-Balance Sheet Commitments

The following table details the amounts and expected maturities of significant off-balance sheet commitments as of September 30, 2016.

               
More than
   
More than
       
               
One Year
   
Three Years
   
Over
 
         
One Year
   
Through
   
Through
   
Five
 
   
Total
   
or Less
   
Three Years
   
Five Years
   
Years
 
   
(In Thousands)
 
Real estate loan commitments (1)
 
$
35,463
   
$
35,463
   
$
-
   
$
-
   
$
-
 
Unused portion of home equity lines of credit (2)
   
13,969
     
13,969
     
-
     
-
     
-
 
Unused portion of construction loans (3)
   
28,507
     
28,507
     
-
     
-
     
-
 
Unused portion of business lines of credit
   
13,345
     
13,345
     
-
     
-
     
-
 
Standby letters of credit
   
392
     
392
     
-
     
-
     
-
 
Total Other Commitments
 
$
91,676
   
$
91,676
   
$
-
   
$
-
   
$
-
 


General: Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract and generally have fixed expiration dates or other termination clauses.
(1)  Commitments for loans are extended to customers for up to 90 days after which they expire.
(2)  Unused portions of home equity loans are available to the borrower for up to 10 years.
(3)  Unused portions of construction loans are available to the borrower for up to one year.


 
 
 
 
 
 
 
 
 
 
 
- 46 -

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Management of Market Risk

General The majority of our assets and liabilities are monetary in nature. Consequently, our most significant form of market risk is interest rate risk. Our assets, consisting primarily of mortgage loans, have longer maturities than our liabilities, consisting primarily of deposits. As a result, a principal part of our business strategy is to manage interest rate risk and reduce the exposure of our net interest income to changes in market interest rates. Accordingly, the Bank's board of directors has established an Asset/Liability Committee which is responsible for evaluating the interest rate risk inherent in our assets and liabilities, for determining the level of risk that is appropriate given our business strategy, operating environment, capital, liquidity and performance objectives, and for managing this risk consistent with the guidelines approved by the board of directors. Management monitors the level of interest rate risk on a regular basis and the Asset/Liability Committee meets weekly to review our asset/liability policies and interest rate risk position, which are evaluated quarterly.

We have sought to manage our interest rate risk in order to minimize the exposure of our earnings and capital to changes in interest rates. We have implemented the following strategies to manage our interest rate risk: (i) emphasizing variable rate loans including variable rate one- to four-family, and commercial real estate loans as well as three- to five- year commercial real estate balloon loans; (ii) reducing and shortening the expected average life of the investment portfolio; and (iii) whenever possible, lengthening the term structure of our deposit base.  These measures should reduce the volatility of our net interest income in different interest rate environments.

Income Simulation.  Simulation analysis is an estimate of our interest rate risk exposure at a particular point in time.  At least quarterly we review the potential effect changes in interest rates may have on the repayment or repricing of rate sensitive assets and funding requirements of rate sensitive liabilities.  Our most recent simulation uses projected repricing of assets and liabilities at September 30, 2016 on the basis of contractual maturities, anticipated repayments and scheduled rate adjustments.  Prepayment rate assumptions may have a significant impact on interest income simulation results.  Because of the large percentage of loans and mortgage-backed securities we hold, rising or falling interest rates may have a significant impact on the actual prepayment speeds of our fixed-rate mortgage related assets that may in turn affect our interest rate sensitivity position.


   
Percentage Increase
(Decrease) in Estimated
Annual Net Interest Income
Over 12 Months
 
400 basis point gradual rise in rates
   
5.36
%
300 basis point gradual rise in rates
   
4.14
%
200 basis point gradual rise in rates
   
2.79
%
100 basis point gradual rise in rates
   
1.45
%
Unchanged rate scenario
   
0.00
%
100 basis point gradual decline in rates (1)
   
(1.42
%)


____________
(1) Given the current low point in the interest rate cycle, rate decline scenarios in excess of 100 basis points are not meaningful.
WaterStone Bank's Asset/Liability policy limits projected changes in net average annual interest income to a maximum decline of 25% for various levels of interest rate changes measured over a 12-month period when compared to the flat rate scenario. In addition, projected changes in the economic value of equity are limited to a maximum decline of 30% for interest rate movements of up to 400 basis points when compared to the flat rate scenario. These limits are re-evaluated on a periodic basis and may be modified, as appropriate.  At September 30, 2016, a 100 basis point gradual increase in interest rates had the effect of increasing forecast net interest income by 1.45% while a 100 basis point decrease in rates had the effect of decreasing net interest income by 1.42%.  At September 30, 2016, a 100 basis point gradual increase in interest rates had the effect of decreasing the economic value of equity by 1.54% while a 100 basis point decrease in rates had the effect of increasing the economic value of equity by 1.12%. While we believe the assumptions used are reasonable, there can be no assurance that assumed prepayment rates will approximate actual future mortgage-backed security and loan repayment activity.


- 47 -


Item 4. Controls and Procedures

Disclosure Controls and Procedures: Company management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this report. Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective.

Internal Control Over Financial Reporting: There have been no material changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.


PART II. OTHER INFORMATION


Item 1. Legal Proceedings

Other than as disclosed below, the Company is not involved in any pending legal proceedings as a defendant other than routine legal proceedings occurring in the ordinary course of business.  At September 30, 2016, the Company believes that any liability arising from the resolution of any pending legal proceedings will not be material to its financial condition or results of operations.
Herrington, et al. v. Waterstone Mortgage Corporation

Waterstone Mortgage Corporation is a defendant in a lawsuit that was filed in the Federal District Court for the Western District of Wisconsin and has been transferred to arbitration alleging that Waterstone Mortgage Corporation violated the Fair Labor Standards Act and failed to pay loan officers consistent with their various contracts. Waterstone Mortgage Corporation is and will continue to vigorously defend its interests in this matter.

Item 1A. Risk Factors
There have been no changes in risk factors applicable to the Company from those disclosed in "Risk Factors" in Item 1A of the Company's annual report on Form 10-K for the year ended December 31, 2015.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Following are the Company's monthly common stock purchases during the third quarter of 2016:

Period
 
Total Number of Shares Purchased(b)
   
Average Price Paid per Share
   
Total Number of Shares Purchased as Part of Publicly Announced Plans
   
Maximum
Number of
Shares that May
Yet Be
Purchased Under
the Plan(a)
 
July 1, 2016 - July 31, 2016
   
-
   
$
-
     
-
     
989,500
 
August 1, 2016 - August 31, 2016
   
-
     
-
     
-
     
989,500
 
September 1, 2016 - September 30, 2016
   
-
     
-
     
-
     
989,500
 
Total
   
-
   
$
-
     
-
     
989,500
 

(a)
On September 4, 2015, the Board of Directors terminated the existing plan and authorized the repurchase of 1,500,000 shares of common stock.
(b)
During the second quarter of 2016, the Company repurchased 1,518 shares for minimum tax withholding settlements on equity compensation. These purchases are included in the monthly common stock purchases table above but do not count against the maximum number of shares that may yet be purchased under the Board of Directors' authorization.


- 48 -


Item 3. Defaults Upon Senior Securities


Not applicable.


Item 4. Mine Safety Disclosures


Not applicable.


Item 5. Other Information


Not applicable.


Item 6. Exhibits

    (a) Exhibits: See Exhibit Index, which follows the signature page hereof.

Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



 
WATERSTONE FINANCIAL, INC.
(Registrant)
     
Date:  October 31, 2016
       
 
 
/s/ Douglas S. Gordon
     
 
Douglas S. Gordon
     
 
Chief Executive Officer
Principal Executive Officer
     
Date:  October 31, 2016
       
 
 
/s/  Mark R. Gerke
     
 
Mark R. Gerke
     
 
Chief Financial Officer
Principal Financial Officer
     







- 49 -








EXHIBIT INDEX

WATERSTONE FINANCIAL, INC.

Form 10-Q for Quarter Ended September 30, 2016



Exhibit No.
 
Description
 
Filed Herewith
 
   
X
 
   
X
 
   
X
 
   
X
 
101
 
The following financial statements from Waterstone Financial, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 2016, formatted in Extensive Business Reporting Language (XBRL): (i) consolidated statements of financial condition, (ii) consolidated statements of income, (iii) consolidated statements of comprehensive income, (iv) consolidated statements of changes in shareholders' equity, (v) consolidated statements of cash flows and (vi) the notes to consolidated financial statements.
 
X
 




 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
- 50 -