Kearny Financial Corp. - Annual Report: 2017 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10‑K

(Mark One)

For the Fiscal Year Ended June 30, 2017

or

For the transition period from             to             

Commission File Number: 001-37399

KEARNY FINANCIAL CORP.

(Exact name of Registrant as specified in its Charter)

Registrant’s telephone number, including area code: (973) 244-4500

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  ☐  YES    ☒  NO

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  ☐  YES    ☒  NO

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    ☐  NO

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  ☒  YES    ☐  NO

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

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

Emerging growth company     ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  ☐  YES    ☒  NO

The aggregate market value of the voting and non-voting common equity held by non‑affiliates of the Registrant on December 31, 2016 (the last business day of the Registrant’s most recently completed second fiscal quarter) was $1.24 billion.  Solely for purposes of this calculation, shares held by directors, executive officers and greater than 10% stockholders are treated as shares held by affiliates.

As of August 24, 2017 there were outstanding 83,011,448 shares of the Registrant’s Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE

KEARNY FINANCIAL CORP.

ANNUAL REPORT ON FORM 10-K

For the Fiscal Year Ended June 30, 2017

INDEX

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PART I

Item 1. Business

Forward-Looking Statements

This Annual Report contains forward-looking statements, which can be identified by the use of words such as “estimate,” “project,” “believe,” “intend,” “anticipate,” “plan,” “seek,” “expect” and words of similar meaning. These forward-looking statements include, but are not limited to:

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.  We are under no duty to and do not take any obligation to update any forward-looking statements after the date of the annual report on Form 10-K.

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:

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Because of these and other uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements.

General

Kearny Financial Corp. (the “Company,” or “Kearny Financial”), is a Maryland corporation that is the holding company for Kearny Bank (the “Bank” or “Kearny Bank”), a nonmember New Jersey stock savings bank.  The Bank was previously a federally charted stock savings bank.  However, the Bank converted its charter to that of a New Jersey savings bank on June 29, 2017.

On May 18, 2015, the Company completed its second-step conversion and stock offering through which it converted from the mutual holding company structure to a fully publicly held company.  In conjunction with that transaction, the Company sold 71,750,000 shares of its common stock at $10.00 per share, resulting in gross proceeds of $717.5 million.  The new shares issued included 3,612,500 shares sold to the Bank’s Employee Stock Ownership Plan (“ESOP”) with an aggregate value of $36.1 million based on the sales price of $10.00 per share.  Concurrent with the closing of the transaction, the Company also issued an additional 500,000 shares of its common stock with an aggregate value of $5.0 million and contributed these shares with an additional $5.0 million in cash to the KearnyBank Foundation.

The Company recognized direct stock offering costs of $10.7 million in conjunction with the transaction which reduced the net proceeds credited to capital.  After adjusting for transaction costs and the value of the shares issued to the Bank’s ESOP, the Company recognized a net increase in equity capital of $670.7 million, of which $353.4 million was contributed to the Bank by the Company as an additional investment in the Bank’s common equity.  Approximately $34.5 million of new capital proceeds were funded through withdrawals of existing customer deposits previously held by the Bank.

Each outstanding share held by the public stockholders of Kearny Financial Corp., a federal corporation, immediately prior to the closing of the conversion and stock offering was converted into 1.3804 shares of the Company’s new common stock while the shares previously held by Kearny MHC, the former mutual holding company, were cancelled concurrent with the closing of the transaction.  As a result of the completion of the second-step conversion and stock offering, all historical share and per share information has been revised to reflect the 1.3804-to-one exchange ratio.  At June 30, 2017, the Company had 84,350,848 shares outstanding.

The Company is a unitary savings and loan holding company, regulated by the Board of Governors of the Federal Reserve Bank (“FRB”) and conducts no significant business or operations of its own.  The Bank’s deposits are federally insured by the Deposit Insurance Fund as administered by the Federal Deposit Insurance Corporation (“FDIC”) and the Bank is primarily regulated by the New Jersey Department of Banking and Insurance (“NJDBI”) and, as a nonmember bank, the FDIC.  References in this Annual Report on Form 10‑K to the Company or Kearny Financial generally refer to the Company and the Bank, unless the context indicates otherwise. References to “we”, “us”, or “our” refer to the Bank or Company, or both, as the context indicates.  

The Company’s primary business is the ownership and operation of the Bank.  The Bank is principally engaged in the business of attracting deposits from the general public in New Jersey and New York and using these deposits, together with other funds, to originate or purchase loans for its portfolio and invest in securities.  Our loan portfolio is primarily comprised of loans collateralized by commercial and residential real estate augmented by secured and unsecured loans to businesses and consumers.  We also maintain a portfolio of investment securities, primarily comprised of U.S. agency mortgage-backed securities, U.S. government and agency debentures, bank-qualified municipal obligations, corporate bonds, asset-backed securities, collateralized loan obligations and subordinated debt.

At June 30, 2017, net loans receivable comprised 66.7% of our total assets while investment securities, including mortgage‑backed and non-mortgage-backed securities, comprised 23.0 % of our total assets.  By comparison, at June 30, 2016, net loans receivable comprised 59.0% of our total assets while securities comprised 27.8% of our total assets.  A significant long term goal of our business plan is to reallocate our balance sheet to reflect a greater percentage of interest-earning assets to loans while, in turn, reducing the relative size of the securities portfolio.  The composition and volume of loan originations and purchases during fiscal 2017 reflected that strategic focus as we increased our commercial loan origination and support staff and expanded relationships with loan participants and other external loan origination resources.

We operate from our administrative headquarters in Fairfield, New Jersey and had 42 branch offices as of June 30, 2017.  Our internet address is www.kearnybank.com.  Information on our website is not and should not be considered to be part of this annual report on Form 10-K.

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Business Strategy

Our goal is to continue to evolve from a traditional thrift business model toward that of a full service community bank, profitably deploying capital and enhancing earnings through a variety of balance sheet growth and diversification strategies. The key strategic initiatives of our business plan are presented below accompanied by an overview of our activities and achievements in support of those initiatives:

During fiscal 2017, our commercial mortgage loan portfolio, including multi-family and nonresidential mortgage loans, increased by 34.2%, or $636.7 million, to $2.50 billion at June 30, 2017 from $1.86 billion at June 30, 2016. This increase reflected commercial mortgage loan originations and purchases in fiscal 2017 totaling $727.4 million and $126.7 million, respectively. At June 30, 2017, our commercial mortgage loan portfolio comprised 77.0% of total loans compared to 69.7% of total loans at June 30, 2016.

We plan to continue to increase our portfolio of commercial mortgage loans by expanding loan acquisition volume through all available channels, including retail and broker originations, which may be supplemented with individual and pooled loan purchases and participations.  Additionally, we intend to continue to expand our commercial lending infrastructure and resources, which will be supported by new product and pricing strategies designed to increase origination volume in a very competitive marketplace.

We plan to continue to focus our efforts on expanding our commercial non-real estate secured and unsecured business lending activities through all available channels. During fiscal 2017, our commercial business loan origination and purchase volume totaled $51.1 million, reflecting retail originations of $34.1 million augmented by the acquisition of commercial and industrial (“C&I”) loans through wholesale channels totaling $17.0 million.

We continued the realignment and expansion of our commercial business lending infrastructure during fiscal 2017 which contributed to a modest increase in aggregate commercial business loan origination and purchase volume for the year.  As a result of those enhancements, we anticipate that the outstanding balance of this loan segment will continue to increase in fiscal 2018 and thereafter.  Moreover, we will attempt to expand our relationships with these borrowers to include commercial deposits and other products, with the goal of increasing our non-interest income.

The noted changes to our commercial business lending resources and infrastructure also served to better support our Small Business Administration (“SBA”) resources.  SBA loan sale volume increased by $5.7 million to $9.6 million in fiscal 2017 compared to $3.9 million in fiscal 2016.

We anticipate a continued increase in the level of non-interest income through greater gains on sale of SBA loans as well as other business loan-related fee income. Moreover, our business lending strategies will continue to be undertaken within a larger set of strategic initiatives designed to promote other business banking services intended to increase commercial deposit balances and services.

We plan to modestly increase our portfolio of one- to four-family home equity loans and home equity lines of credit while allowing our portfolio of one- to four-family first mortgage loans to continue to decrease as a greater portion of such loans originated are sold into the secondary market, as discussed below.  During fiscal 2017, our aggregate portfolio of one- to four-family mortgage loans decreased by $44.6 million to $650.1 million, or 20.1% of total loans, from $694.8 million or 26.0% of total loans at June 30, 2016.  We originated $67.9 million of one- to four-family first mortgage loans during the year ended June 30, 2017 while no such loans were purchased during fiscal 2017.  During the year ended June 30, 2016, we originated and purchased $87.2 million and $36.3 million, respectively, of one- to four-family first mortgage loans.

The overall decrease in the outstanding balance of the residential mortgage loan portfolio, and its decline as a percentage of total loans, continues to reflect our decreased strategic focus on residential first mortgage portfolio lending.  We anticipate that this segment of our loan portfolio will continue to decline as a percentage of total loans and earning assets as other loan categories grow.

We are continuing to expand our residential mortgage lending infrastructure to increase the origination volume of residential mortgage loans for sale into the secondary market.  Our Director of Residential Lending updated the Company’s residential lending infrastructure during the latter half of the fiscal 2016 to support the growth in mortgage banking activity during fiscal 2017.  Our mortgage banking business strategy resulted in the recognition of $713,000 in gains on the sale of $84.4 million of mortgage loans held for sale during the year ended June 30, 2017.  We anticipate an increase in residential mortgage loan origination and sale activity that is expected to support growth in our non-interest income over time through the recognition of recurring loan sale gains, while also serving to help manage the Company’s exposure to interest rate risk (“IRR”) through the sale of longer-duration, fixed-rate loans into the secondary market.

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In recent years, we have diversified the composition and allocation of our investment portfolio into new asset sectors, including asset-backed securities, corporate bonds, municipal obligations, collateralized loan obligations, commercial mortgage-backed securities (“MBS”) and subordinated debt while reducing our concentration in traditional residential MBS. Several of the added sectors include floating rate securities that reduce the level of interest rate risk (“IRR”) embedded in our securities portfolio.

Our securities portfolio decreased by $143.7 million, or 11.5%, to $1.11 billion, or 23.0% of total assets, at June 30, 2017 from $1.25 billion, or 27.8% of total assets, at June 30, 2016, reflecting the reinvestment of security cash flows from repayments and sales into the loan portfolio.  We expect to continue utilizing a significant portion of cash flows from the securities portfolio to fund a portion of our expected loan growth while maintaining the diversity of sectors represented in the portfolio.

We continue to emphasize and maintain strong asset quality as we grow and diversify our loan portfolio. Nonperforming assets decreased by $1.4 million to $20.5 million, or 0.43% of total assets, at June 30, 2017 compared to $21.9 million, or 0.49% of total assets, at June 30, 2016 and $23.8 million, or 0.56% of total assets, at June 30, 2015.

Our total deposit balances increased by $235.3 million during fiscal 2017 with aggregate deposits totaling $2.93 billion at June 30, 2017 compared to $2.69 billion at June 30, 2016.  The increase in overall deposits during fiscal 2017 partly reflected a $151.7 million increase in non-maturity deposits coupled with a net increase of $83.6 million in certificates of deposit.  The net increase in non-maturity deposits included a $28.7 million, or 12.0%, increase in non-interest-bearing deposit accounts for fiscal 2017.

At June 30, 2017, we had a total of 42 branches comprising 40 branches located in northern and central New Jersey with two additional branches located in Brooklyn and Staten Island, New York. We plan to selectively evaluate branch network expansion opportunities, with a particular focus on limited branch expansion in Brooklyn and Staten Island.  We will also continue to evaluate additional de novo branch opportunities to contiguously expand our existing New Jersey branch network with an emphasis on “fill-ins” between our northern and central New Jersey locations.

Notwithstanding the opportunities presented by de novo branching, we expect to place greater strategic emphasis on leveraging the opportunities to increase market share and expand the depth and breadth of customer relationships within our existing branch network while also considering select branch consolidation opportunities to optimize that network. We continue to develop and deploy strategies to promote the “relationship banking” business model throughout our branch network with an emphasis on expanding business customer relationships linked to business lending initiatives.

As a complement to the “organic” growth strategies, we continue to actively seek out opportunities to deploy capital, diversify our balance sheet, enter new markets and enhance earnings through mergers and acquisitions with other financial institutions. We are an experienced acquirer, having acquired five banks in the last 17 years. We expect to place the greatest emphasis on opportunities to expand within the existing markets we serve or to enter new markets that are generally contiguous to such markets.

In addition to potential acquisitions of financial institutions or their branches, we may explore additional opportunities for acquisitions or strategic partnerships to broaden our product and service offerings in the future.

In conjunction with our efforts to improve operating efficiency and control operating expenses, while expanding and enhancing product and service offerings, we continued to deploy a number of technologies during fiscal 2017 that support our internal IT infrastructure as well as our external customer-facing systems.  We consider the noted enhancements to be one of several continuing strategies to control growth in non-interest expenses and improve our overall operating efficiency.

For the year ended June 30, 2017, the Company’s ratio of non-interest expense to average assets totaled 1.76% compared to 1.64% for the year ended June 30, 2016.  For those same comparative periods, the Company’s operating efficiency ratio increased to 71.2% from 68.5%, respectively.  The increase in the non-interest expense ratio and efficiency ratio in fiscal 2017 primarily reflected the additional compensation expense associated with the Company’s 2016 Equity Incentive Plan approved by stockholders in October 2016.  The Company estimates that the recurring compensation expenses associated with that plan increased its ratio of non-interest expense to average assets by 0.08% for the year ended June 30, 2017 while adding 3.18% to its efficiency ratio for the same period.  

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Market Area. At June 30, 2017, our primary market area consisted of the counties in which we currently operate branches, including Bergen, Essex, Hudson, Middlesex, Monmouth, Morris, Ocean, Passaic and Union counties in New Jersey and Kings (Brooklyn) and Richmond (Staten Island) counties in New York.  Our lending is concentrated in these markets and our predominant sources of deposits are the communities in which our offices are located as well as the neighboring communities.

Our primary market area is largely urban and suburban with a broad economic base as is typical within the New York metropolitan area.  Service jobs represent the largest employment sector followed by wholesale/retail trade. A downturn in the local economy could reduce the amount of funds available for deposit and the ability of borrowers to repay their loans which would adversely affect our profitability.

Competition.  We operate in a market area with a high concentration of banking and financial institutions and we face substantial competition in attracting deposits and in originating loans. A number of our competitors are significantly larger institutions with greater financial and managerial resources and lending limits.  Our ability to compete successfully is a significant factor affecting our growth potential and profitability.

Our competition for deposits and loans historically has come from other insured financial institutions such as local and regional commercial banks, savings institutions and credit unions located in our primary market area.  We also compete with mortgage banking and finance companies for real estate loans and with commercial banks and savings institutions for consumer loans.  We also face competition for attracting funds from providers of alternative investment products such as equity and fixed income investments, including securities such as corporate, agency and government securities, as well as the mutual funds that invest in these instruments.

There are large retail banking competitors operating throughout our primary market area, including Bank of America, Citibank, JP Morgan Chase Bank, PNC Bank, TD Bank, and Wells Fargo Bank and we also face strong competition from other community-based financial institutions.

Lending Activities

General.  In conjunction with our strategic efforts to evolve from a traditional thrift to a full-service community bank, our lending strategies have placed increasing emphasis on the origination of commercial loans while diminishing the emphasis on one- to four-family mortgage portfolio lending.  The year-to-year trends in the composition and allocation of our loan portfolio, as reported in the table below, highlight those changes in business strategy.  In particular, the outstanding balance of our commercial mortgages, including loans secured by multi‑family, mixed‑use and nonresidential properties, have significantly increased from both a dollar amount and percentage of portfolio basis over the past several years.  By comparison, the outstanding balance of our residential mortgage loans, including one- to four-family and home equity loans, have consistently declined as a percentage of the loan portfolio over the past several years.

Our commercial loan offerings also include secured business loans, many of which are secured by real estate, and unsecured business loans.  Commercial loan offerings include programs offered through the SBA in which Kearny Bank participates as a Preferred Lender.  Our consumer loan offerings primarily include home equity loans and home equity lines of credit as well as account loans, overdraft lines of credit, vehicle loans and personal loans.  We also offer construction loans to builders/developers as well as individual homeowners.  We have also purchased out-of-state one- to four-family first mortgage loans to supplement our in-house originations. For more information, please see “Lending Activities (Loan Originations, Purchases, Sales, Solicitation and Processing).”

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Loan Portfolio Composition.  The following table sets forth the composition of our loan portfolio in dollar amounts and as a percentage of the total portfolio at the dates indicated.

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Loan Maturity Schedule.  The following table sets forth the maturities of our loan portfolio at June 30, 2017.  Demand loans, loans having no stated maturity and overdrafts are shown as due in one year or less.  Loans are stated in the following table at contractual maturity and actual maturities could differ due to prepayments.  

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The following table shows the dollar amount of loans as of June 30, 2017 due after June 30, 2018 according to rate type and loan category.

Multi-Family and Nonresidential Real Estate Mortgage Loans.  We originate commercial mortgage loans on multi-family and nonresidential properties, including loans on apartment buildings, retail/service properties and land as well as other income-producing properties, such as mixed-use properties combining residential and commercial space.  Our growing strategic emphasis in commercial lending resulted in the origination of approximately $727.4 million of multi-family and nonresidential real estate mortgages during the year ended June 30, 2017, compared to $489.3 million during the year ended June 30, 2016.

Our commercial mortgage acquisition strategies also included purchases of whole loans and participations totaling $126.7 million and $274.9 million during the years ended June 30, 2017 and 2016, respectively.  The loan purchases in fiscal 2017 were funded during the first quarter ended September 30, 2016 and reflected the deployment of excess liquidity that had accumulated through June 30, 2016 due to an increase in loan prepayments during the fourth quarter of fiscal 2016.  The loan purchases during fiscal 2016 largely reflected the deployment of a portion of the proceeds received in conjunction with the closing of the Company’s second-step conversion and stock offering at the end of fiscal 2015.

In total, commercial mortgage loan acquisition volume significantly outpaced loan repayments during fiscal 2017 resulting in the reported net increase in the outstanding balance of this segment of the loan portfolio. Our business plan continues to call for maintaining our strategic emphasis on commercial mortgage lending by increasing this segment of the portfolio on both a dollar and percentage of assets basis.

We generally require no less than a 25% down payment or equity position for mortgage loans on multi-family and nonresidential properties.  For such loans, we generally require personal guarantees.  However, the Bank may consider multi-family and nonresidential real estate mortgages for approval on a non-personally guaranteed (non-recourse) basis when the overall strengths of a proposed loan asset sufficiently mitigates the risk of exculpating the principal owners from their personal guarantee. In such cases, the Bank generally requires borrowers to execute an indemnification agreement which personally obligates those individuals in the circumstances of fraud, negligence, environmental issues, improper conveyance, condemnation, bankruptcy or other additional provisions deemed appropriate by the Bank.

We generally offer fixed-rate and adjustable-rate balloon mortgage loans on multi-family and non-residential properties with final stated maturities ranging from five to twelve years and initial interest rate reset terms ranging from five to seven years, where applicable.  Our balloon mortgage loans within this category generally have payments based on amortization terms from 25 to 30 years.  We also offer fully amortizing fixed-rate and adjustable-rate mortgage loans on multi-family and non-residential properties with terms up to 25 years.  Our commercial mortgage loans are primarily secured by properties located in New Jersey and New York and, to a lesser extent, properties located in eastern Pennsylvania.

Commercial Business Loans.  We also originate commercial term loans and lines of credit to a variety of professionals, sole proprietorships and small businesses in our market area.  Our business loan products include our Small Business Express Loan, which offers customers a simplified and expedited application and approval process for term loans and lines of credit up to $100,000, as well as loans originated through the SBA in which Kearny Bank participates as a Preferred Lender.  We originated approximately $34.1 million of commercial business loans during the year ended June 30, 2017 compared to $20.8 million during the year ended June 30, 2016.

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Our commercial business loan acquisition strategies included purchases of wholesale C&I loan participations totaling $17.0 million and $19.8 million during the years ended June 30, 2017 and 2016, respectively.  Our C&I loan participations at June 30, 2017 included 13 loans with an outstanding balance of $27.4 million.  These participations were comprised entirely of our pro rata interest representing the obligations of 13 separate commercial borrowers that were acquired through Kearny Bank’s membership in BancAlliance, a cooperative network of lending institutions that serves as a conduit for institutional investors to participate in middle-market commercial credits.  The BancAlliance network is supported and managed on a day-to-day basis by Alliance Partners and its wholly-owned subsidiary AP Commercial LLC which acts as investment advisor and asset manager for loans acquired through the BancAlliance network while retaining a portion of such loans as an investor.

At June 30, 2016, our BancAlliance participations had an outstanding balance of $34.6 million representing our pro rata interest in 21 loans.  As of that same date, our C&I participations also included one additional loan with an outstanding balance of $9.7 million that was purchased through the broadly syndicated commercial loan market.  The loan, which was paid off in full during fiscal 2017, represented an obligation of a single commercial borrower that was rated by one or more independent, third-party credit rating agencies.

In total, commercial business loan repayments and sales outpaced loan acquisition volume during fiscal 2017 resulting in the reported net decrease in the outstanding balance of this segment of the loan portfolio.  As noted earlier, we continued to realign and expand our commercial business lending infrastructure during fiscal 2017 which contributed to a modest increase in aggregate commercial business loan origination and purchase volume for the year.  As a result of those enhancements, we anticipate this loan segment will increase as we continue to acquire loans through retail origination channels as well as purchases and participations acquired though wholesale sources with the goal of increasing this portfolio on both a dollar and percentage of assets basis.

Our commercial business loan activity during fiscal 2017 included the sale of $9.6 million of SBA loan participations which resulted in the recognition of related sale gains totaling approximately $822,000 for the year ended June 30, 2017.  By comparison, we sold $2.6 million of SBA loan participations during fiscal 2016 which resulted in the recognition of related sale gains totaling approximately $242,000.  Our business plan calls for a continued increase in SBA lending activity from the levels reported during fiscal 2017.  As noted earlier, the enhancements to our commercial business lending resources and infrastructure that continued to be implemented during fiscal 2017 also served to better support our SBA lending resources.

At June 30, 2017, approximately $47.1 million or 63.2% of our commercial business loans represent loans originated through our retail channel while the remaining $27.4 million or 36.8% comprise loans acquired through the wholesale C&I loan participation channels discussed earlier.  Of the retail originated loans, approximately $38.3 million or 81.3% are “non-SBA” loans consisting of secured and unsecured loans totaling $36.8 million and $1.5 million, respectively.  We generally require personal guarantees on all “non-SBA” commercial business loans originated.  The loan to value limit on secured commercial lines of credit and term loans is otherwise generally limited to 70%. Unsecured commercial loans may take the form of overdraft checking authorization up to $10,000 and unsecured lines of credit up to $100,000.  Our “non-SBA” commercial term loans generally have terms of up to 10 years and are mostly adjustable-rate loans.  Our commercial lines of credit have terms of up to one year and are generally adjustable-rate loans.

The remaining $8.8 million or 18.7% of commercial business loans originated represent the retained portion of SBA loan originations.  Such loans are generally secured by various forms of collateral, including real estate, business equipment and other forms of collateral.  Kearny Bank generally sells the guaranteed portion of eligible SBA loans originated, which ranges from 50% to 90% of the loan’s outstanding balance while retaining the nonguaranteed portion of such loans in portfolio.  Kearny Bank also retains both the guaranteed and non-guaranteed portion of those SBA originations that are generally ineligible for sale in the secondary market.  At June 30, 2017, approximately $846,000 of the retained portion of Kearny Bank’s SBA loans is guaranteed by the SBA.

Construction Lending.  Our construction lending includes loans to individuals for construction of one- to four-family residences or for major renovations or improvements to an existing dwelling.  Our construction lending also includes loans to builders and developers for multi-unit buildings or multi-house projects.  At June 30, 2017, construction loans totaled $3.8 million.

During the year ended June 30, 2017, construction loan disbursements were $3.0 million compared to $1.1 million during the year ended June 30, 2016.  Construction loan disbursements outpaced repayments during fiscal 2017 resulting in the reported increase in the outstanding balance of this segment of the loan portfolio.  

Construction borrowers must hold title to the land free and clear of any liens. Financing for construction loans is limited to 80% of the anticipated appraised value of the completed property. Disbursements are made in accordance with inspection reports by our approved appraisal firms.  Terms of financing are generally limited to one year with an interest rate tied to the prime rate published in the Wall Street Journal and may include a premium of one or more points.  In some cases, we convert a construction loan to a permanent mortgage loan upon completion of construction.

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We have no formal limits as to the number of projects a builder has under construction or development and make a case-by-case determination on loans to builders and developers who have multiple projects under development.  The Board of Directors reviews Kearny Bank’s business relationship with a builder or developer prior to accepting a loan application for processing.  We generally do not make construction loans to builders on a speculative basis.  There must be a contract for sale in place. Financing is provided for up to two houses at a time in a multi-house project, requiring a contract on one of the two houses before financing for the next house may be obtained.

We are currently evaluating lending opportunities and strategies through which we may expand our construction lending activity, funding commitments and outstanding balances in the future.  If undertaken, we expect that the growth in our construction lending program will be supported by a corresponding expansion of our internal lending infrastructure and resources to support a growing number of relationships and projects with builders/borrowers.

One- to Four-Family Mortgage Loans Held in Portfolio.  Our portfolio lending activities include the origination of one- to four-family first mortgage loans, of which approximately $532.8 million or 94.0% are secured by properties located within New Jersey and New York as of June 30, 2017 with the remaining $34.6 million or 6.0% secured by properties in other states.

During the year ended June 30, 2017, Kearny Bank originated $67.9 million of one- to four-family first mortgage portfolio loans compared to $87.2 million in the year ended June 30, 2016.  To supplement portfolio loan originations, we also purchased one- to four-family first mortgages totaling $36.3 million during the year ended June 30, 2016 while no such loans were purchased during fiscal 2017.

In total, loan repayments outpaced origination volume of one- to four-family mortgage portfolio loans during fiscal 2017 resulting in a net decrease in the outstanding balance of this segment of the loan portfolio.  Our business plan calls for generally reducing strategic emphasis on one- to four-family mortgage portfolio lending by modestly decreasing the outstanding balance of this segment and reducing its basis as a percentage of total loans.

We will originate a one- to four-family mortgage loan on an owner-occupied property with a principal amount of up to 95% of the lesser of the appraised value or the purchase price of the property, with private mortgage insurance required if the loan-to-value ratio exceeds 80%. At June 30, 2017, our one- to four-family mortgage loan portfolio was primarily comprised of loans secured by owner-occupied properties.  Our loan-to-value limit on a non-owner-occupied property is 75%.  Loans in excess of $1.0 million are handled on a case-by-case basis and are subject to lower loan-to-value limits, generally no more than 50%.

We offer a first-time homebuyer program for persons who have not previously owned real estate and are purchasing a one- to four-family property in our primary lending area for use as a primary residence.  This program is also available outside these areas, but only to persons who are existing deposit or loan customers of Kearny Bank and/or members of their immediate families.  The financial incentives offered under this program are a one-eighth of one percentage point rate reduction on all first mortgage loan types and the refund of the application fee at closing.

The fixed-rate residential mortgage loans that we originate for portfolio generally meet the secondary mortgage market standards of the Federal Home Loan Mortgage Corporation (“Freddie Mac”).

Substantially all of our residential mortgages include “due on sale” clauses, which give us the right to declare a loan immediately payable if the borrower sells or otherwise transfers an interest in the property to a third party.  Property appraisals on real estate securing our one- to four-family first mortgage loans are made by state certified or licensed independent appraisers approved by Kearny Bank’s Board of Directors.  Appraisals are performed in accordance with applicable regulations and policies.  We require title insurance policies on all first mortgage real estate loans originated.  Homeowners, liability and fire insurance and, if applicable, flood insurance, are also required.

One- to Four-Family Mortgage Loans Held for Sale.  During fiscal 2017, we continued to expand our mortgage banking strategies through which we originate one- to four-family mortgage loans for sale into the secondary market.  As above, the loans we originate for sale generally meet the same secondary mortgage market standards as those applicable to loans originated for portfolio.  Moreover, such loans are generally originated by, and sourced from, the same resources and markets as those loans originated and held in portfolio, as discussed above.

As noted earlier, our mortgage banking business strategy resulted in the recognition of $713,000 in gains associated with the sale of $84.4 million of mortgage loans held for sale during the year ended June 30, 2017.  As of that date, an additional $4.7 million of loans were held and committed for sale into the secondary market.  We anticipate an increase in residential mortgage loan origination and sale activity to support growth in the our non-interest income over time through the recognition of recurring loan sale gains, while also serving to help manage the Company’s exposure to interest rate risk.

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Home Equity Loans and Lines of Credit.  Our home equity loans are fixed-rate loans for terms of generally up to 20 years.  We also offer fixed-rate and adjustable-rate home equity lines of credit with terms of up to 20 years.  During the year ended June 30, 2017, Kearny Bank originated $18.5 million of home equity loans and home equity lines of credit compared to $22.7 million in the year ended June 30, 2016.  However, repayments of home equity loans and lines of credit outpaced loan origination volume during fiscal 2017 resulting in the reported net decline in the outstanding balance of this segment of the loan portfolio.

Collateral value is determined through a property value analysis report, or full appraisal where appropriate, provided by a state certified or licensed independent appraiser.  Home equity loans and lines of credit do not require title insurance but do require homeowner, liability and fire insurance and, if applicable, flood insurance.

Home equity loans and fixed-rate home equity lines of credit are generally originated in our market area and are generally made in amounts of up to 80% of value on term loans and of up to 75% of value on home equity adjustable-rate lines of credit.  We originate home equity loans secured by either a first lien or a second lien on the property.

Consumer Loans.  Our consumer loan portfolio includes unsecured overdraft lines of credit and personal loans as well as loans secured by savings accounts and certificates of deposit on deposit with Kearny Bank.  Our unsecured consumer loans at June 30, 2017 primarily include $12.8 million of loans acquired through the Company’s relationship with Lending Club, an established peer-to-peer (i.e. marketplace) lender.  Through this relationship, the Company has purchased high-quality, unsecured consumer loans originated through Lending Club’s online platform.  The remaining balance of consumer loans at June 30, 2017 includes $2.9 million of loans fully secured by savings accounts or certificates of deposit held by the Bank and $595,000 of other unsecured consumer loans.  We will generally lend up to 90% of the account balance on a loan secured by a savings account or certificate of deposit.

Our consumer loans generally entail greater risks compared to the other categories of loans that we originate or purchase and hold in portfolio.  Consumer loan repayment is dependent on the borrower’s continuing financial stability and is more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. The application of various federal laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on consumer loans in the event of a default.

Our underwriting standards for internally originated consumer loans include a determination of the applicant’s credit history and an assessment of the applicant’s ability to meet existing obligations and payments on the proposed loan.  The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment and any additional verifiable secondary income.  Our externally originated consumer loans purchased through Lending Club are limited to those issued to qualified borrowers falling within the three highest credit tiers defined within Lending Club’s proprietary credit risk model.

Loans to One Borrower.  New Jersey law generally limits the amount that a savings bank may lend to single borrower and related entities to 15% of the institution’s capital funds. Accordingly, as of June 30, 2017, our loans-to-one-borrower limit was approximately $113.1 million.

Notwithstanding regulatory limitations regarding loans to one borrower, the Bank has established a more conservative set of internal thresholds that further limit our lending exposure to any single borrower or set of borrowers affiliated by common ownership.  In that regard, the Bank’s internal “house limits” are $20.0 million for a single loan transaction and $60.0 million for aggregate loans to a common ownership or an affiliated group of borrowers/guarantors. These limits apply irrespective of whether the obligations are on a personally guaranteed/recourse basis or non-personally guaranteed/non-recourse basis.  Exceptions to these internal limits may be considered on a case-by-case basis, subject to the review and approval of each exception by the Bank’s Board of Directors.

At June 30, 2017, our largest single borrower had an aggregate outstanding loan balance of approximately $48.2 million comprising one commercial mortgage loan and three multi-family mortgage loans. Our second largest single borrower had an aggregate outstanding loan balance of approximately $46.3 million comprising three commercial mortgage loans and three multi-family mortgage loans.  Our third largest borrower had an aggregate outstanding loan balance of approximately $44.6 million comprising two commercial mortgage loans and six multi-family mortgage loans.  At June 30, 2017, all of these lending relationships were current and performing in accordance with the terms of their loan agreements.  By comparison, at June 30, 2016, loans outstanding to Kearny Bank’s three largest borrowers totaled approximately $37.3 million, $37.2 million and $35.2 million, respectively.

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Loan Originations, Purchases, Sales, Solicitation and Processing.  The following table shows portfolio loans originated, purchased, acquired and repaid during the periods indicated.

Our customary sources of loan applications include loans originated by our commercial and residential loan officers, repeat customers, referrals from realtors and other professionals and “walk-in” customers.  These sources are supported in varying degrees by our newspaper and electronic advertising and marketing strategies.

During prior years, we had purchased loans under the terms of loan purchase and servicing agreements with three large nationwide lenders, in order to supplement our residential mortgage loan production pipeline.  The original agreements called for the purchase of loan pools that contained mortgages on residential properties in our lending area and were subsequently expanded to include mortgage loans secured by residential real estate located outside of New Jersey.  However, we did not purchase residential mortgage loans under the noted purchase and servicing agreements during the years ended June 30, 2017, 2016 and 2015, but may do so in the future.

Once we purchase the loans, we continually monitor the seller’s performance by thoroughly reviewing portfolio balancing reports, remittance reports, delinquency reports and other data supplied to us on a monthly basis.  We also review the seller’s financial statements and documentation as to their compliance with the servicing standards established by the Mortgage Bankers Association of America.

As of June 30, 2017, our portfolio of “out-of-state” residential mortgages included loans located in eight states outside of New Jersey and New York that totaled approximately $34.6 million or 6.0% of one- to four-family mortgage loans. The states with the three largest concentrations of such loans at June 30, 2017 were Massachusetts, Pennsylvania and Georgia, with outstanding principal balances totaling $25.3 million, $5.7 million and $1.1 million, respectively.  The aggregate outstanding balances of loans in each of

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the remaining five states total approximately $2.6 million and comprise approximately 7.0% of the total balance of out-of-state residential mortgage loans with aggregate balances by state ranging from $184,000 to $646,000.

We have also entered into purchase agreements with a number of bank and non-bank originators to supplement our loan production pipeline.  These agreements call for our purchase of one- to four-family first mortgage loans on either a servicing released or servicing retained basis from the seller.  No additional loans were purchased from these sources during the year ended June 30, 2017.  By comparison, during the year ended June 30, 2016, loans purchased from these sources totaled approximately $36.3 million comprising loans secured by residential properties in New Jersey and Massachusetts.

In addition to purchasing one- to four-family loans, we have also purchased commercial mortgage loans and participations originated by other banks and non-bank originators. As noted earlier, the aggregate carrying value of the loans and participations purchased from these sources during the year ended June 30, 2017 totaled approximately $126.7 million comprising loans secured primarily by multi-family and non-residential properties located in New York and eastern Pennsylvania.  We also purchased commercial business loans totaling $17.0 million during the year ended June 30, 2017, as discussed above.

Loan Approval Procedures and Authority.  Senior management recommends and the Board of Directors approves our lending policies and loan approval limits.  Kearny Bank’s Loan Committee consists of the Chief Executive Officer, Chief Operating Officer, Chief Lending Officer, Chief Credit Officer, Regional President, Director of Commercial Real Estate Lending, Director of C&I Lending, Director of Residential Lending and Special Assets Manager.  Our Chief Lending Officer may approve residential loans up to $750,000.  Loan department personnel of Kearny Bank serving in the following positions may approve loans as follows: residential mortgage loan managers, mortgage loans up to $500,000; residential mortgage loan underwriters, mortgage loans up to $250,000; consumer loan managers, consumer loans up to $250,000; and consumer loan underwriters, consumer loans up to $150,000.  In addition to these principal amount limits, there are established limits for different levels of approval authority as to minimum credit scores and maximum loan-to-value ratios and debt-to-income ratios or debt service coverage.  Our Chief Executive Officer and Chief Operating Officer have authorization to countersign loans for amounts that exceed $750,000 up to a limit of $1.0 million.  Our Chief Lending Officer must approve loans between $750,000 and $1.0 million along with one of these designated officers.  Non-conforming residential mortgage loans and loans over $1.0 million up to $2.0 million require the approval of the Loan Committee.  The Committee may approve individual commercial loans or an aggregate commercial lending relationship up to $5.0 million. Commercial loans or aggregate relationships in excess of $5.0 million require approval by the Board of Directors while such approval is also required for residential mortgage loans in excess of $2.0 million and commercial business loans in excess of $1.0 million.

Asset Quality

Collection Procedures on Delinquent Loans.  We regularly monitor the payment status of all loans within our portfolio and promptly initiate collection efforts on past due loans in accordance with applicable policies and procedures.  Delinquent borrowers are notified by both mail and telephone when a loan is 30 days past due. If the delinquency continues, subsequent efforts are made to contact the delinquent borrower and additional collection notices and letters are sent.  All reasonable attempts are made to collect from borrowers prior to referral to an attorney for collection.  However, when a loan is 90 days delinquent, it is our general practice to refer it to an attorney for repossession, foreclosure or other form of collection action, as appropriate.  In certain instances, we may modify the loan or grant a limited moratorium on loan payments to enable the borrower to reorganize his or her financial affairs and we attempt to work with the borrower to establish a repayment schedule to cure the delinquency.

As to mortgage loans, if a foreclosure action is taken and the loan is not reinstated, paid in full or refinanced, the property is sold at judicial sale at which we may be the buyer if there are no adequate offers to satisfy the debt. Any property acquired as the result of foreclosure or by deed in lieu of foreclosure is classified as real estate owned until it is sold or otherwise disposed of. When real estate owned is acquired, it is recorded at its fair market value less estimated selling costs. The initial write-down of the property, if necessary, is charged to the allowance for loan losses. Adjustments to the carrying value of the properties that result from subsequent declines in value are charged to operations in the period in which the declines are identified.

Past Due Loans.  A loan’s “past due” status is generally determined based upon its “P&I delinquency” status in conjunction with its “past maturity” status, where applicable.  A loan’s “P&I delinquency” status is based upon the number of calendar days between the date of the earliest P&I payment due and the “as of” measurement date.  A loan’s “past maturity” status, where applicable, is based upon the number of calendar days between a loan’s contractual maturity date and the “as of” measurement date.  Based upon the larger of these criteria, loans are categorized into the following “past due” tiers for financial statement reporting and disclosure purposes: Current (including 1-29 days past due), 30-59 days, 60-89 days and 90 or more days.

Nonaccrual Loans.  Loans are generally placed on nonaccrual status when contractual payments become 90 days or more past due, and are otherwise placed on nonaccrual when we do not expect to receive all P&I payments owed substantially in accordance with the terms of the loan agreement.  Loans that become 90 days past maturity, but remain non-delinquent with regard to ongoing P&I payments, may remain on accrual status if: (1) we expect to receive all P&I payments owed substantially in accordance with the

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terms of the loan agreement, past maturity status notwithstanding, and (2) the borrower is working actively and cooperatively with us to remedy the past maturity status through an expected refinance, payoff or modification of the loan agreement that is not expected to result in a troubled debt restructuring (“TDR”) classification.  All TDRs are placed on nonaccrual status for a period of no less than six months after restructuring, irrespective of past due status.  The sum of nonaccrual loans plus accruing loans that are 90 days or more past due are generally defined as “nonperforming loans.”

Payments received in cash on nonaccrual loans, including both the principal and interest portions of those payments, are generally applied to reduce the carrying value of the loan for financial statement purposes.  When a loan is returned to accrual status, any accumulated interest payments previously applied to the carrying value of the loan during its nonaccrual period are recognized as interest income as an adjustment to the loan’s yield over its remaining term.

Loans that are not considered to be TDRs are generally returned to accrual status when payments due are brought current and we expect to receive all remaining P&I payments owed substantially in accordance with the terms of the loan agreement.  Non-TDR loans may also be returned to accrual status when a loan’s payment status falls below 90 days past due and we: (1) expect receipt of the remaining past due amounts within a reasonable timeframe, and (2) expect to receive all remaining P&I payments owed substantially in accordance with the terms of the loan agreement.

Nonperforming Assets.  The following table provides information regarding our nonperforming assets which are comprised of nonaccrual loans, accruing loans 90 days or more past due and real estate owned.

Total nonperforming assets decreased by $1.4 million to $20.5 million at June 30, 2017 from $21.9 million at June 30, 2016.  The decrease comprised a net decline in nonperforming loans of $2.2 million that was partially offset by a net increase in real estate owned of $806,000.  For those same comparative periods, the number of nonperforming loans decreased to 78 loans from 89 loans while the number of real estate owned properties increased to four from three.

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At June 30, 2017, nonperforming loans comprised $18.8 million of “nonaccrual” loans and $74,000 of loans being reported as “accruing loans over 90 days past due.”  By comparison, at June 30, 2016, nonperforming loans comprised $21.0 million of “nonaccrual” loans and $38,000 of loans being reported as “accruing loans over 90 days past due.”

Nonperforming one- to four-family mortgage loans at June 30, 2017 include 35 nonaccrual loans totaling $8.8 million whose net outstanding balances range from $104 to $560,000, with an average balance of approximately $251,000 as of that date.  The loans are in various stages of collection, workout or foreclosure.  Of these loans, 32 are secured by New Jersey properties while two loans are secured by properties located in New York and one loan is secured by a property located in Georgia.  We have identified approximately $154,000 of specific impairment relating to seven of the nonperforming loans for which valuation allowances are maintained in the allowance for loan losses at June 30, 2017.

The number and balance of nonperforming one- to four-family mortgage loans at June 30, 2017 includes 23 loans totaling $6.4 million that were originally acquired from Countrywide with such loans comprising 33.9% of total nonperforming loans as of June 30, 2017.  As of that same date, Kearny Bank owned a total of 39 residential mortgage loans with an aggregate outstanding balance of $11.7 million that were originally acquired from Countrywide.

Nonperforming commercial real estate loans, including multi-family and nonresidential mortgage loans, include 15 nonaccrual loans totaling $5.9 million.  At June 30, 2017, the outstanding balances of these loans range from $60,000 to $1.8 million with an average balance of approximately $392,000 as of that date.  The loans are in various stages of collection, workout or foreclosure and are secured by New Jersey properties.  We have identified approximately $39,000 of specific impairment relating to three of these nonperforming loans for which valuation allowances are maintained in the allowance for loan losses at June 30, 2017.

Nonperforming commercial business loans at June 30, 2017 include 11 nonaccrual loans totaling $2.6 million.  At June 30, 2017, the outstanding balances of these loans range from $2,000 to $1.5 million with an average balance of approximately $239,000 as of that date.  The loans are in various stages of collection, workout or foreclosure and are primarily secured by New Jersey and New York properties and, to a lesser extent, other forms of collateral.  We have identified approximately $6,000 of specific impairment relating to one of these nonperforming loans for which valuation allowances are maintained in the allowance for loan losses at June 30, 2017.

Home equity loans and home equity lines of credit that are reported as nonperforming at June 30, 2017 include 15 nonaccrual loans totaling $1.2 million.  At June 30, 2017, the outstanding balances of these loans range from $210 to $444,000 with an average balance of approximately $83,000 as of that date.  The loans are in various stages of collection, workout or foreclosure and are primarily secured by New Jersey properties.  There was no specific impairment identified relating to these nonperforming loans at June 30, 2017.

Other consumer loans that are reported as nonperforming at June 30, 2017 include one unsecured loan totaling $74,000 reported as “accruing loans over 90 days past due.”

Nonperforming construction loans include one nonaccrual loan totaling $255,000.  The loan is in the workout stage and is secured by a New Jersey property.  We have identified no specific impairment relating to this nonperforming loan at June 30, 2017.

During the years ended June 30, 2017, 2016 and 2015, gross interest income of $883,000, $1.9 million and $1.8 million, respectively, would have been recognized on loans accounted for on a nonaccrual basis if those loans had been current.  Interest income recognized on such loans of $19,000, $80,000 and $132,000 was included in income for the years ended June 30, 2017, 2016 and 2015, respectively.

At June 30, 2017, 2016, and 2015, Kearny Bank had loans with aggregate outstanding balances totaling $11.0 million, $11.6 million and $8.7 million, respectively, reported as troubled debt restructurings.

During the year ended June 30, 2017, gross interest income of $471,000 would have been recognized on loans reported as troubled debt restructurings under their original terms prior to restructuring.  Actual interest income of $144,000 was recognized on such loans for the year ended June 30, 2017 reflecting the interest received under the revised terms of those restructured loans.

During the year ended June 30, 2016, gross interest income of $548,000 would have been recognized on loans reported as troubled debt restructurings under their original terms prior to restructuring.  Actual interest income of $233,000 was recognized on such loans for the year ended June 30, 2016 reflecting the interest received under the revised terms of those restructured loans.

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During the year ended June 30, 2015, gross interest income of $503,000 would have been recognized on loans reported as troubled debt restructurings under their original terms prior to restructuring.  Actual interest income of $194,000 was recognized on such loans for the year ended June 30, 2015 reflecting the interest received under the revised terms of those restructured loans.

Loan Review System.  We maintain a loan review system consisting of several related functions including, but not limited to, classification of assets, calculation of the allowance for loan losses, independent credit file review as well as internal audit and lending compliance reviews.  We utilize both internal and external resources, where appropriate, to perform the various loan review functions.  For example, we have engaged the services of a third party firm specializing in loan review and analysis to perform several loan review functions.  The firm reviews the loan portfolio in accordance with the scope and frequency determined by senior management and the Audit and Compliance Committee of the Board of Directors.  The third party loan review firm assists senior management and the Board of Directors in identifying potential credit weaknesses; in appropriately grading or adversely classifying loans; in identifying relevant trends that affect the collectability of the portfolio and identifying segments of the portfolio that are potential problem areas; in verifying the appropriateness of the allowance for loan losses; in evaluating the activities of lending personnel including compliance with lending policies and the quality of their loan approval, monitoring and risk assessment; and by providing an objective assessment of the overall quality of the loan portfolio. Currently, independent loan reviews are being conducted quarterly and include non-performing loans as well as samples of performing loans of varying types within our portfolio.

Our loan review system also includes the internal audit and compliance functions, which operate in accordance with a scope determined by the Audit and Compliance Committee of the Board of Directors.  Internal audit resources assess the adequacy of, and adherence to, internal credit policies and loan administration procedures.  Similarly, our compliance resources monitor adherence to relevant lending-related and consumer protection-related laws and regulations.  The loan review system is structured in such a way that the internal audit function maintains the ability to independently audit other risk monitoring functions without impairing its independence with respect to these other functions.

As noted, the loan review system also comprises our policies and procedures relating to the regulatory classification of assets and the allowance for loan loss functions each of which are described in greater detail below.

Classification of Assets.  In compliance with the regulatory guidelines, our loan review system includes an evaluation process through which certain loans exhibiting adverse credit quality characteristics are classified “Special Mention”, “Substandard”, “Doubtful” or “Loss”.

An asset is classified as “Substandard” if it is inadequately protected by the paying capacity and net worth of the obligor or the collateral pledged, if any.  Substandard assets include those characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Assets classified as “Doubtful” have all of the weaknesses inherent in those classified as “Substandard”, with the added characteristic that the weaknesses present make collection or liquidation in full highly questionable and improbable, on the basis of currently existing facts, conditions and values. Assets, or portions thereof, classified as “Loss” are considered uncollectible or of so little value that their continuance as assets is not warranted.

Management evaluates loans classified as “Substandard” or “Doubtful” for impairment in accordance with applicable accounting requirements.  As discussed in greater detail below, a valuation allowance is established through the provision for loan losses for any impairment identified through such evaluations.  To the extent that impairment identified on a loan is classified as “Loss”, that portion of the loan is charged off against the allowance for loan losses.

The classification of loan impairment as “Loss” is based upon a confirmed expectation for loss.  For loans primarily secured by real estate, the expectation for loss is generally confirmed when: (a) impairment is identified on a loan individually evaluated in the manner described below, and (b) the loan is presumed to be collateral-dependent such that the source of loan repayment is expected to arise solely from sale of the collateral securing the applicable loan.  Impairment identified on non-collateral-dependent loans may or may not be eligible for a “Loss” classification depending upon the other salient facts and circumstances that affect the manner and likelihood of loan repayment. Loan impairment that is classified as “Loss” is charged off against the ALLL concurrent with that classification.

The timeframe between when we first identify loan impairment and when such impairment may ultimately be charged off varies by loan type.  For example, unsecured consumer and commercial loans are generally classified as “Loss” at 120 days past due, resulting in their outstanding balances being charged off at that time.  For our secured loans, the condition of collateral dependency, as noted above, generally serves as the basis upon which a “Loss” classification is ascribed to a loan’s impairment thereby confirming an expected loss and triggering charge off of that impairment.

While the facts and circumstances that effect the manner and likelihood of repayment vary from loan to loan, we generally consider the referral of a loan to foreclosure, coupled with the absence of other viable sources of loan repayment, to be demonstrable evidence of collateral dependency.  Depending upon the nature of the collections process applicable to a particular loan, an early

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determination of collateral dependency could result in a nearly concurrent charge off of a newly identified impairment.  By contrast, a presumption of collateral dependency may only be determined after the completion of lengthy loan collection and/or workout efforts, including bankruptcy proceedings, which may extend several months or more after a loan’s impairment is first identified.

In a limited number of cases, the entire net carrying value of a loan may be determined to be impaired based upon a collateral-dependent impairment analysis.  However, the borrower’s adherence to contractual repayment terms precludes the recognition of a “Loss” classification and charge off.  In these limited cases, a valuation allowance equal to 100% of the impaired loan’s carrying value may be maintained against the net carrying value of the asset.

Assets which do not currently expose us to a sufficient degree of risk to warrant an adverse classification but have some credit deficiencies or other potential weaknesses are designated as “Special Mention” by management.  Adversely classified assets, together with those rated as “Special Mention”, are generally referred to as “Classified Assets”.  Non-classified assets are internally rated within one of four “Pass” categories or as “Watch” with the latter denoting a potential deficiency or concern that warrants increased oversight or tracking by management until remediated.

Management performs a classification of assets review, including the regulatory classification of assets, generally on a monthly basis.  The results of the classification of assets review are validated by our third party loan review firm during their quarterly independent review.  In the event of a difference in rating or classification between those assigned by the internal and external resources, we will generally utilize the more critical or conservative rating or classification.  Final loan ratings and regulatory classifications are presented monthly to the Board of Directors and are reviewed by regulators during the examination process.

The following table discloses our designation of certain loans as special mention or adversely classified during each of the five years presented.

At June 30, 2017, 14 loans were classified as Special Mention and 132 loans were classified as Substandard.  As of that same date, six loans were classified as Doubtful.  As noted above, all loans, or portions thereof, classified as Loss during fiscal 2017 were charged off against the allowance for loan losses.

Allowance for Loan Losses.  Our allowance for loan loss calculation methodology utilizes a “two-tier” loss measurement process that is generally performed monthly.  Based upon the results of the classification of assets and credit file review processes described earlier, we first identify the loans that must be reviewed individually for impairment.  Factors considered in identifying individual loans to be reviewed include, but may not be limited to, loan type, classification status, contractual payment status, performance/accrual status and impaired status.

The loans we consider to be eligible for individual impairment review include our commercial mortgage loans, comprising multi-family and nonresidential real estate loans, construction loans and commercial business loans as well as our one- to four-family mortgage loans, home equity loans and home equity lines of credit.

A reviewed loan is deemed to be impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement.  Once a loan is determined to be impaired, management performs an analysis to determine the amount of impairment associated with that loan.

In measuring the impairment associated with collateral-dependent loans, the fair value of the collateral securing the loan is generally used as a measurement proxy for that of the impaired loan itself as a practical expedient.  In the case of real estate collateral, such values are generally determined based upon a discounted market value obtained through an automated valuation module or prepared by a qualified, independent real estate appraiser. The value of non-real estate collateral is similarly determined based upon the independent assessment of fair market value by a qualified resource.

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We generally obtain independent appraisals on properties securing mortgage loans when such loans are initially placed on nonperforming or impaired status with such values updated approximately every six to twelve months thereafter throughout the collections, bankruptcy and/or foreclosure processes.  Appraised values are typically updated at the point of foreclosure, where applicable, and approximately every six to twelve months thereafter while the repossessed property is held as real estate owned.

As supported by accounting and regulatory guidance, we reduce the fair value of the collateral by estimated selling costs, such as real estate brokerage commissions, to measure impairment when such costs are expected to reduce the cash flows available to repay the loan.

We establish valuation allowances in the fiscal period during which the loan impairments are identified.  The results of management’s individual loan impairment evaluations are validated by our third party loan review firm during their quarterly independent review.  Such valuation allowances are adjusted in subsequent fiscal periods, where appropriate, to reflect any changes in carrying value or fair value identified during subsequent impairment evaluations which are generally updated monthly by management.

The second tier of the loss measurement process involves estimating the probable and estimable losses on loans not otherwise reviewed individually for impairment as well as those individually reviewed loans that are determined to be non-impaired.  Such loans include groups of smaller-balance homogeneous loans that may generally be excluded from individual impairment analysis, and therefore collectively evaluated for impairment, as well as the non-impaired loans within categories that are otherwise eligible for individual impairment review.

Valuation allowances established through the second tier of the loss measurement process utilize historical and environmental loss factors to collectively estimate the level of probable losses within defined segments of our loan portfolio.  These segments aggregate homogeneous subsets of loans with similar risk characteristics based upon loan type.  For allowance for loan loss calculation and reporting purposes, we currently stratify our loan portfolio into seven primary segments: residential mortgage loans, multi-family mortgage loans, non-residential mortgage loans, construction loans, commercial business loans, home equity loans and other consumer loans.

The risks presented by residential mortgage loans are primarily related to adverse changes in the borrower’s financial condition that threaten repayment of the loan in accordance with its contractual terms.  Such risk to repayment can arise from job loss, divorce, illness and the personal bankruptcy of the borrower.  For collateral dependent residential mortgage loans, additional risk of loss is presented by potential declines in the fair value of the collateral securing the loan.

Home equity loans and home equity lines of credit generally share the same risks as those applicable to residential mortgage loans.  However, to the extent that such loans represent junior liens, they are comparatively more susceptible to such risks given their subordinate position behind senior liens.

In addition to sharing similar risks as those presented by residential mortgage loans, risks relating to multi-family and non-residential mortgage loans also arise from comparatively larger loan balances to single borrowers or groups of related borrowers. Moreover, the repayment of such loans is typically dependent on the successful operation of an underlying real estate project and may be further threatened by adverse changes to demand and supply of multi-family and non-residential real estate as well as changes generally impacting overall business or economic conditions.

The risks presented by construction loans are generally considered to be greater than those attributable to residential, multi-family and non-residential mortgage loans.  Risks from construction lending arise, in part, from the concentration of principal in a limited number of loans and borrowers and the effects of general economic conditions on developers and builders. Moreover, a construction loan can involve additional risks because of the inherent difficulty in estimating both a property's value at completion of the project and the estimated cost, including interest, of the project. The nature of these loans is such that they are comparatively more difficult to evaluate and monitor than permanent mortgage loans.

Commercial business loans are also considered to present a comparatively greater risk of loss due to the concentration of principal in a limited number of loans and/or borrowers and the effects of general economic conditions on the business. Commercial business loans may be secured by varying forms of collateral including, but not limited to, business equipment, receivables, inventory and other business assets which may not provide an adequate source of repayment of the outstanding loan balance in the event of borrower default.  Moreover, the repayment of commercial business loans is primarily dependent on the successful operation of the underlying business which may be threatened by adverse changes to the demand for the business’ products and/or services as well as the overall efficiency and effectiveness of the business’ operations and infrastructure.

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Finally, our unsecured consumer loans generally have shorter terms and higher interest rates than other forms of lending but generally involve more credit risk due to the lack of collateral to secure the loan in the event of borrower default.  Consumer loan repayment is dependent on the borrower's continuing financial stability, and therefore is more likely to be adversely affected by job loss, divorce, illness and personal bankruptcy. By contrast, our consumer loans also include account loans that are fully secured by the borrower’s deposit accounts and generally present nominal risk to the Company.

Each primary category is further stratified to distinguish between loans originated and purchased directly from third party lenders from loans acquired through wholesale channels or through business combinations.  Where applicable, such primary categories separately identify loans that are supported by government guarantees, such as those issued by the SBA.  Within these primary categories, loans are grouped loans into more granular segments based on common risk characteristics.  For example, loans secured by real estate, such as residential and commercial mortgage loans, are generally grouped into segments by underlying property type while commercial business loans are grouped into segments based on business or industry type.

In regard to historical loss factors, our allowance for loan loss calculation calls for an analysis of historical charge-offs and recoveries for each of the defined segments within the loan portfolio.  We currently utilize a two-year moving average of annualized net charge-off rates (charge-offs net of recoveries) by loan segment, where available, to calculate our actual historical loss experience.  The outstanding principal balance of the non-impaired portion of each loan segment is multiplied by the applicable historical loss factor, which is updated quarterly, to estimate the level of probable losses based upon our historical loss experience.

As noted, the second tier of our allowance for loan loss calculation also utilizes environmental loss factors to estimate the probable losses within the loan portfolio. Environmental loss factors are based on specific quantitative and qualitative criteria that are used to assess the level of loss exposure arising from key sources of risk within the loan portfolio.  Such sources of risk include those relating to the level of and trends in nonperforming loans; the level of and trends in credit risk management effectiveness, the levels and trends in lending resource capability; levels and trends in economic and market conditions; levels and trends in loan concentrations; levels and trends in loan composition and terms, levels and trends in independent loan review effectiveness, levels and trends in collateral values and the effects of other external factors.

We utilize a set of seven risk tranches, ranging from “negligible risk” to “severe risk”, that establishes a pre-defined range of potential risk ratings to be ascribed to each criteria component supporting an environmental loss factor.  Risk ratings of zero and 30 are ascribed to the “negligible risk” and “severe risk” tranches, respectively, which generally serve as the upper and lower thresholds for the potential range of risk rating values across all risk tranches.  The remaining five risk tranches, ranging from “low risk” to “high risk”, utilize progressively higher ranges of potential risk ratings reflecting the increased level of risk associated with each tranche.

As noted earlier, we utilize both quantitative and qualitative criteria to support our assessment of risk and associated credit loss estimates using environmental loss factors.  In the case of quantitative criteria, we associate pre-defined ranges of potential criteria values with each of the risk tranches noted above.  Through this mechanism, quantitative criteria values are correlated to specific risk tranches.  For loss factor criteria that are based on wholly qualitative metrics, we simply ascribe a risk tranche directly to that criteria based on management judgement.  In both cases, the actual risk ratings ascribed by management to criteria components are generally expected to fall within the pre-defined range of risk ratings assigned to the applicable risk tranche.  

Risk ratings are multiplied by .01% to calculate a loss factor value attributable to each of the criteria components supporting an environmental loss factor. The average of the loss factor values ascribed to the criteria components generally serves as the aggregate value for that loss factor.  Where appropriate, the criteria components supporting a loss factor may be “weighted” in relation to one another to allow for greater emphasis on certain criteria in the calculation of an environmental loss factor.

Like the historical loss factors discussed above, we generally utilize a two-year moving average of criteria values, where available, to determine the risk tranche and associated set of potential risk ratings to be ascribed to the criteria components supporting an environmental loss factor.  By doing so, estimated losses should be directionally consistent with the overall credit risk characteristics and performance of the loan portfolio over time while avoiding significant short-term volatility arising from incremental changes to criteria values.  Where appropriate, we may extend or compress criteria look-back periods to properly reflect the level of credit risk and estimated losses within a specified subset of loans.  The outstanding principal balance of the non-impaired portion of each loan segment is multiplied by the aggregate value of each environmental loss factor, which is updated quarterly, to estimate the level of probable losses attributable to that factor.

The sum of the probable and estimable loan losses calculated through the first and second tiers of the loss measurement processes as described above, represents the total targeted balance for our allowance for loan losses at the end of a fiscal period.  As noted earlier, we establish all additional valuation allowances in the fiscal period during which additional individually identified loan impairments and additional estimated losses on loans collectively evaluated for impairment are identified.  We adjust our balance of valuation allowances through the provision for loan losses as required to ensure that the balance of the allowance for loan losses reflects all probable and estimable loans losses at the close of the fiscal period.  Notwithstanding calculation methodology and the

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noted distinction between valuation allowances established on loans collectively versus individually evaluated for impairment, our entire allowance for loan losses is available to cover all charge-offs that arise from the loan portfolio.

Although we believe that our allowance for loans losses is established in accordance with management’s best estimate, actual losses are dependent upon future events and, as such, further additions to the level of loan loss allowances may be necessary.

The following table sets forth information with respect to activity in the allowance for loan losses for the periods indicated.

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Allocation of Allowance for Loan Losses.  The following table sets forth the allocation of the total allowance for loan losses by loan category and segment and the percent of loans in each category’s segment to total net loans receivable at the dates indicated.  The portion of the loan loss allowance allocated to each loan segment does not represent the total available for future losses which may occur within a particular loan segment since the total loan loss allowance is a valuation reserve applicable to the entire loan portfolio