CFFN

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended June 30, 2010, for Capitol Federal Financial, Inc. (the "Company") and its subsidiary, Capitol Federal Savings Bank (the "Bank"). The Company is a Maryland corporation organized to facilitate the "second-step" conversion of the Bank from a mutual holding company structure to a stock holding company structure. As of the filing date, the conversion was pending final regulatory approvals and shareholder votes, with completion expected in the fourth quarter of fiscal year 2010. The financial statements presented are for the Company and its subsidiaries, as the new holding company (Capitol Federal Financial, Inc.) had no significant assets or operations at the time of filing.

Key Financial Metrics

Material Changes vs. Prior Period

• Net Income: Net income for the quarter increased by $1.3 million (8.3%) compared to the prior year quarter, driven by a $3.5 million decrease in federal insurance premiums (excluding a one-time special assessment in the prior year) and a $1.7 million decrease in other expenses. This was partially offset by a $5.0 million decrease in net interest income.
• Net Interest Income: Decreased $5.0 million for the quarter and $4.6 million for the nine-month period. The decline was primarily due to lower yields on loans and mortgage-backed securities (MBS) as the portfolio repriced to lower market rates, partially offset by lower interest expense on deposits and borrowings.
• Asset Composition: Total assets increased $140 million from the prior fiscal year-end. The loan portfolio decreased $288 million, largely due to a loan swap transaction where $195 million of loans were exchanged for MBS. Conversely, the investment securities portfolio increased $722 million as cash flows from MBS were reinvested into shorter-term securities.
• Asset Quality: Non-performing loans increased $2.3 million to $33.2 million, primarily driven by purchased loans in states with declining real estate values. The ALLL increased to $15.7 million, reflecting higher specific valuation allowances on purchased loans.

Guidance, Outlook, and Risks

• Conversion Status: The Company received conditional approval from the Office of Thrift Supervision (OTS) for the conversion to a stock holding company. The registration statement was declared effective by the SEC. Completion is subject to final regulatory approvals and shareholder/member votes.
• Interest Rate Risk: The Company maintains a positive one-year cumulative gap of 17.09%, indicating more assets than liabilities will reprice in the next 12 months. This positions the Company to benefit from rising rates but exposes it to risk in a falling rate environment. Management is actively lengthening the maturity of liabilities (FHLB advances) to mitigate this risk.
• Regulatory Changes: The Dodd-Frank Act will eliminate the OTS, transferring primary regulation of the Bank to the Office of the Comptroller of the Currency and the holding company to the Federal Reserve. New capital regulations and higher FDIC assessment rates are anticipated.
• Credit Risk: The Company faces exposure to the U.S. housing market and local economic conditions in Kansas and Missouri. A significant portion of non-performing loans are interest-only adjustable-rate mortgages purchased from nationwide lenders, which are sensitive to unemployment and home price declines.

Investor Verification Checklist

• Conversion Completion: Verify the final approval and closing date of the "second-step" conversion to a stock holding company, as this alters the corporate structure and dividend policies.
• Purchased Loan Performance: Monitor the specific valuation allowances and charge-off rates for the purchased loan portfolio, which currently drives the majority of the provision for loan losses and non-performing asset growth.
• Interest Rate Sensitivity: Review the impact of the positive interest rate gap on net interest income if market rates remain low or decline further, given the Company's strategy of reinvesting in shorter-term, lower-yielding securities.
• FDIC Assessments: Track the amortization of the $25.7 million prepaid FDIC assessment and the impact of future special assessments on earnings.
• Dividend Policy: Confirm the continuation of the Mutual Holding Company's (MHC) waiver of dividends, which is critical for maintaining the current dividend payout to public shareholders.