UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark one)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2014

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ______________ to _____________

Commission file number: 1-35085

FRANKLIN FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Virginia	27-4132729
(State or other jurisdiction	(I.R.S. Employer Identification No.)
of incorporation or organization)
4501 Cox Road, Glen Allen, VA 23060
(Address of principal executive offices, including zip code)
(804) 967-7000
(Registrant’s telephone number, including area code)
Not applicable
(Former name, former address and former fiscal year, if changed since last report)

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 x 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 shorter period that the registrant was required to submit and post such files). Yes x 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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ¨ Accelerated Filer x Non-accelerated filer ¨ 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 x

11,823,623 shares of the registrant’s common stock, par value $0.01 per share, were outstanding at May 6, 2014.

Franklin Financial Corporation

Form 10-Q

Table of Contents

		Page No.
Part I.	Financial Information
Item 1.	Financial Statements
	Consolidated Balance Sheets at March 31, 2014 (unaudited) and September 30, 2013	2
	Consolidated Income Statements for the Three and Six Months Ended March 31, 2014 and 2013 (unaudited)	3
	Consolidated Statements of Comprehensive Income for the Three and Six Months Ended March 31, 2014 and 2013 (unaudited)	4
	Consolidated Statements of Changes in Stockholders’ Equity for the Six Months Ended March 31, 2014 and 2013 (unaudited)	5
	Consolidated Statements of Cash Flows for the Six Months Ended March 31, 2014 and 2013 (unaudited)	6
	Notes to the Unaudited Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	30
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	46
Item 4.	Controls and Procedures	47
Part II.	Other Information
Item 1.	Legal Proceedings	47
Item 1A.	Risk Factors	47
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	47
Item 3.	Defaults Upon Senior Securities	48
Item 4.	Mine Safety Disclosures	48
Item 5.	Other Information	48
Item 6.	Exhibits	48
Signatures

1

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

FRANKLIN FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Balance Sheets

(Dollars in thousands, except per share amounts)	March 31, 2014			September 30, 2013
	(unaudited)
Assets
Cash and cash equivalents:
Cash and due from banks	$	25,047		$	28,005
Interest-bearing deposits in other banks		59,301			67,724
Money market investments		4,827			3,185
Total cash and cash equivalents		89,175			98,914
Securities available for sale		253,289			304,998
Securities held to maturity		114,963			70,249
Loans, net of deferred loan fees		554,793			520,923
Less allowance for loan losses		10,721			9,740
Net loans		544,072			511,183
Federal Home Loan Bank stock		9,503			9,328
Office properties and equipment, net		6,797			6,881
Other real estate owned		25,868			6,715
Accrued interest receivable:
Loans		2,461			2,257
Mortgage-backed securities and collateralized mortgage obligations		835			715
Other investment securities		888			1,109
Total accrued interest receivable		4,184			4,081
Cash surrender value of bank-owned life insurance		34,792			34,296
Prepaid expenses and other assets		12,552			12,676
Total assets	$	1,095,195		$	1,059,321
Liabilities and Stockholders’ Equity
Deposits:
Regular checking	$	2,423		$	1,526
Savings deposits		292,498			281,998
Time deposits		375,699			363,314
Total deposits		670,620			646,838
Federal Home Loan Bank borrowings		174,133			163,485
Advance payments by borrowers for property taxes and insurance		2,886			2,769
Accrued expenses and other liabilities		4,440			4,835
Total liabilities		852,079			817,927
Commitments and contingencies (see note 8)
Stockholders’ equity:
Preferred stock, $0.01 par value: 10,000,000 shares authorized, no shares issued or outstanding		–			–
Common stock, $0.01 par value: 75,000,000 shares authorized, 11,933,023 and 12,250,625 shares issued and outstanding, respectively		119			123
Additional paid-in capital		106,882			112,516
Unearned ESOP shares		(9,585	)		(9,870	)
Unearned equity incentive plan shares		(6,284	)		(7,725	)
Undistributed stock-based deferral plan shares		(2,646	)		(2,646	)
Retained earnings		143,243			136,255
Accumulated other comprehensive income		11,387			12,741
Total stockholders’ equity		243,116			241,394
Total liabilities and stockholders’ equity	$	1,095,195		$	1,059,321

The accompanying notes are an integral part of these consolidated financial statements.

2

FRANKLIN FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Income Statements

Three and Six Months Ended March 31, 2014 and 2013 (Unaudited)

	Three Months Ended March 31,					Six Months Ended March 31,
(Dollars in thousands, except per share amounts)	2014		2013			2014			2013
Interest and dividend income:
Interest and fees on loans	$	7,919	$	7,353		$	15,822		$	14,601
Interest on deposits in other banks		14		49			53			100
Interest and dividends on securities:
Taxable		2,522		2,445			4,899			5,076
Nontaxable		–		67			–			135
Total interest and dividend income		10,455		9,914			20,774			19,912
Interest expense:
Interest on deposits		1,642		1,612			3,296			3,309
Interest on borrowings		1,814		1,911			3,650			3,857
Total interest expense		3,456		3,523			6,946			7,166
Net interest income		6,999		6,391			13,828			12,746
Provision for loan losses		296		126			1,393			361
Net interest income after provision for loan losses		6,703		6,265			12,435			12,385
Noninterest income (expense):
Service charges on deposit accounts		12		11			28			23
Other service charges and fees		151		72			291			335
Gains on sales of loans held for sale		–		45			–			94
Gains on sales of securities, net		2,973		1,382			4,645			1,413
Gains on sales of other real estate owned		40		525			152			1,564
Impairment of securities, net:
Impairment of securities		–		(1,029	)		(266	)		(1,079	)
Less: Impairment recognized in other comprehensive income		–		(953	)		309			(884	)
Net impairment reflected in income		–		(76	)		(575	)		(195	)
Increase in cash surrender value of bank-owned life insurance		313		315			634			642
Other operating income		220		181			456			368
Total noninterest income		3,709		2,455			5,631			4,244
Other noninterest expenses:
Personnel expense		2,747		2,798			5,382			5,534
Occupancy expense		247		245			496			481
Equipment expense		223		227			439			454
Advertising expense		46		32			129			59
Federal deposit insurance premiums		202		157			384			353
Impairment of other real estate owned		8		–			8			–
Other operating expenses		1,392		1,254			2,689			2,425
Total other noninterest expenses		4,865		4,713			9,527			9,306
Income before provision for income taxes		5,547		4,007			8,539			7,323
Provision for income taxes		1,144		1,292			1,551			2,299
Net income	$	4,403	$	2,715		$	6,988		$	5,024
Basic net income per common share	$	0.40	$	0.23		$	0.63		$	0.42
Diluted net income per common share	$	0.38	$	0.23		$	0.61		$	0.42

The accompanying notes are an integral part of these consolidated financial statements.

3

FRANKLIN FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

Three and Six Months Ended March 31, 2014 and 2013 (Unaudited)

	Three Months Ended March 31,
(Dollars in thousands)	2014						2013
Net income				$	4,403					$	2,715
Other comprehensive (loss) income, net of income tax (benefit) expense:
Net unrealized holding gains or losses arising during the period (net of tax 2014: $(129), 2013: $164)	$	373					$	2,751
Reclassification adjustment for gains or losses included in net income (net of tax 2014: $123, 2013: $525)		(2,142	)					(857	)
Other-than-temporary impairment of held-to-maturity securities related to factors other than credit, net of amortization (net of tax 2014: $535, 2013: $(334))		873						(545	)
Other comprehensive (loss) income					(896	)					1,349
Total comprehensive income				$	3,507					$	4,064

	Six Months Ended March 31,
(Dollars in thousands)	2014						2013
Net income				$	6,988					$	5,024
Other comprehensive (loss) income, net of income tax (benefit) expense:
Net unrealized holding gains or losses arising during the period (net of tax 2014: $(413), 2013: $(191))	$	1,349					$	2,812
Reclassification adjustment for gains or losses included in net income (net of tax 2014: $123, 2013: $520)		(3,814	)					(849	)
Other-than-temporary impairment of held-to-maturity securities related to factors other than credit, net of amortization (net of tax 2014: $681, 2013: $(284))		1,111						(462	)
Other comprehensive (loss) income					(1,354	)					1,501
Total comprehensive income				$	5,634					$	6,525

The accompanying notes are an integral part of these consolidated financial statements.

4

FRANKLIN FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Changes in Stockholders’ Equity

Six Months Ended March 31, 2014 and 2013 (Unaudited)

(Dollars in thousands, except per share amount)	Common Stock			Additional Paid-in Capital			Unearned ESOP Shares			Unearned Equity Incentive Plan Shares			Undistributed Stock-Based Deferral Plan Shares			Retained Earnings			Accumulated Other Comprehensive Income			Total Stockholders’ Equity
Balance at September 30, 2012	$	133		$	129,391		$	(10,442	)	$	(7,411	)	$	(2,533	)	$	132,251		$	8,078		$	249,467
ESOP shares allocated		-			205			285			-			-			-			-			490
Repurchase of common stock		(6	)		(10,401	)		-			-			-			-			-			(10,407	)
Stock-based compensation expense		-			1,863			-			-			-			-			-			1,863
Common stock purchased for equity incentive plan		-			-			-			(1,754	)		-			-			-			(1,754	)
Common stock purchased by stock-based deferral plan		-			113			-			-			(113	)		-			-			-
Vesting of restricted stock		-			(1,440	)		-			1,440			-			-			-			-
Tax benefit from restricted stock vesting		-			165			-			-			-			-			-			165
Cash dividend paid ($0.45 per share)		-			-			-			-			-			(5,342	)		-			(5,342	)
Net income		-			-			-			-			-			5,024			-			5,024
Other comprehensive income		-			-			-			-			-			-			1,501			1,501
Balance at March 31, 2013	$	127		$	119,896		$	(10,157	)	$	(7,725	)	$	(2,646	)	$	131,933		$	9,579		$	241,007
Balance at September 30, 2013	$	123		$	112,516		$	(9,870	)	$	(7,725	)	$	(2,646	)	$	136,255		$	12,741		$	241,394
ESOP shares allocated		-			272			285			-			-			-			-			557
Repurchase of common stock		(4	)		(6,178	)		-			-			-			-			-			(6,182	)
Stock-based compensation expense		-			1,504			-			-			-			-			-			1,504
Vesting of restricted stock		-			(1,441	)		-			1,441			-			-			-			-
Tax benefit from restricted stock vesting		-			209			-			-			-			-			-			209
Net income		-			-			-			-			-			6,988			-			6,988
Other comprehensive loss		-			-			-			-			-			-			(1,354	)		(1,354	)
Balance at March 31, 2014	$	119		$	106,882		$	(9,585	)	$	(6,284	)	$	(2,646	)	$	143,243		$	11,387		$	243,116

The accompanying notes are an integral part of these consolidated financial statements.

5

FRANKLIN FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows

Six Months Ended March 31, 2014 and 2013 (Unaudited)

	2014			2013
(Dollars in thousands)
Cash Flows From Operating Activities
Net income	$	6,988		$	5,024
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation and amortization		426			445
Provision for loan losses		1,393			361
Impairment charges on other real estate owned		8			-
Gains on sales of securities, net		(4,645	)		(1,413	)
Impairment charge on securities		575			195
Losses on sales or disposal of office properties and equipment, net		24			1
Gains on sales of other real estate owned, net		(152	)		(1,564	)
Net amortization on securities		737			1,294
Amortization of deferred amounts related to Federal Home Loan Bank borrowings		648			637
Gains on sales of loans held for sale		-			(94	)
Originations of loans held for sale		-			(3,250	)
Sales and principal payments on loans held for sale		-			4,159
ESOP compensation expense		557			490
Stock-based compensation expense		1,504			1,863
Changes in assets and liabilities:
Accrued interest receivable		(103	)		403
Cash surrender value of bank-owned life insurance		(634	)		(642	)
Prepaid expenses and other assets		187			2,390
Advance payments by borrowers for property taxes and insurance		117			497
Accrued expenses and other liabilities		(396	)		(143	)
Net cash and cash equivalents provided by operating activities		7,234			10,653
Cash Flows From Investing Activities
Net (purchases) redemptions of Federal Home Loan Bank stock		(175	)		303
Proceeds from maturities, calls and paydowns of securities available for sale		44,524			73,698
Proceeds from sales and redemptions of securities available for sale		7,388			18,334
Purchases of securities available for sale		-			(41,869	)
Proceeds from maturities and paydowns of securities held to maturity		5,548			2,335
Proceeds from sales of securities held to maturity		9,145			-
Purchases of securities held to maturity		(57,485	)		-
Net increase in loans		(54,120	)		(19,007	)
Purchases of office properties and equipment		(366	)		(1,301	)
Proceeds from sales of other real estate owned		830			9,078
Proceeds from bank-owned life insurance		138			-
Net cash and cash equivalents (used) provided by investing activities		(44,573	)		41,571
Cash Flows From Financing Activities
Net increase in regular checking		897			421
Net increase in savings deposits		10,500			5,104
Net increase (decrease) in time deposits		12,385			(17,019	)
Repurchase of common stock		(6,182	)		(10,407	)
Common stock purchased for equity incentive plan		-			(1,754	)
Net proceeds of long-term Federal Home Loan Bank borrowings		10,000			-
Cash dividends paid to common stockholders		-			(5,342	)
Net cash and cash equivalents provided (used) by financing activities		27,600			(28,997	)
Net (decrease) increase in cash and cash equivalents		(9,739	)		23,227
Cash and cash equivalents at beginning of period		98,914			119,879
Cash and cash equivalents at end of period	$	89,175		$	143,106
Supplemental disclosures of cash flow information
Cash payments for interest	$	6,287		$	6,547
Cash payments for income taxes	$	1,863		$	500
Supplemental schedule of noncash investing and financing activities
Unrealized (losses) gains on securities available for sale	$	(3,000	)	$	1,252
Transfer of loans to other real estate owned	$	20,666		$	1,965
Sales of other real estate owned financed by the Bank	$	828		$	752

.

The accompanying notes are an integral part of these consolidated financial statements.

6

FRANKLIN FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements

Note 1.  Nature of Business and Summary of Significant Accounting Policies

Organization and Description of Business -- Franklin Financial Corporation (“Franklin Financial”), a Virginia corporation, is the holding company for Franklin Federal Savings Bank (“Franklin Federal” or the “Bank”), a federally chartered capital stock savings bank engaged in the business of attracting retail deposits from the general public and originating non-owner-occupied one- to four-family loans, multi-family loans, nonresidential real estate loans, construction loans, land and land development loans, and, on a limited basis, non-real estate loans and second mortgages. The Bank has three wholly owned subsidiaries, Franklin Service Corporation, which provides trustee services on loans originated by the Bank; Reality Holdings LLC, which, through its subsidiaries, holds and manages foreclosed properties purchased upon foreclosure of loans by the Bank; and Franklin Federal Mortgage Holdings LLC, which through a 49% owned joint venture with TowneBank Mortgage, originates, sells and services mortgage loans, primarily on owner-occupied single-family properties. The interim consolidated financial statements presented in this report include the unaudited financial information of Franklin Financial and subsidiaries on a consolidated basis. The Company (as defined below) operates as one segment.

These interim consolidated financial statements do not contain all necessary disclosures required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements and, therefore, should be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2013 (“2013 Form 10-K”).  These interim consolidated financial statements include all normal and recurring adjustments that management believes are necessary in order to conform to GAAP.  The results for the three and six months ended March 31, 2014 are not necessarily indicative of the results that may be expected for the year ending September 30, 2014 or any other future period. The consolidated balance sheet as of September 30, 2013 was derived from the Company’s audited annual consolidated financial statements in the 2013 Form 10-K.

Principles of Consolidation -- The consolidated financial statements include the accounts of Franklin Financial, the Bank, Franklin Service Corporation, Reality Holdings LLC and its subsidiaries, and Franklin Federal Mortgage Holdings LLC and its joint venture (collectively, the “Company”). All significant intercompany transactions and balances have been eliminated in consolidation. The accounting and reporting policies of the Company conform to GAAP.

Use of Estimates -- Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with GAAP. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the allowance for loan losses, the valuation of other real estate owned, the projected benefit obligation for the defined benefit pension plan, the valuation of deferred taxes, the valuation of stock-based compensation, and the analysis of securities for other-than-temporary impairment.

Loans -- Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal balance adjusted for any charge-offs and net of the allowance for loan losses and any deferred fees or costs. Loan origination fees and certain direct loan origination costs are deferred and recognized over the contractual lives of the related loans as an adjustment of the loans’ yields using the level-yield method on a loan-by-loan basis.

Loans are placed on nonaccrual status when they are three monthly payments or more past due unless management believes, based on individual facts, that the delay in payment is temporary and that the borrower will be able to bring past due amounts current and remain current or unless adverse events affecting the borrower indicate that a loan should be placed on nonaccrual status before three monthly payments are past due. All interest accrued but not collected for loans that are placed on nonaccrual status is reversed against interest income. Any payments made on these loans while on nonaccrual status are accounted for on a cash-basis until the loan qualifies for return to accrual status or is subsequently charged-off. Loans are returned to accrual status when the principal and interest amounts due are brought current and management believes that the borrowers will be able to continue to make required contractual payments.

7

Allowance for Loan Losses -- The allowance for loan losses is maintained at an amount estimated to be sufficient to absorb probable principal losses, net of principal recoveries (including recovery of collateral), inherent in the existing loan portfolio. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. The allowance for loan losses consists of specific and general components.

The specific component relates to loans identified as impaired. The Company determines and recognizes impairment of certain loans when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans that experience insignificant delays and payment shortfalls generally are not classified as impaired. Once a loan is identified as impaired, management determines a specific allowance by comparing the outstanding loan balance to net realizable value. The net realizable value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. The amount of any allowance recognized is the amount by which the loan balance exceeds the net realizable value. If the net realizable value exceeds the loan balance, no allowance is recorded. For loans using the collateral method to estimate the net realizable value, a charge-off is recorded instead of a specific allowance for the amount by which the loan balance exceeds the net realizable value, which includes estimated selling costs.

The general component covers loans not identified as impaired and is based on historical loss experience adjusted for various qualitative factors. The allowance for loan losses is increased by provisions for loan losses and decreased by charge-offs (net of recoveries) and credit provisions. In estimating the allowance, management segregates its portfolio by loan type. Management’s periodic determination of the allowance for loan losses is based on consideration of various factors, including the Company’s past loan loss experience, current delinquency status and loan performance statistics, industry loan loss statistics, periodic loan evaluations, real estate value trends in the Company’s primary lending areas, regulatory requirements, and current economic conditions. The delinquency status of loans is computed based on the contractual terms of the loans.

Management’s estimate of the adequacy of the allowance is subject to evaluation and adjustment by the Bank’s regulators. Management believes that the current allowance for loan losses is a reasonable estimate of known and inherent losses in the loan portfolio.

Stock-Based Compensation -- The Company has issued restricted stock and stock options under the Franklin Financial Corporation 2012 Equity Incentive Plan to key officers and outside directors. In accordance with the requirements of ASC 718, Compensation – Stock Compensation, the Company uses a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured based on the fair value of the award as of the grant date and recognized over the vesting period.

Income Taxes -- Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss, capital loss, and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to be in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in earnings in the period that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to the amount deemed more likely than not to be realized in future periods. It is the Company’s policy to provide for uncertain tax positions and the related interest and penalties based upon management’s assessment of whether a tax benefit is more likely than not to be sustained upon examination by tax authorities. Any interest and penalties assessed on tax positions are recognized in income tax expense.

Reclassifications -- Certain reclassifications have been made to the financial statements of prior periods to conform to the current period presentation. Net income, basic and diluted net income per common share, and stockholders’ equity previously reported were not affected by these reclassifications.

8

Concentrations of Credit Risk -- Most of the Company’s activities are with customers in Virginia with primary geographic focus in the Richmond metropolitan area, which includes the city of Richmond and surrounding counties. Securities and loans also represent concentrations of credit risk and are discussed in note 2 “Securities” and note 3 “Loans” in the notes to the unaudited consolidated financial statements. Although the Company believes its underwriting standards are conservative, the nature of the Company’s portfolio of construction loans, land and land development loans, and income-producing nonresidential real estate loans and multi-family loans results in a smaller number of higher-balance loans. As a result, the default of loans in these portfolio segments may result in more significant losses to the Company.

Recent Accounting Pronouncements -- In February 2013, the FASB issued Accounting Standards Update (ASU) No. 2013-02, Comprehensive Income: Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, to improve the transparency of reporting these reclassifications. This ASU requires an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under GAAP to be reclassified in its entirety to net income. For public entities, the ASU is effective for fiscal periods, and interim periods within those fiscal periods, beginning after December 15, 2012. The adoption of ASU 2013-02 did not have an effect on the Company’s consolidated financial statements; however, additional required disclosures are presented herein.

In July 2013, the FASB issued ASU No. 2013-11, Income Taxes: Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The amendments of this ASU provide entities with guidance on the presentation of unrecognized tax benefits when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. This ASU is effective for fiscal periods, and interim periods within those fiscal periods, beginning after December 15, 2013. The Company does not expect the adoption of this standard will have a material impact on its consolidated financial statements.

In January 2014, the FASB issued ASU 2014-01, “Investments—Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects (a consensus of the FASB Emerging Issues Task Force).” The amendments of this ASU permit reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit). The amendments in ASU 2014-01 should be applied retrospectively to all periods presented. A reporting entity that uses the effective yield method to account for its investments in qualified affordable housing projects before the date of adoption may continue to apply the effective yield method for those pre-existing investments. The ASU is effective for fiscal periods, and interim periods within those fiscal periods, beginning after December 15, 2014. Early adoption is permitted. The Company does not expect the adoption of this standard will have a material impact on its consolidated financial statements.

In January 2014, the FASB issued ASU 2014-04, “Receivables—Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure (a consensus of the FASB Emerging Issues Task Force).” The amendments of this ASU clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. This ASU is effective for fiscal periods, and interim periods within those fiscal periods, beginning after December 15, 2014. The Company does not expect the adoption of this standard will have a material impact on its consolidated financial statements.

9

Note 2.  Securities

The amortized cost, gross unrealized gains and losses, and estimated fair value of securities at March 31, 2014 and September 30, 2013 are summarized as follows:

	March 31, 2014
(Dollars in thousands)	Amortized cost		Gross unrealized gains		Gross unrealized losses		Estimated fair value
Available for sale:
States and political subdivisions	$	4,917	$	207	$	–	$	5,124
Agency mortgage-backed securities		103,183		516		1,039		102,660
Agency collateralized mortgage obligations		58,468		486		3		58,951
Corporate equity securities		7,167		8,517		7		15,677
Corporate debt securities		65,888		5,011		22		70,877
Total	$	239,623	$	14,737	$	1,071	$	253,289

	September 30, 2013
(Dollars in thousands)	Amortized cost		Gross unrealized gains		Gross unrealized losses		Estimated fair value
Available for sale:
States and political subdivisions	$	5,370	$	191	$	–	$	5,561
Agency mortgage-backed securities		112,502		695		768		112,429
Agency collateralized mortgage obligations		79,031		1,044		6		80,069
Corporate equity securities		10,941		10,108		7		21,042
Corporate debt securities		80,487		5,429		19		85,897
Total	$	288,331	$	17,467	$	800	$	304,998

	March 31, 2014
(Dollars in thousands)	Amortized cost		Gross unrealized gains		Gross unrealized losses		Estimated fair value
Held to maturity:
Agency mortgage-backed securities	$	86,866	$	402	$	267	$	87,001
Agency collateralized mortgage obligations		28,097		428		–		28,525
Total	$	114,963	$	830	$	267	$	115,526

	September 30, 2013
(Dollars in thousands)	Adjusted amortized cost		OTTI recognized in AOCI		Amortized cost		Gross unrealized gains		Gross unrealized losses		Estimated fair value
Held to maturity:
Agency mortgage-backed securities	$	31,692	$	–	$	31,692	$	389	$	–	$	32,081
Agency collateralized mortgage obligations		30,724		–		30,724		459		148		31,035
Non-agency collateralized mortgage obligations		7,833		1,791		9,624		1,610		1,603		9,631
Total	$	70,249	$	1,791	$	72,040	$	2,458	$	1,751	$	72,747

10

The amortized cost and estimated fair value of securities at March 31, 2014 and September 30, 2013, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties.

	March 31, 2014								September 30, 2013
	Available for sale				Held to maturity				Available for sale				Held to maturity
	Amortized cost		Estimated fair value		Amortized cost		Estimated fair value		Amortized cost		Estimated fair value		Amortized cost		Estimated fair value
Non-mortgage debt securities:
Due in one year or less	$	12,016	$	12,014	$	–	$	–	$	21,351	$	21,522	$	–	$	–
Due after one year through five years		29,868		31,692		–		–		32,263		34,055		–		–
Due after five years through ten years		19,967		22,761		–		–		22,712		25,808		–		–
Due after ten years		8,954		9,534		–		–		9,531		10,073		–		–
Total non-mortgage debt securities		70,805		76,001		–		–		85,857		91,458		–		–
Mortgage-backed securities		103,183		102,660		86,866		87,001		112,502		112,429		31,692		32,081
Collateralized mortgage obligations		58,468		58,951		28,097		28,525		79,031		80,069		40,348		40,666
Corporate equity securities		7,167		15,677		–		–		10,941		21,042		–		–
Total securities	$	239,623	$	253,289	$	114,963	$	115,526	$	288,331	$	304,998	$	72,040	$	72,747

The following tables indicate the length of time that individual securities have been in a continuous unrealized loss position as of March 31, 2014 and September 30, 2013:

	March 31, 2014
	Less Than 12 Months				12 Months or Longer				Total
	Estimated		Gross		Estimated		Gross		Estimated		Gross
	fair		unrealized		fair		unrealized		fair		unrealized
(Dollars in thousands)	value		losses		value		losses		value		losses
Available for sale:
Agency mortgage-backed securities	$	53,675	$	332	$	27,293	$	707	$	80,968	$	1,039
Agency collateralized mortgage obligations		4,226		3		–		–		4,226		3
Corporate equity securities		18		7		–		–		18		7
Corporate debt securities		4,987		13		2,991		9		7,978		22
Total available for sale		62,906		355		30,284		716		93,190		1,071
Held to maturity:
Agency mortgage-backed securities		64,037		267		–		–		64,037		267
Total held to maturity		64,037		267		–		–		64,037		267
Total	$	126,943	$	622	$	30,284	$	716	$	157,227	$	1,338

	September 30, 2013
	Less Than 12 Months				12 Months or Longer				Total
(Dollars in thousands)	Estimated fair value		Gross unrealized losses		Estimated fair value		Gross unrealized losses		Estimated fair value		Gross unrealized losses
Available for sale:
Agency mortgage-backed securities	$	48,006	$	768	$	–	$	–	$	48,006	$	768
Agency collateralized mortgage obligations		10,237		6		–		–		10,237		6
Corporate equity securities		22		7		–		–		22		7
Corporate debt securities		2,995		5		2,986		14		5,981		19
Total available for sale		61,260		786		2,986		14		64,246		800
Held to maturity:
Agency collateralized mortgage obligations		17,057		148		–		–		17,057		148
Non-agency collateralized mortgage obligations		46		101		4,698		1,502		4,744		1,603
Total held to maturity		17,103		249		4,698		1,502		21,801		1,751
Total	$	78,363	$	1,035	$	7,684	$	1,516	$	86,047	$	2,551

11

The Company’s securities portfolio consists of investments in various debt and equity securities as permitted by regulations of the Office of the Comptroller of the Currency (“OCC”) and the Board of Governors of the Federal Reserve System (“FRB”), including mortgage-backed securities, collateralized mortgage obligations, state and local government obligations, corporate debt obligations, and common stock of various companies, almost exclusively community banks.

During the three months ended March 31, 2014 and 2013, the Company recognized gross gains on sales of securities available for sale of $2.3 million and $1.4 million, respectively. During the six months ended March 31, 2014 and 2013, the Company recognized gross gains on sales of securities available for sale of $3.9 million and $1.4 million, respectively. The Company recognized no losses during the three and six months ended March 31, 2014 and 2013. On January 31, 2014, the Company also sold its portfolio of non-agency CMOs, which was classified as held to maturity. This sale was in response to significant deterioration in the creditworthiness of the issuers as well as a significant increase in the risk weights of debt securities used for regulatory risk-based capital purposes. The securities sold had a carrying value of $8.4 million at the time of sale, which generated a gain of $708,000 for the three months ended March 31, 2014.

The Company performs an other-than-temporary impairment analysis of the securities portfolio on a quarterly basis. The determination of whether a security is other-than-temporarily impaired is highly subjective and requires a significant amount of judgment. In evaluating for other-than-temporary impairment, management considers the duration and severity of declines in fair value, the financial condition of the issuers of each security, as well as whether it is more likely than not that the Company will be required to sell these securities prior to recovery, which may be maturity, based on market conditions and cash flow requirements. In performing its analysis for debt securities, the Company’s consideration of the financial condition of the issuer of each security focuses on the issuer’s ability to continue to perform on its debt obligations, including any concerns about the issuer’s ability to continue as a going concern. In performing its analysis for equity securities, the Company’s analysis of the financial condition of the issuer of each security includes the issuer’s economic outlook, distressed capital raises, large write-downs causing dilution of capital, distressed dividend cuts, discontinuation of significant segments, replacement of key executives, and the existence of a pattern of significant operating losses.

The Company recognized no impairment charges in income for the three months ended March 31, 2014 and $76,000 of impairment charges on debt securities for the three months ended March 31, 2013. The Company recognized total impairment charges in income on debt securities of $575,000 and $195,000 for the six months ended March 31, 2014 and 2013, respectively.

The table below provides a cumulative rollforward of credit losses recognized in earnings for debt securities for which a portion of OTTI is recognized in AOCI for the three and six months ended March 31, 2014 and 2013:

	Three Months Ended March 31,						Six Months Ended March 31,
(Dollars in thousands)	2014			2013			2014			2013
Balance of credit losses at beginning of period	$	29		$	61		$	46		$	164
Additions for credit losses on securities not previously recognized		–			5			12			5
Additional credit losses on securities previously recognized as impaired		–			20			243			26
Reductions for securities for which OTTI previously recognized in AOCI was recognized in  earnings		–			(20	)		(243	)		(20	)
Reductions for securities sold or paid off		(29	)		–			(29	)		–
Reductions for increases in expected cash flows		–			(8	)		(29	)		(117	)
Balance of credit losses at end of period	$	–		$	58		$	–		$	58

To determine the amount of other-than-temporary impairment losses that are related to credit versus the portion related to other factors, management compares the current period estimate of future cash flows to the prior period estimated future cash flows, both discounted at each security’s yield at purchase. Any other-than-temporary impairment recognized in excess of the difference of these two values is deemed to be related to factors other than credit.

12

Unrealized losses in the remainder of the Company’s portfolio of collateralized mortgage obligations, mortgage-backed securities, and corporate debt securities were related to sixteen securities and were caused by increases in market interest rates, spread volatility, or other factors that management deems to be temporary; and because management believes that it is not more likely than not that the Company will be required to sell these securities prior to maturity or a full recovery of the amortized cost, the Company does not consider these securities to be other-than-temporarily impaired.

Unrealized losses in the Company’s portfolio of equity securities were related to one security and were considered temporary. Because management believes that it is not more likely than not that the Company will be required to sell this equity position for a reasonable period of time sufficient for a recovery of fair value, the Company does not consider this equity security to be other-than-temporarily impaired.

The Company pledges certain securities as collateral for its FHLB borrowings. Securities collateralizing FHLB borrowings had a carrying value of $262.1 million at March 31, 2014 compared to $157.2 million at September 30, 2013.

Note 3.  Loans

Loans held for investment at March 31, 2014 and September 30, 2013 are summarized as follows:

	March 31,		September 30,
(Dollars in thousands)	2014		2013
Loans
One- to four-family	$	93,928	$	93,301
Multi-family		100,306		105,295
Nonresidential		257,279		243,562
Construction		44,400		35,823
Land and land development		44,678		46,081
Loans to other financial institutions (unsecured)		17,426		–
Other		401		405
Total loans		558,418		524,467
Deferred loan fees		3,625		3,544
Loans, net of deferred loan fees		554,793		520,923
Allowance for loan losses		10,721		9,740
Net loans	$	544,072	$	511,183

The Company pledges certain loans as collateral for its FHLB borrowings. Loans collateralizing FHLB borrowings had a carrying value of $327.1 million at March 31, 2014 compared to $315.0 million at September 30, 2013.

Note 4.  Allowance for Loan Losses

The allowance for loan losses is maintained at a level considered adequate to provide for our estimate of probable credit losses inherent in the loan portfolio. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. While the Company uses the best information available to make its evaluation, future adjustments may be necessary if there are significant changes in conditions.

The allowance is comprised of two components: (1) a general allowance related to loans collectively evaluated and (2) a specific allowance related to loans individually evaluated and identified as impaired. A summary of the methodology the Company employs on a quarterly basis related to each of these components to estimate the allowance for loan losses is as follows.

13

Credit Rating Process

The Company's loan grading system analyzes various risk characteristics of each loan type when considering loan quality, including loan-to-value ratios, debt service coverage ratios, debt yields, current real estate market conditions, location and appearance of properties, income and net worth of any guarantors, and rental stability and cash flows of income-producing nonresidential real estate loans and multi-family loans. The Company grades loans in lending relationships greater than $2.0 million and any individual loan greater than $1.0 million. All remaining loans are included in the Not Rated category. The credit rating process results in one of the following classifications for each loan in order of increasingly adverse classification: Excellent, Good, Satisfactory, Watch List, Special Mention, Substandard, and Impaired. The Company continually monitors the credit quality of loans in the portfolio through communications with borrowers as well as review of delinquency and other reports that provide information about credit quality. Credit ratings are updated at least annually with more frequent updates performed for problem loans or when management becomes aware of circumstances related to a particular loan that could materially impact the loan’s credit rating. Management maintains a classified loan list consisting of watch list loans along with loans rated special mention or lower that is reviewed on a monthly basis by the Company’s Internal Asset Review Committee.

General Allowance

To determine the general allowance, the Company segregates loans by portfolio segment as defined by loan type. The Company determines a base reserve rate for each portfolio segment by calculating the average charge-off rate for each segment over a historical time period determined by management, typically one to three years. The base reserve rate is then adjusted based on qualitative factors that management believes could result in future loan losses differing from historical experience. Such qualitative factors can include delinquency rates, loan-to-value ratios, market interest rate changes, legal and competitive factors, and local economic and real estate conditions. The base reserve rate plus these qualitative adjustments results in a total reserve rate for each portfolio segment.

Specific Allowance for Impaired Loans

Impaired loans include loans identified as impaired through our credit rating system as well as loans modified in a troubled debt restructuring. Loans are identified as impaired when management believes, based on current information and events, it is probable that the Company will be unable to collect all amounts due in accordance with the contractual terms of the underlying loan agreement. Once a loan is identified as impaired, management determines a specific allowance by comparing the outstanding loan balance to net realizable value. The net realizable value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. The amount of any allowance recognized is the amount by which the loan balance exceeds the net realizable value. If the net realizable value exceeds the loan balance, no allowance is recorded. For loans using the collateral method to estimate the net realizable value, a charge-off is recorded instead of a specific allowance for the amount by which the loan balance exceeds the net realizable value, which includes estimated selling costs.

14

Activity in the allowance for loan losses by portfolio segment is summarized as follows:

	Three Months Ended March 31, 2014
(Dollars in thousands)	One- to four- family			Multi- family			Non- residential			Construction			Land and land development		Loans to other financial institutions		Other			Total
Balance, December 31, 2013	$	865		$	1,892		$	5,783		$	479		$	1,329	$	110	$	6		$	10,464
Provision		4			(173	)		(503	)		(3	)		838		134		(1	)		296
Recoveries		87			–			–			3			2		–		1			93
Charge-offs		(132	)		–			–			–			–		–		–			(132	)
Balance, March 31, 2014	$	824		$	1,719		$	5,280		$	479		$	2,169	$	244	$	6		$	10,721

	Three Months Ended March 31, 2013
(Dollars in thousands)	One- to four-family		Multi- family		Non- residential		Construction			Land and land development			Other			Total
Balance, December 31, 2012	$	1,665	$	1,271	$	3,396	$	906		$	3,403		$	8		$	10,649
Provision		78		507		1,143		122			(1,723	)		(1	)		126
Recoveries		1		–		–		3			9			–			13
Charge-offs		–		–		–		(150	)		–			–			(150	)
Balance, March 31, 2013	$	1,744	$	1,778	$	4,539	$	881		$	1,689		$	7		$	10,638

	Six Months Ended March 31, 2014
(Dollars in thousands)	One- to four- family			Multi- family			Non- residential		Construction			Land and land development			Loans to other financial institutions		Other			Total
Balance, September 30, 2013	$	780		$	1,856		$	5,203	$	619		$	1,276		$	–	$	6		$	9,740
Provision		62			(137	)		77		(146	)		1,294			244		(1	)		1,393
Recoveries		207			–			–		6			5			–		1			219
Charge-offs		(225	)		–			–		–			(406	)		–		–			(631	)
Balance, March 31, 2014	$	824		$	1,719		$	5,280	$	479		$	2,169		$	244	$	6		$	10,721

	Six Months Ended March 31, 2013
(Dollars in thousands)	One- to four-family		Multi- family		Non- residential		Construction			Land and land development			Other			Total
Balance, September 30, 2012	$	1,404	$	1,060	$	3,428	$	1,014		$	3,373		$	5		$	10,284
Provision		338		718		1,078		(88	)		(1,701	)		16			361
Recoveries		2		–		33		105			17			–			157
Charge-offs		–		–		–		(150	)		–			(14	)		(164	)
Balance, March 31, 2013	$	1,744	$	1,778	$	4,539	$	881		$	1,689		$	7		$	10,638

15

During the three and six months ended March 31, 2014, the Company recorded net charge-offs of $39,000 and $412,000, respectively, compared to $137,000 and $7,000, respectively, in the three and six months ended March 31, 2013. During the six months ended March 31, 2014, the Company recorded a provision for loan losses of $62,000, $77,000 and $244,000 for its portfolios of one- to four-family loans, nonresidential loans, and loans to other financial institutions, respectively, due to increased loan balances in these portfolios. The Company also recorded a provision for loan losses of $1.3 million for its portfolio of land and land development loans due to a $406,000 charge-off recorded in the first quarter of fiscal 2014 in connection with a foreclosure on collateral securing a nonperforming loan as well as an increase in the balance of land and land development loans included in the general allowance calculation due to new loans originated during the six months ended March 31, 2014. These provisions were partially offset by credit provisions of $146,000 and $137,000 for the Company’s portfolios of construction loans and multi-family loans, respectively, for the six months ended March 31, 2014. The credit provision for the construction loan portfolio was due to a decline in the reserve rate for the portfolio due to improvements in historical loss experience, partially offset by an increased loan balance in the portfolio. The credit provision for the multi-family loan portfolio was due to a decreased loan balance in the portfolio.

Details of the allowance for loan losses by portfolio segment and impairment methodology at March 31, 2014 and September 30, 2013 are as follows:

	March 31, 2014
	General Allowance				Specific Allowance											Allowance as
(Dollars in thousands)	Balance		Allowance		Balance		Allowance		Total Balance		Total Allowance		Coverage			% of total allowance
One- to four-family	$	91,787	$	824	$	2,141	$	–	$	93,928	$	824		0.88	%		7.7	%
Multi-family		87,722		1,719		12,584		–		100,306		1,719		1.71			16.0
Nonresidential		250,259		5,280		7,020		–		257,279		5,280		2.05			49.2
Construction		44,357		479		43		–		44,400		479		1.08			4.5
Land and land development		35,148		2,169		9,530		–		44,678		2,169		4.86			20.2
Loans to other financial institutions		17,426		244		–		–		17,426		244		1.40			2.3
Other		401		6		–		–		401		6		1.45			0.1
Total allowance	$	527,100	$	10,721	$	31,318	$	–	$	558,418	$	10,721		1.92			100.0	%

	September 30, 2013
	General Allowance				Specific Allowance											Allowance as
(Dollars in thousands)	Balance		Allowance		Balance		Allowance		Total Balance		Total Allowance		Coverage			% of total allowance
One- to four-family	$	85,913	$	780	$	7,388	$	–	$	93,301	$	780		0.84	%		8.0	%
Multi-family		92,725		1,856		12,570		–		105,295		1,856		1.76			19.0
Nonresidential		236,520		5,203		7,042		–		243,562		5,203		2.14			53.4
Construction		35,780		619		43		–		35,823		619		1.73			6.4
Land and land development		21,485		1,276		24,596		–		46,081		1,276		2.77			13.1
Other		405		6		–		–		405		6		1.47			0.1
Total allowance	$	472,828	$	9,740	$	51,639	$	–	$	524,467	$	9,740		1.86			100.0	%

16

Details regarding classified loans and impaired loans at March 31, 2014 and September 30, 2013 are as follows:

	March 31,		September 30,
(Dollars in thousands)	2014		2013
Special mention
One- to four-family	$	5,106	$	5,169
Nonresidential		3,591		6,070
Construction		327		411
Land and land development		3,746		5,195
Total special mention loans		12,770		16,845
Substandard
One- to four-family		2,806		2,452
Construction		3		353
Land and land development		39		39
Total substandard loans		2,848		2,844
Impaired
One- to four-family		2,141		7,388
Multi-family		12,584		12,570
Nonresidential		7,020		7,042
Construction		43		43
Land and land development		9,530		24,596
Total impaired loans		31,318		51,639
Total rated loans	$	46,936	$	71,328

The decrease in special mention loans at March 31, 2014 compared to September 30, 2013 was primarily the result of the upgrade of one nonresidential loan totaling $2.4 million to satisfactory as well as payments received on a land and land development loan as a result of lot sales during the six months ended March 31, 2014. The decrease in impaired loans was primarily due to the foreclosure of four land and land development loans totaling $16.0 million secured by three separate tracts of land, all of which were taken into other real estate owned, as well as the payoff of two loans on multiple one- to four-family properties totaling $3.8 million during the six months ended March 31, 2014.

Included in impaired loans are troubled debt restructurings of $16.2 million and $11.3 million at March 31, 2014 and September 30, 2013, respectively, that had related allowance balances of zero. Troubled debt restructurings that were performing in accordance with modified terms were $5.7 million and $5.5 million at March 31, 2014 and September 30, 2013, respectively.

Troubled Debt Restructurings

During the six months ended March 31, 2014, the Company modified five loans in troubled debt restructurings, including three one- to four-family loans and two land and land development loans. The three one-to four-family loan modifications pertained to three separate borrowers. The first modification involved a reduction in the monthly principal payment requirement to a borrower experiencing financial difficulty. This loan, which had an outstanding balance of $207,000, was 91-120 days delinquent and on nonaccrual status at March 31, 2014. The remaining two one- to four-family loan modifications involved loans discharged under bankruptcy proceedings. One of these loans, which had an outstanding balance of $157,000, was current and on nonaccrual status at March 31, 2014. The other loan was foreclosed upon, and the property was taken into other real estate owned for $386,000 during the three months ended March 31, 2014. The two land and land development loans pertained to two separate borrowers. Both modifications involved the extension of current loan terms to borrowers experiencing financial difficulty. The first loan, which was previously identified as impaired, had an outstanding balance of $3.6 million and was over 180 days delinquent at March 31, 2014. The second loan had an outstanding balance of $1.1 million and was current at March 31, 2014. Both loans were on nonaccrual status at March 31, 2014. The Company did not have any loans restructured during the previous twelve months that went into default during the six months ended March 31, 2014. Interest recognized on a cash basis on nonaccrual restructured loans was $49,000 and $144,000 for the three and six months ended March 31, 2014, respectively.

17

During the six months ended March 31, 2013, the Company had no loans modified in troubled debt restructurings. Interest recognized on a cash basis on nonaccrual restructured loans was not material for the three and six months ended March 31, 2013.

Loans summarized by loan type and credit rating at March 31, 2014 and September 30, 2013 are as follows:

	March 31, 2014
(Dollars in thousands)	Total		Excellent		Good		Satisfactory		Watch List		Special Mention		Substandard		Impaired		Not Rated
One- to four-family	$	93,928	$	–	$	2,487	$	27,814	$	1,405	$	5,106	$	2,806	$	2,141	$	52,169
Multi-family		100,306		280		20,242		59,618		2,607		–		–		12,584		4,975
Nonresidential		257,279		–		97,343		140,337		2,806		3,591		–		7,020		6,182
Construction		44,400		–		3,145		34,600		–		327		3		43		6,282
Land and land development		44,678		–		–		14,392		–		3,746		39		9,530		16,971
Loans to other financial institutions		17,426		–		–		10,950		–		–		–		–		6,476
Other		401		–		–		–		–		–		–		–		401
Total loans	$	558,418	$	280	$	123,217	$	287,711	$	6,818	$	12,770	$	2,848	$	31,318	$	93,456

	September 30, 2013
(Dollars in thousands)	Total		Excellent		Good		Satisfactory		Watch List		Special Mention		Substandard		Impaired		Not Rated
One- to four-family	$	93,301	$	–	$	1,386	$	25,172	$	–	$	5,169	$	2,452	$	7,388	$	51,734
Multi-family		105,295		283		22,758		64,702		–		–		–		12,570		4,982
Nonresidential		243,562		–		79,079		132,650		–		6,070		–		7,042		18,721
Construction		35,823		–		–		5,003		–		411		353		43		30,013
Land and land development		46,081		–		184		–		734		5,195		39		24,596		15,333
Other		405		–		–		–		–		–		–		–		405
Total loans	$	524,467	$	283	$	103,407	$	227,527	$	734	$	16,845	$	2,844	$	51,639	$	121,188

Details regarding the delinquency status of the Company’s loan portfolio at March 31, 2014 and September 30, 2013 are as follows:

	March 31, 2014
(Dollars in thousands)	Total		Current		31-60 Days		61-90 Days		91-120 Days		121-150 Days		151-180 Days		180+ Days
One- to four-family	$	93,928	$	88,480	$	1,705	$	41	$	816	$	468	$	–	$	2,418
Multi-family		100,306		87,722		–		2,500		–		–		–		10,084
Nonresidential		257,279		257,279		–		–		–		–		–		–
Construction		44,400		44,400		–		–		–		–		–		–
Land and land development		44,678		41,106		–		–		–		–		–		3,572
Loans to other financial institutions		17,426		17,426		–		–		–		–		–		–
Other		401		401		–		–		–		–		–		–
Total	$	558,418	$	536,814	$	1,705	$	2,541	$	816	$	468	$	–	$	16,074

18

	September 30, 2013
(Dollars in thousands)	Total		Current		31-60 Days		61-90 Days		91-120 Days		121-150 Days		151-180 Days		180+ Days
One- to four-family	$	93,301	$	84,881	$	602	$	–	$	578	$	1,069	$	157	$	6,014
Multi-family		105,295		99,254		–		–		–		–		–		6,041
Nonresidential		243,562		243,102		460		–		–		–		–		–
Construction		35,823		35,823		–		–		–		–		–		–
Land and land development		46,081		23,727		2,632		3,632		–		–		–		16,090
Other		405		405		–		–		–		–		–		–
Total	$	524,467	$	487,192	$	3,694	$	3,632	$	578	$	1,069	$	157	$	28,145

The following is a summary of information pertaining to impaired and nonaccrual loans:

	Six Months Ended March 31, 2014							Six Months Ended March 31, 2013
(Dollars in thousands)	Weighted Average Balance		Interest Income Recognized		Annualized Yield			Weighted Average Balance		Interest Income Recognized		Annualized Yield
Impaired loans
One- to four-family	$	4,661	$	420		18.03	%	$	6,254	$	95		3.03	%
Multi-family		12,570		38		0.60			12,648		249		3.93
Nonresidential		7,033		206		5.85			5,482		178		6.50
Construction		43		1		5.04			54		1		4.08
Land and land development		20,243		190		1.88			9,164		–		–
Total impaired loans	$	44,550	$	855		3.84		$	33,602	$	523		3.11

(Dollars in thousands)	March 31, 2014		September 30, 2013
Nonaccrual loans
One- to four-family	$	5,186	$	10,369
Multi-family		12,584		12,570
Nonresidential		1,579		1,584
Land and land development		9,541		24,608
Total nonaccrual loans	$	28,890	$	49,131

Interest recognized on a cash basis on all nonaccrual loans was $137,000 and $263,000 for the three months ended March 31, 2014 and 2013, respectively, and $774,000 and $455,000 for the six months ended March 31, 2014 and 2013, respectively. There were no loans past due ninety days or more and accruing at March 31, 2014 or September 30, 2013.

19

Note 5. Other Real Estate Owned

Other real estate owned at March 31, 2014 and September 30, 2013 was $25.9 million and $6.7 million, respectively. During the six months ended March 31, 2014, the Company sold other real estate owned totaling $1.5 million. The Company recognized net gains on sales of other real estate owned of $40,000 and $152,000 for the three and six months ended March 31, 2014, respectively, compared with net gains of $525,000 and $1.6 million for the three and six months ended March 31, 2013, respectively. Gains on sales for the three and six months ended March 31, 2014 included the recognition of $62,000 and $98,000, respectively, in gains on properties sold in previous periods that had been deferred in accordance with GAAP because financing was provided by the Company and the sale did not meet either initial or continuing investment criteria to qualify for gain recognition. At March 31, 2014, the Company had deferred gains on sales of other real estate owned of $520,000 compared to $519,000 at September 30, 2013. The Company recognized impairment charges on other real estate owned of $8,000 for both the three and six months ended March 31, 2014. No impairment charges on other real estate owned were recognized for the three and six months ended March 31, 2013.

During the six months ended March 31, 2014, the Company foreclosed on loans with balances totaling $20.6 million, including four land and land development loans totaling $16.0 million secured by three separate tracts of land that had previously been identified as impaired. The properties collateralizing these loans had sufficient value such that there were no loan losses as a result of these foreclosures.

Note 6. Earnings per Share

Basic earnings per share are computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share are computed using the weighted average number of common shares outstanding during the period, including the effect of dilutive potential common shares outstanding attributable to stock awards.

	Three Months Ended March 31,				Six Months Ended     March 31,
(Amounts in thousands, except per share data)	2014		2013		2014		2013
Numerator:
Net income available to common stockholders	$	4,403	$	2,715	$	6,988	$	5,024
Denominator:
Weighted-average common shares outstanding		11,081		11,817		11,142		11,961
Effect of dilutive securities		312		148		326		136
Weighted-average common shares outstanding - assuming dilution		11,393		11,965		11,468		12,097
Earnings per common share - basic	$	0.40	$	0.23	$	0.63	$	0.42
Earnings per common share - diluted	$	0.38	$	0.23	$	0.61	$	0.42

Note 7. Employee Benefit Plans

Pension Plan

The Bank has a noncontributory defined benefit pension plan (the “Pension Plan”) for substantially all of the Bank’s employees who were employed on or before July 31, 2011. The Bank froze the Pension Plan to new participants effective August 1, 2011, and, therefore, employees hired after July 31, 2011 are not eligible to participate in the Pension Plan. Retirement benefits under this plan are generally based on an employee’s years of service and compensation during the five consecutive years of highest compensation in the ten years immediately preceding retirement. The Company uses a September 30 measurement date for the Pension Plan.

The Pension Plan assets are held in a trust fund by the plan trustee. The trust agreement under which assets of the Pension Plan are held is a part of the Virginia Bankers Association Master Defined Benefit Pension Plan (the “Plan”). The Plan’s administrative trustee is appointed by the board of directors of the Virginia Bankers Association Benefits Corporation. At March 31, 2014, Reliance Trust Company was investment manager and administrative trustee for the Plan. Contributions are made to the Pension Plan, at management’s discretion, subject to meeting minimum funding requirements, up to the maximum amount allowed under the Employee Retirement Income Security Act of 1974 (ERISA), based upon the actuarially determined amount necessary for meeting plan obligations. Contributions are intended to provide not only for benefits attributed to service to date, but also for benefits expected to be earned by employees in the future.

20

Components of net periodic benefit (income) cost for the three and six months ended March 31, 2014 and 2013 are as follows:

	Three Months Ended March 31,						Six Months Ended March 31,
(Dollars in thousands)	2014			2013			2014			2013
Service cost	$	88		$	105		$	175		$	211
Interest cost		175			154			351			308
Expected return on plan assets		(264	)		(237	)		(528	)		(474	)
Recognized net actuarial loss		(4	)		30			(8	)		60
Net periodic benefit (income) cost	$	(5	)	$	52		$	(10	)	$	105

The net periodic benefit (income) cost is included in personnel expense in the consolidated income statements.

Equity Incentive Plan

On February 21, 2012, the Company adopted the Franklin Financial Corporation 2012 Equity Incentive Plan (the “2012 Equity Incentive Plan”), which provides for awards of restricted stock and stock options to key officers and outside directors. The cost of the 2012 Equity Incentive Plan is based on the fair value of restricted stock and stock option awards on their grant date. The maximum number of shares that may be awarded under the plan is 2,002,398, including 1,430,284 for stock option exercises and 572,114 restricted stock shares.

Shares of common stock issued under the 2012 Equity Incentive Plan may be authorized unissued shares or, in the case of restricted stock awards, may be shares repurchased on the open market. As of September 30, 2013, the Company, through an independent trustee, had repurchased all 572,114 shares on the open market for $9.2 million, or an average cost of $16.02 per share.

The table below presents stock option activity for the six months ended March 31, 2014:

(Dollars in thousands, except per share amounts)	Options		Weighted- average exercise price		Remaining contractual life (years)		Aggregate intrinsic value
Options outstanding at September 30, 2013	1,107,600		$	13.42	8.50		$	6,136
Granted		315,200		18.40
Exercised		–		–
Forfeited		–		–
Expired		–		–
Options outstanding at March 31, 2014		1,422,800	$	14.52		8.34	$	7,166

During the six months ended March 31, 2014, the Company granted 315,200 stock options to directors and officers under the 2012 Equity Incentive Plan. The stock options are contingent upon meeting service conditions and vest ratably over five years. The fair value of these stock option grants was determined using the Black-Scholes option pricing formula, which resulted in a fair value of $4.98 per option. The following assumptions were used in the formula:

Expected volatility		22.02	%
Risk-free interest rate		1.89	%
Expected dividends		0.00	%
Expected life (in years)		6.5
Grant price for the stock options	$	18.40

21

At March 31, 2014, the Company had $3.8 million of unrecognized compensation expense related to 1,380,904 stock options vested or expected to vest. The period over which compensation cost related to non-vested awards is expected to be recognized was 3.54 years at March 31, 2014. As of March 31, 2014, 438,600 options were vested and outstanding. The table below presents information about stock options vested or expected to vest over the remaining vesting period at March 31, 2014:

(Dollars in thousands, except per share amount)
Options vested or expected to vest at period end		1,380,904
Weighted-average exercise price	$	14.50
Remaining contractual life (years)		8.34
Aggregate intrinsic value	$	6,986

The table below presents restricted stock award activity for the six months ended March 31, 2014:

	Restricted stock awards			Weighted- average grant date fair value
Non-vested at September 30, 2013		359,600		$	13.42
Granted		122,500			18.40
Vested		(89,900	)		13.42
Forfeited		–			–
Non-vested at March 31, 2014		392,200		$	14.98

During the six months ended March 31, 2014, the Company granted 122,500 restricted stock awards to directors and officers under the 2012 Equity Incentive Plan. The restricted stock awards are contingent upon meeting service conditions and vest ratably over five years. Also during the six months ended March 31, 2014, the board of directors of the Company deemed the performance conditions for the 2014 and 2015 vesting periods for the restricted stock awards granted in 2012 to have been met with respect to officers and made the vesting of those awards subject only to meeting service conditions. Performance conditions for the 2016 vesting period remain in place.

At March 31, 2014, unrecognized compensation expense adjusted for expected forfeitures was $3.6 million related to 375,545 shares of restricted stock expected to vest over the remaining vesting period. The weighted-average period over which compensation cost related to non-vested restricted stock awards is expected to be recognized was 3.8 years at March 31, 2014.

The estimated unamortized compensation expense, net of estimated forfeitures, related to nonvested stock options and restricted stock issued and outstanding as of March 31, 2014 that will be recognized in future periods is as follows:

(Dollars in thousands)	Stock Options		Restricted Stock		Total
For the six months ending September 30, 2014	$	560	$	586	$	1,146
For the year ending September 30, 2015		1,117		1,170		2,287
For the year ending September 30, 2016		1,118		909		2,027
For the year ending September 30, 2017		700		540		1,240
For the year ending September 30, 2018		298		428		726
For the year ending September 30, 2019		2		4		6
Total	$	3,795	$	3,637	$	7,432

Share-based compensation related to stock options and restricted stock recognized for the three and six months ended March 31, 2014 was $744,000 and $1.5 million, respectively, and the related income tax benefit was $283,000 and $571,000, respectively. Share-based compensation related to stock options and restricted stock recognized for the three and six months ended March 31, 2013 was $914,000 and $1.9 million, respectively, and the related income tax benefit was $347,000 and $708,000, respectively.

22

Employee Stock Ownership Plan

In connection with the Company’s stock conversion completed in April 2011, the Bank established an employee stock ownership plan (“ESOP”) for the benefit of all of its eligible employees. Employees at the date of conversion and employees of the Bank hired after the conversion who have been credited with at least 1,000 hours of service during a 12-month period and who have attained age 21 are eligible to participate in the ESOP. It is anticipated that the Bank will make contributions to the ESOP in amounts necessary to amortize the ESOP loan payable to Franklin Financial over a period of 20 years.

Unearned ESOP shares are shown as a reduction of stockholders’ equity. Dividends on unearned ESOP shares, if paid, will be considered to be compensation expense. The Company recognizes compensation cost equal to the fair value of the ESOP shares during the periods in which they become committed to be released. To the extent that the fair value of the Company’s ESOP shares differs from the cost of such shares, the differential is recognized in stockholders’ equity. The Company receives a tax deduction equal to the cost of the shares released. As the ESOP is internally leveraged, the loan receivable by Franklin Financial from the ESOP is not reported as an asset nor is the debt of the ESOP shown as a liability in the consolidated financial statements.

Compensation expense related to the ESOP for the three and six months ended March 31, 2014 was $274,000 and $557,000, respectively, compared to $249,000 and $490,000, respectively, for the three and six months ended March 31, 2013. The fair value of unearned ESOP shares, using the closing quoted market price per share of the Company’s stock, was $18.7 million at March 31, 2014. A summary of ESOP share allocation for the six months ended March 31, 2014 is as follows:

Shares allocated at September 30, 2013	155,775
Shares allocated during the period	28,528
Shares distributed during the period	(1,516	)
Allocated shares held by the ESOP trust at March 31, 2014	182,787
Unearned shares at March 31, 2014	958,487
Total ESOP shares	1,141,274

Stock-Based Deferral Plan

In connection with the Company’s stock conversion completed in April 2011, the Company adopted a stock-based deferral plan whereby certain officers and directors could use funds from previously existing nonqualified deferred compensation plans to invest in stock of the Company. The Company established a trust to hold shares purchased through the stock-based deferral plan. The stock-based deferral plan as well as the Bank’s previously existing nonqualified deferred compensation plans were terminated on December 18, 2013 and must be paid out no sooner than December 19, 2014 and no later than December 18, 2015. The trust, which qualifies as a rabbi trust, will be terminated upon distribution of shares held by the trust. Until then, shares held by the trust are accounted for in a manner similar to treasury stock, and the deferred compensation balance is recorded as a component of additional paid-in capital on the Company’s consolidated balance sheet in accordance with GAAP.

Note 8. Financial Instruments with Off-Balance-Sheet Risk

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

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Company uses the same credit and collateral policies in making commitments to extend credit and standby letters of credit as it does for on-balance-sheet instruments.

23

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 by the customer. Since some commitments may expire without being funded, the commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The total amount of loan commitments was $105.9 million and $101.1 million at March 31, 2014 and September 30, 2013, respectively.

Standby letters of credit written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk and recourse provisions involved in issuing letters of credit are essentially the same as those involved in extending loans to customers, and the estimated fair value of these letters of credit, which is included in accrued expenses and other liabilities, was not material at March 31, 2014 and September 30, 2013. The amount of standby letters of credit was $2.7 million and $1.5 million at March 31, 2014 and September 30, 2013, respectively. The Company believes that the likelihood of having to perform on standby letters of credit is remote based on the financial condition of the guarantors and the Company’s historical experience.

Note 9. Fair Value Measurements

In determining fair value, the Company uses various valuation approaches, including market, income and cost approaches. Accounting standards set forth a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability, which are developed based on market data obtained from sources independent of the Company. Unobservable inputs reflect the Company’s assumptions about the variables that the market participants would use in pricing an asset or liability, which are developed based on the best information available in the circumstances.

The fair value hierarchy gives the highest priority to unadjusted quoted market prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). A financial asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The fair value hierarchy is broken down into three levels based on the reliability of inputs as follows:

• Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

• Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

• Level 3: Valuations for assets and liabilities that are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.

The following is a description of valuation methodologies used for assets recorded at fair value on a recurring or non-recurring basis. The determination of where an asset or liability falls in the hierarchy requires significant judgment. The Company evaluates its hierarchy disclosures each quarter and, based on various factors, it is possible that an asset or liability may be classified differently from quarter to quarter. However, the Company expects that changes in classifications between levels will be rare.

24

Securities available for sale: Securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using a combination of methods, including model pricing based on spreads obtained from new market issues of similar securities, dealer quotes, and trade prices. Level 1 securities include common equity securities traded on nationally recognized securities exchanges. Level 2 securities include mortgage-backed securities and collateralized mortgage obligations issued by government sponsored entities, municipal bonds, and corporate debt securities. Level 3 securities include corporate debt securities.

Securities held to maturity: Securities held-to-maturity are recorded at fair value on a non-recurring basis. A held-to-maturity security’s amortized cost is adjusted only in the event that a decline in fair value is deemed to be other-than-temporary.

Impaired loans: The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and, if necessary, a specific allowance for loan losses is established. Loans for which it is probable that payment of principal and interest will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management writes the loan down to net realizable value either through a specific allowance or a charge-off, which, for “collateral dependent” impaired loans, is equal to fair value of the collateral less estimated costs to sell, if the loan balance exceeds net realizable value. For loans deemed to be “collateral dependent,” fair value is estimated using the appraised value of the related collateral. At the time the loan is identified as impaired, the Company determines if an updated appraisal is needed and orders an appraisal if necessary. Subsequent to the initial measurement of impairment, management considers the need to order updated appraisals each quarter if changes in market conditions lead management to believe that the value of the collateral may have changed materially. Impaired loans where net realizable value is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or an appraised value less than one year old estimated utilizing information gathered from an active market, the Company classifies the impaired loan as a Level 2 asset. When an appraised value is not available, is greater than one year old, or if management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company classifies the impaired loan as a Level 3 asset. Additionally, if the fair value of an impaired loan is determined using an appraisal less than one year old that utilizes information gathered from an inactive market or contains material adjustments based upon unobservable market data, the Company classifies the impaired loan as a Level 3 asset.

Other real estate owned: Other real estate owned (“OREO”) is adjusted to net realizable value, which is equal to fair value less costs to sell, upon foreclosure. Subsequently, OREO is adjusted on a non-recurring basis to the lower of carrying value or net realizable value. Fair value is based upon independent market prices, appraised values of the collateral, or management’s estimation of the value of the OREO. When the fair value of OREO is based on an observable market price or an appraised value less than one year old estimated utilizing information gathered from an active market, the Company classifies the OREO as a Level 2 asset. When an appraised value is not available, is greater than one year old, or if management determines the fair value of the OREO is further impaired below the appraised value and there is no observable market price, the Company classifies the OREO as a Level 3 asset. Additionally, if the fair value of the OREO is determined using an appraisal less than one year old that utilizes information gathered from an inactive market or contains material adjustments based upon unobservable market data, the Company classifies the OREO as a Level 3 asset.

Assets measured at fair value on a recurring basis as of March 31, 2014 and September 30, 2013 are summarized below:

	March 31, 2014								September 30, 2013
(Dollars in thousands)	Total		Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3
Securities available for sale
States and political subdivisions	$	5,124	$	–	$	5,124	$	–	$	5,561	$	–	$	5,561	$	–
Agency mortgage-backed securities		102,660		–		102,660		–		112,429		–		112,429		–
Agency collateralized mortgage obligations		58,951		–		58,951		–		80,069		–		80,069		–
Corporate equity securities		15,677		15,677		–		–		21,042		21,042		–		–
Corporate debt securities		70,877		–		66,466		4,411		85,897		–		81,385		4,512
Total assets at fair value	$	253,289	$	15,677	$	233,201	$	4,411	$	304,998	$	21,042	$	279,444	$	4,512

25

A rollforward of securities classified as Level 3 measured at fair value on a recurring basis for the six months ended March 31, 2014 and 2013 is as follows (dollars in thousands):

	Six Months Ended March 31,
	2014			2013
Balance of Level 3 assets measured on a recurring basis at beginning of period	$	4,512		$	6,433
Principal payments in period		(110	)		(101	)
Sales of securities in period		–			(1,496	)
Amortization of premiums or discounts		(13	)		(14	)
Other-than-temporary impairment charges included in noninterest income		–			(44	)
Net change in unrealized gains or losses included in accumulated other comprehensive income		22			47
Balance of Level 3 assets measured on a recurring basis at end of period	$	4,411		$	4,825

Level 3 securities measured at fair value on a recurring basis at March 31, 2014 consisted of one corporate debt security for which the Company was not able to obtain dealer quotes due to lack of trading activity. For this security the Company obtained a bid indication from a third-party trading desk to determine the fair value.

The Company may be required, from time to time, to measure certain assets at fair value on a non-recurring basis in accordance with GAAP. These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period, including held-to-maturity securities, impaired loans, and real estate owned. Held-to-maturity securities are measured at fair value in a period in which an other-than-temporary impairment charge is recognized. Impaired loans are measured at fair value when a change in the value of the underlying collateral or a change in the present value of estimated future cash flows result in a change in the specific allowance for such a loan. Other real estate owned is measured at fair value in the period of foreclosure or in a period in which a change in net realizable value results in an impairment charge.

Assets measured at fair value on a non-recurring basis as of March 31, 2014 and September 30, 2013 are included in the table below:

	March 31, 2014								September 30, 2013
(Dollars in thousands)	Total		Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3
Non-agency collateralized mortgage obligations	$	–	$	–	$	–	$	–	$	7	$	–	$	–	$	7
Impaired loans
One- to four-family		157		–		–		157		3,633		–		–		3,633
Multi-family		–		–		–		–		12,570		–		–		12,570
Land and land development		–		–		–		–		12,681		–		–		12,681
Other real estate owned		11,898		–		5,061		6,837		2,083		–		–		2,083
Total assets at fair value	$	12,055	$	–	$	5,061	$	6,994	$	30,974	$	–	$	–	$	30,974

The following methods and assumptions were used to estimate fair value of other classes of financial instruments:

Cash and cash equivalents: The carrying amount is a reasonable estimate of fair value.

Loans held for investment: The fair value of loans held for investment is determined by discounting the future cash flows using the rates currently offered for loans of similar remaining maturities. Estimates of future cash flows are based upon current account balances, contractual maturities, prepayment assumptions, and repricing schedules.

Federal Home Loan Bank stock: The carrying amount of restricted stock approximates the fair value based on the redemption provisions.

Accrued interest receivable: The carrying amount is a reasonable estimate of fair value.

26

Deposits: The carrying values of checking and savings deposits are reasonable estimates of fair value. The fair value of fixed-maturity certificates of deposit is determined by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.

FHLB borrowings: The fair values of FHLB borrowings are determined by discounting the future cash flows using rates currently offered for borrowings with similar terms.

Accrued interest payable: The carrying amount is a reasonable estimate of fair value.

Advance payments by borrowers for property taxes and insurance: The carrying amount is a reasonable estimate of fair value.

Commitments to extend credit: The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The majority of the Company’s commitments to extend credit carry current interest rates if converted to loans.

Standby letters of credit: The fair value of standby letters of credit is based on fees the Company would have to pay to have another entity assume its obligation under the outstanding arrangement.

The estimated fair values of the Company’s financial instruments, as well as their classifications in the fair value hierarchy, at March 31, 2014 and September 30, 2013 are as follows:

March 31, 2014

Total

Level 1

Level 2

Level 3

Carrying

Fair

Carrying

Fair

Carrying

Fair

Carrying

Fair

(Dollars in thousands)

Value

Value

Value

Value

Value

Value

Value

Value

Financial assets:

Cash and cash equivalents

$

89,175

$

89,175

$

89,175

$

89,175

$

–

$

–

$

–

$

–

Securities available for sale

253,289

253,289

15,677

15,677

233,201

233,201

4,411

4,411

Securities held to maturity

114,963

115,526

–

–

114,963

115,526

–

–

Net loans

544,072

552,113

–

–

–

–

544,072

552,113

FHLB stock

9,503

9,503

9,503

9,503

–

–

–

–

Accrued interest receivable

4,184

4,184

4,184

4,184

–

–

–

–

Financial liabilities:

Deposits

670,620

674,112

–

–

670,620

674,112

–

–

FHLB borrowings

174,133

194,101

–

–

174,133

194,101

–

–

Accrued interest payable

841

841

841

841

–

–

–

–

Advance payments by borrowers for taxes and insurance

2,886

2,886

2,886

2,886

–

–

–

–

Off-balance-sheet financial instruments:

Commitments to extend credit

–

–

–

–

–

–

–

–

Standby letters of credit

–

30

–

–

–

–

–

30

27

September 30, 2013

Total

Level 1

Level 2

Level 3

Carrying

Fair

Carrying

Fair

Carrying

Fair

Carrying

Fair

(Dollars in thousands)

Value

Value

Value

Value

Value

Value

Value

Value

Financial assets:

Cash and cash equivalents

$

98,914

$

98,914

$

98,914

$

98,914

$

–

$

–

$

–

$

–

Securities available for sale

304,998

304,998

21,042

21,042

279,444

279,444

4,512

4,512

Securities held to maturity

70,249

72,747

–

–

62,416

63,116

7,833

9,631

Net loans

511,183

522,494

–

–

–

–

511,183

522,494

FHLB stock

9,328

9,328

9,328

9,328

–

–

–

–

Accrued interest receivable

4,081

4,081

4,081

4,081

–

–

–

–

Financial liabilities:

Deposits

646,838

650,508

–

–

646,838

650,508

–

–

FHLB borrowings

163,485

183,868

–

–

163,485

183,868

–

–

Accrued interest payable

852

852

852

852

–

–

–

–

Advance payments by borrowers for taxes and insurance

2,769

2,769

2,769

2,769

–

–

–

–

Off-balance-sheet financial instruments:

Commitments to extend credit

–

–

–

–

–

–

–

–

Standby letters of credit

–

21

–

–

–

–

–

21

Note 10. Accumulated Other Comprehensive Income

The table below summarizes the reclassifications out of accumulated other comprehensive income (“AOCI”) for the three and six months ended March 31, 2014 and 2013 (dollars in thousands):

	Three Months Ended March 31, 2014				Three Months Ended March 31, 2013
Details about AOCI components	Amount reclassified from AOCI			Affected line item in the consolidated income statement	Amount reclassified from AOCI			Affected line item in the consolidated income statement
Net unrealized holding gains or losses arising during the period on available for sale securities
	$	(2,265	)	Gains on sales of securities, net	$	(1,382	)	Gains on sales of securities, net
		-				-
		(2,265	)	Income before provision for income taxes		(1,382	)	Income before provision for income taxes
		123		Provision for income taxes		525		Provision for income taxes
	$	(2,142	)	Net income	$	(857	)	Net income

	Six Months Ended March 31, 2014				Six Months Ended March 31, 2013
Details about AOCI components	Amount reclassified from AOCI			Affected line item in the consolidated income statement	Amount reclassified from AOCI			Affected line item in the consolidated income statement
Net unrealized holding gains or losses arising during the period on available for sale securities
	$	(3,937	)	Gains on sales of securities, net	$	(1,413	)	Gains on sales of securities, net
		-				44		Net impairment reflected in income
		(3,937	)	Income before provision for income taxes		(1,369	)	Income before provision for income taxes
		123		Provision for income taxes		520		Provision for income taxes
	$	(3,814	)	Net income	$	(849	)	Net income

28

The table below summarizes the changes in AOCI by component, net of tax, for the three and six months ended March 31, 2014 and 2013 (dollars in thousands):

	Three Months Ended March 31, 2014
	Net unrealized gains on investments			Defined benefit pension plan			OTTI on investments			Total
Beginning balance	$	13,475		$	(319	)	$	(873	)	$	12,283
Other comprehensive income before reclassification		373			-			873			1,246
Amounts reclassified from AOCI		(2,142	)		-			-			(2,142	)
Net other comprehensive (loss) income during the period		(1,769	)		-			873			(896	)
Ending balance	$	11,706		$	(319	)	$	-		$	11,387

	Three Months Ended March 31, 2013
	Net unrealized gains on investments			Defined benefit pension plan			OTTI on investments			Total
Beginning balance	$	10,724		$	(1,800	)	$	(694	)	$	8,230
Other comprehensive income before reclassification		2,751			-			(545	)		2,206
Amounts reclassified from AOCI		(857	)		-			-			(857	)
Net other comprehensive income (loss) during the period		1,894			-			(545	)		1,349
Ending balance	$	12,618		$	(1,800	)	$	(1,239	)	$	9,579

	Six Months Ended March 31, 2014
	Net unrealized gains on investments			Defined benefit pension plan			OTTI on investments			Total
Beginning balance	$	14,171		$	(319	)	$	(1,111	)	$	12,741
Other comprehensive income before reclassification		1,349			-			1,111			2,460
Amounts reclassified from AOCI		(3,814	)		-			-			(3,814	)
Net other comprehensive (loss) income during the period		(2,465	)		-			1,111			(1,354	)
Ending balance	$	11,706		$	(319	)	$	-		$	11,387

	Six Months Ended March 31, 2013
	Net unrealized gains on investments			Defined benefit pension plan			OTTI on investments			Total
Beginning balance	$	10,655		$	(1,800	)	$	(777	)	$	8,078
Other comprehensive income before reclassification		2,812			-			(462	)		2,350
Amounts reclassified from AOCI		(849	)		-			-			(849	)
Net other comprehensive income (loss) during the period		1,963			-			(462	)		1,501
Ending balance	$	12,618		$	(1,800	)	$	(1,239	)	$	9,579

Note 11. Stock Repurchase Program

On August 29, 2013, the board of directors approved a fourth stock repurchase program whereby the Company was authorized to repurchase up to 612,530 shares, or approximately 5% of its common stock that was outstanding upon completion of the third stock repurchase program. During the three and six months ended March 31, 2014, the Company repurchased 166,800 shares and 296,400 shares, respectively, of its outstanding common stock under this fourth program for $3.3 million and $5.8 million, respectively, or an average price of $19.53 per share and $19.46 per share, respectively.

29

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

Safe Harbor Statement for Forward-Looking Statements

This report may contain forward-looking statements within the meaning of the federal securities laws. These statements are not historical facts; rather they are statements based on our current expectations regarding our business strategies and their intended results and our future performance. Forward-looking statements are preceded by terms such as “expects,” “believes,” “anticipates,” “intends” and similar expressions. Forward-looking statements are not guarantees of future performance. Numerous risks and uncertainties could cause or contribute to our actual results, performance and achievements being materially different from those expressed or implied by the forward-looking statements. These forward-looking statements are subject to significant risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:

• general economic conditions, either internationally, nationally, or in our primary market area, that are worse than expected;

• a decline in real estate values;

• changes in the interest rate environment that reduce our interest margins or reduce the fair value of financial instruments;

• increased competitive pressures among financial services companies;

• changes in consumer spending, borrowing and savings habits;

• legislative, regulatory or supervisory changes that adversely affect our business;

• adverse changes in the securities markets; and

• changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the Financial Accounting Standards Board or the Public Company Accounting Oversight Board.

Additional factors that may affect our results are discussed in the Company’s Annual Report on Form 10-K for the year ended September 30, 2013 under Item 1A titled “Risk Factors.” These factors should be considered in evaluating the forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, we assume no obligation and disclaim any obligation to update any forward-looking statements.

Critical Accounting Policies

We consider accounting policies involving significant judgments and assumptions by management that have, or could have, a material impact on the carrying value of certain assets and liabilities or on income and expense to be critical accounting policies.

Allowance for Loan Losses. The allowance for loan losses is the amount estimated by management as necessary to cover losses inherent in the loan portfolio at the balance sheet date. The allowance is established through the provision for loan losses, which is charged or credited to income. Determining the amount of the allowance for loan losses involves a high degree of judgment. Among the material estimates required to establish the allowance are: the likelihood of default; the loss exposure at default; the amount and timing of future cash flows on impaired loans; the value of collateral; and the determination of loss factors to be applied to the various elements of the portfolio. All of these estimates are susceptible to significant change. Management reviews the level of the allowance at least quarterly and establishes the provision for loan losses based upon an evaluation of the portfolio, past loss experience, current economic conditions and other factors related to the collectibility of the loan portfolio. Although we believe that we use the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary if economic or other conditions differ substantially from the assumptions used in making the evaluation. In addition, our regulator, as an integral part of its examination process, periodically reviews our allowance for loan losses and may require us to recognize adjustments to the allowance based on its judgments about information available to it at the time of its examination. A large loss could deplete the allowance and require increased provisions to replenish the allowance, which would adversely affect earnings. See note 4 of the notes to the unaudited consolidated financial statements.

30

Other Real Estate Owned. Real estate acquired through foreclosure, consisting of properties obtained through foreclosure proceedings or acceptance of a deed in lieu of foreclosure, is initially recorded at net realizable value, which is equal to fair value less estimated costs to sell, establishing a new cost basis. Fair value is determined using a market valuation established by third party appraisals, broker estimates or internal evaluations as permitted by the OCC. When properties are acquired through foreclosure, any excess of the loan balance at the time of foreclosure over the fair value of the real estate held as collateral is recognized and charged to the allowance for loan losses. If fair value declines subsequent to foreclosure, a write-down is recorded through expense based on an updated fair value estimate less estimated selling costs. The use of different assumptions could produce significantly different results, which could have material positive or negative effects on the Company’s results of operations.

Other-Than-Temporary Impairment. Investment securities are reviewed at each quarter end to determine whether the fair value is below the current amortized cost. When the fair value of any of our investment securities has declined below its amortized cost, management is required to assess whether the decline is other than temporary. In making this assessment, we consider such factors as the type of investment, the length of time and extent to which the fair value has been below the carrying value, the financial condition and near-term prospects of the issuer, and our intent and ability to hold the investment long enough to allow for any anticipated recovery. The decision to record a write-down, its amount and the period in which it is recorded could change if management’s assessment of the above factors were different. We do not record impairment write-downs on debt securities when impairment is due to changes in interest rates, since we have the intent and ability to realize the full value of the investments by holding them to maturity. Quoted market value is considered to be fair value for actively traded securities. For illiquid and thinly traded securities where market quotes are not available, we use discounted cash flows to determine fair value. Additional information regarding our accounting for investment securities is included in note 2 of the notes to the unaudited consolidated financial statements.

Income Taxes. Management makes estimates and judgments to calculate certain tax liabilities and to determine the recoverability of certain deferred tax assets, which arise from temporary differences between the tax and financial statement recognition of revenues and expenses. The Company also estimates a valuation allowance for deferred tax assets if, based on the available evidence, it is more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods. These estimates and judgments are inherently subjective.

In evaluating the recoverability of deferred tax assets, management considers all available positive and negative evidence, including past operating results, recent cumulative losses – both capital and operating – and the forecast of future taxable income – also both capital and operating. In determining future taxable income, management makes assumptions for the amount of taxable income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require judgments about future taxable income and are consistent with the plans and estimates to manage the Company’s business. Any reduction in estimated future taxable income may require the Company to record a valuation allowance against deferred tax assets. An increase in the valuation allowance would result in additional income tax expense in the period and could have a significant impact on future earnings.

Valuation of Stock-Based Compensation. The Company accounts for its stock options and restricted stock in accordance with ASC Topic 718, Compensation – Stock Compensation. ASC Topic 718 requires companies to expense the fair value of stock-based compensation. Management uses the Black-Scholes option valuation model and the Monte Carlo model to estimate the fair value of stock options and restricted stock, respectively. These models require the input of highly subjective assumptions, including expected stock price volatility, option life and ability to achieve performance and market conditions stipulated for restricted stock awards. These subjective input assumptions materially affect the fair value estimate.

Pension Plan. The Company has a noncontributory defined benefit pension plan. This plan is accounted for under the provisions of ASC Topic 715: Compensation-Retirement Benefits, which requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. The funded status of a benefit plan is measured as the difference between plan assets at fair value and the benefit obligation. For a pension plan, the benefit obligation is the projected benefit obligation. ASC Topic 715 also requires an employer to measure the funded status of a plan as of the date of its year-end balance sheet. Management must make certain estimates and assumptions when determining the projected benefit obligation. These estimates and assumptions include the expected return on plan assets, the rate of compensation increases over time, and the appropriate discount rate to be used in determining the present value of the obligation.

31

Comparison of Financial Condition at March 31, 2014 and September 30, 2013

Assets. Total assets at March 31, 2014 were $1.10 billion, an increase of $35.9 million, or 3.4%, from total assets of $1.06 billion at September 30, 2013.

Cash and cash equivalents decreased $9.7 million to $89.2 million at March 31, 2014 compared to $98.9 million at September 30, 2013, a decrease of 9.8%. The decrease in cash and cash equivalents from September 30, 2013 to March 31, 2014 was primarily due to an increase in loans, purchases of securities, and stock repurchases, partially offset by net income, an increase in deposits, an increase in FHLB borrowings, and sales, prepayments and maturities of securities.

Securities decreased $7.0 million, or 1.9%, to $368.3 million at March 31, 2014 compared to $375.3 million at September 30, 2013. The decrease in securities was due to $35.5 million of normal principal payments on securities, $12.3 million of maturities of corporate debt securities, $7.4 million of sales of equity securities, and $9.1 million of sales of private-label collateralized mortgage obligations (“CMOs”), partially offset by the purchase of $57.5 million of mortgage-backed securities (“MBSs”).

Total loans increased $34.0 million, or 6.5%, to $558.4 million at March 31, 2014 compared to $524.4 million at September 30, 2013. Nonresidential loans increased $13.7 million, loans to other financial institutions increased $17.4 million, construction loans increased $8.6 million, and one- to four-family loans increased $627,000. These increases were partially offset by a decline in land and land development loans of $1.4 million and multi-family loans of $5.0 million.

Liabilities. Total liabilities at March 31, 2014 were $852.1 million compared to $817.9 million at September 30, 2013, an increase of $34.2 million, or 4.2%, due to an increase in deposits and FHLB borrowings. Total deposits increased $23.8 million primarily due to a $12.4 million increase in certificates of deposit and a $10.5 million increase in savings deposits. FHLB borrowings increased $10.6 million due to an additional advance of $10.0 million obtained during the three months ended March 31, 2014. The new advance has an interest rate of 1.65% and will mature in September 2018.

Stockholders’ equity. Stockholders’ equity was $243.1 million at March 31, 2014, an increase of $1.7 million, or 0.7%, from September 30, 2013. The increase was the result of net income of $7.0 million, stock-based compensation expense of $1.5, and the allocation of $557,000 of ESOP shares, partially offset by the repurchase of $6.2 million of common stock as part of the Company’s stock repurchase programs and changes in accumulated other comprehensive income of $1.4 million.

32

Average Balances, Interest and Dividend Income and Interest Expense, Yields and Rates

The following table presents information regarding average balances of assets and liabilities, the total dollar amounts of interest income and dividends from average interest-earning assets, the total dollar amounts of interest expense on average interest-bearing liabilities, and the resulting average yields and costs. The yields and costs for the periods indicated are derived by dividing annualized income or expense by the average daily balances of assets or liabilities, respectively, for the periods presented. Nonaccrual loans are included in average loan balances only. Loan fees are included in interest income on loans and are not material.

	For the Three Months Ended March 31,
	2014								2013
(Dollars in thousands)	Average Balance			Interest and Dividends		Yield/ Cost			Average Balance			Interest and Dividends		Yield/ Cost
Assets:
Interest-earning assets:
Loans:
One- to four-family	$	94,903		$	1,595		6.82	%	$	101,050		$	1,725		6.92	%
Multi-family		100,994			1,280		5.14			90,925			1,411		6.29
Nonresidential		256,629			3,776		5.97			213,039			3,409		6.49
Construction		42,663			594		5.65			24,065			324		5.46
Land and land development		47,767			440		3.74			46,090			475		4.18
Loans to other financial institutions		17,027			226		5.38			–			–		–
Other		402			8		8.07			443			9		8.24
Total loans		560,385			7,919		5.73			475,612			7,353		6.27
Securities:
Collateralized mortgage obligations		96,569			456		1.92			144,970			549		1.54
Mortgage-backed securities		187,515			998		2.16			112,601			450		1.62
States and political subdivisions		5,196			75		5.85			11,897			163		5.56
Corporate equity securities		17,549			88		2.03			16,258			87		2.17
Corporate debt securities		72,773			817		4.55			102,072			1,204		4.78
Total securities		379,602			2,434		2.60			387,798			2,453		2.57
Investment in FHLB stock		9,379			88		3.81			10,072			59		2.38
Other interest-earning assets		41,422			14		0.14			102,148			49		0.20
Total interest-earning assets		990,788			10,455		4.28			975,630			9,914		4.12
Allowance for loan losses		(10,560	)							(10,853	)
Noninterest-earning assets		103,933								91,266
Total assets	$	1,084,161							$	1,056,043
Liabilities and stockholders’ equity:
Interest-bearing liabilities:
Deposits:
Money market savings	$	247,872			320		0.52		$	227,361			269		0.48
Money market checking		45,300			49		0.44			47,878			51		0.43
Certificates of deposit		370,967			1,273		1.39			356,369			1,292		1.47
Total deposits		664,139			1,642		1.00			631,608			1,612		1.04
FHLB borrowings		165,920			1,814		4.43			172,635			1,911		4.49
Total interest-bearing liabilities		830,059			3,456		1.69			804,243			3,523		1.78
Noninterest bearing liabilities		9,906								10,757
Total liabilities		839,965								815,000
Stockholders’ equity		244,196								241,043
Total liabilities and stockholders’ equity	$	1,084,161							$	1,056,043
Net interest income				$	6,999							$	6,391
Interest rate spread(1)							2.59	%							2.34	%
Net interest margin(2)							2.86	%							2.66	%
Average interest-earning assets to average interest-bearing liabilities							119	%							121	%

⁽¹⁾ Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.

⁽²⁾ Net interest margin represents net interest income as a percentage of average interest-earning assets.

33

Comparison of Operating Results for the Three Months Ended March 31, 2014 and March 31, 2013

General. We had net income of $4.4 million, or $0.38 per diluted share, for the three months ended March 31, 2014 compared to $2.7 million, or $0.23 per diluted share, for the three months ended March 31, 2013, an improvement of $1.7 million. The increase was the net result of a $608,000 increase in net interest income, a $1.6 million increase in gains on sales of securities, a $76,000 decrease in other-than-temporary impairment charges on securities included in income, a $79,000 increase in other service charges and fees, and a $148,000 decrease in the provision for income taxes, partially offset by a $170,000 increase in the provision for loan losses, a $485,000 decrease in gains on sales of other real estate owned, and a $152,000 increase in other noninterest expenses.

Net Interest Income. Net interest income increased $608,000, or 9.5%, to $7.0 million in the three months ended March 31, 2014 from $6.4 million in the three months ended March 31, 2013. Net interest margin increased 20 basis points to 2.86% for the three months ended March 31, 2014 from 2.66% for the three months ended March 31, 2013. The average balances of interest-earning assets increased $15.2 million from the three months ended March 31, 2013 to the three months ended March 31, 2014, and the yield increased 16 basis points.

Total interest and dividend income increased $541,000, or 5.4%, to $10.5 million for the three months ended March 31, 2014 from $9.9 million for the three months ended March 31, 2013. Interest income on loans increased $566,000 primarily due to an increase of $84.8 million in the average balance of loans, partially offset by a 54 basis point decline in yield. The decline in yield was primarily the result of lower interest rates for new loans due in part to increased competition for quality loans. The average balance of nonresidential loans increased $43.6 million and the yield declined 52 basis points. The average balance of multi-family loans increased $10.1 million and the yield decreased 115 basis points. The average balance of land and land development loans increased $1.7 million and the yield decreased 44 basis points. The average balance of construction loans increased $18.6 million and the yield increased 19 basis points. The increase in both interest income on loans and the average balance of loans was also due to the new loans to other financial institutions portfolio, which had an average balance of $17.0 million and a yield of 5.38% for the three months ended March 31, 2014. These increases in average balances were partially offset by a $6.1 million decrease in the average balance of one- to four-family loans, with a decrease in yield of 10 basis points.

Interest and dividend income on investment securities (excluding FHLB stock) decreased $19,000, or 0.8%, due to an $8.2 million decrease in the average balance of investment securities for the three months ended March 31, 2014 compared to the three months ended March 31, 2013, partially offset by a 3 basis point increase in yield. The average balance of corporate debt securities decreased $29.3 million and the yield decreased 23 basis points due to the sale of longer-term corporate bonds, resulting in a decrease in interest income of $387,000. The average balance of CMOs decreased $48.4 million due to prepayments as well as the sale of our portfolio of non-agency CMOs during the current quarter and the yield increased 38 basis points, resulting in a decrease in interest income of $93,000. The average balance of state and political subdivision obligations decreased $6.7 million primarily due to the sale of a substandard municipal bond backed by student loans in March 2013, and the yield increased 29 basis points, resulting in a decrease in interest income of $88,000. These decreases were partially offset by a $74.9 million increase in the average balance of MBSs as well as a 54 basis point increase in yield, resulting in an increase in interest income of $548,000. The Company has significantly increased its investment in short-term MBSs to meet regulatory qualified thrift lender requirements and to better position the Company for rising interest rates.

Total interest expense was $3.5 million for the three months ended March 31, 2014 and 2013, decreasing $67,000, or 1.9%. The decline was the result of a $97,000 decrease in Federal Home Loan Bank (“FHLB”) borrowings costs, partially offset by a $30,000 increase in deposit costs. The average balance of interest-bearing deposits increased $32.5 million due to a $20.5 million increase in the average balance of money market savings accounts and a $14.6 million increase in the average balance of certificates of deposit. The average interest rate paid on deposits decreased 4 basis points as a result of the maturity of higher-yielding time deposits and their renewal at lower prevailing rates. The average balance of FHLB borrowings decreased $6.7 million and the average interest rate paid declined 6 basis points due to a prepayment made during the fourth quarter of fiscal 2013, slightly offset by a new advance obtained on March 14, 2014.

34

Provision for Loan Losses. The provision for loan losses increased $170,000 to $296,000 for the three months ended March 31, 2014 compared to $126,000 for the three months ended March 31, 2013. Net loan charge-offs were $39,000 for the three months ended March 31, 2014 compared to $137,000 for the three months ended March 31, 2013. The overall allowance rate increased 2 basis points at March 31, 2014 to 1.92% of total loans from 1.90% of total loans at December 31, 2013. See note 4 of the notes to the unaudited consolidated financial statements for a discussion of our methodology for estimating the allowance for loan losses.

Noninterest Income.

The following table presents the components of noninterest income and the percentage increase (decrease) from the comparable prior year quarter:

	Three Months Ended March 31,					Increase (Decrease)
(Dollars in thousands)	2014		2013			%
Service charges on deposit accounts	$	12	$	11			17.2	%
Other service charges and fees		151		72			108.9
Gains on sales of loans held for sale		-		45			(100.0	)
Gains on sales of securities, net		2,973		1,382			115.2
Gains on sales of other real estate owned		40		525			(92.4	)
Impairment of securities		-		(1,029	)		(100.0	)
Impairment recognized in OCI		-		(953	)		(100.0	)
Net impairment reflected in earnings		-		(76	)		(100.0	)
Increase in cash surrender value of bank-owned life insurance		313		315			(0.8	)
Other operating income		220		181			21.8
Total noninterest income	$	3,709	$	2,455			51.1

Gains, Losses, and Impairment Charges on Securities. Other-than-temporary-impairment charges on securities reflected in earnings decreased $76,000 for the three months ended March 31, 2014 compared to the three months ended March 31, 2013. Impairment charges reflected in earnings for the three months ended March 31, 2013 related to the Company’s portfolio of non-agency CMOs. There were no impairment charges reflected in earnings for the three months ended March 31, 2014. Sales of securities resulted in gains of $3.0 million for the three months ended March 31, 2014 compared to $1.4 million for the three months ended March 31, 2013. Securities sold during the three months ended March 31, 2014 included equity securities of local community bank holding companies as well as the company’s portfolio of non-agency CMOs. Gains on sales of securities also included a $323,000 gain on a corporate bond called during the three months ended March 31, 2014. Securities sold during the three months ended March 31, 2013 were primarily corporate debt securities.

Noninterest Income, Excluding Gains, Losses, and Impairment Charges on Securities. Total other noninterest income excluding gains, losses, and impairment charges on securities decreased $413,000, or 35.9%, for the three months ended March 31, 2014 compared to the three months ended March 31, 2013. The decrease was primarily the result of net gains on sales of other real estate owned of $40,000 in the three months ended March 31, 2014 compared to $525,000 in the three months ended March 31, 2013, a decrease of $485,000. The decrease was partially offset by an increase in other service charges and fees of $79,000 primarily due to an increase in prepayment fees on loans.

35

Other Noninterest Expenses.

The following table presents the components of other noninterest expenses and the percentage increase (decrease) from the comparable prior year quarter:

	Three Months Ended March 31,				Increase (Decrease)
(Dollars in thousands)	2014		2013		%
Personnel expense	$	2,747	$	2,798		(1.8	)%
Occupancy expense		247		245		0.5
Equipment expense		223		227		(2.0	)
Advertising expense		46		32		43.3
Federal deposit insurance premiums		202		157		28.8
Impairment of other real estate owned		8		-		NM
Other operating expenses		1,392		1,254		11.0
Total other noninterest expenses	$	4,865	$	4,713		3.2

Total noninterest expenses increased $152,000, or 3.2%, to $4.9 million for the three months ended March 31, 2014 compared to $4.7 million for the three months ended March 31, 2013. The increase was primarily due to a $138,000 increase in other operating expenses due to increased foreclosure expenses and legal costs as well as an increase in federal deposit insurance premiums of $45,000. These increases were partially offset by a $51,000 decrease in personnel expense due to decreased stock compensation expense related to the stock options and restricted stock granted under the Company’s 2012 Equity Incentive Plan.

Income Tax Expense. Income tax expense was $1.1 million for the three months ended March 31, 2014 compared to $1.3 million for the three months ended March 31, 2013. The effective income tax rate for the three months ended March 31, 2014 was 20.6% compared to an effective income tax rate of 32.2% for the three months ended March 31, 2013. The decrease in the effective tax rate was due to the $1.8 million increase in gains on sales of corporate equity securities. Gains on sales of corporate securities were $1.9 million for the three months ended March 31, 2014, compared to $70,000 for the three months ended March 31, 2013. Gains on sales of corporate equity securities are capital gains and can be offset by capital losses. Because the Company is in a capital loss carryforward position, these gains were offset completely by prior period losses, for which a deferred tax valuation allowance had previously been recorded, resulting in no tax expense on these capital gains for the three months ended March 31, 2014.

36

Average Balances, Interest and Dividend Income and Interest Expense, Yields and Rates

The following table presents information regarding average balances of assets and liabilities, the total dollar amounts of interest income and dividends from average interest-earning assets, the total dollar amounts of interest expense on average interest-bearing liabilities, and the resulting average yields and costs. The yields and costs for the periods indicated are derived by dividing annualized income or expense by the average daily balances of assets or liabilities, respectively, for the periods presented. Nonaccrual loans are included in average loan balances only. Loan fees are included in interest income on loans and are not material.

	For the Six Months Ended March 31,
	2014								2013
(Dollars in thousands)	Average Balance			Interest and Dividends		Yield/ Cost			Average Balance			Interest and Dividends		Yield/ Cost
Assets:
Interest-earning assets:
Loans:
One- to four-family	$	93,862		$	3,528		7.54	%	$	102,059		$	3,413		6.71	%
Multi-family		102,028			2,639		5.19			88,041			2,711		6.18
Nonresidential		253,605			7,501		5.93			208,777			6,788		6.52
Construction		40,083			1,128		5.64			23,829			700		5.89
Land and land development		46,129			652		2.84			45,117			970		4.31
Loans to other financial institutions		13,067			357		5.48			–			–		–
Other		403			17		8.46			453			19		8.41
Total loans		549,177			15,822		5.78			468,276			14,601		6.25
Securities:
Collateralized mortgage obligations		105,320			1,023		1.95			158,648			1,164		1.47
Mortgage-backed securities		171,768			1,657		1.93			102,563			871		1.70
States and political subdivisions		5,324			154		5.80			12,444			333		5.37
Corporate equity securities		18,871			172		1.83			15,578			172		2.21
Corporate debt securities		76,303			1,738		4.57			107,476			2,550		4.76
Total securities		377,586			4,744		2.52			396,709			5,090		2.57
Investment in FHLB stock		9,353			155		3.32			10,077			121		2.41
Other interest-earning assets		61,633			53		0.17			102,001			100		0.20
Total interest-earning assets		997,749			20,774		4.18			977,063			19,912		4.09
Allowance for loan losses		(10,218	)							(10,719	)
Noninterest-earning assets		95,558								94,812
Total assets	$	1,083,089							$	1,061,156
Liabilities and stockholders’ equity:
Interest-bearing liabilities:
Deposits:
Money market savings	$	245,580			641		0.52		$	226,263			510		0.45
Money market checking		45,366			98		0.44			46,927			102		0.44
Certificates of deposit		368,666			2,557		1.39			361,094			2,697		1.50
Total deposits		659,612			3,296		1.00			634,284			3,309		1.05
FHLB borrowings		164,746			3,650		4.44			172,475			3,857		4.48
Total interest-bearing liabilities		824,358			6,946		1.69			806,759			7,166		1.78
Noninterest bearing liabilities		14,810								10,459
Total liabilities		839,168								817,218
Stockholders’ equity		243,921								243,938
Total liabilities and stockholders’ equity	$	1,083,089							$	1,061,156
Net interest income				$	13,828							$	12,746
Interest rate spread(1)							2.49	%							2.31	%
Net interest margin(2)							2.78	%							2.62	%
Average interest-earning assets to average interest-bearing liabilities							121	%							121	%

⁽¹⁾ Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.

⁽²⁾ Net interest margin represents net interest income as a percentage of average interest-earning assets.

37

Comparison of Operating Results for the Six Months Ended March 31, 2014 and March 31, 2013

General. We had net income of $7.0 million, or $0.61 per diluted share, for the six months ended March 31, 2014 compared to $5.0 million, or $0.42 per diluted share, for the six months ended March 31, 2013, an improvement of $2.0 million. The increase was primarily the net result of a $1.1 million increase in net interest income, a $3.2 million increase in gains on sales of securities, and a $748,000 decrease in the provision for income taxes, partially offset by a $1.0 million increase in the provision for loan losses, a $380,000 increase in other-than-temporary impairment charges on securities included in income, a $1.4 million decrease in gains on sales of other real estate owned, and a $221,000 increase in other noninterest expenses.

Net Interest Income. Net interest income increased $1.1 million, or 8.5%, to $13.8 million in the six months ended March 31, 2014 from $12.7 million in the six months ended March 31, 2013. Net interest margin increased 16 basis points to 2.78% for the six months ended March 31, 2014 from 2.62% for the six months ended March 31, 2013. The average balances of interest-earning assets increased $20.7 million from the six months ended March 31, 2013 to the six months ended March 31, 2014, and the yield increased 9 basis points.

Total interest and dividend income increased $862,000, or 4.3%, to $20.8 million for the six months ended March 31, 2014 from $19.9 million for the six months ended March 31, 2013. Interest income on loans increased $1.2 million primarily due to an increase of $80.9 million in the average balance of loans, partially offset by a 47 basis point decline in yield. The decline in yield was the result of lower interest rates for new loans due in part to increased competition for quality loans as well as an increase in the average balance of nonaccrual loans. The average balance of nonresidential loans increased $44.8 million and the yield declined 59 basis points. The average balance of multi-family loans increased $14.0 million and the yield decreased 99 basis points. The average balance of construction loans increased $16.3 million and the yield decreased 25 basis points. The average balance of land and land development loans increased $1.0 million and the yield decreased 147 basis points. The increase in both interest income on loans and the average balance of loans was also due to the new loans to other financial institutions portfolio, which had an average balance of $13.1 million and a yield of 5.48% for the six months ended March 31, 2014. These increases in average balances were partially offset by an $8.2 million decrease in the average balance of one- to four-family loans, with an increase in yield of 83 basis points. This increase in yield was due to the collection of $321,000 of interest income as a result of the repayment of two non-accrual loans with the same borrower totaling $3.8 million.

Interest and dividend income on investment securities (excluding FHLB stock) decreased $346,000, or 6.8%, due to a $19.1 million decrease in the average balance of investment securities for the six months ended March 31, 2014 compared to the six months ended March 31, 2013 as well as a 5 basis point decline in yield. The average balance of corporate debt securities decreased $31.2 million and the yield decreased 19 basis points due to the sale of longer-term corporate bonds, resulting in a decrease in interest income of $812,000. The average balance of CMOs decreased $53.3 million due to prepayments as well as the sale of our portfolio of non-agency CMOs during the current period and the yield increased 48 basis points, resulting in a decrease in interest income of $141,000. The average balance of state and political subdivision obligations decreased $7.1 million primarily due to the sale of a substandard municipal bond backed by student loans in March 2013, and the yield increased 43 basis points, resulting in a decrease in interest income of $179,000. These decreases were partially offset by a $69.2 million increase in the average balance of MBSs as well as a 23 basis point increase in yield, resulting in an increase in interest income of $786,000. The Company has significantly increased its investment in short-term MBSs to meet regulatory qualified thrift lender requirements and to better position the Company for rising interest rates.

Total interest expense decreased $220,000, or 3.1%, to $6.9 million for the six months ended March 31, 2014 from $7.2 million for the six months ended March 31, 2013. The decline was the result of a $13,000 decrease in deposit costs and a $207,000 decrease in Federal Home Loan Bank (“FHLB”) borrowings costs. The average balance of interest-bearing deposits increased $25.3 million due to a $19.3 million increase in the average balance of money market savings accounts and a $7.6 million increase in the average balance of certificates of deposit. The average interest rate paid on deposits decreased 5 basis points as a result of the maturity of higher-yielding time deposits and their renewal at lower prevailing rates. The average balance of FHLB borrowings decreased $7.7 million and the average interest rate paid declined 4 basis points due to a prepayment made during the fourth quarter of fiscal 2013, slightly offset by a new advance obtained on March 14, 2014.

38

Provision for Loan Losses. The provision for loan losses increased $1.0 million to $1.4 million for the six months ended March 31, 2014 compared to $361,000 for the six months ended March 31, 2013. Net loan charge-offs were $412,000 for the six months ended March 31, 2014 compared to $7,000 for the six months ended March 31, 2013. The overall allowance rate increased 6 basis points at March 31, 2014 to 1.92% of total loans from 1.86% of total loans at September 30, 2013. See note 4 of the notes to the unaudited consolidated financial statements for a discussion of our methodology for estimating the allowance for loan losses.

Noninterest Income.

The following table presents the components of noninterest income and the percentage increase (decrease) from the comparable prior year quarter:

	Six Months Ended March 31,						Increase (Decrease)
(Dollars in thousands)	2014			2013			%
Service charges on deposit accounts	$	28		$	23			22.1	%
Other service charges and fees		291			335			(13.1	)
Gains on sales of loans held for sale		-			94			(100.0	)
Gains on sales of securities, net		4,645			1,413			NM
Gains on sales of other real estate owned		152			1,564			(90.3	)
Impairment of securities		(266	)		(1,079	)		(75.4	)
Impairment recognized in OCI		309			(884	)		NM
Net impairment reflected in earnings		(575	)		(195	)		194.7
Increase in cash surrender value of bank-owned life insurance		634			642			(1.3	)
Other operating income		456			368			24.1
Total noninterest income	$	5,631		$	4,244			32.7

Gains, Losses, and Impairment Charges on Securities. Other-than-temporary-impairment charges on securities reflected in earnings increased $380,000 to $575,000 for the six months ended March 31, 2014 compared to $195,000 for the six months ended March 31, 2013. Impairment charges reflected in earnings for the six months ended March 31, 2014 related entirely to the Company’s portfolio of non-agency CMOs, which were sold in January 2014. Impairment charges reflected in earnings for the six months ended March 31, 2013 related to the Company’s portfolio of non-agency CMOs as well as an auction-rate municipal bond backed by student loans that experienced deteriorating collateral quality. Sales of securities resulted in gains of $4.6 million for the six months ended March 31, 2014 compared to $1.4 million for the six months ended March 31, 2013. Securities sold during the six months ended March 31, 2014 included equity securities of local community bank holding companies as well as the company’s portfolio of non-agency CMOs, as noted above. Gains on sales of securities also included a $323,000 gain on a corporate bond called during the six months ended March 31, 2014. Securities sold during the six months ended March 31, 2013 were primarily corporate debt securities.

Noninterest Income, Excluding Gains, Losses, and Impairment Charges on Securities. Total other noninterest income excluding gains, losses, and impairment charges on securities decreased $1.5 million, or 48.4%, for the six months ended March 31, 2014 compared to the six months ended March 31, 2013. The decrease was primarily the result of net gains on sales of other real estate owned of $152,000 in the six months ended March 31, 2014 compared to $1.6 million in the six months ended March 31, 2013, a decrease of $1.4 million. The decrease was also due to a decrease in gains on sales of loans held for sale of $94,000 as a result of Franklin Federal’s discontinuation of single-family, owner-occupied residential mortgage lending subsequent to its formation of a joint venture with TowneBank Mortgage in January 2013.

39

Other Noninterest Expenses.

The following table presents the components of other noninterest expenses and the percentage increase (decrease) from the comparable prior year quarter:

	Six Months Ended March 31,				Increase (Decrease)
(Dollars in thousands)	2014		2013		%
Personnel expense	$	5,382	$	5,534		(2.7	)%
Occupancy expense		496		481		3.0
Equipment expense		439		454		(3.3	)
Advertising expense		129		59		119.2
Federal deposit insurance premiums		384		353		8.7
Impairment of other real estate owned		8		-		NM
Other operating expenses		2,689		2,425		10.9
Total other noninterest expenses	$	9,527	$	9,306		2.4

Total noninterest expenses increased $221,000, or 2.4%, to $9.5 million for the six months ended March 31, 2014 compared to $9.3 million for the six months ended March 31, 2013. The increase was primarily due to a $264,000 increase in other operating expenses due to increased foreclosure expenses, legal costs and technology costs as well as an increase in advertising expenses of $70,000 and federal deposit insurance premiums of $31,000. These increases were partially offset by a $152,000 decrease in personnel expense due to decreased stock compensation expense related to the stock options and restricted stock granted under the Company’s 2012 Equity Incentive Plan.

Income Tax Expense. Income tax expense was $1.6 million for the six months ended March 31, 2014 compared to $2.3 million for the six months ended March 31, 2013. The effective income tax rate for the six months ended March 31, 2014 was 18.2% compared to an effective income tax rate of 31.4% for the six months ended March 31, 2013. The decrease in the effective tax rate was due to the $3.5 million increase in gains on sales of corporate equity securities. Gains on sales of corporate equity securities were $3.6 million for the six months ended March 31, 2014, compared to $80,000 for the six months ended March 31, 2013. Gains on sales of corporate equity securities are capital gains and can be offset by capital losses. Because the Company is in a capital loss carryforward position, these gains were offset completely by prior period losses, for which a deferred tax valuation allowance had previously been recorded, resulting in no tax expense on these capital gains for the six months ended March 31, 2014.

40

Rate/Volume Analysis

The following table sets forth the effects of changing rates and volumes on our net interest income. 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. The net changes attributable to the combined impact of both rate and volume have been allocated proportionately to the changes due to volume and the changes due to rate.

	Three Months Ended March 31, 2014 Compared to Three Months Ended March 31, 2013									Six Months Ended March 31, 2014 Compared to Six Months Ended March 31, 2013
	Increase (Decrease) Due to:									Increase (Decrease) Due to:
(Dollars in thousands)	Volume			Rate			Net			Volume			Rate			Net
Interest income:
Loans	$	3,844		$	(3,278	)	$	566		$	3,917		$	(2,696	)	$	1,221
Securities		(162	)		143			(19	)		(247	)		(99	)		(346	)
Investment in FHLB stock		(26	)		55			29			(23	)		57			34
Other interest earning assets		(24	)		(11	)		(35	)		(34	)		(13	)		(47	)
Total		3,632			(3,091	)		541			3,613			(2,751	)		862
Interest expense:
Deposits:
Money market savings		26			25			51			47			84			131
Money market checking		(8	)		6			(2	)		(4	)		-			(4	)
Certificates of deposit		237			(256	)		(19	)		146			(286	)		(140	)
FHLB borrowings		(73	)		(24	)		(97	)		(173	)		(34	)		(207	)
Total		182			(249	)		(67	)		16			(236	)		(220	)
Increase/(decrease) in net interest income	$	3,450		$	(2,842	)	$	608		$	3,597		$	(2,515	)	$	1,082

Asset Quality

Nonperforming Assets (NPAs)

At March 31, 2014, nonperforming assets (NPAs) totaled $54.8 million, a decrease of $1.0 million from $55.8 million at September 30, 2013. Our level of NPAs remains elevated over historical experience as a result of stresses in the real estate market. While we intend to actively work to reduce our NPAs, these levels are likely to remain elevated in the near term as problem loans work to resolution and as we actively market the $20.6 million of other real estate obtained by foreclosure during the six months ended March 31, 2014.

Nonperforming assets at March 31, 2014 included $28.9 million in nonperforming loans (NPLs) as summarized in the table below. The following table reflects the balances and changes from September 30, 2013:

(Dollars in thousands)	March 31, 2014		September 30, 2013		Increase (Decrease)
Nonaccrual loans:
One- to four-family	$	5,186	$	10,369	$	(5,183	)
Multi-family		12,584		12,570		14
Nonresidential		1,579		1,584		(5	)
Land and land development		9,541		24,608		(15,067	)
Total nonperforming loans	$	28,890	$	49,131	$	(20,241	)

The decrease in nonperforming loans at March 31, 2014 was primarily due to the foreclosure of four land and land development loans totaling $16.0 million secured by three separate tracts of land, all of which were taken into other real estate owned, as well as the payoff of two loans on multiple one- to four-family properties totaling $3.8 million during the six months ended March 31, 2014.

At March 31, 2014, the allowance for loan losses as a percentage of total loans was 1.92% compared to 1.86% at September 30, 2013. See note 4 of the notes to the unaudited consolidated financial statements for further analysis of the allowance for loan losses.

41

The following table sets forth selected asset quality data and ratios for the dates indicated:

(Dollars in thousands)	March 31, 2014			September 30, 2013
Nonperforming loans	$	28,890		$	49,131
Other real estate owned		25,868			6,715
Total nonperforming assets		54,758			55,846
Performing troubled debt restructurings (1)		5,666			5,501
Total nonperforming assets and troubled debt restructurings	$	60,424		$	61,347
Allowance for loan losses	$	10,721		$	9,740
Total loans	$	558,418		$	524,467
Ratios
Allowance as a percentage of total loans		1.92	%		1.86	%
Allowance as a percentage of nonperforming loans		37.11	%		19.82	%
Total nonperforming loans to total loans		5.17	%		9.37	%
Total nonperforming loans to total assets		2.64	%		4.64	%
Total nonperforming assets and troubled debt restructurings to total assets		5.52	%		5.79	%

⁽¹⁾ Performing troubled debt restructurings do not include troubled debt restructurings that remain on nonaccrual status and are included in nonaccrual loans above.

At March 31, 2014, nonaccrual loans were primarily comprised of the following:

• Land and land development loans:

- One loan on over one hundred acres of mixed-use land in central Virginia. This loan had a balance of $4.9 million and was classified as impaired at March 31, 2014. The collateral was valued at $8.9 million based upon an April 2013 appraisal. This loan was current at March 31, 2014.

- One loan secured by several hundred acres of partially-developed residential land in central Virginia. The remaining property is zoned for approximately 100 potential lots. This loan had a balance of $3.6 million and was classified as impaired at March 31, 2014. The collateral was valued at $7.1 million based upon a July 2013 appraisal. This loan was over 180 days delinquent at March 31, 2014.

- One loan secured by over two acres of mixed use land in central Virginia. This loan had a balance of $1.1 million and was classified as impaired at March 31, 2014. The collateral was valued at $2.1 million based upon recent sales and contracts to sell lots on this property. This loan was current at March 31, 2014.

• Multifamily

- Three loans on a 580-unit apartment complex in central Virginia that had a combined balance of $11.4 million. The apartment complex is valued at $12.3 million based upon June/July 2013 appraisals. These loans were considered impaired at March 31, 2014. At March 31, 2014, one loan with a balance of $2.5 million was 61 to 90 days delinquent and two loans with a combined balance of $8.9 million were over 180 days delinquent.

- One loan on a 64-unit apartment complex in central Virginia with a balance of $1.2 million at March 31, 2014. The apartment complex does not generate enough cash to service the debt and requires support from the guarantor. The apartment complex is valued at $1.5 million based upon an August 2013 appraisal. This loan was identified as impaired at March 31, 2014. This loan was over 180 days delinquent at March 31, 2014.

• One- to four-family

- Forty-two loans on one- to four-family residential properties in central Virginia to multiple borrowers with an aggregate balance of $5.2 million at March 31, 2014.

42

· Nonresidential

- One loan secured by a day care center in central Virginia. This loan had a balance of $1.6 million and was current at March 31, 2014. This loan was identified as impaired at March 31, 2014. The collateral for this loan was valued at $1.8 million based on a June 2013 appraisal.

The following table shows the aggregate amounts of our classified and criticized loans and securities at the dates indicated in accordance with regulatory classification definitions.

(Dollars in thousands)	March 31, 2014		September 30, 2013
Loans(1)
Special mention	$	12,770	$	16,845
Substandard		28,500		48,982
Total criticized loans		41,270		65,827
Other real estate owned
Substandard		25,868		6,715
Total classified other real estate owned		25,868		6,715
Securities
Substandard(2)		–		6,866
Total classified securities		–		6,866
Total criticized assets	$	67,138	$	79,408

⁽¹⁾ For regulatory reporting, performing troubled debt restructurings can be reclassified at the beginning of each calendar year. As a result, total classified and criticized loans for GAAP and regulatory reporting may be different.

⁽²⁾ These securities and all other unclassified non-agency CMOs that the Company obtained in 2008 by a redemption-in-kind from three frozen mutual funds were sold on January 31, 2014 for $9.1 million, resulting in a gain of $708,000.

Liquidity and Capital Resources

Liquidity

Liquidity is the ability to meet current and future financial obligations of a short-term and long-term nature. Our primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of securities and borrowings from the FHLB. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows, calls of investment securities and borrowed funds, and prepayments on loans, mortgage-backed securities and collateralized mortgage obligations are greatly influenced by general interest rates, economic conditions and competition.

Our most liquid assets are cash and cash equivalents and securities classified as available-for-sale. The levels of these assets depend on our operating, financing, lending and investing activities during any given period. At March 31, 2014, cash and cash equivalents totaled $89.2 million. In addition, at March 31, 2014, we had the ability to borrow a total of approximately $283.9 million in additional funds from the FHLB. Additionally, we established a borrowing arrangement with the Federal Reserve Bank of Richmond, although no borrowings have occurred to date. We intend to use corporate bonds as collateral for this arrangement and have pledged bonds with an estimated fair value of $5.5 million at March 31, 2014.

At March 31, 2014, we had $105.9 million in loan commitments outstanding, which included $102.1 million in undisbursed loans. Certificates of deposit due within one year of March 31, 2014 totaled $187.4 million. If these maturing deposits are not renewed, we will be required to seek other sources of funds, including other certificates of deposit and borrowings. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on the certificates of deposit. Management believes, however, based on past experience that a significant portion of our certificates of deposit will be renewed. We have the ability to attract and retain deposits by adjusting the interest rates offered.

43

In addition, we believe that our branch network, which is presently comprised of eight full-service retail banking offices located throughout our primary market area, and the general cash flows from our existing lending and investment activities, will afford us sufficient long-term liquidity.

Regulatory Capital

The Bank is subject to various regulatory capital requirements administered by the OCC. Failure to meet minimum capital requirements can initiate certain mandatory and possible discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's consolidated 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 Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. In addition, the Bank is required to notify the OCC before paying dividends to Franklin Financial.

At March 31, 2014, the Bank had regulatory capital in excess of that required under each requirement and was classified as a “well capitalized” institution as determined by the OCC. There are no conditions or events that management believes have changed the Bank’s classification. As a savings and loan holding company regulated by the Federal Reserve, Franklin Financial is not currently subject to any separate regulatory capital requirements. The Dodd-Frank Act, however, requires the Federal Reserve to promulgate consolidated capital requirements for depository institution holding companies that are no less stringent, both quantitatively and in terms of components of capital, than those applicable to the depository institutions themselves. These capital requirements will apply to savings and loan holding companies beginning in 2015. Revised capital requirements have been adopted by the OCC and the Federal Reserve for all thrifts and their savings and loan holding companies as part of Basel III.

The following table reflects the level of required capital and actual capital of the Bank at March 31, 2014 and September 30, 2013:

	Actual					Amount required to be "adequately capitalized"					Amount required to be "well capitalized"
(Dollars in thousands)	Amount		Percentage			Amount		Percentage			Amount		Percentage
March 31, 2014
Tier 1 capital (to adjusted tangible assets)	$	198,647		18.68	%	$	42,537		4.00	%	$	53,331		5.00	%
Tier 1 risk-based capital (to risk weighted assets)		198,647		28.48			27,898		4.00			41,847		6.00
Risk-based capital (to risk weighted assets)		207,390		29.74			55,796		8.00			69,745		10.00
September 30, 2013
Tier 1 capital (to adjusted tangible assets)	$	179,935		17.83	%	$	40,374		4.00	%	$	50,616		5.00	%
Tier 1 risk-based capital (to risk weighted assets)		179,935		26.32			27,345		4.00			41,017		6.00
Risk-based capital (to risk weighted assets)		188,495		27.57			54,690		8.00			68,362		10.00

In December 2013, Franklin Financial made an equity contribution of $14.7 million to the Bank in the form of five substandard, impaired and collateral dependent loans that it had previously purchased from the Bank in June 2012.

44

The following is a reconciliation of the Bank’s GAAP capital to regulatory capital at March 31, 2014 and September 30, 2013 (dollars in thousands):

	March 31, 2014
(Dollars in thousands)	Tier 1 capital			Tier 1 risk -based capital			Risk-based capital
GAAP capital	$	201,524		$	201,524		$	201,524
Accumulated gains on certain available-for-sale securities		(3,196	)		(3,196	)		(3,196	)
Pension plan		319			319			319
General allowance for loan losses		–			–			8,743
Regulatory capital – computed	$	198,647		$	198,647		$	207,390

	September 30, 2013
(Dollars in thousands)	Tier 1 capital			Tier 1 risk- based capital			Risk-based capital
GAAP capital	$	182,576		$	182,576		$	182,576
Accumulated gains on certain available-for-sale securities		(2,960	)		(2,960	)		(2,960	)
Pension plan		319			319			319
General allowance for loan losses		–			–			8,560
Regulatory capital – computed	$	179,935		$	179,935		$	188,495

Off-Balance Sheet Arrangements

In the normal course of operations, we engage in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in our financial statements. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments and lines of credit.

For the year ended September 30, 2013 and the six months ended March 31, 2014, we engaged in no off-balance sheet transactions reasonably likely to have a material effect on our consolidated financial condition, results of operations or cash flows.

45

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Sensitivity Analysis

Management uses an interest rate sensitivity analysis to review our level of interest rate risk. This analysis measures interest rate risk by computing changes in the present value of our cash flows from assets, liabilities and off-balance sheet items in the event of a range of assumed changes in market interest rates. The present value of equity is equal to the market value of assets minus the market value of liabilities, with adjustments made for off-balance sheet items. This analysis assesses the risk of loss in market risk sensitive instruments in the event of a sudden and sustained 100 to 300 basis point increase or a 100 basis point decrease in market interest rates with no effect given to any future steps that management might take to counter the impact of that interest rate movement. The following table presents the change in the present value of equity at March 31, 2014 that would occur in the event of an immediate change in interest rates based on management assumptions.

	Present Value of Equity
Change in	Market
Basis Points	Value		$ Change			% Change
	(Dollars in thousands)
300	$	273,527	$	(926	)		(0.3	)%
200		274,657		204			0.1
100		274,806		353			0.1
0		274,453		-			-
-100		265,230		(9,223	)		(3.4	)

Using the same assumptions as above, the sensitivity of our projected net interest income for the twelve months ending March 31, 2015 is as follows:

	Projected Net Interest Income
Change in	Net Interest
Basis Points	Income		$ Change			% Change
	(Dollars in thousands)
300	$	26,189	$	(114	)		(0.4	)%
200		26,249		(54	)		(0.2	)
100		26,197		(106	)		(0.4	)
0		26,303		-			-
-100		25,770		(533	)		(2.0	)

Assumptions made by management relate to interest rates, loan prepayment rates, deposit decay rates, and the market values of certain assets under differing interest rate scenarios, among others. As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets have features, such as rate caps or floors, that restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, expected rates of prepayments on loans and early withdrawals from certificates could deviate significantly from those assumed in calculating the table.

46

Item 4. Controls and Procedures

The Company’s management has carried out an evaluation, under the supervision and with the participation of the Company’s principal executive officer and principal financial officer, of the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on this evaluation, the Company’s principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective for the purpose of ensuring that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act (1) is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure.

In addition, based on that evaluation, there has been no change in the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

We are not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Our management believes that such routine legal proceedings, in the aggregate, are immaterial to our consolidated financial condition and results of operations.

Item 1A. Risk Factors

For information regarding the Company’s risk factors, see “Risk Factors” in the Company’s Annual Report filed on Form 10-K for the year ended September 30, 2013. As of March 31, 2014, the risk factors of the Company have not changed materially from those disclosed in the Form 10-K.

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

(a) Not applicable.

(b) Not applicable.

(c) Purchases of securities

The Company’s purchases of its common stock made during the three months ended March 31, 2014 are summarized as follows:

	Total Number of Shares Purchased (1)		Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans (2)		Maximum Remaining Number of Shares Available for Repurchase Pursuant to Publicly-Announced Plans
January 1 – 31, 2014		41,600	$	19.23		41,600		441,330
February 1 – 28, 2014		56,600		19.23		56,600		384,730
March 1 – 31, 2014		89,802		19.86		68,600		316,130
Total		188,002		19.53		166,800

(1) Includes 21,202 shares withheld by the Company to facilitate the satisfaction of the holders’ tax obligations upon the vesting of restricted stock.

(2) On August 29, 2013, the board of directors approved a fourth stock repurchase program whereby the Company was authorized to repurchase up to 612,530 shares, or approximately 5% of its common stock that was outstanding upon completion of the third stock repurchase program. During the three months ended March 31, 2014, the Company repurchased 166,800 shares of its outstanding common stock under this fourth program.

47

Item 3.  Defaults Upon Senior Securities

Not applicable.

Item 4.  Mine Safety Disclosures

Not applicable.

Item 5.  Other Information

Not applicable.

Item 6.  Exhibits

3.1 Articles of Incorporation of Franklin Financial Corporation (1)

3.2 Bylaws of Franklin Financial Corporation (2)

4.0 Form of Common Stock Certificate of Franklin Financial Corporation (3)

31.1 Rule 13a-14(a) Certification of Chief Executive Officer

31.2 Rule 13a-14(a) Certification of Chief Financial Officer

32 Section 1350 Certifications

101 The following materials from the Franklin Financial Corporation Quarterly Report on Form 10-Q for the quarter ended March 31, 2014 are formatted in Extensible Business Reporting Language (XBRL): (i) the Consolidated Balance Sheets; (ii) the Consolidated Income Statements;  (iii) the Consolidated Statements of Comprehensive Income; (iv) the Consolidated Statements of  Changes in Stockholders’ Equity; (v) the Consolidated Statements of Cash Flows; and (vi) related notes.

(1) Incorporated herein by reference to Exhibit 3.1 of pre-effective amendment No. 1 to the Company’s Registration Statement on Form S-1 (File No. 333-171108), filed with the Securities and Exchange Commission on January 28, 2011.

(2) Incorporated herein by reference to Exhibit 3.2 of pre-effective amendment No. 1 to the Company’s Registration Statement on Form S-1 (File No. 333-171108), filed with the Securities and Exchange Commission on January 28, 2011.

(3) Incorporated herein by reference to Exhibit 4.0 to the Company’s Registration Statement on Form S-1 (File No. 333-171108), as amended, initially filed with the Securities and Exchange Commission on December 10, 2010.

48

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.

	FRANKLIN FINANCIAL CORPORATION
	Registrant
May 9, 2014	By:	/s/ Richard T. Wheeler, Jr.
		Richard T. Wheeler, Jr.
		Chairman, President and Chief Executive Officer
		(Principal Executive Officer)
May 9, 2014	By:	/s/ Donald F. Marker
		Donald F. Marker
		Vice President, Chief Financial Officer and Secretary/Treasurer
		(Principal Financial and Accounting Officer)