Mfb Corp - Annual Report (10-K)

FORM 10-K

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

(Mark one)

[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934 For the fiscal year ended September 30, 2007
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: 0-23374

MFB CORP.
(Exact name of registrant as specified in its charter)

Indiana
State or other jurisdiction of
incorporation or organization

 35-1907258
 (I.R.S. Employer Identification Number)

4100 Edison Lakes Parkway, P.O. Box 528 Mishawaka, Indiana 46546
 (Address of principal executive offices) Zip Code

Registrant's telephone number, including area code: (574) 273-7600

Securities Registered Pursuant to Section 12(b) of the Act:

Title of Each Class Name of each exchange on which registered Common Stock, without par value NASDAQ Stock Market LLC Common Share Purchase Rights NASDAQ Stock Market LLC

Securities Registered Pursuant to Section 12(g) of the Act: None

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ___ No _X_

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes ___ No _X_

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 if disclosure of delinquent filers pursuant to Item 405, Regulation S-K (229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. _______

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated file" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer __ Accelerated filer___ Non-accelerated filer X

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ___ No _X_

The aggregate market value of the issuer's voting stock held by non-affiliates, as of March 31, 2007, was $36,755,466.

The number of shares of the registrant's common stock, without par value, outstanding as of December 14, 2007, was 1,313,671 shares.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of Registrant's Annual Report to Shareholders for the fiscal year ended September 30, 2007 are incorporated by reference into Part II. Portions of the Proxy Statement for the 2007 Annual Meeting of the Shareholders are incorporated into Part I and Part III.

MFB CORP.
Form 10-K
INDEX

PART I
Item 1. Business 3
Item 1A. Risk Factors 41
Item 1B. Unresolved Staff Comments 42
Item 2. Properties 43
Item 3. Legal Proceedings 44
Item 4. Submission of Matters to a Vote of Security Holders 45
Item 4.5 Executive Officers of Registrant 45

PART II

Item 5. Market for Registrant's Common Equity, Related Stockholder
 Matters and Issuer Purchases of Equity Securities 46
Item 6. Selected Financial Data 47
Item 7. Management's Discussion and Analysis of Financial
 Condition and Results of Operations 47
Item 7A. Quantitative and Qualitative Disclosures
 About Market Risk 47
Item 8. Financial Statements and Supplementary Data 47
Item 9. Changes in and Disagreements with Accountants on
 Accounting and Financial Disclosure 48
Item 9A. Controls and Procedures 48
Item 9B. Other Information 48

PART III

Item 10. Directors, Executive Officers and Corporate Governance 48
Item 11. Executive Compensation 49
Item 12. Security Ownership of Certain Beneficial Owners
 and Management and Related Stockholder Matters 49
Item 13. Certain Relationships and Related Transactions, and Director Independence 49
Item 14. Principal Accountant Fees and Services 49

PART IV

Item 15. Exhibits and Financial Statement Schedules 50
Signatures 51
Exhibit List 52

Certifications 54

PART 1

Item 1. Business.

General

MFB Corp. ("MFB" or the "Company") is an Indiana corporation organized in December, 1993, and parent company of its wholly owned savings bank subsidiary, MFB Financial ("MFB Financial" or the "Bank"). MFB Corp. became a unitary savings and loan holding company upon the conversion of Mishawaka Federal Savings from a federal mutual savings and loan association to a federal stock savings bank on March 24, 1994. On November 1, 1996, Mishawaka Federal Savings officially changed its name to MFB Financial.

MFB Financial offers a number of consumer and business financial services. These services include: (i) residential real estate loans; (ii) home equity and second mortgage loans; (iii) construction loans; (iv) commercial loans; (v) loans secured by deposits and other consumer loans; (vi) NOW accounts; (vii) statement savings accounts; (viii) certificates of deposit; (ix) consumer and commercial demand deposit accounts; (x) individual retirement accounts; (xi) health savings accounts; (xii) trust, investment management and brokerage services; and (xiii) health and life insurance products. The Bank's wholly-owned subsidiaries, MFB Investments I, Inc., MFB Investments II, Inc. and MFB Investments, LP are Nevada corporations and a Nevada limited partnership that manage a portion of the Bank's investment portfolio. The Bank's wholly-owned subsidiary, Community Wealth Management Group, Inc., is based out of Hamilton and Montgomery counties in Indiana, and attracts high net worth clients and offers trust, investment, insurance, broker advisory, retirement plan and private banking services in the Bank's market area. MFB Financial provides banking services through twelve offices in St. Joseph, Elkhart, and Hamilton counties in Indiana. MFBC Statutory Trust I is MFB Corp's wholly-owned trust preferred security subsidiary.

The company's operations are managed and financial performance is evaluated on a company-wide basis and, accordingly, considered a single operation segment.

Lending Activities

General. The Company's principal source of revenue is interest income from residential mortgage loans, construction loans, commercial loans and consumer loans. MFB Financial has concentrated its mortgage lending activities on the origination of loans secured by first mortgage liens for the purchase, construction or refinancing of one-to-four family residential real property. At September 30, 2007, $201.8 million, or 49.4% of the Company's total loan portfolio, consisted of mortgage loans and residential construction loans on one-to-four family residential real property, and multi-family loans which are generally secured by first mortgages on the property. A large majority of the residential real estate loans originated by MFB Financial are secured by properties located in St. Joseph and Elkhart Counties. In an effort to diversify the asset mix of the Bank and enhance growth, commercial loans have been generated over the past ten years. Commercial loans include term loans, construction loans for commercial buildings, working capital lines of credit and letters of credit. At September 30, 2007, commercial loans totaled $154.1 million, or 37.7% of the Company's loan portfolio. Consumer loans include loans secured by deposits, home equity and second mortgage loans, new and used car loans, boat and recreational vehicle loans and personal loans. At September 30, 2007, $52.6 million, or 12.9% of the loan portfolio consisted of consumer loans.

Residential Mortgage Loans. Residential mortgage loans consist of one-to-four family loans. MFB Financial offers fixed-rate loans with a maximum term of forty years for the purpose of purchasing or refinancing residential properties and building sites. It is the Company's intent to document and underwrite these loans to standards established by the secondary market to assure that they meet the investor quality guidelines.

A significant number of the residential mortgage loans made and retained in the loan portfolio by MFB Financial feature adjustable rates. Adjustable rate loans permit the Bank to better match the interest it earns on loans with the interest it pays on deposits. A variety of programs are offered to borrowers. A majority of these loans adjust on an annual basis after initial terms of one to seven years. Initial offering rates, adjustment caps and margins are adjusted periodically to reflect market conditions and the loans are underwritten to secondary market standards to allow salability as an option.

MFB Financial normally requires private mortgage insurance on all conventional residential first mortgages with loan-to-value ratios in excess of 80%. In accordance with the Homeowners Protection Act of 1998, MFB has adopted policies to assure compliance with automatic cancellation provisions, depending on the date the loan was originated. On first mortgages, MFB will generally lend up to 103% loan-to-value, based upon the lesser of the purchase price or appraisal value. MFB also offers programs that target first-time homebuyers when the applicants have successfully completed a homebuyer's education course and earn less than 80% of the area median income. Second mortgages and home equity loans may be originated with loan-to-values up to 100% with higher yields to compensate for potentially higher risk.

All of the residential mortgage loans that MFB Financial originates include "due-on-sale" clauses, which give MFB Financial the right to declare a loan immediately due and payable in the event that, among other things, the borrower sells or otherwise disposes of the real property subject to the mortgage and the loan is not repaid.

All residential mortgage loans must be approved by named individuals appearing on the board approved "Individual Lending Limits" approval matrix, or the loan committee. Approvals are subject to the limits appearing in this matrix and monitored by management for appropriate authority. Approval for loans outside these limits is referred to the Bank's Loan Committee. The voting members of the loan committee consist of members of the Board of Directors and the Chief Operating Officer, as Chairman. This committee approves all loans above the individual officer lending limits.

Construction Loans. MFB Financial offers construction loans on residential and commercial real estate to builders or developers constructing such properties and to owners who are to occupy the premises. Both residential and commercial construction and development loans to builders are underwritten in the commercial loan department with consistent underwriting standards, including adequate collateral and sufficient debt coverage ratios. The loan reviews are based on current economic conditions and personal guarantees are generally required. Residential construction loans to owners who will occupy the premises are underwritten in the mortgage loan department.

Generally, construction loans are 12-month adjustable rate mortgage loans with interest calculated on the amount disbursed under the loan and payable on a monthly basis. Interest rates for such loans are generally tied to the National Prime Rate. A construction loan fee may also be charged for these loans. MFB Financial normally requires an 80% or less loan-to-value ratio for its construction loans. Inspections are made in conjunction with disbursements under a construction loan, and the construction phase is generally limited to six to twelve months.

Commercial Loans. MFB Financial's commercial lending department focuses on meeting the borrowing needs of local businesses primarily located in St. Joseph and Elkhart counties. Loans may be secured by real estate, equipment, inventory, receivables or other appropriate collateral. Terms vary and adjustable rate loans are generally indexed to the prime rate. Loans with longer amortization periods generally contain fixed interest rate balloon payment provisions of seven years or less. Personal guarantees by business principals may be required in order to manage risk on these loans.

When appropriate, MFB Financial uses guaranteed lending programs, such as the Small Business Administration and the Indiana Department of Finance Authority, to reduce risk. Lending activity is controlled with individual loan officer lending limits and a loan committee consisting of board members and the commercial loan officers. Commercial lending activity has allowed MFB Financial to diversify its balance sheet, increase market penetration and improve earnings.

Consumer Loans. Federal laws and regulations permit federally chartered savings institutions to make secured and unsecured consumer loans in an aggregate amount of up to 35% of the Bank's total assets. In addition, a federally chartered savings institution has lending authority above the 35% limit for certain consumer loans, such as property improvement loans and deposit account secured loans. However, the Qualified Thrift Lender test places additional limitations on a savings institution's ability to make consumer loans.

Consumer loans involve a higher level of risk than one-to-four family residential mortgage loans because the collateral, if any, tends to be less stable. However, the relatively higher yields and shorter terms to maturity of consumer loans are believed to be helpful in reducing interest-rate risk. MFB Financial makes secured consumer loans for amounts specifically tied to the value of the collateral and smaller unsecured loans with higher interest rates. Consumer loans would include home equity loans and lines of credit, new and used automobile, boat and recreational vehicle loans, savings account loans, overdraft lines of credit and Visa credit card loans.

Origination and Sale of Loans. Fixed-rate mortgages secured by single family owner occupied dwellings are documented and underwritten to conform to the standards for sale in the secondary market. This provides management with the opportunity to deliver loans with the intent of increasing its servicing portfolio and corresponding fee income and creates liquidity in order to fund the acquisition of other assets for the Bank. As loans are originated with the intent of sale in the secondary market, the Bank can choose to manage and mitigate interest rate risk by committing forward sales utilizing a Best Efforts program in which no penalties are incurred for non-delivery of a loan, or utilizing FHLMC mandatory delivery programs. Adjustable rate mortgages continue to be originated by the Bank utilizing standard industry notes and mortgages. They also can be sold should the Bank desire additional liquidity or held in portfolio and provide yields that should better reflect changing market conditions. MFB Financial confines its loan origination activities primarily in St. Joseph and Elkhart Counties and the surrounding area including a loan production office in New Buffalo, Michigan. MFB's loan originations are generated from referrals from builders, developers, real estate brokers, existing customers, and limited newspaper and periodical advertising. All loan applications are underwritten at MFB Financial's corporate office. MFB Financial does not originate or purchase sub-prime mortgage loans.

A savings institution generally may not make any loans to one borrower or its related entities if the total of all such loans exceeds 15% of its capital (plus up to an additional 10% of capital in the case of loans fully collateralized by readily marketable collateral); provided, however, that loans up to $500,000, regardless of the percentage limitations, may be made and certain housing development loans of up to $30 million or 30% of capital, whichever is less, are permitted. MFB Financial's portfolio of loans currently contains no combinations of loans to any one borrower that exceed the 15% of capital limitation.

MFB Financial's loan approval process is intended to assess the borrower's ability to repay the loan, the viability of the loan and the adequacy of the value of the property that will secure the loan. Fixed rate mortgage loans are generally underwritten to FHLMC and FNMA standards.

MFB Financial generally requires appraisals on all property securing its loans and requires title insurance and a valid lien on its mortgaged real estate. Appraisals for residential real property are generally performed by an in-house appraiser who is a state-certified residential appraiser. From time to time, MFB Financial also uses the services of other certified residential appraisers who are not in-house. MFB Financial requires fire and extended coverage insurance in amounts at least equal to the principal amount of the loan. It also requires flood insurance to protect the property securing its interest if the property is in a flood plain. Tax and insurance payments are typically required to be escrowed by MFB Financial on new loans.

Origination and Other Fees. MFB Financial realizes loan fee income from late charges, origination fees, and miscellaneous fees. MFB Financial charges application fees for most loan applications. If the loan is denied, MFB Financial retains a portion of the application fee. Due to competitive issues, MFB Financial has originated most of its mortgages without charging points. However, borrowers from time to time wish to pay points and management negotiates rates on an individual basis. Late charges are generally assessed if payment is not received within a specified number of days after it is due. The grace period depends on the individual loan documents.

Nonperforming and Classified Assets

Nonperforming assets. Nonperforming assets were $5.2 million and $8.3 million at September 30, 2007 and 2006, respectively. Nonperforming assets include nonperforming loans (loans delinquent 90 days or more and non-accrual loans), other real estate owned, repossessions and nonperforming investment securities. Total nonperforming loans for MFB Financial were $5.1 million and $7.0 million at September 30, 2007 and 2006, respectively. Nonperforming loans decreased from last year in part due to payments received on an outstanding debt from one loan relationship and the improved financial condition of another commercial customer. Impaired loans consist of non-accrual loans and other loans where principal and interest is not expected to be collected in accordance with the original loan terms. Impaired loans were $3.7 million and $6.9 million at September 30, 2007 and 2006, respectively. The decrease in impaired loans from last year was due primarily to the improved financial condition of a commercial loan customer and loan repayments. Other real estate owned, repossessions and foreclosures were $144,000 and $1.2 million at September 30, 2007 and 2006, respectively. The decrease was due primarily to one specific situation. At September 30, 2006, the Company re-classified a $1.2 million property as held and used, which was previously accounted for as held for sale. This change in classification was driven by the longer than expected holding period. This property was subsequently sold during the first quarter of fiscal year 2007.

The largest loan relationship included in impaired loans as of September 30, 2007 totaled approximately $1.5 million for which $1.5 million of the allowance for loan losses has been allocated. Principal payments of approximately $1.6 million were made on this impaired loan during fiscal year 2007. The Bank maintained the $1.5 million allowance for the loan losses allocation based upon the history of unreliable and inconsistent financial reporting and cash flows of the customer's business. The actual loss on this loan relationship may vary significantly from the current estimate contingent upon the borrower's ability to seek alternative financing or pay down the loan. At September 30, 2006, this relationship totaled approximately $3.1 million, and $3.1 million of the allowance was allocated to it. This loan was still performing at September 30, 2006; however it is reported as non-performing at September 30, 2007.

Classified assets. Federal regulations and MFB Financial's Classification of Assets policy provide for the classification of loans and other assets such as debt and equity securities considered by the Office of Thrift Supervision ("OTS") to be of lesser quality as "substandard," "doubtful" or "loss" assets. An asset is considered "substandard" if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. "Substandard" assets include those characterized by the "distinct possibility" that the Bank will sustain "some loss" if the deficiencies are not corrected. Assets classified as "doubtful" have all of the weaknesses inherent in those classified "substandard," with the added characteristic that the weaknesses present make "collection or liquidation in full," on the basis of currently existing facts, conditions, and values, "highly questionable and improbable." Assets classified as "loss" are those considered "uncollectible" and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Assets which do not currently expose the insured institution to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are required to be designated "special mention" by management. At September 30, 2007, the Bank had classified $13.6 million of its assets as "special mention," $3.0 million as "substandard," $3.7 million as "doubtful" and $0 as "loss" for regulatory purposes.

An insured institution is required to establish a specific allowance for loan losses in an amount deemed prudent by management for loans classified substandard, doubtful or impaired, as well as for other problem loans. General allowances represent loss allowances on pools or types of loans, which have been established to recognize the inherent risk associated with lending activities. Unlike specific allowances, general allowances have not been allocated to particular problem assets. When an insured institution classifies problem assets as "loss", it is required by the OTS to either establish a specific allowance for the identified loss or charge off such amount. An institution's determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the OTS which can order the establishment of additional general or specific loss allowances. MFB Financial regularly reviews its loan portfolio to determine whether any loans require classification in accordance with applicable regulations.

The Company has also adopted an internal risk classification system, and all commercial loans are assigned a risk grade based on factors such as capacity to repay, capital, collateral, character of the borrower, and economic conditions. The risk grading process assists in identifying classified assets for regulatory purposes, as well as determining the general and specific loss allowances for classified commercial loans.

The Company maintains an internal loan review function reporting directly to the President and Chief Executive Officer. The Loan Review function entails examining credit and collateral files, attending loan committee meetings, and communicating with Business Banking and Senior Management. Business Banking officers are responsible for assigning a risk grade to new loan relationships. Loan Review is responsible for on-going reviews, subsequent risk grade monitoring, and approving risk grade modifications. The loan review criteria used by both Business Banking and Loan Review is uniform. The Company has established a goal of reviewing at least 50% of all commercial loans annually, based on dollar amounts outstanding at each fiscal year end. It is left up to the discretion of the Loan Review Officer which loans are chosen for review, with the exception of watch list loans. Watch list loans have a formal review at least annually. Other factors impacting which loans are selected for review are the loan size, industry, and other perceived risk factors such as operating performance, financial condition, credit structure, management changes, and payment delinquency. The intent is to review the majority of large dollar non-watch list loans at least annually, although some may not be chosen. Loan grades are tracked on the main frame commercial loan accounting system.

When completing a review, information regarding the borrower and loan structure are summarized in an excel spreadsheet. Loan grades are based on a weighted average of the following components: cash flow for debt service, financial condition, operating performance, collateral structure, guarantor support, management ability, industry risks, and payment history. The adequacy of the applicable loan documentation is also considered. The financial component used to calculate the loan grade is generally based on the most recent three year history of financial performance. Trend analysis and peer group comparisons are also part of the process. The possible loan grades are:

o Grade 1 - Excellent o Grade 5 - Special Mention
o Grade 2 - Good o Grade 6 - Substandard
o Grade 3 - Satisfactory o Grade 7 - Doubtful
o Grade 4 - Satisfactory / Monitored o Grade 8 - Loss

Loan relationships with a risk grade of 5 or higher are reported on the watch list. Loan Review meets with Business Banking on a monthly basis to discuss the watch list. The Business Bankers discuss their individual action plans and provide updates on watch list loans. Senior Management, as well as members of the Board of Directors, are invited to attend this meeting. The watch list is presented to the Board of Directors on a quarterly basis. The collectability of performing and non-performing commercial loans is discussed monthly during the watch list meeting and reviewed in more detail at least quarterly during the preparation of the allowance for loan losses allocation. During the twelve months ending September 30, 2007, 63% of the commercial loans were reviewed at least once.

All mortgage and consumer loans are reviewed by the Company on a regular basis and generally are placed on a non-accrual status when the loans become contractually past due ninety days or more. In cases where there is sufficient equity in the property and/or the borrowers are willing and able to ultimately pay all accrued amounts in full, the loan may be allowed to remain on accrual status. At the end of each month, delinquency notices are sent to all borrowers from whom payments have not been received. Contact by phone or in person is made, if feasible, to all such borrowers.

When a loan is 30 days in default, personal contact is made with the borrower to establish an acceptable repayment schedule. When loans are ninety days in default, contact is made with the borrower by an employee of MFB Financial after consultation with a Senior Loan Officer who attempts to establish an acceptable repayment schedule. Management is authorized to commence foreclosure or repossession proceedings for any loan upon making a determination that it is prudent to do so. All loans on which foreclosure or repossession proceedings have been commenced are placed on non-accrual status.

Allowance for Loan Losses

The allowance for loan losses is maintained through the provision for loan losses, which is charged to earnings. The provision is determined in conjunction with management's review and evaluation of current economic conditions, changes in the character and size of the loan portfolio, delinquencies (current status as well as past trends) and adequacy of collateral securing loan delinquencies, historical and estimated net charge-offs, and other pertinent information derived from a review of the loan portfolio. Allocations to the allowance for loan losses may be made for specific loans, but the entire allowance for loan losses is available for any loan that, in management's judgment, should be charged-off. Loan losses are charged against the allowance for loan losses when management believes the loan balance is uncollectible.

During the year ended September 30, 2007 management received payments from one impaired commercial loan relationship and noted a few other commercial watch list loans with improved credit performance. These improved loans were partially offset by one commercial loan with a deterioration of credit quality. The Company's allowance for loan losses at September 30, 2007 was $5.3 million or 1.30% of loans, comparable to the $7.2 million or 1.91% of loans at the end of last year. The ratio of non-performing loans to loans was 1.85% at September 30, 2006 compared to 1.25% at September 30, 2007. A negative provision of $1.3 million was recorded to the allowance for loan losses during the year ended September 30, 2007 compared to a provision expense of $1.0 million recorded to the allowance for loan losses during the prior year ended September 30, 2006. The change in the allowance for loan losses was due predominantly to payments received on impaired loans during the year ended September 30, 2007, which were previously reserved for in the allowance for loan losses. In management's opinion, the Company's allowance for loan losses at September 30, 2007 and loan loss provision for the year is appropriate for the loan portfolio.

Investments

General. Federally chartered savings institutions have the authority to invest in various types of liquid assets, including U.S. Treasury obligations, securities of various federal agencies, certain certificates of deposit of insured banks and savings institutions, certain bankers' acceptances, repurchase agreements and federal funds sold. Subject to various restrictions, federally chartered savings institutions may also invest a portion of their assets in commercial paper, corporate debt securities and asset-backed securities. The investment policy of MFB Financial, which is established and implemented by MFB Financial's Asset/Liability Committee ("ALCO"), is designed primarily to maximize the yield on the investment portfolio subject to liquidity risk, default risk, interest rate risk, and prudent asset/liability management.

The Company's investment portfolio consists of U.S. government agency securities, mortgage-backed securities, corporate debt securities, equity securities, Federal Home Loan Bank ("FHLB") stock, low income housing projects and certificates of deposits in other financial institutions. Investments decreased from $69.3 million at September 30, 2006 to $43.1 million at September 30, 2007 due to continued principal payments and maturities of the Company's various securities, while no purchases of investments were made during the twelve month period.

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

Of the total gross unrealized losses of $850,000 in securities available for sale at September 30, 2007, $388,000 relates to the reduced value of a trust preferred bond issued by a regional banking organization. The current unrealized loss on that bond is the result of the current interest rate structure of the market for trust preferred instruments, and not credit issues.

During the fiscal year ended September 30, 2002, the Company recorded an $895,000 write down on a $1.0 million WorldCom, Inc. corporate debt security. That security was sold in October 2002 for $160,000. During fiscal year 2007 the Company received notification and payment of $402,000 representing a partial distribution of funds recovered by the U.S. Securities and Exchange Commission and the WorldCom Securities Litigation in their respective actions against WorldCom, Inc. The Company may receive an additional distribution depending upon the resolution of disputed claims, appeals from court determinations and additional administrative expenses, interest and taxes incurred by the settlement funds; however, any further distribution would likely be relatively small.

Liquidity. Liquidity relates primarily to the Company's ability to fund loan demand, meet deposit customers' withdrawal requirements and provide for operating expenses. Liquid assets include cash, certain certificates of deposit of insured banks and savings institutions, certain bankers' acceptances and securities available for sale. Subject to various restrictions, FHLB-member savings institutions may also invest in certain corporate debt securities, commercial paper, mutual funds, mortgage-related securities, and first lien residential mortgage loans. Savings associations remain subject to the OTS regulation that requires them to maintain sufficient liquidity to ensure their safe and sound operation. Liquid assets were $57.4 million as of September 30, 2007, compared to $75.6 million at September 30, 2006, and management believes the liquidity level as of the current year end is sufficient to meet anticipated liquidity needs.

Sources of Funds

General. Deposits have traditionally been MFB Financial's primary source of funds for use in lending and investment activities. In addition to deposits, MFB Financial derives funds from scheduled loan payments, loan prepayments, secondary market loan sales, Federal Home Loan Bank advances and income provided from operations. While scheduled loan payments and income on earning assets are relatively stable sources of funds, deposit inflows and outflows and secondary market sales can vary widely and are influenced by prevailing interest rates, market conditions and levels of competition. Borrowings from the FHLB of Indianapolis are used to compensate for reductions in deposits or deposit inflows at less than projected levels.

Deposits. Deposits are attracted principally from within St. Joseph and Elkhart counties in Indiana, and beginning in 2005 in Hamilton County, Indiana, through the offering of a broad selection of deposit instruments including NOW, business checking and other transaction accounts, certificates of deposit, individual retirement accounts, and savings accounts. MFB Financial does not actively solicit or advertise for deposits outside of these counties. Substantially all of MFB Financial's depositors are residents of these counties. Deposit account terms vary, with the principal differences being the minimum balance required, the amount of time the funds remain on deposit and the interest rate. MFB Financial does not pay a fee for any deposits it receives. At September 30, 2007, noninterest bearing demand deposits totaled $39.0 million, savings, NOW, MMDA deposits were $123.7 million and time deposits were $171.0 million.

Interest rates paid, maturity terms, service fees and withdrawal penalties are established by MFB Financial on a periodic basis. Determination of rates and terms are predicated on funds acquisition and liquidity requirements, rates paid by competitors, growth goals, and federal regulations. MFB Financial relies, in part, on customer service and long-standing relationships with customers to attract and retain its deposits, but also prices its deposits in relation to rates offered by its competitors.

The flow of deposits is influenced significantly by general economic conditions, changes in money market and prevailing interest rates and competition. The variety of deposit accounts offered by MFB Financial has allowed it to be competitive in obtaining funds and to respond with flexibility to changes in consumer demand. MFB Financial manages the pricing of its deposits in keeping with its asset/liability management and profitability objectives. Based on its experience, the Bank's savings, NOW and non-interest-bearing checking accounts have been relatively stable sources of deposits. However, the ability of the Bank to attract and maintain certificates of deposit, and the rates paid on these deposits, has been and will continue to be significantly affected by market conditions.

Borrowings. MFB Financial focuses on generating high quality loans and then seeks the best source of funding from deposits, investments or borrowings. Short-term borrowings or long term debt may be used to compensate for reduction in other sources of funds such as deposits, and to assist in asset/liability management. The Bank's policy has been to utilize borrowings when they are a less costly source of funds, when they can be invested at a positive interest rate spread or when the Bank desires additional capacity to fund loan demand.

MFB Financial's borrowings consist mainly of advances from the FHLB of Indianapolis secured by a blanket collateral agreement and based on percentage of unencumbered loans and investment securities held by the Bank. Such advances can be made pursuant to several different credit programs, each of which has its own interest rate and range of maturities. There are regulatory restrictions on advances from the Federal Home Loan Banks. Refer to "Federal Home Loan Bank System" and "Qualified Thrift Lender" in the Regulation section of this report for further documentation. At September 30, 2007, MFB Financial had $124.3 million in Federal Home Loan Bank borrowings outstanding at an average rate of 5.32% compared to $97.1 million at September 30, 2006 at an average rate of 5.52%. The Company's additional borrowing capacity with FHLB was $23.5 million at September 30, 2007.

MFBC Statutory Trust I, a trust formed by the Company, issued $5.0 million of trust preferred securities on July 29, 2005 as part of a private placement of such securities. The Company issued subordinated debentures to the trust in exchange for the proceeds of the offering; the debentures and related debt issuance costs represent the sole assets of the trust. The securities mature in 30 years from the date of issuance, require quarterly distributions and bear a fixed rate of interest of 6.22% per annum for the first five years, resetting quarterly thereafter at the prevailing three-month LIBOR rate plus 1.7% per annum. Interest on the securities is payable quarterly in arrears each September 15, December 15, March 15, and June 15 commencing September 15, 2005. The Company may redeem the trust preferred securities, in whole or in part, without penalty, on or after September 15, 2010, or earlier upon the occurrence of certain events with the payment of a premium upon redemption. The securities mature on September 15, 2035.

Bank Subsidiaries

The Bank's insurance agency subsidiary, Mishawaka Financial Services, Inc. ("MFB Insurance"), was organized in 1975 and currently is engaged in the sale of life insurance and credit-life and health insurance, as agent to the Bank's customers and the general public. During the fiscal year 2006, Mishawaka Financial sold the property and casualty segment of its business for a gain of $200,000. During the fiscal year ending September 30, 2002, the Company established three new wholly-owned subsidiaries of the Bank to manage a portion of its investment portfolio. MFB Investments I, Inc. and MFB Investments II, Inc. are Nevada corporations which jointly own MFB Investments, LP, a Nevada limited partnership which holds and manages investment securities previously owned by the Bank. A total of $33.7 million in investment securities are, as of September 30, 2007, managed by MFB Investments, LP. During the fiscal year ending September 30, 2007, the Company acquired Community Wealth Management Group, Inc., a wholly-owned subsidiary of the Bank, which attracts high net worth clients and offers trust, investment, broker advisory, retirement plan and private banking services in the Bank's market area. All intercompany balances and transactions between all of the subsidiaries have been eliminated in the consolidation.

Employees

As of September 30, 2007, MFB Financial employed 143 persons on a full-time basis and 21 persons on a part-time basis. None of MFB Financial's employees are represented by a collective bargaining group. Management considers its employee relations to be excellent.

(1) Average outstanding balances reflect unrealized gain (loss) on securities available for sale. (2) Total loans less deferred net loan fees and loans in process, and including non accrual loans.

I. DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY; INTEREST RATES AND INTEREST DIFFERENTIAL

 A. The following are the average balance sheets for the years ending
September 30:


 2007 2006 2005
 Average Average Average
 Outstanding Outstanding Outstanding
 Balance Balance Balance
 ------- ------- -------
Assets: (Dollars in thousands)
Interest-earning assets:
 Interest-earning deposits $ 6,132 $ 26,337 $ 22,157
 Mortgage-backed securities (1) 29,032 37,554 39,021
 Other securities available for sale (1) 21,126 28,436 22,429
 FHLB stock 7,796 8,809 8,952
 Loans held for sale 254 802 1,105
 Loans receivable (2) 389,758 379,568 399,469
 ------------- ------------ ------------
 Total interest-earning assets 454,098 481,506 493,133
Non-interest earning assets, net
 of allowance for loan losses 43,924 38,734 39,057
 ------------- ------------ ------------

 Total assets $ 498,022 $ 520,240 $ 532,190
 ============= ============ ============

Liabilities and shareholders' equity:
Interest-bearing liabilities:
 Savings accounts $ 52,966 $ 58,887 $ 47,071
 NOW and money market accounts 74,098 77,428 89,443
 Certificates of deposit 179,219 186,109 185,268
 Securities sold under agreements to repurchase 74 - -
 Federal Home Loan Bank advances 104,197 108,815 131,101
 Other borrowings 1,849 6,330 6,500
 Subordinated notes - trust 5,000 5,000 875
 ------------- ------------ ------------
 Total interest-bearing liabilities 417,403 442,569 460,258
Other liabilities 40,632 39,634 35,345
 ------------- ------------ ------------
 Total liabilities 458,035 482,203 495,603

Shareholders' equity
 Common stock 12,256 11,731 12,413
 Retained earnings 36,650 34,629 32,222
 Net unrealized gain(loss) on securities
 available for sale (110) (506) (418)
 Treasury stock (8,809) (7,817) (7,630)
 ------------- ------------ ------------
 Total shareholders' equity 39,987 38,037 36,587
 ------------- ------------ ------------

 Total liabilities and shareholders' equity $ 498,022 $ 520,240 $ 532,190
 ============= ============ ============

(1) Average balance does not reflect unrealized gain (loss) on securities available for sale. Yield is based on amortized cost without adjustment for unrealized gain (loss) on securities available for sale.
(2) Total loans less deferred net loan fees and loans in process and including non accrual loans. (3) Interest rate spread is calculated by subtracting average interest rate cost from average interest rate earned for the period indicated.
(4) The net yield on average interest-earning assets is calculated by dividing net interest income by average interest-earning assets for the period indicated.