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See accompanying notes to consolidated interim financial statements.
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See accompanying notes to consolidated interim financial statements.

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See accompanying notes to consolidated interim financial statements.

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The accompanying consolidated financial statements of Capitol Federal Financial and subsidiary (the "Company") have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information and footnotes required by generally accepted accounting principles in the United States of America ("GAAP") for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. These statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's 2003 Annual Report on Form 10-K to the Securities and Exchange Commission. Interim results are not necessarily indicative of results for a full year.

In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the valuation of mortgage servicing rights and allowances for losses on loans. While management believes that these allowances are adequate, future additions to the allowances may be necessary based on changes in economic conditions.

All dollar amounts are in thousands except per share data, unless otherwise indicated.

The Company has adopted the disclosure requirements of SFAS No. 148. The Company applies the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees," as allowed by SFAS Nos. 123 and 148, and related interpretations in accounting for our stock-based compensation plans.

For purposes of the pro forma disclosures required by SFAS No. 148, the estimated fair value of the options is amortized to expense on a straight-line method over the options' vesting period. If the fair value provisions under SFAS No. 123 would have been adopted, salary and employee benefit expense would have been $12.0 million for the three months ended December 31, 2003 and $10.8 million for the same period last year.

The following table presents the pro forma impact on earnings and earnings per share.

On October 29, 2003, the Board approved an increase in the quarterly dividend to $0.50 per share which was paid on November 21, 2003 to holders of record as of November 7, 2003. On November 10, 2003, the Board approved a year end dividend of $0.81 per share, payable on December 5, 2003 to holders of record on November 21, 2003. On January 27, 2004, the Board approved a dividend of $0.50 per share which will be paid on February 20, 2004 to holders of record as of February 6, 2004.

After a review of the dividend policy, the Board adjusted its policy for calendar year 2004 to intend to pay its total dividend in four equal quarterly installments. No dividend payout ratio has been targeted and one is not currently contemplated. See "Management's Discussion and Analysis - Capital" for information regarding Capitol Federal Savings Bank's ("Capitol Federal Savings" or the "Bank") ability to pay capital distributions to the Company.

During the quarter ended December 31, 2003, the Bank did not complete any mortgage loan sales.During the same quarter in the previous fiscal year, a total of $544.0 million in fixed rate single family loans, originated at historically low interest rates, were sold into the secondary market. The Bank recognized a gain of $17.2 million, pre-tax, on the sale of these loans. As a result of retaining servicing rights on these mortgage loan sales, the Bank recorded an increase of $4.9 million in its mortgage servicing rights.

On December 15, 2003, the Bank entered into interest rate swap agreements with a notional amount of $800.0 million. The Bank is utilizing the interest rate swaps to reduce the interest expense associated with some Federal Home Loan Bank ("FHLB") advances and to modify its interest rate risk profile. The Bank has agreed to receive interest from counterparties on the $800.0 million notional amount at a fixed rate matching the hedged FHLB advances and to pay interest at a variable rate indexed to the one month LIBOR rate plus an average spread of 248 basis points during the entire term of the interest rate swap and remaining term of the hedged FHLB advances. As a result of these interest rate swaps, the interest rate on the $800.0 million of hedged FHLB advances at December 31, 2003 was effectively reduced from 6.16% to 3.63%. The decrease in the interest rate equates to an $853 thousand decrease in interest expense during the quarter ended December 31, 2003.

The interest rate swaps are designated and qualify as fair value hedges under SFAS No. 133. The Bank has assumed no ineffectiveness in the hedging relationship as all the terms in the interest rate swap agreements match the terms of the FHLB advances. The Bank is accounting for the interest rate swap agreements using the shortcut method, whereby, any gain or loss in the fair value on the interest rate swaps is offset by a gain or loss on the hedged FHLB advances. The fair value of the hedged FHLB advances will generally decrease when interest rates rise and increase when interest rates fall. The fair value of the Bank's interest rate swap agreements are estimated by discounting anticipated cashflows associated with the receive-fixed rate component of the swap and the pay-variable rate component of the swap over the remaining contractual terms of each swap. The pay-variable rate component cash flows are estimated using forward interest rate curves for the one month LIBOR as of December 31, 2003. The fair v alue of the interest rate swaps at December 31, 2003 was $3.4 million, which resulted in a decrease of $3.4 million in the hedged FHLB advances at December 31, 2003.

The effect of the interest rate swaps on our interest rate risk profile results in an increase in our net portfolio value (See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Quantitative and Qualitative Disclosure about Market Risk" in the Annual Report to Stockholders attached as Exhibit 13 to our Annual Report on Form 10-K for the year ended September 30, 2003) in a constant and decreasing rate environment and increases our relative exposure in increasing rate environments. While we have the ability to enter into interest rate swaps of a greater notional amount, management believes that this amount is adequate at this time to effect the changes to earnings and risk management objectives desired.

The FHLB advances selected for the interest rate swaps have maturities ranging from May 2008 to August 2010. Information on the interest rate swaps, by maturity date, is as follows:

Basic and diluted earnings per share were both $0.06 for the quarter ended December 31, 2003. The Company accounts for the 3,024,574 shares acquired by its ESOP in accordance with SOP 93-6 and the shares acquired for its Recognition and Retention Plan ("RRP") in a manner similar to the ESOP shares. Shares acquired by the ESOP and the RRP are not considered in the basic average shares outstanding until the shares are committed for allocation or vested to an employee's individual account. The following is a reconciliation of the denominators of the basic and diluted earnings per share calculations.