Securities and Exchange Commission Washington, D.C. 20549
Form 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of theSecurities Exchange Act of 1934
For the Quarter Ended December 31, 2001
Commission File No. 001-12647
Oriental Financial Group Inc.
Incorporated in the Commonwealth of Puerto Rico
IRS Employer Identification No. 66-0538893
Principal Executive Offices:
1000 San Roberto StreetProfessional Office Park, S.E.Río Piedras, Puerto Rico 00926Telephone Number: (787) 771-6800
Number of shares outstanding of the registrant's common stock, as of the latest practicable date:
12,406,889 common shares ($1.00 par value per share)outstanding as of December 31, 2001
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 / /
TABLE OF CONTENTS
PART 1—FINANCIAL INFORMATION Item 1—Financial Statements
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITIONDECEMBER 31, 2001 AND JUNE 30, 2001 (In thousands, except shares information)
The accompanying notes are an integral part of these consolidated financial statements.
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CONSOLIDATED STATEMENTS OF INCOME (LOSS) (UNAUDITED)FOR THE QUARTER AND SIX-MONTH PERIODS ENDED DECEMBER 31, 2001 AND 2000(In thousands, except per share information)
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CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (UNAUDITED)FOR THE SIX-MONTH PERIODS ENDED DECEMBER 31, 2001 AND 2000(In thousands)
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS) (UNAUDITED)FOR THE QUARTER AND SIX-MONTH PERIODS ENDED DECEMBER 31, 2001 AND 2000(In thousands)
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CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)FOR THE SIX-MONTH PERIODS ENDED DECEMBER 31, 2001 AND 2000(In thousands)
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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSORIENTAL FINANCIAL GROUP INC.
NOTE 1—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
The accounting and reporting policies of Oriental Financial Group Inc. (the "Group" or "Oriental") conform with accounting principles generally accepted in the United States of America ("GAAP") and to financial services industry practices.
The unaudited Consolidated Financial Statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). In the opinion of management, these financial statements include all adjustments (which consist of normal recurring accruals) necessary, to present fairly the consolidated financial condition as of December 31, 2001 and June 30, 2001, and the results of operations and cash flows for the quarter and six-month periods ended December 31, 2001 and 2000. All significant intercompany balances and transactions have been eliminated in the accompanying unaudited condensed financial statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles ("GAAP") have been condensed or omitted pursuant to such SEC rules and regulations. Management believes that the disclosures made are adequate to make the information presented not misleading. Financial information as of June 30, 2001 has been derived from the Group's audited Consolidated Financial Statements. The results of operations and cash flows for the six-month periods ended December 31, 2001 and 2000 are not necessarily indicative of the results to be expected for the full year. For further information, refer to the Consolidated Financial Statements and footnotes thereto for the year ended June 30, 2001, included in the Group's Annual Report on Form 10-K.
Certain reclassifications have been made to prior periods financial statements to conform to the current period presentation.
The following is a description of the Group's most significant accounting policies:
Nature of Operations
Oriental is a bank holding company incorporated under the laws of the Commonwealth of Puerto Rico. It has four subsidiaries, Oriental Bank and Trust (the "Bank"), Oriental Financial Services Corp. ("Oriental Financial Services"), FISA Insurance Agency, Inc., and Oriental Financial Group, Inc. Statutory Trust I (the "Trust") (See Note 5). Through these subsidiaries, the Group provides a wide range of financial services such as mortgage, commercial and consumer lending, financial planning, insurance sales, money management and investment brokerage services, as well as corporate and individual trust services. Note 7 to the consolidated financial statements presents further information about the operations of the Group's business segments.
Main offices for the Group and its subsidiaries are located in San Juan, Puerto Rico. The Bank operates through twenty branches located throughout the island and is subject to the supervision, examination and regulation of the Federal Reserve Bank, Office of the Commissioner of Financial Institutions of Puerto Rico and the Federal Deposit Insurance Corporation (FDIC), which insures its deposits through the Savings Association Insurance Fund (SAIF). Oriental Financial Services is subject to the supervision, examination and regulation of the National Association of Securities Dealers, the Securities and Exchange Commission, and the Office of the Commissioner of Financial Institutions of Puerto Rico.
NOTE 2—INVESTMENTS AND SECURITIES:
The Group's securities are classified as held-to-maturity, available-for-sale or trading. Securities for which the Group has the positive intent and ability to hold to maturity are classified as held-to-maturity
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and are carried at amortized cost. There were no held-to-maturity securities as of December 31, 2001 and June 30, 2001. Securities that might be sold prior to maturity because of interest rate changes, to meet liquidity needs, or to better match the reprising characteristics of funding sources are classified as available-for-sale. These securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of deferred taxes, in other comprehensive income.
The Group classifies as trading those securities that are acquired and held principally for the purpose of selling them in the near term. These securities are carried at fair value with realized and unrealized changes in fair value included in earnings in the period in which the changes occur. Interest revenue arising from trading instruments is included in the statements of income as part of net interest income rather than in the trading profit or loss account. The Group's investment in the Federal Home Loan Bank (FHLB) of New York has no readily determinable fair value and can only be sold to the FHLB at par value. Therefore, this investment is carried at cost and its redemption value represents its fair value.
Premiums and discounts are amortized to interest income over the life of the related securities using the interest method. Net realized gains or losses on sales of investment securities and unrealized loss valuation adjustments considered other than temporary, if any, on securities classified as either available-for-sale or held-to-maturity are reported separately in the statement of income. The cost of securities is determined using the specific identification method.
Trading Securities
A summary of trading securities owned by the Group at December 31, 2001 and June 30, 2001 is as follows:
At December 31, 2001, the Group's trading portfolio weighted average yield was 6.88% (June 30, 2001—7.92%).
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Investment securities available-for-sale
The amortized cost, gross unrealized gains and losses, fair value, and weighted average yield of the investment securities available- for-sale owned by the Group at December 31, 2001 and June 30, 2001, were as follows:
The amortized cost and fair value of the Group's investment securities available-for-sale at December 31, 2001, by contractual maturity, are shown in the next table. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
Proceeds from the sale of investment securities available-for-sale during the first six months of fiscal 2002 totaled $185,274,000 (Fiscal 2001—$249,759,000). Gross realized gains and losses on those sales during the first six months of fiscal 2002 were $5,157,000 and $2,426,000, respectively, (Fiscal 2001—547,000 and $3,742,000 respectively).
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NOTE 3—LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES:
Loans Receivable
The Group's business activity is with consumers located in Puerto Rico. Oriental's loan transactions are encompassed within three main categories: mortgage, commercial, and consumer. Oriental's loan portfolio has a higher concentration of loans to consumers such as residential mortgage loans and personal loans. The composition of the Group's loan portfolio at December 31, 2001 and June 30, 2001 was as follows:
Allowance for Loan Losses
The Group maintains an allowance for loan losses at a level that management considers adequate to provide for probable losses based upon an evaluation of known and inherent risks. Oriental's allowance for loan losses policy provides for a detailed quarterly analysis of probable losses. The analysis includes a review of historical loan loss experience, value of underlying collateral, current economic conditions, financial condition of borrowers and other pertinent factors.
While management uses available information in estimating probable loan losses, future additions to the allowance may be necessary based on factors beyond Oriental's control, such as factors affecting Puerto Rico economic conditions. Refer to Table 5 of the "Management's Discussion and Analysis of Financial Condition and Results of Operations" for the changes in the allowance for loan losses for the quarter and six-month periods ended December 31, 2001 and 2000.
The Group evaluates all loans, some individually and other as homogeneous groups, for purposes of determining impairment. At December 31, 2001 and June 30, 2001, the Group determined that no impairment allowance was necessary.
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NOTE 4—PLEDGED ASSETS:
At December 31, 2001, residential mortgage loans and investment securities available for sale amounting to $299,050,000 and $1,569,920,000, respectively, were pledged to secure public fund deposits, investment securities sold under agreements to repurchase, letters of credit, advances and borrowings from the Federal Home Loan Bank of New York, term notes and interest rate swap agreements.
NOTE 5—SUBORDINATED CAPITAL NOTES
In October 2001, Oriental Financial Group, Inc. Statutory Trust I, a wholly-owned special purpose subsidiary of Oriental, was formed for the purpose of issuing company-obligated securities. On December 18, 2001, $35 million of trust redeemable preferred securities were issued by the Trust as part of a pooled underwriting transaction. Pooled underwriting involves participating with other bank-holding companies in issuing the securities through a special purpose pooling vehicle created by the underwriters. The securities have a par value of $35 million, bear interest based on 3 months LIBOR plus 360 basis points (5.60% at December 31, 2001) (provided, however, that prior to December 18, 2006, this interest rate shall not exceed 12.5%), payable quarterly, and mature on December 23, 2031. The securities may be called at par after five years. The proceeds from this issuance were used to purchase a like amount of floating rate junior subordinated deferrable interest debentures issued by Oriental, which have the same maturity and call provisions as the redeemable capital securities.
These company-obligated securities of the subsidiary grantor trust (trust preferred securities) are accounted for as a liability on the consolidated statements of financial condition. Dividends on the trust preferred securities are accounted for as an interest expense on an accrual basis. These debts are treated as Tier-1 capital for regulatory purposes.
NOTE 6—DERIVATIVES AND HEDGING ACTIVITIES
The Group uses interest rate swaps and caps as an interest rate risk hedging mechanism. Under the swaps, the Group pays a fixed annual cost and receives a floating ninety-day payment based on LIBOR. Floating rate payments received from the swap counterparty correspond to the floating rate payments made on the borrowings thus resulting in a net fixed rate cost to the Group (Cash flows hedging instruments). Under the caps, Oriental pays an up front premium or fee for the right to receive cash flow payments in excess of the predetermined cap rate; thus, effectively capping its interest rate cost for the duration of the agreement. The Group's swaps and caps outstanding and their terms at December 31, 2001 and June 30, 2001 are set forth in the table below:
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The agreements were signed to convert short-term borrowings into fixed rate liabilities for longer periods of time and provide protection against increases in interest rates. The amounts potentially subject to credit loss are the net streams of payments under the agreements and not the notional principal amounts used to express the volume of the swaps. The Group controls the credit risk of its interest rate swap agreements through approvals, limits, monitoring procedures and collateral, where considered necessary. The Group does not anticipate nonperformance by the counterparties.
The Bank offers its customers certificates of deposit tied to the performance of one of the following stock market indexes, Standard & Poor's 500 Composite Stock Index, Dow Jones Industrial Average and Russell 2000 Small Stock Index. At the end of five years, the depositor will receive a specified percent of the average increase of the month-end value of the corresponding stock index. If such index decreases, the depositor receives the principal without any interest. The Group uses option agreements with major money center banks to manage its exposure to the stock market. Under the terms of the agreements, the Group will receive the average increase in the month-end value of the corresponding index in exchange for a fixed premium. At December 31, 2001, the notional amount of these agreements totaled $203,265,000 (June 30, 2001—$180,950,000). Changes in fair value of options purchased and options embedded in certificates of deposit are recorded in earnings.
At December 31, and June 30, 2001, the fair value of derivatives was recognized as either assets or liabilities in the Consolidated Statements of Financial Condition as follows: the fair value of the equity indexed options represented as investment of $21.3 million ($27.0 million, June 2001) and the options sold to customers embedded in the certificates of deposits represented a liability of $26.3 million ($34.2 million, June 2001) recorded in deposits. The interest rate swaps represented a liability of $17.9 million ($10.3 million, June 2001) presented in "Accrued Expenses and Other Liabilities". The Caps did not have a carrying value as of December 31, and June 30, 2001.
NOTE 7—SEGMENT REPORTING:
The Group operates three major reportable segments: Financial Services, Mortgage Banking, and Retail Banking. Management determined the reportable segments based on the internal reporting used to evaluate performance and to assess where to allocate resources. Other factors such as the Group's organizational chart, nature of products, distribution channels and economic characteristics of the products were also considered in the determination of the reportable segments. The Group measures the performance of these reportable segments, based on pre-established goals of different financial parameters such as net income, net interest income, loan production, and fees generated.
The Group's largest business segment is retail banking. The Bank's branches and treasury functions are its main components, with traditional banking products such as deposit, and electronic banking.
Oriental's second largest business segment is the financial services, which is comprised of the Bank's trust division (Oriental Trust), the brokerage subsidiary (Oriental Financial Services) and the insurance subsidiary (FISA Insurance Agency, Inc.). The core operations of this segment are financial planning, money management and investment brokerage services, investment banking, insurance sales activity, as well as corporate and individual trust services.
The Group's last business segment is mortgage banking. It consists of Oriental Mortgage, whose principal activity is to originate and purchase mortgage loans for the Group's own portfolio, as well as sale of loans in the secondary market.
The accounting policies of the segments are the same as those described in the "Summary of Significant Accounting Policies" included in the Group Annual Report on Form 10-K. Following are
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the results of operations and the selected financial information by operating segment for each of the second quarter and six-month period ended December 31:
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NOTE 8—RECENT ACCOUNTING DEVELOPMENTS
In August 2001, the Financial Accounting Standards Board issued Statement of Financial Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"). SFAS 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This statement supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets to Be Disposed Of", and the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions". SFAS 144 became effective on December 15, 2001, and had not a material effect on the Oriental's consolidated financial statements.
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ITEM 2—MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Table of Contents
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SELECTED FINANCIAL DATAFOR THE QUARTER AND SIX-MONTH PERIODS ENDED DECEMBER 31, 2001 AND 2000(In thousands, except for per share information)
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SELECTED FINANCIAL DATAFOR THE SIX-MONTH PERIODS ENDED DECEMBER 31, 2001 AND 2000*(Dollars in thousands)
TABLE 1—FISCAL YEAR-TO-DATE ANALYSIS OF NET INTEREST INCOME ANDCHANGES DUE TO VOLUME/RATE:
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SELECTED FINANCIAL DATAQUARTERS ENDED DECEMBER 31, 2001 AND 2000*(Dollars in thousands)
TABLE 1A—QUARTERLY ANALYSIS OF NET INTEREST INCOME AND CHANGES DUE TO VOLUME/RATE:
* Certain adjustments were made to conform figures to current quarter presentation. (1)—Real estate averages include loans held-for-sale. (2)—Discontinued on June 2000(3)—Excluding Managers Checks
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SELECTED FINANCIAL DATAFOR THE QUARTER AND SIX-MONTH PERIODS ENDED DECEMBER 31, 2001 AND 2000(Dollars in thousands)
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SELECTED FINANCIAL DATAFOR THE QUARTER AND SIX-MONTH PERIODS ENDED DECEMBER 31, 2001 AND 2000 (Dollars in thousands)
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SELECTED FINANCIAL DATAFOR THE SIX-MONTH PERIODS ENDED DECEMBER 31, 2001 AND 2000(Dollars in thousands)
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SELECTED FINANCIAL DATAAS OF DECEMBER 31, 2001, 2000 and JUNE 30, 2001(Dollars in thousands)
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The following provides the high and low prices and dividend per share of the Group's stock for each quarter of the last three fiscal periods. Common stock prices were adjusted to give retroactive effect to the stock splits declared on the Group's common stock.
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OVERVIEW OF FINANCIAL PERFORMANCE
Net income for the quarter ended December 31, 2001, was $10.4 million ($0.75 diluted per share), an increase of 282% compared with net income of $2.7 million ($0.17 diluted per share) reported in the quarter ended December 31, 2000. For the first six months of fiscal 2002 ended December 31, 2001, net income was $17 million, an increase of 1,926% compared with the $838,000 reported for the same period of previous fiscal year 2001.
Return on common equity (ROE) was 38.8% for the quarter ended December 31, 2001 a significant increase from the 11.8% reported in the second quarter of fiscal 2001 ended December 31, 2000. Return on assets (ROA) was 1.85% for second quarter of fiscal 2002 versus a 0.64% reported for the second quarter of previous fiscal 2001.
Interest rate cuts made by the Federal Reserve during calendar year 2001 combined with management's emphasis on secured lending facilitated improvements in the Group's performance. For the quarter ended December 31, 2001 net interest income increased 134.0%, to $14.2 million, compared with $6.1 million registered in the quarter ended December 31, 2000.
Interest income increased 21.9%, from $28.6 million in the quarter ended December 31, 2000, to $34.8 million in the quarter ended December 31, 2001. On the other hand, interest expense declined 8.4%, from $22.5 million for the quarter ended December 31, 2000, to $20.6 million for the quarter ended December 31, 2001, as a result of interest rate reductions. The quarterly provision for loan losses increased slightly, from $500,000 for the December 2000 quarter to $525,000 for the December 2001 quarter, reflecting the benefits of management's strategy to focus on secured lending.
Management's emphasis on operations that generate fees continued to strengthen the Group's earnings outlook, as brokerage, investment banking, trust and insurance revenues grew 50.0%, from $2.7 million in the December 2000 quarter to $4.0 million this past December quarter.
Revenues from mortgage-banking activities decreased 27%, from $2.4 million for the December 2000 quarter to $1.7 million for the December 2001 quarter. Although mortgage production increased 61 percent, from $69.6 million for the quarter ended December 31, 2000, to $112 million for the quarter ended December 31, 2001, revenues decreased because of management's current strategy to maintain a larger portion of its production in portfolio instead of selling it on the secondary market, consequently deferring the recognition of the amount of fees derived from the sale of loans.
Non-interest expenses (excluding non-operating charges) increased 21.5% from $8.7 million for the quarter ended December 31, 2000, to $10.6 million for the quarter ended December 31, 2001. The increase is attributable to the Group's new strategic positioning during the past year, which has included the opening of new and the remodeling of financial centers, aggressive advertising, investments in technology, professional fees for consulting engagements related to new services, and increased variable compensation for increased insurance and mortgage services.
During the quarter ended September 30, 2001, the Group recognized a non-cash, non-operating expense of $799,000, with a corresponding offsetting charge against additional paid-in capital, related to the cancellation by the Board of Directors of approximately 211,500 non-vested stock options granted to its directors, officers and employees during calendar years 1999 and 1998.
Total financial assets (including assets managed by the trust department and broker-dealer subsidiary) increased 18.1% to a record $4.827 billion as of December 31, 2001, compared to $4.087 billion as of December 31, 2000. Assets managed by the Group's trust department and broker-dealer subsidiary increased 7.2% year-to-year to $2.499 billion from $2.331 billion. The Group's bank assets increased a robust 32.6%, reaching $2.328 billion as of December 31, 2001 versus $1.756 billion as of December 31, 2000.
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On the liability side, deposits increased 26.9% from $690 million at December 31, 2000, to $875 million at December 31, 2001, as the Group aggressively continues to expand its banking business within its ongoing strategy to position itself as a financial planning service provider.
Finally, the Group continued its program for repurchasing its common stock, reacquiring 125,492 shares during the six month period ended December 31, 2001 for an approximated cost of $2.4 million. Stockholders' equity as of December 31, 2001 was $131.7 million, increasing 19.6 percent from $110.1 million as of December 31, 2000. This increase mainly reflects the impacts of net income, net of dividend declared and of the mark-to-market valuation required by Statement of Financial Accounting Standards No. 115 related to investments available-for-sale.
Net Interest Income
Net interest income is affected by the difference between rates earned on the Group's interest-earning assets and rates paid on its interest-bearing liabilities (interest rate spread) and the relative amounts of its interest-earning assets and interest-bearing liabilities (interest rate margin). As further discussed in the Risk Management section of this report, the Group constantly monitors the composition and repricing of its assets and liabilities to maintain its net interest income at adequate levels.
For the second quarter of fiscal 2002, the Group's net interest income amounted to $14.2 million, up 134% from $6.1 million in the same period of fiscal 2001. This increase was mainly due to a positive rate variance of $7.5 million caused by a significantly lower cost of funds, particularly of repurchase agreements (2.38% for the quarter ended on December 31, 2001 compared to 6.70% for the same period of fiscal 2001) that stems from the impact of the Federal Reserve interest rate drop. For the six-month period ended December 31, 2001, net interest income amounted to $25.2 million, up 101% from $12.6 million for the six-month period ended December 31, 2000. This increase was primarily due to a positive rate variance of $12.5 million that also resulted from the impact of the Federal Reserve interest rate drop resulting in a lower average cost of funds (4.29% for the six-month periods ended on December 31, 2001 versus 6.00% in the same period of fiscal 2001), combined with a positive growth of the investment and loan portfolios.
Interest rate spread increased 140 basis points during the second quarter of fiscal 2002, to 2.68% from 1.28% in the second quarter of fiscal 2001. For the six-month period ended December 31, 2001, the interest rate spread rose 124 basis points (to 2.44%) when compared with the same period of fiscal 2001 (1.20%). These increase were mainly due to: (1) a decrease in the average cost of funds; and (2) a higher yield on secured mortgage loans. Tables 1 and 1A analyze the major categories of interest-earning assets and interest-bearing liabilities, their respective interest income, expenses, yields and costs, and their impact on net interest income due to changes in volume and rates.
The Group's interest income for the second quarter of fiscal 2002 totaled $34.8 million, up 21.9% from $28.6 million posted in the same period of fiscal 2001. This increase is attributable to a larger volume of average interest—earnings assets ($2.081 billion in fiscal 2002 versus $1.563 billion in fiscal 2001). For the six-month periods ended December 31, interest income increased 15.0% from $58.9 million reported in fiscal 2001 to $67.8 million reported in fiscal 2002. The increase in interest income results from a larger volume of average interest-earning assets ($2.014 billion in fiscal 2002 versus $1.633 billion in fiscal 2001) tempered by a decline in their yield performance (6.73% in fiscal 2002 versus 7.20% in fiscal 2001).
Most of the increase in interest-earning assets was mainly on the investment portfolio and real estate loans. For the second quarter of fiscal 2002, the average volume of total investments grew by 38.55% ($1.536 billion in fiscal 2002 versus $1.108 million in fiscal 2001) when compared to the same period a year earlier. The average volume of real estate loans grew by 20.36% from $408.2 million to $491.3 million in fiscal 2002 and 2001, respectively. Likewise, the average volume of total investments
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grew by 26.4% in fiscal 2002 when compared with the same period in fiscal 2001 ($1.496 billion in fiscal 2002 versus $1.184 billion in fiscal 2001). This increase was concentrated in mortgage-backed securities as Oriental continued converting residential real estate loans sold in the secondary market into tax-advantaged mortgage-backed securities.
For the second quarter of fiscal 2002, the average yield on interest-earning assets was 6.69%, 62 basis points lower than the 7.31% reported in the same period of fiscal 2001. Likewise, the average yield on interest-earning assets was 6.73%, 47 basis points lower than the 7.20% in fiscal 2001 when comparing both six-month periods ended in December. The quarterly and six-month period yield dilution experienced was mainly related to: (i) the strong expansion of Group's investment portfolio, which carries a lower yield than the loan portfolio but provides less risk and generates a significant amount of tax-exempt interest; and (ii) partially offset by an increase on the yield of the loan portfolio (8.56% and 8.49% for the quarter and six-month periods ended December 31, 2001, versus 8.26% and 8.28% respectively for the same periods in fiscal 2001).
Interest expense for the second quarter and six-month periods of fiscal 2002 narrowed 8.4% and 8.3% respectively (to $20.6 million and $42.5 million in fiscal 2002, from $22.5 million and $46.4 million in fiscal 2001). A lower average cost of funds (4.01% and 4.29% for the second quarter and six-month periods ended December 31, 2001 versus 6.03% and 6.00% for the same periods in fiscal 2001, respectively), drove the decreases. Larger volumes of repurchase agreements and deposits, which were necessary to fund the growth of the Group's investment portfolio, drove an increase in average interest-bearing liabilities. See Tables 1 and 1A for the impact in interest expense due to changes in volume and rates.
The cost of short-term financing has substantially decreased since lately fiscal 2001. For the second quarter ended December 31, 2001, the cost of borrowings decreased 250 basis points (4.0% in fiscal 2002 from 6.50% in fiscal 2001). This funding category experience its larger cost reduction of 258 basis point in repurchases agreements, 3.95% for quarter ended December 2001 versus 6.53% for the same quarter of fiscal 2001. Equally, the year to date cost decrease is mainly due to a lower average cost of repurchases agreements, that drop 216 basis points, from 6.46% for the six-month period of fiscal 2001 to 4.30% for the same period of fiscal 2002.
Non-Interest Income
As a diversified financial services provider (see Table 2), the Group's earnings depend not only on the net interest income generated from its banking activity, but also from fees and other non-interest income generated from the wide array of financial services offered. Non-interest income, the second largest source of earnings, is affected by the level of trust assets under management, transactions generated by gathering of financial assets and investment banking activities by the broker-dealer subsidiary, the level of mortgage banking activities, fees generated from loans and deposit accounts and insurance (See Table 2).
Recurrent non-interest income rose 10.7% to $6.7 million in the second quarter of fiscal 2002, compared to $6.1 million in the second quarter of fiscal 2001. For the six-month period, the increase was 6.5% (to $12.2 million in fiscal 2002 from $11.5 million in fiscal 2001) when compared to the same period in fiscal 2001.
Trust, money management, brokerage, investment banking, and insurance fees, the principal components of recurrent non-interest income, continued an excellent growth pattern during the second quarter of fiscal 2002, rising 48.1% to $4.0 million from $2.7 million in the second quarter of fiscal 2001. The larger volume of accounts and assets managed by both the Group's trust department and the broker-dealer subsidiary triggered this growth along with the results of the new investment banking division's earnings of $1.1 million for this quarter (See table 2). For the six-month period ended December 31, 2001 and 2000, these revenues were $7.2 million and $5.5 million, respectively.
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The second largest component of non-interest revenues is mortgage-banking activities, which decreased 27%, to $1.7 million in the quarter ended December 31, 2001 from $2.4 million reported for the same period of fiscal 2001. When comparing six-month periods ended in December 2001 and 2000, mortgage-banking activities decreased 21% from $3.9 million, to $3.1 million. This decrease reflects a lower volume of loans sold. Although mortgage production increase 61%, from $69.6 million for the quarter ended December 31, 2000, to $112 million for the quarter ended December 31, 2001, mortgage banking revenues decreased because of management's current strategy to retain a larger portion of its production in the loan portfolio instead of selling it on the secondary market, consequently deferring the recognition of the amount of fees derived from the sale.
Bank service revenues consist primarily of fees generated by deposit accounts, electronic banking and customer services. These revenues totaled $985,000 in the second quarter of fiscal 2002, a 5.1% decrease versus $1.0 million reported in the same period of fiscal 2001. This decrease is mainly due to fewer revenues from deposits fees, $533,000 for current quarter versus $561,000 for same period of fiscal 2001. When comparing both six-month periods, these revenues dropped 5.9% to $1.9 million in fiscal 2002 against $2.1 million reported in fiscal 2001.
As shown in Table 2, the second quarter of fiscal 2002, reflect a gain of $2.4 million on sale of securities available for sale compared to the $510,000 posted in the second quarter of fiscal 2001.
The six-month period of fiscal 2002, reflect a gain of $2.7 million on sale of securities compared to a loss of $3.2 million in the fiscal 2001 period. Securities gain and losses are dependable on market changing conditions.
Derivative activities unrealized losses amounted to $766,000 and $930,000 for the quarter and six-month periods ended December 31, 2001, respectively; and $721,000 and $2.3 million for the quarter and six-month periods ended December 31, 2000, respectively, relate to the mark-to-market of certain derivatives activities (See Note 6 to the unaudited Consolidated Financial Statements).
Non-Interest Expenses
As shown in Table 3, recurrent non-interest expenses for the second quarter of fiscal 2002 increased 21.5%, to $10.6 million from $8.7 million in the comparable period of fiscal 2001. For the six-month period, the increase was 18.7%, to $20.0 million compared to $16.8 million in the same period in fiscal 2001. The increase on non-interest expenses reflects the impact of the Group's restructuring strategy in advertising and business promotion which includes the opening of new and the remodeling of financial centers, and the cost of outsourcing of certain internal procedures to provide new and better services to our customers. In addition, professional expenses have doubled normal trends due to additional charges relating to an evaluation of the Group's operations.
Employee compensation and benefits is the Group's largest non-interest expense category. For the quarter ended December 31, 2001, it increased 10.5%, to $3.8 million versus $3.4 million reported in the same period of fiscal 2001 reflecting an expansion of the work force (see Table 3) and increasing variable compensation (Commissions) due to higher volume of business and related incentives. Refer to Table 3 for more selected data regarding employee compensation and benefits.
Other non-recurrent expenses are mainly related to litigation and settlement of legal cases, primarily litigation against fidelity bond carrier (See Part-2, item 1. Legal Proceedings).
Provision for Loan Losses
The provision for loan losses in the second quarter of fiscal 2002 totaled $525,000, in line with the $500,000 reported in the same period of fiscal 2001. For the six-month period ended December 31, 2001, the provision for loan losses declined 38.6% from $1.9 million in the same period for fiscal 2001, to $1.2 million in fiscal 2002. The decline was in response to the lower level of net credit losses. The
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reduction in credit losses reflects the sale of the unsecured personal loans and lease portfolios on June 30, 2000, as previously reported. Please refer to the allowance for loan losses and non-performing assets section on Table 4 to Table 8 for a more detailed analysis of the allowances for loan losses, net credit losses and credit quality statistics.
Provision (Credit) for Income Taxes
The Group recognized a provision for income tax of $532,000 and $571,000 in the second quarter and six-month periods ended December 31, 2001 compared to a credit of $269,000 and $1.5 million for the same periods of fiscal 2001. The current income tax provision is lower than the provision based on the statutory tax rate for the Group, which is 39%, due to the high level of tax-advantage interest income earned on certain investments and loans, net of the disallowance of related expenses attributable to the exempt income. The tax benefit recognized in the fiscal 2001 quarter and six-month periods mainly resulted from non-operating activities.
FINANCIAL CONDITION
Group's Assets
At December 31, 2001, the Group's total assets amounted to $2.328 billion, an increase of 32.6% when compared to $1.756 billion a year ago. At the same date, interest-earning assets reached $2.234 billion, up 32.7% versus $1.683 billion a year earlier.
As detailed in Table 9, investments are Oriental's largest interest-earning assets component. It mainly consists of money market investments, U.S. Treasury notes, U.S. Government agencies bonds, mortgage-backed securities, CMO's and P. R. Government municipal bonds. At December 31, 2001, the Group's investment portfolio was of high quality. Approximately 98% was rated AAA and it generated a significant amount of tax-exempt interest, which substantially lowered the Group's effective tax rate. See Note 2 to the Consolidated Financial Statements for further explanation of the Group's investments.
A strong growth in mortgage-backed securities and CMO's drove the investment portfolio expansion. They increased 55% to $1.541 billion (92.1% of the total investment portfolio) from $994.1 million (80.7% of the total investment portfolio) the year before, as Oriental continued its strategy of pooling residential real estate loans into mortgage-backed securities.
At December 31, 2001, Oriental's loan portfolio, the second largest category of the Group's interest-earning assets, amounted to $561.9 million, 24.7% higher than the $450.6 million a year ago. Late in the second quarter of fiscal 2001, the Group's loan originations changed toward collateralized loans, primarily mortgage loans and personal loans with mortgage collateral, while de-emphasizing unsecured personal loans. In addition, on June 30, 2000, Oriental sold over $160 million of leases and unsecured personal loans. These strategies significantly reduced credit losses and enhanced the portfolio quality. Table 9 and Note 3 to the unaudited Consolidated Financial Statements presents the Group's loan portfolio composition and mix at the end of the periods analyzed.
The Group's real estate loans portfolio is mainly comprised of residential loans, home equity loans and personal loans collateralized by real estate. As shown in Table 9, the real estate loans portfolio amounted to $509.4 million or 90.2% of the loan portfolio as of December 31, 2001, compared with a 90.4% share at December 31, 2000, in line with the Group's lending strategy of concentrate on collateralized originations, primarily mortgage loans and personal loans with mortgage collateral, as mentioned before.
The second largest component of the Group's loan portfolio is commercial loans, most of which collateralized by real estate. At December 31, 2001, the commercial loan portfolio totaled $33.2 million (5.9% of the Group's loan portfolio). The consumer loan portfolio totaled $21.7 million (3.8% of the
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loan portfolio). The Group discontinued lease originations on June 30, 2000 and sold it portfolio as previously reported.
Liabilities and Funding Sources
As shown in Table 10, at December 31, 2001, Oriental's total liabilities reached $2.197 billion, 33.4% higher than the $1.646 billion reported a year earlier. Interest-bearing liabilities, the Group's funding sources, amounted to $2.158 billion at the end of the second quarter of fiscal 2002 versus $1.616 billion the year before, a 33.5% increase. The rise in repurchase agreements and FHLB funds to fund the expansion of the investment portfolio drove this growth along with an increase in saving, demand, time and IRA accounts.
Borrowings are Oriental's largest interest-bearing liability component. It consists mainly of diversified funding sources through the use of Federal Home Loan Bank of New York (FHLB) advances and borrowings, repurchase agreements, term notes, subordinated capital note, and lines of credit. At December 31, 2001, they amounted to $1.283 billion, 38.5% higher than the $926.3 million a year ago, mainly in repurchase agreements, FHLB funds and the assumption of a subordinated capital note (see Note 5 to the unaudited Consolidated Financial Statements). This increase reflects the funding required to maintain the Group's investment portfolio growth as previously mentioned.
The FHLB system functions as a source of credit to financial institutions that are members of a regional Federal Home Loan Bank. As a member of the FHLB, the Group can obtain advances from the FHLB, secured by the FHLB stock owned by the Group, as well as by certain of the Group's mortgages and investment securities. Table 10 presents the composition of the Group's other borrowings at the end of the periods analyzed.
At December 31, 2001, deposits, the second largest category of the Group's interest-bearing liabilities and a cost-effective source of funding, reached $875.4 million, up 26.9% versus the $690.0 million a year ago. A $130.5 million or 23.7% increase in time deposits and IRA accounts realized most of the growth. In addition, a $55.4 million or 40.4% increase in demand and savings deposits contributed to this growth. Table 10 presents the composition of the Group's deposits at the end of the periods analyzed.
Stockholders' Equity
At December 31, 2001, Oriental's total stockholders' equity was $131.7 million, a 19.6% increase from $110.1 million a year ago. In addition to earnings from operations (See "Overview of Financial Performance"), this rise reflects an increase on the unrealized gain of investment securities available for sale partially offset for the impact of FAS 133 derivatives activities. For more of the Group's stockholders' equity activity, refer to the Unaudited Consolidated Statement of Changes in Stockholders' Equity and of Comprehensive Income (loss) included in Table 11 and as part of the unaudited Consolidated Financial Statements.
During the six-month period ended December 31, 2001, the Group repurchased 125,492 common shares bringing to 1,504,191 shares (with a cost of $2.4 million) the number of shares held by the Group's treasury. The Group's common stock is traded in the New York Stock Exchange (NYSE) under the symbol OFG. At December 31, 2001, the Group's market value for its outstanding stock was $230.8 million ($18.60 per share).
During the six-month period ended December 31, 2001, the Group declared dividends, on its common stock amounting to $3.7 million ($0.30 per share). Dividend yield was 3.14% and 4.75%, for fiscal 2002 and 2001 respectively.
Financial holding companies are considered well capitalized under the regulatory framework for prompt corrective action if they meet or exceed a Tier I risk-based capital ratio of 6 percent, a total
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risk-based capital ratio of 10 percent and a leverage capital ratio of 5 percent. As shown in Table 12, the Group comfortably exceeds these benchmarks due to the high level of capital and subordinated capital notes and the quality and conservative nature of its assets.
Group's Financial Assets
Table 12 shows, the Group's total financial assets include the Group's assets and assets managed by the trust and brokerage business. At December 31, 2001, they reached $4.827 billion—up 18.1% from $4.087 billion a year ago. The Group's financial assets main component is the assets owned by the Group, of which about 99% are owned by the Group's banking subsidiary. For more on this financial asset component, refer to Group's Assets under Financial Condition.
Oriental's second largest financial assets component is assets managed by the trust. The Group's trust offers various different types of IRA products and manages 401(K) and Keogh retirement plans, custodian and corporate trust accounts. At December 31, 2001, total assets managed by the Group's trust amounted to $1.455 billion, 3.5% higher than the $1.406 billion a year ago. This increase was mainly fueled by the market value recovery after September 11, 2001 market disruption caused by the terrorist attack.
The other financial asset component is assets gathered by the broker-dealer. The Group's broker-dealer subsidiary offers a wide array of investment alternatives to its client's base such as fixed and variable annuities, tax-advantaged fixed income securities, mutual funds, stocks and bonds. At December 31, 2001, total assets gathered by the broker-dealer from its customer investment accounts reached $1.043 billion, up 12.7% from $925.4 million a year ago.
ALLOWANCE FOR LOAN LOSSES AND NON-PERFORMING ASSETS:
At December 31, 2001, the Group's allowance for loan losses amounted to $3.0 million (.54% of total loans) versus $2.9 million (0.66% of total loans) a year earlier. The Group maintains an allowance for loan losses at a level that management considers adequate to provide for potential losses based upon an evaluation of known and inherent risks. Oriental's allowance for loan losses policy provides for a detailed quarterly analysis of possible losses.
The principal factors that the Group uses to determine the level of allowance for loan losses are the Group's historical and current credit loss experience. These factors are combined with qualitative factors such as: the growth of the loan portfolio, concentrations of credit (e.g., local industries, etc.) that might affect loss experience across one or more components of the portfolio, delinquencies, effects of any changes in lending policies and procedures (including underwriting standards), collections and general economic conditions.
The methodology that the Group uses follows a loan credit risk rating process that involves dividing loans into risk categories. The following are the credit risk categories (established by the FDIC Interagency Policy Statement of 1993) used:
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The Group, using an aged-based rating system, applies an overall allowance percentage to each loan portfolio category based on historical credit losses adjusted for current conditions and trends. This delinquency-based calculation is the starting point for management's determination of the required level of the allowance for loan losses. Other data considered in this determination includes:
Loan loss ratios and credit risk categories, are updated quarterly and are applied in the context of accounting principles generally accepted in the United States ("GAAP") and the Joint Interagency Guidance on the importance of depository institutions having prudent, conservative, but not excessive loan loss allowances that fall within an acceptable range of estimated losses. While management uses available information in estimating possible loan losses, future changes to the allowance may be necessary based on factors beyond the Group's control, such as factors affecting general economic conditions.
Net credit losses for the second quarter of fiscal 2002, totaled $408,000 (.30% of average loans), a 91% significant decrease when compared to $4.5 million (3.93% of average loans) reported in the same period of fiscal 2001. The lower level of net credit losses experienced was primarily associated to a reduction in consumer loans and financing leases net credit losses as a result of the sale of both unsecured and leasing loan portfolios, as previously discussed. Tables 5 through 7 set forth an analysis of activity in the allowance for loan losses and presents selected loan loss statistics.
The Group's non-performing assets include non-performing loans, foreclosed real estate owned and other repossessed assets (see Table 8). At December 31 2001, the Group's non-performing assets totaled $19.4 million (.83% of total assets) versus $16.1 million (0.91% of total assets) at the same date of previous fiscal year 2001. The increase was principally due to a higher level of non-performing loans; mainly to non-performing secured mortgage loans.
At December 31, 2001, the allowance for loan losses to non-performing loans coverage ratio was 16.3%. Excluding the lesser-risk real estate loans, the ratio is much higher, 195%. Detailed information concerning each of the items that comprise non-performing assets follows:
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Item—3
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risk and Asset/Liability Management
The Group's interest rate risk and asset/liability management is the responsibility of the Asset and Liability Management Committee ("ALCO"), which reports to the Board of Directors and is composed of members of the Group's senior management. The principal objective of ALCO is to enhance profitability while maintaining an appropriate level of interest rate and liquidity risks. ALCO is also involved in formulating economic projections and strategies used by the Group in its planning and budgeting process; and oversees the Group's sources, uses and pricing of funds.
Interest rate risk can be defined as the exposure of the Group's operating results or financial position to adverse movements in market interest rates which mainly occurs when assets and liabilities reprice at different times and at different rates. This difference is commonly referred to as a "maturity mismatch" or "gap". The Group employs various techniques to assess the degree of interest rate risk.
The Group is liability sensitive due to its fixed rate and medium to long-term asset composition being funded with shorter-term reprising liabilities. As a result, the Group uses interest rate swaps and caps as a hedging mechanism to offset said mismatch and control exposures of interest rate risk. Under the swaps, the Group pays a fixed annual cost and receives a floating ninety-day payment based on LIBOR. Floating rate payments received from the swap counterparty correspond to the floating rate payments made on the borrowings or notes thus resulting in a net fixed rate cost to the Group. Interest rate caps provide protection against increases in interest rates above cap rates.
The Group is exposed to a reduction in the level of Net Interest Income ("NII") in a rising interest rate environment. NII will fluctuate with changes in the levels of interest rate affecting interest-sensitive assets and liabilities. If (1) the rates in effect at December 31, 2001 remained constant, or increase or decrease on an instantaneous and sustained change of plus or minus 200 basis points, and
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(2) all scheduled reprising, reinvestments and estimated prepayments, and reissuances are constant, or increase or decrease accordingly; NII will fluctuate as shown on the following table:
Note:
Liquidity Risk Management
Liquidity refers to the level of cash, eligible investments easily converted into cash and lines of credit available to meet unanticipated requirements. The objective of the Group's liquidity management is to meet operating expenses and ensure sufficient cash flow to fund the origination and acquisition of assets, the repayment of deposit withdrawals and the maturities of borrowings. Other objectives pursued in the Group's liquidity management are the diversification of funding sources and the control of interest rate risk. Management tries to diversify the sources of financing used by the Group to avoid undue reliance on any particular source.
At December 31, 2001, the Group's liquidity was deemed appropriate. At such date the Group's liquid assets amounted to $1.463 billion, this includes $24.4 million available from unused lines of credit with other financial institutions and $37.2 million of borrowing potential with the FHLB. The Group's liquidity position is reviewed and monitored by the ALCO Committee on a regular basis. Management believes that the Group will continue to maintain adequate liquidity levels in the future.
The Group's principal sources of funds are net deposit inflows, loan repayments, mortgage-backed and investment securities principal and interest payments, reverse repurchase agreements, FHLB advances and other borrowings. The Group has obtained long-term funding through the issuance of notes and long-term reverse repurchase agreements. The Group's principal uses of funds are the origination and purchase of loans, the purchase of mortgage-backed and investment securities, the repayment of maturing deposits and borrowings.
PART—2 OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Group and its subsidiaries are defendants in a number of legal claims under various theories of damages arising out of, and incidental to their business. The Group is vigorously contesting those claims. Based upon a review with legal counsel and the development of these matters to date, management is of the opinion that the ultimate aggregate liability, if any, resulting from these claims will not have a material adverse effect on the Group's financial position or results of operations.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS—NONE
ITEM 3. DEFAULTS UPON SENIOR SECURITIES—NONE
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Group's Annual Meeting of Stockholders was held on October 23, 2001. A quorum was obtained with 10,893,408 votes represented in person or by proxy, which represented approximately
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87% of all votes eligible to be cast at the meeting. Two directors of the Group, Emilio Rodriguez, Jr. and Alberto Richa Angelini, were reelected for additional three-year terms. The results of the voting are as follows:
ITEM 5. OTHER INFORMATION—NONE
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
A—EXHIBITS
None
B—REPORTS ON FORM 8-K
The Group filed a report on Form 8-K related to the issuance of trust-preferred securities by a wholly owned business trust subsidiary of the Group:
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Signatures
Pursuant to the requirements of Section 13 or 15(d) 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.
ORIENTAL FINANCIAL GROUP INC.(Registrant)
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