OFG Bancorp - 10-Q quarterly report FY

Securities and Exchange Commission

Washington, D.C. 20549

Form 10-Q

Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarter Ended September 30, 2002

Commission File No. 001-12647

Oriental Financial Group Inc.

Incorporated in the Commonwealth of Puerto Rico

Number of shares outstanding of the registrant’s common stock, as of the latest practicable date:

13,778,475 common shares ($1.00 par value per share)

outstanding as of September 30, 2002

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        ý        No       o.

TABLE OF CONTENTS

PART 1 - FINANCIAL INFORMATION

Item 1 - Financial Statements

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
SEPTEMBER 30, 2002 AND JUNE 30, 2002

(In thousands, except shares information)

See notes to consolidated financial statements.

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CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
FOR THE QUARTERS ENDED SEPTEMBER 30, 2002 AND 2001

(In thousands, except for per share data)

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

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CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)

FOR THE QUARTERS ENDED SEPTEMBER 30, 2002 AND 2001

(In thousands)

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME  (UNAUDITED)

FOR THE QUARTERS ENDED SEPTEMBER 30, 2002 AND 2001

(In thousands)

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

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CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

FOR THE QUARTERS ENDED SEPTEMBER 30, 2002 AND 2001

(In thousands)

See notes to consolidated financial statements.

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ORIENTAL FINANCIAL GROUP INC.

Notes to Unaudited Consolidated Financial Statements

NOTE 1 - BASIS OF PRESENTATION:

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 September 30, 2002 and June 30, 2002, and the results of operations and cash flows for the quarters ended September 30, 2002 and 2001. 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 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, 2002 has been derived from the Group’s audited Consolidated Financial Statements. The results of operations and cash flows for the quarters ended September 30, 2002 and 2001 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, 2002, 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.

Nature of Operations

Oriental is a financial 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”), Oriental Insurance, 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 8 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-three 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 and are carried at amortized cost. There were no held-to-maturity securities as of September 30, 2002 and June 30, 2002. 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 tax, 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 future.  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 consolidated 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, carrying 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

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temporary, are reported separately in the consolidated statements of income.  The cost of securities sold is determined using the specific identification method.

Trading Securities

A summary of trading securities owned by the Group at September 30, 2002 and June 30, 2002 is as follows:

At September 30, 2002, the Group’s trading portfolio weighted average yield was 4.45% (June 30, 2002 - 5.94%).

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 at September 30, 2002 and June 30, 2002, were as follows:

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The amortized cost and fair value of the Group’s investment securities available-for-sale at September 30 2002, 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 quarter of fiscal 2003 totaled $130,143,000 (2002 - $78,027,000). Gross realized gains and losses on those sales during the first quarter of fiscal 2003 were $5,428,000 and $1,096,000, respectively, (2002 - $754,000 and $425,000 respectively).

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.  The composition of the Group’s loan portfolio at September 30, 2002 and June 30, 2002 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 4 of the

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“Management’s Discussion and Analysis of Financial Condition and Results of Operations” for the changes in the allowance for loan losses for the quarters ended September 30, 2002 and 2001.

The Group evaluates all loans, some individually and other as homogeneous groups, for purposes of determining impairment. At September 30, 2002 and June 30, 2002, the Group determined that no specific impairment allowance was required for those loans evaluated for impairment.

NOTE 4 - PLEDGED ASSETS:

At September 30, 2002, residential mortgage loans and investment securities available for sale amounting to $350,349,900 and  $1,344,248,000 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 (4.84% at September 30, 2002 and 5.48% at June 30, 2002) 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 utilizes various derivative instruments for hedging purposes, as part of the asset/liability management, and other than hedging purposes.  These transactions involve both credit and market risk.  The notional amounts are amounts on which calculations and payments are based.  Notional amounts do not represent direct credit exposures.  Direct credit exposure is limited to the net difference between the calculated amounts to be received and paid, if any.  The actual risk of loss is the cost of replacing, at market, these contracts in the event of default by the counterparties.  The Group controls the credit risk of its derivative financial instrument agreements through credit approvals, limits, monitoring procedures and collateral, when considered necessary.

The Group generally uses interest rate swaps and interest rate options, such as caps and options, in managing its interest rate risk exposure.  The swaps were entered into to convert short-term borrowings into fixed rate liabilities for longer periods and provide protection against increases in short-term interest rates. Under these swaps, the Group pays a fixed monthly or quarterly cost and receives a floating thirty or ninety-day payment based on LIBOR. Floating rate payments received from the swap counterparties correspond to the floating rate payments made on the short-term borrowings thus resulting in a net fixed rate cost to the Group (cash flow hedging instruments used to hedge a forecasted transaction). Under the caps, the Group 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.

Derivative instruments are recognized as assets and liabilities at fair value. If certain conditions are met, the derivative may qualify for hedge accounting treatment and be designated as one of the following types of hedges: (a) hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment ("fair value hedge"); (b) a hedge of the exposure to variability of cash flows of a recognized asset, liability or forecasted transaction ("cash flow hedge") or (c) a hedge of foreign currency exposure ("foreign currency hedge").

In the case of a qualifying fair value hedge, changes in the value of the derivative instruments that have been highly effective are recognized in current period earnings along with the change in value of the designated hedge item.  In the case of a qualifying cash flow hedge, changes in the value of the derivative instruments that have been highly effective are recognized in other comprehensive income, until such time as those earnings are affected by the variability of the cash flows of the underlying hedge item.  In either a fair value hedge or a cash flow hedge, net earnings may be impacted to the extent the changes in the value of the derivative instruments do not perfectly offset changes in the value of the hedge items.  If the derivative is not designated as a hedging instrument, the changes in fair value of the derivative are recorded in earnings.

Certain contracts contain embedded derivatives.  When the embedded derivative possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract, it should be bifurcated, carried at fair value, and designated as a trading or non-hedging derivative instrument.

The Group’s swaps, excluding those used to manage exposure to the stock market discussed below, and caps outstanding and their terms at September 30, 2002 June 30, 2002 are set forth in the table below:

The Group offers its customers certificates of deposit with an option tied to the performance of one of the following stock market indexes: Standard & Poor’s 500, Dow Jones Industrial Average and Russell 2000. At the end of five years, the depositor will receive a specified percentage 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 swap and option agreements with major money center banks and major broker dealer companies to manage its exposure to changes in those indexes. Under the terms of the option agreements, the

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Group will receive the average increase in the month-end value of the corresponding index in exchange for a fixed premium. Under the term of the swap agreements, the Group will receive the average increase in the month-end value of the corresponding index in exchange for a quarterly fixed interest cost. The changes in fair value of the options purchased, the swap agreements and the options embedded in the certificates of deposits are recorded in earnings.  At September 30, 2002, the notional amount of these agreements totaled $230,790,000 (June 30, 2002 - $226,140,000). Changes in fair value of options purchased and options embedded in certificates of deposit are recorded in earnings.

At September 30, 2002 and June 30, 2002, 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 an other asset of $3.6 million  ($7.8 million, June 2002) and the options sold to customers embedded in the certificates of deposits represented a liability of $5.1 million  ($10.5 million, June 2002) recorded in deposits. The fair value of the interest rate swaps represented a liability of $35.7 million ($22.6 million, June 2002) presented in “Accrued Expenses and Other Liabilities”. The fair value of the Caps represented an other asset of $3.0 million ($4.3 million as of June 30, 2002).

NOTE 7 - STOCK DIVIDEND:

On January 29, 2002, the Group declared a ten percent (10%) stock dividend on common stock held by registered shareholders as of April 1, 2002. As a result, 1,249,125 shares of common stock were distributed on April 15, 2002. For purpose of the computation of income per common share, the dividend was retroactively recognized for all periods presented in the accompanying consolidated financial statements.

NOTE 8 - 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 deposits and personal and commercial loans.

The Group’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 (Oriental Insurance, Inc.). The core operations of this segment are financial planning, money management and investment brokerage services, insurance sales activity, as well as corporate and individual trust services.

The Group’s third business segment is mortgage banking. It consists of the mortgage banking division, whose principal activity is to originate and purchase mortgage loans for the Group’s own portfolio. From time to time, if conditions so warrant, it may sell loans to other financial institutions or securitize conforming loans into GNMA, FNMA and FHLMC certificates using as issuer another institution. The other institution services mortgages included in the resulting GNMA, FNMA, and FHLMC pools. The Group also sells the rights to service mortgage loans for others.

Intersegment sales and transfers, if any, are accounted for as if the sales or transfers were to third parties, that is, at current market prices.  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 the results of operations and the selected financial information by operating segment for each of the quarters ended September 30:

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NOTE 9 - RECENT ACCOUNTING DEVELOPMENTS

Effective July 1, 2002 the Group adopted the following Statements of Financial Accounting Standards (“SFAS”), which did not have a material effect on the Group’s consolidated financial Statements:

•                  SFAS No. 142, “Goodwill and Other Intangible Assets”. SFAS No. 142 changes the accounting for goodwill from an amortization method to an impairment-only approach. Thus, amortization of goodwill, including goodwill recorded in past business combinations, will cease upon adoption of that statement.

•                  SFAS No. 143, “Accounting for Asset Retirement Obligations”. SFAS No. 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs.

•                  SFAS No. 144, “Accounting 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 No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of SFAS No. 13, and Technical Corrections”. SFAS No. 145 rescinds SFAS No. 4, “Reporting Gains and Losses from Extinguishments of Debt - an amendment of APB Opinion No. 30”, which required all gains and losses from extinguishments of debt to be aggregated and, if material, classified as extraordinary item, net of related income tax effect. As a result, the criteria in Opinion No. 30 will now be used to classify those gains and losses.  SFAS No.145 also amends SFAS No. 13, “Accounting for Leases”, which requires that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. This amendment became effective for transactions occurring after May 15, 2002.

In June 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 146, “Accounting for Costs Associated With Exit or Disposal Activities”.  SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity  (including Certain Costs Incurred in a Restructuring).”  This Statement requires that a liability for a cost associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred.  SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged.  SFAS No. 146 is not expected to have a material effect on the Group's financial condition or results of operations.

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In October 2002, the FASB issued SFAS No. 147, “Acquisitions of Certain Financial Institutions, an amendment of FASB Statement No. 72 and 144 and FASB Interpretation No. 9”. Except for transaction between two or more mutual enterprises, SFAS No. 147 removes acquisitions of financial institutions from the scope of both SFAS No. 72 and Interpretation No. 9 and requires that those transactions be accounted with SFAS No. 141, “Business Combinations” and SFAS No. 142 "Goodwill and Other Intangible Assets".  In addition, SFAS No. 147 amends SFAS No. 144 "Accounting for Impairment or Disposal of Long-Lived Assets", to include in its scope long-term customer-relationships intangible assets and credit cardholders intangible assets. SFAS No. 147 is effective for acquisitions or impairment measurement of above intangibles effected on or after October 1, 2002. SFAS No. 147 is not expected to have a material effect on the Group's financial condition or results of operations.

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

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SELECTED FINANCIAL DATA

FOR THE QUARTERS ENDED SEPTEMBER 30, 2002 AND 2001

(In thousands, except for per share information)