SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
For the Quarterly Period ended March 31, 2006
OR
For the Transition Period from ___________ to ___________
Commission file number 000-51201
BofI HOLDING, INC.
(Exact name of registrant as specified in its charter)
12777 High Bluff Drive, Suite 100, San Diego, CA 92130
(Address of principal executive offices and zip code)
(858) 350-6200
(Registrant’s telephone number and area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter Period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large filer” 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 number of shares outstanding of the registrant’s common stock on the last practicable date: 8,437,225 shares of common stock as of April 30, 2006.
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TABLE OF CONTENTS
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets (unaudited) at March 31, 2006 and June 30, 2005
Condensed Consolidated Statements of Income (unaudited) for the three months and nine months ended March 31, 2006 and 2005
Condensed Consolidated Statements of Stockholders’ Equity and Comprehensive Income (unaudited) for the nine months ended March 31, 2006
Condensed Consolidated Statements of Cash Flows (unaudited) for the nine months ended March 31, 2006 and 2005
Notes to Condensed Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Selected Consolidated Financial Information
Overview
Results of Operations
Financial Condition
Liquidity
Contractual Obligations and Commitments
Capital Resources and Requirements
Quantitative and Qualitative Disclosures about Market Risk
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Item 4. Controls and Procedures
PART II – OTHER INFORMATION
Item 1. Legal Proceedings
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 3. Defaults Upon Senior Securities
Item 4. Submission of Matters to a Vote of Securities Holders
Item 5. Other Information
Item 6. Exhibits
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BofI HOLDING, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share data)
(Unaudited)
ASSETS
Cash and due from banks
Money market mutual funds
Federal funds sold
Total cash and cash equivalents
Time deposits in financial institutions
Investment securities held to maturity
Stock of the Federal Home Loan Bank, at cost
Mortgage-backed securities available for sale
Loans — net of allowance for loan losses of $1,575 in March 2006, $1,415 in June 2005
Loans held for sale
Accrued interest receivable
Furniture, equipment and software — net
Deferred income tax
Bank-owned life insurance — cash surrender value
Other assets
TOTAL
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits:
Non-interest bearing
Interest bearing
Total deposits
Advances from the Federal Home Loan Bank
Junior subordinated debentures
Accrued interest payable
Income tax payable
Accounts payable and accrued liabilities
Total liabilities
STOCKHOLDERS’ EQUITY:
Convertible preferred stock — $10,000 stated value; 1,000,000 shares authorized;525 shares issued and outstanding (March 2006) and 675 issued and outstanding (June 2005)
Common stock — $.01 par value; 25,000,000 shares authorized; 8,509,312 shares issued and 8,384,812 shares outstanding (March 2006) and 8,299,823 shares issued and outstanding (June 2005)
Additional paid-in capital
Unearned restricted stock awards
Accumulated other comprehensive income (loss), net of tax
Retained earnings
Treasury stock
Total stockholders’ equity
See condensed notes to consolidated financial statements.
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CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except earnings per share)
INTEREST AND DIVIDEND INCOME:
Loans, including fees
Investments
Total interest and dividend income
INTEREST EXPENSE:
Deposits
Other borrowings
Total interest expense
Net interest income
Provision for loan losses
Net interest income, after provision for loan losses
NON-INTEREST INCOME:
Prepayment penalty fee income
Mortgage banking income
Banking service fees and other income
Total non-interest income
NON-INTEREST EXPENSE:
Compensation:
Salaries and benefits
Stock options and stock grants
Total compensation
Professional services
Occupancy and equipment
Data processing and internet
Depreciation and amortization
Service contract termination
Other general and administrative
Total non-interest expense
INCOME BEFORE INCOME TAXES
INCOME TAXES
NET INCOME
NET INCOME ATTRIBUTABLE TO COMMON STOCK
COMPREHENSIVE INCOME
Basic earnings per share
Diluted earnings per share
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CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME
Additional
Paid inCapital
RetainedEarnings
TreasuryStock
Total
BALANCE — July 1, 2005
Comprehensive income:
Net income
Net unrealized loss from available for sale securities — net of income tax benefit
Total comprehensive income
Purchase of treasury stock
Conversion of preferred to common stock
Exercise of common stock options
Cash dividends on convertible preferred stock
Restricted stock awards
Restricted stock compensation expense
Stock option compensation expense
BALANCE — March 31, 2006
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of premiums on securities
Amortization of premiums and deferred loan fees
Amortization of debt issue costs
Accrued stock option and stock grant compensation
Deferred income taxes
Origination of loans held for sale
Gain on sales of loans held for sale
Proceeds from sale of loans held for sale
Loss on disposal of furniture, equipment, and software
Stock dividends from the Federal Home Loan Bank
Net changes in assets and liabilities which provide (use) cash:
Net cash provided by operating activities
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of securities available for sale
Purchases of investment securities held to maturity and time deposits
Proceeds from repayments of available for sale securities
Proceeds from repayments of investment securities held to maturity and time deposits
Purchase of stock of Federal Home Loan Bank
Origination of loans
Purchases of loans
Principal repayments and participation sales on loans
Purchases of furniture, equipment and software
Net cash used in investing activities
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits
Proceeds from Federal Home Loan Bank advances
Proceeds from revolving line term loan facility
Repayment of notes payable
Proceeds from exercise of common stock options and warrants
Proceeds from issuance of common stock, net of costs
Proceeds from the issuance of junior subordinated debentures
Costs of issuance of junior subordinated debentures
Net cash provided by financing activities
NET CHANGE IN CASH AND CASH EQUIVALENTS
CASH AND CASH EQUIVALENTS — Beginning of year
CASH AND CASH EQUIVALENTS — End of period
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Interest paid on deposits and borrowed funds
Income taxes paid
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE MONTHS ENDED MARCH 31, 2006 AND 2005
(Dollars in thousands, except per share data)
1. BASIS OF PRESENTATION
The condensed consolidated financial statements include the accounts of BofI Holding, Inc. and its wholly owned subsidiary, Bank of Internet USA (the “Bank” and collectively with BofI Holding, the “Company”). All significant intercompany balances have been eliminated in consolidation.
The accompanying interim condensed consolidated financials statements, presented in accordance with accounting principles generally accepted in the United States of America (“GAAP”), are unaudited and reflect all adjustments which, in the opinion of management, are necessary for a fair statement of financial condition and results of operations for the interim periods. All adjustments are of a normal and recurring nature. Results for the nine months ended March 31, 2006 are not necessarily indicative of results that may be expected for any other interim period or for the year as a whole. Certain information and note disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted. The unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes for the year ended June 30, 2005 included in our Annual Report on Form 10-K.
Certain reclassifications have been made to the prior-period financial statements to conform to the current-period presentation.
2. SIGNIFICANT ACCOUNTING POLICIES
Allowance for Loan Losses — The allowance for loan losses is maintained at a level estimated to provide for probable losses in the loan portfolio. Management determines the adequacy of the allowance based on reviews of individual loans and pools of loans, recent loss experience, current economic conditions, the risk characteristics of the various categories of loans and other pertinent factors. This evaluation is inherently subjective and requires estimates that are susceptible to significant revision as more information becomes available. The allowance is increased by the provision for loan losses, which is charged against current period operating results and recoveries of loans previously charged-off. The allowance is decreased by the amount of charge-offs of loans deemed uncollectible.
Under the allowance for loan loss policy, impairment calculations are determined based on general portfolio data for general reserves and loan level data for specific reserves. Specific loans are evaluated for impairment and are classified as nonperforming or in foreclosure when they are 90 days or more delinquent. A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if repayment of the loan is expected primarily from the sale of collateral.
General loan loss reserves are calculated by grouping each loan by collateral type and by grouping the loan-to-value ratios of each loan within the collateral type. Loan-to-value ratios are calculated using the loan principal balance at period end and the loan valuation at the time of origination or purchase of loan. An estimated allowance rate for each loan-to-value group within each type of loan is multiplied by the total principal amount in the group to calculate the required general reserve attributable to that group. Management uses an allowance rate that provides a larger loss allowance for loans with greater loan-to-value ratios. Specific reserves are calculated when an internal asset review of a loan identifies a significant adverse change in the financial position of the borrower or the value of the collateral. The specific reserve is based on discounted cash flows, observable market prices or the estimated value of underlying collateral.
Derivatives and Hedging Activities— Derivative contracts, such as an interest rate cap, are recorded on the balance sheet, either as an asset or a liability or as a component of the hedged item, at their fair value. On the date that we enter into a derivative contract, we designate the derivative as (1) a hedge of (a) a forecasted transaction or (b) the variability of cash flows that are to be received or paid in connection with a recognized asset or liability (a “cash flow” hedge); (2) a hedge of (a) the exposure to changes in the fair value of a recognized asset or liability or (b) an unrealized firm commitment; or (3) an instrument that is held for trading or non-hedging purposes (a “trading” or “non-hedging” instrument). Changes in the fair value of derivative trading and non-hedging instruments are reported in current-period earnings. We formally document all relationships between hedging instruments and hedged items, as well as our risk management objective and strategy for undertaking various hedge transactions.
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The fair value of derivative instruments is based on quoted market prices received from independent sources. Active markets may not exist for our derivative instruments. Consequently, the independent sources we use to obtain quoted market prices may be using estimating techniques, such as discounted cash flow analysis and comparison to similar instruments to determine the fair value of our derivative instruments. Estimates developed by these independent sources are subjective and require the judgment of the independent sources regarding significant matters such as the amount, timing and probabilities of potential future cash flows. Since these estimates are made as of a specific point in time, they are susceptible to material change over time.
Stock-Based Compensation — Prior to July 1, 2005, the Company accounts for its stock-based employee compensation under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost is reflected in the income statements for periods ending June 30, 2005, or before. Effective July 1, 2005, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-based Payment, and has included the stock-based employee compensation expense in its income statement for the three months and nine months ended March 31, 2006. Refer to Note 6, Stock Options, Stock Grant and Stock Purchase Plans below, for additional disclosures.
New Accounting Pronouncements — During the quarter ended December 31, 2005, the FASB issued FSP FAS 115-1, The Meaning of Other Than Temporary Impairment and Its Application to Certain Investments. FSP FAS 115-1 clarifies that an investor in debt or equity securities should recognize an impairment loss no later than when the impairment is deemed other than temporary, even if a decision to sell has not been made. FSP FAS 115-1 is effective for other-than-temporary impairment analyses conducted in periods beginning after December 15, 2005. The adoption of FSP FAS 115-1 did not have a material impact on the Company’s financial position and results of operations.
3. INVESTMENT SECURITIES
The following table sets forth the amortized cost and the estimated fair values of investment securities available for sale as of March 31, 2006:
Available for sale
Amortized
Cost
Unrealized
Gains
Losses
Mortgage-backed securities(GNMA, FNMA, FHLMC)
The following table sets forth the amortized cost and the estimated fair values of investment securities held to maturity as of March 31, 2006:
Held to maturity
Mortgage-backed securities (FHLMC, FNMA)
U.S. Government agency debt
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The Bank intends to hold its investment securities held to maturity until the amortized cost is realized. The unrealized losses are due primarily to interest rate fluctuations.
4. LOANS
The following table sets forth the composition of the portfolio of loans held for investment as of the dates indicated:
Residential real estate loans:
Single family (one to four units)
Multifamily (five units or more)
Commercial real estate and land
Consumer loans and other
Total loans
Allowance for loan losses
Unamortized premiums, net of deferred loan fees
Net loans
In the ordinary course of business, the Bank has made loans collateralized by real property to principal officers, directors and their affiliates and employees with interest rates at 5.50%. At March 31, 2006, these loans amounted to $4,068.
The Bank originates and purchases mortgage loans with terms that may include repayments that are less than the repayments for fully amortizing loans, including interest only loans, option adjustable-rate mortgages, and other loan types that permit payments that may be smaller than interest accruals. Through March 31, 2006, the net amount of deferred interest on these loan types was not material to the financial position or operating results of the Company.
5. STOCKHOLDERS’ EQUITY
Common Stock — The Company had 8,384,812 and 8,299,823 shares of common stock outstanding at March 31, 2006 and June 30, 2005, respectively. During the nine months ended March 31, 2006, the Company reduced its common shares outstanding by purchasing 107,000 shares of treasury stock for $883 under the Company’s common stock buy back program approved on June 30, 2005. Also during the nine months ended March 31, 2006, the Company added issued and outstanding shares totaling 49,189 from the exercise of stock options. The Company had issued 8,509,312 and 8,299,823 shares of common stock at March 31, 2006 and June 30, 2005, respectively. The Company granted 19,300 shares of common stock, subject to restrictions, in connection with the Company’s 2004 Stock Incentive Plan. Of the 19,300 shares granted, 1,800 shares were forfeited during the nine months ending March 31, 2006. Of the net 17,500 shares remaining, none of the shares were vested and none were considered outstanding at March 31, 2006.
Common Stock Warrants — Warrants to purchase 59,950 shares of the Company’s common stock that were outstanding at June 30, 2005, all expired without being exercised on July 31, 2005. The Company had no outstanding warrants to purchase common stock at March 31, 2006.
Convertible Preferred Stock — Effective January 1, 2006, holders of 150 shares ($1,500,000 face value) of the Company’s Series A – 6% Cumulative Nonparticipating Perpetual Preferred Stock, Convertible through January 1, 2009 elected to convert to 142,800 shares of the Company’s common stock at a price of approximately $10.50 per share.
6. STOCK OPTIONS, STOCK GRANT AND STOCK PURCHASE PLANS
Effective July 1, 2005, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-based Payment, and has included the stock-based employee compensation cost in its income statements for the three month and nine month periods ended March 31, 2006. Prior periods have not been restated.
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Share Based Payment Arrangements— At March 31, 2006, the Company has three share-based payment plans for employees, which are described below. Amounts recognized in the financial statements with respect to these plans are as follows:
Three Months Ended
March 31,
Nine Months Ended
Amounts charged against income, before tax benefit
Amount of related income tax benefit recognized in income
1999 Stock Option Plan— In July 1999, the Company’s Board of Directors approved the 1999 Stock Option Plan (the “1999 Plan”). In August 2001, the Company’s shareholders approved an amendment to the 1999 Plan such that 15% of the outstanding shares of the Company would always be available for grants under the 1999 Plan (1,316,432 shares at June 30, 2005). The 1999 Plan is designed to encourage selected employees and directors to improve operations and increase profits, to accept or continue employment or association with the Company through participation in the growth in the value of the common stock. The 1999 Plan provisions require that option exercise prices be not less than fair market value per share of common stock on the option grant date for incentive and nonqualified options. The options issued under the 1999 Plan generally vest in four years. Option expiration dates are established by the plan administrator but may not be later than 10 years after the date of the grant.
Prior to March 15, 2005, when the Company’s common stock began trading publicly, the Company’s stock options were valued without consideration of a volatility factor. All of the options granted under the 1999 Plan were granted prior to March 15, 2005. The weighted-average fair value at grant date for options granted during the nine months ended March 31, 2005 and the years ended June 30, 2005, 2004 and 2003 were $2.37, $2.37, $2.52, and $1.83 per share, respectively.
The following assumptions were used to determined the weighted-average grant-date fair values of options granted:
Year Ended
June 30
Risk-free interest rates
Dividends
Volatility
Weighted-average expected life
No stock options were granted under the 1999 Plan during the three months ended March 31, 2005.
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A summary of share option activity under this plan for the nine months ended March 31, 2006 and for four years prior is presented below:
Outstanding—June 30, 2002
Granted
Forfeited/canceled
Outstanding—June 30, 2003
Exercised
Outstanding—June 30, 2004
Outstanding—June 30, 2005
Outstanding—March 31, 2006
Options exercisable—June 30, 2003
Options exercisable—June 30, 2004
Options exercisable—June 30, 2005
Options exercisable—March 31, 2006
The aggregate intrinsic value of options outstanding and options exercisable under the 1999 Plan at March 31, 2006 were $1,438 and $1,436, respectively. The aggregate intrinsic value of options exercised for the nine months ended March 31, 2006 was $182. The Company recorded stock option compensation expense related to the 1999 Plan of $36 and $110 for the three months and the nine months ended March 31, 2006, respectively.
2004 Stock Incentive Plan—In October 2004, the Company’s Board of Directors and the stockholders approved the 2004 Stock Incentive Plan (“2004 Plan”), which provides for the grant of stock options, restricted stock, restricted stock units, stock appreciation rights and dividend equivalent rights to employees, directors and consultants. The maximum number of shares of common stock available for issuance under the 2004 Plan, plus the number of shares of common stock available for issuance under the 1999 Plan will be equal to 14.8% of the Company’s outstanding common stock at any time. However, the number of shares available for issuance as restricted stock grants may not exceed 5% of the Company’s outstanding common stock (subject to the overall maximum of 14.8% of the outstanding shares of common stock). Each share of restricted stock that is issued under the 2004 Plan and vests will be deemed to be the issuance of three shares for purposes of calculating the overall maximum number of shares of common stock available for issuance under the 2004 Plan but not for purposes of calculating the above 5% limit applicable to the issuance of restricted stock.
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Stock Options Granted—In July 2005, the Company’s Board of Directors approved the first grant of stock options under the 2004 Plan. The non-qualified stock options were issued with grant-day exercise prices equal to market prices and vesting periods of three years for directors and four years for employees with no vesting until after 12 months. The following assumptions were used to determine the weighted-average grant-date fair values of options granted:
There were no options granted during the quarter ended March 31, 2006. The weighted-average fair value was $3.95 per share for options granted under the 2004 Plan during the nine months ended March 31, 2006. A forfeiture rate of 1.50% was estimated based upon past experience. A summary of share option activity under the 2004 Plan for the nine months ended March 31, 2006 is presented below:
Outstanding— June 30, 2005
Forfeited / Cancelled
Aggregate intrinsic value- March 31, 2006
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For the three months and the nine months ended March 31, 2006, stock option compensation expense of $59 and $157 was recognized in connection with the 2004 Plan. At March 31, 2006, compensation expense related to non-vested stock option grants aggregated to $762 and is expected to be recognized as follows:
Remainder of fiscal 2006
For the fiscal year ended June 30,:
2007
2008
2009
2010
Restricted Stock Grants—In July 2005, the Company’s Board of Directors approved the first restricted stock grants under the 2004 Plan. Restricted stock totaling 19,300 shares were granted to directors and an employee on July 25, 2005 when the closing market price was $9.50. At March 31, 2006, 17,500 of the restricted stock grants remain as 1,800 shares were forfeited by a former director. The restricted stock vests one-third on each one-year anniversary of the grant date and no shares were vested at March 31, 2006. Compensation expense of $14 and $38 were recognized for the three months and nine months ended March 31, 2006, respectively, based upon grantee service period. The remaining compensation cost of $128 will be recognized $14, $56, $56 and $2 during each of the fiscal years ended June 30, 2006, 2007, 2008 and 2009.
2004 Employee Stock Purchase Plan—In October 2004, the Company’s Board of Directors and stockholders approved the 2004 Employee Stock Purchase Plan, which is intended to qualify as an “Employee Stock Purchase Plan” under Section 423 of the Internal Revenue Code. An aggregate of 500,000 shares of the Company’s common stock has been reserved for issuance and will be available for purchase under the 2004 Employee Stock Purchase Plan. No shares have been issued under the 2004 Employee Stock Purchase Plan.
Period of Adoption Disclosures— Under the 1999 Stock Option Plan, the Company had share-based payment arrangements with employees accounted for under the intrinsic value method. The following presents information as if the fair value method had applied to all awards:
2005
Net income attributable to common
Deduct:
Total stock-based employee compensation expense determined under fair-value-based method for all awards—net of related tax effect
Pro forma net income
Earnings per share
Basic—as reported
Basic—pro forma
Diluted—as reported
Diluted—pro forma
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7. EARNINGS PER SHARE
Information used to calculate earnings per share was as follows:
Dividends on preferred stock
Weighted-average shares:
Basic weighted-average number of common shares outstanding and average common shares earned on restricted stock awards
Dilutive effect of stock options
Dilutive effect of warrants
Dilutive weighted-average number of common shares outstanding
Net income per common share:
Basic
Diluted
Options and stock grants of 744,352 and 490,233 shares for the three months ended March 31, 2006 and 2005, respectively, were not included in determining diluted earnings per share, as they were antidilutive. For the nine months ended March 31, 2006 and 2005, options and grants of 714,288 and 496,822 shares, respectively, were antidilutive and were not included in determining diluted earnings per share.
8. COMMITMENTS AND CONTINGENCIES
Operating Leases — On April 25, 2005, the Company entered into an operating lease for its new corporate office, which commenced on June 15, 2005 and will expire on October 31, 2012. Under the lease terms, the Company leases 12,364 square feet and pays utilities and its proportional share of “Common Operating Costs”. The future minimum lease payments under this noncancelable lease as of June 30, 2005 are: $198, $306, $315, $323, and $1,154 for the years ending June, 30, 2006, 2007, 2008, 2009, and thereafter, respectively. The Company’s operating lease for its former corporate office expired on June 30, 2005.
Credit-Related Financial Instruments — The Company is a party to credit-related financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. At March 31, 2006, the Company had $1,351 commitments to fund loans.
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The following discussion provides information about the results of operations, financial condition, liquidity, off balance sheet items, contractual obligations and capital resources of BofI Holding, Inc. and subsidiary. This information is intended to facilitate the understanding and assessment of significant changes and trends related to our financial condition and the results of our operations. This discussion and analysis should be read in conjunction with our financial information in our Annual Report on Form 10-K and the accompanying interim unaudited condensed consolidated financial statements and notes thereto.
Certain matters discussed in this report may constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and as such, may involve risks and uncertainties. These forward-looking statements can be identified by the use of terminology such as “estimate,” “project,” “anticipate,” “expect,” “intends,” “believe,” “will,” or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategy that involve risks and uncertainties. These forward-looking statements relate to, among other things, expectations of the environment in which the Company operates and projections of future performance. Forward-looking statements are inherently unreliable and actual results may vary. Factors that could cause actual results to differ from these forward-looking statements include economic conditions, changes in the interest rate environment, changes in the competitive marketplace, risks associated with credit quality and other risk factors discussed under the heading “Risk Factors” in our Prospectus dated March 14, 2005, and under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Factors That May Affect Our Performance” in our Annual Report on Form 10-K for the year ended June 30, 2005, both of which have been filed with the Securities and Exchange Commission. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. All written and oral forward-looking statements made in connection with this report, which are attributable to us or persons acting on our behalf are expressly qualified in their entirety by the foregoing information.
General
Our company, BofI Holding, Inc., is the holding company for Bank of Internet USA, a consumer-focused, nationwide savings bank operating primarily over the Internet. We offer loans and deposits in all 50 states to our customers directly through our websites, including www.BankofInternet.com, www.BofI.com, www.SeniorBofI.com and www.Apartmentbank.com. We are a unitary savings and loan holding company and, along with Bank of Internet USA, are subject to primary federal regulation by the Office of Thrift Supervision.
Using online applications on our websites, our customers apply for deposit products, including time deposits, interest-bearing demand accounts (including interest-bearing checking accounts) and savings accounts (including money market savings accounts). We specialize in originating and purchasing small- to medium-size multifamily mortgage loans. We manage our cash and cash equivalents based upon our need for liquidity, and we seek to minimize the assets we hold as cash and cash equivalents by investing our excess liquidity in higher yielding assets such as loans or securities.
Critical Accounting Policies
Our consolidated financial statements and the notes thereto, have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make a number of estimates and assumptions that affect the reported amounts and disclosures in the consolidated financial statements. On an ongoing basis, we evaluate our estimates and assumptions based upon historical experience and various factors and circumstances. We believe that our estimates and assumptions are reasonable under the circumstances. However, actual results may differ significantly from these estimates and assumptions that could have a material effect on the carrying value of assets and liabilities at the balance sheet dates and our results of operations for the reporting periods.
Our significant accounting policies and practices are described in greater detail in Note 1 to our June 30, 2005 audited consolidated financial statements and under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies” contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission.
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Selected Financial Data
The following tables set forth certain selected financial data concerning the periods indicated:
SELECTED CONSOLIDATED FINANCIAL INFORMATION
Selected Balance Sheet Data:
Total assets
Loans - net of allowance for loan losses
Advances from the FHLB
Selected Income Statement Data:
Interest and dividend income
Interest expense
Net interest income after provision for loan losses
Non-interest income
Non-interest expense
Income before income tax expense
Income tax expense
Net income attributable to common stock
Per Share Data:
Net income:
Book value per common share
Tangible book value per common share
Weighted average number of common shares outstanding:
Common shares outstanding at end of period
Common shares issued at end of period
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Performance Ratios and Other Data:
Loan originations
Loan originations for sale
Loan purchases
Return on average assets
Return on average common stockholders’ equity
Interest rate spread(1)
Net interest margin(2)
Efficiency ratio(3)
Capital Ratios:
Equity to assets at end of period
Tier 1 leverage (core) capital to adjusted tangible assets(4)
Tier 1 risk-based capital ratio(4)
Total risk-based capital ratio(4)
Tangible capital to tangible assets(4)
Asset Quality Ratios:
Net charge-offs to average loans outstanding(5)
Nonperforming loans to total loans(5)
Allowance for loan losses to total loans held for investment at end of period
Allowance for loan losses to nonperforming loans(5)
OVERVIEW
During the quarter ended March 31, 2006, we earned $828,000, or $0.09 per diluted share compared to $859,000, or $0.13 per diluted share for the three months ended March 31, 2005. Our quarterly net income decreased 3.6% and our earnings per share decreased 30.8% in the 2006 quarter compared to 2005. During the quarter ended March 31, 2005, we completed our initial public offering and issued 3,052,174 common shares adding $31.3 million in equity capital for growth. The percentage decline in diluted earnings per share for the 2006 quarter compared to 2005 was larger than the percentage decline in net income primarily due to our initial public offering shares added late in the 2005 quarter, and not fully included in the weighted average outstanding shares for the 2005 quarter. Similarly, the increased equity from our initial public offering was added late in the 2005 quarter contributing to a larger percentage decline in the annualized return on average equity which decreased to 4.65% for 2006, down from 9.19% for March 2005. Key comparisons between our operating results for the quarter ended March 2006 compared to March 2005 are:
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For the nine months ended March 31, 2006, net income increased $0.4 million to $2.4 million or $0.25 per diluted share, compared to $2.0 million, or $0.32 per diluted share for the nine months ended March 31, 2005. The 19.2% increase in net income was primarily the result of a 42.0% increase in average interest earning assets, partially offset by a 39 basis point decrease in our net interest margin, which increased net interest income $874,000. Our annualized return on average equity was 4.52% for the nine months ended March 31, 2006, down from 8.16% for 2005. The timing of our initial public offering also contributed to the percentage decrease in diluted earnings per share and annualized return on equity for the nine months ended March 31, 2006 compared to 2005.
Our earnings rely on our net interest income and our net interest income has been negatively impacted by the flattening yield curve. Our net interest margin declined to 1.54% and to 1.55% for the three months and the nine months ended March 31, 2006 from 1.88% and 1.94% for the three months and the nine months ended March 31, 2005. The flattening yield curve has caused our deposit rates and interest expense to increase without a proportional increase in our interest earned on our loan originations and purchases. Recently the yield curve slope has minimally increased. This trend of increased yield curve slope must continue or our net interest margin will continue to decrease and our ability to grow the assets and the liabilities of the Bank could be adversely affected.
RESULTS OF OPERATIONS – Comparison of Three Months and Nine Months Ended March 31, 2006 and 2005
Net income for the three months ended March 31, 2006 decreased $31,000 to $828,000 or $0.09 per diluted share, compared to $859,000 or $0.13 per diluted share for the three months ended March 31, 2005. Net income before income tax for the three months ended March 31, 2006 decrease by approximately $45,000 to $1,393,000 compared to $1,438,000 for the three months ended March 31, 2005. The decrease resulted primarily from the $405,000 increase in non-interest expense partially offset by a $236,000 increase in net interest income and a $129,000 increase in non-interest income.
Net income for the nine months ended March 31, 2006 increased $0.4 million to $2.4 million or $0.25 per diluted share, compared to $2.0 million, or $0.32 per diluted share for the nine months ended March 31, 2005. Net income before income tax for the nine months ended March 31, 2006 increase by $0.7 million to $4.1 million compared to $3.4 million for the nine months ended March 31, 2005. The increase resulted primarily from an $874,000 increase in net interest income and a $509,000 increase in non-interest income, partially offset by an increase in non-interest expense of $744,000.
Net Interest Income
Net interest income for the quarter ended March 31, 2006 totaled $2.6 million, a 13.0% increase over net interest income of $2.3 million for the quarter ended March 31, 2005. Net interest income for the nine months ended March 31, 2006 increased 13.6% to $7.5 million, up from $6.6 million for the nine months ended March 31, 2005.
Total interest and dividend income during the quarter ended March 31, 2006 increased 42.4% to $8.4 million, compared with $5.9 million during the quarter ended March 31, 2005. For the nine months, total interest and dividend income increased 46.6% to $23.6 million, compared with $16.1 million for the nine months ended March 31, 2005. The increases in interest and dividend income for the quarter and for the nine months are attributable to growth in average earning assets, primarily average loans held for investment and average investment securities (primarily mortgage-back securities). Comparing average balances for the quarters, March 2006 compared to 2005, loans held for investment and investment securities grew 33.5% and 45.6%, respectively. Comparing average balances for the nine months ended March 31, 2006 to 2005, loans held for investment and investment securities grew 38.2% and 98.6%, respectively. Higher rates on new loans and rate adjustments in the loan portfolio caused the loan portfolio yield for the 2006 quarter to increase 21 basis points and to increase 9 basis points for the nine months of 2006 compared with the same period in 2005, contributing to the increase in interest income. The net growth in average earning assets for the three month and nine month periods was funded largely by increases in time deposits and advances from the FHLB, which account for the majority of the increases in interest expense. Total interest expense during the quarter ended March 31, 2006 increased 61.1% to $5.8 million, compared with $3.6 million during the quarter ended March 31, 2005. For the nine months, interest expense increased 69.5% to $16.1 million, compared with $9.5 million for the nine months ended March 31, 2005. Comparing average balances for the quarter ended March 2006 to 2005; time deposits and advances from the FHLB grew 50.3% and 49.6%, respectively. Comparing average balances for the
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nine months ended March 31, 2006 to 2005; time deposits and advances from the FHLB grew 65.9% and 58.7%, respectively. Higher rates paid on new time deposits caused the time deposit rate for the 2006 quarter to increase 76 basis points and to increase 61 basis points for the nine months of 2006 compared with same period in 2005. Similarly, higher rates paid on new FHLB advances caused the rate for the 2006 quarter to increase 43 basis points and to increase 30 basis points for the nine months of 2006 compared with same period in 2005. The combined rate and rate / volume variance (primarily from increases in time deposits and FHLB advance rates) accounted for 45.1% and 35.3% of the total increase in interest expense for the quarter and for the nine month comparisons, respectively.
Net interest margin, defined as net interest income divided by average earning assets, decreased by 34 basis points to 1.54% for the quarter ended March 31, 2006, compared with 1.88% for the quarter ended March 31, 2005. Similarly, the net interest margin decreased by 39 basis points to 1.55% for the nine months ended March 31, 2006, compared with 1.94% for the nine months ended March 31, 2005. The net interest margin declined for the quarter and for the nine months as a result of the flattening of the yield curve and the addition of lower-rate mortgage-backed securities. During the first quarter of fiscal 2005, we increased our investment in mortgage-backed securities, because we believed they offered better relative credit risk compared to the pricing levels of mortgage whole loans. The mortgage-backed securities we purchased provide a guarantee from a government sponsored entity like FNMA, while single-family whole loan originations and purchases do not have a credit guarantee. Generally, the credit risk premiums on mortgage whole loans (the difference between the interest rate earned on a whole loan and the rate earned on a long-term U.S. Treasury) have decreased due to the strong housing market and the lower mortgage default levels over the last few years. As result, high quality mortgage loan rates remain relatively low, contributing to our decrease in net interest margin.
Our net interest margin has also been negatively influenced by the flattening of the yield curve. The interest rates we pay on our deposits generally move with short-term rates and the interest yield on our loans generally moves with long-term rates. Increases in the Fed Funds rates over the past two years have caused short-term rates to rise, without corresponding increases in long-term rates causing the yield curve to flatten. Our cost of funds (primarily deposit interest) for the quarter and for the nine-month period ended March 31, 2006, increased 77 basis points and 72 basis points, respectively. Our yield on earning assets (primarily loan interest) for the quarter and for the nine-month period ended March 31, 2006, increased only 28 basis points and 15 basis points, respectively. Recently the yield curve slope has minimally increased and we believe that the slope will continue to increase, although there can be no assurances that this will occur. If the slope of the yield curve does not continue to increase, we may not be able to grow the size of our earning assets at the same rate we have experienced over the past four years and our net interest margin may continue to decline and remain below historic levels.
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Average Balances, Net Interest Income, Yields Earned and Rates Paid
The following table presents information regarding (i) average balances; (ii) the total amount of interest income from interest-earning assets and the weighted average yields on such assets; (iii) the total amount of interest expense on interest-bearing liabilities and the weighted average rates paid on such liabilities; (iv) net interest income; (v) interest rate spread; and (vi) net interest margin for the three months ended March 31, 2006 and 2005:
Interest
Income /
Expense
Rates
Earned /
Paid(1)
Assets
Loans (2) (3)
Interest-bearing deposits in other financial institutions
Investment securities (3) (4)
Stock of FHLB, at cost
Total interest-earning assets
Noninterest-earning assets
Liabilities and Stockholders’ Equity:
Interest-bearing demand and savings
Time deposits
Total interest-bearing liabilities
Noninterest-bearing demand deposits
Other interest-free liabilities
Stockholders’ equity
Total liabilities and stockholders’ equity
Net interest spread (5)
Net interest margin (6)
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The following table presents information regarding (i) average balances; (ii) the total amount of interest income from interest-earning assets and the weighted average yields on such assets; (iii) the total amount of interest expense on interest-bearing liabilities and the weighted average rates paid on such liabilities; (iv) net interest income; (v) interest rate spread; and (vi) net interest margin for the nine months ended March 31, 2006 and 2005.
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Analysis of Changes in Net Interest Income
Changes in net interest income are a function of changes in rates and volumes of both interest-earning assets and interest-bearing liabilities. The following table presents information regarding changes in interest income and interest expense for the periods indicated. The total change for each category of interest earning asset and interest-bearing liability is segmented into the change attributable to changes in volume (changes in volume multiplied by prior rate), the change attributable to variations in interest rates (changes in rates multiplied by old volume) and the change attributable to changes in rate/volume (change in rate multiplied by the change in volume):
Increase / (decrease) in interest income:
Loans
Investment securities
Increase / (decrease) in interest expense:
Provision for Loan Losses
The provision for loan losses amounted to $15,000 for the quarter ended March 31, 2006, compared to $10,000 for the quarter ended March 31, 2005. For the nine months ended March 31, 2006, loan loss provisions amounted to $160,000, compared to $185,000 for the nine months ended March 31, 2005. Provisions for loan losses are charged to income to bring the allowance for credit losses to a level deemed appropriate by management based on the factors discussed under the “Allowance for Loan Losses” section of this report.
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Non-interest Income
The following table sets forth information regarding our non-interest income for the periods shown:
Mortgage banking fee income
Non-interest income for the quarter ended March 31, 2006 increased $129,000, or 70.5% to $312,000 compared to $183,000 for the quarter ended March 31, 2005. For the nine months ended March 31, 2006, non-interest income increased 89.6% to $1,077,000 compared to $568,000 for the period in 2005. Increases in prepayment penalty fee income and mortgage banking income are the primary reasons for the increase in non-interest income. Higher fee income from mortgage loan prepayments is the result of more multifamily loans repaying earlier in the loan life. This increase is generally due to the increase in the size of the multifamily loan portfolio, however, there are many factors influencing borrowers’ to payoff loans early, making prepayment penalty fee income somewhat unpredictable. During the first quarter of this fiscal year, we implemented a new correspondent program, which added $16,000 in fee income for the quarter and $259,000 in fee income for the nine months ended March 31, 2006. This new correspondent program, plus an increase in single-family loan sales increased mortgage banking fee income in 2006 compared to 2005.
Non-interest Expense
The following table sets forth information regarding our non-interest expense for the periods shown:
Stock option and stock grants
Efficiency ratio (1)
Noninterest expense as annualized % of average assets
Non-interest expense, which is comprised primarily of compensation, data processing and internet expenses, occupancy and other operating expenses, was $1.5 million for the three months ended March 31, 2006 and $1.1 million for the three months ended March 31, 2005. Non-interest expense increased 22.2% to $4.4 million for the nine months ended 2006 compared to $3.6 million for the nine months ended 2005.
Total compensation increased $214,000 to $755,000 for the quarter ended March 31, 2006, compared to $541,000 for the same quarter last year. For the nine months ended in 2006, compensation increased $0.2 million to $2.1 million, compared with $1.9 million for the same period ended March 31, 2005. Effective July 1, 2005, the Company adopted SFAS No. 123(R), Share-based Payment, and has included the stock-based employee compensation expense of $109,000 and $304,000 in its compensation expense –
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stock option and stock grants - for the three months and nine months ended March 31, 2006. Salaries and benefits increased $105,000 for the three months ended March 31, 2006 due primarily to certain employee relocation and temporary labor costs. Salaries and benefits included $280,000 of one-time bonus accruals for executives for the nine months ended March 31, 2005. Without the one-time bonus amounts in 2005, salaries and employee benefits for the nine months ended March 31, 2006, would have increased approximately 12.4% for salary increases and staff additions.
Professional services which includes accounting and legal fees, increased $64,000 and $157,000 for quarter and the nine months ended March 31, 2006, respectively. The increases in professional services were primarily due to increased compliance costs associated with public company filings, audits and other routine work, not required for part of 2005, before we became a public entity.
Occupancy and equipment expense increased in 2006 compared to 2005 due to the relocation of the corporate office in June 2005 to a larger office with increased rent.
Data processing and internet expense increased in 2006 compared to 2005 generally due to the increase in the number of deposit customers and due to new website development costs.
Other general and administrative expenses include advertising and promotion, telephone, postage, supplies, insurance and other miscellaneous deposit and loan related expenses. Other general and administrative expenses increased $75,000 and $225,000 for the quarter and nine months ended March 31, 2006, respectively. The primary reasons for these increases in other general and administrative expenses relate to increased levels of corporate insurance, franchise tax and, to a lesser extent, higher levels of deposit and loan customers.
Our efficiency ratio was 51.3% for the three months ended March 31, 2006, compared to 42.7% for the corresponding period in 2005. Our non-interest expense as a percent of average assets (G & A ratio) was 0.87% for the three months ended March 31, 2006, compared to 0.85% for the corresponding period in 2005. Without the new requirement to expense stock options, our efficiency ratios would have been 47.5% and 47.4% for the three months and the nine months ended March 31, 2006 and our G&A ratios would have improved to 0.81% and 0.83% for the three months and the nine months ended March 31, 2006, when compared to 2005 ratios.
Provision for Income Taxes
Our effective income tax rates (income tax provision divided by net income before income tax) for the three months ended March 31, 2006 and 2005 were 40.56% and 40.26%, respectively. Our effective income tax rates for the nine months ended March 31, 2006 and 2005 were 40.19% and 39.98%, respectively. The variations in our effective tax rate have been primarily related to our investment in bank-owned life insurance (BOLI), which generates non-taxable income.
FINANCIAL CONDITION
Balance Sheet Analysis
Our total assets increased $95.2 million, or 15.6%, to $704.7 million, as of March 31, 2006, up from $609.5 million at June 30, 2005. The increase in total assets was primarily due to the purchase and origination of new loans, which contributed to the $78.7 million net increase in loans held for investment. The purchase of mortgage-backed securities contributed to a net increase in mortgage-backed securities available for sale of $10.7 million. The asset growth was funded by a net increase in deposits totalling $44.7 million and a net increase in FHLB advances of $49.1 million.
During the nine months ended March 31, 2006, our asset and liability mix changed primarily two ways. First, time deposits increased to 83.0% of total deposits, up from 74.6% at June 30, 2005. We expect this trend to continue as the rise in short-term rates has increased bank competition for time deposits making time deposit rates more attractive to many consumers. Second, we increased our single family loan portfolio to 23.0% of total loans, up from 12.9% at June 30, 2005. During the nine months we purchased $166.0 million in whole loans and $33.1 million in mortgage-backed securities. Our decision to invest in either whole loans or mortgage-backed securities depends on a number of factors which often change from day to day including the number of opportunities to originate and purchase loan pools, the credit risk of certain loan pools compared to mortgage-backed securities, changing mortgage repayment rates and the flattening in the yield curve. Furthermore, until the trends toward a flattening or inverting yield curve reverse, our ability to obtain loans and mortgage-backed securities that meet our yield requirements will be adversely affected.
Net loans held for investment increased $78.7 million, or 16.2% to $565.6 million at March 31, 2006 from $486.9 million at June 30, 2005. The growth in loans during the nine months was primarily due to purchases of single-family and multifamily loans, which, net of repayments, increased our single-family portfolio by $66.5 million and our multifamily portfolio by $11.3 million at March 31, 2006. Total loan purchases and originations for the nine months ended March 31, 2006 were $166.0 million and $6.9 million, respectively. Loan repayments were $92.5 million for the nine months ended March 31, 2006.
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The following table sets forth the composition of the loan portfolio as of the dates indicated:
Nonperforming Assets
Nonperforming assets are comprised of nonaccrual loans, loans past due 90 days or more but not on nonaccrual, restructured loans and other real estate owned, net. There were no nonperforming assets on March 31, 2006.
Allowance for Loan Losses
We are committed to maintaining the allowance for loan losses at a level that is considered to be commensurate with estimated and known risks in the portfolio. Although the adequacy of the allowance is reviewed quarterly, our management performs an ongoing assessment of the risks inherent in the portfolio. While we believe that the allowance for loan losses is adequate at March 31, 2006, future additions to the allowance will be subject to continuing evaluation of estimated and known, as well as inherent, risks in the loan portfolio.
The assessment of the adequacy of our allowance for loan losses is based upon a number of quantitative and qualitative factors, including levels and trends of past due and nonaccrual loans, change in volume and mix of loans and collateral values. We did not have any nonperforming loans at March 31, 2006 or 2005. We believe that our history is limited and it is unlikely that every loan in our investment portfolio will continue to perform without exception so we provide general allowances based upon the overall volume of loans, the loan types and the estimated collateral values.
The provision for loan losses amounted to $15,000 for the quarter ended March 31, 2006, compared to $10,000 for the quarter ended March 31, 2005. For the nine months ended March 31, 2006, the provision for loan losses amounted to $160,000 compared to $185,000 for the nine months ended March 31, 2005. General reserves are a function of our portfolio loan balance. Generally, the larger the increase in our loans held for investment the higher loan loss provisions. The loss provision for the nine-month 2005 period was higher than the 2006 period because more multifamily loans were added in 2005.
The following table summarizes activity in the allowance for loan losses for the nine months ended March 31, 2006:
Balance at July 1, 2005
Provision for loan loss
Balance at March 31, 2006
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The following table reflects management’s allocation of the allowance for loan losses by loan category and the ratio of each loan category to total loans as of the dates indicated:
Single family
Multifamily
Consumer
Investment Securities
Total mortgage-backed securities available for sale was $73.5 million as of March 31, 2006, compared with $62.8 million at June 30, 2005. During the nine months ended March 31, 2006, we purchased $33.1 million in mortgage-backed securities and received principal repayments of approximately $21.4 million.
Mortgage-backed securities (GNMA, FNMA, FHLMC)
The Bank intends to hold its held to maturity securities until the amortized cost is realized. The unrealized losses are due primarily to interest rate fluctuations.
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Deposits increased a net $44.6 million, or 12.4%, to $405.7 million at March 31, 2006, from $361.1 million at June 30, 2005. Our deposit growth was comprised of increases in time deposit accounts of $67.3 million offset by a decline in checking, savings, and money market accounts of $22.7 million. Our growth in deposits was the result of increased promotion and competitive pricing on time deposits. Our money market savings decreased as a result of less competitive rate pricing resulting in customer transfers to our higher rate time deposits or withdrawals.
The following table sets forth the number of deposit accounts by type at the date indicated:
Checking and savings accounts
Total number of deposit accounts
FHLB Advances
We regularly use FHLB advances to manage our interest rate risk and, to a lesser extent, manage our liquidity position. FHLB advances increased 28.4% to $221.6 million as of March 31, 2006, representing an increase of $49.1 million from June 30, 2005. FHLB advances with terms between two and five years were used to fund the purchase of single family and multifamily mortgages and to provide us with interest rate risk protection should rates rise. We also had outstanding short-term advances (less than 30 days) of $5.0 million and $23.0 million at March 31, 2006 and June 30, 2005, respectively. Typically, we use short-term advances to temporarily fund loan purchases and then repay the advances with customers’ deposits as they are received.
Stockholders’ Equity
Stockholders’ equity increased $1.3 million to $69.9 million at March 31, 2006 compared to $68.6 million at June 30, 2005. The increase was the result of our net income for the nine months of $2.4 million and $0.6 million for paid in capital from exercise of stock option and stock option expense, partially offset by a $0.5 million unrealized loss from our available for sale securities, a $0.3 million reduction for dividends paid to holders of our convertible preferred stock and a $0.9 million reduction for our buyback of 107,000 shares of our common stock. During the quarter ended March 31, 2006, 150 shares of preferred stock were converted into common shares.
LIQUIDITY
During the nine months ended March 31, 2006, we had net cash inflows from operating activities of $3.2 million compared to $3.8 million for the nine months ended March 31, 2005. Net cash inflows for the periods ended in 2006 and 2005 were primarily due to net income earned during the period and the timing of loan funding and loan sales in our originated for sale portfolio.
Net cash outflows from investing activities totaled $97.6 million and $132.2 million for the nine months ended March 31, 2006 and 2005, respectively. Net cash outflows from investing activities decreased $34.6 million for the nine months ended March 31, 2006 due to higher loan principal repayments, which reduced cash outflow by $38.7 million, and increased proceeds from maturing investments which reduced cash outflow by $17.9 million, partially offset by net changes in the mix of activities to purchase securities, and to originate and purchase loans.
Our net cash provided by financing activities totaled $92.8 million and $124.6 million for the nine months ended March 31, 2006 and 2005, respectively. Net cash provided from financing activities decreased $31.8 million for the nine months ended March 31, 2006 primarily due to the $31.4 million from issuance of common stock and $5.2 million in proceeds from the issuance of junior subordinated debentures that were received in 2005 offset by cash inflows from FHLB advances of $16.0 million and a reduction in deposits of $8.9 million.
As an additional source of funds, Bank of Internet USA can borrow up to 35.0% of its total assets from the FHLB. Borrowings are collateralized by the pledge of certain mortgage loans and investment securities to the FHLB. Based on the loans and securities pledged at March 31, 2006 we had total borrowing capacity of $238.4 million, of which $221.9 million was outstanding and $16.5 million was available. At March 31, 2006, we also had a $10.0 million unsecured federal funds purchase line with a major bank under
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which no borrowings were outstanding. In the past, we have used long-term borrowings to fund our loans and to minimize our interest rate risk.
We believe our liquidity sources to be stable and adequate for our anticipated needs and contingencies. However, during the last two years, interest income earned on loans and interest expense paid on deposits were influenced by the flattening of the yield curve. Recently the yield curve slope has minimally increased however, if the yield curve continues to flatten, we may have more difficulty maintaining our deposits. We believe we can adjust the interest rates we pay on our deposits to reduce deposit outflows should they occur. We can also increase our level of borrowings to address our future liquidity needs.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
At March 31, 2006 we had commitments to fund loans of $1.4 million. Time deposits due within one year of March 31, 2006 totaled $222.4 million. We believe the large percentage of time deposits that mature within one year reflects customers’ hesitancy to invest their funds long term when they expect interest rates to rise. If these maturing deposits do not remain with us, we may be required to seek other sources of funds, including other time deposits and borrowings. Depending on market conditions, we may be required to pay higher rates on deposits and borrowings than we currently pay on time deposits maturing within one year. We believe, however, based on past experience, a significant portion of our time deposits will remain with us. We believe we have the ability to attract and retain deposits by adjusting interest rates offered.
The following table presents certain of our contractual obligations as of March 31, 2006.
Long-term debt obligations (2)
Time deposits (2)
Operating lease obligations (3)
CAPITAL RESOURCES AND REQUIREMENTS
Bank of Internet USA is subject to various regulatory capital requirements set by the federal banking agencies. Failure by our bank to meet minimum capital requirements could result in certain mandatory and discretionary actions by regulators that could have a material adverse effect on our consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, our bank must meet specific capital guidelines that involve quantitative measures of our bank’s assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. Our bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation require our bank to maintain certain minimum capital amounts and ratios. The Office of Thrift Supervision requires our bank to maintain minimum ratios of tangible capital to tangible assets of 1.5%, core capital to tangible assets of 4.0% and total risk-based capital to risk-weighted assets of 8.0%. At March 31, 2006 our bank met all the capital adequacy requirements to which it was subject.
At March 31, 2006, our bank was “well capitalized” under the regulatory framework for prompt corrective action. To be “well capitalized,” our bank must maintain minimum leverage, tier 1 risk-based and total risk-based capital ratios of at least 5.0%, 6.0% and 10.0%, respectively. No conditions or events have occurred since that date that management believes would materially adversely change the bank’s capital levels. From time to time, we may need to raise additional capital to support our bank’s further growth and to maintain its “well capitalized” status.
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Bank of Internet capital amounts, ratios and requirements at March 31, 2006 were as follows:
Tier 1 leverage (core ) capital to adjusted tangible assets
Tier 1 capital (to risk weighted assets)
Total capital (to risk-weighted assets)
Tangible capital (to tangible assets)
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We measure interest rate sensitivity as the difference between amounts of interest-earning assets and interest-bearing liabilities that mature within a given period of time. The difference, or the interest rate sensitivity gap, provides an indication of the extent to which an institution’s interest rate spread will be affected by changes in interest rates. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities and negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. In a rising interest rate environment, an institution with a positive gap would be in a better position than an institution with a negative gap to invest in higher yielding assets or to have its asset yields adjusted upward, which would result in the yield on its assets to increase at a faster pace than the cost of its interest-bearing liabilities. During a period of falling interest rates, however, an institution with a positive gap would tend to have its assets mature at a faster rate than one with a negative gap, which would tend to reduce the growth in its net interest income. The following table sets forth the interest rate sensitivity of our assets and liabilities at March 31, 2006:
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Term to Repricing,
Repayment, or Maturity at March 31, 2006
Interest-earning assets:
Cash and cash equivalents
Investment securities (1)
Stock of the FHLB, at cost
Loans - net of allowance for loan loss (2)
Non-interest earning assets
Interest-bearing liabilities:
Interest-bearing deposits (3)
Other borrowed funds
Other noninterest-bearing liabilities
Total liabilities and equity
Net interest rate sensitivity gap
Cumulative gap
Net interest rate sensitivity gap - as a % of interest earning assets
Cumulative gap - as a % of cumulative
Interest earning assets
Although “gap” analysis is a useful measurement device available to management in determining the existence of interest rate exposure, its static focus as of a particular date makes it necessary to utilize other techniques in measuring exposure to changes in interest rates. For example, gap analysis is limited in its ability to predict trends in future earnings and makes no assumptions about changes in prepayment tendencies, deposit or loan maturity preferences or repricing time lags that may occur in response to a change in the interest rate environment.
We attempt to measure the effect market interest rate changes will have on the net present value of assets and liabilities, which is defined as market value of equity. We use the measurement model developed and maintained by our Bank regulators, the Office of Thrift Supervision. At December 31, 2005 (the most recent period for which data is available), we analyzed the market value of equity sensitivity to an immediate parallel and sustained shift in interest rates derived from the current treasury and LIBOR yield curves. For rising interest rate scenarios, the base market interest rate forecast was increased by 100, 200 and 300 basis points. For the falling interest rate scenarios, we used 100 and 200 basis point decreases due to limitations inherent in the current rate environment. The following table indicates the sensitivity of market value of equity to the interest rate movement described above at December 31, 2005:
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Assumed Interest Rate Change
Percentage
Change from
Base
Up 300 basis points
Up 200 basis points
Up 100 basis points
Down 100 basis points
Down 200 basis points
The board of directors of our bank establishes limits on the amount of interest rate risk we may assume, as estimated by the net present value model for each 100 basis point movement. As of December 31, 2005 and June 30, 2005, the board’s established minimum was 7.5%, meaning that the net present value after a theoretical instantaneous increase or decrease in interest rates must be greater than 7.5%. The 7.14 % in the table above for a 300 basis point upward movement of interest rate was below the board requirement at December 31, 2005. To mitigate the increased risk, an additional $2.0 million in capital was contributed by BofI Holding, Inc. (parent) to the Bank during the quarter ended March 31, 2006. The additional capital is expected to increase the March 31, 2006 net present value and maintain future compliance with the 7.5% limit.
The computation of the prospective effects of hypothetical interest rate changes is based on numerous assumptions, including relative levels of interest rates, asset prepayments, runoffs in deposits and changes in repricing levels of deposits to general market rates, and should not be relied upon as indicative of actual results. Furthermore, these computations do not take into account any actions that we may undertake in response to future changes in interest rates.
Prior to February 2005, we had not entered into any derivative financial instruments such as futures, forwards, swaps and options. On February 15, 2005, we entered into an interest rate cap, with a notional amount of $5.0 million and a term of four years expiring in March 2009, to lower the interest payments on the junior subordinated debentures should the three-month LIBOR increase above 5.25%. We designated this derivative as a non-hedging instrument and we report changes in the fair value of this instrument as charges or credits to current-period earnings.
For quantitative and qualitative disclosures regarding market risks in our portfolio, see, “Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations—Quantitative and Qualitative Disclosures About Market Risk.”
The Company’s management, with the participation of its Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures, pursuant to Exchange Act Rule 13a-15(e). Based upon that evaluation, our Chief Executive Officer along with our Chief Financial Officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission’s rules and forms.
There were no changes in the Company’s internal control over financial reporting identified in connection with the evaluation referred to above that occurred during the quarter that have materially affected, or are reasonably likely to materially affect, the registrant’s internal control over financial reporting.
The Company’s size dictates that it conducts business with a minimal number of financial and administrative employees, which inherently results in a lack of documented controls and segregation of duties within the Company. Management will continue to evaluate the employees involved and the controls procedures in place, the risks associated with such lack of segregation and whether the potential benefits of adding employees to clearly segregate duties justifies the expense associated with such added personnel. In addition, management is aware that many of the internal controls that are in place at the Company are undocumented controls. The Company is working to document these controls and take other steps required to be in compliance with Section 404 of the Sarbanes –Oxley Act of 2002 as of June 30, 2008, the Company’s deadline under current implementing rules and regulations.
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The Company believes that a control system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the control are met and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.
PART II—OTHER INFORMATION
We are not involved in any material legal proceedings. From time to time we are a party to claims or litigation that arises in the ordinary course of business, such as claims to enforce liens, claims involving the origination and servicing of loans, and other issues related to the business of the Bank. In the opinion of our management, the resolution of any such issues would not have a material adverse impact on our financial position, results of operations, or liquidity.
There were no repurchases of our common stock during the quarter ended March 31, 2006.
None.
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SIGNATURE
In accordance with the requirements of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
By:
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