SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)OF THE SECURITIES EXCHANGE ACT OF 1934
POPULAR, INC.
Popular Center Building209 Muñoz Rivera Avenue, Hato ReySan Juan, Puerto Rico 00918
Not Applicable
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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:
POPULAR, INC.INDEX
Forward-Looking Information. This Quarterly Report on Form 10-Q contains certain forward-looking statements with respect to the adequacy of the allowance for loan losses, the Corporation’s market and liquidity risks and the effect of legal proceedings on Popular, Inc.’s financial condition and results of operations, among others. These forward-looking statements involve certain risks, uncertainties, estimates and assumptions by management. Various factors could cause actual results to differ from those contemplated by such forward-looking statements.
With respect to the adequacy of the allowance for loan losses and market risk, these factors include, among others, the rate of growth in the economy, the relative strength and weakness in the consumer and commercial credit sectors and in the real estate markets, the performance of the stock and bond market and the magnitude of interest rate and foreign currency exchange rate changes. Moreover, the outcome of litigation, as discussed in “Part II, Item I. Legal Proceedings,” is inherently uncertain and depends on judicial interpretations of law and the findings of judges and juries.
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TABLE OF CONTENTS
ITEM 1. FINANCIAL STATEMENTS
POPULAR, INC.CONSOLIDATED STATEMENTS OF CONDITION(UNAUDITED)
The accompanying notes are an integral part of these unaudited consolidated financial statements.
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POPULAR, INC.CONSOLIDATED STATEMENTS OF INCOME(UNAUDITED)
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POPULAR, INC.CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY(UNAUDITED)
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POPULAR, INC.CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME(UNAUDITED)
Disclosure of accumulated other comprehensive income:
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POPULAR, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(UNAUDITED)
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Notes to Unaudited Consolidated Financial Statements(Dollars in thousands, except per share information)
Note 1 – Nature of operations and basis of presentation
Popular, Inc. (the Corporation) is a financial holding company offering a full range of financial products and services to consumer and corporate customers through its offices in Puerto Rico, the United States, the Caribbean, including the U.S. and British Virgin Islands, and Central America. The Corporation’s subsidiaries are engaged in the following businesses: commercial banking, auto loans and lease financing, mortgage and consumer lending, broker/dealer activities, retail financial services, insurance agency services and information technology, ATM and data processing services through its subsidiaries in Puerto Rico, the United States, the Caribbean and Central America. Note 14 to the unaudited consolidated financial statements presents further information about the Corporation’s business segments.
The unaudited consolidated financial statements include the accounts of Popular, Inc. and its subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation. These statements are, in the opinion of management, a fair statement of the results for the periods presented. These results are unaudited, but, in the opinion of management, include all necessary adjustments, of a normal recurring nature, for a fair statement of such results. Certain minor reclassifications have been made to the prior period consolidated financial statements to conform with the 2003 presentation.
Certain information and note disclosures normally included in the financial statements prepared in accordance with generally accepted accounting principles in the United States of America have been condensed or omitted from these statements pursuant to the rules and regulations of the Securities and Exchange Commission and, accordingly, these financial statements should be read in conjunction with the audited Consolidated Financial Statements of the Corporation for the year ended December 31, 2002, included in the Corporation’s Annual Report on Form 10-K.
Note 2 – Accounting Changes
FIN No. 45 “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”
FASB’s Interpretation No. 45 (FIN No. 45) requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The provisions for initial recognition are effective for guarantees that are issued or modified after December 31, 2002. The adoption of FIN No. 45 did not have a material impact on the Corporation’s financial position and results of operations for the quarter and six months ended June 30, 2003. Refer to Note 8 to the unaudited consolidated financial statements for further information.
FIN No. 46 “Consolidation of Variable Interest Entities”
FASB’s Interpretation No. 46 (FIN No. 46) expands upon and strengthens existing accounting guidance that addresses when a company should include in its financial statements the assets, liabilities and activities of another entity. A variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN No. 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or is entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of FIN No. 46 apply to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after June 15, 2003. As of June 30, 2003 the adoption of this Interpretation has not have an impact on the Corporation’s financial position or results of operations.
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SFAS No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”
SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 149 (1) clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative discussed in paragraph 6(b) of SFAS No. 133, (2) clarifies when a derivative contains a financing component, (3) amends the definition of an underlying to conform it to language used in FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, and (4) amends certain other existing pronouncements. Those changes will result in more consistent reporting of contracts as either derivatives or hybrid instruments. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, with certain exceptions, and for hedging relationships designated after June 30, 2003. In addition, except for certain situations, all provisions of this Statement should be applied prospectively. Also, the provisions related to forward purchases or sales of when-issued securities or other securities that do not yet exist, should be applied to both existing contracts and new contracts entered into after June 30, 2003. Management is currently evaluating the impact that SFAS No. 149 may have on the Corporation’s financial condition or results of operations.
SFAS No. 150 “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”
SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 applies specifically to a number of financial instruments that companies have historically presented within their financial statements either as equity or between the liabilities section and the equity section, rather than as liabilities. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. Management is currently evaluating the impact that SFAS No. 150 may have on the Corporation’s financial statements.
Note 3 – Investment Securities Available-For-Sale
The amortized cost, gross unrealized gains and losses, approximate market value (or fair value for certain investment securities where no market quotations are available), and contractual maturities of investment securities available-for-sale as of June 30, 2003, December 31, 2002 and June 30, 2002 were as follows:
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Securities not due on a single contractual maturity date, such as mortgage-backed securities and collateralized mortgage obligations, are classified in the period of final contractual maturity.
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The expected maturities of collateralized mortgage obligations, mortgage-backed securities and certain other securities may differ from their contractual maturities because they may be subject to prepayments or callable features.
Stock that is owned by the Corporation to comply with regulatory requirements, such as Federal Reserve Bank and Federal Home Loan Bank stock, is included as equity securities available-for-sale, at cost.
Note 4 – Investment Securities Held-to-Maturity
The amortized cost, gross unrealized gains and losses, approximate market value (or fair value for certain investment securities where no market quotations are available), and contractual maturities of investment securities held-to-maturity as of June 30, 2003, December 31, 2002 and June 30, 2002 were as follows:
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Note 5 – Pledged assets
Securities and loans were pledged to secure public and trust deposits, securities sold under agreements to repurchase, other borrowings and credit facilities available. The classification and carrying amount of the Corporation’s pledged assets, which the secured parties are not permitted to sell or repledge the collateral, were as follows:
Pledged securities and loans that the creditor has the right by custom or contract to repledge are presented separately in the consolidated statements of condition.
Note 6 – Derivative Instruments and Hedging Activities
In managing its market risk the Corporation enters, to a limited extent, into certain derivatives primarily interest rate swaps, interest rate forwards and future contracts, interest rate caps, swaptions, foreign exchange contracts and interest-rate caps, floors and options embedded in financial contracts. During the quarter ended June 30, 2003, there were no significant changes in derivative instruments and hedging activities since December 31, 2002, except for the cancellation of certain interest rate contracts as described below.
The Corporation uses interest rate swaps to convert floating rate debt to fixed rate debt in order to fix the future cost of the portfolio of short-term borrowings. The specific terms and notional amounts of the swaps are determined based on management’s assessment of future interest rates, as well as other factors. During this quarter, the Corporation terminated the interest rate contracts outstanding with a notional amount of $500,000 and recognized a gain of $1,565. These swaps did not qualify as hedges in accordance with SFAS No. 133, as amended.
For the quarters ended June 30, 2003 and June 30, 2002, the Corporation recognized a gain of $2,548 and a loss of $855, respectively, as a result of the changes in fair value of the non-hedging derivatives.
Note 7 – Goodwill and Other Intangible Assets
SFAS No. 142 requires that goodwill and other indefinite-life intangible assets be tested for impairment at least annually using a two-step process at each reporting unit level. The Corporation’s management has defined the reporting units based on legal entity, which is the way that operating decisions are made and performance is measured. For presentation purposes, these reporting units have been aggregated by reportable segments based on the provisions of SFAS No. 131 “Segment Reporting.” These segments have been defined as follows: Commercial Banking, Mortgage and Consumer Lending, Auto and Lease Financing and Other. All the operating segments and components that constitute reporting units were determined evaluating the nature of the products and services offered, types of customers, methods used to distribute their products and provide their services, and the nature of their regulatory environment, as well as other similar economic characteristics. Goodwill is assigned to each reporting unit at the time of acquisition.
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The changes in the carrying amount of goodwill for the six months ended June 30, 2003, are as follows:
As of June 30, 2003, December 31, 2002 and June 30, 2002, goodwill totaled $188,310, $182,965 and $178,739, respectively. The Corporation has no other intangible assets not subject to amortization.
The following table reflects the components of other intangible assets subject to amortization as of June 30, 2003, December 31, 2002 and June 30, 2002:
During the quarter ended June 30, 2003, the Corporation recognized $2,028 in amortization expense related to other intangible assets with definite lives (June 30, 2002 – $2,556). For the six months ended June 30, 2003, the amortization expense totaled $4,055 (June 30, 2002 – $5,099).
Certain core deposits were fully amortized as of June 30, 2003, and as such, their gross amount and accumulated amortization were excluded from the accounting records and the tabular disclosure presented above for June 30, 2003.
The following table presents the estimated aggregate amortization expense of the intangible assets with definite lives that the Corporation has as of June 30, 2003, for each of the following fiscal years:
No significant events or circumstances have occurred that would reduce the fair value of any reporting unit below its carrying amount.
Note 8 – Commitments and Contingencies
In the normal course of business there are commercial letters of credit and stand-by letters of credit outstanding, which contract amounts at June 30, 2003 were $22,832 and $138,821, respectively (June 30, 2002 – $11,972 and $87,356; December 31, 2002 – $19,564 and $126,383). There are also other commitments outstanding and contingent liabilities, such as commitments to extend credit, which are not reflected in the accompanying financial statements.
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In accordance with the recognition provisions of FIN No. 45, during the six months ended June 30, 2003, the Corporation recorded a liability of $267, which represents the fair value of the obligations undertaken in issuing the guarantees under the stand-by letters of credit issued or modified after December 31, 2002. This liability was included as part of “other liabilities” in the Statement of Condition. The stand-by letters of credit were issued to guarantee the performance of various customers to third parties. The contract amounts in stand-by letters of credit outstanding as of June 30, 2003 and 2002, and December 31, 2002 represent the maximum potential amount of future payments the Corporation could be required to make under the guarantees in the event of nonperformance by the customers. These stand-by letters of credit are used by the customer as a credit enhancement and typically expire without being drawn upon, normally within a year. The Corporation’s stand-by letters of credit are generally secured and in the event of nonperformance by the customers, the Corporation has rights to the underlying collateral provided, which normally includes cash and marketable securities, real estate, receivables and others.
As of June 30, 2003, the Corporation has two outstanding commitments to purchase mortgage loans from other institutions at market. In 2002, the Corporation entered into a commitment to purchase $100,000 of mortgage loans with the option of purchasing $75,000 in additional loans. The commitment expires on June 30, 2004. As of June 30, 2003, $50,000 in loans had been purchased under this agreement. The other commitment, entered into by the Corporation during the first quarter of 2003, provides for the purchase of $150,000 of mortgage loans with the option of purchasing $50,000 in additional loans. This commitment expires on September 30, 2004. As of June 30, 2003, $50,000 in loans had been purchased under this agreement.
The Corporation fully and unconditionally guarantees certain borrowing obligations issued by certain of the Corporation’s wholly-owned subsidiaries approximating $3,587,000 at June 30, 2003 (December 31, 2002 – $3,382,800).
The Corporation is a defendant in a number of legal proceedings arising in the normal course of business. Based on the opinion of legal counsel, management believes that the final disposition of these matters will not have a material adverse effect on the Corporation’s financial position or results of operations. Refer to Item 1 – Legal Proceedings in Part II – Other Information in this Form 10-Q for further information.
Note 9 – Stock Option Plan
In September 2002, the Corporation opted to use the fair value method for recording stock options as described in SFAS No. 123 “Accounting for Stock-Based Compensation.” During the quarter and six months ended June 30, 2003, the Corporation recognized $339 and $1,066, respectively, in stock option expense.
The following table summarizes information about stock options outstanding at June 30, 2003:
The following table summarizes the stock option activity and related information:
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The fair value of these options was estimated on the date of the grants using the Black-Scholes Option Pricing Model. The weighted average assumptions used for the grants issued during 2003 were the following: an expected dividend yield of 2.42% (2002 – 2.16%), an average expected life of options of 10 years (2002 – 10 years), an expected volatility of 24.02% (2002 – 26.48%) and a risk-free interest rate of 3.75% (2002 – 4.91%). The weighted average fair value of options granted during 2003 was $9.04 per option (2002 – $9.80).
Subordinated notes of $125,000 consist of notes issued by the Corporation on December 12, 1995, maturing on December 15, 2005, with interest payable semi-annually at 6.75%.
On February 5, 1997, BanPonce Trust I, a statutory business trust created under the laws of the State of Delaware that is wholly-owned by Popular North America, Inc. (PNA) and indirectly wholly-owned by the Corporation, sold to institutional investors $150,000 of BanPonce Trust I’s 8.327% Capital Securities Series A (liquidation amount one thousand dollars per Capital Security) through certain underwriters. The proceeds of the issuance, together with the proceeds of the purchase by PNA of $4,640 of BanPonce Trust I’s 8.327% common securities (liquidation amount one thousand dollars per common security) were used to purchase $154,640 aggregate principal amount of PNA 8.327% Junior Subordinated Deferrable Interest Debentures, Series A (the “Junior Subordinated Debentures”). As of June 30, 2003, the Corporation had reacquired $6,000 of the capital securities. BanPonce Trust I is a 100% owned finance subsidiary of the Corporation. The capital securities qualify as Tier 1 capital, are fully and unconditionally guaranteed by the Corporation, and are presented in the Consolidated Statements of Condition as “Preferred Beneficial Interests in Popular North America’s Junior Subordinated Deferrable Interest Debentures Guaranteed by the Corporation.” The obligations of PNA under the Junior Subordinated Debentures and its guarantees of the obligations of BanPonce Trust I are fully and unconditionally guaranteed by the Corporation. The assets of BanPonce Trust I consisted of $148,640 of Junior Subordinated Debentures at June 30, 2003 (June 30, 2002 – $148,640; December 31, 2002 – $148,640) and a related accrued interest receivable of $4,126 (June 30, 2002 – $4,177; December 31, 2002 - $4,126). The Junior Subordinated Debentures mature on February 1, 2027; however, under certain circumstances, the maturity of the Junior Subordinated Debentures may be shortened (which shortening would result in a mandatory redemption of the Capital Securities).
Note 11- Stockholders’ Equity
The Corporation declared cash dividends on common stock amounting to $62,338 for the six-month period ended June 30, 2003 (June 30, 2002 – $53,749).
During the first quarter of 2003, the Corporation issued 7,475,000 shares of its 6.375% noncumulative monthly income preferred stock, Series A, at a price of $25 per share. The net proceeds to the Corporation, after the underwriting discounts and expenses, amounted to $182,140. Dividends declared on the preferred stock during the six months ended June 30, 2003 amounted to $3,962.
These shares of preferred stock are nonconvertible and are redeemable at the option of the Corporation. The redemption price per share is $25.50 from March 31, 2008 through March 30, 2009, $25.25 from March 31, 2009 through March 30, 2010 and $25.00 from March 31, 2010 and thereafter. Dividends on the Series A preferred stock are noncumulative and are payable monthly at an annual rate of 6.375% of the liquidation preference value of $25.00 per share.
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Note 12 – Earnings per Common Share
A computation of earnings per common share follows:
Potential common shares consist of common stock issuable under the assumed exercise of stock options granted under the Corporation’s stock option plan, using the treasury stock method. This method assumes that the potential common shares are issued and the proceeds from exercise in addition to the amount of compensation cost attributed to future services are used to purchase common stock at the exercise date. The difference between the number of potential shares issued and the shares purchased will be added as incremental shares to the actual number of shares outstanding to compute diluted earnings per share. Stock options that result in lower potential shares issued than shares purchased under the treasury stock method are not included in the computation of dilutive earnings per share since their inclusion would have an antidilutive effect in earnings per share.
During the second quarter of 2003 there were 470,985 weighted average antidilutive stock options outstanding (2002 – 422,243) and for the six months ended on June 30, 2003 there were 444,969 weighted average antidilutive stock options outstanding (2002 – 325,527).
Note 13 – Supplemental Disclosure on the Consolidated Statements of Cash Flows
During the six-month period ended June 30, 2003, the Corporation paid interest and income taxes amounting to $387,904 and $84,803, respectively (2002 – $423,980 and $72,245). In addition, loans receivable transferred to other real estate and other property for the six months ended June 30, 2003 amounted to $38,046 and $13,555, respectively (2002 – $20,192 and $16,184).
During the first quarter of 2003, the Corporation transferred $637,925 of loans held-for-sale to the loan portfolio (held-for-investment) based on management intent and ability.
Note 14 – Segment Reporting
Popular, Inc. operates three major reportable segments: commercial banking, mortgage and consumer lending, and auto and lease financing. Management has determined its reporting units based on legal entity, which is the way that operating decisions are made and performance is measured. These reporting units have then been aggregated into segments by products, services and markets with similar characteristics.
The Corporation’s commercial banking segment includes all banking subsidiaries, which provide individuals, corporations and institutions with commercial and retail banking services, including loans and deposits, trust, mortgage banking and servicing, asset management, credit cards and other financial services. These services are offered through a delivery system of branches throughout Puerto Rico, the U.S. and British Virgin Islands and the United States.
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The Corporation’s mortgage and consumer lending segment includes those non-banking subsidiaries whose principal activity is originating mortgage and consumer loans such as Popular Mortgage, Popular Finance, Equity One and Levitt Mortgage.
The Corporation’s auto and lease financing segment provides financing for vehicles and equipment through Popular Auto in Puerto Rico and Popular Leasing, USA in the U.S. mainland. The “Other” category includes all holding companies and non-banking subsidiaries which provide insurance agency services, retail financial services, broker/dealer activities, as well as those providing ATM processing services, electronic data processing and consulting services, sale and rental of electronic data processing equipment and selling and maintenance of computer software.
The accounting policies of the segments are the same as those followed by the Corporation in the ordinary course of business and conform with generally accepted accounting principles and with general practices within the financial industry. Following are the results of operations and selected financial information by operating segment for the quarters and six-month periods ended June 30, 2003 and 2002.
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During the quarter ended June 30, 2003, the Corporation’s parent holding company realized gains on the sale of marketable securities approximating $29,300 ($25,700 after-tax). These gains are included in “other income” within the “other” reportable segment category.
Intersegment Revenues*
Geographic Information
The following condensed consolidating financial information presents the financial position of Popular, Inc. Holding Company (PIHC) (parent only), Popular International Bank, Inc. (PIBI), Popular North America, Inc. (PNA) and all other subsidiaries of the Corporation as of June 30, 2003, December 31, 2002 and June 30, 2002, and the results of their operations and cash flows for the periods ended June 30, 2003 and 2002. PIBI, PNA, and their wholly-owned subsidiaries, except Banco Popular North America (BPNA) and Banco Popular, National Association (BP, N.A.), have a fiscal year that ends on November 30. Accordingly, the consolidated financial information of PIBI and PNA as of May 31, 2003, November 30, 2002 and May 31, 2002, corresponds to their financial information included in the consolidated financial statements of Popular, Inc. as of June 30, 2003, December 31, 2002 and June 30, 2002, respectively.
PIHC, PIBI and PNA are authorized issuers of debt securities and preferred stock under various shelf registrations filed with the SEC.
PIBI is an operating subsidiary of PIHC and is the holding company of its wholly-owned subsidiaries, ATH Costa Rica, CreST, S.A., Popular Insurance, V.I., Inc. and PNA.
PNA is an operating subsidiary of PIBI and is the holding company of its wholly-owned subsidiaries, Popular Cash Express, Inc., Equity One, Inc., BPNA, including its wholly-owned subsidiaries Popular Leasing, U.S.A. and Popular Insurance, U.S.A.; and BP, N.A., including its wholly-owned subsidiary Popular Insurance, Inc.
PIHC fully and unconditionally guarantees all registered debt securities and preferred stock issued by PIBI and PNA. The principal source of cash flows for PIHC consists of dividends from Banco Popular de Puerto Rico.
As a member subject to the regulations of the Federal Reserve Board, BPPR must obtain the approval of the Federal Reserve Board for any dividend if the total of all dividends declared in any calendar year would exceed the total of net profits for that year, as defined by the Federal Reserve Board, combined with its retained net profits for the preceding two years. The payment of dividends may also be affected by other regulatory requirements and policies, such as the maintenance of certain minimum capital levels. At June 30, 2003, BPPR could have declared a dividend of approximately $105,306 without the approval of the Federal Reserve Board.
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF CONDITIONJUNE 30, 2003(UNAUDITED)
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF CONDITIONDECEMBER 31, 2002(UNAUDITED)
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF CONDITIONAS OF JUNE 30, 2002(UNAUDITED)
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF INCOMEFOR THE QUARTER ENDED JUNE 30, 2003(UNAUDITED)
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF INCOMEFOR THE QUARTER ENDED JUNE 30, 2002(UNAUDITED)
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF INCOMEFOR THE SIX MONTHS ENDED JUNE 30, 2003(UNAUDITED)
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF INCOMEFOR THE SIX MONTHS ENDED JUNE 30, 2002(UNAUDITED)
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWSFOR THE PERIOD ENDED JUNE 30, 2003(UNAUDITED)
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWSFOR THE PERIOD ENDED JUNE 30, 2002(UNAUDITED)
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
TABLE AFinancial Highlights
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This financial review contains an analysis of the consolidated financial position and financial performance of Popular, Inc. and its subsidiaries (the Corporation). All accompanying tables, financial statements and notes included elsewhere in this report should be considered an integral part of this analysis. The Corporation is a financial holding company, which offers a wide range of products and services to consumer and corporate customers in Puerto Rico, the United States, the Caribbean and Central America. The Corporation’s subsidiaries are engaged in the following businesses:
Commercial Banking – Banco Popular de Puerto Rico (BPPR), Banco Popular North America (BPNA) and Banco Popular, National Association (BP, N.A.).
Auto Loans and Lease Financing – Popular Auto, Inc. and Popular Leasing, U.S.A.
Mortgage and Consumer Lending – Popular Mortgage, Inc., Equity One, Inc., Popular Finance, Inc. and Levitt Mortgage Corporation.
Broker / Dealer – Popular Securities, Inc.
Processing and Information Technology Services and Products – GM Group, ATH Costa Rica and CreST, S.A.
Retail Financial Services – Popular Cash Express, Inc.
Insurance Agency- Popular Insurance, Inc., Popular Insurance Agency U.S.A., Inc. and Popular Insurance V.I., Inc.
CRITICAL ACCOUNTING POLICIES
The Corporation’s accounting policies are essential to the understanding of its financial statements. The Corporation has identified as critical accounting policies those related to the allowance for loan losses, investment securities, the assessment of fair market value, goodwill and other intangible assets, and pension and post retirement benefit obligations. These accounting policies involve significant management judgment associated with estimates about the effect of matters that are inherently uncertain and that involve a high degree of subjectivity. For a summary of the corporation’s critical accounting policies, refer to that particular section in the Management’s Discussion and Analysis included in Popular, Inc.’s 2002 Financial Review and Supplementary Information to Stockholders, incorporated by reference in Popular, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2002. Also, refer to Note 1 to the consolidated financial statements included in said report for a summary of the Corporation’s significant accounting policies, as well as to the accompanying notes to the unaudited consolidated financial statements included in this Form 10-Q. No significant changes in critical accounting policies have occurred since year-end 2002.
NET INCOME
The Corporation’s net income reached $134.6 million for the second quarter of 2003, a 40% increase compared with $96.3 million for the same quarter of 2002. Earnings per common share (EPS), basic and diluted, for the quarter ended June 30, 2003, were $0.99, compared with $0.72 in the same period of 2002. Refer to Note 12 to the unaudited consolidated financial statements for a detail of the average shares used in the computation of basic and diluted EPS. Return on assets (ROA) and return on common equity (ROE) for the second quarter of 2003 were 1.58% and 22.63%, respectively, compared with 1.23% and 18.14%, respectively, for the same period in 2002.
The Corporation’s net income for the second quarter of 2003, when compared with the same period in the previous year, reflected higher net interest income by $32.5 million and non-interest income by $37.2 million. The provision for loan losses decreased by $0.8 million. These items were partially offset by increases in operating expenses of $28.6 million and in income taxes of $3.4 million.
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For the first six months of 2003 the Corporation’s net income rose to $233.7 million, compared with $185.3 million for the same period in 2002. EPS for the first six months of 2003 and 2002 were $1.73 and $1.35, respectively. ROA and ROE for the six-month period ended June 30, 2003 were 1.40% and 20.09%, respectively. For the same six-month period in 2002, these ratios were 1.21% and 17.43%.
NET INTEREST INCOME
Net interest income for the quarter ended June 30, 2003 reached $327.2 million, an increase of $32.5 million, or 11%, over the same quarter of 2002. On a taxable equivalent basis, net interest income increased to $358.1 million from $319.2 million in the same quarter of 2002.
The improvement for the second quarter of 2003 of $38.9 million in net interest income, on a taxable equivalent basis, compared with the second quarter of 2002 resulted from a $26.8 million increase due to a higher volume of average earning assets and a $12.1 million increase due to a higher net interest margin.
Tables B and C present the different components of the Corporation’s net interest income for the quarter and six-months ended June 30, 2003, respectively, as compared with the same periods in 2002, segregated by major categories of earning assets and interest bearing liabilities. Some of the assets, mostly investments in obligations of the U.S. Government and the Puerto Rico Commonwealth and its agencies, generate interest, which is exempt for income tax purposes, principally in Puerto Rico. Therefore, to facilitate the comparison of all interest data related to these assets, the interest income has been converted to a taxable equivalent basis, using the applicable statutory income tax rates (In Puerto Rico the statutory tax rate is 39%).
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TABLE BANALYSIS OF LEVELS & YIELDS ON A TAXABLE EQUIVALENT BASISQuarter ended June 30, 2003
Note: The changes that are not due solely to volume or rate are allocated to volume and rate based on the proportion of the change in each category.
The increase in average earning assets for the quarter ended June 30, 2003 of $2.6 billion, compared with the second quarter of 2002, was driven principally by a $1.7 billion increase in the average loan portfolio and a $0.9 billion increase in money market, trading and investment securities. The rise in the average loan portfolio was primarily in mortgage and commercial loans, which rose $1.1 billion and $436 million, respectively. The interest rate environment has stimulated mortgage loan originations and the refinancing through mortgage loans. Investment securities rose in average by $562 million, or 5%, mostly in U.S. Agency securities, while the trading portfolio increased in average by $337 million, mainly in mortgage-backed securities.
The average yield on earning assets, on a taxable equivalent basis, declined 42 basis points from 7.13% in the second quarter of 2002 to 6.71% for the same period in 2003. The average yield on the investment portfolio decreased by 24 basis points, due to the growth of the portfolio, and to the maturities of securities with higher yields that were replaced, during a lower interest rate scenario. On the other hand, the yield in the trading portfolio increased by 166 basis points, mainly due to a higher proportion of mortgage-backed securities in the portfolio. The
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average yield on the loan portfolio decreased by 59 basis points. The commercial loans yield, including construction, fell by 55 basis points due to its repricing characteristics and to the origination of new loans in a lower rate environment. As of June 30, 2003, approximately 56% of the commercial and construction loan portfolios had floating or adjustable rates, compared with approximately 50% a year ago. The average yield on mortgage loans also declined 34 basis points, mainly due to the current interest rate scenario and higher loan prepayments/refinancings, while the consumer loans yield declined 91 basis points, due in part to the interest rate scenario, coupled with promotional campaigns with lower rates.
Interest-bearing liabilities for the second quarter of 2003, increased in average by $2.1 billion, or 8%, compared with the same quarter in 2002. Average interest-bearing deposits, mainly savings deposits, increased by $452 million, or 3%, while average borrowings rose by $1.7 billion, or 14%. Also, non-interest bearing sources of funds, including demand deposits and other funds, such as capital raised through the recent preferred stock issuance, rose $274 million and $180 million, respectively.
Average short-term borrowings, comprised mostly of repurchase agreements and federal funds, increased by $817 million, or 11%, in the second quarter of 2003, compared with the same quarter in the previous year, while longer-term borrowings increased by $869 million, or 20%. The latter includes the issuance during the second quarter of 2003 of $500 million in five-year, fixed-rate medium-term notes, and the issuance of secured borrowings arising in securitization transactions.
The average cost of interest-bearing liabilities for the quarter ended June 30, 2003 declined by 65 basis points, compared with the same quarter of 2002. The principal factors to the decrease were revisions made to interest rates on interest-bearing deposits since the last quarter of 2002, and the impact of the current low interest rate environment.
The Corporation’s net interest margin, on a taxable equivalent basis, for the second quarter of 2003 increased by 14 basis points, reaching 4.42%, while the net interest spread, which is the difference between the yield on earning assets and the cost of interest-bearing liabilities, increased by 23 basis points, rising to 4.04%. In addition to the factors described above, the issuance of the preferred stock in 2003 and the increase in the average volume of demand deposits also had an impact on the net interest margin, since these funds do not carry an interest cost. The increase in net interest spread resulted from a decrease in the cost of interest-bearing liabilities, partially offset by a reduction in the yield of earning assets mainly related to the investment portfolio run-off in a declining interest rate environment.
As shown in Table C, for the six-month period ended June 30, 2003, net interest income, on a taxable equivalent basis, rose $66.1 million, or 10%, compared with the same period of 2002. The improvement resulted from a $47.7 million increase due to a higher average volume of earning assets and a $18.4 million increase due to a higher net interest yield.
Average earning assets for the six-month period ended June 30, 2003 increased by $2.6 billion, or 9%, compared with the same period of 2002. Average interest-bearing liabilities increased by $2.3 billion, or 9%, compared with the six-month period ended June 30, 2002. Also, non-interest bearing sources of funds, including demand deposits and other funds, rose $178 million and $114 million, respectively.
The net interest margin, on a taxable equivalent basis, for the six-month period ended June 30, 2003 improved by 7 basis points, compared with the same period in 2002, reaching 4.36%, while the net interest spread increased by 17 basis points, rising to 3.97%. The improvement in margin and spread was mostly associated with similar factors that impacted the outcome of the quarterly results.
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TABLE CANALYSIS OF LEVELS & YIELDS ON A TAXABLE EQUIVALENT BASISSix-month period ended June 30, 2003
PROVISION AND ALLOWANCE FOR LOAN LOSSES
The provision for loan losses reflects management’s assessment of the adequacy of the allowance for loan losses to cover probable losses inherent in the loan portfolio after taking into account loan impairment and net charge-offs for the current period. The provision for loan losses amounted to $49.3 million for the second quarter of 2003, a decrease of $0.8 million, compared with $50.1 million in the second quarter of 2002. The decrease in the provision is due in part to lower net charge-offs and to the fact that most of the growth in the loan portfolio was in mortgage loans, which represents a lower-risk portfolio. Net charge-offs for the quarter ended June 30, 2003, were $38.1 million, or 0.76% of average loans, compared with $45.8 million, or 0.99% of average loans for the second quarter of 2002. The provision for loan losses represented 130% of net charge-offs for the quarter ended June 30, 2003, compared with 109% for the same quarter in the previous year. For the six-month period ended June 30, 2003, the provision for loan losses totaled $97.5 million, a decrease of $7.0 million, or 7%, compared with $104.5 million for the same period in 2002.
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The allowance for loan losses totaled $398 million at June 30, 2003, or 1.90% of loans, compared with $347 million, or 1.84% of loans, at the same date in 2002. At December 31, 2002, the allowance for loan losses totaled $373 million or 1.90% of loans. The Corporation’s management considers the allowance for loan losses to be at a level sufficient to provide for inherent losses based on current economic conditions, the expected level of net loan losses and the methodology established to evaluate the adequacy of the allowance for loan losses. For more information regarding the allowance for loan losses and asset quality information for the period ended June 30, 2003 refer to the Credit Quality section of this report. Also, for information on the Corporation’s allowance for loan losses methodology refer to the Credit Risk and Loan Quality section in the Management’s Discussion and Analysis included in Popular, Inc.’s 2002 Financial Review and Supplementary Information to Stockholders, incorporated by reference in Popular, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2002.
The Corporation has defined impaired loans as loans with interest and/or principal past due 90 days or more and other specific loans for which, based on current information and events, it is probable that the debtor will be unable to pay all amounts due according to the contractual terms of the loan agreement. Loan impairment is measured based on the present value of the expected future cash flows discounted at the loan’s effective rate, on the observable market price of the loan, or on the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment based on past experience adjusted for current conditions. Larger balance commercial loans are evaluated on a loan-by-loan basis. Once a specific measurement methodology is chosen, it is consistently applied unless there is a significant change in the financial position of the borrower. An impaired loan for which the discounted cash flows, collateral value or market price is less than its carrying value requires an allowance. The allowance for impaired loans is part of the Corporation’s overall allowance for loan losses.
The following table shows the Corporation’s recorded investment in impaired loans and the related valuation allowance calculated under SFAS No. 114 (as amended by SFAS No. 118) at June 30, 2003, December 31, 2002 and June 30, 2002.
Average impaired loans during the second quarter of 2003 and 2002 were $165 million and $144 million, respectively. The Corporation recognized interest income on impaired loans of $1.1 million and $0.7 million for the quarters ended June 30, 2003 and 2002, respectively.
Table D summarizes the movement in the allowance for loan losses and presents several loan loss statistics for the quarters and six months ended June 30, 2003 and 2002.
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TABLE DAllowance for Loan Losses and Selected Loan Losses Statistics
Also, Table E presents annualized net charge-offs to average loans by loan category for the quarters and six months ended June 30, 2003 and 2002.
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TABLE EAnnualized Net Charge-offs to Average Loans
The decrease in commercial and construction loans net charge-offs for the quarter ended June 30, 2003, compared with the same period of 2002, was partly attributed to a $7 million charge-off of a commercial loan pertaining to a client who filed for bankruptcy in the second quarter of 2002. Also, the results for the six-month period ended June 30, 2002 were impacted by a $3.7 million charge-off of a participation loan pertaining to a large commercial relationship. Excluding these items, and notwithstanding the economic conditions that have prevailed in the U.S. and Puerto Rico, the decrease in the net charge-offs to average loan ratio was also influenced by the continuing identification and monitoring of potential problem loans.
The decline in consumer loans net charge-offs is partly due to the Corporation’s tightening of its credit criteria for consumer borrowings prompted by the current economic environment, coupled with improved collection and recovery initiatives. Also, it is partly due to the fact that most of the Corporation’s growth in the consumer portfolio has been in auto loans, a secured portfolio.
Lease financing net charge-offs declined partly as a result of better portfolio credit quality, coupled with collection efforts.
The increase in mortgage loans net charge-offs for the quarter and six-month period ended June 30, 2003, compared with the same periods in the previous year was mostly the result of portfolio growth coupled with increased delinquency due to current economic conditions. Equity One, the Corporation’s mortgage and consumer lending subsidiary in the United States, which caters to non-prime mortgage borrowers, experienced an increase of $5.0 million in mortgage net charge-offs for the six-months ended June 30, 2003, as compared with the same period in 2002. The mortgage loans net charge-offs to average loans ratio at this subsidiary was 0.41% for the first six months of 2003, compared with 0.26% for the same period in the previous year. This increase is associated with a general economic slowdown, which has resulted in a stateside recession that has lasted longer than expected. As a result of this, the job market has continued deteriorating, and bankruptcy levels have increased, thus adversely affecting the market segment that this subsidiary caters to.
CREDIT QUALITY
The Corporation places commercial loans and commercial leases on non-accrual status if payments of principal or interest are delinquent 60 days rather than the standard industry practice of 90 days. Consumer financing leases, conventional mortgages and closed-end consumer loans are placed on non-accrual status if payments are delinquent 90 days or four scheduled payments in arrears. Closed-end consumer loans are charged-off when payments are delinquent 120 days, while open-end (revolving credit) consumer loans are charged-off when payments are delinquent 180 days. Certain loans, which would be treated as non-accrual loans pursuant to the foregoing policy, are treated as accruing loans if they are considered well-secured and in the process of collection. Unsecured retail loans to borrowers who declare bankruptcy are charged-off within 60 days of receipt of notification of filing from the bankruptcy court. Under the standard industry practice, closed-end consumer loans are charged-off when delinquent 120 days, but are not customarily placed on non-accrual status prior to being charged-off.
Non-performing assets consist of past-due loans that are no longer accruing interest, renegotiated loans and real estate property acquired through foreclosure. A summary of non-performing assets by loan categories and related ratios is presented in Table F.
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TABLE FNon-Performing Assets
The increase in non-performing assets since June 30, 2002 was primarily associated with mortgage loans, which rose by $102 million, or 46%. Non-performing mortgage loans represented 52% of total non-performing assets and 3.87% of total mortgage loans as of June 30, 2003, compared with 44% of total non-performing assets and 3.10% of total mortgage loans as of June 30, 2002. At December 31, 2002, non-performing mortgage loans were $279 million or 52% of total non-performing assets and 3.74% of total mortgage loans. The increase in non-performing mortgage loans was primarily driven by portfolio growth, coupled with increased delinquency due to current economic conditions. This growth in mortgage non-performing loans was mostly reflected in the Corporation’s consumer and mortgage-banking subsidiary in the United States, Equity One. Of the total mortgage non-performing loans at June 30, 2003, 69% or $223 million pertained to Equity One, compared with 61% or $135 million at June 30, 2002, and 66% or $186 million at December 31, 2002.
Non-performing commercial and construction loans represented 2.42% of that loan portfolio as of June 30, 2003, compared with 2.58% at June 30, 2002 and 2.09% at December 31, 2002. The increase in non-performing commercial and construction loans since the end of 2002 reflects the impact of the current economic conditions. The Corporation continues identifying and monitoring potential problem loans to reduce eventual charge-offs.
Non-performing consumer loans were 1.13% of consumer loans at June 30, 2003, compared with 1.16% at June 30, 2002 and 1.29% at December 31, 2002. The decline was principally the result of a better credit quality mix, coupled with collection initiatives and strategies. Also, there has been a partial shift in loan originations from personal loans to mortgage loans.
Non-performing financing leases represented 0.91% of the lease financing portfolio at June 30, 2003, compared with 1.11% at June 30, 2002, and 1.20% at December 31, 2002. The decline in non-performing leases was the result of lower delinquency levels, better portfolio credit quality and collection strategies.
Other real estate assets, which are recorded at fair value less estimated costs to sell, reached $48 million at June 30, 2003, or 8% of non-performing assets, compared with $35 million, or 7%, respectively, at June 30, 2002, and $39 million, or 7%, respectively, at December 31, 2002. The increase in other real estate assets was associated with the growth in the non-performing mortgage loan portfolio due mostly to higher delinquencies in the housing sector prompted by the economic slowdown.
The allowance for loan losses as a percentage of non-performing loans was 69.83% at June 30, 2003, compared with 74.31% at June 30, 2002 and 74.58% at December 31, 2002. The lower allowance to non-performing loans ratio reflects the changing composition of the loan portfolio and the non-performing loans, as most of the growth was realized in mortgage loans, which represents a lower-risk portfolio.
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Assuming the standard industry practice of placing commercial loans on non-accrual status when payments of principal and interest are past due 90 days or more and excluding the closed-end consumer loans from non-accruing, the Corporation’s non-performing assets as of June 30, 2003 would have been $542 million or 2.60% of loans, and the allowance for loan losses would have been 80.44% of non-performing loans. At June 30, 2002 and December 31, 2002, adjusted non-performing assets would have been $434 million or 2.30% of loans and $478 million or 2.44% of loans, respectively. The allowance to non-performing loans would have been 86.99% and 85.01% at June 30, 2002 and December 31, 2002, respectively.
In addition to the non-performing loans discussed earlier, there was $55 million of loans at June 30, 2003, which in management’s opinion are currently subject to potential future classification as non-performing, and therefore are considered impaired under SFAS No. 114. At December 31, 2002 and June 30, 2002, these potential problem loans approximated $36 million and $29 million, respectively.
NON-INTEREST INCOME
Non-interest income reached $172.2 million for the quarter ended June 30, 2003, compared with $135.0 million in the same period of 2002, an increase of $37.2 million, or 28%.
For the quarter ended June 30, 2002, service charges on deposit accounts totaled $39.7 million, a slight increase of $0.2 million, compared with the same quarter of 2002. This non-interest income category has benefited from higher commercial account analysis fees, compensated by lower charges derived from consumer accounts, including account charges, ATM service fees and returned checks, due in part to higher deposit balances and campaigns to attract depositors.
Other service fees for the quarter ended June 30, 2003 rose $3.0 million, or 5%, compared with the quarter ended June 30, 2002. Table G provides a breakdown of other service fees by major categories. Commissions derived from the insurance agency business, rose 28% compared with the same quarter in 2002, mostly associated with business expansion and by capitalizing on the Corporation’s broad delivery channels and client base. Another driver for the growth in other service fees was higher debit card fees that resulted mostly from higher transactional volume. The rise in check cashing fees is mostly related to the Corporation’s retail financial services subsidiary in the United States, Popular Cash Express (PCE). These favorable variances were partially offset by lower trust fees, mostly due to the sale of the Corporation’s U.S. trust operations during the second quarter of 2002. These operations contributed approximately $0.5 million in trust fees for the quarter ended June 30, 2002. Also, mortgage servicing fees declined due in part to the recording of $0.3 million in write-downs in the value of mortgage servicing rights.
TABLE GOther Service Fees
Gain on sale of securities for the quarter ended June 30, 2003 amounted to $29.9 million, an increase of $29.8 million over the $85 thousand reported for the same period in 2002. These gains arose mainly from the sale of marketable equity securities held by the Corporation. Derivative gains for the second quarter of 2003 totaled $2.5 million, compared with losses of $0.9 million for the same period in 2002. The derivative gains were principally attributed to changes in the fair value of the Corporation’s interest rate swaps. These contracts with notional amounts totaling $500 million were cancelled during the second quarter of 2003 as part of the Corporation’s risk management strategies. The aforementioned gains were partially offset by trading losses of $4.2 million in the second quarter of 2003, compared with losses of $0.4 million in the same period of the previous year.
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Gain on sales of loans, including loans held-for-sale, totaled $15.4 million for the quarter ended June 30, 2003, compared with $11.6 million for the same period in 2002, an increase of $3.8 million, or 32%.
Other operating income amounted to $19.9 million for the quarter ended June 30, 2003, an increase of $1.0 million, or 5%, compared with the amounts reported in the same period of the previous year. The rise in other operating income was due in part to higher dividend income derived from the Corporation’s ownership participation in Telecomunicaciones de Puerto Rico, Inc., which amounted to $6.5 million for the second quarter of 2003, compared with $1.5 million in the second quarter of 2002. In the second quarter of 2002, the Corporation had gains of approximately $3.7 million on the sale of Banco Popular North America’s trust operations and the sale of 15 branches of Popular Finance.
For the six-month period ended June 30, 2003, non-interest income amounted to $304.3 million, compared with $265.4 million, an increase of $38.9 million, or 15%. Service charges on deposit accounts contributed with $1.0 million of this increase, mainly due to higher commercial account analysis fees, while other services fees rose by $7.7 million, or 6%, driven by higher insurance agency fees, debit card fees, check cashing fees and credit card fees and discounts. These increases were partially offset by lower trust fees, mostly due to the sale of the Corporation’s trust operations in the United States during 2002.
Gain on sale of securities amounted to $31.3 million for the first six months of 2003, compared with losses of $3.9 million, for the same period in 2002. As explained before, these gains resulted mostly from the sale of marketable equity securities. These gains were partially offset by increases in trading and derivatives losses of $3.8 million and $7.8 million, respectively, the latter mainly arising from adjustments to the market value of the interest rate swaps.
Gain on sale of loans totaled $34.9 million for the six-month period ended June 30, 2003, an increase of $5.3 million, or 18%, compared with the same period in 2002. This rise resulted from the sale of mortgage loans, partially offset by lower gains on sale of loans guaranteed by the Small Business Administration by $2.2 million, since no transactions of this type have taken place in 2003.
Other operating income rose by $1.2 million, or 3%, compared with the first six months of 2002, mainly due to higher dividend income of $8.8 million derived from the Corporation’s ownership participation in Telecomunicaciones de Puerto Rico, Inc., compared with $1.6 million for the first six months of 2002. This favorable variance was partially offset by lower underwriting profits derived from the Corporation’s broker/dealer subsidiary. Also, the results for 2002 include the gains realized on the sale of the U.S. trust operations and the branches of Popular Finance.
OPERATING EXPENSES
Operating expenses totaled $279.3 million, an increase of $28.6 million, or 11%, compared with $250.7 million reported in the same period of 2002. Refer to the unaudited consolidated statements of income for a breakdown of operating expenses by major categories.
Personnel costs, the largest category of operating expenses, totaled $129.8 million in the second quarter of 2003, an increase of $7.2 million, or 6%, compared with the same period in the previous year. Salaries, pension and incentive compensation were among the principal contributors to this increase. The increase in salaries is partly due to merit increases and higher headcount. As of the end of this quarter, full time equivalent employees (FTE’s) totaled 11,379, compared with 11,207 as of the end of the same period in 2002. At December 31, 2002, the Corporation lowered the assumed discount rate for 2003 from 6.75% to 6.50%, and the expected rate of return on its pension plan assets from 8.50% to 8.00%. It also increased the rate of salary compensation assumption in calculating the cost for the pension plan. All these changes resulted in an increase of $2.5 million in the pension plan expense for the quarter ended June 30, 2003, compared with the same period in the previous year. For further information on this topic refer to the critical accounting policies section in the Management’s Discussion and Analysis included in Popular, Inc.’s 2002 Financial Review and Supplementary Information to Stockholders, incorporated by reference in Popular, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2002.
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Operating expenses, excluding personnel costs, totaled $149.5 million for the second quarter of 2003, an increase of $21.4 million, or 17%, compared to the same period in 2002. This rise was mainly reflected in the categories of equipment, communications and other operating expenses. Equipment expenses increased mainly due to higher amortization of software packages to support the Corporation’s internal technology infrastructure and higher maintenance and repairs charges for data processing and other equipment. The rise in communications expenses was mainly related to additional data lines to support business applications, and higher postage expenses. The other operating expenses category rose, mainly due to an increase in sundry losses of $15 million. These losses resulted mostly from unauthorized credit card transactions conducted on credit cards issued by Banco Popular de Puerto Rico. The Bank has taken remedial action to prevent further losses from this illegal external scheme.
For the six-month period ended June 30, 2003, operating expenses amounted to $542.9 million, an increase of $50.1 million, or 10%, compared with the same period in 2002. Personnel costs rose $19.2 million, or 8%, mostly associated with salaries, incentive compensation, bonuses, and stock options. Operating expenses, excluding personnel costs, increased $30.9 million, or 12%, for the six-months ended June 30, 2003 compared with the amounts reported for the same period in the previous year. Equipment and communication expenses increased due to the same reasons explained above. The rise in net occupancy expenses resulted mostly from higher rental expenses, related in part to business expansion and the new headquarters offices in BPNA, higher property taxes and electricity expenses, partly offset by higher building rental and parking income. The increase in business promotion was associated with the PREMIA rewards program, launched in the second quarter of 2002, partially offset by lower public relations expenses. The increase in professional fees was mostly associated with legal costs and programming services, while the rise in other operating expenses was mainly the result of higher sundry losses, as described above, and other real estate and credit card interchange expenses. These increases were offset in part by lower amortization of intangible assets as a result of some intangibles that became fully amortized during 2002.
INCOME TAX
Income tax expense for the quarter ended June 30, 2003 amounted to $35.9 million, an increase of $3.3 million, or 10%, from $32.6 million in the same quarter of 2002. The increase was primarily due to higher pretax earnings for the current period, partially offset by a decrease in the disallowance of expenses attributed to tax exempt investments in Puerto Rico and by an increase in gains on sale of securities subject to a lower tax rate. The effective tax rate for these quarters were 21.06% and 25.28% respectively.
Income tax expense for the six-month period ended June 30, 2003 amounted to $66.8 million, an increase of $4.1 million, or 7%, over the $62.7 million reported for the same period in 2002. The effective tax rate for the first six months of 2003 was 22.22%, compared with 25.28% in 2002. The decline in the effective tax rate resulted mostly from the preferential tax rate on capital gains.
BALANCE SHEET COMMENTS
The Corporation’s total assets at June 30, 2003 reached $36.1 billion, an increase of $2.4 billion, or 7%, compared with $33.7 billion at December 31, 2002. Total assets at June 30, 2002 amounted to $32.7 billion. Earning assets totaled $33.9 billion at June 30, 2003, compared with $31.9 billion at December 31, 2002 and $30.6 billion at June 30, 2002.
Investment and trading securities reached $12.3 billion at June 30, 2003, an increase of $1.1 billion compared with $11.2 billion at December 31, 2002. The Corporation has increased its securities portfolio as part of its asset / liability management strategies. This growth has been mostly in the form of U.S. Government obligations, which as mentioned earlier, are tax-exempt in Puerto Rico. Investment and trading securities at June 30, 2002 totaled $10.7 billion. For a breakdown of the Corporation’s available-for-sale and held-to-maturity investment portfolios refer to Notes 3 and 4 to the unaudited consolidated financial statements. At June 30, 2003, money market investments totaled $783 million, a decrease of $311 million, or 28%, over the $1.1 billion at December 31, 2002. At June 30, 2002, money market investments amounted to $1.1 billion. The decrease from December 31, 2002 was mostly in the form of federal funds sold by the banking subsidiaries and resale agreements.
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A breakdown of the Corporation’s loan portfolio is presented in Table H. At June 30, 2003, total loans amounted to $20.9 billion, resulting in an increase of $1.3 billion, or 7%, from December 31, 2002. This increase resulted from higher mortgage loans by $874 million, or 12%, while commercial loans, including construction, rose by $168 million, or 2%. The lease financing portfolio also grew by $164 million, or 18%, mostly associated with the acquisition of certain lease portfolios of medical and communications equipment by the Corporation’s banking and lease financing subsidiaries in the United States during this quarter. Moreover, the consumer loan portfolio also increased by $85 million, or 3%, mainly due to strong sales efforts in the auto loan market. When compared with June 30, 2002, the loan portfolio grew by $2.0 billion, or 10% at June 30, 2003. The mortgage and commercial loan portfolios, including construction loans, accounted for the largest increases, rising $1.2 billion and $560 million, respectively, from June 30, 2002. The growth in mortgage loans was associated with strong sales efforts, the prevailing low interest rate environment and portfolio acquisitions, while the growth in the commercial loan portfolio resulted in part from higher working capital needs from borrowers in the current economic environment. The consumer and lease financing portfolios increased by $35 million and $164 million, respectively, from June 30, 2002, mostly associated with the same factors previously discussed.
TABLE HLoans Ending Balances
Cash and due from banks amounted to $905 million at June 30, 2003, compared with $653 million at the end of 2002. The increase was partly associated with funds received at the end of June 2003 from deposits in trust from governmental sources.
Premises and equipment totaled $474 million at June 30, 2003, compared with $461 million at December 31, 2002 and $404 million at June 30, 2002. The increase of $70 million since June 30, 2002 is mostly associated with office remodeling and building acquisitions, as well as premises under construction for business expansion or relocations.
Other assets amounted to $729 million at June 30, 2003, compared with $578 million at December 31, 2002, an increase of $151 million or 26%. Beginning in 2003, the Corporation has $76 million in bank owned life insurance, which is included in other assets in the statement of condition. The increase in other assets since the end of 2002 was also associated with advances on securitizations. The rise since June 30, 2002 of $212 million, or 41%, was also associated with the factors described above.
At June 30, 2003, total deposits amounted to $18.3 billion, an increase of $661 million, or 4%, compared with December 31, 2002. Demand deposits rose by $849 million, while time deposits decreased by $215 million, of which $127 million were in brokered certificates of deposit. The increase in demand deposits is partly due to deposits in trust from governmental sources used to repay government obligations on July 1st 2003, and higher deposits from public funds. When compared with June 30, 2002, total deposits rose $446 million, or 3%. Savings and demand deposits accounted for the largest increases, rising $397 million and $204 million, respectively, from June 30, 2002. Time deposits, which include brokered certificates of deposits, decreased by $155 million, or 2%, since June 30, 2002.
Borrowed funds, including subordinated notes and capital securities, increased by $1.4 billion, or 11% since December 31, 2002, reaching $14.4 billion at June 30, 2003. This increase in borrowed funds was used primarily to fund the Corporation’s loan growth and investment activities. Borrowed funds at June 30, 2002 were $12.2 billion. Further information related to the composition of the Corporation’s funding sources is available in the Liquidity section of this report.
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The Corporation’s stockholders’ equity at June 30, 2003 was $2.8 billion, compared with $2.4 billion at December 31, 2002 and $2.2 billion at June 30, 2002. The increase of $402 million since the end of 2002 reflects in part the issuance of the Corporation’s preferred stock during 2003. Also, contributing to the increase in stockholders’ equity were earnings retention and higher unrealized gains in the securities available-for-sale portfolio. The increase in stockholders’ equity of $605 million from June 30, 2002 is also related to these factors. Refer to the consolidated statement of condition and the consolidated statement of comprehensive income for detailed information on these particular items.
The Corporation continues to exceed the well-capitalized guidelines under the federal banking regulations. Ratios and amounts of total risk-based capital, Tier 1 risk-based capital and Tier 1 leverage as of June 30, 2003 and 2002, and December 31, 2002 are presented on Table I. Also, at June 30, 2003, December 31, 2002 and June 30, 2002, BPPR, BPNA and BP, N.A. were all well-capitalized.
The Corporation’s common and preferred stocks are traded on the National Association of Securities Dealers Automated Quotation (NASDAQ) under the symbols BPOP and BPOPO, respectively. Table A presents limited data on the Corporation’s common stock for the quarters and six-month periods ended June 30, 2002 and 2003. The Corporation’s market capitalization at June 30, 2003 was $5.1 billion, compared with $4.5 billion at June 30, 2002 and at December 31, 2002.
TABLE ICapital Adequacy Data
OFF-BALANCE SHEET ACTIVITIES
In the ordinary course of business, the Corporation has conducted asset securitizations involving the transfer of mortgage loans to a qualifying special purpose entity (QSPE), which in turned has transferred the assets, including their titles, to different trusts, thus isolating those loans from the Corporation’s assets. The transactions qualified for sale accounting based on the provisions of SFAS No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities”, as such trusts are not consolidated in the Corporation’s financial statements. As of June 30, 2003, these trusts held approximately $202 million in assets in the form of mortgage loans. Their liabilities in the form of debt principal due to investors approximated $193 million at the end of the second quarter of 2003. In these securitizations, the Corporation retained servicing responsibilities and certain subordinated interest in the form of interest-only securities. The investors and the securitization trusts have no recourse to the Corporation’s assets. The servicing rights and the interest-only securities retained by the
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Corporation are recorded in the statement of condition at the lower of amortized cost or market, and fair value, respectively. During the quarter ended June 30, 2003 the Corporation recorded approximately $1.7 million of write-downs related to interest-only strips, in which the decline in fair value was considered other than temporary. For the six-months ended June 30, 2003, these write-downs amounted to $2.1 million.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
MARKET RISK
Market risk refers to the impact of changes in interest rates on the Corporation’s net interest income, market value of equity and trading operations. It also arises from fluctuations in the value of some foreign currencies against the U.S. dollar. Despite the varied nature of market risks, the primary source of this risk at the Corporation is the impact of changes in interest rates. Depending on the duration and repricing characteristics of the Corporation’s assets, liabilities and derivatives instruments, changes in interest rates could either increase or decrease the level of net interest income. The Corporation maintains a formal asset and liability management process to quantify, monitor and control interest rate risk (IRR) and to assist management in maintaining stability in the net interest margin under varying interest rate environments.
An interest rate sensitivity analysis performed at the Corporation level is the primary tool used in expressing the potential loss in future earnings resulting from selected hypothetical changes in interest rates. Sensitivity analysis is calculated on a monthly basis using a simulation model, which incorporates actual balance sheet figures detailed by maturity and interest yields or costs, the expected balance sheet dynamics, reinvestments, and other non-interest related data. Simulations are processed using various interest rate scenarios to determine potential changes to the future earnings of the Corporation.
Computations of the prospective effects of hypothetical interest rate changes are based on many assumptions, including relative levels of market interest rates, loan prepayments and deposit decay. They should not be relied upon as indicative of actual results. Further, the computations do not contemplate actions that management could take to respond to changes in interest rates. By their nature, these forward-looking computations are only estimates and may be different from what actually may occur in the future.
Based on the results of the sensitivity analysis as of June 30, 2003, the change in net interest income, on a hypothetical rising rate scenario, for the next twelve months is an estimated decrease of $0.3 million and the change for the same period, utilizing a hypothetical declining rate scenario, is an estimated increase of $4.2 million. Both hypothetical rate scenarios consider a gradual change of 100 basis points up and down during the twelve-month period from the prevailing rates at June 30, 2003. These estimated changes are within the policy guidelines established by the Board of Directors.
The Corporation maintains an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in net interest income that are caused by interest rate volatility. Refer to Note 6 to the consolidated financial statements for further information on the Corporation’s limited involvement in derivative instruments and hedging activities. The Corporation was a participant in certain interest rate swaps with an aggregate notional amount of $500 million. In such agreements, the Corporation converted floating rate debt to fixed rate debt. These contracts were cancelled during the second quarter of 2003 as part of the Corporation’s risk management strategies.
The Corporation conducts business in certain Latin American markets through several of its processing and information technology services and products subsidiaries. Also, it holds interests in Consorcio de Tarjetas Dominicanas, S.A. and Centro Financiero BHD, S.A. in the Dominican Republic. Although not significant, some of these businesses are conducted in the country’s particular foreign currency. At June 30, 2003 the Corporation had $15 million in foreign currency translation adjustment as part of accumulated other comprehensive income, compared with $2 million at December 31, 2002. The increase was mostly associated with a devaluation of the Dominican peso. However, management does not expect future exchange rate volatility between the U.S. dollar and the particular foreign currency to affect significantly the Corporation’s consolidated financial condition or results of operations.
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The Corporation believes that there have been no significant changes in market risk compared with the disclosures in Popular, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2002.
LIQUIDITY
The Corporation manages liquidity to provide adequate funds to meet its anticipated financial obligations, including withdrawals by depositors and debt service requirements, as well as to fund customer’s demand for credit.
Core deposits are one of the Corporation’s primary sources of funding. The extensive branch network of the Corporation in the Puerto Rico market and its expanding network in major U.S. markets have enabled it to maintain a significant and stable base of deposits.
The Corporation has established borrowing relationships with the Federal Home Loan Bank (FHLB), the Federal Reserve Bank of New York and other correspondent banks, which further support and enhance liquidity. Wholesale or institutional sources of funds are comprised primarily of other financial intermediaries such as commercial banks, securities dealers, investment companies, insurance companies, as well as non-financial corporations. Wholesale or institutional sources of funding include the repo, federal funds and Eurodollar markets, commercial paper, medium-term notes, senior debentures and asset securitizations.
Liquidity is provided also by the regularly scheduled maturities of the Corporation’s investment portfolio. Refer to Notes 3 and 4 to the consolidated financial statements for further information as to the composition of the available-for-sale and held-to-maturity investment portfolios. Liquid U.S. Treasury and Agency securities can be used to raise funds in the repo markets. The loan portfolio can also be used to obtain funding in the capital markets. In particular, mortgage loans and some types of consumer loans, and to a lesser extent commercial loans, have highly developed secondary markets. In addition, other sources of liquidity include maturities of money market investments, repayments of loans and investment securities, and cash generated from operations, such as fees collected for services.
Also, the Corporation obtains liquidity in the capital markets through the sale of its debt and equity securities. The Corporation has a shelf registration with the Securities and Exchange Commission, which is intended to permit the Corporation to raise funds through sales of preferred stock, medium-term notes or other debt securities with a relatively short lead-time. At June 30, 2003, the Corporation had available approximately $1.3 billion under this shelf registration.
During the six-month period ended June 30, 2003 the Corporation issued preferred stock under this shelf registration, which net proceeds, after the underwriting discounts and expenses, amounted to $182 million. These proceeds were used to fund operations. Also, the Corporation issued $500 million of medium-term notes under this same shelf registration.
Risks to Liquidity
The Corporation’s ability to compete successfully in the marketplace for deposits depends on various factors, including service, convenience and financial stability as reflected by operating results and credit ratings. Although a downgrade in the credit rating of the Corporation may impact its ability to raise deposits, the fact that most deposits at the Corporation’s banking subsidiaries are federally insured, is expected to mitigate the effect of a downgrade in credit rating.
Although the Corporation raises the majority of its financing from retail deposits, it still borrows a material amount of funds from institutional sources. Institutional lenders tend to be sensitive to the perceived credit risk of the entities to which they lend and this exposes the Corporation to the possibility of having its access to funding affected by how the market perceives its credit quality; this in part, may be due to factors beyond its control.
Changes in the credit rating of the Corporation or any of its subsidiaries to a level below “investment grade” may affect the Corporation’s access to the capital markets. The Corporation’s counterparties are sensitive to the risk of a rating downgrade. In the event of a downgrade, it may be expected that the cost of borrowing funds in the institutional market would increase. In addition, the ability of the Corporation to raise new funds or renew maturing debt may be more difficult. Management does not anticipate changes in the credit ratings of the Corporation based on its expected outlook for the P.R./U.S. economy, interest rates and expected financial results of the Corporation.
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In the course of borrowing from institutional lenders, the Corporation has entered into contractual agreements to maintain certain levels of debt, capital and non-performing loans, among other financial covenants. If the Corporation does not comply with those agreements, an event of default may occur. Such failure may accelerate the repayment of the related borrowings. It could also affect the ability of the Corporation to raise new funds or renew maturing borrowings. The Corporation is currently in full compliance with all financial covenants in effect and expects to remain so in the future.
The Corporation’s non-banking subsidiaries may be subject to a higher degree of liquidity risk than the banking subsidiaries, due to the latter’s access to federally-insured deposits and the Federal Reserve Discount Window. A higher proportion of the funding of the non-banking subsidiaries is from institutional sources, as compared to the banking subsidiaries, and these are more sensitive to the perceived credit risk of the Corporation than providers of deposits. In the event of a downgrade in the credit ratings of the Corporation, the non-banking subsidiaries may experience an increase in their cost of funds and reduced availability of financing. Management does not anticipate such a scenario developing in the foreseeable future.
The importance of the Puerto Rico market for the Corporation is an additional risk factor that could affect its financing activities. In the case of an extended economic slowdown in Puerto Rico, the credit quality of the Corporation could be affected as a result of higher credit costs and possible decreases in profitability. The substantial integration of Puerto Rico with the U.S. economy should limit the probability of a prolonged recession in Puerto Rico (except if there is a prolonged recession in the U.S.) and its related risks to the Corporation.
Management intends to finance the future operations of the Corporation with a combination of retail and commercial deposits, and to a lesser extent, short and long-term borrowed funds. The sources and the maturities of these borrowings will be diversified to avoid undue reliance on any single source and maintain an orderly volume of borrowings maturing in the future.
Factors that the Corporation does not control, such as the economic outlook of its principal markets, could affect its ability to obtain funding. In order to prepare for the possibility of such a scenario, management has adopted contingency plans for raising financing under stress scenarios, where important sources of funds that are usually fully available are temporarily not willing to lend to the Corporation.
These plans provide for using alternate funding mechanisms such as the pledging or securitization of certain asset classes, committed credit lines, and loan facilities implemented with the Federal Home Loan Bank of New York and the Federal Reserve Bank of New York. The Corporation has a substantial amount of assets available for raising funds through non-traditional channels.
The Corporation believes that there have been no significant changes in liquidity risk compared with the disclosures in Popular, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2002.
Item 4. Controls and Procedures
Disclosure Controls and Procedures
The Corporation’s management, with the participation of the Corporation’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Corporation’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on such evaluation, the Corporation’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Corporation’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Corporation in the reports that it files or submits under the Exchange Act.
Internal Control Over Financial Reporting
Except as disclosed below, there have been no changes in the Corporation’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the second quarter of 2003 that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.
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In connection with credit card losses incurred during the second quarter, BPPR has implemented various measures designed to enhance its systems for the detection and prevention of credit card fraud including changes to its authorization procedures and the parameters for issuing cards to its customers.
Part II – Other Information
Item 1. Legal Proceedings
The Corporation and its subsidiaries are defendants in various lawsuits arising in the ordinary course of business. Management believes, based on the opinion of legal counsel, that the aggregate liabilities, if any, arising from such actions would not have a material adverse effect on the financial position and results of operations of the Corporation.
As disclosed on page 15 of the 10-K, on January 16, 2003 the U.S. District Court for the District of Puerto Rico approved a Deferred Prosecution Agreement (the “Agreement”) among Banco Popular, the U.S. Department of Justice, the Board of Governors of the Federal Reserve System, and the Financial Crimes Enforcement Network of the U.S. Department of the Treasury (“FinCEN”). The Agreement concludes an investigation related principally to the circumstances surrounding the activities of a former customer of the Bank, including Banco Popular’s reporting and compliance efforts, as well as certain other customers. The former customer has pleaded guilty to money laundering, including in connection with transactions made through an account at Banco Popular. No current or former Bank officer, director or employee has been charged with a crime or accused of benefiting financially from the transactions described in the Agreement.
Under the Agreement, Banco Popular agreed to the filing of a one-count information charging it with failure to file suspicious activity report in a timely and complete manner. The Agreement provides for Banco Popular to forfeit $21.6 million to the United States, and resolves all claims the United States, FinCEN or the Federal Reserve may have against Banco Popular arising from the matters that were subject to investigation.
This settlement also terminates the Written Agreement Banco Popular signed with the Federal Reserve Bank of New York on March 9, 2000, which required enhancements to Banco Popular’s anti-money laundering and Bank Secrecy Act program. The Federal Reserve found Banco Popular to be fully complaint with the Written Agreement on November 26, 2001. Finally, the Agreement provides that the court will dismiss the information and the Deferred Prosecution Agreement will expire 12 months following the settlement, provided that Banco Popular complies with its obligations under the Agreement.
Item 4. Submission of Matters to a Vote of Security Holders
The Annual Stockholders Meeting of Popular, Inc. was held on April 30, 2003. A quorum was obtained with 111,164,119 shares represented in person or by proxy, which represented approximately 83.85% of all votes eligible to be cast at the meeting. Five Directors of the Corporation, Juan J. Bermúdez, Richard L. Carrión, Jorge A. Junquera, Francisco M. Rexach Jr and Frederic V. Salerno, were elected for a three-year term. The following directors were not up for reelection and continued to hold office after the meeting: David H. Chafey Jr, Antonio Luis Ferré, Félix J. Serrallés Jr, José B. Carrión Jr, Héctor R. González, Manuel Morales Jr and Julio E. Vizcarrondo Jr. The ratification of PricewaterhouseCoopers LLP as the Corporation’s independent auditors for 2003 was also approved at the Annual Meeting. The result of the voting on each of the proposals is set forth below:
Issue 1: Election of five (5) Class 1 Directors:
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Item 6. Exhibits and Reports on Form 8-K
b) Four reports on Form 8-K were filed for the quarter ended June 30, 2003:
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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