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.
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:
TABLE OF CONTENTS
INDEX
Forward-Looking Information. The information included in this Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 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. Forward-looking statements are typically identified by words or phrases such as “believe,” “expect,” “anticipate,” “intend,” “estimate,” “may increase,” “may fluctuate,” and similar expressions or future or conditional verbs such as “will,” “should,” “would,” and “could.” These forward-looking statements involve certain risks, uncertainties, estimates and assumptions by management. Various factors such as regional and national economic conditions, competitive and regulatory factors, and legislative changes, 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. The Corporation assumes no obligation to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such Statements.
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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 (LOSS)(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 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 nine months ended September 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. Certain variable interest entities that are qualifying special purpose entities subject to the reporting requirements for SFAS No. 140, “Accounting for Transfers and servicing of Financial Assets and Extinguishment of Liabilities,” will not be required to be consolidated under the provisions of FIN No. 46. The consolidation requirements of FIN No. 46 apply to variable interest entities created after January 31, 2003. The provisions of FIN No. 46 for variable interest entities created on or before January 31, 2003 were delayed until December 31, 2003 by FASB Staff Position No. FIN 46-6, issued in October 2003. Management is currently evaluating the impact that FIN No. 46 may have on the Corporation’s financial condition or results of operations. Based on management’s current understanding, which could change as a result of evolving changes in the interpretation of certain provisions of FIN No. 46 by the accounting industry, the impact that FIN No. 46 may have on the Corporation’s financial statements would include:
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– As issued, FIN No. 46 would require the Corporation, beginning in the fourth quarter of 2003, to deconsolidate BanPonce Trust I (the “Trust”). Refer to Note 10 to the unaudited consolidated financial statements for information on this Trust. Deconsolidation would result in the re-characterization of the liability currently reflected as “Preferred Beneficial interest in Popular North America’s junior subordinated deferrable interest debentures guaranteed by the Corporation” (the “Capital Securities”) in the consolidated statement of condition as a liability (the “Junior Subordinated Debentures”) to the Trust that issued the Capital Securities. The Corporation’s equity interest in the Trust would be included in “available-for-sale securities” in the statement of condition. Management currently understands that the adoption of FIN No. 46 as it relates to the Trust would not have a significant impact on the Corporation’s consolidated financial statements.
The Capital Securities presently qualify as Tier 1 regulatory capital and are reported in Federal Reserve regulatory reports as a minority interest in a consolidated subsidiary. The Junior Subordinated Debentures do not qualify as Tier 1 regulatory capital. The Federal Reserve Bank has indicated that until further notice, the Capital Securities will continue to qualify as Tier 1 regulatory capital, even if, as a result of deconsolidation, they are no longer included on the consolidated statements of condition. As of September 30, 2003, assuming the Corporation was not allowed to include the Capital Securities issued by the Trust as Tier 1 regulatory capital, the Corporation’s regulatory capital would have been reduced by approximately $144 million. The Corporation would still exceed the regulatory threshold for well capitalized institutions.
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 are 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. The adoption of SFAS No. 149 did not have an impact on the Corporation’s financial condition or results of operations for the quarter ended September 30, 2003.
SFAS No. 150 “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”
SFAS No. 150 establishes how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify certain financial instruments, including some previously classified as equity, as a liability (or an asset in some circumstances) because the financial instrument embodies an obligation of the issuer. Specifically, SFAS No. 150 requires that financial instruments issued in the form of shares that are mandatorily redeemable, financial instruments that embody an obligation to repurchase the issuer’s equity shares or are indexed to such an obligation, or financial instruments that embody an unconditional obligation or a conditional obligation that can be settled in certain ways, be classified as liabilities. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and effective for other financial instruments held by the Corporation at the beginning of the first interim period beginning after June 15, 2003. In October 2003, the FASB deferred the provisions related to mandatorily redeemable noncontrolling interests until further notice. The adoption of the required provisions of SFAS No. 150 did not have an impact on the Corporation’s consolidated statements of condition or results of operations as of September 30, 2003.
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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 September 30, 2003, December 31, 2002 and September 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.
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 September 30, 2003, December 31, 2002 and September 30, 2002 were as follows:
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Note 5 – Pledged assets
Certain 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 September 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 and an option entered into by the Corporation, 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 the second quarter of 2003, the Corporation terminated the interest rate contracts outstanding with a notional amount of $500,000. These swaps did not qualify as hedges in accordance with SFAS No. 133, as amended.
On September 30, 2003, the Corporation purchased an option to cover its exposure related to the issuance of $31,152 in notes linked to the S&P 500 Index. In accordance with SFAS No. 133, the Corporation bifurcated the embedded option from the host contract.
For the quarters ended September 30, 2003 and September 30, 2002, the Corporation recognized a gain of $282 and a loss of $21,759, respectively, as a result of the changes in fair value of the derivatives not accounted for as hedges.
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 performed the annual impairment test during the third quarter of 2003. The results of this test did not indicate an impairment in the Corporation’s recorded goodwill.
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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.
The changes in the carrying amount of goodwill for the nine months ended September 30, 2003, are as follows:
As of September 30, 2003, December 31, 2002 and September 30, 2002, goodwill totaled $190,655, $182,965 and $180,337, 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 September 30, 2003, December 31, 2002 and September 30, 2002:
During the quarter ended September 30, 2003, the Corporation recognized $1,978 in amortization expense related to other intangible assets with definite lives (September 30, 2002 – $1,938). For the nine months ended September 30, 2003, the amortization expense totaled $6,033 (September 30, 2002 – $7,037).
Certain core deposit intangibles became fully amortized as of September 30, 2003, and as such, their gross amount and accumulated amortization were eliminated from the accounting records and the tabular disclosure presented above for September 30, 2003.
The following table presents the estimated aggregate annual amortization expense of the intangible assets with definite lives 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.
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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 September 30, 2003 were $18,202 and $137,827, respectively (September 30, 2002 – $16,504 and $128,359; 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.
In accordance with the provisions of FIN No. 45, during the nine months ended September 30, 2003, the Corporation recorded a liability of $276, 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 consolidated 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 September 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 September 30, 2003, the Corporation has various outstanding commitments to purchase mortgage loans from other institutions at market. In 2002 and 2003, the Corporation entered into loan commitments to purchase an aggregate amount of $250,000 of mortgage loans with the option of purchasing $125,000 in additional loans. The commitments expire completely by September 30, 2004. As of September 30, 2003, $150,000 in loans had been purchased under these agreements.
The Corporation fully and unconditionally guarantees certain borrowing obligations issued by certain of the Corporation’s wholly-owned subsidiaries approximating $3,766,643 at September 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 nine months ended September 30, 2003, the Corporation recognized $342 and $1,408, respectively, in stock option expense.
The following table summarizes information about stock options outstanding at September 30, 2003:
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The following table summarizes the stock option activity and related information:
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 23.98% (2002 – 26.48%) and a risk-free interest rate of 3.77% (2002 – 4.91%). The weighted average fair value of options granted during 2003 was $9.06 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 September 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 September 30, 2003 (September 30, 2002 – $148,640; December 31, 2002 – $148,640) and a related accrued interest receivable of $1,031 (September 30, 2002 – $1,031; 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). Refer to Note 2 to the unaudited consolidated financial statements for information on the potential impact of FIN No. 46.
Note 11 – Stockholders’ Equity
The Corporation declared cash dividends on common stock amounting to $98,193 for the nine-month period ended September 30, 2003 (September 30, 2002 – $80,219).
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 $183,159. Dividends declared on the preferred stock during the nine months ended September 30, 2003 amounted to $6,941.
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These shares of preferred stock are nonconvertible and are redeemable solely at the option of the Corporation beginning on March 31, 2008. 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.
Note 12 – Earnings per Common Share
A computation of earnings per common share follows:
Potential common shares consist of common stock issuable based on 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 third quarter of 2003, there were 471,346 weighted average antidilutive stock options outstanding (2002 – 430,257) and for the nine months ended on September 30, 2003 there were 453,858 weighted average antidilutive stock options outstanding (2002 – 360,821).
Note 13 – Supplemental Disclosure on the Consolidated Statements of Cash Flows
During the nine-month period ended September 30, 2003, the Corporation paid interest and income taxes amounting to $564,396 and $112,565, respectively (2002 – $635,309 and $97,204). In addition, loans receivable transferred to other real estate and other property for the nine months ended September 30, 2003 amounted to $61,914 and $19,978, respectively (2002 – $40,092 and $23,783).
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 the following reportable segments: commercial banking, mortgage and consumer lending, auto and lease financing, and other. 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.
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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.
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 nine-month periods ended September 30, 2003 and 2002.
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During the quarter and nine-month periods ended September 30, 2003, the Corporation’s parent holding company realized gains on the sale of marketable equity securities approximating $38,600 ($33,800 after-tax) and $67,900 ($59,400 after-tax) for each respective period. These gains are included in “other income” within the “other” reportable segment category.
Intersegment Revenues*
Geographic Information
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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 September 30, 2003, December 31, 2002 and September 30, 2002, and the results of their operations and cash flows for the periods ended September 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 August 31, 2003, November 30, 2002 and August 31, 2002, corresponds to their financial information included in the consolidated financial statements of Popular, Inc. as of September 30, 2003, December 31, 2002 and September 30, 2002, respectively.
PIHC, PIBI and PNA are authorized issuers of debt securities and preferred stock under a shelf registration 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 September 30, 2003, BPPR could have declared a dividend of approximately $138,777 without the approval of the Federal Reserve Board.
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF CONDITIONSEPTEMBER 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 CONDITIONSEPTEMBER 30, 2002(UNAUDITED)
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF INCOMEFOR THE QUARTER ENDED SEPTEMBER 30, 2003(UNAUDITED)
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF INCOMEFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003(UNAUDITED)
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF INCOMEFOR THE QUARTER ENDED SEPTEMBER 30, 2002(UNAUDITED)
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF INCOMEFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2002(UNAUDITED)
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWSFOR THE NINE MONTHS ENDED SEPTEMER 30, 2003(UNAUDITED)
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POPULAR, INC.CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWSFOR THE NINE MONTHS ENDED SEPTEMBER 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.
This discussion and analysis contains statements that are considered “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995. Refer to the footnotes on the Index page of this Form 10-Q for additional information regarding forward-looking statements.
CRITICAL ACCOUNTING POLICIES
The preparation of consolidated financial statements requires management to make judgments in the application of certain of its accounting policies that involve significant estimates and assumptions about the effect of matters that are inherently uncertain. These estimates and assumptions are based on information available as of the date of the financial statements. The accounting principles followed by the Corporation and the methods of applying these principles conform with generally accepted accounting principles in the United States and with general practices within the banking industry. The Corporation has identified as critical accounting policies those related to the allowance for loan losses, investment securities’classification and related values, goodwill and other intangible assets, and pension and post retirement benefit obligations. 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. During the third quarter of 2003, the Corporation opted to follow a more conservative policy with respect to interest recognition on non-accruing mortgage loans at Equity One, the Corporation’s U.S. based mortgage and consumer lending subsidiary. Effective in the beginning of the third quarter of 2003, Equity One began to charge against current earnings the balance of all accrued and uncollected interest on loans that were placed on non-accrual status in that period. Prior to this date, Equity One ceased to accrue interest on all mortgage loans that were 90 days or four scheduled payments in arrears, but did not take a charge against current earnings for uncollected interest that had accrued prior to the loan being placed on non-accrual status. In connection with this decision, the Corporation took a charge against earnings of approximately $1.9 million corresponding to mortgage loans placed in non-accrual status by Equity One during the third quarter of 2003.
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NET INCOME
The Corporation’s net income for the third quarter of 2003 was $130.9 million, compared with $85.8 million for the same quarter of 2002, an increase of $45.1 million or 53%. Earnings per common share (EPS), basic and diluted, for the quarter ended September 30, 2003, were $0.96, compared with $0.65 for 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. Popular Inc.’s return on assets (ROA) and return on common equity (ROE) for the third quarter of 2003 were 1.47% and 20.85%, respectively, compared with 1.07% and 16.03%, respectively, for the same period in 2002.
The increase in the Corporation’s net income for the third quarter of 2003, when compared with the same period in the previous year, was principally attributed to higher net interest income by $32.0 million and non-interest income by $54.3 million. The provision for loan losses decreased by $2.3 million. These items were partially offset by a rise in operating expenses of $33.4 million and in income taxes of $10.1 million.
For the first nine months of 2003 the Corporation’s net income reached $364.6 million, compared with $271.1 million for the same period in 2002. EPS for the first nine months of 2003 and 2002 were $2.69 and $2.00, respectively. ROA and ROE for the nine-month period ended September 30, 2003 were 1.42% and 20.35%, respectively. For the same period in 2002, these ratios were 1.16% and 16.92%, respectively.
NET INTEREST INCOME
Net interest income for the quarter ended September 30, 2003 reached $329.0 million, an increase of $32.0 million, or 11%, over the same quarter of 2002. On a taxable equivalent basis, net interest income increased to $360.0 million from $321.8 million in the same quarter of 2002.
The improvement for the third quarter of 2003 of $38.2 million in net interest income, on a taxable equivalent basis, compared with the third quarter of 2002 resulted from a $37.2 million increase due to a higher volume of average earning assets and a $1.0 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 nine-months ended September 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 September 30,
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 of $3.2 billion in average earning assets for the quarter ended September 30, 2003, compared with the third quarter of 2002, was driven principally by a $2.1 billion increase in the average loan portfolio and a $1.1 billion increase in average money market, trading and investment securities. The rise in the average loan portfolio was primarily in mortgage and commercial loans, which rose $1.4 billion and $512 million, respectively. The interest rate environment has stimulated mortgage loan originations and the refinancing through mortgage loans. Investment securities rose in average by $914 million, or 9%, mostly in U.S. Agency securities and mortgage-backed securities, while the trading portfolio increased in average by $339 million, mainly in mortgage-backed securities.
The average yield on earning assets, on a taxable equivalent basis, declined 59 basis points from 7.03% in the third quarter of 2002 to 6.44% for the same period in 2003. The average yield on the investment securities portfolio decreased by 26 basis points, due to the growth of the portfolio, and to the maturity of securities with higher yields that were replaced during a lower interest rate environment. Also, during the third quarter of 2003, the Corporation did not earn dividends on its investment in Federal Home Loan Bank of New York stock as a result of investment
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portfolio actions at that institution, which prompted the FHLB of N.Y. not to pay dividends in this quarter. In the third quarter of 2002, the Corporation recorded approximately $0.4 million in dividends from its investment in this stock. On the other hand, the yield in the trading portfolio increased by 138 basis points, mainly due to a higher proportion of mortgage-backed securities in that portfolio.
The average yield on the loan portfolio decreased by 84 basis points. The commercial loans yield, including construction, fell by 76 basis points due to new loan growth and repricing in a lower rate environment. As of September 30, 2003, approximately 57% of the commercial and construction loan portfolios had floating or adjustable rates, compared with approximately 53% at the end of the third quarter in the previous year. The average yield on mortgage loans also declined 75 basis points, mainly due to the current interest rate scenario and higher loan prepayments and refinancing at current rates. Furthermore, the consumer loans yield declined 79 basis points, due in part to the interest rate scenario, coupled with promotional campaigns with lower rates for auto and personal loans. The lease financing yield declined 157 basis points, associated in part with the interest rate scenario and with a large medical and communications equipment lease portfolio purchased by the Corporation during the second quarter of 2003, which had a lower average yield than that of the remaining lease portfolio.
Interest-bearing liabilities for the third quarter of 2003, increased in average by $2.6 billion, or 10%, compared with the same quarter in 2002. Average interest-bearing deposits, mainly savings deposits, increased by $486 million, or 4%, while average borrowings rose by $2.1 billion, or 18%. Also, non-interest bearing sources of funds, including demand deposits and other sources of funds, such as capital raised through preferred stock issuance, rose $595 million.
Average short-term borrowings, comprised mostly of repurchase agreements and federal funds, increased by $1.2 billion, or 16%, in the third quarter of 2003, compared with the same quarter in the previous year, while longer-term borrowings increased by $940 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 September 30, 2003 declined by 73 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 third quarter of 2003 increased by four basis points, reaching 4.30%, while the net interest spread, which is the difference between the yield on earning assets and the cost of interest-bearing liabilities, increased by 14 basis points, rising to 3.95%, as compared with the same period of 2002.
As shown in Table C, for the nine-month period ended September 30, 2003, net interest income, on a taxable equivalent basis, rose $104.3 million, or 11%, compared with the same period of 2002. The improvement resulted from a $86.9 million increase due to a higher average volume of earning assets and a $17.4 million increase due to a higher net interest yield.
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TABLE CANALYSIS OF LEVELS & YIELDS ON A TAXABLE EQUIVALENT BASISNine-month period ended September 30,
Average earning assets for the nine-month period ended September 30, 2003 increased by $2.8 billion, or 9%, compared with the same period of 2002. Average interest-bearing liabilities increased by $2.4 billion, or 9%, compared with the nine-month period ended September 30, 2002. Also, non-interest bearing sources of funds, including demand deposits and other funds, rose $395 million.
The net interest margin, on a taxable equivalent basis, for the nine-month period ended September 30, 2003 reached 4.34%, an improvement of five basis points when compared with 4.29% reported during the same period in 2002. The net interest spread increased by 15 basis points, rising to 3.96%. The improvement in margin and spread was mostly associated with similar factors as explained above for the quarterly results.
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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 $48.7 million for the third quarter of 2003, a decrease of $2.3 million, compared with $51.0 million in the third quarter of 2002. Net charge-offs for the quarter ended September 30, 2003 were $49.5 million, or 0.94% of average loans, compared with $44.4 million, or 0.93% of average loans for the third quarter of 2002. The provision for loan losses represented 98% of net charge-offs for the quarter ended September 30, 2003, compared with 115% for the same quarter in the previous year. For the nine-month period ended September 30, 2003, the provision for loan losses totaled $146.2 million, a decrease of $9.3 million, or 6%, compared with $155.5 million for the same period in 2002. The provision for loan losses represented 116% of net charge-offs for the nine months ended September 30, 2003, compared with 111% for the same period in the previous year.
The allowance for loan losses totaled $399 million at September 30, 2003, or 1.84% of loans, compared with $354 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 September 30, 2003 refer to the Credit Quality section of this report.
The methodology used to establish the allowance for loan losses is based on SFAS No. 114 (as amended by SFAS No. 118) and SFAS No. 5. Under SFAS No. 114, commercial loans over a predefined amount are identified for impairment evaluation on an individual basis. 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. 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. Meanwhile, SFAS No. 5 provides for the recognition of a loss allowance for groups of homogeneous loans. Under SFAS No. 5, the allowance for loan losses calculation for the Corporation is based on historical net charge-off experience by loan type and legal entity. For more 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 following table shows the Corporation’s recorded investment in impaired loans and the related valuation allowance calculated under SFAS No. 114 at September 30, 2003, December 31, 2002 and September 30, 2002.
Average impaired loans during the third quarter of 2003 and 2002 were $170 million and $139 million, respectively. The Corporation recognized interest income on impaired loans of $1.0 million and $0.8 million for the quarters ended September 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 nine months ended September 30, 2003 and 2002.
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TABLE DAllowance for Loan Losses and Selected Loan Losses Statistics
* (Income before income tax and minority interest plus provision for loan losses) divided by net charge-offs.
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Also, Table E presents annualized net charge-offs to average loans by loan category for the quarters and nine months ended September 30, 2003 and 2002.
TABLE EAnnualized Net Charge-offs to Average Loans
The increase in mortgage loans net charge-offs for the quarter and nine-month period ended September 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. Also, the increase was associated with approximately $3.8 million in charge-offs recorded on the disposition of approximately $32 million in non-performing and other historically delinquent mortgage loans during the third quarter of 2003. 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 $11 million in mortgage net charge-offs for the nine-months ended September 30, 2003, as compared with the same period in 2002. The mortgage loans net charge-offs to average loans ratio at this subsidiary was 0.49% for the nine-months ended September 30, 2003, compared with 0.27% for the same period in the previous year. The increase at Equity One is partially related to $3.1 million in net charge-offs realized at this subsidiary on the sale of non-performing mortgage loans during this quarter. Also, the increase is associated with a general economic slowdown. As a result, the job market has continued sluggish and bankruptcy levels have remained at high levels, thus adversely affecting the market segment that this subsidiary caters to. Notwithstanding the above, measures have been taken to improve collections and recovery processes with enhanced initiatives and strategies to expedite foreclosures and the subsequent sale of such properties.
For the quarter ended September 30, 2003, commercial and construction net charge-offs increased moderately a 3% compared with the same period of 2002, while for the nine months ended September 30, 2003, commercial and construction net charge-offs declined 27%, compared with the same period in the previous year.
Lease financing net charge-offs as a percentage of the average lease financing portfolio declined partly as a result of a better portfolio credit quality mix, coupled with enhanced collection strategies and initiatives.
Consumer loans net charge-offs declined by 11% and 14%, for the quarter and nine-month period ended September 30, 2003, as compared with each respective period in the previous year. This decline in consumer loans net charge-offs was partly due to the Corporation’s tightening of its credit criteria for consumer borrowings prompted by the current economic environment, coupled with enhanced collection/recovery strategies and initiatives. Also, this decline 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.
CREDIT QUALITY
The Corporation places commercial loans on non-accrual status if payments of principal or interest are delinquent 60 days rather than the standard industry practice of 90 days. 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.
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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.
TABLE FNon-Performing Assets
The increase in non-performing assets since September 30, 2002 was primarily associated with mortgage loans, which rose by $67 million, or 27%. Non-performing mortgage loans represented 51% of total non-performing assets and 3.48% of total mortgage loans as of September 30, 2003, compared with 48% of total non-performing assets and 3.39% of total mortgage loans at September 30, 2002. As of 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 September 30, 2003, 69% or $220 million pertained to Equity One, compared with 64% or $161 million at September 30, 2002, and 66% or $186 million at December 31, 2002. Non-performing mortgage loans decreased by $5 million since June 30, 2003, resulting in part from the previously mentioned sale of mortgage loans in non-performing status and other loans with a history of delinquency in the third quarter of 2003. The sale of non-performing mortgage loans in particular, approximated $24 million. At June 30, 2003, non-performing mortgage loans were $323 million or 52% of total non-performing assets and 3.87% of total mortgage loans.
Non-performing commercial and construction loans represented 2.57% of that loan portfolio as of September 30, 2003, compared with 2.44% at September 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. Since June 30, 2003, commercial and construction non-performing loans increased by $12 million, mostly associated with one large commercial relationship.
Non-performing consumer loans were 1.10% of consumer loans at September 30, 2003, compared with 1.27% at September 30, 2002 and 1.29% at December 31, 2002. The decline was principally the result of a better credit quality mix, coupled with collection strategies and initiatives. Also, there has been a partial shift in loan originations from personal loans to mortgage loans.
Non-performing financing leases represented 0.67% of the lease financing portfolio at September 30, 2003, compared with 1.24% at September 30, 2002, and 1.20% at December 31, 2002. The decline in non-performing leases was primarily attributed to the strong quality of these portfolios, coupled with enhanced collection strategies and initiatives.
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Other real estate assets reached $54 million at September 30, 2003, or 9% of non-performing assets, compared with $34 million, or 6%, respectively, at September 30, 2002, and $39 million, or 7%, respectively, at December 31, 2002. This increase was associated with higher foreclosures in the mortgage business together with strengthened and more dynamic foreclosure procedures.
The allowance for loan losses as a percentage of non-performing loans was 69.43% as of September 30, 2003, compared with 71.84% at September 30, 2002 and 74.58% at December 31, 2002. The lower allowance to non-performing loans ratio reflects the changing composition of the non-performing loans and the changing loan portfolio mix toward loans with lower inherent loss characteristics.
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 September 30, 2003 would have been $551 million or 2.54% of loans, and the allowance for loan losses would have been 80.17% of non-performing loans. At September 30, 2002 and December 31, 2002, adjusted non-performing assets would have been $455 million or 2.36% of loans and $478 million or 2.44% of loans, respectively. The allowance to non-performing loans would have been 84.13% and 85.01% at September 30, 2002 and December 31, 2002, respectively.
In addition to the non-performing loans discussed earlier, at September 30, 2003, there was $38 million of loans 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 September 30, 2002, these potential problem loans approximated $36 million and $25 million, respectively.
NON-INTEREST INCOME
For the quarter ended September 30, 2003, non-interest income amounted to $171.8 million, compared with $117.5 million in the same period of 2002, an increase of $54.3 million, or 46%.
Service charges on deposit accounts reached $41.2 million for the quarter ended September 30, 2003, an increase of $1.7 million, or 4%, compared with the same quarter of 2002. This rise was mostly derived from commercial account analysis fees and charges related to authorized paid checks on accounts with nonsufficient funds.
For the quarter ended September 30, 2003, other service fees rose $5.2 million, or 8%, compared with the same quarter of 2002. Refer to Table G for a breakdown of other service fees by major categories. When comparing the results for the third quarter of 2003 with the same period in the previous year, insurance agency commissions rose by 19%, mainly due to higher volume driven by business expansion and strategic initiatives directed to capitalize on the Corporation’s broad delivery channels and client base. Also, mortgage servicing fees, net of amortization, increased by 38%, mainly due to an unfavorable adjustment in the fair value of mortgage servicing rights by approximately $1 million recorded in the third quarter of 2002. Another category contributing to the rise in other service fees was debit card fees, which rose by 7%, resulting mainly from higher transactional volume. Furthermore, check cashing fees rose 15%, mostly related to Popular Cash Express (PCE), the Corporation’s retail financial services subsidiary in the United States, while fees derived from the sale and administration of investment products rose by 13%, associated with the administration of mutual funds and commissions on the sale of stocks and bonds.
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TABLE GOther Service Fees
Gain on sale of securities for the quarter ended September 30, 2003 amounted to $39.1 million, compared with $1.3 million for the same period in 2002. These gains arose mainly from the sale of marketable equity securities held by the Corporation. The results of operations for the quarter ended September 30, 2002 included pre-tax derivative losses of $21.7 million related to the interest rate swaps that were canceled in the second quarter of 2003, with a total notional amount of $500 million. These favorable variances were partially offset by trading losses of $4.6 million for the quarter ended September 30, 2003, compared with trading gains of $1.2 million in the same quarter in the previous year. These trading account losses were mostly related to mortgage-backed securities, whose market value was negatively impacted by the increase in the long-term interest rate scenario experienced in this quarter.
Another variance included in non-interest income for the quarter ended September 30, 2003 was lower gains on the sales of loans, including loans held-for-sale, which decreased by $1.5 million, or 10%, compared with the same quarter in 2002. Also, other operating income declined by $5.1 million, or 28%, partly associated with lower management fees and dividends derived from the Corporation’s ownership participation in Telecomunicaciones de Puerto Rico, Inc., partially offset by an increase in placement and underwriting fees derived by the Corporation’s broker / dealer subsidiary, among other factors.
For the nine-month period ended September 30, 2003, non-interest income amounted to $476.2 million, compared with $382.9 million, an increase of $93.3 million, or 24%. Service charges on deposit accounts contributed with $2.7 million of this increase, mainly due to higher commercial account analysis fees, partially offset by lower charges derived from consumer accounts due in part to higher deposit balances and campaigns to attract depositors.
Other service fees rose by $12.9 million, or 7%, reaching $204.6 million for the nine-month period ended September 30, 2003, as compared with the same period of 2002. The factors described above for the quarterly results also explain the major variances for the nine-month periods, which comparative results are presented in Table G. In addition, credit card fees and discounts contributed to the positive variance, mostly as a result of higher transactional volume. Also, there were higher processing fees due to increased transactional volume and new service contracts. These favorable variances were partially offset by lower trust fees, mostly due to the sale of the Corporation’s trust operations in the United States during 2002. These trust operations contributed with approximately $1.0 million for the nine-month period ended September 30, 2002.
Gain on sale of securities amounted to $70.4 million for the first nine months of 2003, compared with losses of $2.7 million for the same period in 2002. The gains in 2003 resulted mostly from the sale of marketable equity securities held by the Corporation. Derivative losses amounted to $7.8 million for the nine-month period ended September 30, 2003, compared with losses of $22.1 million for the same period a year earlier. These favorable variances were partially offset by trading losses of $9.8 million for the nine-month period ended September 30, 2003, compared with a $0.1 million loss during the same period in the previous year. As previously mentioned, these trading losses during 2003 were partly related to mortgage-backed securities.
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Gain on sale of loans totaled $48.3 million for the nine-month period ended September 30, 2003, an increase of $3.8 million, or 9%, compared with the same period in 2002, while other operating income decreased by $3.9 million, or 7%, when comparing the same periods. The results for 2002 included the gains on the sale of the U.S. trust operations and some branches of Popular Finance, which totaled $3.7 million.
OPERATING EXPENSES
Operating expenses totaled $287.3 million for the quarter ended September 30, 2003, an increase of $33.4 million, or 13%, compared with $253.9 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 $132.2 million in the third quarter of 2003, an increase of $8.7 million, or 7%, compared with the same period in the previous year. This rise was driven mostly by higher pension and post retirement benefit costs, incentive compensation and other bonuses, salaries and health insurance costs. The increase in salaries is partly due to higher headcount. As of the end of the third quarter of 2003, full time equivalent employees (FTE’s) totaled 11,393, compared with 11,199 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 $2.3 million in the pension plan expense for the quarter ended September 30, 2003, compared with the same period in the previous year.
Operating expenses, excluding personnel costs, totaled $155.0 million for the quarter ended September 30, 2003, an increase of $24.7 million, or 19%, compared with the same period in 2002. This rise was mainly reflected in the categories of business promotion, equipment, net occupancy, communications and other operating expenses. Business promotion increased partly due to higher public relations and advertising expenses, mainly related with the sponsorship of various sporting events and a new advertising campaign for the mortgage lending business in Puerto Rico. The rise in equipment expenses was mainly due to higher amortization of software packages to support the internal technology infrastructure of the Corporation, and higher maintenance and repairs charges for data processing and other equipment. Net occupancy expenses increased mainly as a result of the Corporation’s continuous business expansion and new headquarter offices in the U.S., while the rise in communication expenses was mainly associated with the electronic and data network which supports business applications, support for the debit card business and higher postage expenses. The other operating expenses category rose in part due to a $12.1 million charge recorded in the third quarter of 2003 on the early cancellation of certain long-term borrowings as part of the Corporation’s asset / liability management strategies. Also, the rise was associated with higher miscellaneous losses, including the settlement of legal cases, other real estate expenses and credit card and ATM interchange expenses, among the most significant categories. The unfavorable variances in the above operating expense categories were partially offset by lower professional fees principally due to lower legal expenses.
For the nine-month period ended September 30, 2003, operating expenses amounted to $830.2 million, an increase of $83.5 million, or 11%, compared with the same period in 2002. Personnel costs rose $27.9 million, or 8%, mostly associated with the same categories previously described for the quarterly results. As previously stated, at December 31, 2002, the Corporation adopted some changes in the computation of the cost for the pension plan which resulted in an increase of $6.8 million in this expense for the nine-month period ended September 30, 2003, compared with the same period in the previous year. Also, during 2002 the Corporation began to expense its stock options. This item contributed with approximately $0.8 million of the increase in personnel costs for the nine months ended September 30, 2003, compared with the same period in 2002. Operating expenses, excluding personnel costs, for the nine months ended September 30, 2003 increased $55.6 million, or 15%, compared with the same period in the previous year. Besides the reasons previously explained for the quarterly variances in operating expenses, the results for the nine months ended September 30, 2003 were impacted by higher costs associated with the PREMIA customer rewards program and higher sundry losses. The latter increased by $17.0 million when compared with the same nine-month period in 2002, mostly related to the losses that resulted from unauthorized credit card transactions conducted on credit cards issued by BPPR, as explained in the Form 10-Q filed for the quarter ended June 30, 2003. Also, the results for 2003 included the $12.1 million charge on the early cancellation of certain long-term borrowings. These unfavorable variances were partially offset by lower amortization of intangible assets since certain intangibles became fully amortized during 2002.
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INCOME TAX
Income tax expense for the quarter ended September 30, 2003 increased to $33.8 million, from $23.7 million in the same quarter in the previous year, representing an increase of $10.1 million, or 43%. The increase was primarily due to higher pretax earnings for the current period, partially offset by a higher benefit on tax exempt investments. The effective tax rate for these quarters were 20.50 % and 21.65 % respectively. The third quarter of 2003 was also impacted by an increase in gains on the sale of securities which are subject to a preferential tax rate on capital gains.
Income tax expense for the nine-month period ended September 30, 2003 amounted to $100.7 million, an increase of $14.2 million, or 16%, over the $86.5 million reported for the same period in 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, mainly due to lower cost of funds. The effective tax rate for the nine months ended September 30, 2003 was 21.62%, compared with 24.17 % in 2002, mostly as a result of higher amount of tax exempt revenues in Puerto Rico and by an increase in gains on the sale of securities subject to a lower tax rate.
BALANCE SHEET COMMENTS
The Corporation’s total assets at September 30, 2003 reached $35.8 billion, an increase of $2.1 billion, or 6%, compared with $33.7 billion at December 31, 2002. Total assets at September 30, 2002 amounted to $32.8 billion. Earning assets totaled $33.7 billion at September 30, 2003, compared with $31.9 billion at December 31, 2002 and $31.2 billion at September 30, 2002.
Investment and trading securities reached $11.2 billion at September 30, 2003, remaining at the same levels when compared with December 31, 2002. Investment and trading securities at September 30, 2002 totaled $10.8 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 September 30, 2003, money market investments totaled $773 million, a decrease of $321 million, or 29%, from the $1.1 billion at December 31, 2002, mostly in federal funds sold at the banking subsidiaries and resale agreements. At September 30, 2002, money market investments amounted to $1.2 billion. The decrease from September 30, 2002 to the same date in 2003 was mostly in federal funds sold.
A breakdown of the Corporation’s loan portfolio is presented in Table H. At September 30, 2003, total loans amounted to $21.7 billion, an increase of $2.1 billion, or 11%, from December 31, 2002. This increase resulted from higher mortgage loans by $1.7 billion, or 23%, while commercial loans, including construction loans, rose by $183 million, or 2%. The lease financing portfolio also grew by $145 million, or 16%, 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 the second quarter of 2003. Moreover, the consumer loan portfolio increased by $115 million, or 4%, mainly due to strong sales efforts in the auto loan market. When compared with September 30, 2002, the loan portfolio grew by $2.4 billion, or 13% at September 30, 2003. The mortgage and commercial loan portfolios, including construction loans, accounted for the largest increases, rising $1.7 billion and $459 million, respectively, from September 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 $94 million and $147 million, respectively, from September 30, 2002, mostly associated with the same factors previously discussed.
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TABLE HLoans Ending Balances
* Includes loans held-for-sale
Premises and equipment totaled $477 million at September 30, 2003, compared with $461 million at December 31, 2002 and $446 million at September 30, 2002. The increase of $31 million since September 30, 2002 was mostly associated with office remodeling, as well as premises under construction for business expansion or relocations.
Other assets amounted to $773 million at September 30, 2003, compared with $578 million at December 31, 2002, an increase of $195 million or 34%. 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 and deferred tax assets. The rise since September 30, 2002 of $227 million, or 42%, was also associated with the factors described above.
At September 30, 2003, total deposits amounted to $17.7 billion, an increase of $41 million compared with December 31, 2002. Demand deposits rose by $189 million, while time deposits, excluding brokered certificates of deposits, increased by $47 million. On the other hand, savings deposits and brokered certificates of deposits decreased by $28 million and $167 million, respectively. When compared with September 30, 2002, total deposits rose $598 million, or 4%. Savings and demand deposits accounted for the largest increases, rising $338 million and $282 million, respectively. Time deposits, excluding brokered certificates of deposits, increased by $120 million. Brokered certificates of deposits declined by $142 million.
Other liabilities were $596 million at September 30, 2003, a decrease of $81 million, or 12%, compared with December 31, 2002. This decrease in other liabilities was mainly related to payables to broker/dealers and counterparties related to transactions accounted at trade date, lower accrued interest expense, the forfeiture payable under the Deferred Prosecution Agreement which was outstanding at the end of 2002 and lower derivative liabilities as a result of the cancellation of the interest rate swaps in 2003, among others. Other liabilities totaled $632 million at September 30, 2002. The decrease from that date was partly associated with lower derivative liabilities as explained above.
Borrowed funds, including subordinated notes and capital securities, increased by $1.8 billion, or 14%, since December 31, 2002, reaching $14.8 billion at September 30, 2003. Borrowed funds at September 30, 2002 were $12.8 billion. The increase in borrowed funds was used primarily to fund the Corporation’s loan and investment portfolio growth. During the nine-month period ended September 30, 2003, the Corporation sold $500 million in five-year fixed-rate medium-term notes and issued $31 million in corporate debt with its yield linked to the Standard & Poor’s 500 index. Also, during 2003 the Corporation has securitized approximately $1.7 billion in asset-backed securities, supported by mortgage loans. These transactions have been accounted as secured borrowings since they do not qualify as sales under SFAS No. 140.
The Corporation’s stockholders’ equity at September 30, 2003 was $2.8 billion, compared with $2.4 billion at December 31, 2002 and $2.3 billion at September 30, 2002. The increase of $340 million since the end of 2002 reflects the issuance of the Corporation’s preferred stock during 2003 and earnings retention. The rise was partially offset by lower unrealized gains in the securities available-for-sale portfolio and an unfavorable foreign currency translation adjustment. The increase in stockholders’ equity of $432 million from September 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.
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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 September 30, 2003 and 2002, and December 31, 2002 are presented on Table I. Also, at September 30, 2003, December 31, 2002 and September 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 nine-month periods ended September 30, 2002 and 2003. The Corporation’s market capitalization at September 30, 2003 was $5.3 billion, compared with $4.2 billion at September 30, 2002 and $4.5 billion 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 September 30, 2003, these trusts held approximately $177 million in assets in the form of mortgage loans. Their liabilities in the form of debt principal due to investors approximated $176 million at the end of the third 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 Corporation are recorded in the statement of condition at the lower of amortized cost or market, and fair value, respectively.
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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 on net interest income. 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. Thus, 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 September 30, 2003, the change in net interest income, on a hypothetical rising rate scenario, for the next twelve months is an estimated increase of $0.3 million and the change for the same period, utilizing a hypothetical declining rate scenario, is an estimated increase of $8.6 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 September 30, 2003. It should be mentioned that some short-term rates are below 1% at September 30, 2003. In the scenario of interest rates decreasing 100 basis points, rates were not permitted to fall below 0.1%. 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 September 30, 2003 the Corporation had $23 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.
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.
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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.
Deposits are one of the Corporation’s primary sources of funding, and represent 49% of total assets. 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’s core deposits, which consist of demand, savings, money market and time deposits under $100 thousand, constituted 82% of total deposits at September 30, 2003.
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 scheduled maturities of the Corporation’s investment and loan portfolios, and from cash generated from operations, such as fees collected for services.
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.
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 September 30, 2003, the Corporation had available approximately $1.2 billion under this shelf registration.
During the nine-month period ended September 30, 2003 the Corporation issued preferred stock under this shelf registration, which net proceeds, after the underwriting discounts and expenses, amounted to $183 million. These proceeds were used to fund operations.
Refer to the Balance Sheet comments section of this Form 10-Q for further information on major debt issuances and securitization transactions performed by the Corporation during the quarter ended September 30, 2003.
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.
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The Corporation and BPPR’s debt ratings as of September 30, 2003 were as follows:
Some of the Corporation’s borrowings and deposits are subject to “rating triggers”, contractual provisions that accelerate the maturity of the underlying obligations in the case of a change in rating. Therefore, the need for the Corporation to raise funding in the marketplace could increase more than usual in the case of a rating downgrade. The amount of borrowings and deposits subject to rating triggers was $230 million at September 30, 2003.
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 latters’ 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, short and long-term borrowed funds, and the issuance of trust preferred securities. The sources and the maturities of the 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.
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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
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 third quarter of 2003 that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.
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.
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Item 6. Exhibits and Reports on Form 8-K
b) Two reports on Form 8-K were filed for the quarter ended September 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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