UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
For the quarterly period ended June 30, 2011
Commission File Number: 001-34084
POPULAR, INC.
(Exact name of registrant as specifies in its charter)
(State or other jurisdiction of
Incorporation or organization)
(787) 765-9800
(Registrant’s telephone number, including area code)
NOT APPLICABLE
(Former name, former address and former fiscal year, if change since last report)
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. x Yes ¨ No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes ¨ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer, large accelerated filer and smaller reporting company” in Rule 12b-2 of the Exchange Act:
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes x No
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: Common Stock $0.01 par value 1,024,137,020 shares outstanding as of July 27, 2011.
INDEX
Item 1. Financial Statements
Unaudited Consolidated Statements of Condition at June 30, 2011, December 31, 2010 and June 30, 2010
Unaudited Consolidated Statements of Operations for the quarters and six months ended June 30, 2011 and 2010
Unaudited Consolidated Statements of Changes in Stockholders’ Equity for the six months ended June 30, 2011 and 2010
Unaudited Consolidated Statements of Cash Flows for the six months ended June 30, 2011 and 2010
Notes to Unaudited Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Item 4. Controls and Procedures
Item 1. Legal Proceedings
Item 1A. Risk Factors
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 6. Exhibits
Signatures
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Forward-Looking Information
The information included in this Form 10-Q contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements may relate to Popular, Inc’s (the “Corporation”, “Popular”, “we, “us”, “our”) financial condition, results of operations, plans, objectives, future performance and business, including, but not limited to, statements with respect to the adequacy of the allowance for loan losses, delinquency trends, market risk and the impact of interest rate changes, capital markets conditions, capital adequacy and liquidity, and the effect of legal proceedings and new accounting standards on the Corporation’s financial condition and results of operations. All statements contained herein that are not clearly historical in nature are forward-looking, and the words “anticipate,” “believe,” “continues,” “expect,” “estimate,” “intend,” “project” and similar expressions and future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may,” or similar expressions are generally intended to identify forward-looking statements.
These statements are not guarantees of future performance and involve certain risks, uncertainties, estimates and assumptions by management that are difficult to predict.
Various factors, some of which are beyond Popular’s control, could cause actual results to differ materially from those expressed in, or implied by, such forward-looking statements. Factors that might cause such a difference include, but are not limited to:
the rate of growth in the economy and employment levels, as well as general business and economic conditions;
changes in interest rates, as well as the magnitude of such changes;
the fiscal and monetary policies of the federal government and its agencies;
changes in federal bank regulatory and supervisory policies, including required levels of capital;
the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) on our businesses, business practices and cost of operations;
regulatory approvals that may be necessary to undertake certain actions or consummate strategic transactions such as acquisitions and dispositions;
the relative strength or weakness of the consumer and commercial credit sectors and of the real estate markets in Puerto Rico and the other markets in which borrowers are located;
the performance of the stock and bond markets;
competition in the financial services industry;
additional Federal Deposit Insurance Corporation (“FDIC”) assessments; and
possible legislative, tax or regulatory changes.
Other possible events or factors that could cause results or performance to differ materially from those expressed in these forward-looking statements include the following: negative economic conditions that adversely affect the general economy, housing prices, the job market, consumer confidence and spending habits which may affect, among other things, the level of non-performing assets, charge-offs and provision expense; changes in interest rates and market liquidity which may reduce interest margins, impact funding sources and affect our ability to originate and distribute financial products in the primary and secondary markets; adverse movements and volatility in debt and equity capital markets; changes in market rates and prices which may adversely impact the value of financial assets and liabilities; liabilities resulting from litigation and regulatory investigations; changes in accounting standards, rules and interpretations; increased competition; our ability to grow our core businesses; decisions to downsize, sell or close units or otherwise change our business mix; and management’s ability to identify and manage these and other risks. Moreover, the outcome of legal proceedings, as discussed in “Part II, Item I. Legal Proceedings,” is inherently uncertain and depends on judicial interpretations of law and the findings of regulators, judges and juries. Investors should refer to the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2010 as well as “Part II, Item 1A” of this Form 10-Q for a discussion of such factors and certain risks and uncertainties to which the Corporation is subject.
All forward-looking statements included in this document are based upon information available to the Corporation as of the date of this document, and other than as required by law, including the requirements of applicable securities laws, we assume no obligation to update or revise any such 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
CONSOLIDATED STATEMENTS OF CONDITION (UNAUDITED)
(In thousands, except share information)
Assets
Cash and due from banks
Money market investments:
Federal funds sold
Securities purchased under agreements to resell
Time deposits with other banks
Total money market investments
Trading account securities, at fair value:
Pledged securities with creditors’ right to repledge
Other trading securities
Investment securities available-for-sale, at fair value:
Other investment securities available-for-sale
Investment securities held-to-maturity, at amortized cost (fair value at June 30, 2011 - $136,959; December 31, 2010 - $120,873; June 30, 2010 - $209,207)
Other investment securities, at lower of cost or realizable value (realizable value at June 30, 2011 - $176,114; December 31, 2010 - $165,233; June 30, 2010 - $153,845)
Loans held-for-sale, at lower of cost or fair value
Loans held-in-portfolio:
Loans not covered under loss sharing agreements with the FDIC
Loans covered under loss sharing agreements with the FDIC
Less – Unearned income
Allowance for loan losses
Total loans held-in-portfolio, net
FDIC loss share asset
Premises and equipment, net
Other real estate not covered under loss sharing agreements with the FDIC
Other real estate covered under loss sharing agreements with the FDIC
Accrued income receivable
Mortgage servicing assets, at fair value
Other assets
Goodwill
Other intangible assets
Total assets
Liabilities and Stockholders’ Equity
Liabilities:
Deposits:
Non-interest bearing
Interest bearing
Total deposits
Federal funds purchased and assets sold under agreements to repurchase
Other short-term borrowings
Notes payable
Other liabilities
Total liabilities
Commitments and contingencies (See note 20)
Stockholders’ equity:
Preferred stock, 30,000,000 shares authorized; 2,006,391 shares issued and outstanding in all periods presented (aggregated liquidation preference value of $50,160)
Common stock, $0.01 par value; 1,700,000,000 shares authorized in all periods presented; 1,024,201,427 shares issued at June 30, 2011
(December 31, 2010 – 1,022,929,158; June 30, 2010 – 1,022,878,228) and 1,023,977,895 outstanding at June 30, 2011 (December 31, 2010 – 1,022,727,802; June 30, 2010 – 1,022,695,797)
Surplus
Accumulated deficit
Treasury stock – at cost, 223,532 shares at June 30, 2011 (December 31, 2010 – 201,356 shares; June 30, 2010 – 182,431 shares)
Accumulated other comprehensive (loss) income, net of tax of ($51,544) (December 31, 2010 – ($55,616); June 30, 2010 – ($17,744))
Total stockholders’ equity
Total liabilities and stockholders’ equity
The accompanying notes are an integral part of these consolidated financial statements.
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CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(In thousands, except per share information)
Interest income:
Loans
Money market investments
Investment securities
Trading account securities
Total interest income
Interest expense:
Deposits
Short-term borrowings
Long-term debt
Total interest expense
Net interest income
Provision for loan losses
Net interest income after provision for loan losses
Service charges on deposit accounts
Other service fees
Net (loss) gain on sale and valuation adjustments of investment securities
Trading account profit
Net (loss) gain on sale of loans, including valuation adjustments on loans held-for-sale
Adjustments (expense) to indemnity reserves on loans sold
FDIC loss share income (expense)
Fair value change in equity appreciation instrument
Other operating income
Total non-interest income
Operating expenses:
Personnel costs
Net occupancy expenses
Equipment expenses
Other taxes
Professional fees
Communications
Business promotion
FDIC deposit insurance
Loss on early extinguishment of debt
Other real estate owned (OREO) expenses
Other operating expenses
Amortization of intangibles
Total operating expenses
Income (loss) before income tax
Income tax (benefit) expense
Net Income (Loss)
Net Income (Loss) Applicable to Common Stock
Net Income (Loss) per Common Share – Basic
Net Income (Loss) per Common Share – Diluted
Dividends Declared per Common Share
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CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
(In thousands)
Balance at December 31, 2009
Net loss
Issuance of stock
Issuance of common stock upon conversion of preferred stock
Issuance costs
Deemed dividend on preferred stock
Common stock purchases
Other comprehensive income, net of tax
Balance at June 30, 2010
Balance at December 31, 2010
Net income
Dividends declared:
Preferred stock
Balance at June 30, 2011
Issuance and subsequent conversion of depositary shares representing interests in shares of contingent convertible non-cumulative preferred stock, Series D, into common stock.
Issuance costs related to issuance and conversion of depository shares (Preferred Stock - Series D).
Disclosure of changes in number of shares:
Preferred Stock:
Balance at beginning of year
Conversion of stock
Balance at end of the period
Common Stock – Issued:
Issuance of stock upon conversion of preferred stock
Treasury stock
Common Stock – Outstanding
Issuance of 46,000,000 in depositary shares; converted into 383,333,333 common shares (full conversion of depositary shares, each representing a 1/40th interest in shares of contingent convertible perpetual non-cumulative preferred stock).
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CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
Net income (loss)
Other comprehensive income before tax:
Foreign currency translation adjustment
Reclassification adjustment for losses included in net income (loss)
Adjustment of pension and postretirement benefit plans
Unrealized holding gains on securities available-for-sale arising during the period
Unrealized net gains (losses) on cash flow hedges
Reclassification adjustment for losses (gains) included in net income (loss)
Other comprehensive income before tax
Income tax expense
Total other comprehensive income, net of tax
Comprehensive income (loss), net of tax
Tax effect allocated to each component of other comprehensive income:
Underfunding of pension and postretirement benefit plans
Unrealized net (gains) losses on cash flow hedges
Disclosure of accumulated other comprehensive income (loss):
Tax effect
Net of tax amount
Unrealized holding gains on securities available-for-sale
Unrealized gains (losses) on cash flow hedges
Accumulated other comprehensive income (loss)
The accompanying notes are an integral part of the consolidated financial statements.
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CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities:
Adjustments to reconcile net income (loss) to net cash (used in) provided by operating activities:
Depreciation and amortization of premises and equipment
Impairment losses on net assets to be disposed of
Fair value adjustments of mortgage servicing rights
Net (accretion of discounts) amortization of premiums and deferred fees
Net loss (gain) on sale and valuation adjustments of investment securities
FDIC loss share (income) expense
FDIC deposit insurance expense
Net gain on disposition of premises and equipment
Net loss (gain) on sale of loans, including valuation adjustments on loans held-for-sale
Losses (earnings) from investments under the equity method
Gain on sale of equity method investment
Net disbursements on loans held-for-sale
Acquisitions of loans held-for-sale
Proceeds from sale of loans held-for-sale
Net decrease in trading securities
Net decrease in accrued income receivable
Net increase in other assets
Net decrease in interest payable
Deferred income taxes
Net (decrease) increase in pension and other postretirement benefit obligation
Net decrease in other liabilities
Total adjustments
Net cash (used in) provided by operating activities
Cash flows from investing activities:
Net increase in money market investments
Purchases of investment securities:
Available-for-sale
Held-to-maturity
Other
Proceeds from calls, paydowns, maturities and redemptions of investment securities:
Proceeds from sale of investment securities available-for-sale
Proceeds from sale of other investment securities
Net repayments on loans
Proceeds from sale of loans
Acquisition of loan portfolios
Cash received from acquisitions
Net proceeds from sale of equity method investments
Mortgage servicing rights purchased
Acquisition of premises and equipment
Proceeds from sale of premises and equipment
Proceeds from sale of foreclosed assets
Net cash (used in) provided by investing activities
Cash flows from financing activities:
Net increase (decrease) in deposits
Net increase (decrease) in federal funds purchased and assets sold under agreements to repurchase
Net decrease in other short-term borrowings
Payments of notes payable
Proceeds from issuance of notes payable
Net proceeds from issuance of depositary shares
Dividends paid
Proceeds from issuance of common stock
Treasury stock acquired
Net cash provided by (used in) financing activities
Net increase in cash and due from banks
Cash and due from banks at beginning of period
Cash and due from banks at end of period
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Notes to Consolidated Financial
Statements (Unaudited)
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Note 1 – Summary of significant accounting policies
Principles of Consolidation and Basis of Presentation
The consolidated financial statements include the accounts of Popular, Inc. and its subsidiaries (the “Corporation”). All significant intercompany accounts and transactions have been eliminated in consolidation. In accordance with the consolidation guidance for variable interest entities, the Corporation would also consolidate any variable interest entities (“VIEs”) for which it has a controlling financial interest and therefore is the primary beneficiary. Assets held in a fiduciary capacity are not assets of the Corporation and, accordingly, are not included in the consolidated statements of condition. The results of operations of companies or assets acquired are included only from the dates of acquisition.
Unconsolidated investments, in which there is at least 20% ownership, are generally accounted for by the equity method. These investments are included in other assets and the Corporation’s proportionate share of income or loss is included in other operating income. Investments, in which there is less than 20% ownership, are generally carried under the cost method of accounting, unless significant influence is exercised. Under the cost method, the Corporation recognizes income when dividends are received. Limited partnerships are accounted for by the equity method unless the Corporation’s interest is so “minor” that it may have virtually no influence over partnership operating and financial policies.
Statutory business trusts that are wholly-owned by the Corporation and are issuers of trust preferred securities are not consolidated in the Corporation’s consolidated financial statements.
The consolidated interim financial statements have been prepared without audit. The consolidated statement of condition data at December 31, 2010 was derived from audited financial statements. The unaudited interim financial statements are, in the opinion of management, a fair statement of the results for the periods reported and include all necessary adjustments, all of a normal recurring nature, for a fair statement of such results.
Certain reclassifications have been made to the 2010 consolidated financial statements and notes to the financial statements to conform with the 2011 presentation.
Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted from the unaudited financial statements pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, these financial statements should be read in conjunction with the audited consolidated financial statements of the Corporation for the year ended December 31, 2010, included in the Corporation’s 2010 Annual Report (the “2010 Annual Report”). Operating results for the interim periods disclosed herein are not necessarily indicative of the results that may be expected for a full year or any future period.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
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Nature of Operations
The Corporation is a diversified, publicly-owned financial holding company subject to the supervision and regulation of the Board of Governors of the Federal Reserve System. The Corporation has operations in Puerto Rico, the continental United States, and the U.S. and British Virgin Islands. In Puerto Rico, the Corporation provides retail and commercial banking services through its principal banking subsidiary, Banco Popular de Puerto Rico (“BPPR”), as well as auto and equipment leasing and financing, mortgage loans, investment banking, broker-dealer and insurance services through specialized subsidiaries. In the United States, the Corporation operates Banco Popular North America (“BPNA”), including its wholly-owned subsidiary E-LOAN. BPNA focuses efforts and resources on the core community banking business. BPNA operates branches in New York, California, Illinois, New Jersey and Florida. E-LOAN markets deposit accounts under its name for the benefit of BPNA. As part of the rebranding of the BPNA franchise, some of its branches operate under a new name, Popular Community Bank. Note 30 to the consolidated financial statements presents information about the Corporation’s business segments. The Corporation has a 49% interest in EVERTEC, which provides transaction processing services throughout the Caribbean and Latin America, including servicing many of Popular’s system infrastructures and transaction processing businesses.
On April 30, 2010, BPPR acquired certain assets and assumed certain deposits and liabilities of Westernbank Puerto Rico (“Westernbank”) from the Federal Deposit Insurance Corporation (the “FDIC”). The transaction is referred to herein as the “Westernbank FDIC-assisted transaction”. Refer to Note 3 to the consolidated financial statements and to the Corporation’s 2010 Annual Report for information on this business combination. Assets subject to loss sharing agreements with the FDIC, including loans and other real estate owned, are labeled “covered” on the consolidated statements of condition and applicable notes to the consolidated financial statements. Loans acquired in the Westernbank FDIC-assisted transaction, except for credit cards, and other real estate owned are considered “covered” because the Corporation will be reimbursed for 80% of any future losses on these assets subject to the terms of the FDIC loss sharing agreements.
Note 2 – New Accounting Pronouncements
FASB Accounting Standards Update 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income (“ASU 2011-05”)
The FASB issued Accounting Standards Update (“ASU”) 2011-05 in June 2011. The amendment of this ASU allows an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. Under either method, the entity is required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statements where the components of net income and the components of other comprehensive income are presented. The amendments to the Codification in the ASU do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. The ASU also do not change the option for an entity to present components of other comprehensive income either net of related tax effects or before related tax effects, with one amount shown for the aggregate income tax expense or benefit related to the total of other comprehensive income items.
The amendments of this guidance are effective for fiscal years, and interim periods within those years, beginning on or after December 15, 2011. ASU 2011-05 should be applied retrospectively. Early adoption is permitted.
The provisions of this guidance impact presentation disclosure only and will not have an impact on the Corporation’s consolidated financial statements.
FASB Accounting Standards Update 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS (“ASU 2011-04”)
The FASB issued ASU 2011-04 in May 2011. The amendment of this ASU provides a consistent definition of fair value between U.S. GAAP and International Financial Reporting Standards (“IFRS”). The ASU modifies some fair value measurement principles and disclosure requirements including the application of the highest and best use and valuation premise concepts, measuring the fair value of an instrument classified in a reporting entity’s shareholders’ equity, measuring the fair value of financial instruments that
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are managed within a portfolio, application of premiums and discounts in a fair value measurement, disclosing quantitative information about unobservable inputs used in Level 3 fair value measurements, and other additional disclosures about fair value measurements.
The new guidance is effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively and early application is not permitted.
The Corporation will be evaluating the potential impact, if any, that the adoption of this guidance will have on its consolidated financial statements.
FASB Accounting Standards Update 2011-03, Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements (“ASU 2011-03”)
The FASB issued ASU 2011-03 in April 2011. The amendment of this ASU affects all entities that enter into agreements to transfer financial assets that both entitle and obligate the transferor to repurchase or redeem the financial assets before their maturity. The ASU modifies the criteria for determining when these transactions would be accounted for as financings (secured borrowings/lending agreements) as opposed to sales (purchases) with commitments to repurchase (resell). This ASU does not affect other transfers of financial assets. ASC Topic 860 prescribes when an entity may or may not recognize a sale upon the transfer of financial assets subject to repo agreements. That determination is based, in part, on whether the entity has maintained effective control over transferred financial assets.
Specifically, the amendments in this ASU remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) eliminates the requirement to demonstrate that the transferor possesses adequate collateral to fund substantially all the cost of purchasing replacement financial assets.
The new guidance is effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early application is not permitted.
FASB Accounting Standards Update 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring (“ASU 2011-02”)
The FASB issued ASU 2011-02 in April 2011. This ASU clarifies which loan modifications constitute troubled debt restructurings. It is intended to assist creditors in determining whether a modification of the terms of a receivable meets the criteria to be considered a troubled debt restructuring, both for purposes of recording an impairment loss and for disclosure of troubled debt restructurings.
The new guidance will require creditors to evaluate modifications and restructurings of receivables using a more principles-based approach. This Update clarifies the existing guidance on whether (1) the creditor has granted a concession and (2) whether the debtor is experiencing financial difficulties. Specifically this Update (1) provides additional guidance on determining whether a creditor has granted a concession, including guidance on collection of all amounts due, receipt of additional collateral or guarantees from the debtor, and restructuring the debt at a below-market rate; (2) includes examples for creditors to determine whether an insignificant delay in payment is considered a concession; (3) prohibits creditors from using the borrower’s effective rate test in ASC Subtopic 470-50 to evaluate whether a concession has been granted to the borrower; (4) adds factors for creditors to use to determine whether the debtor is experiencing financial difficulties; and (5) ends the deferral of the additional disclosures about TDR activities required by ASU 2010-20 and requires public companies to begin providing these disclosures in the period of adoption.
For public companies, the new guidance is effective for interim and annual periods beginning on or after June 15, 2011, and applies retrospectively to restructurings occurring on or after the beginning of the fiscal year of adoption. Early application is permitted. For purposes of measuring impairment for receivables that are newly considered impaired under the new guidance, an entity should apply the amendments prospectively in the first period of adoption and disclose the total amount of receivables and the allowance for credit losses as of the end of the period of adoption.
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The Corporation is evaluating the potential impact, if any, that the adoption of this guidance will have on its consolidated financial statements.
FASB Accounting Standards Update 2010-29, Business Combinations (Topic 805): Disclosure of Supplementary Pro Forma Information for Business Combinations (“ASU 2010-29”)
The FASB issued ASU 2010-29 in December 2010. The amendments in ASU 2010-29 affect any public entity that enters into business combinations that are material on an individual or aggregate basis. This ASU specifies that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. The amendments also expand the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The amendments are effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Early adoption is permitted. This guidance impacts disclosures only and has not had an impact on the Corporation’s consolidated statements of condition or results of operations at June 30, 2011.
FASB Accounting Standards Update 2010-28, Intangibles - Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts (“ASU 2010-28”)
The amendments in ASU 2010-28, issued in December 2010, modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. The qualitative factors are consistent with the existing guidance and examples, which require that goodwill of a reporting unit be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. For public entities, the amendments in this ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. Early adoption is not permitted. The adoption of this guidance has not had an impact on the Corporation’s consolidated statement of condition or results of operations at June 30, 2011.
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Note 3 – Business combination
Westernbank FDIC-assisted transaction
As indicated in Note 1 to these consolidated financial statements, on April 30, 2010, the Corporation’s Puerto Rico banking subsidiary, BPPR, acquired certain assets and assumed certain deposits and liabilities of Westernbank Puerto Rico from the FDIC, as receiver for Westernbank.
The following table presents the fair values of major classes of identifiable assets acquired and liabilities assumed by the Corporation at the acquisition date. The Corporation recorded goodwill of $87 million at acquisition.
Assets:
Cash and money market investments
Investment in Federal Home Loan Bank stock
FDIC loss share indemnification asset
Covered other real estate owned
Core deposit intangible
Receivable from FDIC (associated to the note issued to the FDIC)
Note issued to the FDIC (including a premium of $12,411 resulting from the fair value adjustment)
Equity appreciation instrument
Contingent liability on unfunded loan commitments
Accrued expenses and other liabilities
During the fourth quarter of 2010, retrospective adjustments were made to the estimated fair values of assets acquired and liabilities assumed associated with the Westernbank FDIC-assisted transaction to reflect new information obtained during the measurement period (as defined by ASC Topic 805), about facts and circumstances that existed as of the acquisition date that, if known, would have affected the acquisition-date fair value measurements. The retrospective adjustments were mostly driven by refinements in credit loss assumptions because of new information that became available after the closing of the transaction. The revisions principally resulted in a decrease in the estimated credit losses, thus increasing the fair value of acquired loans and reducing the FDIC loss share indemnification asset.
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The following table presents the principal changes in fair value as previously reported in Form 10-Qs filed during 2010 and the revised amounts recorded during the measurement period with general explanations of the major changes.
Less: Discount
Net loans
Note issued to the FDIC
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The following table depicts the principal changes in the consolidated statement of operations as a result of the recasting for retrospective adjustments for the quarters ended June 30, 2010 and September 30, 2010.
Non-interest income
Operating expenses
(Loss) income before income tax
Net (loss) income
Note 4 – Related party transactions with affiliated company
On September 30, 2010, the Corporation completed the sale of a 51% majority interest in EVERTEC to an unrelated third-party, including the Corporation’s merchant acquiring and processing and technology businesses (the “EVERTEC transaction”), and retained a 49% ownership interest in Carib Holdings (referred to as “EVERTEC”). EVERTEC continues to provide various processing and information technology services to the Corporation and its subsidiaries and gives BPPR access to the ATH network owned and operated by EVERTEC. The investment in EVERTEC was initially recorded at a fair value of $177 million at September 30, 2010, which was determined based on the third-party buyer’s enterprise value of EVERTEC as determined in an orderly transaction between market participants, reduced by the debt incurred, net of debt issue costs, utilized as part of the sale transaction. Prospectively, the investment in EVERTEC is accounted for under the equity method and evaluated for impairment if events or circumstances indicate that a decrease in value of the investment has occurred that is other than temporary. Refer to the Corporation’s 2010 Annual Report for details on this sale to an unrelated third-party.
The Corporation’s investment in EVERTEC, including the impact of intra-entity eliminations, amounted to $210 million at June 30, 2011 (December 31, 2010 - $197 million), and is included as part of “other assets” in the consolidated statements of condition. The increase in the investment balance from December 31, 2010 to June 30, 2011 is due to the recognition of the Corporation’s share of the earnings of EVERTEC, net of intra-entity profits and losses. The Corporation did not receive any distributions from EVERTEC during the period from January 1, 2011 through June 30, 2011.
The Corporation’s proportionate share of income or loss from EVERTEC is included in other operating income in the consolidated statements of operations since October 1, 2010. The Corporation recognized a $12.0 million loss in other operating income for the quarter ended June 30, 2011 as part of its equity method investment in EVERTEC ($14.0 million loss for the six months ended June 30, 2011), which consisted of $0.7 million of the Corporation’s share in EVERTEC’s net income ($12.5 million for the six months ended June 30, 2011), more than offset by $12.7 million of intercompany income eliminations (investor-investee transactions at 49%) ($26.5 million for the six months ended June 30, 2011). The unfavorable impact of the elimination in non-interest income was offset by the elimination of 49% of the professional fees (expense) paid by the Corporation to EVERTEC during the same period.
The following tables present the impact of transactions and service payments between the Corporation and EVERTEC (as an affiliate) and their impact on the results of operations for the quarter and six months ended June 30, 2011. Items that represent expenses to the Corporation are presented with parenthesis. For consolidation purposes, the Corporation eliminates 49% of the
16
income (expense) between EVERTEC and the Corporation from the corresponding categories in the consolidated statements of operations and the net effect of all items at 49% is eliminated against other operating income, which is the category used to record the Corporation’s share of income (loss) as part of its equity method investment in EVERTEC. The 51% majority interest in the table that follows represents the share of transactions with the affiliate that is not eliminated in the consolidation of the Corporation’s results of operations.
Interest income on loan to EVERTEC
Interest income on investment securities issued by EVERTEC
Interest expense on deposits
ATH and credit cards interchange income from services to EVERTEC
Processing fees on services provided by EVERTEC
Rental income charged to EVERTEC
Transition services provided to EVERTEC
The Corporation had the following financial condition accounts outstanding with EVERTEC at June 30, 2011 and December 31, 2010. The 51% majority interest represents the share of transactions with the affiliate that is not eliminated in the consolidation of the Corporation’s statement of condition.
Accounts receivables (Other assets)
Accounts payable (Other liabilities)
Prior to the EVERTEC sale transaction on September 30, 2010, EVERTEC had certain performance bonds outstanding, which were guaranteed by the Corporation under a general indemnity agreement between the Corporation and the insurance companies issuing the bonds. The Corporation agreed to maintain, for a 5-year period following September 30, 2010, the guarantee of the performance bonds. The EVERTEC’s performance bonds guaranteed by the Corporation amounted to approximately $10.4 million at June 30, 2011. Also, EVERTEC had an existing letter of credit issued by BPPR, for an amount of $2.9 million. As part of the merger agreement, the Corporation also agreed to maintain outstanding this letter of credit for a 5-year period. EVERTEC and the Corporation entered into a Reimbursement Agreement, in which EVERTEC will reimburse the Corporation for any losses incurred by the Corporation in connection with the performance bonds and the letter of credit. Possible losses resulting from these agreements are considered insignificant.
Furthermore, under the terms of the sale of EVERTEC, the Corporation was required for a period of twelve months following September 30, 2010 to sell its equity interests in Serfinsa and Consorcio de Tarjetas Dominicanas, S.A (“CONTADO”) to EVERTEC, subject to complying with certain rights of first refusal in favor of the Serfinsa and CONTADO shareholders. During the six months ended June 30, 2011, the Corporation sold its equity interest in CONTADO to CONTADO shareholders and EVERTEC and recognized a gain of $16.7 million, net of tax, upon the sale. The Corporation’s investment in CONTADO, accounted for under the equity method, amounted to $16 million at December 31, 2010. During the quarter ended June 30, 2011, the Corporation sold its equity investment in Serfinsa and recognized a gain of approximately $212 thousand, net of tax. The Corporation’s investment in Serfinsa, accounted for under the equity method, amounted to $1.8 million at December 31, 2010.
17
Note 5 – Restrictions on cash and due from banks and certain securities
The Corporation’s subsidiary banks are required by federal and state regulatory agencies to maintain average reserve balances with the Federal Reserve Bank of New York (the “Fed”) or other banks. Those required average reserve balances were approximately $833 million at June 30, 2011 (December 31, 2010 - $835 million; June 30, 2010 - $788 million). Cash and due from banks, as well as other short-term, highly liquid securities, are used to cover the required average reserve balances.
As required by the Puerto Rico International Banking Center Law, at June 30, 2011, December 31, 2010 and June 30, 2010, the Corporation maintained separately for its two international banking entities (“IBEs”), $0.6 million in time deposits, equally split for the two IBEs, which were considered restricted assets.
At June 30, 2011, the Corporation maintained restricted cash of $2 million to support a letter of credit. The cash is being held in an interest-bearing money market account (December 31, 2010 - $5 million; June 30, 2010 - $6 million).
At June 30, 2011 and December 31, 2010, the Corporation maintained restricted cash of $1 million that represents funds deposited in an escrow account which are guaranteeing possible liens or encumbrances over the title and insured properties (June 30, 2010 - $2 million).
At June 30, 2011, the Corporation maintained restricted cash of $14 million to comply with the requirements of the credit card networks (December 31, 2010 and June 30, 2010 - $12 million).
Note 6 – Pledged assets
Certain securities, loans and other real estate owned were pledged to secure public and trust deposits, assets sold under agreements to repurchase, other borrowings and credit facilities available, derivative positions, loan servicing agreements and the loss sharing agreements with the FDIC. The classification and carrying amount of the Corporation’s pledged assets, in which the secured parties are not permitted to sell or repledge the collateral, were as follows:
Investment securities available-for-sale, at fair value
Investment securities held-to-maturity, at amortized cost
Loans held-for-sale measured at lower of cost or fair value
Loans held-in-portfolio covered under loss sharing agreements with the FDIC
Loans held-in-portfolio not covered under loss sharing agreements with the FDIC
Total pledged assets
Pledged securities and loans that the creditor has the right by custom or contract to repledge are presented separately on the consolidated statements of condition.
At June 30, 2011, investment securities available-for-sale and held-to-maturity totaling $ 1.7 billion, and loans of $ 0.4 billion, served as collateral to secure public funds (December 31, 2010 - $ 1.3 billion and $ 0.5 million, respectively; June 30, 2010 - $ 2.0 billion in investment securities available-for-sale).
At June 30, 2011, the Corporation’s banking subsidiaries had short-term and long-term credit facilities authorized with the FHLB aggregating $1.7 billion (December 31, 2010 - $1.6 billion; June 30, 2010- $1.7 billion). Refer to Note 16 to the consolidated financial statements for borrowings outstanding under these credit facilities. At June 30, 2011, the credit facilities authorized with the
18
FHLB were collateralized by $ 4.9 billion in loans held-in-portfolio (December 31, 2010 - $ 3.8 billion in loans held-in-portfolio; June 30, 2010 - $ 3.0 billion in loans held-in-portfolio and investment securities available-for-sale). Also, BPPR had a borrowing capacity at the Fed discount window of $2.5 billion (December 31, 2010 - $2.7 billion; June 30, 2010 - $2.7 billion), which remained unused as of such date. The amount available under this credit facility is dependent upon the balance of loans and securities pledged as collateral. At June 30, 2011, the credit facilities with the Fed discount window were collateralized by $3.8 billion in loans held-in-portfolio (December 31, 2010- $4.2 billion; June 30, 2010 - $4.4 billion). These pledged assets are included in the above table and were not reclassified and separately reported in the consolidated statement of condition.
Loans held-in-portfolio and other real estate owned that are covered by loss sharing agreements with the FDIC amounting to $ 4.4 billion at June 30, 2011 (December 31, 2010 - $ 4.8 billion; June 30, 2010- $ 4.9 billion), serve as collateral to secure the note issued to the FDIC. Refer to Note 16 to the consolidated financial statements for descriptive information on the note issued to the FDIC.
Note 7 – Investment securities available for sale
The following table presents the amortized cost, gross unrealized gains and losses, approximate fair value, weighted average yield and contractual maturities of investment securities available-for-sale at June 30, 2011, December 31, 2010 and June 30, 2010.
U.S. Treasury securities
After 1 to 5 years
Total U.S. Treasury securities
Obligations of U.S. Government sponsored entities
Within 1 year
After 5 to 10 years
Total obligations of U.S. Government sponsored entities
Obligations of Puerto Rico, States and political subdivisions
After 10 years
Total obligations of Puerto Rico, States and political subdivisions
Collateralized mortgage obligations - federal agencies
Total collateralized mortgage obligations - federal agencies
Collateralized mortgage obligations - private label
Total collateralized mortgage obligations - private label
Mortgage - backed securities
Total mortgage - backed securities
Equity securities (without contractual maturity)
Total other
Total investment securities available-for-sale
19
20
Equity securities
The weighted average yield on investment securities available-for-sale is based on amortized cost; therefore, it does not give effect to changes in fair value.
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 may be called by the issuer.
Proceeds from the sale of investment securities available-for-sale for the six months ended June 30, 2011 amounted to $19.1 million, with realized losses of $90 thousand. This compares with proceeds of $19.5 million for the six months ended June 30, 2010, with no realized gains or losses as the securities were sold at par value.
21
The following tables present the Corporation’s fair value and gross unrealized losses of investment securities available-for-sale, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2011, December 31, 2010 and June 30, 2010.
Mortgage-backed securities
Total investment securities available-for-sale in an unrealized loss position
22
Management evaluates investment securities for other-than-temporary (“OTTI”) declines in fair value on a quarterly basis. Once a decline in value is determined to be other-than-temporary, the value of a debt security is reduced and a corresponding charge to earnings is recognized for anticipated credit losses. Also, for equity securities that are considered other-than-temporarily impaired, the excess of the security’s carrying value over its fair value at the evaluation date is accounted for as a loss in the results of operations. The OTTI analysis requires management to consider various factors, which include, but are not limited to: (1) the length of time and the extent to which fair value has been less than the amortized cost basis, (2) the financial condition of the issuer or issuers, (3) actual collateral attributes, (4) the payment structure of the debt security and the likelihood of the issuer being able to make payments, (5) any rating changes by a rating agency, (6) adverse conditions specifically related to the security, industry, or a geographic area, and (7) management’s intent to sell the debt security or whether it is more likely than not that the Corporation would be required to sell the debt security before a forecasted recovery occurs.
At June 30, 2011, management performed its quarterly analysis of all debt securities in an unrealized loss position. Based on the analyses performed, management concluded that no individual debt security was other-than-temporarily impaired as of such date. At June 30, 2011, the Corporation did not have the intent to sell debt securities in an unrealized loss position and it is not more likely than not that the Corporation will have to sell the investment securities prior to recovery of their amortized cost basis. Also, management evaluated the Corporation’s portfolio of equity securities at June 30, 2011. During the quarter ended June 30, 2011, the Corporation did not record any other-than-temporary impairment losses on equity securities. Management has the intent and ability to hold the investments in equity securities that are at a loss position at June 30, 2011, for a reasonable period of time for a forecasted recovery of fair value up to (or beyond) the cost of these investments.
The unrealized losses associated with “Collateralized mortgage obligations – private label” are primarily related to securities backed by residential mortgages. In addition to verifying the credit ratings for the private-label CMOs, management analyzed the underlying mortgage loan collateral for these bonds. Various statistics or metrics were reviewed for each private-label CMO, including among others, the weighted average loan-to-value, FICO score, and delinquency and foreclosure rates of the underlying assets in the securities. At June 30, 2011, there were no “sub-prime” securities in the Corporation’s private-label CMOs portfolios. For private-label CMOs with unrealized losses at June 30, 2011, credit impairment was assessed using a cash flow model that estimates the cash flows on the underlying mortgages, using the security-specific collateral and transaction structure. The model estimates cash flows from the underlying mortgage loans and distributes those cash flows to various tranches of securities, considering the transaction structure and any subordination and credit enhancements that exist in that structure. The cash flow model incorporates actual cash flows through the current period and then projects the expected cash flows using a number of assumptions, including default rates, loss severity and prepayment rates. Management’s assessment also considered tests using more stressful parameters. Based on the assessments, management concluded that the tranches of the private-label CMOs held by the Corporation were not other-than-temporarily impaired at June 30, 2011, thus management expects to recover the amortized cost basis of the securities.
The following table states the name of issuers, and the aggregate amortized cost and fair value of the securities of such issuer (includes available-for-sale and held-to-maturity securities), in which the aggregate amortized cost of such securities exceeds 10% of stockholders’ equity. This information excludes securities backed by the full faith and credit of the U.S. Government. Investments in obligations issued by a state of the U.S. and its political subdivisions and agencies, which are payable and secured by the same source of revenue or taxing authority, other than the U.S. Government, are considered securities of a single issuer.
FNMA
FHLB
Freddie Mac
23
Note 8 – Investment securities held-to-maturity
The following tables present the amortized cost, gross unrealized gains and losses, approximate fair value, weighted average yield and contractual maturities of investment securities held-to-maturity at June 30, 2011, December 31, 2010 and June 30, 2010.
Total investment securities held-to-maturity
24
Securities not due on a single contractual maturity date, such as collateralized mortgage obligations, are classified in the period of final contractual maturity. The expected maturities of collateralized mortgage obligations and certain other securities may differ from their contractual maturities because they may be subject to prepayments or may be called by the issuer.
The following tables present the Corporation’s fair value and gross unrealized losses of investment securities held-to-maturity, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2011, December 31, 2010 and June 30, 2010:
Total investment securities held-to-maturity in an unrealized loss position
Collateralized mortgage obligations- private label
25
As indicated in Note 7 to these consolidated financial statements, management evaluates investment securities for other-than-temporary (“OTTI”) declines in fair value on a quarterly basis.
The “Obligations of Puerto Rico, States and political subdivisions” classified as held-to-maturity at June 30, 2011 are primarily associated with securities issued by municipalities of Puerto Rico and are generally not rated by a credit rating agency. The Corporation performs periodic credit quality reviews on these issuers. The decline in fair value at June 30, 2011 was attributable to changes in interest rates and not credit quality, thus no other-than-temporary decline in value was necessary to be recorded in these held-to-maturity securities at June 30, 2011. At June 30, 2011, the Corporation does not have the intent to sell securities held-to-maturity and it is not more likely than not that the Corporation will have to sell these investment securities prior to recovery of their amortized cost basis.
Note 9 – Loans
Because of the loss protection provided by the FDIC, the risks of the Westernbank FDIC-assisted transaction acquired loans are significantly different from those loans not covered under the FDIC loss sharing agreements. Accordingly, the Corporation presents loans subject to the loss sharing agreements as “covered loans” in the information below and loans that are not subject to the FDIC loss sharing agreements as “non-covered loans”.
For a summary of the accounting policy related to loans and allowance for loan losses refer to the summary of significant accounting policies included in Note 2 to the consolidated financial statements included in the Corporation’s 2010 Annual Report.
The following tables present the composition of loans held-in-portfolio (“HIP”), net of unearned income at June 30, 2011 and December 31, 2010.
Commercial real estate
Commercial and industrial
Construction
Mortgage
Lease financing
Consumer:
Credit cards
Home equity lines of credit
Personal
Auto
Total loans held-in-portfolio[a]
26
The following table provides a breakdown of loans held-for-sale (“LHFS”) at June 30, 2011 and December 31, 2010 by main categories.
Commercial
Total
Non-covered loans
The following tables present non-covered loans held-in-portfolio that are in non-performing status and accruing loans past due 90 days or more by loan class at June 30, 2011 and December 31, 2010. Accruing loans past due 90 days or more consist primarily of credit cards, FHA / VA and other insured mortgage loans, and delinquent mortgage loans included in the Corporation’s financial statements pursuant to GNMA’s buy-back option program. Servicers of loans underlying GNMA mortgage-backed securities must report as their own assets the defaulted loans that they have the option (but not the obligation) to repurchase, even when they elect not to exercise that option. Also, accruing loans past due 90 days or more include residential conventional loans purchased from other financial institutions that, although delinquent, the Corporation has received timely payment from the sellers / servicers, and, in some instances, have partial guarantees under recourse agreements. However, residential conventional loans purchased from other financial institutions, which are in the process of foreclosure, are classified as non-performing mortgage loans.
27
At June 30, 2011
Leasing
Total[a]
At December 31, 2010
At June 30, 2011 non-covered loans held-in-portfolio on which the accrual of interest income had been discontinued amounted to $1.7 billion (December 31, 2010—$1.6 billion). Non-accruing loans at June 30, 2011 include $49 million in consumer loans (December 31, 2010—$60 million).
28
The following tables present loans by past due status at June 30, 2011 and December 31, 2010 for non-covered loans held-in-portfolio (net of unearned income).
June 30, 2011
Puerto Rico
U.S. Mainland
29
Popular, Inc.
December 31, 2010
30
Covered loans
Covered loans acquired in the Westernbank FDIC-assisted transaction, except for lines of credit with revolving privileges, are accounted for by the Corporation in accordance with ASC Subtopic 310-30. Under ASC Subtopic 310-30, the acquired loans were aggregated into pools based on similar characteristics. Each loan pool is accounted for as a single asset with a single composite interest rate and an aggregate expectation of cash flows. The covered loans which are accounted for under ASC Subtopic 310-30 by the Corporation are not considered non-performing and will continue to have an accretable yield as long as there is a reasonable expectation about the timing and amount of cash flows expected to be collected. The Corporation measures additional losses for this portfolio when it is probable the Corporation will be unable to collect all cash flows expected at acquisition plus additional cash flows expected to be collected arising from changes in estimates after acquisition. Lines of credit with revolving privileges that were acquired as part of the Westernbank FDIC-assisted transaction are accounted under the guidance of ASC Subtopic 310-20, which requires that any differences between the contractually required loan payment receivable in excess of the Corporation’s initial investment in the loans be accreted into interest income. Loans accounted for under ASC Subtopic 310-20 are placed on non-accrual status when past due in accordance with the Corporation’s non-accruing policy and any accretion of discount is discontinued.
31
The following table presents covered loans in non-performing status and accruing loans past-due 90 days or more by loan class at June 30, 2011 and December 31, 2010.
Consumer
The following tables present loans by past due status at June 30, 2011 and December 31, 2010 for covered loans held-in-portfolio. The information considers covered loans accounted for under ASC Subtopic 310-20 and ASC Subtopic 310-30.
Covered Loans
Total covered loans
Acquired loans in an FDIC-assisted transaction
The following table presents loans acquired as part of the Westernbank FDIC-assisted transaction accounted for pursuant to ASC Subtopic 310-30 at the April 30, 2010 acquisition date. The information presented includes loans determined to be impaired at the time of acquisition (“credit impaired loans”), and loans that were considered to be performing at the acquisition date and are accounted for by analogy to ASC Subtopic 310-30 (“non-credit impaired loans”). Refer to Note 1 to the consolidated financial
32
statements and the Critical Accounting Policies / Estimated section of the 2010 Annual Report for a description of the Corporation’s significant accounting policies related to acquired loans and criteria considered by management to apply ASC 310-30 by analogy to non-credit impaired loans.
Contractually-required principal and interest
Non-accretable difference
Cash flows expected to be collected
Accretable yield
Fair value of loans accounted for under
ASC Subtopic 310-30
The cash flows expected to be collected consider the estimated remaining life of the underlying loans and include the effects of estimated prepayments. The unpaid principal balance of the acquired loans from the Westernbank FDIC-assisted transaction that are accounted under ASC Subtopic 310-30 amounted to $8.1 billion at the April 30, 2010 transaction date.
The carrying amount of the loans acquired as part of the Westernbank FDIC-assisted transaction at June 30, 2011 and December 31, 2010 consisted of loans determined to be impaired at the time of acquisition, which are accounted for in accordance with ASC Subtopic 310-30 (“credit impaired loans”), and loans that were considered to be performing at the acquisition date, accounted for by analogy to ASC Subtopic 310-30 (“non-credit impaired loans”), as detailed in the following tables.
Carrying amount
Less: Allowance for loan losses
Carrying amount, net of allowance
The outstanding principal balance of covered loans accounted pursuant to ASC Subtopic 310-30, including amounts charged off by the Corporation, amounted to $6.8 billion at June 30, 2011 (December 31, 2010 - $7.7 billion). At June 30, 2011, none of the acquired loans from the Westernbank FDIC-assisted transaction accounted for under ASC Subtopic 310-30 were considered non-performing loans. Therefore, interest income, through accretion of the difference between the carrying amount of the loans and the expected cash flows, was recognized on all acquired loans.
33
Changes in the carrying amount and the accretable yield for the acquired loans in the Westernbank FDIC-assisted transaction at and for the year ended December 31, 2010 and at and for the six months ended June 30, 2011, and which are accounted pursuant to the ASC Subtopic 310-30, were as follows:
Balance at January 1, 2010
Additions[1]
Accretion
Collections
Decrease in cash flow estimates
Reclassifications from nonaccretable balance
Balance at June 30, 2011, net of allowance for loan losses
During the quarter and six months ended June 30, 2011, the Corporation recorded an allowance for loan losses related to the acquired covered loans that are accounted for under ASC Subtopic 310-30 as certain pools reflected lower expected cash flows. The following table provides the activity in the allowance for loan losses related to these acquired loans for the quarter and six months ended June 30, 2011.
Balance at beginning of period
Charge-offs
Balance at end of period
There was no need to record an allowance for loan losses related to the covered loans at December 31, 2010 and June 30, 2010.
The Corporation accounts for lines of credit with revolving privileges under the accounting guidance of ASC Subtopic 310-20, which requires that any differences between the contractually required loan payment receivable in excess of the initial investment in the loans be accreted into interest income over the life of the loan, if the loan is accruing interest. The following table presents acquired loans accounted for under ASC Subtopic 310-20 at the April 30, 2010 acquisition date (as recasted):
Fair value of loans accounted under ASC Subtopic 310-20
Gross contractual amounts receivable (principal and interest)
Estimate of contractual cash flows not expected to be collected
The cash flows expected to be collected consider the estimated remaining life of the underlying loans and include the effects of estimated prepayments.
34
Covered loans accounted for under ASC Subtopic 310-20 amounted to $0.4 billion at June 30, 2011 (December 31, 2010 and June 30, 2010 - $0.3 billion).
Note 10 – Allowance for loan losses
The following tables present the changes in the allowance for loan losses for the quarters and six months ended June 30, 2011 and 2010.
Recoveries
Recoveries related to loans transferred to loans held-for-sale
The Corporation’s allowance for loan losses at June 30, 2011 includes $57 million related to the covered loan portfolio acquired in the Westernbank FDIC-assisted transaction. This allowance covers the estimated credit loss exposure related to: (i) acquired loans accounted for under ASC Subtopic 310-30, which required an allowance for loan losses of $48 million at quarter end, as nine pools reflected a higher than expected credit deterioration; and (ii) acquired loans accounted for under ASC Subtopic 310-20, which required an allowance for loan losses of $9 million. Decreases in expected cash flows after the acquisition date for loans (pools) accounted for under ASC Subtopic 310-30 are recognized by recording an allowance for loan losses in the current period. For purposes of loans accounted for under ASC 310-20 and new loans originated as a result of loan commitments assumed, the Corporation’s assessment of the allowance for loan losses is determined in accordance with the accounting guidance of loss contingencies in ASC Subtopic 450-20 (general reserve for inherent losses) and loan impairment guidance in ASC Section 310-10-35 for individually impaired loans. Concurrently, the Corporation recorded an increase in the FDIC loss share asset for the expected reimbursement from the FDIC under the loss sharing agreements.
35
The following tables present the changes in the allowance for loan losses and the loan balance by portfolio segments for the quarter and six months ended June 30, 2011.
For the quarter ended June 30, 2011
Allowance for credit losses:
Beginning balance
Provision
Ending balance
Ending balance: non-covered loans individually evaluated for impairment
Ending balance: non-covered loans collectively evaluated for impairment
Ending balance: covered loans individually evaluated for impairment accounted for under ASC 310-20
Ending balance: covered loans collectively evaluated for impairment accounted for under ASC 310-30 and ASC 310-20
Ending balance - Total
36
37
38
For the six months ended June 30, 2011
39
Recoveries related to loans transferred to LHFS
40
Impaired loans
Disclosures related to loans that were considered impaired based on ASC Section 310-10-35 are included in the table below.
Impaired loans with related allowance
Impaired loans that do not require an allowance
Total impaired loans
Allowance for impaired loans
Average balance of impaired loans during the quarter
Interest income recognized on impaired loans during the quarter
Average balance of impaired loans during the six months ended June 30,
Interest income recognized on impaired loans during the six months ended June 30,
41
The following tables present commercial, construction, mortgage and covered loans individually evaluated for impairment at June 30, 2011 and December 31, 2010.
Total Puerto Rico
Total U.S. Mainland
Total Popular, Inc.
42
There were no mortgage loans individually evaluated for impairment in the U.S. Mainland portfolio at December 31, 2010.
43
The following table presents the average recorded investment and interest income recognized on impaired loans for the quarter and six months ended June 30, 2011.
Troubled debt restructurings related to non-covered loans portfolio amounted to $673 million at June 30, 2011 (December 31, 2010 - $561 million). The amount of outstanding commitments to lend additional funds to debtors owing receivables whose terms have been modified in troubled debt restructurings amounted to $486 thousand related to the construction loan portfolio and $1 million related to the commercial loan portfolio at June 30, 2011 (December 31, 2010 - $3 million and $1 million, respectively).
Credit Quality
The Corporation has defined a dual risk rating system to assign a rating to all credit exposures, particularly for the commercial and construction loan portfolios. Risk ratings in the aggregate provide the Corporation’s management the asset quality profile for the loan portfolio. The dual risk rating system provides for the assignment of ratings at the obligor level based on the financial condition of the borrower, and at the credit facility level based on the collateral supporting the transaction. The Corporation’s consumer and mortgage loans are not subject to the dual risk rating system. Consumer and mortgage loans are classified substandard or loss based on their delinquency status. All other consumer and mortgage loans that are not classified as substandard or loss would be considered “unrated”.
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The Corporation’s obligor risk rating scales range from rating 1 (Excellent) to rating 14 (Loss). The obligor risk rating reflects the risk of payment default of a borrower in the ordinary course of business.
Pass Credit Classifications:
Pass (Scales 1 through 8) - Loans classified as pass have a well defined primary source of repayment very likely to be sufficient, with no apparent risk, strong financial position, minimal operating risk, profitability, liquidity and capitalization better than industry standards.
Watch (Scale 9) - Loans classified as watch have acceptable business credit, but borrowers operations, cash flow or financial condition evidence more than average risk, requires above average levels of supervision and attention from Loan Officers.
Special Mention (Scale 10) - Loans classified as special mention have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Corporation’s credit position at some future date.
Adversely Classified Classifications:
Substandard (Scales 11 and 12) - Loans classified as substandard are deemed to be inadequately protected by the current net worth and payment capacity of the obligor or of the collateral pledged, if any. Loans classified as such have well-defined weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Doubtful (Scale 13) - Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the additional characteristic that the weaknesses make the collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Loss (Scale 14) - Uncollectible and of such little value that continuance as a bankable asset is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this asset even though partial recovery may be affected in the future.
Risk ratings scales 10 through 14 conform to regulatory ratings. The assignment of the obligor risk rating is based on relevant information about the ability of borrowers to service their debts such as current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors.
The Corporation periodically reviews loans classified as watch list or worse, to evaluate if they are properly classified, and to determine impairment, if any. The frequency of these reviews will depend on the amount of the aggregate outstanding debt, and the risk rating classification of the obligor. In addition, during the renewal process of applicable credit facilities, the Corporation evaluates the corresponding loan grades.
Loans classified as pass credits are excluded from the scope of the review process described above until: (a) they become past due; (b) management becomes aware of deterioration in the credit worthiness of the borrower; or (c) the customer contacts the Corporation for a modification. In these circumstances, the credit facilities are specifically evaluated to assign the appropriate risk rating classification.
45
The following table presents the outstanding balance, net of unearned, of non-covered loans held-in-portfolio based on the Corporation’s assignment of obligor risk ratings as defined at June 30, 2011 and December 31, 2010.
Puerto Rico[1]
Total Commercial
The following table presents the weighted average obligor risk rating for those classifications that consider a range of rating scales.
Puerto Rico:[1]
U.S. Mainland:
46
United States:
47
Note 11 – FDIC loss share asset
In connection with the Westernbank FDIC-assisted transaction, BPPR entered into loss sharing agreements with the FDIC with respect to the covered loans and other real estate owned. Pursuant to the terms of the loss sharing agreements, the FDIC’s obligation to reimburse BPPR for losses with respect to covered assets begins with the first dollar of loss incurred. The FDIC will reimburse BPPR for 80% of losses with respect to covered assets, and BPPR will reimburse the FDIC for 80% of recoveries with respect to losses for which the FDIC paid BPPR 80% reimbursement under the loss sharing agreements. The loss sharing agreement applicable to single-family residential mortgage loans provides for FDIC loss and recoveries sharing for ten years. The loss sharing agreement applicable to commercial and consumer loans provides for FDIC loss sharing for five years and BPPR reimbursement to the FDIC for eight years, in each case, on the same terms and conditions as described above.
In addition, as disclosed in the 2010 Annual Report, BPPR has agreed to make a true-up payment to the FDIC on the date that is 45 days following the last day (the “True-Up Measurement Date”) of the final shared-loss month, or upon the final disposition of all covered assets under the loss sharing agreements in the event losses on the loss sharing agreements fail to reach expected levels. The estimated true-up payment is recorded as a reduction of the FDIC loss share asset. As of June 30, 2011, the carrying amount (discounted value) of the true-up provision was estimated at approximately $95 million (December 31, 2010 - $92 million; June 30, 2010 - $89 million).
The following table sets forth the activity in the FDIC loss share asset for the periods presented.
FDIC loss share indemnification asset recorded at business combination
Accretion of loss share indemnification asset, net
Credit impairment losses to be covered under loss sharing agreements
Decrease due to reciprocal accounting on the discount accretion for loans and unfunded commitments accounted for under ASC Subtopic 310-20
Credit impairment losses reclassified to claims receivables, net of recoveries
Other net benefits attributable to FDIC loss sharing agreements
Claims receivables filed with FDIC and outstanding [1]
Balance at June 30
The loss share agreements contain specific terms and conditions regarding the management of the covered assets that BPPR must follow to receive reimbursement on losses from the FDIC. Under the loss share agreements, BPPR must:
manage and administer the covered assets and collect and effect charge-offs and recoveries with respect to such covered assets in a manner consistent with its usual and prudent business and banking practices and, with respect to single family shared-loss loans, the procedures (including collection procedures) customarily employed by BPPR in servicing and administering mortgage loans for its own account and the servicing procedures established by FNMA or FHLMC, as in effect from time to time, and in accordance with accepted mortgage servicing practices of prudent lending institutions;
exercise its best judgment in managing, administering and collecting amounts on covered assets and effecting charge-offs with respect to the covered assets;
use commercially reasonable efforts to maximize recoveries with respect to losses on single family shared-loss assets and best efforts to maximize collections with respect to commercial shared-loss assets;
retain sufficient staff to perform the duties under the loss share agreements;
adopt and implement accounting, reporting, record-keeping and similar systems with respect to the commercial shared-loss assets;
comply with the terms of the modification guidelines approved by the FDIC with or another federal agency for any single-family shared loss loan;
provide notice with respect to proposed transactions pursuant to which a third party or affiliate will manage, administer or collect any commercial shared-loss assets; and
file monthly and quarterly certificates with the FDIC specifying the amount of losses, charge-offs and recoveries.
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Under the loss share agreements, BPPR is also required to maintain books and records sufficient to ensure and document compliance with the terms of the loss share agreements.
Note 12 – Transfers of financial assets and mortgage servicing assets
The Corporation typically transfers conforming residential mortgage loans in conjunction with GNMA and FNMA securitization transactions whereby the loans are exchanged for cash or securities and servicing rights. The securities issued through these transactions are guaranteed by the corresponding agency and, as such, under seller/service agreements the Corporation is required to service the loans in accordance with the agencies’ servicing guidelines and standards. Substantially, all mortgage loans securitized by the Corporation in GNMA and FNMA securities have fixed rates and represent conforming loans. As seller, the Corporation has made certain representations and warranties with respect to the originally transferred loans and, in some instances, has sold loans with credit recourse to a government-sponsored entity, namely FNMA. Refer to Note 19 to the consolidated financial statements for a description of such arrangements.
During the quarter ended June 30, 2011, the Corporation obtained as proceeds $270 million of assets as result of securitization transactions with FNMA and GNMA, consisting of $265 million in mortgage-backed securities and $5 million in servicing rights. During the six months ended June 30, 2011, the Corporation obtained as proceeds $ 605 million of assets as result of securitization transactions with FNMA and GNMA, consisting of $ 594 million in mortgage-backed securities and $ 11 million in servicing rights. During the quarter ended June 30, 2010, the Corporation obtained as proceeds $ 210 million of assets as result of securitization transactions with FNMA and GNMA, consisting of $ 206 million in mortgage-backed securities and $ 4 million in servicing rights. During the six months ended June 30, 2010, the Corporation obtained as proceeds $ 419 million of assets as result of securitization transactions with FNMA and GNMA, consisting of $ 411 million in mortgage-backed securities and $ 8 million in servicing rights. No liabilities were incurred as a result of these transfers during the quarters and six months ended June 30, 2011 and 2010 because they did not contain any credit recourse arrangements. The Corporation recorded a net gain $4.1 million and $5.0 million, respectively, during the quarters ended June 30, 2011 and 2010 related to these residential mortgage loans securitized. The Corporation recorded a net gain $10.4 million and $10.3 million, respectively, during the six months ended June 30, 2011 and 2010 related to these residential mortgage loans securitized.
The following tables present the initial fair value of the assets obtained as proceeds from residential mortgage loans securitized during the quarters and six months ended June 30, 2011 and 2010:
Trading account securities:
Mortgage-backed securities - GNMA
Mortgage-backed securities - FNMA
Total trading account securities
Mortgage servicing rights
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Investments securities available for sale:
During the six months ended June 30, 2011, the Corporation retained servicing rights on whole loan sales involving approximately $53 million in principal balance outstanding (June 30, 2010 - $41 million), with realized gains of approximately $1.1 million (June 30, 2010 - gains of $0.8 million). All loan sales performed during the six months ended June 30, 2011 were without credit recourse agreements.
The Corporation recognizes as assets the rights to service loans for others, whether these rights are purchased or result from asset transfers such as sales and securitizations.
Classes of mortgage servicing rights were determined based on the different markets or types of assets being serviced. The Corporation recognizes the servicing rights of its banking subsidiaries that are related to residential mortgage loans as a class of servicing rights. These mortgage servicing rights (“MSRs”) are measured at fair value. Fair value determination is performed on a subsidiary basis, with assumptions varying in accordance with the types of assets or markets served.
The Corporation uses a discounted cash flow model to estimate the fair value of MSRs. The discounted cash flow model incorporates assumptions that market participants would use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, cost to service, escrow account earnings, contractual servicing fee income, prepayment and late fees, among other considerations. Prepayment speeds are adjusted for the Corporation’s loan characteristics and portfolio behavior.
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The following table presents the changes in MSRs measured using the fair value method for the six months ended June 30, 2011 and 2010.
Residential MSRs
Fair value at beginning of period
Purchases
Servicing from securitizations or asset transfers
Changes due to payments on loans [1]
Changes in fair value due to changes in valuation model inputs or assumptions
Other disposals
Fair value at end of period
Residential mortgage loans serviced for others were $17.4 billion at June 30, 2011 (December 31, 2010 - $18.4 billion; June 30, 2010 - $17.9 billion).
Net mortgage servicing fees, a component of other service fees in the consolidated statements of operations, include the changes from period to period in the fair value of the MSRs, which may result from changes in the valuation model inputs or assumptions (principally reflecting changes in discount rates and prepayment speed assumptions) and other changes, including changes due to collection / realization of expected cash flows. Mortgage servicing fees, excluding fair value adjustments, for the quarter and six months ended June 30, 2011 amounted to $12.4 million and $24.8 million, respectively (June 30, 2010 - $11.9 million and $23.8 million, respectively). The banking subsidiaries receive servicing fees based on a percentage of the outstanding loan balance. At June 30, 2011, those weighted average mortgage servicing fees were 0.26% (June 30, 2010 – 0.27%). Under these servicing agreements, the banking subsidiaries do not generally earn significant prepayment penalty fees on the underlying loans serviced.
The section below includes information on assumptions used in the valuation model of the MSRs, originated and purchased.
Key economic assumptions used in measuring the servicing rights retained at the date of the residential mortgage loan securitizations and whole loan sales by the banking subsidiaries during the quarter ended June 30, 2011 and the year ended December 31, 2010 were as follows:
Prepayment speed
Weighted average life
Discount rate (annual rate)
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Key economic assumptions used to estimate the fair value of MSRs derived from sales and securitizations of mortgage loans performed by the banking subsidiaries and the sensitivity to immediate changes in those assumptions at June 30, 2011 and December 31, 2010 were as follows:
Originated MSRs
Fair value of retained interests
Weighted average prepayment speed (annual rate)
Impact on fair value of 10% adverse change
Impact on fair value of 20% adverse change
Weighted average discount rate (annual rate)
The banking subsidiaries also own servicing rights purchased from other financial institutions. The fair value of purchased MSRs, their related valuation assumptions and the sensitivity to immediate changes in those assumptions at June 30, 2011 and December 31, 2010 were as follows:
Purchased MSRs
The sensitivity analyses presented in the tables above for servicing rights are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10 and 20 percent variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in the sensitivity tables included herein, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without changing any other assumption. In reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments and increased credit losses), which might magnify or counteract the sensitivities.
At June 30, 2011 the Corporation serviced $3.7 billion (December 31, 2010 - $4.0 billion; June 30, 2010 - $4.2 billion) in residential mortgage loans with credit recourse to the Corporation.
Under the GNMA securitizations, the Corporation, as servicer, has the right to repurchase (but not the obligation), at its option and without GNMA’s prior authorization, any loan that is collateral for a GNMA guaranteed mortgage-backed security when certain delinquency criteria are met. At the time that individual loans meet GNMA’s specified delinquency criteria and are eligible for repurchase, the Corporation is deemed to have regained effective control over these loans if the Corporation was the pool issuer. At June 30, 2011 the Corporation had recorded $156 million in mortgage loans on its financial statements related to this buy-back option program (December 31, 2010 - $168 million; June 30, 2010 - $141 million). During the six months ended June 30, 2011 and 2010, the Corporation did not exercise its option to repurchase delinquency loans that meet the criteria indicated above. As long as the Corporation continues to service the loans that continue to be collateral in a GNMA guaranteed mortgage-backed security, the MSR is recognized by the Corporation.
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Note 13 - Other assets
The caption of other assets in the consolidated statements of condition consists of the following major categories:
Net deferred tax assets (net of valuation allowance)
Investments under the equity method
Bank-owned life insurance program
Prepaid FDIC insurance assessment
Other prepaid expenses
Derivative assets
Trade receivables from brokers and counterparties
Others
Total other assets
Note 14 – Goodwill and other intangible assets
The changes in the carrying amount of goodwill for the six months ended June 30, 2011 and 2010, allocated by reportable segments and corporate group, were as follows (refer to Note 30 for the definition of the Corporation’s reportable segments):
2011
Banco Popular de Puerto Rico
Banco Popular North America
2010
Corporate
Purchase accounting adjustments consists of adjustments to the value of the assets acquired and liabilities assumed resulting from the completion of appraisals or other valuations, adjustments to initial estimates recorded for transaction costs, if any, and contingent consideration paid during a contractual contingency period.
The goodwill recognized in the BPPR reportable segment during the 2010 relates to the Westernbank FDIC-assisted transaction.
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The following table presents the gross amount of goodwill and accumulated impairment losses by reportable segments and Corporate group.
At June 30, 2011, December 31, 2010 and June 30, 2010, the Corporation had $6 million of identifiable intangible assets, with indefinite useful lives, mostly associated with E-LOAN’s trademark.
The following table reflects the components of other intangible assets subject to amortization:
Core deposits
Other customer relationships
Other intangibles
During the quarter ended June 30, 2011, the Corporation recognized $2.2 million in amortization expense related to other intangible assets with definite useful lives (June 30, 2010 - $2.5 million). During the six months ended June 30, 2011 and June 30, 2010, the Corporation recognized $4.5 million in amortization related to other intangible assets within definite useful lives.
The following table presents the estimated amortization of the intangible assets with definite useful lives for each of the following periods:
Remaining 2011
Year 2012
Year 2013
Year 2014
Year 2015
Year 2016
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Note 15 – Deposits
Total interest bearing deposits consisted of:
Savings accounts
NOW, money market and other interest bearing demand deposits
Total savings, NOW, money market and other interest bearing demand deposits
Certificates of deposit:
Under $100,000
$100,000 and over
Total certificates of deposit
Total interest bearing deposits
A summary of certificates of deposit by maturity at June 30, 2011, follows:
2012
2013
2014
2015
2016 and thereafter
At June 30, 2011, the Corporation had brokered certificates of deposit amounting to $2.7 billion (December 31, 2010 - $2.3 billion; June 30, 2010 - $2.0 billion).
The aggregate amount of overdrafts in demand deposit accounts that were reclassified to loans was $25 million at June 30, 2011 (December 31, 2010 - $52 million; June 30, 2010 - $34 million).
Note 16 – Borrowings
The composition of federal funds purchased and assets sold under agreements to repurchase were as follows:
Federal funds purchased
Assets sold under agreements to repurchase
Total federal funds purchased and assets sold under agreements to repurchase
The repurchase agreements outstanding at June 30, 2011 were collateralized by $ 1.9 billion in investment securities available-for-sale, $ 735 million in trading securities and $ 37 million in other assets. At December 31, 2010 and June 30, 2010, the repurchase agreements were collateralized by investment securities available-for-sale and trading securities of $ 2.1 billion and $ 492 million; and $ 2.0 billion and $ 372 million; respectively. It is the Corporation’s policy to maintain effective control over assets sold under agreements to repurchase; accordingly, such securities continue to be carried on the consolidated statements of condition.
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In addition, there were repurchase agreements outstanding collateralized by $ 264 million in securities purchased underlying agreements to resell to which the Corporation has the right to repledge (December 31, 2010 - $ 172 million; June 30, 2010 - $ 177 million). It is the Corporation’s policy to take possession of securities purchased under agreements to resell. However, the counterparties to such agreements maintain effective control over such securities, and accordingly are not reflected in the Corporation’s consolidated statements of condition.
Other short-term borrowings consisted of:
Advances with the FHLB paying interest at maturity, at fixed rates of 0.35%
Term funds purchased paying interest at maturity, at fixed rates of 0.65%
Securities sold not yet purchased
Total other short-term borrowings
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Notes payable consisted of:
Advances with the FHLB:
-with maturities ranging from 2011 through 2021 paying interest at monthly fixed rates ranging from 0.66% to 4.95% (June 30, 2010 - 1.48% to 5.10%)
-maturing in 2010 paying interest quarterly at a fixed rate of 5.10%
Note issued to the FDIC, including unamortized premium of $1,202; paying interest monthly at an annual fixed rate of 2.50%; maturing on April 30, 2015 or such earlier date as such amount may become due and payable pursuant to the terms of the note
Term notes with maturities ranging from 2012 to 2016 paying interest semiannually at fixed rates ranging from 5.25% to 7.86% (June 30, 2010 - 5.25% to 13.00%)
Term notes with maturities ranging from 2011 to 2013 paying interest monthly at a floating rate of 3.00% over the 10-year U.S. Treasury note rate
Term notes maturing in 2011 paying interest quarterly at a floating rate of 9.75% over the 3-month LIBOR rate
Junior subordinated deferrable interest debentures (related to trust preferred securities) with maturities ranging from 2027 to 2034 with fixed interest rates ranging from 6.125% to 8.327% (Refer to Note 17)
Junior subordinated deferrable interest debentures (related to trust preferred securities) ($936,000 less discount of $478,995 as of June 30, 2011 and $502,113 at June 30, 2010) with no stated maturity and a fixed interest rate of 5.00% until, but excluding December 5, 2013 and 9.00% thereafter (Refer to Note 17)
Total notes payable
Note: Refer to the Corporation’s 2010 Annual Report, for rates and maturity information corresponding to the borrowings outstanding at December 31, 2010. Key index rates as of June 30, 2011 and June 30, 2010, respectively, were as follows: 3-month LIBOR rate = 0.25% and 0.53%; 10-year U.S. Treasury note = 3.16% and 2.93%.
On June 30, 2011, Popular North America, Inc. (“PNA”), the parent bank holding company of all of the Corporation’s U.S. mainland operations, modified $233.2 million in aggregate principal amount of the $275 million 6.85% Senior Notes due 2012, fully and unconditionally guaranteed by the Corporation, issued by PNA on December 21, 2007 for (1) $78.0 million aggregate principal amount of 7.47% Senior Notes due 2014, (2) $35.2 million aggregate principal amount of 7.66% Senior Notes due 2015 and (3) $120.0 million aggregate principal amount of 7.86% Senior Notes due 2016 issued by PNA, also fully and unconditionally guaranteed by the Corporation.
In consideration for the excess assets acquired over liabilities assumed as part of the Westernbank FDIC-assisted transaction, BPPR issued to the FDIC a secured note (the “note issued to the FDIC”) in the amount of $5.8 billion at April 30, 2010, which has full recourse to BPPR. As indicated in Note 6 to the consolidated financial statements, the note issued to the FDIC is collateralized by the loans (other than certain consumer loans) and other real estate acquired in the agreement with the FDIC and all proceeds
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derived from such assets, including cash inflows from claims to the FDIC under the loss sharing agreements. Proceeds received from such sources are used to pay the note under the conditions stipulated in the agreement. The entire outstanding principal balance of the note issued to the FDIC is due five years from issuance (April 30, 2015), or such date as such amount may become due and payable pursuant to the terms of the note. Borrowings under the note bear interest at an annual fixed rate of 2.50% and are paid monthly. If the Corporation fails to pay any interest as and when due, such interest shall accrue interest at the note interest rate plus 2.00% per annum. The Corporation may repay the note in whole or in part without any penalty subject to certain notification requirements indicated in the agreement. During the six months ended June 30, 2011, the Corporation prepaid $480 million of the note issued to the FDIC from funds unrelated to the assets securing the note.
A breakdown of borrowings by contractual maturities at June 30, 2011 is included in the table below. Given its nature, the maturity of the note issued to the FDIC was based on expected repayment dates and not on its April 30, 2015 contractual maturity date. The expected repayments consider the timing of expected cash inflows on the loans, OREO and claims on the loss sharing agreements that will be applied to repay the note during the period that the note payable to the FDIC is outstanding.
Year
Later years
No stated maturity
Subtotal
Total borrowings
Note 17 – Trust Preferred Securities
At June 30, 2011, December 31, 2010 and June 30, 2010, four statutory trusts established by the Corporation (BanPonce Trust I, Popular Capital Trust I, Popular North America Capital Trust I and Popular Capital Trust II) had issued trust preferred securities (also referred to as “capital securities”) to the public. The proceeds from such issuances, together with the proceeds of the related issuances of common securities of the trusts (the “common securities”), were used by the trusts to purchase junior subordinated deferrable interest debentures (the “junior subordinated debentures”) issued by the Corporation. In August 2009, the Corporation established the Popular Capital Trust III for the purpose of exchanging the shares of Series C preferred stock held by the U.S. Treasury at the time for trust preferred securities issued by this trust. In connection with this exchange, the trust used the Series C preferred stock, together with the proceeds of issuance and sale of common securities of the trust, to purchase junior subordinated debentures issued by the Corporation.
The sole assets of the five trusts consisted of the junior subordinated debentures of the Corporation and the related accrued interest receivable. These trusts are not consolidated by the Corporation pursuant to accounting principles generally accepted in the United States of America.
The junior subordinated debentures are included by the Corporation as notes payable in the consolidated statements of condition, while the common securities issued by the issuer trusts are included as other investment securities. The common securities of each trust are wholly-owned, or indirectly wholly-owned, by the Corporation.
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The following table presents financial data pertaining to the different trusts at June 30, 2011, December 31, 2010 and June 30, 2010.
(Dollars in thousands)
Issuer
Capital securities
Distribution rate
9.000%thereafter
Common securities
Junior subordinated debentures aggregate liquidation amount
Stated maturity date
Reference notes
In accordance with the Federal Reserve Board guidance, the trust preferred securities represent restricted core capital elements and qualify as Tier 1 capital, subject to certain quantitative limits. The aggregate amount of restricted core capital elements that may be included in the Tier 1 capital of a banking organization must not exceed 25% of the sum of all core capital elements (including cumulative perpetual preferred stock and trust preferred securities). At June 30, 2011, December 31, 2010, and June 30, 2010 the Corporation’s restricted core capital elements did not exceed the 25% limitation. Thus, all trust preferred securities were allowed as Tier 1 capital. Amounts of restricted core capital elements in excess of this limit generally may be included in Tier 2 capital, subject to further limitations. Effective March 31, 2011, the Federal Reserve Board revised the quantitative limit which would limit restricted core capital elements included in the Tier 1 capital of a bank holding company to 25% of the sum of core capital elements (including restricted core capital elements), net of goodwill less any associated deferred tax liability. Furthermore, the Dodd-Frank Act, enacted in July 2010, has a provision to effectively phase out the use of trust preferred securities issued before May 19, 2010 as Tier 1 capital over a 3-year period commencing on January 1, 2013. Trust preferred securities issued on or after May 19, 2010 no longer qualify as Tier 1 capital. At June 30, 2011, the Corporation had $ 427 million in trust preferred securities (capital securities) that are subject to the phase-out. The Corporation has not issued any trust preferred securities since May 19, 2010. At June 30, 2011, the remaining $935 million of trust preferred securities corresponded to capital securities issued to the U.S. Treasury pursuant to the Emergency Economic Stabilization Act of 2008, which are exempt from the phase-out provision.
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Note 18 – Stockholders’ equity
BPPR statutory reserve
The Banking Act of the Commonwealth of Puerto Rico requires that a minimum of 10% of BPPR’s net income for the year be transferred to a statutory reserve account until such statutory reserve equals the total of paid-in capital on common and preferred stock. Any losses incurred by a bank must first be charged to retained earnings and then to the reserve fund. Amounts credited to the reserve fund may not be used to pay dividends without the prior consent of the Puerto Rico Commissioner of Financial Institutions. The failure to maintain sufficient statutory reserves would preclude BPPR from paying dividends. BPPR’s statutory reserve fund totaled $402 million at June 30, 2011 (December 31, 2010 - $402 million; June 30, 2010 - $402 million). There were no transfers between the statutory reserve account and the retained earnings account during the six months ended June 30, 2011 and June 30, 2010.
Note 19 – Guarantees
At June 30, 2011 the Corporation recorded a liability of $0.4 million (December 31, 2010 - $0.5 million and June 30, 2010 - $0.5 million), which represents the unamortized balance of the obligations undertaken in issuing the guarantees under the standby letters of credit. Management does not anticipate any material losses related to these instruments.
Also, the Corporation securitized mortgage loans into guaranteed mortgage-backed securities subject to lifetime credit recourse on the loans that serve as collateral for the mortgage-backed securities. Also, from time to time, the Corporation may sell, in bulk sale transactions, residential mortgage loans and SBA commercial loans subject to credit recourse or to certain representations and warranties from the Corporation to the purchaser. These representations and warranties may relate, for example, to borrower creditworthiness, loan documentation, collateral, prepayment and early payment defaults. The Corporation may be required to repurchase the loans under the credit recourse agreements or representation and warranties.
At June 30, 2011 the Corporation serviced $3.7 billion (December 31, 2010 - $4.0 billion; June 30, 2010 - $4.2 billion) in residential mortgage loans subject to credit recourse provisions, principally loans associated with FNMA and FHLMC residential mortgage loan securitization programs. In the event of any customer default, pursuant to the credit recourse provided, the Corporation is required to repurchase the loan or reimburse the third party investor for the incurred loss. The maximum potential amount of future payments that the Corporation would be required to make under the recourse arrangements in the event of nonperformance by the borrowers is equivalent to the total outstanding balance of the residential mortgage loans serviced with recourse and interest, if applicable. During the quarter and six months ended June 30, 2011 the Corporation repurchased approximately $53 million and $115 million, respectively, of unpaid principal balance in mortgage loans subject to the credit recourse provisions (June 30, 2010 - $38 million for the quarter and $55 million for six-month period). In the event of nonperformance by the borrower, the Corporation has rights to the underlying collateral securing the mortgage loan. The Corporation suffers losses on these loans when the proceeds from a foreclosure sale of the property underlying a defaulted mortgage loan are less than the outstanding principal balance of the loan plus any uncollected interest advanced and the costs of holding and disposing the related property. At June 30, 2011 the Corporation’s liability established to cover the estimated credit loss exposure related to loans sold or serviced with credit recourse amounted to $55 million (December 31, 2010 - $54 million; June 30, 2010 - $37 million).
The following table shows the changes in the Corporation’s liability of estimated losses from these credit recourses agreements, included in the consolidated statements of condition for the quarters and six months ended June 30, 2011 and 2010.
(in thousands)
Balance as of beginning of period
Additions for new sales
Provision for recourse liability
Net charge-offs / terminations
Balance as of end of period
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The probable losses to be absorbed under the credit recourse arrangements are recorded as a liability when the loans are sold and are updated by accruing or reversing expense (categorized in the line item “adjustments (expense) to indemnity reserves on loans sold” in the consolidated statements of operations) throughout the life of the loan, as necessary, when additional relevant information becomes available. The methodology used to estimate the recourse liability is a function of the recourse arrangements given and considers a variety of factors, which include actual defaults and historical loss experience, foreclosure rate, estimated future defaults and the probability that a loan would be delinquent. Statistical methods are used to estimate the recourse liability. Expected loss rates are applied to different loan segmentations. The expected loss, which represents the amount expected to be lost on a given loan, considers the probability of default and loss severity. The probability of default represents the probability that a loan in good standing would become 90 days delinquent within the following twelve-month period. Regression analysis quantifies the relationship between the default event and loan-specific characteristics, including credit scores, loan-to-value rates, loan aging, among others.
When the Corporation sells or securitizes mortgage loans, it generally makes customary representations and warranties regarding the characteristics of the loans sold. The Corporation’s mortgage operations in the Puerto Rico group conforming mortgage loans into pools which are exchanged for FNMA and GNMA mortgage-backed securities, which are generally sold to private investors, or may sell the loans directly to FNMA or other private investors for cash. As required under the government agency programs, quality review procedures are performed by the Corporation to ensure that asset guideline qualifications are met. To the extent the loans do not meet specified characteristics, the Corporation may be required to repurchase such loans or indemnify for losses and bear any subsequent loss related to the loans. For the six-month period ended June 30, 2011, repurchases under representation and warranty arrangements in which the Corporation’s Puerto Rico banking subsidiaries were obligated to repurchase the loans approximated $10 million in unpaid principal balance with losses amounting to $0.7 million for the six months ended June 30, 2011. A substantial amount of these loans reinstate to performing status or have mortgage insurance, and thus the ultimate losses on the loans are not deemed significant.
During the quarter ended June 30, 2011, the Corporation’s banking subsidiary, BPPR, reached an agreement (the “June 2011 agreement”) with the FDIC, as receiver for a local Puerto Rico institution, and the financial institution with respect to a loan servicing portfolio that BPPR services since 2008, related to FHLMC and GNMA pools. The loans were originated and sold by the financial institution and the servicing rights were transferred to BPPR in 2008. As part of the 2008 servicing agreement, the financial institution was required to repurchase from BPPR any loans that BPPR, as servicer, was required to repurchase from the investors under representation and warranty obligations. As part of the June 2011 agreement, the Corporation received $15 million to discharge the financial institution from any repurchase obligation and other claims over the serviced portfolio of approximately $3.7 billion. The Corporation recorded a representation and warranty reserve for the amount of the proceeds received from the third-party financial institution.
Servicing agreements relating to the mortgage-backed securities programs of FNMA and GNMA, and to mortgage loans sold or serviced to certain other investors, including FHLMC, require the Corporation to advance funds to make scheduled payments of principal, interest, taxes and insurance, if such payments have not been received from the borrowers. At June 30, 2011, the Corporation serviced $17.4 billion in mortgage loans for third-parties, including the loans serviced with credit recourse (December 31, 2010 - $18.4 billion; June 30, 2010 - $17.9 billion). The Corporation generally recovers funds advanced pursuant to these arrangements from the mortgage owner, from liquidation proceeds when the mortgage loan is foreclosed or, in the case of FHA/VA loans, under the applicable FHA and VA insurance and guarantees programs. However, in the meantime, the Corporation must absorb the cost of the funds it advances during the time the advance is outstanding. The Corporation must also bear the costs of attempting to collect on delinquent and defaulted mortgage loans. In addition, if a defaulted loan is not cured, the mortgage loan would be canceled as part of the foreclosure proceedings and the Corporation would not receive any future servicing income with respect to that loan. At June 30, 2011 the outstanding balance of funds advanced by the Corporation under such mortgage loan servicing agreements was approximately $29 million (December 31, 2010 - $24 million; June 30, 2010 - $26 million). To the extent the mortgage loans underlying the Corporation’s servicing portfolio experience increased delinquencies, the Corporation would be required to dedicate additional cash resources to comply with its obligation to advance funds as well as incur additional administrative costs related to increases in collection efforts.
At June 30, 2011 the Corporation has reserves for customary representation and warranties related to loans sold by its U.S. subsidiary E-LOAN prior to 2009. These loans had been sold to investors on a servicing released basis subject to certain representation and warranties. Although the risk of loss or default was generally assumed by the investors, the Corporation made certain representations relating to borrower creditworthiness, loan documentation and collateral, which if not correct, may result in requiring the Corporation to repurchase the loans or indemnify investors for any related losses associated to these loans. At June 30, 2011 the Corporation’s reserve for estimated losses from such representation and warranty arrangements amounted to $29
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million, which was included as part of other liabilities in the consolidated statement of condition (December 31, 2010 - $31 million; June 30, 2010 - $33 million). E-LOAN is no longer originating and selling loans since the subsidiary ceased these activities in 2008. On a quarterly basis, the Corporation reassesses its estimate for expected losses associated to E-LOAN’s customary representation and warranty arrangements. The analysis incorporates expectations on future disbursements based on quarterly repurchases and make-whole events. The analysis also considers factors such as the average length-time between the loan’s funding date and the loan repurchase date, as observed in the historical loan data. Make-whole events are typically defaulted cases in which the investor attempts to recover by collateral or guarantees, and the seller is obligated to cover any impaired or unrecovered portion of the loan. Claims have been predominantly for first mortgage agency loans and principally consist of underwriting errors related to undisclosed debt or missing documentation. The following table presents the changes in the Corporation’s liability for estimated losses associated with customary representations and warranties related to loans sold by E-LOAN, included in the consolidated statement of condition for the quarters and six months ended June 30, 2011 and 2010.
(Reversal) provision for representation and warranties
During 2008, the Corporation provided indemnification for the breach of certain representations or warranties in connection with certain sales of assets by the discontinued operations of Popular Financial Holdings (“PFH”). The sales were on a non-credit recourse basis. At June 30, 2011, the agreements primarily include indemnification for breaches of certain key representations and warranties, some of which expire within a definite time period; others survive until the expiration of the applicable statute of limitations, and others do not expire. Certain of the indemnifications are subject to a cap or maximum aggregate liability defined as a percentage of the purchase price. The indemnification agreements outstanding at June 30, 2011 are related principally to make-whole arrangements. At June 30, 2011, the Corporation’s reserve related to PFH’s indemnity arrangements amounted to $4 million (December 31, 2010 - $8 million; June 30, 2010 - $7 million), and is included as other liabilities in the consolidated statement of condition. The reserve balance at June 30, 2011 contemplates historical indemnity payments. Popular, Inc. Holding Company (“PIHC”) and PNA have agreed to guarantee certain obligations of PFH with respect to the indemnification obligations. The following table presents the changes in the Corporation’s liability for estimated losses associated to loans sold by the discontinued operations of PFH, included in the consolidated statement of condition for the quarters and six months ended June 30, 2011, and 2010.
(Reversal) provision for representations and warranties
Other - settlements paid
PIHC fully and unconditionally guarantees certain borrowing obligations issued by certain of its wholly-owned consolidated subsidiaries totaling $0.7 billion at June 30, 2011 (December 31, 2010 and June 30, 2010 - $0.6 billion). In addition, at June 30, 2011, December 31, 2010 and June 30, 2010, PIHC fully and unconditionally guaranteed on a subordinated basis $1.4 billion of capital securities (trust preferred securities) issued by wholly-owned issuing trust entities to the extent set forth in the applicable guarantee agreement. Refer to Note 17 to the consolidated financial statements for further information on the trust preferred securities.
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Note 20 – Commitments and Contingencies
Off-balance sheet risk
The Corporation is a party to financial instruments with off-balance sheet credit risk in the normal course of business to meet the financial needs of its customers. These financial instruments include loan commitments, letters of credit, and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of condition.
The Corporation’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, standby letters of credit and financial guarantees written is represented by the contractual notional amounts of those instruments. The Corporation uses the same credit policies in making these commitments and conditional obligations as it does for those reflected on the consolidated statements of condition.
Financial instruments with off-balance sheet credit risk, whose contract amounts represent potential credit risk were as follows:
Commitments to extend credit:
Credit card lines
Commercial lines of credit
Other unused credit commitments
Commercial letters of credit
Standby letters of credit
Commitments to originate mortgage loans
At June 30, 2011, the Corporation maintained a reserve of approximately $11 million for potential losses associated with unfunded loan commitments related to commercial and consumer lines of credit (December 31, 2010 - $21 million; June 30, 2010 - $34 million), including $3 million of the unamortized balance of the contingent liability on unfunded loan commitments recorded with the Westernbank FDIC-assisted transaction (December 31, 2010 - $6 million; June 30, 2010 - $24 million).
Other commitments
At June 30, 2011, the Corporation also maintained other non-credit commitments for $10 million, primarily for the acquisition of other investments (December 31, 2010 and June 30, 2010 - $10 million).
Business concentration
Since the Corporation’s business activities are currently concentrated primarily in Puerto Rico, its results of operations and financial condition are dependent upon the general trends of the Puerto Rico economy and, in particular, the residential and commercial real estate markets. The concentration of the Corporation’s operations in Puerto Rico exposes it to greater risk than other banking companies with a wider geographic base. Its asset and revenue composition by geographical area is presented in Note 30 to the consolidated financial statements.
The Corporation’s loan portfolio is diversified by loan category. However, approximately $12.6 billion, or 61% of the Corporation’s loan portfolio not covered under the FDIC loss sharing agreements, excluding loans held-for-sale, at June 30, 2011, consisted of real estate related loans, including residential mortgage loans, construction loans and commercial loans secured by commercial real estate (December 31, 2010 - $12.0 billion, or 58%; June 30, 2010 - $13.4 billion, or 60%).
Except for the Corporation’s exposure to the Puerto Rico Government sector, no individual or single group of related accounts is considered material in relation to our total assets or deposits, or in relation to our overall business. At June 30, 2011, the Corporation had approximately $894 million of credit facilities granted to or guaranteed by the Puerto Rico Government, its municipalities and public corporations, of which $140 million were uncommitted lines of credit (December 31, 2010 - $1.4 billion and $199 million, respectively; June 30, 2010 - $972 million and $215 million, respectively). Of the total credit facilities granted, $754 million was outstanding at June 30, 2011 (December 31, 2010 - $1.1 billion; June 30, 2010 - $754 million). Furthermore, at June 30, 2011, the Corporation had $121 million in obligations issued or guaranteed by the Puerto Rico Government, its municipalities and public corporations as part of its investment securities portfolio (December 31, 2010 - $145 million; June 30, 2010 - $232 million).
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Other contingencies
As indicated in Note 11 to the consolidated financial statements, as part of the loss sharing agreements related to the Westernbank FDIC-assisted transaction, the Corporation agreed to make a true-up payment to the FDIC on the date that is 45 days following the last day of the final shared loss month, or upon the final disposition of all covered assets under the loss sharing agreements in the event losses on the loss sharing agreements fail to reach expected levels. The true-up payment contingency (undiscounted estimated true-up payment) was estimated at $176 million at June 30, 2011 (December 31, 2010 - $169 million; June 30, 2010 - $169 million).
Legal Proceedings
The nature of Popular’s business ordinarily results in a certain number of claims, litigation, investigations, and legal and administrative cases and proceedings. When the Corporation determines it has meritorious defenses to the claims asserted, it vigorously defends itself. The Corporation will consider the settlement of cases (including cases where it has meritorious defenses) when, in management’s judgment, it is in the best interests of both the Corporation and its shareholders to do so.
On at least a quarterly basis, Popular assesses its liabilities and contingencies in connection with outstanding legal proceedings utilizing the latest information available. For matters where it is probable that the Corporation will incur a loss and the amount can be reasonably estimated, the Corporation establishes an accrual for the loss. Once established, the accrual is adjusted on at least a quarterly basis as appropriate to reflect any relevant developments. For matters where a loss is not probable or the amount of the loss cannot be estimated, no accrual is established.
In certain cases, exposure to loss exists in excess of the accrual to the extent such loss is reasonably possible, but not probable. Management believes and estimates the aggregate range of reasonably possible losses for those matters where a range may be determined, in excess of amounts accrued, for current legal proceedings is from $0 to approximately $30.0 million at June 30, 2011. For certain other cases, management cannot reasonably estimate the possible loss at this time. Any estimate involves significant judgment, given the varying stages of the proceedings (including the fact that many of them are currently in preliminary stages), the existence of multiple defendants in several of the current proceedings whose share of liability has yet to be determined, the numerous unresolved issues in many of the proceedings, and the inherent uncertainty of the various potential outcomes of such proceedings. Accordingly, management’s estimate will change from time-to-time, and actual losses may be more or less than the current estimate.
While the final outcome of legal proceedings is inherently uncertain, based on information currently available, advice of counsel, and available insurance coverage, management believes that the amount it has already accrued is adequate and any incremental liability arising from the Corporation’s legal proceedings will not have a material adverse effect on the Corporation’s consolidated financial position as a whole. However, in the event of unexpected future developments, it is possible that the ultimate resolution of these matters, if unfavorable, may be material to the Corporation’s consolidated financial position in a particular period.
Between May 14, 2009 and September 9, 2009, five putative class actions and two derivative claims were filed in the United States District Court for the District of Puerto Rico and the Puerto Rico Court of First Instance, San Juan Part, against Popular, Inc., and certain of its directors and officers, among others. The five class actions were consolidated into two separate actions: a securities class action captioned Hoff v. Popular, Inc., et al. (consolidated with Otero v. Popular, Inc., et al.) and an Employee Retirement Income Security Act (ERISA) class action entitled In re Popular, Inc. ERISA Litigation(comprised of the consolidated cases of Walsh v. Popular, Inc., et al.; Montañez v. Popular, Inc., et al.; and Dougan v. Popular, Inc., et al.).
On October 19, 2009, plaintiffs in the Hoff case filed a consolidated class action complaint which included as defendants the underwriters in the May 2008 offering of Series B Preferred Stock, among others. The consolidated action purported to be on behalf of purchasers of Popular’s securities between January 24, 2008 and February 19, 2009 and alleged that the defendants violated Section 10(b) of the Exchange Act, and Rule 10b-5 promulgated thereunder, and Section 20(a) of the Exchange Act by issuing a series of allegedly false and/or misleading statements and/or omitting to disclose material facts necessary to make statements made by the Corporation not false and misleading. The consolidated action also alleged that the defendants violated Section 11, Section 12(a)(2) and Section 15 of the Securities Act by making allegedly untrue statements and/or omitting to disclose material facts necessary to make statements made by the Corporation not false and misleading in connection with the May 2008 offering of Series B Preferred Stock. The consolidated securities class action complaint sought class certification, an award of compensatory damages and reasonable costs and expenses, including counsel fees. On January 11, 2010, Popular, the underwriter defendants and the individual defendants moved to dismiss the consolidated securities class action complaint. On August 2, 2010, the U.S. District Court for the District of Puerto Rico granted the motion to dismiss filed by the underwriter defendants on statute of limitations grounds. The Court also dismissed the Section 11 claim brought against Popular’s directors on statute of limitations grounds and the
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Section 12(a)(2) claim brought against Popular because plaintiffs lacked standing. The Court declined to dismiss the claims brought against Popular and certain of its officers under Section 10(b) of the Exchange Act (and Rule 10b-5 promulgated thereunder), Section 20(a) of the Exchange Act, and Sections 11 and 15 of the Securities Act, holding that plaintiffs had adequately alleged that defendants made materially false and misleading statements with the requisite state of mind.
On November 30, 2009, plaintiffs in the ERISA case filed a consolidated class action complaint. The consolidated complaint purported to be on behalf of employees participating in the Popular, Inc. U.S.A. 401(k) Savings and Investment Plan and the Popular, Inc. Puerto Rico Savings and Investment Plan from January 24, 2008 to the date of the Complaint to recover losses pursuant to Sections 409 and 502(a)(2) of ERISA against Popular, certain directors, officers and members of plan committees, each of whom was alleged to be a plan fiduciary. The consolidated complaint alleged that defendants breached their alleged fiduciary obligations by, among other things, failing to eliminate Popular stock as an investment alternative in the plans. The complaint sought to recover alleged losses to the plans and equitable relief, including injunctive relief and a constructive trust, along with costs and attorneys’ fees. On December 21, 2009, and in compliance with a scheduling order issued by the Court, Popular and the individual defendants submitted an answer to the amended complaint. Shortly thereafter, on December 31, 2009, Popular and the individual defendants filed a motion to dismiss the consolidated class action complaint or, in the alternative, for judgment on the pleadings. On May 5, 2010, a magistrate judge issued a report and recommendation in which he recommended that the motion to dismiss be denied except with respect to Banco Popular de Puerto Rico, as to which he recommended that the motion be granted. On May 19, 2010, Popular filed objections to the magistrate judge’s report and recommendation. On September 30, 2010, the Court issued an order without opinion granting in part and denying in part the motion to dismiss and providing that the Court would issue an opinion and order explaining its decision. No opinion was, however, issued prior to the settlement in principle discussed below.
The derivative actions (García v. Carrión, et al. and Díaz v. Carrión, et al.) were brought purportedly for the benefit of nominal defendant Popular, Inc. against certain executive officers and directors and alleged breaches of fiduciary duty, waste of assets and abuse of control in connection with Popular’s issuance of allegedly false and misleading financial statements and financial reports and the offering of the Series B Preferred Stock. The derivative complaints sought a judgment that the action was a proper derivative action, an award of damages, restitution, costs and disbursements, including reasonable attorneys’ fees, costs and expenses. On October 9, 2009, the Court coordinated for purposes of discovery the García action and the consolidated securities class action. On October 15, 2009, Popular and the individual defendants moved to dismiss theGarcía complaint for failure to make a demand on the Board of Directors prior to initiating litigation. On November 20, 2009, plaintiffs filed an amended complaint, and on December 21, 2009, Popular and the individual defendants moved to dismiss the García amended complaint. At a scheduling conference held on January 14, 2010, the Court stayed discovery in both the Hoff and García matters pending resolution of their respective motions to dismiss. On August 11, 2010, the Court granted in part and denied in part the motion to dismiss the Garcia action. The Court dismissed the gross mismanagement and corporate waste claims, but declined to dismiss the breach of fiduciary duty claim. The Díaz case, filed in the Puerto Rico Court of First Instance, San Juan, was removed to the U.S. District Court for the District of Puerto Rico. On October 13, 2009, Popular and the individual defendants moved to consolidate the García and Díaz actions. On October 26, 2009, plaintiff moved to remand the Diaz case to the Puerto Rico Court of First Instance and to stay defendants’ consolidation motion pending the outcome of the remand proceedings. On September 30, 2010, the Court issued an order without opinion remanding the Diaz case to the Puerto Rico Court of First Instance. On October 13, 2010, the Court issued a Statement of Reasons In Support of Remand Order. On October 28, 2010, Popular and the individual defendants moved for reconsideration of the remand order. The court denied Popular’s request for reconsideration shortly thereafter.
On April 13, 2010, the Puerto Rico Court of First Instance in San Juan granted summary judgment dismissing a separate complaint brought by plaintiff in the García action that sought to enforce an alleged right to inspect the books and records of the Corporation in support of the pending derivative action. The Court held that plaintiff had not propounded a “proper purpose” under Puerto Rico law for such inspection. On April 28, 2010, plaintiff in that action moved for reconsideration of the Court’s dismissal. On May 4, 2010, the Court denied plaintiff’s request for reconsideration. On June 7, 2010, plaintiff filed an appeal before the Puerto Rico Court of Appeals. On June 11, 2010, Popular and the individual defendants moved to dismiss the appeal. On June 22, 2010, the Court of Appeals dismissed the appeal. On July 6, 2010, plaintiff moved for reconsideration of the Court’s dismissal. On July 16, 2010, the Court of Appeals denied plaintiff’s request for reconsideration.
At the Court’s request, the parties to the Hoff and García cases discussed the prospect of mediation and agreed to nonbinding mediation in an attempt to determine whether the cases could be settled. On January 18 and 19, 2011, the parties to the Hoff and García cases engaged in nonbinding mediation before the Honorable Nicholas Politan. As a result of the mediation, the Corporation and the other named defendants to the Hoff matter entered into a memorandum of understanding to settle this matter. Under the terms of the memorandum of understanding, subject to certain customary conditions including court approval of a final settlement agreement in consideration for the full settlement and release of all defendants, the parties agreed that the amount of $37.5 million
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would be paid by or on behalf of defendants. On June 17, 2011, the parties filed a stipulation of settlement and a joint motion for preliminary approval of such settlement. On June 20, 2011, the Court entered an order granting preliminary approval of the settlement and set a settlement conference for November 1, 2011, which was subsequently moved to November 2, 2011. On or before July 5, 2011, the amount of $37.5 million was paid to the settlement fund by or on behalf of defendants. Specifically, the amount of $26 million was paid by insurers and the amount of $11.5 million was paid by Popular (after which approximately $4.7 million was reimbursed by insurers per the terms of the relevant insurance agreement).
In addition, the Corporation is aware that a suit asserting similar claims on behalf of certain individual shareholders under the federal securities laws was filed on January 18, 2011. On June 19, 2011, such shareholders sought leave to intervene in the securities class action. On June 28, 2011, the Court denied their motion to intervene as untimely.
A separate memorandum of understanding was subsequently entered by the parties to theGarcía and Diaz actions in April 2011. Under the terms of this memorandum of understanding, subject to certain customary conditions, including court approval of a final settlement agreement, and in consideration for the full and final settlement and release of all defendants, Popular agreed, for a period of three years, to maintain or implement certain corporate governance practices, measures and policies, as set forth in the memorandum of understanding. Aside from the payment by or on behalf of Popular of approximately $2.1 million of attorneys’ fees and expenses of counsel for the plaintiffs (of which management expects $1.6 million will be covered by insurance), the settlement does not require any cash payments by or on behalf of Popular or the defendants. On June 14, 2011, a motion for preliminary approval of settlement was filed. On July 8, 2011, the Court granted preliminary approval of such settlement and set the final approval hearing date for September 12, 2011.
Prior to the Hoff and derivative action mediation, the parties to the ERISA class action entered into a separate memorandum of understanding to settle that action. Under the terms of the ERISA memorandum of understanding, subject to certain customary conditions including court approval of a final settlement agreement and in consideration for the full settlement and release of all defendants, the parties agreed that the amount of $8.2 million would be paid by or on behalf of the defendants. The parties filed a joint request to approve the settlement on April 13, 2011. On June 8, 2011, the Court held a preliminary approval hearing, and on June 23, 2011, the Court preliminarily approved such settlement. On June 30, 2011, the amount of $8.2 million was transferred to the settlement fund by insurers on behalf of the defendants. A final fairness hearing has been set for August 26, 2011.
Popular does not expect to record any material gain or loss as a result of the settlements. Popular has made no admission of liability in connection with these settlements.
At this point, the settlement agreements are not final and are subject to a number of future events, including approval of the settlements by the relevant courts.
In addition to the foregoing, Banco Popular is a defendant in two lawsuits arising from its consumer banking and trust-related activities. On October 7, 2010, a putative class action for breach of contract and damages captioned Almeyda-Santiago v. Banco Popular de Puerto Rico, was filed in the Puerto Rico Court of First Instance against Banco Popular de Puerto Rico. The complaint essentially asserts that plaintiff has suffered damages because of Banco Popular’s allegedly fraudulent overdraft fee practices in connection with debit card transactions. Such practices allegedly consist of: (a) the reorganization of electronic debit transactions in high-to-low order so as to multiply the number of overdraft fees assessed on its customers; (b) the assessment of overdraft fees even when clients have not overdrawn their accounts; (c) the failure to disclose, or to adequately disclose, its overdraft policy to its customers; and (d) the provision of false and fraudulent information regarding its clients’ account balances at point of sale transactions and on its website. Plaintiff seeks damages, restitution and provisional remedies against Banco Popular for breach of contract, abuse of trust, illegal conversion and unjust enrichment. On January 13, 2011, Banco Popular submitted a motion to dismiss the complaint, which is still pending resolution.
On December 13, 2010, Popular was served with a class action complaint captioned García Lamadrid, et al. v. Banco Popular, et al.which was filed in the Puerto Rico Court of First Instance. The complaint generally seeks damages against Banco Popular de Puerto Rico, other defendants and their respective insurance companies for their alleged breach of certain fiduciary duties, breach of contract, and alleged violations of local tort law. Plaintiffs seek in excess of $600 million in damages, plus costs and attorneys fees.
More specifically, plaintiffs - Guillermo García Lamadrid and Benito del Cueto Figueras - are suing Defendant BPPR for the losses they (and others) experienced through their investment in the RG Financial Corporation-backed Conservation Trust Fund securities. Plaintiffs essentially claim that Banco Popular allegedly breached its fiduciary duties to them by failing to keep all relevant parties informed of any developments that could affect the Conservation Trust notes or that could become an event of default under the relevant trust agreements; and that in so doing, it acted imprudently, unreasonably and grossly negligently. Popular and the other defendants submitted separate motions to dismiss on or about February 28, 2011. Plaintiffs submitted a consolidated opposition thereto on April 15, 2011. The parties were allowed to submit replies and surreplies to such motions, and the motion has now been deemed submitted by the Court and is pending resolution.
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Note 21 – Non-consolidated variable interest entities
The Corporation is involved with four statutory trusts which it established to issue trust preferred securities to the public. Also, it established Popular Capital Trust III for the purpose of exchanging Series C preferred stock shares held by the U.S. Treasury for trust preferred securities issued by this trust. These trusts are deemed to be VIEs since the equity investors at risk have no substantial decision-making rights. The Corporation does not have a significant variable interest in these trusts. Neither the residual interest held, since it was never funded in cash, nor the loan payable to the trusts is considered a variable interest since they create variability.
Also, it is involved with various special purpose entities mainly in guaranteed mortgage securitization transactions, including GNMA and FNMA. These special purpose entities are deemed to be VIEs since they lack equity investments at risk. The Corporation’s continuing involvement in these guaranteed loan securitizations includes owning certain beneficial interests in the form of securities as well as the servicing rights retained. The Corporation is not required to provide additional financial support to any of the variable interest entities to which it has transferred the financial assets. The mortgage-backed securities, to the extent retained, are classified in the Corporation’s consolidated statement of condition as available-for-sale or trading securities.
ASU 2009-17 requires that an ongoing primary beneficiary assessment should be made to determine whether the Corporation is the primary beneficiary of any of the variable interest entities (“VIEs”) it is involved with. The conclusion on the assessment of these trusts and guaranteed mortgage securitization transactions has not changed since their initial evaluation. The Corporation concluded that it is still not the primary beneficiary of these VIEs, and therefore, are not required to be consolidated in the Corporation’s financial statements at June 30, 2011.
The Corporation concluded that it did not hold a controlling financial interest in these trusts since the decisions of the trust are predetermined through the trust documents and the guarantee of the trust preferred securities is irrelevant since in substance the sponsor is guaranteeing its own debt. In the case of the guaranteed mortgage securitization transactions, the Corporation concluded that, essentially, these entities (FNMA and GNMA) control the design of their respective VIEs, dictate the quality and nature of the collateral, require the underlying insurance, set the servicing standards via the servicing guides and can change them at will, and remove a primary servicer with cause, and without cause in the case of FNMA. Moreover, through their guarantee obligations, agencies (FNMA and GNMA) have the obligation to absorb losses that could be potentially significant to the VIE.
The Corporation holds variable interests in these VIEs in the form of agency mortgage-backed securities and collateralized mortgage obligations, including those securities originated by the Corporation and those acquired from third parties. Additionally, the Corporation holds agency mortgage-backed securities, agency collateralized mortgage obligations and private label collateralized mortgage obligations issued by third party VIEs in which it has no other form of continuing involvement. Refer to Note 22 to the consolidated financial statements for additional information on the debt securities outstanding at June 30, 2011, December 31, 2010 and June 30, 2010, which are classified as available-for-sale and trading securities in the Corporation’s consolidated statement of condition. In addition, the Corporation may retain the right to service the transferred loans in those government-sponsored special purpose entities (“SPEs”) and may also purchase the right to service loans in other government-sponsored SPEs that were transferred to those SPEs by a third-party. Pursuant to ASC Subtopic 810-10, the servicing fees that the Corporation receives for its servicing role are considered variable interests in the VIEs since the servicing fees are subordinated to the principal and interest that first needs to be paid to the mortgage-backed securities’ investors and to the guaranty fees that need to be paid to the federal agencies.
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The following table presents the carrying amount and classification of the assets related to the Corporation’s variable interests in non-consolidated VIEs and the maximum exposure to loss as a result of the Corporation’s involvement as servicer with non-consolidated VIEs at June 30, 2011, December 31, 2010 and June 30, 2010.
Servicing assets:
Total servicing assets
Other assets:
Servicing advances
Maximum exposure to loss
The size of the non-consolidated VIEs, in which the Corporation has a variable interest in the form of servicing fees, measured as the total unpaid principal balance of the loans, amounted to $9.4 billion at June 30, 2011 ($9.3 billion at December 31, 2010 and June 30, 2010).
Maximum exposure to loss represents the maximum loss, under a worst case scenario, that would be incurred by the Corporation, as servicer for the VIEs, assuming all loans serviced are delinquent and that the value of the Corporation’s interests and any associated collateral declines to zero, without any consideration of recovery. The Corporation determined that the maximum exposure to loss includes the fair value of the MSRs and the assumption that the servicing advances at June 30, 2011, December 31, 2010 and June 30, 2010, will not be recovered. The agency debt securities are not included as part of the maximum exposure to loss since they are guaranteed by the related agencies.
Note 22 – Fair value measurement
ASC Subtopic 820-10 “Fair Value Measurements and Disclosures” establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three levels in order to increase consistency and comparability in fair value measurements and disclosures. The hierarchy is broken down into three levels based on the reliability of inputs as follows:
Level 1 - Unadjusted quoted prices in active markets for identical assets or liabilities that the Corporation has the ability to access at the measurement date. Valuation on these instruments does not necessitate a significant degree of judgment since valuations are based on quoted prices that are readily available in an active market.
Level 2 - Quoted prices other than those included in Level 1 that are observable either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or that can be corroborated by observable market data for substantially the full term of the financial instrument.
Level 3 - Inputs are unobservable and significant to the fair value measurement. Unobservable inputs reflect the Corporation’s own assumptions about assumptions that market participants would use in pricing the asset or liability.
The Corporation maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the observable inputs be used when available. Fair value is based upon quoted market prices when available. If listed prices or quotes are not available, the Corporation employs internally-developed models that primarily use market-based inputs including yield curves, interest rates, volatilities, and credit curves, among others. Valuation adjustments are limited to those necessary to ensure that the financial instrument’s fair value is adequately representative of the price that would be received or paid in the marketplace. These adjustments include amounts that reflect counterparty credit quality, the Corporation’s credit standing, constraints on liquidity and unobservable parameters that are applied consistently.
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The estimated fair value may be subjective in nature and may involve uncertainties and matters of significant judgment for certain financial instruments. Changes in the underlying assumptions used in calculating fair value could significantly affect the results.
Fair Value on a Recurring Basis
The following fair value hierarchy tables present information about the Corporation’s assets and liabilities measured at fair value on a recurring basis at June 30, 2011, December 31, 2010 and June 30, 2010:
Investment securities available-for-sale:
Trading account securities, excluding derivatives:
Collateralized mortgage obligations
Residential mortgage-backed securities - federal agencies
Derivatives
Liabilities
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Trading liabilities
70
At June 30, 2010
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The following tables present the changes in Level 3 assets and liabilities measured at fair value on a recurring basis for the quarters and six months ended June 30, 2011 and 2010.
Quarter ended June 30, 2011
(In millions)
Six months ended June 30, 2011
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Quarter ended June 30, 2010
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Six months ended June 30, 2010
There were no transfers in and/or out of Level 3 for financial instruments measured at fair value on a recurring basis during the quarters and six months ended June 30, 2011. There were $79 million in transfers out of Level 3 for financial instruments measured at fair value on a recurring basis during the quarter and six months ended June 30, 2010. These transfers resulted from exempt FNMA mortgage-backed securities, which were transferred out of Level 3 and into Level 2, as a result of a change in valuation methodology from an internally-developed matrix pricing to pricing them based on a bond’s theoretical value from similar bonds defined by credit quality and market sector. Their fair value incorporates an option adjusted spread. Pursuant to the Corporation’s policy, these transfers were recognized as of the end of the reporting period. There were no transfers in and/or out of Level 1 during the quarters and six months ended June 30, 2011 and 2010.
Gains and losses (realized and unrealized) included in earnings for the quarter and six months ended June 30, 2011 and 2010 for Level 3 assets and liabilities included in the previous tables are reported in the consolidated statement of operations as follows:
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Additionally, in accordance with generally accepted accounting principles, the Corporation may be required to measure certain assets at fair value on a nonrecurring basis in periods subsequent to their initial recognition. The adjustments to fair value usually result from the application of lower of cost or fair value accounting, identification of impaired loans requiring specific reserves under ASC Section 310-10-35 “Accounting by Creditors for Impairment of a Loan”, or write-downs of individual assets. The following tables present financial and non-financial assets that were subject to a fair value measurement on a nonrecurring basis during the six months ended June 30, 2011 and 2010, and which were still included in the consolidated statement of condition as of such dates. The amounts disclosed represent the aggregate fair value measurements of those assets as of the end of the reporting period.
Carrying value at June 30, 2011
Loans[1]
Loans held-for-sale [2]
Other real estate owned [3]
Carrying value at June 30, 2010
Loans held-for-sale[2]
Other real estate owned[3]
Following is a description of the Corporation’s valuation methodologies used for assets and liabilities measured at fair value. The disclosure requirements exclude certain financial instruments and all non-financial instruments. Accordingly, the aggregate fair value amounts of the financial instruments disclosed do not represent management’s estimate of the underlying value of the Corporation.
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Trading Account Securities and Investment Securities Available-for-Sale
U.S. Treasury securities: The fair value of U.S. Treasury securities is based on yields that are interpolated from the constant maturity treasury curve. These securities are classified as Level 2.
Obligations of U.S. Government sponsored entities: The Obligations of U.S. Government sponsored entities include U.S. agency securities, which fair value is based on an active exchange market and on quoted market prices for similar securities. The U.S. agency securities are classified as Level 2.
Obligations of Puerto Rico, States and political subdivisions: Obligations of Puerto Rico, States and political subdivisions include municipal bonds. The bonds are segregated and the like characteristics divided into specific sectors. Market inputs used in the evaluation process include all or some of the following: trades, bid price or spread, two sided markets, quotes, benchmark curves including but not limited to Treasury benchmarks, LIBOR and swap curves, market data feeds such as MSRB, discount and capital rates, and trustee reports. The municipal bonds are classified as Level 2.
Mortgage-backed securities: Certain agency mortgage-backed securities (“MBS”) are priced based on a bond’s theoretical value from similar bonds defined by credit quality and market sector. Their fair value incorporates an option adjusted spread. The agency MBS are classified as Level 2. Other agency MBS such as GNMA Puerto Rico Serials are priced using an internally-prepared pricing matrix with quoted prices from local brokers dealers. These particular MBS are classified as Level 3.
Collateralized mortgage obligations: Agency and private collateralized mortgage obligations (“CMOs”) are priced based on a bond’s theoretical value from similar bonds defined by credit quality and market sector and for which fair value incorporates an option adjusted spread. The option adjusted spread model includes prepayment and volatility assumptions, ratings (whole loans collateral) and spread adjustments. These CMOs are classified as Level 2. Other CMOs, due to their limited liquidity, are classified as Level 3 due to the insufficiency of inputs such as broker quotes, executed trades, credit information and cash flows.
Equity securities: Equity securities with quoted market prices obtained from an active exchange market are classified as Level 1. Other equity securities that do not trade in highly liquid markets are classified as Level 2.
Corporate securities, commercial paper and mutual funds (included as “other” in the “trading account securities” category): Quoted prices for these security types are obtained from broker dealers. Given that the quoted prices are for similar instruments or do not trade in highly liquid markets, these securities are classified as Level 2. The important variables in determining the prices of Puerto Rico tax-exempt mutual fund shares are net asset value, dividend yield and type of assets in the fund. All funds trade based on a relevant dividend yield taking into consideration the aforementioned variables. In addition, demand and supply also affect the price. Corporate securities that trade less frequently or are in distress are classified as Level 3.
Mortgage servicing rights (“MSRs”) do not trade in an active market with readily observable prices. MSRs are priced internally using a discounted cash flow model. The valuation model considers servicing fees, portfolio characteristics, prepayments assumptions, delinquency rates, late charges, other ancillary revenues, cost to service and other economic factors. Due to the unobservable nature of certain valuation inputs, the MSRs are classified as Level 3.
Interest rate swaps, interest rate caps and indexed options are traded in over-the-counter active markets. These derivatives are indexed to an observable interest rate benchmark, such as LIBOR or equity indexes, and are priced using an income approach based on present value and option pricing models using observable inputs. Other derivatives are liquid and have quoted prices, such as forward contracts or “to be announced securities” (“TBAs”). All of these derivatives are classified as Level 2. The non-performance risk is determined using internally-developed models that consider the collateral held, the remaining term, and the creditworthiness of the entity that bears the risk, and uses available public data or internally-developed data related to current spreads that denote their probability of default.
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Loans held-in-portfolio considered impaired under ASC Section 310-10-35 that are collateral dependent
The impairment is measured based on the fair value of the collateral, which is derived from appraisals that take into consideration prices in observed transactions involving similar assets in similar locations, in accordance with the provisions of ASC Section 310-10-35. Currently, the associated loans considered impaired are classified as Level 3.
Loans measured at fair value pursuant to lower of cost or fair value adjustments
Loans measured at fair value on a nonrecurring basis pursuant to lower of cost or fair value were priced based on bids received from potential buyers, secondary market prices, and discounted cash flow models which incorporate internally-developed assumptions for prepayments and credit loss estimates. These loans are classified as Level 3.
Other real estate owned and other foreclosed assets
Other real estate owned includes real estate properties securing mortgage, consumer, and commercial loans. Other foreclosed assets include automobiles securing auto loans. The fair value of foreclosed assets may be determined using an external appraisal, broker price opinion or an internal valuation. These foreclosed assets are classified as Level 3 given certain internal adjustments that may be made to external appraisals.
Note 23 – Fair Value of Financial Instruments
The fair value of financial instruments is the amount at which an asset or obligation could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Fair value estimates are made at a specific point in time based on the type of financial instrument and relevant market information. Many of these estimates involve various assumptions and may vary significantly from amounts that could be realized in actual transactions.
The information about the estimated fair values of financial instruments presented hereunder excludes all nonfinancial instruments and certain other specific items.
For those financial instruments with no quoted market prices available, fair values have been estimated using present value calculations or other valuation techniques, as well as management’s best judgment with respect to current economic conditions, including discount rates, estimates of future cash flows, and prepayment assumptions.
The fair values reflected herein have been determined based on the prevailing interest rate environment at June 30, 2011 and December 31, 2010, as applicable. In different interest rate environments, fair value estimates can differ significantly, especially for certain fixed rate financial instruments. In addition, the fair values presented do not attempt to estimate the value of the Corporation’s fee generating businesses and anticipated future business activities, that is, they do not represent the Corporation’s value as a going concern. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Corporation. The methods and assumptions used to estimate the fair values of significant financial instruments are described in the paragraphs below.
Short-term financial assets and liabilities have relatively short maturities, or no defined maturities, and little or no credit risk. The carrying amounts of other liabilities reported in the consolidated statements of condition approximate fair value because of the short-term maturity of those instruments or because they carry interest rates which approximate market. Included in this category are: cash and due from banks, federal funds sold and securities purchased under agreements to resell, time deposits with other banks, assets sold under agreements to repurchase and short-term borrowings. The equity appreciation instrument is included in other liabilities and is accounted for at fair value. Resell and repurchase agreements with long-term maturities are valued using discounted cash flows based on market rates currently available for agreements with similar terms and remaining maturities.
Trading and investment securities, except for investments classified as other investment securities in the consolidated statements of condition, are financial instruments that regularly trade on secondary markets. The estimated fair value of these securities was determined using either market prices or dealer quotes, where available, or quoted market prices of financial instruments with similar characteristics. Trading account securities and securities available-for-sale are reported at their respective fair values in the consolidated statements of condition since they are marked-to-market for accounting purposes.
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The estimated fair value for loans held-for-sale was based on secondary market prices, bids received from potential buyers and discounted cash flow models. The fair values of the loans held-in-portfolio have been determined for groups of loans with similar characteristics. Loans were segregated by type such as commercial, construction, residential mortgage, consumer, and credit cards. Each loan category was further segmented based on loan characteristics, including interest rate terms, credit quality and vintage. Generally, fair values were estimated based on an exit price by discounting scheduled cash flows for the segmented groups of loans using a discount rate that considers interest, credit and expected return by market participant under current market conditions. Additionally, prepayment, default and recovery assumptions have been applied in the mortgage loan portfolio valuations. Generally accepted accounting principles do not require a fair valuation of the lease financing portfolio, therefore it is included in the loans total at its carrying amount.
The fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, savings, NOW, and money market accounts was, for purposes of this disclosure, equal to the amount payable on demand as of the respective dates. The fair value of certificates of deposit was based on the discounted value of contractual cash flows using interest rates being offered on certificates with similar maturities. The value of these deposits in a transaction between willing parties is in part dependent of the buyer’s ability to reduce the servicing cost and the attrition that sometimes occurs. Therefore, the amount a buyer would be willing to pay for these deposits could vary significantly from the presented fair value.
Long-term borrowings were valued using discounted cash flows, based on market rates currently available for debt with similar terms and remaining maturities and in certain instances using quoted market rates for similar instruments at June 30, 2011 and December 31, 2010.
As part of the fair value estimation procedures of certain liabilities, including repurchase agreements (regular and structured) and FHLB advances, the Corporation considered, where applicable, the collateralization levels as part of its evaluation of non-performance risk. Also, for certificates of deposit, the non-performance risk was determined using internally-developed models that consider, where applicable, the collateral held, amounts insured, the remaining term, and the credit premium of the institution.
Derivatives are considered financial instruments and their carrying value equals fair value.
Commitments to extend credit were valued using the fees currently charged to enter into similar agreements. For those commitments where a future stream of fees is charged, the fair value was estimated by discounting the projected cash flows of fees on commitments. The fair value of letters of credit was based on fees currently charged on similar agreements.
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The following table presents the carrying or notional amounts, as applicable, and estimated fair values for financial instruments.
Financial Assets:
Investment securities available-for-sale
Investment securities held-to-maturity
Other investment securities
Loans held-for-sale
Loans not covered under loss sharing agreement with the FDIC
Financial Liabilities:
Commitments to extend credit
Letters of credit
Note 24 – Net income (loss) per common share
The following table sets forth the computation of net income (loss) per common share (“EPS”), basic and diluted, for the quarters and six months ended June 30, 2011 and 2010:
Preferred stock dividends
Deemed dividend on preferred stock[1]
Net income (loss) applicable to common stock
Average common shares outstanding
Average potential dilutive common shares
Average common shares outstanding - assuming dilution
Basic and dilutive EPS
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Potential common shares consist of common stock issuable under the assumed exercise of stock options and restricted stock awards 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 is added as incremental shares to the actual number of shares outstanding to compute diluted earnings per share. Warrants, stock options, and restricted stock awards 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 common share.
For the quarter ended and six months ended June 30, 2011, there were 2,103,034 and 2,112,275 weighted average antidilutive stock options outstanding, respectively (June 30, 2010 – 1,272,058 and 2,541,337). Additionally, the Corporation has outstanding a warrant issued to the U.S. Treasury to purchase 20,932,836 shares of common stock, which have an antidilutive effect at June 30, 2011.
Note 25 – Other service fees
The caption of other services fees in the consolidated statements of operations consist of the following major categories:
Debit card fees
Insurance fees
Credit card fees and discounts
Sale and administration of investment products
Mortgage servicing fees, net of fair value adjustments
Trust fees
Processing fees
Other fees
Total other services fees
Note 26 – Pension and postretirement benefits
The Corporation has a noncontributory defined benefit pension plan and supplementary pension benefit restoration plans for regular employees of certain of its subsidiaries. At June 30, 2011, the accrual of benefits under the plans was frozen to all participants.
The components of net periodic pension cost for the periods presented were as follows:
Pension Plan
Quarters ended June 30,
Interest cost
Expected return on plan assets
Amortization of net loss
Settlement loss
Total net periodic pension cost
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Pension Plans
Six months ended June 30,
The Corporation made contributions to the pension and benefit restoration plans for the quarter and six months ended June 30, 2011 amounting to $39 thousand and $124.6 million, respectively. The total contributions expected to be paid during the year 2011 for the pension and benefit restoration plans amount to approximately $126.7 million.
The Corporation also provides certain health care benefits for retired employees of certain subsidiaries. The table that follows presents the components of net periodic postretirement benefit cost.
Service cost
Amortization of prior service cost
Amortization of net loss (gain)
Total net periodic postretirement benefit cost
Contributions made to the postretirement benefit plan for the quarter and six months ended June 30, 2011, amounted to approximately $1.6 million and $3.6 million, respectively. The total contributions expected to be paid during the year 2011 for the postretirement benefit plan amount to approximately $6.6 million.
Note 27 – Stock-based compensation
The Corporation maintained a Stock Option Plan (the “Stock Option Plan”), which permitted the granting of incentive awards in the form of qualified stock options, incentive stock options, or non-statutory stock options of the Corporation. In April 2004, the Corporation’s shareholders adopted the Popular, Inc. 2004 Omnibus Incentive Plan (the “Incentive Plan”), which replaced and superseded the Stock Option Plan. The adoption of the Incentive Plan did not alter the original terms of the grants made under the Stock Option Plan prior to the adoption of the Incentive Plan.
Stock Option Plan
Employees and directors of the Corporation or any of its subsidiaries were eligible to participate in the Stock Option Plan. The Board of Directors or the Compensation Committee of the Board had the absolute discretion to determine the individuals that were eligible to participate in the Stock Option Plan. This plan provided for the issuance of Popular, Inc.’s common stock at a price equal to its fair market value at the grant date, subject to certain plan provisions. The shares are to be made available from authorized but unissued shares of common stock or treasury stock. The Corporation’s policy has been to use authorized but unissued shares of common stock to cover each grant. The maximum option term is ten years from the date of grant. Unless an option agreement provides otherwise, all options granted are 20% exercisable after the first year and an additional 20% is exercisable after each subsequent year, subject to an acceleration clause at termination of employment due to retirement.
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(Not in thousands)
Exercise Price Rangeper Share
$ 14.39 - $ 18.50
$ 19.25 - $ 27.20
$ 14.39 - $ 27.20
There was no intrinsic value of options outstanding at June 30, 2011 and 2010. There was no intrinsic value of options exercisable at June 30, 2011 and 2010.
The following table summarizes the stock option activity and related information:
Outstanding at December 31, 2009
Granted
Exercised
Forfeited
Expired
Outstanding at December 31, 2010
Outstanding at June 30, 2011
The stock options exercisable at June 30, 2011 totaled 2,103,034 (June 30, 2010 – 2,530,137). There were no stock options exercised during the quarters and six months ended June 30, 2011 and 2010. Thus, there was no intrinsic value of options exercised during the quarters and six months ended June 30, 2011 and 2010.
There were no new stock option grants issued by the Corporation under the Stock Option Plan during 2010 and 2011.
There was no stock option expense recognized for the quarters and six months ended June 30, 2011 and 2010.
Incentive Plan
The Incentive Plan permits the granting of incentive awards in the form of Annual Incentive Awards, Long-term Performance Unit Awards, Stock Options, Stock Appreciation Rights, Restricted Stock, Restricted Units or Performance Shares. Participants in the Incentive Plan are designated by the Compensation Committee of the Board of Directors (or its delegate as determined by the Board). Employees and directors of the Corporation and/or any of its subsidiaries are eligible to participate in the Incentive Plan.
Under the Incentive Plan, the Corporation has issued restricted shares, which become vested based on the employees’ continued service with Popular. Unless otherwise stated in an agreement, the compensation cost associated with the shares of restricted stock is determined based on a two-prong vesting schedule. The first part is vested ratably over five years commencing at the date of grant and the second part is vested at termination of employment after attainment of 55 years of age and 10 years of service. The five-year vesting part is accelerated at termination of employment after attaining 55 years of age and 10 years of service.
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The following table summarizes the restricted stock activity under the Incentive Plan for members of management.
Non-vested at December 31, 2009
Vested
Non-vested at December 31, 2010
Non-vested at June 30, 2011
During the quarter ended June 30, 2011, 636,889 shares of restricted stock were awarded to management under the Incentive Plan, from which 187,880 shares were awarded to management consistent with the requirements of the TARP Interim Final Rule. For the six-month period ended June 30, 2011, 1,559,463 shares of restricted stock were awarded to management under the Incentive Plan, from which 1,110,454 shares were awarded to management consistent with the requirements of the TARP Interim Final Rule.
During the quarter ended June 30, 2010, 563,043 shares of restricted stock were awarded to management under the Incentive Plan, from which 360,527 shares were awarded to management consistent with the requirements of the TARP Interim Final Rule. For the six-month period ended June 30, 2010, 1,525,416 shares of restricted stock were awarded to management under the Incentive Plan, from which 1,246,755 shares were awarded to management consistent with the requirements of the TARP Interim Final Rule.
Beginning in 2007, the Corporation authorized the issuance of performance shares, in addition to restricted shares, under the Incentive Plan. The performance share awards consist of the opportunity to receive shares of Popular Inc.’s common stock provided that the Corporation achieves certain performance goals during a three-year performance cycle. The compensation cost associated with the performance shares is recorded ratably over a three-year performance period. The performance shares are granted at the end of the three-year period and vest at grant date, except when the participant’s employment is terminated by the Corporation without cause. In such case, the participant would receive a pro-rata amount of shares calculated as if the Corporation would have met the performance goal for the performance period. During the six months ended June 30, 2011, no performance shares were granted under this plan (June 30, 2010 – 12,426).
During the quarter ended June 30, 2011, the Corporation recognized $0.8 million of restricted stock expense related to management incentive awards, with a tax benefit of $0.2 million (June 30, 2010 - credit of $0.2 million, with an income tax expense of $56 thousand). For the six-month period ended June 30, 2011, the Corporation recognized $1.3 million of restricted stock expense related to management incentive awards, with a tax benefit of $0.3 million (June 30, 2010 - $0.1 million, with a tax benefit of $71 thousand). The fair market value of the restricted stock vested was $90 thousand at grant date and $74 thousand at vesting date. This triggers a shortfall of $3 thousand that was recorded as an additional income tax expense at the applicable income tax rate. No additional income tax expense was recorded for the U.S. employees due to the valuation allowance of the deferred tax asset. There was no performance share expense recognized for the quarter ended June 30, 2011 and June 30, 2010. There was no performance share expense recognized for the six months ended June 30, 2011 (June 30, 2010 - $0.1 million, with a tax benefit of $60 thousand). The total unrecognized compensation cost related to non-vested restricted stock awards and performance shares to members of management at June 30, 2011 was $5.5 million and is expected to be recognized over a weighted-average period of 2 years.
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The following table summarizes the restricted stock activity under the Incentive Plan for members of the Board of Directors:
During the quarter ended June 30, 2011, the Corporation granted 195,423 shares of restricted stock to members of the Board of Directors of Popular, Inc. and BPPR, which became vested at grant date (June 30, 2010 – 207,261). During this period, the Corporation recognized $0.1 million of restricted stock expense related to these restricted stock grants, with a tax benefit of $35 thousand (June 30, 2010 - $0.1 million, with a tax benefit of $60 thousand). For the six-month period ended June 30, 2011, the Corporation granted 218,707 shares of restricted stock to members of the Board of Directors of Popular, Inc. and BPPR, which became vested at grant date (June 30, 2010 – 242,394). During this period, the Corporation recognized $0.2 million of restricted stock expense related to these restricted stock grants, with a tax benefit of $70 thousand (June 30, 2010 - $0.3 million, with a tax benefit of $0.1 million). The fair value at vesting date of the restricted stock vested during the six months ended June 30, 2011 for directors was $0.6 million.
Note 28 – Income taxes
The reasons for the difference between the income tax (benefit) expense applicable to income before taxes and the amount computed by applying the statutory tax rate in Puerto Rico are included in the following tables.
Computed income tax at statutory rates
Net benefit of net tax exempt interest income
Effect of income subject to preferential tax rate
Deferred tax asset valuation allowance
Non-deductible expenses
Difference in tax rates due to multiple jurisdictions
Recognition of tax benefits from previous years [1]
State taxes and others
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Initial adjustment in deferred tax due to change in tax rate
The results for the second quarter of 2011 reflect a tax benefit of $59.6 million related to the timing of loan charge-offs for tax purposes. In May 2011, the Puerto Rico Department of the Treasury (the “P.R. Treasury”) issued a private ruling to the Corporation (the “Ruling”) creating an agreement to establish the criteria to determine when a charge-off for accounting and financial reporting purposes should be reported as a deduction for tax purposes. On June 30, 2011, the P.R. Treasury and the Corporation signed a closing agreement in which both parties agreed that for tax purposes the deductions related to certain charge-offs recorded on the financial statements of the Corporation for the years 2009 and 2010 will be deferred until 2013, 2014, 2015 and 2016. As a result of the agreement, the Corporation made a payment of $89.4 million to the P.R. Treasury and recorded a tax benefit on its financial statements of $143 million, or $53.6 net of the payment made to the P.R. Treasury, resulting from the recovery of certain tax benefits not previously recorded during years 2009 (the benefit of reduced tax rates for capital gains) and 2010 (the benefit of exempt income) that were previously unavailable to the Corporation as a result of being in a loss position for tax purposes in such years. Also, the Corporation recorded a tax benefit of $6.0 million related to the tax benefit of the exempt income for the first quarter of 2011. The effective tax rate for the Corporation’s Puerto Rico banking operations for 2011 is estimated at 22%.
On January 31, 2011, the Governor of Puerto Rico signed into law a new Internal Revenue Code for Puerto Rico (the “2011 Tax Code”) which resulted in a reduction in the Corporation’s net deferred tax asset with a corresponding charge to income tax expense of $103.3 million due to a reduction in the marginal corporate income tax rate. Under the provisions of the 2011 Tax Code, the maximum marginal corporate income tax rate is 30% for years commenced after December 31, 2010. Prior to the 2011 Tax Code, the maximum marginal corporate income tax rate in Puerto Rico was 39%, which had increased to 40.95% due to a temporary 5% surtax approved in March 2009 for years beginning on January 1, 2009 through December 31, 2011. The 2011 Tax Code, however, eliminated the special 5% surtax on corporations for tax year 2011.
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The following table presents the components of the Corporation’s deferred tax assets and liabilities.
Deferred tax assets:
Tax credits available for carryforward
Net operating loss and other carryforward available
Postretirement and pension benefits
Deferred loan origination fees
Deferred gains
Accelerated depreciation
Intercompany deferred gains
Other temporary differences
Total gross deferred tax assets
Deferred tax liabilities:
Differences between the assigned values and the tax bases of assets and liabilities recognized in purchase business combinations
Difference in outside basis between financial and tax reporting on sale of a business
FDIC-assisted transaction
Unrealized net gain on trading and available-for-sale securities
Deferred loan origination costs
Total gross deferred tax liabilities
Valuation allowance
Net deferred tax asset
The net deferred tax asset shown in the table above at June 30, 2011 is reflected in the consolidated statements of condition as $362 million in net deferred tax assets (in the “Other assets” caption) (December 31, 2010 - $388 million) and $14 million in deferred tax liabilities in the “Other liabilities” caption (December 31, 2010 - $11 million), reflecting the aggregate deferred tax assets or liabilities of individual tax-paying subsidiaries of the Corporation.
A deferred tax asset should be reduced by a valuation allowance if based on the weight of all available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or the entire deferred tax asset will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized. The determination of whether a deferred tax asset is realizable is based on weighting all available evidence, including both positive and negative evidence. The realization of deferred tax assets, including carryforwards and deductible temporary differences, depends upon the existence of sufficient taxable income of the same character during the carryback or carryforward period. The analysis considers all sources of taxable income available to realize the deferred tax asset, including the future reversal of existing taxable temporary differences, future taxable income exclusive of reversing temporary differences and carryforwards, taxable income in prior carryback years and tax-planning strategies.
The Corporation’s U.S. mainland operations are in a cumulative loss position for the three-year period ended June 30, 2011. For purposes of assessing the realization of the deferred tax assets in the U.S. mainland, this cumulative taxable loss position is considered significant negative evidence and has caused management to conclude that it is more likely than not that the Corporation will not be able to realize the associated deferred tax assets in the future. At June 30, 2011, the Corporation recorded a valuation allowance of approximately $1.3 billion on the deferred tax assets of its U.S. operations (December 31, 2010 - $1.3 billion).
At June 30, 2011, the Corporation’s deferred tax assets related to its Puerto Rico operations amounted to $371 million. The Corporation assessed the realization of the Puerto Rico portion of the net deferred tax asset based on the weighting of all available evidence. The Corporation’s Puerto Rico Banking operation is in a cumulative loss position for the three-year period ended June 30, 2011. This situation is mainly due to the performance of the construction loan portfolio, including the charges related to the proposed sale of the portfolio. The Corporation’s banking operations in Puerto Rico has been historically profitable, and it is management’s view, based on that history, that the event causing this loss is not a continuing condition of the operations. In addition, as a result of the Ruling described above, the realization of the Puerto Rico net deferred tax asset has further improved. Accordingly, there is enough positive evidence to outweigh the negative evidence of the cumulative loss. As indicated
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earlier, in May 2011, the Corporation received a Ruling from the P.R. Treasury establishing the treatment of the loan charge-offs for tax purposes. In summary, the government ruled that the criteria to have a loan loss for taxes are more rigorous than the criteria to have a loan loss for accounting and financial reporting purposes. Based on Puerto Rico law and regulations, the P.R. Treasury ruled that if the Corporation decides to take a loan loss deduction in the tax return for the loan charge-off taken for accounting reporting purposes during the same year, a conclusive presumption is made as to the non-collectability of the loan. On the other hand, if the tax deduction is not taken in the same accounting period, eventually it will have to prove the non-collectability of the loan based on stated criteria. On June 30, 2011, the Corporation entered into a Closing Agreement with the P.R. Treasury, in which both parties agreed that pursuant to the Ruling, the Corporation’s Puerto Rico Banking operation would not take any tax deduction for bad debts related to the construction and commercial loans portfolio on the tax returns for 2009 and 2010. It was also agreed that such deferred deductions will be taken evenly over taxable years 2013 through 2016, even if the loans are sold in the future. As a result of the agreement, the Corporation adjusted its Puerto Rico banking operation taxable income previously reported to the P.R. Treasury on the 2009 return. On the other hand, the Corporation reduced its deferred tax asset related to the carryover of net operating losses previously recorded in the year 2010 and for the six months period ended June 30, 2011 and increased the deferred tax asset related to the allowance for loan losses as a result of the deferral of the construction and commercial loans charge offs. Based on the facts explained above, the Corporation has concluded that it is more likely than not that the net deferred tax asset of its Puerto Rico operations will be realized. Management reassesses the realization of the deferred tax assets each reporting period.
The reconciliation of unrecognized tax benefits was as follows:
Balance at January 1
Additions for tax positions - January through March
Reduction as a result of settlements - January through March
Balance at March 31
Additions for tax positions - April through June
Additions for tax positions taken in prior years - April through June
Reduction for tax positions - April through June
At June 30, 2011, the related accrued interest approximated $7.2 million (December 31, 2010 - $6.1 million; June 30, 2010 - $7.1 million). Management determined that at June 30, 2011, December 31, 2010 and June 30, 2010 there was no need to accrue for the payment of penalties.
After consideration of the effect on U.S. federal tax of unrecognized U.S. state tax benefits, the total amount of unrecognized tax benefits, including U.S. and Puerto Rico, that if recognized, would affect the Corporation’s effective tax rate, was approximately $33.4 million at June 30, 2011 (December 31, 2010 - $31.6 million, June 30, 2010 - $32.1 million).
The amount of unrecognized tax benefits may increase or decrease in the future for various reasons including adding amounts for current tax year positions, expiration of open income tax returns due to the statutes of limitation, changes in management’s judgment about the level of uncertainty, status of examinations, litigation and legislative activity and the addition or elimination of uncertain tax positions.
The Corporation and its subsidiaries file income tax returns in Puerto Rico, the U.S. federal jurisdiction, various U.S. states and political subdivisions, and foreign jurisdictions. At June 30, 2011, the following years remain subject to examination in the U.S. Federal jurisdiction: 2008 and thereafter; and in the Puerto Rico jurisdiction, 2006 and thereafter. The Corporation anticipates a reduction in the total amount of unrecognized tax benefits within the next 12 months, which could amount to approximately $8 million.
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Note 29 – Supplemental disclosure on the consolidated statements of cash flows
Additional disclosures on cash flow information and non-cash activities for the six months ended June 30, 2011 and June 30, 2010 are listed in the following table:
Non-cash activities:
Loans transferred to other real estate
Loans transferred to other property
Total loans transferred to foreclosed assets
Transfers from loans held-in-portfolio to loans held-for-sale
Transfers from loans held-for-sale to loans held-in-portfolio
Loans securitized into investment securities [1]
Recognition of mortgage servicing rights on securitizations or asset transfers
Conversion of preferred stock to common stock:
Preferred stock converted
Common stock issued
For the six months ended June 30, 2010 the changes in operating assets and liabilities included in the reconciliation of net income to net cash provided by operating activities, as well as the changes in assets and liabilities presented in the investing and financing sections are net of the effect of the assets acquired and liabilities assumed from the Westernbank FDIC-assisted transaction. Refer to Note 3 to the consolidated financial statements for the composition and balances of the assets and liabilities recorded at fair value by the Corporation on April 30, 2010.
The cash received in the transaction, which amounted to $261 million, is presented in the investing activities section of the Consolidated Statement of Cash Flows as “Cash received from acquisition”.
Note 30 – Segment Reporting
The Corporation’s corporate structure consists of two reportable segments – Banco Popular de Puerto Rico and Banco Popular North America.
On September 30, 2010, the Corporation completed the sale of a 51% ownership interest in EVERTEC, which included the merchant acquiring business of BPPR. EVERTEC was reported as a reportable segment prior to such date, while the merchant acquiring business was originally included in the BPPR reportable segment through June 30, 2010. As a result of the sale, the Corporation no longer presents EVERTEC as a reportable segment and therefore, historical financial information for the processing and merchant acquiring businesses have been reclassified under the Corporate group for all periods presented. Additionally, the Corporation retained Tarjetas y Transacciones en Red Tranred, C.A. (“TRANRED”) (formerly EVERTEC DE VENEZUELA, C.A). and its equity investments in Consorcio de Tarjetas Dominicanas, S.A. (“CONTADO”) and Serfinsa, which were included in the EVERTEC reportable segment through June 30, 2010. As indicated in Note 4 to the consolidated financial statements, the Corporation sold its equity investments in CONTADO and Serfinsa during 2011. In 2011, the Corporation recorded $8.7 million in operating expenses because of the write-off of its investment in TRANRED as the Corporation determined to wind-down these operations. The results for TRANRED and the equity investments are included in the Corporate group for all periods presented. Revenue from the 49% ownership interest in EVERTEC is reported as non-interest income in the Corporate group.
Management determined the reportable segments based on the internal reporting used to evaluate performance and to assess where to allocate resources. The segments were determined based on the organizational structure, which focuses primarily on the markets the segments serve, as well as on the products and services offered by the segments.
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Banco Popular de Puerto Rico:
Given that Banco Popular de Puerto Rico constitutes a significant portion of the Corporation’s results of operations and total assets at June 30, 2011, additional disclosures are provided for the business areas included in this reportable segment, as described below:
Commercial banking represents the Corporation’s banking operations conducted at BPPR, which are targeted mainly to corporate, small and middle size businesses. It includes aspects of the lending and depository businesses, as well as other finance and advisory services. BPPR allocates funds across business areas based on duration matched transfer pricing at market rates. This area also incorporates income related with the investment of excess funds, as well as a proportionate share of the investment function of BPPR.
Consumer and retail banking represents the branch banking operations of BPPR which focus on retail clients. It includes the consumer lending business operations of BPPR, as well as the lending operations of Popular Auto and Popular Mortgage. Popular Auto focuses on auto and lease financing, while Popular Mortgage focuses principally in residential mortgage loan originations. The consumer and retail banking area also incorporates income related with the investment of excess funds from the branch network, as well as a proportionate share of the investment function of BPPR.
Other financial services include the trust and asset management service units of BPPR, the brokerage and investment banking operations of Popular Securities, and the insurance agency and reinsurance businesses of Popular Insurance, Popular Insurance V.I., Popular Risk Services, and Popular Life Re. Most of the services that are provided by these subsidiaries generate profits based on fee income.
Banco Popular North America:
Banco Popular North America’s reportable segment consists of the banking operations of BPNA, E-LOAN, Popular Equipment Finance, Inc. and Popular Insurance Agency, U.S.A. BPNA operates through a retail branch network in the U.S. mainland, while E-LOAN supports BPNA’s deposit gathering through its online platform. All direct lending activities at E-LOAN were ceased during the fourth quarter of 2008. Popular Equipment Finance, Inc. also holds a running-off loan portfolio as this subsidiary ceased originating loans during 2009. Popular Insurance Agency, U.S.A. offers investment and insurance services across the BPNA branch network.
The Corporate group consists primarily of the holding companies: Popular, Inc., Popular North America and Popular International Bank. Also, as discussed previously, it includes the results of EVERTEC for all periods presented. The Corporate group also includes the expenses of certain corporate areas that are identified as critical to the organization: Finance, Risk Management and Legal.
The accounting policies of the individual operating segments are the same as those of the Corporation. Transactions between reportable segments are primarily conducted at market rates, resulting in profits that are eliminated for reporting consolidated results of operations.
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The tables that follow present the results of operations and total assets by reportable segments:
Depreciation expense
Segment assets
Net interest income (loss)
Income tax benefit
90
Income tax expense (benefit)
For the quarter ended June 30, 2010
91
For the six months ended June 30, 2010
Additional disclosures with respect to the Banco Popular de Puerto Rico reportable segment are as follows:
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93
Additional disclosures with respect to the Banco Popular North America reportable segments are as follows:
Net income ( loss)
Non-interest income (loss)
94
Geographic Information
Revenues:[1]
United States
Total consolidated revenues
Selected Balance Sheet Information:
Deposits [1]
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Note 31 – Subsequent events
Subsequent events are events and transactions that occur after the balance sheet date but before financial statements are issued. The effects of subsequent events and transactions are recognized in the financial statements when they provide additional evidence about conditions that existed at the balance sheet date. The Corporation has evaluated events and transactions occurring subsequent to June 30, 2011. Such evaluation resulted in no adjustments in the consolidated financial statements for the quarter ended June 30, 2011.
Certain Regulatory Matters
On July 25, 2011 the Corporation and Banco Popular de Puerto Rico (“BPPR”) entered into a Memorandum of Understanding (the “Corporation/BPPR MOU”) with the Federal Reserve Bank of New York (the “FRB-NY”) and the Office of the Commissioner of Financial Institutions of the Commonwealth of Puerto Rico (the “Office of the Commissioner”). On July 25, 2011 Banco Popular North America (“BPNA”) entered into a Memorandum of Understanding (the “BPNA MOU” and collectively with the Corporation/BPPR MOU, the “MOUs”) with the FRB-NY and the New York State Banking Department (the “Banking Department”). The MOUs provide, among other things, for the Corporation and BPPR to take steps to improve their credit risk management practices, for BPNA to take steps to improve its asset quality, and for the Corporation, BPPR, and BPNA to develop strategic plans to improve earnings and to develop capital plans. The Corporation does not expect the capital plans to require the Corporation to maintain capital ratios in excess of those it currently has achieved. The MOUs require BPPR to obtain approval from the Office of the Commissioner and the Federal Reserve System prior to declaring or paying dividends or incurring, increasing or guaranteeing debt, require BPNA to obtain approval from the Banking Department and the Federal Reserve System prior to declaring or paying dividends, and require the Corporation to obtain approval from the Federal Reserve System prior to declaring or paying dividends, incurring, increasing or guaranteeing debt, or making any distributions on its Trust Preferred Securities or subordinated debt.
In connection with the resumption of payment of monthly dividends on its Preferred Stock, in December 2010, the Corporation committed to the Federal Reserve System to fund the dividend payments out of newly-issued Common Stock issued to employees under the Corporation’s existing savings and investment plans or, if such issuances are insufficient, other common equity capital raised by the Corporation. It is currently anticipated that the Corporation will receive approval from the Federal Reserve System to make dividend payments on its Preferred Stock subject to the same commitments in the future, but there can be no assurance that such approvals will continue to be received. It is anticipated that sufficient Common Stock will be issued under those plans to cover the dividend payments.
Subsequent to entering into the MOU the Corporation received approval from the Federal Reserve System to pay regularly scheduled dividends on its Preferred Stock and distributions on its Trust Preferred Securities through September 30, 2011. The Corporation has no current intention to seek approval to resume dividend payments on its Common Stock.
Note 32 – Condensed consolidating financial information of guarantor and issuers of registered guaranteed securities
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 at June 30, 2011, December 31, 2010 and June 30, 2010, and the results of their operations and cash flows for periods ended June 30, 2011 and 2010.
PIBI is an operating subsidiary of PIHC and is the holding company of its wholly-owned subsidiaries: Popular Insurance V.I., Inc; Tarjetas y Transacciones en Red Tranred, C.A.; and PNA. Prior to the internal reorganization and sale of the ownership interest in EVERTEC, ATH Costa Rica S.A., and T.I.I. Smart Solutions Inc. were also wholly-owned subsidiaries of PIBI.
PNA is an operating subsidiary of PIBI and is the holding company of its wholly-owned subsidiaries: Equity One, Inc.; and Banco Popular North America (“BPNA”), including its wholly-owned subsidiaries Popular Equipment Finance, Inc., Popular Insurance Agency, U.S.A., and E-LOAN, Inc.
PIHC fully and unconditionally guarantees all registered debt securities issued by PNA.
A source of income for PIHC consists of dividends from BPPR. Under the existing federal banking regulations, the prior approval of the Federal Reserve System is required for any dividend from BPPR or BPNA to the PIHC if the total of all dividends declared by each entity during the calendar year would exceed the total of its net income for that year, as defined by the Federal Reserve Board, combined with its retained net income for the preceding two years, less any required transfers to surplus or to a fund for the retirement of any preferred stock. Under this test, at June 30, 2011, BPPR could have declared a dividend of approximately $197 million (June 30, 2010 - $96 million; December 31, 2010 - $78 million). However, as disclosed in Note 31, on July 25, 2011, PIHC
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and BPPR entered into a Memorandum of Understanding with the Federal Reserve Bank of New York and the Office of the Commissioner of Financial Institutions of Puerto Rico that requires the prior approval of these entities prior to the payment of any dividends by BPPR to PIHC. BPNA could not declare any dividends without the approval of the Federal Reserve Board.
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Condensed Consolidated Statement of Condition (Unaudited)
ASSETS
Trading account securities, at fair value
Other investment securities, at lower of cost or realizable value
Investment in subsidiaries
Less - Unearned income
LIABILITIES AND STOCKHOLDERS’ EQUITY
Subordinated notes
98
Common stock
Treasury stock, at cost
Accumulated other comprehensive income, net of tax
99
100
Accumulated other comprehensive (loss) income, net of tax
101
102
Accumulated other comprehensive income (loss), net of tax
103
Condensed Statement of Operations (Unaudited)
INTEREST INCOME:
INTEREST EXPENSE:
Net interest (expense) income
Net interest (expense) income after provision for loan losses
Net loss on sale and valuation adjustments of investment securities
Net loss on sale of loans, including valuation adjustments on loans held-for-sale
FDIC loss share income
Other operating income (loss)
Total non-interest income (loss)
OPERATING EXPENSES:
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(Loss) income before income tax and equity in earnings (losses) of subsidiaries
(Loss) income before equity in earnings (losses) of subsidiaries
Equity in undistributed earnings (losses) of subsidiaries
NET INCOME (LOSS)
105
Condensed Statement of Operations
(Unaudited)
(Loss) income before income tax and equity in earnings of subsidiaries
106
(Loss) income before equity in earnings of subsidiaries
Equity in undistributed earnings of subsidiaries
NET INCOME
107
Net gain on sale and valuation adjustments of investment securities
Net gain on sale of loans, including valuation adjustments on loans held-for-sale
FDIC loss share expense
Other operating (loss) income
Total non-interest (loss) income
(Loss) income before income tax and equity in losses of subsidiaries
108
(Loss) income before equity in losses of subsidiaries
Equity in undistributed losses of subsidiaries
NET LOSS
109
INTEREST AND DIVIDEND INCOME:
Dividend income from subsidiaries
Total interest and dividend income
Net interest income (expense)
Net interest income (expense) after provision for loan losses
110
Income (loss) before income tax and equity in losses of subsidiaries
Income (loss) before equity in losses of subsidiaries
111
Condensed Consolidating Statement of Cash Flows (Unaudited)
Adjustments to reconcile net income to net cash
(used in) provided by operating activities:
Net amortization of premiums and deferred fees
(accretion of discounts)
Net loss on sale and valuation adjustment of investment securities
Net loss on sale of loans, including valuation adjustments on loans held for sale
(Earnings) losses from investments under the equity method
Net decrease (increase) in accrued income receivable
Net (increase) decrease in other assets
Net (decrease) increase in interest payable
Net decrease in pension and other postretirement benefit obligations
Proceeds from sale of investment securities available for sale
Capital contribution to subsidiary
Net cash provided by (used in) investing activities
112
Net increase in deposits
Net increase in federal funds purchased and assets sold under agreements to repurchase
Return of capital
Capital contribution from parent
Net cash (used in) provided by financing activities
Net increase (decrease) in cash and due from banks
113
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Net amortization of premiums and deferred fees (accretion of discounts)
Net gain on sale and valuation adjustment of investment securities
Fair value change of equity appreciation instrument
Net loss (gain) on disposition of premises and equipment
Net gain on sale of loans, including valuation adjustments on loans held for sale
Net (increase) decrease in accrued income receivable
Net increase (decrease) in interest payable
Net increase in pension and other postretirement benefit obligations
Net (decrease) increase in other liabilities
Net cash provided by (used in) operating activities
Net decrease (increase) in money market investments
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Net decrease in deposits
Net decrease in federal funds purchased and assets sold under agreements to repurchase
Net (decrease) increase in other short-term borrowings
Dividends paid to parent company
Net proceeds from issuance of depository shares
Net cash provided by (used in) by financing activities
Net (decrease) increase in cash and due from banks
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This report includes management’s discussion and analysis (“MD&A”) of the consolidated financial position and financial performance of Popular, Inc. (the “Corporation” or “Popular”). All accompanying tables, financial statements and notes included elsewhere in this report should be considered an integral part of this analysis.
OVERVIEW
The Corporation reported net income of $110.7 million for the quarter ended June 30, 2011, compared with a net loss of $44.5 million for the quarter ended June 30, 2010. Pre-tax income for the quarter ended June 30, 2011 amounted to $72.6 million, compared with a pre-tax loss of $17.3 million for the quarter ended June 30, 2010.
For the six months ended June 30, 2011, the Corporation’s net income and pre-tax income amounted to $120.8 million and $229.9 million, respectively, compared with a net loss and pre-tax loss of $129.5 million and $111.6 million, respectively, for the same period in 2010.
Main events for the quarter and six months ended June 30, 2011
Income taxes
The results for the second quarter of 2011 reflect a tax benefit of $59.6 million related to the timing of loan charge-offs for tax purposes. In May 2011, the Puerto Rico Department of the Treasury (the “P.R. Treasury”) issued a private ruling to the Corporation (the “Ruling”) establishing the criteria to determine when a charge-off for accounting and financial reporting purposes should be reported as a deduction for tax purposes. On June 30, 2011, the P.R. Treasury and the Corporation signed a closing agreement in which both parties agreed that for tax purposes the deductions related to certain charge-offs recorded on the financial statements of the Corporation for the years 2009 and 2010 will be deferred until 2013 through 2016. As a result of the agreement, the Corporation made a payment of $89.4 million to the P.R. Treasury and recorded a tax benefit on its financial statements of $143 million, or $53.6 million net of the payment made to the P.R. Treasury, resulting from the recognition of certain tax benefits not previously recorded during years 2009 (the benefit of reduced tax rates for capital gains) and 2010 (the benefit of exempt income) that were previously unavailable to the Corporation as a result of being in a loss position for tax purposes in such years. Also, the Corporation recorded a tax benefit of $6.0 million related to the tax benefit of the exempt income for the first quarter of 2011. The effective tax rate for the Corporation’s Puerto Rico banking operations for 2011 is estimated at 22%.
On January 31, 2011, the Governor of Puerto Rico signed into law a new Internal Revenue Code for Puerto Rico (the “2011 Tax Code”), which resulted in a reduction in the Corporation’s net deferred tax asset with a corresponding charge to income tax expense of $103.3 million due to a reduction in the marginal corporate income tax rate. Under the provisions of the 2011 Tax Code, the maximum marginal corporate income tax rate is 30% for years commenced after December 31, 2010. Prior to the 2011 Tax Code, the maximum marginal corporate income tax rate in Puerto Rico was 39%, which had increased to 40.95% due to a temporary 5% surtax approved in March 2009 for years
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beginning on January 1, 2009 through December 31, 2011. The 2011 Tax Code, however, eliminated the special 5% surtax on corporations for tax year 2011. Under the 2011 Tax Code, the Corporation has an irrevocable one-time election to defer the application of the 2011 Tax Code for five years. This election must be made with the filing of the 2011 income tax return.
Westernbank loans
The performance of the covered loan portfolio from the Westernbank transaction continues to exceed management’s expectations and has elevated the Corporation’s revenue-generating capacity at a time of limited loan demand. During the second quarter of 2011, the Corporation updated the cash flow estimates on the Westernbank acquired covered loan portfolio to reflect the current and expected credit performance of the portfolio. Management’s loan review during the quarter ended June 30, 2011 of the covered loan portfolio reflected that overall expected credit losses declined versus previous estimates. However, certain Westernbank loans in some of the loan pools did show increased expected losses, and the provision for loan losses was increased to reflect this increase in expected losses. During the quarter and six months ended June 30, 2011, the Corporation recognized $48.6 million and $64.2 million, respectively, in provision for loan losses on covered loans related to certain loan relationships. The negative effect of the provision to the Corporation’s results of operations before tax is approximately 20% of the covered loans related provision since the loss sharing agreement covers 80% of the losses and is included as part of FDIC loss share income in the statement of operations. Interest income derived from covered loans for the quarter and six months ended June 30, 2011 amounted to $115.9 million and $218.4 million, respectively, compared with $76.6 million for the quarter and six months ended June 30, 2010. The interest yield on covered loans was 9.91% for the quarter ended June 30, 2011, compared with 9.07% for the same quarter in the previous year. For the six months ended June 30, 2011, the yield on covered loans was 9.26% compared with 9.06% for the same period in 2010. Refer to Note 9 to the consolidated financial statements for a table presenting the changes in the carrying amount and the accretable yield of the covered loans accounted pursuant to ASC 310-30. The accretable yield will benefit prospectively from higher expected cash flows as credit losses are currently expected to be lower than initially estimated and loan defaults are expected to occur at a slower pace than originally projected, thus, producing higher interest cash inflows.
Assets subject to loss sharing agreements with the FDIC, including loans and other real estate owned, are identified as “covered” on the consolidated statements of condition and applicable notes to the consolidated financial statements. Loans acquired in the Westernbank FDIC-assisted transaction, except for credit cards, and other real estate owned are considered “covered” because the Corporation will be reimbursed for 80% of any future losses on these assets subject to the terms of the FDIC loss sharing agreements.
Loan sales and purchases
In the first quarter of 2011, the Corporation completed the sale of $457 million (legal balance) in U.S. non-conventional residential mortgage loans by Banco Popular North America that were reclassified to loans held-for-sale during the fourth quarter of 2010. This sale had a positive impact of approximately $16.4 million to the results of operations for the six months ended June 30, 2011, which included a gain on sale of loans of $2.6 million and a reduction of $13.8 million to the original write-down booked as part of the allowance for loan losses as a result of higher than anticipated pricing.
The Corporation continues to hold the construction and commercial loans from the BPPR reportable segment that were reclassified to held-for-sale in December 2010. Management continues to pursue transactions to sell these portfolios, which amounted to $399 million at June 30, 2011.
The Corporation continues to seek additional opportunities to acquire interest earning assets with appropriate risk profiles. During the second quarter of 2011, Popular completed its second bulk purchase of residential mortgage loans in the last six months, adding an additional $282 million in performing mortgages loans. The purchased loans, including the $236 million acquired in the first quarter, have an average FICO score of 718 and a loan-to-value (“LTV”) of 81%.
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Other transactions for the six months ended June 30, 2011
During 2011, the Corporation completed the sale of its equity investment in the processing business of Consorcio de Tarjetas Dominicanas, S.A. (“CONTADO”) with a positive impact in earnings of $16.7 million, net of tax, for the six months ended June 30, 2011. The Corporation’s investment in CONTADO, accounted for under the equity method, amounted to $16 million at December 31, 2010.
During the first quarter of 2011, the Corporation incurred prepayment penalties of $8.0 million on the early cancellation of $100 million in medium-term notes. Furthermore, in the second quarter of 2011, Popular North America, Inc. (“PNA”), the parent holding company of all of the Corporation’s U.S. mainland operations, exchanged $233.2 million in aggregate principal amount of the $275 million outstanding of 6.85% Senior Notes due 2012 for new notes, in order to extend their maturity and further improve the Corporation’s liquidity position.
During the six months ended June 30, 2011, the Corporation recognized impairment losses of $8.7 million related to the Corporation’s full write-off of its investment in Tarjetas y Transacciones en Red Tranred, C.A. (“TRANRED”), the Corporation’s Venezuela processing subsidiary, as the Corporation has decided to wind down these operations.
The discussion that follows provides highlights of the Corporation’s results of operations for the quarter ended June 30, 2011 compared to the results of operations for the same quarter in 2010. It also provides some highlights with respect to the Corporation’s financial condition, credit quality, capital and liquidity. Table A provides selected financial data and performance indicators for the quarters ended June 30, 2011 and 2010.
Financial highlights:
Net interest income for the second quarter of 2011 increased by $61.4 million, on a taxable equivalent basis, compared with the second quarter of 2010. The net interest margin on a taxable equivalent basis increased from 3.77% for the quarter ended June 30, 2010 to 4.72% for the quarter ended June 30, 2011. Covered loans, which on average approximated $4.7 billion for the quarter ended June 30, 2011 contributed with interest income of $115.9 million for the quarter, compared with $76.6 million for the second quarter of 2010. The improvement in the net interest margin was mainly influenced by the yield contribution of the covered loans accompanied with a reduction in the cost of deposits. The favorable variance from the acquired covered loans was partially offset by a decline in the average volume of non-covered loans, principally in the commercial and construction loan portfolios. The reduction in the average balance of the note issued to the FDIC, which carries a 2.50% rate, also contributed to a reduction in interest expense. Also, there was a decrease in investment securities. Refer to the Net Interest Income section of this MD&A for a discussion of the major variances in net interest income, including yields and costs.
The provision for loan losses for the quarter ended June 30, 2011 decreased by $57.9 million compared with the same quarter in the previous year. The lower provision for loan losses was mainly the result of lower provision required for the non-covered commercial, construction and mortgage loan portfolios, driven principally by: (i) the transfer during the fourth quarter of 2010 of $1.0 billion of commercial, construction and mortgage loans, primarily non-accruing loans, from the held-in-portfolio to held-for-sale category, and (ii) the downsizing of other portfolio segments of the Corporation, such as the legacy portfolio of the business lines exited at the BPNA reportable segment. This was offset by $48.6 million in provision for loan losses recorded during the quarter on the covered loans. Refer to the Credit Risk Management and Loan Quality section of this MD&A for information on the allowance for loan losses, non-performing assets, troubled debt restructurings, net charge-offs and credit quality metrics.
Non-interest income for the quarter ended June 30, 2011 decreased by $74.7 million, compared with the quarter ended June 30, 2010, mainly due to lower impact of the fair value changes in the FDIC equity appreciation instrument that expired in May 2011 without further exercise, lower other service fees, and the impact of lower of cost or fair value adjustments on loans held-for-sale, among other factors. These unfavorable variances were partially offset by higher FDIC loss share income. The variance in other service fees was principally because of lower processing, debit and credit card fees due to the sale of the processing and merchant banking business on September 30, 2010. Refer to the Non-Interest Income section of this MD&A for detailed information.
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Operating expenses for the quarter ended June 30, 2011 decreased by $46.6 million compared with the same quarter of the previous year mainly due to lower personnel costs, equipment expenses, other real estate owned expenses and credit card processing, volume and interchange expenses, partially offset by higher professional fees, principally related to the sale of the processing and merchant banking business, and FDIC deposit insurance costs. The reduction in personnel costs was principally due to lower headcount due to the sale of the processing and merchant banking business in the third quarter of 2010. Refer to the Operating Expenses section of this MD&A for additional explanations.
Income tax benefit amounted to $38.1 million for the quarter ended June 30, 2011, compared with an income tax expense of $27.2 million for the same quarter of 2010. The decrease in income tax expense was primarily due to a tax benefit of $59.6 million recorded in June 2011 which was previously explained in this MD&A and in Note 28 to the consolidated financial statements. The Corporation also benefited in the second quarter of 2011 from a lower marginal corporate income tax rate due to the change in the Puerto Rico tax code.
Total assets amounted to $39.0 billion at June 30, 2011, compared with $38.7 billion at December 31, 2010. Total loans, including held-for-sale, declined $676 million, principally in commercial loans and mortgage loans held-for-sale, partially offset by higher volume of mortgage loans held-in-portfolio due to the loan purchases of performing mortgage loans previously described. The reduction in commercial loans was principally attributable to portfolio run-off and charge-offs, combined with soft loan origination volumes due to the weak Puerto Rico economy.
The allowance for loan losses on the non-covered loan portfolio decreased by $104 million from December 31, 2010 to June 30, 2011. It represented 3.34% of non-covered loans held-in-portfolio at June 30, 2011, compared with 3.83% at December 31, 2010. Non-covered loans refer to loans not covered by the FDIC loss sharing agreements. This decrease includes a reduction in the Corporation’s general allowance component of approximately $110 million, offset by an increase in the specific allowance component of approximately $6 million. The reduction in the general component of the allowance for loan losses for the quarter ended June 30, 2011, was primarily attributable to lower portfolio balances, principally commercial and construction loans, and reduced level of net charge-offs. The Corporation’s non-performing loans held-in-portfolio (non-covered) increased by $81 million from December 31, 2010 to June 30, 2011, reaching $1.7 billion or 8.0% of total non-covered loans held-in-portfolio at June 30, 2011. The increase in non-performing loans held-in-portfolio was driven by the commercial and residential mortgage loan portfolios of the BPPR reportable segment. Weak economic conditions in Puerto Rico have continued to adversely impact the commercial and residential mortgage loan delinquency rates. Non-performing construction loans within the BPPR reportable segment decreased as most of the portfolio is now classified as held-for-sale and a lower level of problem loans remaining as held-in-portfolio. Consumer and lease financing loans in non-performing status in the BPPR reportable segment continue to reflect signs of a stable credit performance. Non-performing loans in the BPNA reportable segment decreased from December 31, 2010 to June 30, 2011. Most loan portfolios within the BPNA reportable segment continue to show signs of credit stabilization. The Corporation’s allowance for loan losses at June 30, 2011 includes $57 million related to the covered loans. Refer to the Provision for Loan Losses and Credit Risk Management and Loan Quality sections of this MD&A for quantitative and qualitative credit information on the loan portfolios.
Refer to Table I in the Financial Condition section of this MD&A for the percentage allocation of the composition of the Corporation’s financing to total assets. Deposits were $28.0 billion at June 30, 2011, compared with $26.8 billion at December 31, 2010. The increase in deposits was mostly associated with the deposits in trust, public funds and brokered certificates of deposit, partially offset by lower volume of retail certificates of deposit. The Corporation’s borrowings amounted to $6.1 billion at June 30, 2011, compared with $6.9 billion at December 31, 2010. The decrease in borrowings was mostly related to a reduction of $975 million in the note issued to the FDIC as part of the Westernbank FDIC-assisted transaction. The Corporation has prepaid a significant amount of the note with proceeds from maturities and pay downs of investment securities.
Stockholders’ equity amounted to $4.0 billion at June 30, 2011, compared with $3.8 billion at December 31, 2010. The increase in stockholders’ equity was mostly due to earnings for the period.
The Corporation continues to be well-capitalized. The Corporation’s regulatory capital ratios improved from December 31, 2010 to June 30, 2011. The Tier 1 capital and Tier 1 common equity to risk-weighted assets stood at 15.22% and 11.53%, respectively, at June 30, 2011, compared with 14.54% and 10.95%, respectively, at December 31, 2010. The
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improvement in the Corporation’s regulatory capital ratios from December 31, 2010 to June 30, 2011 was principally due to: (i) balance sheet composition including the increase in lower risk-assets such as trading and investment securities and mortgage loans; and (ii) internal capital generation.
The Corporation will continue to manage credit costs and pursue transactions for its held-for-sale portfolios. The Corporation continues to seek opportunities to broaden its business through asset acquisitions that can be absorbed by its existing business platforms without undue added risk.
In August 2011, the Corporation announced it entered into a definitive asset purchase agreement with Citibank, N.A., to acquire the American Airlines co-branded credit card portfolio in Puerto Rico and the U.S. Virgin Islands, which represents approximately $130 million in balances and approximately 30,000 active accounts. Also, in July 2011, Popular announced that it entered into a definitive asset purchase agreement with Wells Fargo Advisors, LLC for the acquisition of certain assets and assumption of certain liabilities of Wells Fargo Advisors’ Puerto Rico branch. This transaction gives the opportunity to the Corporation to transition approximately 1,750 accounts with assets under management of approximately $500 million to Popular Securities. Both transactions closed during the third quarter of 2011.
Reflecting the diversity of BPNA’s business and to strengthen the commitment to serve all members of its community, the Corporation will continue rolling out a rebranding campaign. Pursuant to this campaign, which began in the Illinois region and will continue in the regions of California and Florida, BPNA will operate under the name “Popular Community Bank”.
As a financial services company, the Corporation’s earnings are significantly affected by general business and economic conditions. Lending and deposit activities and fee income generation are influenced by the level of business spending and investment, consumer income, spending and savings, capital market activities, competition, customer preferences, interest rate conditions and prevailing market rates on competing products. The Corporation continuously monitors general business and economic conditions, industry-related indicators and trends, competition, interest rate volatility, credit quality indicators, loan and deposit demand, operational and systems efficiencies, revenue enhancements and changes in the regulation of financial services companies. The Corporation operates in a highly regulated environment and may be adversely affected by changes in federal and local laws and regulations. Also, competition with other financial institutions could adversely affect its profitability.
The description of the Corporation’s business contained in Item 1 of the Corporation’s 2010 Annual Report, while not all inclusive, discusses additional information about the business of the Corporation and risk factors, many beyond the Corporation’s control that, in addition to the other information in this Form 10-Q, readers should consider.
The Corporation’s common stock is traded on the NASDAQ Global Select Market under the symbol BPOP.
On July 25, 2011, the Corporation and BPPR entered into a Memorandum of Understanding (the “Corporation/BPPR MOU”) with the Federal Reserve Bank of New York (the “FRB-NY”) and the Office of the Commissioner of Financial Institutions of the Commonwealth of Puerto Rico (the “Office of the Commissioner”). On July 25, 2011, BPNA entered into a Memorandum of Understanding (the “BPNA MOU” and collectively with the Corporation/BPPR MOU, the “MOUs”) with the FRB-NY and the New York State Banking Department (the “Banking Department”). The MOUs provide, among other things, for the Corporation and BPPR to take steps to improve their credit risk management practices, for BPNA to take steps to improve its asset quality, and for the Corporation, BPPR, and BPNA to develop strategic plans to improve earnings and to develop capital plans. The Corporation does not expect the capital plans to require the Corporation to maintain capital ratios in excess of those it currently has achieved. The MOUs require BPPR to obtain approval from the Office of the Commissioner and the Federal Reserve System prior to declaring or paying dividends or incurring, increasing or guaranteeing debt; require BPNA to obtain approval from the Banking Department and the Federal Reserve System prior to declaring or paying dividends; and require the Corporation to obtain approval from the Federal Reserve System prior to declaring or paying dividends, incurring, increasing or guaranteeing debt, or making any distributions on its Trust Preferred Securities or subordinated debt.
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Subsequent to entering into the MOU, the Corporation received approval from the Federal Reserve System to pay regularly scheduled dividends on its Preferred Stock and distributions on its Trust Preferred Securities through September 30, 2011. The Corporation has no current intention to seek approval to resume dividend payments on its Common Stock.
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TABLE A
Financial Highlights
Financial Condition Highlights
Investment and trading securities
Earning assets
Deposits*
Borrowings
Stockholders’ equity
Operating Highlights
Net income (loss) per common share - basic and diluted
Selected Statistical Information
Common Stock Data
Market price
High
Low
End
Book value per common share at period end
Profitability Ratios
Return on assets
Return on common equity
Net interest spread (taxable equivalent)
Net interest margin (taxable equivalent)
Capitalization Ratios
Average equity to average assets
Tier I capital to risk-weighted assets
Total capital to risk-weighted assets
Leverage ratio
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ADOPTION OF NEW ACCOUNTING STANDARDS AND ISSUED BUT NOT YET EFFECTIVE ACCOUNTING STANDARDS
The FASB issued ASU 2011-04 in May 2011. The amendment of this ASU provides a consistent definition of fair value between U.S. GAAP and International Financial Reporting Standards (“IFRS”). The ASU modifies some fair value measurement principles and disclosure requirements including the application of the highest and best use and valuation premise concepts, measuring the fair value of an instrument classified in a reporting entity’s shareholders’ equity, measuring the fair value of financial instruments that are managed within a portfolio, application of premiums and discounts in a fair value measurement, disclosing quantitative information about unobservable inputs used in Level 3 fair value measurements, and other additional disclosures about fair value measurements.
123
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The amendments in ASU 2010-28, issued in December 2010, modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. The qualitative factors are consistent with the existing guidance and examples, which require that goodwill of a reporting unit be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. For public entities, the amendments in this ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. Early adoption is not permitted. The adoption of this guidance did not have an impact on the Corporation’s consolidated financial statements as of and for the six months ended June 30, 2011.
CRITICAL ACCOUNTING POLICIES / ESTIMATES
The accounting and reporting policies followed by the Corporation and its subsidiaries conform to generally accepted accounting principles in the United States of America and general practices within the financial services industry. Various elements of the Corporation’s accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. These estimates are made under facts and circumstances at a point in time and changes in those facts and circumstances could produce actual results that differ from those estimates.
Management has discussed the development and selection of the critical accounting policies and estimates with the Corporation’s Audit Committee. The Corporation has identified as critical accounting policies those related to: (i) Fair Value Measurement of Financial Instruments; (ii) Loans and Allowance for Loan Losses; (iii) Acquisition Accounting for Loans and Related Indemnification Asset; (iv) Income Taxes; (v) Goodwill, and (vi) Pension and Postretirement Benefit Obligations. For a summary of these critical accounting policies and estimates, refer to that particular section in the MD&A included in Popular, Inc.’s 2010 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, 2010 (the “2010 Annual Report”). Also, refer to Note 1 to the consolidated financial statements included in the 2010 Annual Report for a summary of the Corporation’s significant accounting policies.
NET INTEREST INCOME
Net interest income, on a taxable equivalent basis, is presented with its different components on Tables B and C for the quarter and six months ended June 30, 2011, as compared with the same periods in 2010, segregated by major categories of interest earning assets and interest bearing liabilities.
The interest earning assets include the investment securities and loans that are exempt from income tax, principally in Puerto Rico. The main sources of tax-exempt interest income are certain investments in obligations of the U.S. Government, its agencies and sponsored entities, and certain obligations of the Commonwealth of Puerto Rico and its agencies. Assets held by the Corporation’s international banking entities, which previously were tax exempt under Puerto Rico law, have a temporary 5% tax rate. To facilitate the comparison of all interest related to these assets, the interest income has been converted to a taxable equivalent basis, using the applicable statutory income tax rates at each quarter and period reported. The taxable equivalent computation considers the interest expense disallowance required by the Puerto Rico tax law.
Average outstanding securities balances are based upon amortized cost excluding any unrealized gains or losses on securities available-for-sale. Non-accrual loans have been included in the respective average loans and leases categories. Loan fees collected and costs incurred in the origination of loans are deferred and amortized over the term of the loan as an adjustment to interest yield. Prepayment penalties, late fees collected and the amortization of premiums / discounts on purchased loans are also included as part of the loan yield. Interest income for the quarter and six months ended June 30, 2011 included a favorable impact related to those items of $5.4 million and $10.5 million, respectively, compared to a favorable impact of $4.1 million and $8.0 million for the quarter and six months ended June 30, 2010, respectively. These figures exclude the discount accretion on covered loans accounted for under ASC Subtopic 310-20 and ASC Subtopic 310-30. The discount accretion on covered loans accounted for under ASC Subtopic 310-30 and 310-20 was $100.2 million and $9.1 million, respectively, for the quarter and $173.1 million and $33.6 million, respectively, for the six months ended June 30, 2011. The discount accretion on covered loans accounted for under ASC Subtopic 310-30 and 310-20 was $53.4 million and $19.5 million, respectively, for the quarter and six months ended June 30, 2010.
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TABLE B
Analysis of Levels & Yields on a Taxable Equivalent Basis
Variance
Attributable to
Trading securities
Total money market, investment and trading securities
Loans:
Commercial and construction
Sub-total loans
Total loans
Total earning assets
Interest bearing deposits:
NOW and money market*
Savings
Time deposits
Medium and long-term debt
Total interest bearing liabilities
Non-interest bearing demand deposits
Other sources of funds
Total source of funds
Net interest margin
Net interest income on a taxable equivalent basis
Net interest spread
Taxable equivalent adjustment
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.
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Net interest income on a taxable equivalent basis for the quarter ended June 30, 2011 increased $61.4 million when compared with the same period in 2010. The increase in net interest margin, on a taxable equivalent basis, for the quarter ended June 30, 2011, compared with the same period in 2010, was driven mostly by:
a decrease in deposit costs associated to both a low interest rate scenario and management actions to reduce deposit costs;
improved yield on mortgage loans related to two large whole loan purchases by the BPPR reportable segment involving $518 million in performing mortgage loans during the first six months on 2011; and a
higher yield on covered loans that resulted principally from higher accretion on loans accounted for under ASC Subtopic 310-30 by $46.8 million, partially offset by a reduction of $10.4 million on the discount accretion of covered loans accounted for under ASC Subtopic 310-20 due to their short-term nature. This impact is included in the line item “Covered loans” in Table B. The increase in the accretable yield for covered loans under ASC Subtopic 310-30 is due to one additional month in 2011 (acquisition was on April 30, 2010) and the impact of loan defaults coming in at a slower pace than originally projected, thus, producing higher interest income, and improved actual and expected cash flows on the majority of the loan pools to reflect improved expected credit performance of the portfolio.
All loan categories, except mortgage loans and covered loans, decreased in average volume for the quarter ended June 30, 2011 compared with the same quarter in 2010. The decline in the commercial and construction loan portfolios was principally due to loan repayments not being replaced with new loans at the same rate given the lower level of origination activity in the current economic environment, and the impact of loan charge-offs. The consumer loan portfolio shows a decrease due to the slowdown in the auto and consumer loan origination activity in Puerto Rico, and the run-off of E-LOAN’s home equity lines of credit (“HELOCs”) and closed-end second mortgages. On the positive side, covered loans acquired in the Westernbank FDIC-assisted transaction with an increase of $1.3 billion in average loan volume for the second quarter of 2011 as compared to the same period in 2010, mostly related to the timing of the acquisition, mitigated the decrease in the volume of earning assets. Covered loans contributed $115.9 million to the Corporation’s interest income during second quarter 2011, compared to $76.6 million in the same period of 2010. Also, the increase in mortgage loans positively impacted interest income with good quality assets. Investment securities decreased in average volume as a result of maturities and prepayments of mortgage-related investment securities, which funds were not reinvested due in part to deleveraging strategies, and to the sale of certain investment securities during the third quarter of 2010. The decrease was partially offset by the purchase of $753 million in investment securities by BPNA during the first quarter of 2011. The increase of $424 million in the average volume of demand deposits contributed to the improved net interest margin with no associated funding costs. Also, positively impacting net interest income is the prepayment of several high cost liabilities from July 2010 to June 2011 as part of the Corporation’s efforts to reduce funding costs, including $363 million in Federal Home Loan Bank advances and the early extinguishment of $100 million in medium-term notes. Also, there was a reduction of $2.0 billion in the average volume of the note issue to the FDIC which carries a 2.50% annual rate.
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TABLE C
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As shown in Table C, net interest income on a taxable equivalent basis for the six months ended June 30, 2011 had a positive variance of 72 basis points mostly due to the contribution to interest income of the covered loans as the results for the six months ended June 30, 2011 included six months versus two months in 2010 due to the timing of the business combination. Also, the increase in yield on covered loans was influenced by the variance in discount accretion as explained above, partially offset by the related funding costs. Covered loans contributed $218.4 million to the Corporation’s interest income during the six months ended June 30, 2011, compared with $76.6 million for the same period in 2010.
Furthermore, positively impacting net interest income was a reduction in the cost of interest bearing funds by 47 basis points, mainly deposits, associated to management actions to reduce funding costs as well as a sustained low interest rate environment that has impacted time deposit originations and rollovers. These positive variances were partially offset by the decrease in volume of commercial and consumer loans and investment securities as explained above. The decrease in the taxable equivalent adjustment for the six months ended June 30, 2011, compared with the previous year, relates to the reduction in Puerto Rico of the marginal income tax rate from 40.95% in 2010 to 30% as dictated by the 2010 income tax reform, and results from a lower benefit obtained from exempt assets.
PROVISION FOR LOAN LOSSES
The Corporation’s provision for loan losses totaled $144.3 million and $219.6 million for the quarter and six months ended June 30, 2011, respectively, compared with $202.3 million and $442.5 million for the same periods in 2010. The lower provision for loan losses for both periods in 2011, compared with 2010, was mainly the result of lower provision required for the non-covered commercial, construction and mortgage loan portfolios, driven principally by: (i) the transfer during the fourth quarter of 2010 of $1.0 billion of commercial, construction and mortgage loans, primarily non-accruing loans, from the held-in-portfolio to held-for-sale category, thus reducing the need to record provision for loan losses since loans held-for-sale are accounted for at lower of cost or fair value and were written down to fair value upon reclassification, and (ii) the downsizing of other portfolio segments of the Corporation, such as the legacy portfolio of the business lines exited at the BPNA reportable segment.
During the first quarter of 2011, the BPNA reportable segment completed the sale of $457 million (legal balance) in U.S. non-conventional residential mortgage loans that were reclassified to loans held-for-sale during the fourth quarter of 2010. The sale had a positive impact on the provision for loan losses of $13.8 million in the first quarter of 2011 since the benefit of improved pricing on the sale was classified as a reduction to the original write-down booked as part of the activity in the allowance for loan losses. The $13.8 million contributed to the favorable variance in the provision for loan losses for the six months ended June 30, 2011 when compared with the same period in 2010.
Partially offsetting such reductions in the provision for loan losses was the impact of the reserve requirement on covered loans during 2011. The Corporation’s provision for loan losses for the quarter and six months ended June 30, 2011 includes a provision for loans losses on covered loans of $48.6 million and $64.2 million, respectively, mainly driven by: (i) provisions of $43.6 million and $52.7 million for the three and six months ended June 30, 2011, respectively, on covered loans accounted for under ASC Subtopic 310-30, as certain loans pools, principally commercial real estate pools, reflected higher than expected credit deterioration, and (ii) provisions of $6.1 million and $10.9 million for the quarter and six months ended June 30, 2011, respectively, for covered loans accounted for under ASC Subtopic 310-20. No provision for loan losses was necessary to be recorded during the quarter and six months ended June 30, 2010 on the covered loans. When the Corporation records a provision for loan losses on the covered loans, it also records a benefit of 80% attributable to the FDIC loss sharing agreements, which is recorded in non-interest income.
Refer to the Credit Risk Management and Loan Quality Section of this MD&A for a detailed analysis of net charge-offs, non-performing assets, the allowance for loan losses and selected loan losses statistics.
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NON-INTEREST INCOME
Refer to Table D for a breakdown on non-interest income by major categories for the quarters and six months ended June 30, 2011 and 2010.
TABLE D
Non-Interest Income
Other service fees:
Total other service fees
Trading account gain (loss)
Gain on sale of loans, including valuation adjustment on loans held-for-sale
Adjustment (expense) to indemnity reserves on loans sold
The decrease in non-interest income for the quarter and six months ended June 30, 2011, when compared with the same periods of the previous year, was negatively impacted by the following factors:
lower service charges on deposit accounts by $3.9 million and $8.8 million, respectively, mostly in the BPNA reportable segment related to lower nonsufficient funds fees and reduced fees from money services clients and the impact of Regulation E;
lower other service fees by $45.4 million and $88.1 million, respectively, due to lower credit and debit card fees of $29.6 million and $56.0 million, respectively, mostly as a result of transferring the merchant banking business to EVERTEC as part of the sale and lower volume of credit cards subject to late payment fees and lower average rate charged per transaction. Processing fees decreased by $12.4 million and $24.7 million, respectively, since they were previously generated by the Corporation’s processing business which was also transferred as part of the EVERTEC sale;
unfavorable impact in the caption of net gain on sale of loans, including valuation adjustments on loans held-for-sale, by $17.9 million and $15.7 million, respectively, mostly due to $12.7 million in fair value adjustments recorded during the second quarter of 2011 in the BPPR reportable segment on commercial and construction loans held-for-sale due to new advances made on these loans and $6.7 million in fair value adjustments recorded during the second quarter of 2011 in the BPPR reportable segment on transfers from held-for-sale to other real estate owned.
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The components of net gain on sale of loans, including valuation adjustments on loans held-for-sale, are as follows:
Net gain on sale of loans
Adjustments related to repurchases of unreserved loans without credit recourse
Lower of cost or market valuation adjustment on loans held-for-sale
unfavorable impact in the fair value of the equity appreciation instrument issued to the FDIC by $23.8 million and $16.1 million, respectively, resulting from the expiration of the instrument on May 7, 2011; and an
unfavorable variance in other operating income by $40.3 million and $19.2 million, respectively, due to losses of $12.0 million and $14.0 million for the quarter and six months ended June 30, 2011, respectively, from the retained ownership interest in EVERTEC, which represented $0.7 million and $12.5 million, respectively, of the share of EVERTEC’s net income which mostly resulted from the $13.8 million positive impact related to the reversal of EVERTEC’s deferred tax liability upon application of the Puerto Rico income tax reform during the first quarter of 2011. The share of EVERTEC’s net income was offset by the 49% of intercompany eliminations of $12.7 million and $26.5 million for the quarter and six months, respectively. Refer to Note 4 to the consolidated financial statements for a list of intra-entity eliminations for transactions and service payments between the Corporation and EVERTEC as an affiliate. The unfavorable impact in non-interest income was offset by the elimination of 49% of the professional fees (expense) paid by the Corporation to EVERTEC. The variance in other operating income was also related to lower income by $20.3 million and $17.9 million for the quarter and six-month periods related to the accretion of the contingency for unfunded lending commitments that was recorded at fair value as part of the FDIC-assisted transaction (with an offset of 80% recorded as a reduction to income in the category of FDIC loss share income). These revolving lines of credit were mostly with maturities of one year or less. For the six months ended June 30, 2011, the unfavorable variance in other operating income was offset by the gain of $20.6 million (before tax) on the sale of the equity interest in CONTADO during the first quarter of 2011.
These unfavorable variances for the quarter and six months ended June 30, 2011, when compared with the same periods of the previous year, were partially offset by the following positive factors:
favorable variance resulting from lower adjustments recorded to indemnity reserves on loans sold by $4.9 million and $12.4 million, respectively, consisting of $1.9 million and $7.9 million, respectively, in the BPPR reportable segment and $3.0 million and $4.5 million, respectively, in the BPNA reportable segment and the discontinued operations of Popular Financial Holdings (“PFH”), the latter which is part of the Corporate group; and a
favorable variance in FDIC loss share income by $53.7 million and $69.7 million, respectively. The increase in FDIC loss share income during the quarter ended June 30, 2011, compared with the same quarter of the previous year, resulted mostly from the positive impact of $38.9 million corresponding to the increase in the FDIC loss share indemnification asset due to the recording of provision for loan losses on loans covered under the loss sharing agreements as mentioned in the Overview and Provision for Loan Losses section of this MD&A. Also, the increase in FDIC loss share income was the result of a decrease of $24.2 million in the discount accretion for the acquired loans accounted for pursuant to ASC Subtopic 310-20 and the unfunded commitments, which as a result of reciprocal accounting, caused an 80% reduction in the related FDIC loss share expense, partially offset by $10.6 million in lower accretion of the FDIC loss share indemnification asset due to a reduction in expected credit losses. The increase in FDIC loss share income for the six months ended June 30, 2011, when compared with the same period of the previous year, was mostly the result of the positive impact of $51.3 million corresponding to the increase in the FDIC loss share indemnification asset due to the recording of provision for loan losses on loans covered under the loss sharing agreements, $13.7 million in accretion of the indemnification asset and $14.5 million in lower accretion of the contingency for unfunded lending commitments explained previously (80% reciprocal accounting), partially offset by $11.8 million in losses resulting from the Corporation’s reciprocal accounting on the accretion of the discount for covered loans accounted for pursuant to ASC Subtopic 310-20.
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OPERATING EXPENSES
Table E provides a breakdown of operating expenses by major categories.
TABLE E
Operating Expenses
Personnel costs:
Salaries
Commissions, incentives and other bonuses
Pension, postretirement and medical insurance
Other personnel costs, including payroll taxes
Total personnel costs
Professional fees:
Collections, appraisals and other credit related fees
Programming, processing and other technology services
Other professional fees
Total professional fees
Other operating expenses:
Credit and debit card processing, volume and interchange expenses
Transportation and travel
Printing and supplies
All other
Total other operating expenses
The decrease in personnel costs was principally related to the reduction in headcount due to the sale of EVERTEC. Personnel costs for the former EVERTEC reportable segment amounted to $21.3 million for the quarter ended June 30, 2010 and $42.4 million for the six months ended June 30, 2010. Full time equivalent employees totaled 8,365 at June 30, 2011 compared with 10,659 at June 30, 2010. EVERTEC had 1,843 employees at June 30, 2010. The reductions resulting from the exclusion of EVERTEC were partially offset by the salaries from the employees hired from the former Westernbank operations and to the impact of annual salary revisions. Also, during the quarter ended June 30, 2010, the Corporation paid special compensation benefits to Westernbank terminated employees. Furthermore, influencing the variance in personnel costs was lower pension cost by $6.0 million and $8.6 million for the quarter and six months ended June 30, 2011, respectively, compared with the same periods in 2010. This variance was mainly due to the recognition in the second quarter of 2010 of a settlement loss of $3.4 million related to the Corporation’s U.S. retirement plan, and to the impact of higher expected return on plan assets in 2011. The variance in other personnel costs was principally due to the recognition during the second quarter of 2010 of $3.1 million in severance payments for a former executive officer.
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The decrease in net occupancy expenses was primarily from a reduction in rental expense of $3.9 million and $7.9 million for the quarter and six months ended June 30, 2011, respectively, when compared with the same periods in 2010, mainly as a result of the EVERTEC sale, including the merchant business, and also due to fewer branches in the BPNA reportable segment.
The decrease in equipment expenses was mainly due to lower amortization of software licenses and depreciation of electronic equipment as a result of the transfer of software and equipment to EVERTEC as part of the sale in the third quarter of 2010. Also, BPPR incurred higher rental equipment expenses during 2010 as part of the integration of Westernbank.
The increase in professional fees was principally in the categories of system application processing and hosting, which represent services provided by EVERTEC to the Corporation’s subsidiaries. Prior to the sale of EVERTEC, these costs were fully eliminated in consolidation, but now 51% of such costs are not eliminated when consolidating the Corporation’s financial results of operations, resulting in an increase for the second quarter and first six months of 2011.
The reduction in communication expenses was principally the result of the transferring of communication lines to EVERTEC, including those related to the merchant banking business. The former EVERTEC reportable segment, including merchant, recorded communication costs of $3.2 million and $6.3 million for the quarter and six months ended June 30, 2010, respectively.
There were also higher FDIC deposit insurance assessments during 2011 due to the change in assessment and higher losses on early extinguishment of debt during the six months period ended June 30, 2011 mainly related to $8.0 million in prepayment penalties on the repayment of $100 million in medium-term notes in the first quarter of 2011.
OREO expenses decreased during the second quarter and six months ended June 30, 2011 as compared to the same periods of 2010 mainly as a result of lower write-downs in commercial properties since 2010 included large reappraisal adjustments on high-value properties.
The decrease in credit and debit card processing, volume and interchange expenses was also due to the sale of the processing and merchant banking businesses to EVERTEC. The reduction in all other categories within other operating expenses for the quarter ended June 30, 2011 compared with the second quarter of 2010 was mainly due to lower provision for unfunded commitments, which reflected a variance of $4.9 million. Favorable variances in the provision for unfunded commitments and sundry losses, among others, for the six months ended June 30, 2011 compared with the same period in 2010, offset the negative impact of the impairment losses of $8.7 million recognized during the first six months of 2011 related to the write-down of the net assets of the Corporation’s Venezuela operations.
INCOME TAXES
Income tax benefit amounted to $38.1 million for the quarter ended June 30, 2011, compared with an income tax expense of $27.2 million for the same quarter of 2010. The decrease in income tax expense was primarily due to a tax benefit of $53.6 million recorded in June 2011 for the recognition of certain tax benefits not previously recorded during years 2009 (the benefit of reduced tax rates for capital gains) and 2010 (the benefit of the exempt income) as a result of the closing agreement between the Corporation and the P.R. Treasury described in the Overview section of this MD&A. The Corporation and P.R. Treasury agreed that for tax purposes the deductions related to certain loan charge-offs recorded on the consolidated financial statements for the years 2009 and 2010 could be deferred until 2013 through 2016. Also, during the second quarter of 2011 and as part of the impact of the closing agreement, the Corporation recorded a tax benefit of $6.0 million related to the tax benefit of the exempt income for the first quarter of 2011. The Corporation also benefited in the second quarter of 2011 from a lower marginal corporate income tax rate, which was reduced from 39% to 30% effective January 1, 2011. The effective tax rate for the Corporation’s Puerto Rico banking operations for 2011 is estimated at 22%.
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The components of income tax for the quarter ended June 30, 2011 and 2010 were as follows:
Income Taxes
Income tax expense amounted to $109.1 million for the six months ended June 30, 2011, compared with an income tax expense of $18.0 million for the same period of 2010.
The increase in income tax expense was primarily due to higher income before tax on the Puerto Rico operations.
Also, in January 2011, the Governor of Puerto Rico signed into law a new Internal Revenue Code for Puerto Rico, which among the most significant changes applicable to the Corporation was the reduction in the marginal tax rate indicated above from 39% to 30%. Consequently, as a result of this reduction in rate, the Corporation recognized during the first quarter of 2011 an income tax expense of $103.3 million and a corresponding reduction in the net deferred tax assets of the Puerto Rico operations. This increase in income tax expense was partially offset by the benefit recognized during the second quarter of 2011 related to the closing agreement between the Corporation and the P.R. Treasury.
The components of income tax for the six months ended June 30, 2011 and 2010 were as follows:
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Refer to Note 28 to the consolidated financial statements for a breakdown of the Corporation’s deferred tax assets at June 30, 2011 and December 31, 2010.
REPORTABLE SEGMENT RESULTS
The Corporation’s reportable segments for managerial reporting purposes consist of Banco Popular de Puerto Rico and Banco Popular North America. A Corporate group has been defined to support the reportable segments. For managerial reporting purposes, the costs incurred by the corporate group are not allocated to the reportable segments.
As a result of the sale of a 51% interest in EVERTEC, the Corporation no longer presents EVERTEC as a reportable segment and therefore, historical financial information for EVERTEC, including the merchant acquiring business that was part of the BPPR reportable segment but transferred to EVERTEC in connection with the sale, has been reclassified under Corporate for all periods discussed. Revenues from the Corporation’s equity interest in EVERTEC are being reported as non-interest income in the Corporate group.
For a description of the Corporation’s reportable segments, including additional financial information and the underlying management accounting process, refer to Note 30 to the consolidated financial statements.
The Corporate group had a net loss of $31.6 million for the second quarter of 2011, compared with a net loss of $18.2 million for the quarter ended June 30, 2010, and a net loss of $47.9 million for the six months ended June 30, 2011 and $23.9 million for the same period in the previous year.
Highlights on the earnings results for the reportable segments are discussed below.
The Banco Popular de Puerto Rico reportable segment’s net income amounted to $139.8 million for the quarter ended June 30, 2011, compared with $33.1 million for the same quarter in 2010. The principal factors that contributed to the variance in the financial results for the second quarter of 2011, when compared with the same quarter of the previous year, included the following:
higher net interest income by $57.5 million, or 21%, mainly as a result of the covered loans acquired in the Westernbank FDIC-assisted transaction which contributed with interest income for the quarter ended June 30, 2011 of $115.9 million, compared to $76.6 million in the same period of 2010, due to a higher yield on covered loans and to an increase of $1.3 billion in average loan volume mostly related to the timing of the purchase which mitigated the decrease in the volume of earning assets. Also, the improvement in net interest income was associated with an improved yield on mortgage loans related to the purchase of performing mortgage loans during the six months ended June 30, 2011; and a lower cost of deposits, primarily in certificates of deposit and brokered certificates of deposit, as a result of both a low interest rate scenario and management actions to reduce deposit costs. Negatively impacting net interest income is the FDIC loss share indemnification asset of $2.4 billion at June 30, 2011, which is a non-interest earning asset, but is being funded mainly through the FDIC Note at a 2.50% annual fixed interest rate. The accretion or amortization of the FDIC loss share indemnification asset is recorded in non-interest income. Also, excluding the loans acquired in the FDIC-assisted transaction, the commercial, construction and consumer loan portfolios decreased in volume due to low origination activity and loan charge-offs. Furthermore, there was lower interest income from investment securities as a result of maturities and prepayments of mortgage-related investment securities, which funds were not reinvested due in part to deleveraging strategies. Also positively impacting net interest income is the partial prepayment of the note issued to the FDIC. The BPPR reportable segment had a net interest margin of 5.19% for the quarter ended June 30, 2011, compared with 4.15% for the same quarter in 2010;
lower non-interest income by $16.1 million, or 12%, mostly due to the unfavorable impact in the caption of gain on sale of loans, including valuation adjustments on loans held-for-sale, of $21.4 million, which in the most part was due to lower of cost or fair value adjustments on loans held-for-sale. Furthermore, there was a lower impact of the change in fair value of the equity appreciation instrument by $23.8 million since the instrument expired in May 7, 2011 without further exercise. Also, the reduction in non-interest income was due to lower accretion by $20.3 million in the second quarter of 2011 of the contingent liability for unfunded lending commitments of Westernbank as explained in the Non-Interest Income section of this MD&A. These unfavorable variances were partially offset by higher FDIC loss share income of $53.7 million as described in the Non-Interest Income section of this MD&A;
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lower operating expenses by $3.5 million, or 2%, mainly due to lower personnel costs, equipment expenses and other operating expenses. The decrease in personnel costs was mostly due to special payments paid during 2010 to Westernbank terminated employees and to lower pension costs. The decrease in equipment expenses was the result of rental equipment expenses incurred during 2010 as part of the integration of Westernbank. The decrease in other operating expenses was mostly due to lower other real estate owned expenses particularly in commercial properties and a favorable variance in the provision for unfunded credit commitments, partially offset by an increase in the amortization of the FDIC prepaid deposit insurance; and an
income tax benefit of $37.5 million in 2011, compared with an income tax expense of $21.5 million in 2010, primarily due to a tax benefit of $53.6 million for the recognition of certain tax benefits not previously recorded during years 2009 (the benefit of reduced tax rates for capital gains) and 2010 (the benefit of the exempt income) as a result of a Closing Agreement signed by the Corporation and PR Department of the Treasury.
Net income for the six months ended June 30, 2011 totaled $143.4 million, compared with $57.3 million for the same period in the previous year. These results reflected:
higher net interest income by $133.7 million, or 27%, mainly as a result of the covered loans acquired in the Westernbank FDIC-assisted transaction which contributed with interest income for the six month ended June 30, 2011 of $218.4 million, compared to $76.6 million in the same period of 2010, due to a higher yield on covered loans and to an increase of $3.0 billion in average loan volume mostly related to the timing of the purchase which mitigated the decrease in the volume of earning assets. Also, the improvement in net interest income was associated with an improved yield on mortgage loans related to the purchase of performing mortgage loans during the six months ended June 30, 2011; and a lower cost of deposits, primarily in certificates of deposit and brokered certificates of deposit, as a result of both a low interest rate scenario and management actions to reduce deposit costs;
lower provision for loan losses by $44.1 million, or 19%, in part due to lower level of net charge-offs, principally in construction loans. The decrease in net-charge offs of the BPPR construction loan portfolio was principally driven by reclassifications of loans from the held-in-portfolio to held-for-sale category in 2010. This favorable variance was partially offset by the recording of provision for loan losses of $64.2 million related to the covered loan portfolio from the Westernbank FDIC-assisted transaction during the six months ended June 30, 2011. Refer to the Credit Risk Management and Loan Quality section for detailed information by loan portfolio and credit quality metrics;
higher non-interest income by $16.9 million, or 8%, due to higher FDIC loss share income of $69.7 million; partially offset by the unfavorable impact in the caption of gain on sale of loans, including valuation adjustments on loans held-for-sale, of $21.4 million mainly due to lower of cost or fair value adjustments on loans held-for-sale; the unfavorable impact in the fair value of the equity appreciation instrument of $16.1 million; and lower accretion related to the contingency for unfunded lending commitments by $17.9 million as described in the Non-Interest Income section of this MD&A;
higher operating expenses by $20.4 million, or 5%, mainly due to higher professional fees as a result of higher appraisal fees, collection costs, and technology consulting fees; and
higher income tax expense by $88.1 million mainly due to a reduction in the net deferred tax asset with a corresponding charge to income tax expense of $103.3 million during the first quarter of 2011 due to a reduction in the marginal corporate income tax rate due to the Puerto Rico tax reform, partially offset by the tax benefit of $53.6 million for the recognition of certain tax benefits not previously recorded as mentioned above and to the tax benefit of $11.9 million related to the net benefit of net tax exempt interest income as a result of the Closing Agreement.
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For the quarter ended June 30, 2011, the reportable segment of Banco Popular North America reported net income of $2.6 million, compared with a net loss of $57.8 million for the same quarter of the previous year. The principal factors that contributed to the variance in the financial results for the quarter ended June 30, 2011, when compared with the second quarter of 2010, included the following:
lower provision for loan losses by $55.0 million, or 69%, principally as a result of reductions in all loan portfolios and lower net charge-offs by $46.1 million, consisting of reductions in all loan categories;
higher non-interest income by $3.2 million, or 20%, principally due to $3.4 million in higher gains on the sale of loans, net of lower of cost or market valuation adjustments on loans held-for-sale; and $4.8 million in lower charges to increase the indemnity reserves for representations and warranties on loans sold; partially offset by lower service charges on deposit accounts by $2.8 million due to lower non-sufficient funds fees and reduced fees from money services clients and the impact of Regulation E; and lower other operating income by $1.1 million mostly as a result of lower favorable credit risk valuation adjustments on interest rate swaps by $0.8 million and lower bank-owned life insurance income by $0.3 million; and
lower operating expenses by $3.0 million, or 4%, principally as a result of lower personnel costs by $2.5 million mainly due to the curtailment of the pension plan in 2010 and lower professional fees by $1.2 million mostly due to lower lease negotiation fees and armored car service fees.
Net income for the six months ended June 30, 2011 totaled $24.9 million, compared with a net loss of $162.0 million for the same period in the previous year. These results reflected:
lower provision for loan losses by $178.8 million, or 84%, as a result of reductions in all loan portfolios and lower net charge-offs by $114.3 million, consisting of reductions in all loan categories. Also, there was the $13.8 million reduction in the provision for loan losses for the first quarter of 2011 related to the benefit of improved pricing on the sale of the non-conventional mortgage loan portfolio;
higher non-interest income by $4.1 million, or 12%, principally due to $6.3 million in higher gains on the sale of loans, net of lower of cost or market valuation adjustments on loans held-for-sale; and $5.6 million in lower charges to increase the indemnity reserves for representations and warranties on loans sold; partially offset by lower service charges on deposit accounts by $7.0 million due to lower non-sufficient funds fees and reduced fees from money services clients and the impact of Regulation E; and
lower operating expenses by $9.1 million, or 7%, mainly in personnel costs, net occupancy expenses, and professional fees. The decrease in personnel costs by $1.8 million was mainly due to the curtailment of the pension plan in 2010, the decrease in net occupancy expenses by $2.7 million was due to fewer branch locations, and the decrease in professional fees by $2.9 million was mostly due to lower computer service fees (item processing costs) and armored car service fees.
FINANCIAL CONDITION
The Corporation’s total assets were $39.0 billion at June 30, 2011, $38.7 billion at December 31, 2010, and $42.3 billion at June 30, 2010. Refer to the consolidated financial statements included in this report for the Corporation’s consolidated statements of condition as of such dates. The decrease in total assets from June 30, 2010 to the same date in 2011, was principally due to a reduction in money market investments, principally time deposits with other banks by $1.1 billion, investment securities available-for-sale by $1.1 billion and in total loans by $1.8 billion.
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Table F provides a breakdown of the Corporation’s portfolio of investment securities available-for-sale (“AFS”) and held-to-maturity (“HTM”) on a combined basis. Also, Notes 7 and 8 to the consolidated financial statements provide additional information with respect to the Corporation’s investment securities AFS and HTM.
TABLE F
Breakdown of Investment Securities Available-for-Sale and Held-to-Maturity
Total investment securities AFS and HTM
The increase in investment securities on a combined basis from December 31, 2010, was primarily related to the purchase of AFS and HTM securities representing cash outflows of $0.9 billion for the six months ended June 30, 2011. The investment securities were principally U.S. Government agency-issued collateralized mortgage obligations and U.S. agency securities purchased by the BPNA reportable segment during the first quarter of 2011 in order to deploy excess liquidity. This increase was partially offset by maturities, prepayments and redemptions by the issuers of securities during the period. The proceeds obtained were used mostly to partially prepay the note payable issued to the FDIC as part of the FDIC-assisted transaction.
The decrease in investment securities from June 30, 2010 to the same date in 2011 was also related to maturities, prepayments and redemptions of securities. Also, the reduction was associated to the sale of approximately $0.4 billion of investment securities available-for-sale, principally during the third quarter of 2010. These reductions were partially offset by the impact of the purchase of securities by BPNA during the quarter ended March 31, 2011.
Refer to Table G, for a breakdown of the Corporation’s loan portfolio, the principal category of earning assets. Loans covered under the FDIC loss sharing agreements are presented in a separate line item in Table G. Because of the loss protection provided by the FDIC, the risks of covered loans are significantly different, thus they are segregate in Table G.
In general, the changes in most loan categories generally reflect weak loan demand, the high level of loan charge-offs as a result of the downturn in the real estate market and continued weakened economy, portfolio runoff of the exited loan origination channels at the BPNA reportable segment and mortgage loan sales in the BPNA reportable segment. The decreases were partially offset by mortgage loan growth in the Puerto Rico operations due to loan acquisitions and loan origination volumes generated by government incentives.
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TABLE G
Loans Ending Balances
Loans not covered under FDIC loss sharing agreements:
Total non-covered loans held-in-portfolio
Loans covered under FDIC loss sharing agreements [1]
Total loans held-in-portfolio
Loans held-for-sale:
Total loans held-for-sale
The explanations for loan portfolio variances discussed below exclude the impact of the covered loans.
The decrease in commercial loans held-in-portfolio from December 31, 2010 to June 30, 2011 was reflected in the BPPR and BPNA reportable segments by $0.5 billion and $0.3 billion, respectively, when compared to December 31, 2010. The decrease in the BPPR reportable segment was principally the result of the repayment of commercial lines of credit from the Puerto Rico public sector during the quarter ended June 30, 2011, overall portfolio runoff, and the impact of $88 million in loan charge-offs during the six months ended June 30, 2011. The decrease in the BPNA reportable segment was in part because of the run-off of the legacy portfolio of the exited lines of business and loan charge-offs amounting to $65 million for the six months ended June 30, 2011. Overall the Corporation continues to experience lower levels of origination activity due to the economic environment and more stringent underwriting criteria. Commercial loans held-in-portfolio at BPNA and BPPR reportable segments declined by $0.7 billion and $0.6 billion, respectively, when compared to June 30, 2010. The decrease at both reportable segments was principally due to net charge-offs, lower levels of origination activity and portfolio run-off, as well as the reclassification of commercial loans to held-for-sale by the BPPR reportable segment in December 2010.
The decrease in construction loans was principally in the BPNA reportable segment by $101 million, when compared to December 31, 2010, mainly due to loan repayments. The decline in the construction loan portfolio from June 30, 2010 to the same date in 2011 was principally driven by the held-for-sale transaction reclassification that took place in the fourth quarter of 2010 in which $503.9 million (book value) of construction loans were transferred from the loans held-in-portfolio category to the loans held-for-sale category. Also, this decline in construction loans was related to loan charge-offs, conversion to repossessed properties and new activity at a controlled pace.
The decline in the lease financing portfolio from December 31, 2010 to June 30, 2011 was at experienced at both BPPR and BPNA reportable segment by approximately $8 million each. The decrease from June 30, 2010 to June 30, 2011 at the BPPR reportable segment was $30 million, which as well as the other loan portfolios continues to reflect the general slowdown in originations. BPNA, which lease financing portfolio decreased by $21 million, is no longer originating lease financing and as such, the outstanding portfolio in those operations is running off.
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The increase in mortgage loans held-in-portfolio from December 31, 2010 was principally related to the acquisition of loans held-in-portfolio of $744 million during the six months ended June 30, 2011, principally related to two large whole loan purchases from a Puerto Rico financial institution that involved approximately $518 million in unpaid principal balance of performing residential mortgage loans and to $115 million of loans repurchased under credit recourse arrangements. The increase was also due to retained loan origination activity by the BPPR reportable segment given the increase in origination volumes prompted by Puerto Rico government housing-incentive law that put into effect temporary measures that seek to stimulate demand for housing. The increase from June 30, 2010 to the same date in 2011 was associated to similar factors, partially offset by the impact of the reclassification of non-conventional mortgage loans to loans held-for-sale in December 2010 by BPNA and which were subsequently sold during 2011.
The decrease in consumer loans from December 31, 2010 and June 30, 2010 to June 30, 2011 was related to the BPNA reportable segment due to runoff of the portfolio at exited lines of business, including E-LOAN. Also, there were declines in personal loans and in the credit card portfolio at the BPPR reportable segment.
The decrease in mortgage loans held-for-sale from December 31, 2010 to June 30, 2011 was principally at the BPNA reportable segment by $197 million due to the sale of the non-conventional mortgage loans during 2011 and at the BPPR reportable segment by $113 million due to loans securitized into mortgage-backed securities. The increase in construction loans held-for-sale was due to the loan reclassification in the BPPR reportable segment in December 2010. The Corporation continues to pursue transactions for the sale of such loans. The decrease in construction loans held-for-sale since December 31, 2010 was due to collections and reclassification of certain loans to other real estate owned.
Covered loans were initially recorded at fair value. Their carrying value approximated $4.6 billion at June 30, 2011, of which approximately 56% pertained to commercial loans, 14% to construction loans, 27% to mortgage loans and 3% to consumer loans. Note 9 to the consolidated financial statements presents the carrying amount of the covered loans broken down by major loan type categories. A substantial amount of the covered loans, or approximately $4.3 billion of their carrying value at June 30, 2011, is accounted for under ASC Subtopic 310-30. The decline in covered loans from December 31, 2010 and June 30, 2010 to June 30, 2011 was principally due to collections. Net loan charge-offs are not significant given that the portfolio was initially recorded at fair value.
As part of the loan portfolio fair value estimation in the Westernbank FDIC-assisted transaction, the Corporation established the FDIC loss share indemnification asset, which was measured separately from the covered loans. The FDIC loss share indemnification asset was recorded at fair value at the acquisition date and represented the present value of the estimated cash payments expected to be received from the FDIC for future losses on covered assets, based on the credit adjustment estimated for each covered asset and the loss sharing percentages. The cash flows were discounted at a market-based rate to reflect the uncertainty of the timing and receipt of the loss sharing reimbursements from the FDIC, the cost to service the indemnification asset, and the level of uncertainty in estimating the indemnification asset cash flows, including factors such as: (1) the amount of expected credit losses on the covered assets; (2) the associated timing of those credit losses; (3) the accurate and timely completion of the loss certifications; and (4) the uncertainties surrounding the expected draws and associated losses on unfunded commitments.
Based on the accounting guidance in ASC Topic 805, at each reporting date subsequent to the initial recording of the indemnification asset, the Corporation measures the indemnification asset on the same basis as the covered loans and assesses its collectability. The Corporation accounted for the majority of the acquired covered loans pursuant to the expected cash flows framework of ASC 310-30, thus on a prospective basis, the accounting for these loans and the indemnification asset is based on expected cash flows, similar to how the loans and the associated indemnification asset was initially accounted for at acquisition. A minority of the covered loans, approximately 6% at acquisition, constituted revolving lines of credit. These lines of credit were accounted for at fair value upon acquisition, which value considered expected cash flows. Due to their revolving characteristics, these loans are subsequently accounted for under ASC 310-20 and not based on the expected cash flows framework of ASC 310-30 loans. As the acquisition date discount on these revolving lines of credit is accreted into income, the carrying value of the loans increases. Since the indemnification asset must be measured on the same basis as the indemnified item, the Corporation reduces the indemnification asset at the same time that the indemnified loan carrying amount increases due to the discount accretion. Simultaneously, the Corporation evaluates these ASC 310-20 loans on a quarterly basis to determine if a general and/or specific allowance for loan losses is necessary under the provisions of ASC Subtopic 450-20 and ASC Section 310-10-35.
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Credit losses on covered loans recognized through a charge to provision for loan losses result in an increase in the FDIC loss share asset. Conversely, if credit losses are less than anticipated, the improvement is recognized on a prospective basis through higher accretable yield.
The time value of money incorporated into the present value computation is accreted into earnings over the shorter of the life of the shared-loss agreements or the holding period of the covered assets. The FDIC loss share asset is reduced as losses are recognized on covered loans and payments are received from the FDIC.
The amount ultimately collected for the indemnification asset is dependent upon the performance of the underlying covered assets, the passage of time, claims submitted to the FDIC and the Corporation’s compliance with the terms of the loss sharing agreements. Refer to Note 11 to the consolidated financial statements for additional information on the FDIC loss share agreements.
The following table sets forth the activity in the FDIC loss share asset for the six months ended June 30, 2011 and 2010.
Table H provides a breakdown of the principal categories that comprise the caption of “Other assets” in the consolidated statements of condition at June 30, 2011, December 31, 2010 and June 30, 2010.
TABLE H
Breakdown of Other Assets
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The decrease in other assets from December 31, 2010 to June 30, 2011 was principally due to reduction in the prepaid FDIC insurance assessment due to amortization, a reduction of $34.2 million in the receivable from insurers related to the legal proceedings described in Note 20 to the consolidated financial statements and lower deferred tax assets. Refer to Note 28 to the consolidated financial statements for a table presenting the composition of the Corporation’s net deferred tax assets at June 30, 2011 and December 31, 2010. These decreases were partially offset by higher receivables from brokers and counterparties as a result of mortgage-backed securities sold in June 2011 with settlement date in July 2011. When compared with June 30, 2010, the main variance in other assets is in the category of investments under the equity method and was principally associated with the 49% ownership interest in EVERTEC.
Deposits and Borrowings
The composition of the Corporation’s financing to total assets at June 30, 2011 and December 31, 2010 is included in Table I.
TABLE I
Financing to Total Assets
(Dollars in millions)
Non-interest bearing deposits
Interest-bearing core deposits
Other interest-bearing deposits
Repurchase agreements
A breakdown of the Corporation’s deposits at period-end is included in Table J.
TABLE J
Deposits Ending Balances
Demand deposits [1]
Savings, NOW and money market deposits
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Brokered certificates of deposit, which are included as time deposits, amounted to $2.7 billion at June 30, 2011 compared with $2.3 billion at December 31, 2010 and $2.0 billion at June 30, 2010.
The increase in demand deposits from December 31, 2010 to June 30, 2011 was principally due to an increase in the volume of public fund deposits and deposits in trust. The increase in savings, NOW and money market is a combination of higher deposits from the private and public sector. The variance in time deposits was associated with an increase in brokered certificates of deposit, partially offset by lower volume of retail certificates of deposit and individual retirement accounts.
The increase in demand deposits from June 30, 2010 to the same date in 2011 was also related to the factor explained above as well as higher volume of checking account deposits from retail customers. The decrease in time deposits was principally due to lower volume of retail certificates of deposit and individual retirement accounts, partially offset by the increase in brokered certificates of deposit.
The Corporation’s borrowings amounted to $6.1 billion at June 30, 2011, compared with $6.9 billion at December 31, 2010 and $10.5 billion at June 30, 2010. The decrease in borrowings from December 31, 2010 to June 30, 2011 was mostly related to a reduction of $975 million in the note issued to the FDIC as part of the Westernbank FDIC-assisted transaction, which had a carrying amount of $1.5 billion at June 30, 2011, compared with $2.5 billion at December 31, 2010. This decrease was due to the impact of payments of principal from loan collections submitted to the FDIC during the quarter. Also, during the year-to-date period ended June 30, 2011, the Corporation prepaid $480 million of the note issued to the FDIC from funds unrelated to the assets securing the note. The decline was also influenced by the early extinguishment of $100 million in medium-term notes in 2011. These decreases were partially offset by an increase of $170 million in advances from the FHLB in part to fund loan purchases and by an increase in repurchase agreements of $158 million.
The decrease in borrowings from June 30, 2010 to the same date in 2011 was principally due to a reduction of $4.2 billion in the note issued to the FDIC.
Refer to Note 16 to the consolidated financial statements for detailed information on the Corporation’s borrowings at June 30, 2011, December 31, 2010 and June 30, 2010. Also, refer to the Liquidity section in this MD&A for additional information on the Corporation’s funding sources.
The decrease in other liabilities of $269 million from December 31, 2010 to June 30, 2011 was principally due to a decrease in the Corporation’s pension benefit obligation of $131 million due to contributions made to the plan and to lower income tax payable.
Stockholders’ Equity
Stockholders’ equity totaled $4.0 billion at June 30, 2011, $3.8 billion at December 31, 2010, and $3.6 billion at June 30, 2010. Refer to the consolidated statements of condition and of stockholders’ equity for information on the composition of stockholders’ equity. Also, the disclosures of accumulated other comprehensive income (loss), an integral component of stockholders’ equity, are included in the consolidated statements of comprehensive loss. The increase in stockholders’ equity from December 31, 2010 and June 30, 2010 to June 30, 2011 was mostly due to net income for the periods.
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REGULATORY CAPITAL
The Corporation continues to exceed the well-capitalized guidelines under the federal banking regulations. The regulatory capital ratios and amounts of total risk-based capital, Tier 1 risk-based capital and Tier 1 leverage at June 30, 2011, December 31, 2010, and June 30, 2010 are presented on Table K. As of such dates, BPPR and BPNA were well-capitalized.
TABLE K
Capital Adequacy Data
Risk-based capital:
Tier I capital
Supplementary (Tier II) capital
Total capital
Risk-weighted assets:
Balance sheet items
Off-balance sheet items
Total risk-weighted assets
Average assets
Ratios:
Tier I capital (minimum required – 4.00%)
Total capital (minimum required – 8.00%)
Leverage ratio [1]
The improvement in the Corporation’s regulatory capital ratios from December 31, 2010 to June 30, 2011 was principally due to: (i) balance sheet composition including the increase in lower risk-assets such as trading and investment securities and mortgage loans; and (ii) internal capital generation.
In accordance with the Federal Reserve Board guidance, the trust preferred securities represent restricted core capital elements and qualify as Tier 1 capital, subject to certain quantitative limits. The aggregate amount of restricted core capital elements that may be included in the Tier 1 capital of a banking organization must not exceed 25% of the sum of all core capital elements (including cumulative perpetual preferred stock and trust preferred securities). At June 30, 2011, December 31, 2010 and June 30, 2010, the Corporation’s restricted core capital elements did not exceed the 25% limitation. Thus, all trust preferred securities were allowed as Tier 1 capital. Amounts of restricted core capital elements in excess of this limit generally may be included in Tier 2 capital, subject to further limitations. Effective March 31, 2011, the Federal Reserve Board revised the quantitative limit which would limit restricted core capital elements included in the Tier 1 capital of a bank holding company to 25% of the sum of core capital elements (including restricted core capital elements), net of goodwill less any associated deferred tax liability. Furthermore, the Dodd-Frank Act, enacted in July 2010, has a provision to effectively phase-out the use of trust preferred securities issued before May 19, 2010 as Tier 1 capital over a 3-year period commencing on January 1, 2013. Trust preferred securities issued on or after May 19, 2010 no longer qualify as Tier 1 capital. At June 30, 2011, the Corporation had $427 million in trust preferred securities (capital securities) that are subject to the phase-out. The Corporation has not issued any trust preferred securities since May 19, 2010. At June 30, 2011, the remaining $935 million in trust preferred securities corresponded to capital securities issued to the U.S. Treasury pursuant to the Emergency Economic Stabilization Act of 2008. The Dodd-Frank Act includes an exemption from the phase-out provision that applies to these capital securities.
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During the third quarter of 2010, the Basel Committee on Banking Supervision revised the Capital Accord (Basel III), which narrows the definition of capital and increases capital requirements for specific exposures. The new capital requirements will be phased-in over six years beginning in 2013. If these revisions were adopted currently, the Corporation estimates they would not have a significant negative impact on our regulatory capital ratios based on our current understanding of the revisions to capital qualification. We await clarification from our banking regulators on their interpretation of Basel III and any additional requirements to the stated thresholds.
The Corporation’s tangible common equity ratio was 8.38% at June 30, 2011 and 8.01% at December 31, 2010. The Corporation’s Tier 1 common equity to risk-weighted assets ratio was 11.53% at June 30, 2011, compared with 10.95% at December 31, 2010.
The tangible common equity ratio and tangible book value per common share, which are presented in the table that follows, are non-GAAP measures. Management and many stock analysts use the tangible common equity ratio and tangible book value per common share in conjunction with more traditional bank capital ratios to compare the capital adequacy of banking organizations with significant amounts of goodwill or other intangible assets, typically stemming from the use of the purchase accounting method of accounting for mergers and acquisitions. Neither tangible common equity nor tangible assets or related measures should be considered in isolation or as a substitute for stockholders’ equity, total assets or any other measure calculated in accordance with accounting principles generally accepted in the United States of America (“GAAP”). Moreover, the manner in which the Corporation calculates its tangible common equity, tangible assets and any other related measures may differ from that of other companies reporting measures with similar names.
The table that follows provides a reconciliation of total stockholders’ equity to tangible common equity and total assets to tangible assets at June 30, 2011 and December 31, 2010.
(In thousands, except share or per share information)
Less: Preferred stock
Less: Goodwill
Less: Other intangibles
Total tangible common equity
Total tangible assets
Tangible common equity to tangible assets
Common shares outstanding at end of period
Tangible book value per common share
The Tier 1 common equity to risk-weighted assets ratio is another non-GAAP measure. Ratios calculated based upon Tier 1 common equity have become a focus of regulators and investors, and management believes ratios based on Tier 1 common equity assist investors in analyzing the Corporation’s capital position. In connection with the Supervisory Capital Assessment Program (“SCAP”), the Federal Reserve Board began supplementing its assessment of the capital adequacy of a bank holding company based on a variation of Tier 1 capital, known as Tier 1 common equity.
Because Tier 1 common equity is not formally defined by GAAP or, unlike Tier 1 capital, codified in the federal banking regulations, this measure is considered to be a non-GAAP financial measure. Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied and are not audited. To mitigate these limitations, the Corporation has procedures in place to calculate these measures using the appropriate GAAP or regulatory components. Although these non-GAAP financial measures are frequently used by stakeholders in the evaluation of a company, they have limitations as analytical tools, and should not be considered in isolation, or as a substitute for analyses of results as reported under GAAP.
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The following table reconciles the Corporation’s total common stockholders’ equity (GAAP) at June 30, 2011 and December 31, 2010 to Tier 1 common equity as defined by the Federal Reserve Board, FDIC and other bank regulatory agencies (non-GAAP).
Common stockholders’ equity
Less: Unrealized gains on available-for-sale securities, net of tax [1]
Less: Disallowed deferred tax assets [2]
Less: Intangible assets:
Other disallowed intangibles
Less: Aggregate adjusted carrying value of all non-financial equity investments
Add: Pension liability adjustment, net of tax and accumulated net gains (losses) on cash flow hedges [3]
Total Tier 1 common equity
CREDIT RISK MANAGEMENT AND LOAN QUALITY
Non-performing assets include primarily past-due loans that are no longer accruing interest, renegotiated loans, and real estate property acquired through foreclosure. A summary, including certain credit quality metrics, is presented in Table L.
The Corporation’s non-accruing and charge-off policies by major categories of loan portfolios are as follows:
Commercial and construction loans - recognition of interest income on commercial and construction loans is discontinued when the loans are 90 days or more in arrears on payments of principal or interest or when other factors indicate that the collection of principal and interest is doubtful. The impaired portions of secured loans past due as to principal and interest is charged-off not later than 365 days past due. However, in the case of collateral dependent loans individually evaluated for impairment, the excess of the recorded investment over the fair value of the collateral (portion deemed as uncollectible) is generally promptly charged-off, but in any event not later than the quarter following the quarter in which such excess was first recognized. Overdrafts in excess of 60 days are charged-off no later than 60 days past their due date.
Lease financing - recognition of interest income for lease financing is ceased when loans are 90 days or more in arrears. Leases are charged-off when they are 120 days in arrears.
Mortgage loans - recognition of interest income on mortgage loans is generally discontinued when loans are 90 days or more in arrears on payments of principal or interest. The impaired portion of a mortgage loan is charged-off when the loan is 180 days past due.
Consumer loans - recognition of interest income on closed-end consumer loans and home-equity lines of credit is discontinued when the loans are 90 days or more in arrears on payments of principal or interest. Income is generally recognized on open-end consumer loans, except for home equity lines of credit, until the loans are charged-off. Closed-end consumer loans are charged-off when they are 120 days in arrears. Open-end consumer loans are charged-off when they are 180 days in arrears. Overdrafts in excess of 60 days are charged-off no later than 60 days past their due date.
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Troubled debt restructurings (“TDRs”) - loans classified as TDRs are reported in non-accrual status if the loan was in non-accruing status at the time of the modification. The TDR loan should continue in non-accrual status until the borrower has demonstrated a willingness and ability to make the restructured loan payments (generally at least six months of sustained performance after classified as a TDR).
Acquired covered loans from the Westernbank FDIC-assisted transaction that are restructured after acquisition are not considered restructured loans for purposes of the Corporation’s accounting and disclosure if the loans are accounted for in pools pursuant to ASC Subtopic 310-30.
Covered loans acquired in the Westernbank FDIC-assisted transaction, except for revolving lines of credit, are accounted for by the Corporation in accordance with ASC Subtopic 310-30. Under ASC Subtopic 310-30, the acquired loans were aggregated into pools based on similar characteristics. Each loan pool is accounted for as a single asset with a single composite interest rate and an aggregate expectation of cash flows. The covered loans which are accounted for under ASC Subtopic 310-30 by the Corporation are not considered non-performing and will continue to have an accretable yield as long as there is a reasonable expectation about the timing and amount of cash flows expected to be collected. Also, loans charged-off against the non-accretable difference established in purchase accounting are not reported as charge-offs. Charge-offs will be recorded only to the extent that losses exceed the purchase accounting estimates.
Revolving lines of credit acquired as part of the Westernbank FDIC-assisted transaction are accounted for under the guidance of ASC Subtopic 310-20, which requires that any differences between the contractually required loan payment receivable in excess of the Corporation’s initial investment in the loans be accreted into interest income using the effective yield method over the life of the loan. Loans accounted for under ASC Subtopic 310-20 are placed on non-accrual status when past due in accordance with the Corporation’s non-accruing policy and any accretion of discount is discontinued.
Because of the application of ASC Subtopic 310-30 to the Westernbank acquired loans and the loss protection provided by the FDIC which limits the risks on the covered loans, the Corporation has determined to provide certain quality metrics in this MD&A that exclude such covered loans to facilitate the comparison between loan portfolios and across quarters or year-to-date periods. Given the significant amount of covered loans that are past due but still accruing due to the accounting under ASC Subtopic 310-30, the Corporation believes the inclusion of these loans in certain asset quality ratios in the numerator or denominator (or both) would result in a significant distortion to these ratios. In addition, because charge-offs related to the acquired loans are recorded against the non-accretable balance, the net charge-off ratio including the acquired loans is lower for portfolios that have significant amounts of covered loans. The inclusion of these loans in the asset quality ratios could result in a lack of comparability across quarters or years, and could negatively impact comparability with other portfolios that were not impacted by acquisition accounting. The Corporation believes that the presentation of asset quality measures excluding covered loans and related amounts from both the numerator and denominator provides better perspective into underlying trends related to the quality of its loan portfolio.
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A summary of non-performing assets, including certain credit quality metrics, is presented in Table L, below.
Non-Performing Assets
Total non-performing loans held-in- portfolio, excluding covered loans
Non-performing loans held-for-sale [5]
Other real estate owned (“OREO”), excluding covered OREO
Total non-performing assets, excluding covered assets
Covered loans and OREO [1]
Total non-performing assets
Accruing loans past due 90 days or more [3]
Ratios excluding covered loans and OREO [4]:
Non-performing loans held-in-portfolio to loans held-in-portfolio
Non-performing assets to total assets
Allowance for loan losses to loans held-in-portfolio
Allowance for loan losses to non-performing loans, excluding held-for-sale
Ratios including covered loans and OREO:
HIP = “held-in-portfolio”
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At June 30, 2011, non-performing loans secured by real estate held-in-portfolio, excluding covered loans, amounted to $1.2 billion, in the Puerto Rico operations and $369 million in the U.S. mainland operations. These figures compare to $811 million in the Puerto Rico operations and $404 million in the U.S. mainland operations at December 31, 2010.
In addition to the non-performing loans included in Table K, at June 30, 2011, there were $49 million of performing loans, excluding covered loans, which in management’s opinion are currently subject to potential future classification as non-performing and are considered impaired, compared with $111 million at December 31, 2010.
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Table M summarizes the detail of the changes in the allowance for loan losses, including charge-offs and recoveries by loan category, for the quarters and six months ended June 30, 2011 and 2010.
TABLE M
Allowance for Loan Losses and Selected Loan Losses Statistics
Losses:
Recoveries:
Net loans charged-off (recovered):
Recovery related to loans transferred to loans held-for-sale
Annualized net charge-offs to average loans held-in-portfolio
Provision for loan losses to net charge-offs
The Corporation’s allowance for loan losses at June 30, 2011 decreased by approximately $530 million or 42% when compared with June 30, 2010. The Corporation’s general and specific allowances decreased by $168 million and $363 million, respectively, when compared to $894 million and $383 million at June 30, 2010, respectively. The reduction in the general component of the allowance for loan losses at June 30, 2011 was attributable to lower non-covered loan held-in-portfolio balances and net charge-off activity,
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principally from the Corporation’s non-covered commercial, construction and consumer loan portfolios. The decrease in the specific allowance component was mainly driven by: (i) the Corporation’s decision to accelerate the charge-off of previously reserved impaired amounts of collateral dependent loans both in the BPPR and BPNA reportable segments and (ii) a lower level of problem loans remaining in loans held-in-portfolio, as a result of the loans held-for-sale reclassification in the BPPR and BPNA reportable segments.
Overall, the Corporation’s non-covered loan held-in-portfolio balances decreased by $1.8 billion to $20.7 billion at June 30, 2011, when compared to the same period in 2010, mainly driven by reductions in the commercial, construction and consumer loan portfolios.
The BPPR reportable segment non-covered loans held-in-portfolio at June 30, 2011 decreased by $177 million, compared to June 30, 2010, driven principally by the commercial and construction loans held-for-sale reclassification that took place in the fourth quarter of 2010, coupled with the normal portfolio attrition and net charge-offs of the loan portfolio. These variances were partially offset by an increase of $1.2 billion in the mortgage loan portfolio of the BPPR reportable segment, driven principally by residential mortgage loan originations and mortgage loan purchases. As indicated in the Overview section of this MD&A, the Corporation completed two large purchases of performing mortgage loans during the six months ended June 30, 2011.
The BPNA reportable segment loans held-in-portfolio at June 30, 2011 decreased by $1.7 million, compared to June 30, 2010, mainly driven by: (i) decreases of $700 million and $291 million in the commercial and construction loan portfolios, respectively, principally associated with the downsizing of the legacy portfolio of the business lines exited by BPNA, (ii) the $396 million (book value) loan reclassification of non-conventional mortgage loans, mainly non-accruing loans, that took place in the fourth quarter of 2010, and (iii) a decrease of $114 million in the BPNA home equity lines of credit (“HELOCs”) loan portfolio, principally prompted by a decrease of $87 million in E-LOAN’s HELOCs, due to loan pay-offs, principal repayments and net charge-offs.
Table N presents annualized net charge-offs to average loans held-in-portfolio (“HIP”) for the non-covered portfolio by loan category for the quarters and six months ended June 30, 2011 and June 30, 2010.
TABLE N
Annualized Net Charge-offs to Average Loans Held-in-Portfolio (Non-covered loans)
Total annualized net charge-offs to average loans held-in-portfolio
Note: Average loans held-in-portfolio excludes covered loans acquired in the Westernbank FDIC-assisted transaction which were recorded at fair value on date of acquisition, and thus, considered a credit discount component.
The Corporation’s annualized net charge-offs to average non-covered loans held-in-portfolio ratio decreased 99 and 106 basis points, from 3.58% and 3.72% for the quarter and six months ended June 30, 2010 to 2.59% and 2.66% for the respective periods in 2011. Both decreases were mainly driven by the loan portfolio reclassifications to held-for-sale that took place in the fourth quarter of 2010. As previously explained, in December 2010, the Corporation transferred approximately $603 million (book value) of commercial and construction loans of the BPPR reportable segment and $396 million (book value) of non-conventional mortgage loans of the U.S. mainland reportable segment, mainly non-accruing loans, from the held-in-portfolio to held-for-sale category, at the lower of cost or fair value. This transfer resulted in a decrease in net charge-offs and loan delinquencies in each portfolio, driven by a lower level of problem loans remaining in loans held-in-portfolio. The reduction in the net charge-off ratio was also related to the improvement in the credit quality of certain portfolios and the positive results of steps taken by the Corporation to mitigate the overall credit risks.
151
Commercial loans
The level of non-performing commercial non-covered loans held-in-portfolio at June 30, 2011, compared to December 31, 2010, increased on a consolidated basis by $60 million, primarily in the BPPR reportable segment. The percentage of non-performing commercial non-covered loans held-in-portfolio to commercial non-covered loans held-in-portfolio increased from 6.36% at December 31, 2010 to 7.31% at June 30, 2011. This increase was mainly attributed to weak economic conditions in Puerto Rico, which have continued to adversely impact the commercial loan delinquency rates. The level of non-performing commercial non-covered loans held-in-portfolio in the BPPR reportable segment at June 30, 2011 remained high while the level of non-performing commercial loans held-in-portfolio in the United States operations has reflected certain signs of stabilization.
The table that follows provides information on commercial non-performing loans at June 30, 2011, December 31, 2010, and June 30, 2010 and net charge-offs information for the quarters and six months ended June 30, 2011 and June 30, 2010 for the BPPR (excluding the Westernbank covered loan portfolio) and BPNA reportable segments.
BPPR Reportable Segment:
Non-performing commercial loans
Non-performing commercial loans to commercial loans HIP, both excluding covered loans and loans held-for-sale
Commercial loan net charge-offs
Commercial loan net charge-offs (annualized) to average commercial loans HIP, excluding covered loans and loans held-for-sale
BPNA Reportable Segment:
Non-performing commercial loans to commercial loans HIP, excluding loans held-for-sale
Commercial loan net charge-offs (annualized) to average commercial loans HIP, excluding loans held-for-sale
Non-performing loans held-in-portfolio in the BPPR reportable segment increased by $72 million, from $485 million at December 31, 2010 to $557 million at June 30, 2011, as weak economic conditions in Puerto Rico have continued to adversely impact the delinquency rates of BPPR commercial loan portfolio. At the BPNA reportable segment, non-performing loans held-in-portfolio decreased by $13 million, from $240 million at December 31, 2010 to $227 million at June 30, 2011, as the loan portfolio continue to show signs of credit stabilization, in terms of delinquencies.
There was 1 commercial loan relationship greater than $10 million in non-accrual status with an aggregate outstanding balance of approximately $14 million at June 30, 2011, compared with 1 commercial loan relationship with an outstanding balance of approximately $10 million at December 31, 2010, and 3 commercial loan relationships with an outstanding balance of approximately $33 million at June 30, 2010.
152
The table that follows presents the changes in non-performing commercial non-covered loans held in-portfolio for the quarter and six months ended June 30, 2011, for the BPPR (excluding the Westernbank covered loan portfolio) and BPNA reportable segments.
Beginning Balance
Plus:
New non-performing loans
Less:
Non-performing loans transferred to OREO
Non-performing loans charged-off
Loans returned to accrual status / loan collections
Ending balance June 30, 2011
For the quarter ended June 30, 2011, non-covered commercial loans held-in-portfolio newly classified in non-performing status at the BPPR reportable segment (excluding commercial lines of credit and business credit cards) amounted to $112 million, a decrease of $9 million, when compared to the additions for the quarter ended March 31, 2011. Additions to non-covered commercial loans held-in-portfolio in non-performing status decreased by $25 million, when compared to the quarter ended December 31, 2010. Although the Corporation continues to reflect additions to non-performing loans because of current economic conditions in Puerto Rico, the additions in the second quarter of 2011 were at a lower pace than in the previous two quarters.
Additions to commercial loans held-in-portfolio in non-performing status at the BPNA reportable segment during the second quarter of 2011 amounted to $75 million, an increase of $26 million, when compared to the additions for the first quarter of 2011. The increase in commercial non-performing loans for the BPNA reportable segment was principally attributable to one commercial credit relationship with an outstanding principal balance of $21 million, before charge-offs, which was restructured and placed in non-accrual status during the second quarter of 2011. Concurrently, BPNA recorded a charge-off of $5 million with respect to this credit relationship. At June 30, 2011, the outstanding principal balance on this credit relationship was $16 million and no specific valuation allowance was required. When compared to the quarter ended December 31, 2010, additions to non-covered commercial loans held-in-portfolio in non-performing status during the quarter ended June 30, 2011 decreased by $23 million, driven by positive results of steps taken by the Corporation to mitigate the overall credit risk.
The Corporation’s commercial loan net charge-offs, excluding net charge-offs for covered loans, for the quarter ended June 30, 2011 increased by $11 million when compared with the quarter ended June 30, 2010. This increase was primarily driven by an increase of $18 million in commercial loan net charge-offs in the BPPR reportable segment, partially offset by a decrease of $7 million in commercial loan net charge-offs in the BPNA reportable segment. The increase in commercial loan net charge-offs for the quarter ended June 30, 2011 in the BPPR reportable segment as compared to the quarter ended June 30, 2010 was principally due to the current economic conditions in Puerto Rico. The commercial loan portfolio in the BPPR reportable segment continues to reflect high delinquencies and reductions in the value of the underlying collaterals. For the quarter ended June 30, 2011, the charge-offs associated to collateral dependent commercial loans amounted to approximately $18.8 million and $25.5 million in the BPPR and BPNA reportable segments, respectively.
The decrease in the commercial loan net charge-offs at the BPNA reportable segment was mostly attributable to a lower volume of commercial loans due to run-off of the legacy portfolio of exited or downsized business lines at BPNA, accompanied by certain signs of credit stabilization in this reportable segment reflected in the reduction of approximately $12 million in non-performing loans from December 31, 2010 to June 30, 2011.
The allowance for loan losses corresponding to commercial loans held-in-portfolio, excluding covered loans, represented 3.84% of that portfolio at June 30, 2011, compared with 4.06% at December 31, 2010. The ratio of allowance to non-performing loans held-in portfolio in the commercial loan category was 52.48% at June 30, 2011, compared with 63.78% at December 31, 2010. The decrease in the ratio was principally driven by a lower allowance for loan losses for the commercial loan portfolio of the BPNA reportable segment, prompted by a lower portfolio balance and a lower level of problem loans remaining in the portfolio. The allowance for loan losses for the commercial loan portfolio of the BPPR reportable segment also decreased, mainly driven by lower levels of specific reserves as a result of the Corporation’s decision to accelerate the charge-off of previously reserved impaired amounts of commercial collateral dependent loans.
153
The Corporation’s commercial loan portfolio secured by real estate (“CRE”), excluding covered loans, amounted to $6.8 billion at June 30, 2011, of which $3.3 billion was secured with owner occupied properties, compared with $7.0 billion and $3.1 billion, respectively, at December 31, 2010. CRE non-performing loans, excluding covered loans amounted to $587 million at June 30, 2011, compared to $553 million at December 31, 2010. The CRE non-performing loans ratios for the Corporation’s Puerto Rico and U.S. mainland operations were 11.43% and 5.42%, respectively, at June 30, 2011, compared with 9.61% and 5.79%, respectively, at December 31, 2010.
At June 30, 2011, the Corporation’s commercial loans held-in-portfolio, excluding covered loans, included a total of $162 million of loan modifications for the BPPR reportable segment and $19 million for the BPNA reportable segment, which were considered TDRs since they involved granting a concession to borrowers under financial difficulties. The outstanding commitments for these loan TDRs amounted to $683 thousand in the BPPR reportable segment and no commitments outstanding in the BPNA reportable segment at June 30, 2011. The commercial loan TDRs in non-performing status for the BPPR and BPNA reportable segments at June 30, 2011 amounted to $96 million and $19 million, respectively. At June 30, 2011, commercial TDRs which were evaluated for impairment resulted in a specific reserve of $2 million at the BPPR reportable segment. Commercial TDRs at the BPNA reportable segment did not require any specific reserve at June 30, 2011.
Construction loans
Non-performing construction loans held-in-portfolio decreased by $40 million from December 31, 2010 to June 30, 2011 mainly attributed to a lower level of problem loans remaining in the held-in-portfolio classification for the Puerto Rico and U.S. operations. The ratio of non-performing construction loans to construction loans held-in-portfolio, excluding covered loans, increased from 47.63% at December 31, 2010 to 50.34% at June 30, 2011, mainly due to reductions in the loan portfolio. The ratio of non-performing construction loans to construction loans held-in-portfolio was 56.42% at June 30, 2010.
The tables below provides information on construction non-performing loans held-in-portfolio at June 30, 2011, December 31, 2010, and June 30, 2010 and net charge-offs information for the quarters and six months ended June 30, 2011 and June 30, 2010 for the BPPR and BPNA reportable segments.
Non-performing construction loans
Non-performing construction loans to construction loans HIP, both excluding covered loans and loans held-for-sale
Construction loan net charge-offs (recoveries)
Construction loan net charge-offs (annualized) to average construction loans HIP, excluding covered loans and loans held-for-sale
154
The table that follows provides information on construction non-performing loans held-in-portfolio at June 30, 2011, December 31, 2010 and June 30, 2010 and net charge-offs information for the quarters and six months ended June 30, 2011 and June 30, 2010 for the BPNA reportable segment.
Non-performing construction loans to construction loans HIP, excluding loans held-for-sale
Construction loan net charge-offs
Construction loan net charge-offs (annualized) to average construction loans HIP, excluding loans held-for-sale
Non-performing construction loans held-in-portfolio in the BPPR reportable segment decreased by $6 million, from $65 million at December 31, 2010 to $59 million at June 30, 2011, driven principally by a lower level of problem loans in the remaining construction loan portfolio classified as held-in-portfolio, prompted by the construction loans held-for-sale reclassification that took place in the fourth quarter of 2010 at the BPPR reportable segment. At the BPNA reportable segment, non-performing loans held-in-portfolio decreased by $34 million, from $174 million at December 31, 2010 to $140 million at June 30, 2011, resulting from the downsizing of the construction loan portfolio at the BPNA reportable segment.
There were 6 construction loan relationships greater than $10 million in non-performing status with an aggregate outstanding balance of $70 million at June 30, 2011, compared with 7 construction loan relationships with an aggregate outstanding principal balance of $99 million at December 31, 2010. Although the portfolio balance of construction loans held-in-portfolio has decreased considerably, the construction loan portfolio is considered one of the high-risk portfolios of the Corporation as it continues to be adversely impacted by weak economic and real estate market conditions, particularly in Puerto Rico.
The BPPR reportable segment construction loan portfolio, excluding covered loans and loans held-for-sale, totaled $162 million at June 30, 2011, compared with $168 million at December 31, 2010 and $973 million at June 30, 2010. The decrease in the ratio of non-performing construction loans held-in-portfolio to construction loans held-in-portfolio, excluding covered loans, was primarily attributed to the reclassification to loans held-for-sale during the fourth quarter of 2010, mostly of non-accruing loans.
The construction loan portfolio of the BPNA reportable segment, totaled $232 million at June 30, 2011, compared with $332 million at December 31, 2010 and $523 million at June 30, 2010. The increase in the ratio of non-performing construction loans held-in-portfolio to construction loans held-in-portfolio, was primarily attributed to a lower portfolio balance.
155
The table that follows presents the changes in non-performing construction loans held in-portfolio for the quarter ended June 30, 2011, for the BPPR (excluding the Westernbank covered loan portfolio) and BPNA reportable segments.
Advances on existing non-performing loans
Ending balance at June 30, 2011
For the quarter ended June 30, 2011, non-covered construction loans held-in-portfolio newly classified to non-performing status at the BPPR and BPNA reportable segments amounted to $5 million and $3 million, respectively, which represented decreases of $7 million and $8 million, when compared to the additions for the quarter ended March 31, 2011. Additions to non-covered construction loans held-in-portfolio in non-performing status decreased by $32 million and $34 million for the BPPR and BPNA reportable segments, respectively, when compared to the quarter ended December 31, 2010. Both decreases are attributable to a lower level of problem loans remaining in the portfolio, principally prompted by the construction loans held-for-sale reclassification that took place in the fourth quarter of 2010 at the BPPR segment and the downsizing of the construction loan portfolio at the BPNA reportable segment.
Construction loans net charge-offs for the quarter ended June 30, 2011, compared with the quarter ended June 30, 2010, decreased by $37 million and $17 million in the BPPR and BPNA reportable segments, respectively. These decreases resulted from the steps taken by the Corporation to mitigate the overall credit risk, which included the BPPR loans held-for-sale reclassification that took place in the fourth quarter of 2010 and the decision to downsize the construction loan portfolio at the BPNA reportable segment. The construction loan portfolio of the BPPR reportable segment continues to be impacted by generally weak market conditions, decreases in property values, oversupply in certain areas, and reduced absorption rates.
For the quarter ended June 30, 2011, the charge-offs associated to collateral dependent construction loans amounted to approximately $4.6 million in BPNA reportable segment. For the quarter ended June 30, 2011, recoveries from previously charged-off construction loans amounted to $6.2 million in the BPPR reportable segment. Lower level of net charge-offs have been experienced in the construction loan portfolios at both reportable segments principally attributable to lower portfolio balances and a lower level of problem loans remaining in the portfolios. Management has identified construction loans considered impaired and has charged-off specific reserves based on the value of the collateral.
The allowance for loan losses corresponding to construction loans, represented 5.02% of that portfolio, excluding covered loans, at June 30, 2011, compared with 9.53% at December 31, 2010. The ratio of allowance to non-performing loans held-in-portfolio in the construction loans category was 9.98% at June 30, 2011, compared with 20.01% at December 31, 2010. As explained before, the decrease was driven by a lower level of net charge-offs, thus, requiring a lower allowance, coupled with decreases in loan portfolio and non-performing loans in both reportable segments.
The allowance for loan losses corresponding to the construction loan portfolio for the BPPR reportable segment, excluding the allowance for covered loans, totaled $7 million or 4.36% of construction loans held-in-portfolio, excluding covered loans, at June 30, 2011 compared to $16 million or 9.55%, respectively, at December 31, 2010. The decrease was driven by a lower level of net charge-offs, thus, requiring a lower allowance, coupled with decreases in loan portfolio and non-performing loans.
The allowance for loan losses corresponding to the construction loan portfolio for the BPNA reportable segment totaled $13 million or 5.49% of construction loans held-in-portfolio at June 30, 2011, compared to $32 million or 9.52%, respectively, at December 31, 2010. The reduction in net charge-offs observed in the construction loan portfolio of the BPNA reportable segment for the quarter ended June 30, 2011, when compared to same quarter in 2010, was attributable to a lower portfolio balance and lower level of problem loans remaining in the portfolio.
156
The construction loans held-in-portfolio, excluding covered loans, included $1 million in TDRs for the BPPR reportable segment and $77 million for the BPNA reportable segment, which were considered TDRs at June 30, 2011. The outstanding commitments for these construction TDR loans at June 30, 2011 were $486 thousand for the BPPR reportable segment and no outstanding commitments for the BPNA reportable segment. There were $34 thousand in construction TDR loans in non-performing status for the BPPR reportable segment and $77 million in the BPNA reportable segment at June 30, 2011. These construction TDR loans were individually evaluated for impairment resulting in no specific reserves for the BPPR and BPNA reportable segments at June 30, 2011. The impaired portions of collateral dependent construction TDR loans were charged-off during the fourth quarter of 2010.
In the current housing market, the value of the collateral securing the loan has become the most important factor in determining the amount of loss incurred and the appropriate level of the allowance for loan losses. The likelihood of losses that are equal to the entire recorded investment for a real estate loan is remote. However, in some cases during recent quarters declining real estate values have resulted in the determination that the estimated value of the collateral was insufficient to cover all of the recorded investment in the loans.
Mortgage loans
Non-performing mortgage loans held-in-portfolio increased by $74 million from December 31, 2010 to June 30, 2011, primarily as a result of an increase of $64 million in the BPPR reportable segment, accompanied by an increase of $9 million in the BPNA reportable segment. The increase in the BPPR reportable segment was driven principally by weak economic conditions in Puerto Rico, coupled with the level of mortgage loans repurchased under credit recourse arrangements. During the second quarter of 2011, the BPPR reportable segment repurchased $53 million of mortgage loans under credit recourse arrangements, an increase of $25 million, when compared to $28 million for the fourth quarter of 2010. The mortgage business has continued to be negatively impacted by the weak economic conditions in Puerto Rico as evidenced by the increased levels of non-performing mortgage loans and delinquency rates.
During the fourth quarter of 2010, approximately $396 million (book value) of U.S. non-conventional residential mortgage loans were reclassified as loans held-for-sale at the BPNA reportable segment, most of which were delinquent mortgage loans, mortgages in non-performing status, or troubled debt restructurings.
For the quarter ended June 30, 2011, the Corporation’s mortgage loans net charge-offs to average mortgage loans held-in-portfolio decreased to 0.89%, down by 142 basis points when compared to the quarter ended June 30, 2010. The decrease in the mortgage loan net charge-off ratio was mainly due to lower losses in the U.S. mainland non-conventional mortgage business driven by the previously explained loans held-for-sale transaction that took place in December 31, 2010.
At the BPPR reportable segment, mortgage loan net charge-offs (excluding covered loans) for the quarter ended June 30, 2011 amounted to $7.1 million, an increase of $1.2 million, when compared to same quarter in 2010. The mortgage business has continued to be negatively impacted by the current economic conditions in Puerto Rico which has resulted in increased levels of non-performing mortgage loans. However, high reinstatement experience associated with the mortgage loans under foreclosure process in Puerto Rico have helped to maintain losses at manageable levels.
The BPPR reportable segment’s mortgage loans held-in-portfolio (excluding covered loans) totaled $4.5 billion at June 30, 2011, compared with $3.6 billion at December 31, 2010. The increase in mortgage loans held-in-portfolio (excluding covered loans) for the BPPR reportable segment was as a result of the acquisition of approximately $518 million in unpaid principal balance of performing residential mortgage loans, loans repurchased under credit recourse arrangements and the loan origination activity in this reportable segment. The allowance for loan losses corresponding to the mortgage loan portfolio for the BPPR reportable segment, excluding the allowance for covered loans, totaled $55 million or 1.23% of mortgage loans held-in-portfolio, excluding covered loans, at June 30, 2011, compared to $42 million or 1.15%, at December 31, 2010.
At June 30, 2011, the mortgage loan TDRs for the BPPR’s reportable segment amounted to $285 million (including $91 million guaranteed by U.S. Government sponsored entities), of which $146 million were in non-performing status. Although the criteria for specific impairment excludes large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment (e.g. mortgage loans), it specifically requires its application to modifications considered TDRs. These mortgage loan TDRs were evaluated for impairment resulting in a specific allowance for loan losses of $8.2 million at June 30, 2011. There were no outstanding commitments for these mortgage loan TDRs in the BPPR reportable segment at June 30, 2011.
157
The table that follows provides information on mortgage non-performing loans at June 30, 2011, December 31, 2010, and June 30, 2010 and net charge-offs information for the quarters and six months ended June 30, 2011 and June 30, 2010 for the BPPR reportable segment.
Non-performing mortgage loans
Non-performing mortgage loans to mortgage loans HIP, both excluding covered loans and loans held- for-sale
Mortgage loan net charge-offs
Mortgage loan net charge-offs (annualized) to average mortgage loans HIP, excluding covered loans and loans held-for-sale
The BPNA reportable segment mortgage loan portfolio totaled $847 million at June 30, 2011, compared with $875 million at December 31, 2010. As compared to the quarter ended June 30, 2010, this portfolio has reflected better performance in terms of losses.
The table that follows provides information on mortgage non-performing loans at June 30, 2011, December 31, 2010, and June 30, 2010 and net charge-offs information for the quarters and six months ended June 30, 2011 and June 30, 2010 for the BPNA reportable segment.
Non-performing mortgage loans to mortgage loans HIP, excluding loans held-for-sale
Mortgage loan net charge-offs (annualized) to average mortgage loans HIP, excluding loans held- for-sale
As explained previously, in December 2010, approximately $396 million (book value) of U.S. non-conventional residential mortgage loans were reclassified as loans held-for-sale at the BPNA reportable segment, most of which were delinquent mortgage loans, mortgages in non-performing status, or troubled debt restructurings. Substantially all these loans were sold in the first quarter of 2011.
BPNA’s non-conventional mortgage loan portfolio outstanding at June 30, 2011 amounted to approximately $503 million with a related allowance for loan losses of $17 million, which represents 3.36% of that particular loan portfolio, compared with $513 million with a related allowance for loan losses of $22 million or 4.29%, respectively, at December 31, 2010. The Corporation is no longer originating non-conventional mortgage loans at BPNA.
There were $1.6 million in net charge-offs for BPNA’s non-conventional mortgage loans held-in-portfolio for the quarter ended June 30, 2011 or 1.23% of average non-conventional mortgage loans held-in-portfolio. Net charge-offs of BPNA’s non-conventional mortgage loans held-in-portfolio amounted to $19 million for the quarter ended June 30, 2010, and represented 7.61% of average non-conventional mortgage loans held-in-portfolio for that period. The decrease is principally due to the fact that most of this portfolio was classified as held-for-sale and adjusted to fair value in December 2010.
158
At June 30, 2011, mortgage loans held-in-portfolio, included a total of $17 million in TDRs for the BPNA reportable segment. There were no outstanding commitments for these mortgage loan TDRs. The mortgage loan TDRs in non-performing status for the BPNA reportable segments at June 30, 2011 amounted to $5 million. The mortgage loan TDRs were evaluated for impairment resulting in specific reserve of $3 million for the BPNA reportable segment, at June 30, 2011.
Consumer loans
Non-performing consumer loans (excluding covered loans) decreased from December 31, 2010 to June 30, 2011, as a result of decreases of $3 million and $8 million in the BPPR and BPNA reportable segments, respectively. The decrease in the BPPR reportable segment was principally related to an overall improvement in the consumer lines of business, mainly personal and leasing loans, as the portfolios continue to reflect signs of a more stable credit performance. The decrease in the BPNA reportable segment was primarily associated with home equity lines of credit and closed-end second mortgages, which are categorized by the Corporation as consumer loans. This portfolio has experienced improvements in terms of delinquencies and net charge-offs.
Consumer loans net charge-offs as a percentage of average consumer loans held-in-portfolio decreased mostly due to lower delinquencies at both reportable segments. The decrease in the ratio of consumer loans net charge-offs to average consumer loans held-in-portfolio in both segments was attributable to an improvement in the delinquency levels, as the portfolios continue to reflect signs of a more stable credit performance.
The consumer loans held-in-portfolio, excluding covered loans, included $102 million in TDRs for the BPPR reportable segment and $3 million for the BPNA reportable segment, which were considered TDRs at June 30, 2011. There were $5 million in consumer TDR loans in non-performing status for the BPPR reportable segment and $869 thousand in the BPNA reportable segment at June 30, 2011.
The table that follows provides information on consumer non-performing loans at June 30, 2011, December 31, 2010, and June 30, 2010 and net charge-offs information for the quarters and six months ended June 30, 2011 and June 30, 2010 for the BPPR reportable segment.
Non-performing consumer loans
Non-performing consumer loans to consumer loans HIP, both excluding covered loans and loans held-for-sale
Consumer loan net charge-offs
Consumer loan net charge-offs (annualized) to average consumer loans HIP, excluding covered loans and loans held-for-sale
159
The table that follows provides information on mortgage non-performing loans at June 30, 2011, December 31, 2010, and June 30, 2010 and net charge-offs information for the quarter and six months ended June 30, 2011, and June 30, 2010 for the BPNA reportable segment.
Non-performing consumer loans to consumer loans HIP, excluding loans held-for-sale
Consumer loan net charge-offs (annualized) to average consumer loans HIP, excluding loans held-for-sale
As previously explained, the decrease in non-performing consumer loans for the BPNA reportable segment was attributable in part to home equity lines of credit and closed-end second mortgages. As compared to 2010, these loan portfolios showed signs of improved performance due to significant charge-offs recorded in previous periods improving the quality of the remaining portfolio, combined with aggressive collection efforts and loan modification programs. Combined net charge-offs for E-LOAN’s home equity lines of credit and closed-end second mortgages amounted to approximately $10 million or 8.22% of this particular average loan portfolio for the quarter ended June 30, 2011, compared with $12 million or 9.69%, respectively, for the quarter ended June 30, 2010. With the downsizing of E-LOAN, this subsidiary ceased originating these types of loans. Home equity lending includes both home equity loans and lines of credit. This type of lending, which is secured by a first or second mortgage on the borrower’s residence, allows customers to borrow against the equity in their home. Real estate market values at the time the loan or line is granted directly affect the amount of credit extended and, in addition, changes in these values impact the severity of losses. E-LOAN’s portfolio of home equity lines of credit and closed-end second mortgages outstanding at June 30, 2011 totaled $450 million with a related allowance for loan losses of $35 million, representing 7.85% of that particular portfolio. E-LOAN’s portfolio of home equity lines of credit and closed-end second mortgages outstanding at December 31, 2010 totaled $437 million with a related allowance for loan losses of $41 million, representing 9.29% of that particular portfolio.
Troubled debt restructurings
In general, loans classified as TDRs are maintained in accrual status if the loan was in accrual status at the time of the modification. Other factors considered in this determination include a credit evaluation of the borrower’s financial condition and prospects for repayment under the revised terms.
The following tables present the loans classified as TDRs according to their accruing status at June 30, 2011 and December 31, 2010.
160
The Corporation’s TDR loans totaled $673 million at June 30, 2011, an increase of $112 million or 20% from December 31, 2010. The increase was mainly due to the intensification of loss mitigation efforts on the mortgage portfolio. Mortgage TDRs increased by $125 million or 71% during the six months ended on June 30, 2011 including $82 million of accruing loans of which $51 million were guaranteed by U.S. sponsored agencies.
Accruing loans past due 90 days or more
Accruing loans past due 90 days or more disclosed in Table K consist primarily of credit cards, FHA / VA and other insured mortgage loans, and delinquent mortgage loans included in the Corporation’s financial statements pursuant to GNMA’s buy-back option program. Servicers of loans underlying GNMA mortgage-backed securities must report as their own assets the defaulted loans that they have the option (but not the obligation) to repurchase, even when they elect not to exercise that option. Also, accruing loans past due 90 days or more include residential conventional loans purchased from other financial institutions that, although delinquent, the Corporation has received timely payment from the sellers / servicers, and, in some instances, have partial guarantees under recourse agreements. However, residential conventional loans purchased from other financial institutions, which are in the process of foreclosure, are classified as non-performing mortgage loans.
161
Allowance for Loan Losses
Refer to the 2010 Annual Report for detailed description of the Corporation’s accounting policy for determining the allowance for loan losses and for the Corporation’s definition of impaired loans.
Allowance for loan losses for loans related to the non-covered loan portfolio
The following tables set forth information concerning the composition of the Corporation’s allowance for loan losses (“ALLL”), excluding the allowance for the covered loan portfolio, at June 30, 2011, December 31, 2010, and June 30, 2010 by loan category and by whether the allowance and related provisions were calculated individually pursuant to the requirements for specific impairment or through a general valuation allowance.
Specific ALLL
Impaired loans [1]
Specific ALLL to impaired loans [1]
General ALLL
Loans held-in-portfolio, excluding impaired loans [1]
General ALLL to loans held-in-portfolio, excluding impaired loans [1]
Total ALLL
Total non-covered loans held-in-portfolio [1]
ALLL to loans held-in-portfolio [1]
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As compared to December 31, 2010, the allowance for loan losses, excluding covered loans, at June 30, 2011 decreased by approximately $104 million from 3.83% to 3.34% as a percentage of loans held-in-portfolio. This decrease considers a reduction in the Corporation’s general allowance component of approximately $110 million and an increase in the specific allowance component of approximately $6 million. The reduction in the general component of the allowance for loan losses for the quarter ended June 30, 2011, was primarily attributable to lower portfolio balances and net charge-offs, principally from the Corporation’s commercial, construction and consumer loan portfolios. The allowance for loan losses to loans held-in-portfolio at June 30, 2010 was 5.68%.
The decrease in the allowance for loan losses, excluding the allowance for covered loans, for the commercial loan portfolio at June 30, 2011 when compared with December 31, 2010 was mainly related to a reduction of $29 million and $21 million in the general component of the allowance for loan losses of the BPPR and BPNA reportable segments, respectively, principally due to a lower portfolio balances and net charge-offs. The general component of the allowance for loan losses of the construction loan portfolio amounted to $19 million at June 30, 2011, a decrease of $28 million compared with December 31, 2010. This decrease was prompted principally by the previously mentioned reclassification of construction loans held-for-sale of the BPPR reportable segment that took place in the fourth quarter of 2010, which resulted in a lower level of problem loans in the remaining portfolio, coupled with decreases in loan portfolio and non-performing loans in the U.S. mainland reportable segment.
The allowance for loan losses of the mortgage loan portfolio, excluding the allowance for covered loans, increased by $7 million from $71 million at December 31, 2010 to $78 million at June 30, 2011. The increase was principally driven by the BPPR reportable segment which contributed with a higher loan portfolio balance, higher delinquencies and an increase in specific reserves on mortgage loan TDRs, partially offset by the decreases in the volume of mortgage loans and related net charge-offs in the BPNA reportable segment, as a result of the previously explained held-for-sale transaction.
The allowance for loan losses of the consumer loan portfolio, excluding the allowance for covered loans, decreased by $25 million from $199 million at December 31, 2010 to $174 million at June 30, 2011. The consumer loan portfolios in both the BPPR and BPNA reportable segments have continued to reflect favorable credit trends.
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The following table presents the Corporation’s recorded investment in commercial, construction and mortgage loans that were considered impaired and the related valuation allowance at June 30, 2011, December 31, 2010, and June 30, 2010.
Impaired loans:
No valuation allowance required
With respect to the $660 million portfolio of impaired commercial and construction loans for which no allowance for loan losses was required at June 30, 2011, management followed the guidance for specific impairment of a loan. When a loan is impaired, the measurement of the impairment may be based on: (1) the present value of the expected future cash flows of the impaired loan discounted at the loan’s original effective interest rate; (2) the observable market price of the impaired loan; or (3) the fair value of the collateral if the loan is collateral dependent. A loan is collateral dependent if the repayment of the loan is expected to be provided solely by the underlying collateral. At June 30, 2011, $650 million or 96% of the $678 million impaired commercial and construction loans with no valuation allowance were collateral dependent loans. For collateral dependent loans, management performed an analysis based on the fair value of the collateral less estimated costs to sell, and determined that the collateral was deemed adequate to cover any inherent losses at June 30, 2011. Impaired portions on collateral dependent commercial and construction loans were charged-off during the quarters ended June 30, 2011 and December 31, 2010.
Average impaired loans during the quarters ended June 30, 2011 and June 30, 2010 were $860 million and $1.7 billion, respectively. The Corporation recognized interest income on impaired loans of $3.7 million and $4.8 million for the quarters ended June 30, 2011 and June 30, 2010, respectively.
The following tables set forth the activity in the specific reserves for impaired loans, excluding covered loans, for the quarters ended June 30, 2011 and 2010.
Specific allowance for loan losses at March 31, 2011
Provision for impaired loans
Less: Net charge-offs
Specific allowance for loan losses at June 30, 2011
Specific allowance for loan losses at March 31, 2010
Specific allowance for loan losses at June 30, 2010
For the quarter ended June 30, 2011, total net charge-offs for individually evaluated impaired loans amounted to approximately $31 million, of which $19 million pertained to the BPPR reportable segment and $12 million to the BPNA reportable segment. Most of these net charge-offs were related to the commercial and construction portfolios. The decrease in net charge-offs for loans considered impaired was attributable to: (i) the benefits provided by the previously mentioned reclassification of commercial, construction and mortgage loans held-for-sale that took place in the fourth quarter of 2010, which resulted in a lower level of problem loans in the remaining portfolio, and (ii) a lower portfolio balance of commercial loans at the BPNA reportable segment, driven by the Corporation’s decision to exit or downsize certain business lines.
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The Corporation requests updated appraisal reports from pre-approved appraisers for loans that are considered impaired and individually analyzes them following the Corporation’s reappraisal policy. This policy requires updated appraisals for loans secured by real estate (including construction loans) either annually, every two or three years depending on the total exposure of the borrower. Generally, the specialized appraisal review unit of the Corporation’s Credit Risk Management Division internally reviews appraisals following certain materiality benchmarks. In addition to evaluating the reasonability of the appraisal reports, these reviews monitor that appraisals are performed following the Uniform Standards of Professional Appraisal Practice (“USPAP”).
Appraisals may be adjusted due to age or general market conditions. The adjustments applied are based upon internal information, like other appraisals and/or loss severity information that can provide historical trends in the real estate market. Specifically, in commercial and construction impaired loans for the BPPR reportable segment, and depending on the type of property and/or the age of the appraisal, currently, downward adjustments currently range from 10% to 40% (including costs to sell). At June 30, 2011, the weighted average discount rate for the BPPR reportable segment was 21%. For commercial and construction loans at the BPNA reportable segment, the most typically applied collateral discount rate is 30%.
For mortgage loans secured by residential real estate properties, a current assessment of value is made not later than 180 days past the contractual due date. Any outstanding balance in excess of the estimated value of the property, less costs to sell, is charged-off. For this purpose and for residential real estate properties, the Corporation requests Independent Broker Price Opinion of Value of the subject collateral property at least annually. In the case of the mortgage loan portfolio for the BPPR reportable segment, Independent Broker Price Opinions of Value of the subject collateral properties are currently subject to downward adjustment (cost to sell) of 5%. In the case of the U.S. mortgage loan portfolio, downward adjustments currently range from 0% to 30%, depending on the age of the appraisal and the location of the property.
The table that follows presents the approximate amount and percentage of non-covered impaired loans for which the Corporation relied on appraisals dated more than one year old for purposes of impairment requirements at June 30, 2011.
Total commercial
Total construction
The Corporation evaluates the discount factors applied to appraisals due to age or general market conditions comparing these to the aggregate value trends in commercial and construction properties. The main source of information is new appraisals received by the Corporation and/or recent sales data. In Puerto Rico, for commercial and construction appraisals less than one year old, the Corporation generally uses 90% of the appraised value for determination of the allowance for loan losses. In the case of commercial loans, if the appraisal is over one year old, the Corporation generally uses 75% of the appraised value. In the case of construction loans this factor can reach up to 60% of the appraised value. In the Corporation’s U.S. operations, the Corporation generally uses 70% of appraised value. This discount was determined based on a study of OREO, short sale and loan sale transactions during the past two years, comparing net proceeds received by the bank relative to most recent appraised value of the properties. However, additional haircuts can be applied depending upon the age of appraisal, the region and the condition of the project. Factors are based on appraisal changes and/or trends in loss severities. Discount rates discussed above include costs to sell and may change from time to time based on market conditions.
The Corporation requests updated appraisal reports for loans that are considered impaired following a corporate reappraisal policy. This policy requires updated appraisals for loans secured by real estate (including construction loans) either annually, every two years or every three years depending on the total exposure of the borrower. As a general procedure, the Corporation internally reviews appraisals as part of the underwriting and approval process and also for credits considered impaired.
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The percentage of the Corporation’s impaired construction loans that we relied upon “as developed” and “as is” for the period ended June 30, 2011 is presented in the table below.
Loans held-in-portfolio
At June 30, 2011, the Corporation accounted for $105 million impaired construction loans under the “as developed” value. This approach is used since the current plan is that the project will be completed and it reflects the best strategy to reduce potential losses based on the prospects of the project. The costs to complete the project and the related increase in debt are considered an integral part of the individual reserve determination.
Costs to complete are deducted from the subject “as developed” collateral value on impaired construction loans. Impairments determinations are calculated following the collateral dependent method, comparing the outstanding principal balance of the respective impaired construction loan against the expected realizable value of the subject collateral. Realizable values of subject collaterals have been defined as the “as developed” appraised value less costs to complete, costs to sell and discount factors. Costs to complete represent an estimate of the amount of money to be disbursed to complete a particular phase of a construction project. Costs to sell have been determined as a percentage of the subject collateral value, to cover related collateral disposition costs (e.g. legal and commission fees). Discount factors are applied to appraisals due to age or general market conditions comparing these to the aggregate value trends in commercial and construction properties. The main source of information is new appraisals received by the Corporation and/or recent sales data. In the BPPR reportable segment, for commercial and construction appraisals less than 1 year old the Corporation generally uses 90% (including the cost to sell) of the appraised value for reserve determination. If the appraisal is over one year old, the Corporation generally use 75% (including the cost to sell) of the appraised value, in the case for commercial loans. In the case of construction loans this factor can reach up to 60% (including the cost to sell) of the appraised value. In the BPNA reportable segment, the Corporation usually uses 70% (including the cost to sell) of appraised value, no matter the age of the appraisal. However, additional haircuts can be applied depending upon the region and the condition of the projects.
Allowance for loan losses for loans – Covered loan portfolio
The Corporation’s allowance for loan losses at June 30, 2011 includes $57 million related to the covered loan portfolio acquired in the Westernbank FDIC-assisted transaction. This allowance covers the estimated credit loss exposure related to: (i) acquired loans accounted for under ASC Subtopic 310-30, which required an allowance for loan losses of $48 million at quarter end, as one pool reflected a higher than expected credit deterioration; (ii) acquired loans accounted for under ASC Subtopic 310-20, which required an allowance for loan losses of $8 million, and (iii) loan advances on loan commitments assumed by the Corporation as part of the acquisition, which required an allowance of $1 million. Decreases in expected cash flows after the acquisition date for loans (pools) accounted for under ASC Subtopic 310-30 are recognized by recording an allowance for loan losses. For purposes of loans accounted for under ASC 310-20 and new loans originated as result of loan commitments assumed, the Corporation’s assessment of the allowance for loan losses is determined in accordance with the accounting guidance of loss contingencies in ASC Subtopic 450-20 (general reserve for inherent losses) and loan impairment guidance in ASC Section 310-10-35 for individually impaired loans. Concurrently, the Corporation recorded an increase in the FDIC loss share indemnification asset for the expected reimbursement from the FDIC under the loss sharing agreements. No allowance for loans losses for covered loans was required at December 31, 2010.
Geographic and government risk
The Corporation is exposed to geographical and government risk. The Corporation’s assets and revenue composition by geographical area and by business segment reporting are presented in Note 30 to the consolidated financial statements. A significant portion of the Corporation’s financial activities and credit exposure is concentrated in Puerto Rico. Since 2006, the Puerto Rico economy has been experiencing recessionary conditions. Based on information published by the Puerto Rico Planning Board (the “Planning Board”), the Puerto Rico real gross national product decreased an estimated 3.6% during fiscal year ended June 30, 2010. The unemployment rate in Puerto Rico remains high at 14.9% in June 2011 down from 16.9% in March 2011. The Puerto Rico economy continues to be challenged, primarily, by a housing sector that remains under pressure, contraction in the manufacturing sector and a fiscal deficit that constrains government spending.
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The Puerto Rico economy is still vulnerable, but the government has made progress in addressing the budget deficit while the banking sector has been substantially recapitalized and consolidated through FDIC-assisted transactions.
During 2011, the Puerto Rico government signed into law several economic and fiscal measures to help counter the prolonged recession. The implementation of a temporary excise tax on certain manufacturers is expected to add nearly $1 billion annual to consumers’ purchasing power. The marginal corporate tax rate in Puerto Rico was also reduced from 39% to 30% in January 2011.
In 2010, the government also enacted a housing-incentive law that put into effect temporary measures that seek to stimulate demand for housing and reduce the significant excess supply of new homes. The incentives which were available up to June 30, 2011, included reductions in taxes and government closing fees, tax exemption on rental income from new properties for 10 years, exemption on long-term capital gain tax in future sale of new properties and no property taxes for five years on new housing, among others. In July 2011, the Puerto Rico government extended the housing-incentive law until October 31, 2011. The incentives continue to attract home buyers into the market, especially in the more reasonably priced segment. However, the high-end market is still under pressure due to excess supply.
Several major projects are under consideration by the Puerto Rico Government in areas such as energy and road infrastructure. These are expected to be structured as public and private partnerships and are expected to generate economic activity as they are awarded and construction commences. In June 2011, the government awarded a public private partnership to a consortium, effectively monetizing the future toll stream of a highway strip in the northern part of the island for the next 40 years, in a deal valued at $1.4 billion. The administration also sold $304 million in general-obligation bonds in June 2011 to fund infrastructure projects, including the completion of the remaining expansion of a highway that runs on the northeastern coast, road improvements and municipal projects.
The current state of the economy and uncertainty in the private and public sectors has resulted in, among other things, a downturn in the Corporation’s loan originations; deterioration in the credit quality of the Corporation’s loan portfolios as reflected in high levels of non-performing assets, loan loss provisions and charge-offs, particularly in the Corporation’s construction and commercial loan portfolios; an increase in the rate of foreclosures on mortgage loans; and a reduction in the value of the Corporation’s loans and loan servicing portfolio, all of which have adversely affected its profitability. A persistent economic slowdown could cause those adverse effects to continue, as delinquency rates may increase in the short-term, until sustainable growth resumes. Also, a potential reduction in consumer spending may also impact growth in the Corporation’s other interest and non-interest revenues.
On August 8, 2011, Moody’s Investors Service downgraded the rating of the outstanding general obligation (GO) bonds of the Commonwealth of Puerto Rico from ‘A3’ to ‘Baa1’ with a negative outlook.
At June 30, 2011, the Corporation had $894 million of credit facilities granted to or guaranteed by the Puerto Rico Government and its political subdivisions, of which $140 million were uncommitted lines of credit. Of these total credit facilities granted, $754 million were outstanding at June 30, 2011. A substantial portion of the Corporation’s credit exposure to the Government of Puerto Rico is either collateralized loans or obligations that have a specific source of income or revenues identified for their repayment. Some of these obligations consist of senior and subordinated loans to public corporations that obtain revenues from rates charged for services or products, such as water and electric power utilities. Public corporations have varying degrees of independence from the central Government and many receive appropriations or other payments from it. The Corporation also has loans to various municipalities in Puerto Rico for which, in most cases, the good faith, credit and unlimited taxing power of the applicable municipality has been pledged to their repayment. These municipalities are required by law to levy special property taxes in such amounts as shall be required for the payment of all of its general obligation bonds and loans. Another portion of these loans consists of special obligations of various municipalities that are payable from the basic real and personal property taxes collected within such municipalities.
Furthermore, at June 30, 2011, the Corporation had outstanding $125 million in obligations of Puerto Rico, States and political subdivisions as part of its investment securities portfolio. Refer to Notes 7 and 8 to the consolidated financial statements for additional information. Of that total, $121 million was exposed to the creditworthiness of the Puerto Rico Government and its municipalities. Refer to Item 1A-Risk Factors of the Corporation’s Form 10-K for the year ended December 31, 2010 for additional information about how downgrades on the Government of Puerto Rico’s debt obligations could affect the value of our loans to the Government and our portfolio of Puerto Rico Government securities.
As further detailed in Notes 7 and 8 to the consolidated financial statements, a substantial portion of the Corporation’s investment securities represented exposure to the U.S. Government in the form of obligations of U.S. Government sponsored entities, as well as agency mortgage-backed and U.S. Treasury securities. In addition, $638 million of residential mortgages and $242 million in commercial loans were insured or guaranteed by the U.S. Government or its agencies at June 30, 2011. On August 5, 2011, Standard & Poor’s lowered its long term sovereign credit rating on the United States of America from AAA to AA+ and on August 8, 2011, Standard & Poor’s lowered its credit ratings of the obligations of certain U.S. Government sponsored entities, including FNMA, FHLB and Freddie Mac, and other agencies with securities linked to long-term U.S. Government debt. These downgrades could have material adverse impact on global financial markets and economic conditions, and its ultimate impact is unpredictable and may not be immediately apparent.
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Contractual Obligations and Commercial Commitments
The Corporation has various financial obligations, including contractual obligations and commercial commitments, which require future cash payments on debt and lease agreements. Also, in the normal course of business, the Corporation enters into contractual arrangements whereby it commits to future purchases of products or services from third parties. Obligations that are legally binding agreements, whereby the Corporation agrees to purchase products or services with a specific minimum quantity defined at a fixed, minimum or variable price over a specified period of time, are defined as purchase obligations.
Purchase obligations include major legal and binding contractual obligations outstanding at June 30, 2011, primarily for services, equipment and real estate construction projects. Services include software licensing and maintenance, facilities maintenance, supplies purchasing, and other goods or services used in the operation of the business. Generally, these contracts are renewable or cancelable at least annually, although in some cases the Corporation has committed to contracts that may extend for several years to secure favorable pricing concessions.
As previously indicated, the Corporation also enters into derivative contracts under which it is required either to receive or pay cash, depending on changes in interest rates. These contracts are carried at fair value on the consolidated statements of condition with the fair value representing the net present value of the expected future cash receipts and payments based on market rates of interest as of the statement of condition date. The fair value of the contract changes daily as interest rates change. The Corporation may also be required to post additional collateral on margin calls on the derivatives and repurchase transactions.
The aggregate contractual cash obligations, including purchase obligations and borrowings, by maturities, have not changed significantly from December 31, 2010. Refer to Note 16 for a breakdown of long-term borrowings by maturity.
The Corporation utilizes lending-related financial instruments in the normal course of business to accommodate the financial needs of its customers. The Corporation’s exposure to credit losses in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, standby letters of credit and commercial letters of credit is represented by the contractual notional amount of these instruments. The Corporation uses credit procedures and policies in making those commitments and conditional obligations as it does in extending loans to customers. Since many of the commitments may expire without being drawn upon, the total contractual amounts are not representative of the Corporation’s actual future credit exposure or liquidity requirements for these commitments.
The following table presents the contractual amounts related to the Corporation’s off-balance sheet lending and other activities at June 30, 2011:
Unfunded investment obligations
At June 30, 2011, the Corporation maintained a reserve of approximately $11 million for potential losses associated with unfunded loan commitments related to commercial and consumer lines of credit, including $3 million of the unamortized balance of the contingent liability on unfunded loan commitments recorded with the Westernbank FDIC-assisted transaction. The estimated reserve is principally based on the expected draws on these facilities using historical trends and the application of the corresponding reserve factors determined under the Corporation’s allowance for loan losses methodology. This reserve for unfunded exposures remains separate and distinct from the allowance for loan losses and is reported as part of other liabilities in the consolidated statement of condition.
Refer to Note 20 to the consolidated financial statements for additional information on credit commitments and contingencies.
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Guarantees associated with loans sold / serviced
At June 30, 2011, the Corporation serviced $3.7 billion in residential mortgage loans subject to lifetime credit recourse provisions, principally loans associated with FNMA and FHLMC residential mortgage loan securitization programs, compared with $4.0 billion at December 31, 2010. The Corporation has not sold any mortgage loans subject to credit recourse during 2010 and 2011.
In the event of any customer default, pursuant to the credit recourse provided, the Corporation is required to repurchase the loan or reimburse the third party investor for the incurred loss. The maximum potential amount of future payments that the Corporation would be required to make under the recourse arrangements in the event of nonperformance by the borrowers is equivalent to the total outstanding balance of the residential mortgage loans serviced with recourse and interest, if applicable. In the event of nonperformance by the borrower, the Corporation has rights to the underlying collateral securing the mortgage loan. The Corporation suffers losses on these loans when the proceeds from a foreclosure sale of the property underlying a defaulted mortgage loan are less than the outstanding principal balance of the loan plus any uncollected interest advanced and the costs of holding and disposing the related property.
In the case of Puerto Rico, most claims are settled by repurchases of delinquent loans, the majority of which are greater than 90 days past due. The average time period to prepare an initial response to a repurchase request is from 30 to 120 days from the initial written notice depending on the type of the repurchase request. Failure by the Corporation to respond to a request for repurchase on a timely basis could result in a deterioration of the seller/servicer relationship and the seller/servicer’s overall standing. In certain instances, investors could require additional collateral to ensure compliance with the servicer’s repurchase obligation or cancel the seller/servicer license and exercise their rights to transfer the servicing to an eligible seller/servicer.
The table below presents the delinquency status of the residential mortgage loans serviced by the Corporation that are subject to lifetime credit recourse provisions at June 30, 2011 and December 31, 2010.
Total portfolio
Days past due:
30 days and over
90 days and over
As a percentage of total portfolio:
30 days past due or more
90 days past due or more
During the quarter and six months ended June 30, 2011, the Corporation repurchased approximately $53 million and $115 million, respectively, of unpaid principal balance in mortgage loans subject to the credit recourse provisions. This compares to repurchases of $38 million and $55 million, respectively, for the quarter and six months ended June 30, 2010, and $121 million for the year ended December 31, 2010. There are no particular loan characteristics, such as loan vintages, loan type, loan-to-value ratio, or other criteria, that denote any specific trend or a concentration of repurchases in any particular segment. Based on historical repurchase experience, the loan delinquency status is the main factor which causes the repurchase request. The current economical situation has provoked a closer monitoring by investors of loan performance and recourse triggers, thus causing an increase in loan repurchases.
At June 30, 2011, there were 8 outstanding unresolved claims related to the recourse portfolio with a principal balance outstanding of $1 million, compared with 27 and $2 million, respectively, at December 31, 2010. All the outstanding unresolved claims pertained to FNMA.
At June 30, 2011, the Corporation’s liability established to cover the estimated credit loss exposure related to loans sold or serviced with credit recourse amounted to $55 million, compared with $54 million at December 31, 2010.
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The following table presents the activity in the liability established to cover the estimated credit loss exposure on serviced loans where credit recourse is provided for the quarters and six months ended June 30, 2011 and 2010.
The best estimate of losses to be absorbed under the credit recourse arrangements are recorded as a liability when the loans are sold and are updated by accruing or reversing expense (categorized in the line item “adjustments (expense) to indemnity reserves on loans sold” in the consolidated statements of operations) throughout the life of the loan, as necessary, when additional relevant information becomes available. The methodology used to estimate the recourse liability is a function of the recourse arrangements given and considers a variety of factors, which include actual defaults and historical loss experience, foreclosure rate, estimated future defaults and the probability that a loan would be delinquent. Statistical methods are used to estimate the recourse liability. Expected loss rates are applied to different loan segments. The expected loss, which represents the amount expected to be lost on a given loan, considers the probability of default and loss severity. The probability of default represents the probability that a loan in good standing would become 90 days delinquent within the following twelve-month period. Regression analysis quantifies the relationship between the default event and loan-specific characteristics, including credit scores, loan-to-value rates and loan aging, among others.
The decrease of $2 million and $8 million in the provision for credit recourse liability experienced for the quarter and six months ended June 30, 2011, when compared to the same periods in 2010, was driven by the following factors: (i) an improvement in the portfolio probability of default, which decreased by 11 basis points, from 6.87% at June 30, 2010 to 6.76% at June 30, 2011, and (ii) higher constant prepayment rates when compared to those reported for June 30, 2010.
When the Corporation sells or securitizes mortgage loans, it generally makes customary representations and warranties regarding the characteristics of the loans sold. The Corporation’s mortgage operations in Puerto Rico group conforming mortgage loans into pools which are exchanged for FNMA and GNMA mortgage-backed securities, which are generally sold to private investors, or are sold directly to FNMA or other private investors for cash. As required under the government agency programs, quality review procedures are performed by the Corporation to ensure that asset guideline qualifications are met. To the extent the loans do not meet specified characteristics, the Corporation may be required to repurchase such loans or indemnify for losses and bear any subsequent loss related to the loans. Repurchases under representation and warranty arrangements in which the Corporation’s Puerto Rico banking subsidiaries were obligated to repurchase the loans approximated $10 million in unpaid principal balance with losses amounting to $0.7 million for the six months ended June 30, 2011. A substantial amount of these loans reinstate to performing status or have mortgage insurance, and thus the ultimate losses on the loans are not deemed significant.
Servicing agreements relating to the mortgage-backed securities programs of FNMA and GNMA, and to mortgage loans sold or serviced to certain other investors, including FHLMC, require the Corporation to advance funds to make scheduled payments of principal, interest, taxes and insurance, if such payments have not been received from the borrowers. At June 30, 2011, the Corporation serviced $17.4 billion in mortgage loans for third-parties, including the loans serviced with credit recourse, compared with $18.4 billion at December 31, 2010. The Corporation generally recovers funds advanced pursuant to these arrangements from
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the mortgage owner, from liquidation proceeds when the mortgage loan is foreclosed or, in the case of FHA/VA loans, under the applicable FHA and VA insurance and guarantees programs. However, in the meantime, the Corporation must absorb the cost of the funds it advances during the time the advance is outstanding. The Corporation must also bear the costs of attempting to collect on delinquent and defaulted mortgage loans. In addition, if a defaulted loan is not cured, the mortgage loan would be canceled as part of the foreclosure proceedings and the Corporation would not receive any future servicing income with respect to that loan. At June 30, 2011, the outstanding balance of funds advanced by the Corporation under such mortgage loan servicing agreements was approximately $29 million, compared with $24 million at December 31, 2010. To the extent the mortgage loans underlying the Corporation’s servicing portfolio experience increased delinquencies, the Corporation would be required to dedicate additional cash resources to comply with its obligation to advance funds as well as incur additional administrative costs related to increases in collection efforts.
At June 30, 2011, the Corporation has reserves for customary representations and warranties related to loans sold by its U.S. subsidiary E-LOAN prior to 2009. Loans had been sold to investors on a servicing released basis subject to certain representations and warranties. Although the risk of loss or default was generally assumed by the investors, the Corporation made certain representations relating to borrower creditworthiness, loan documentation and collateral, which if not correct, may result in requiring the Corporation to repurchase the loans or indemnify investors for any related losses associated to these loans. At June 30, 2011 and December 31, 2010, the Corporation’s reserve for estimated losses from such representation and warranty arrangements amounted to $29 million and $31 million, respectively. E-LOAN is no longer originating and selling loans since the subsidiary ceased these activities in 2008.
On a quarterly basis, the Corporation reassesses its estimate for expected losses associated to E-LOAN’s customary representation and warranty arrangements. The analysis incorporates expectations on future disbursements based on quarterly repurchases and make-whole events. The analysis also considers factors such as the average length of time between the loan’s funding date and the loan repurchase date, as observed in the historical loan data. The liability is estimated as follows: (1) three year average of disbursement amounts (two year historical and one year projected) are used to calculate an average quarterly amount; (2) the quarterly average is annualized and multiplied by the repurchase distance, which currently averages approximately three years, to determine a liability amount; and (3) the calculated reserve is compared to current claims and disbursements to evaluate adequacy. The Corporation’s success rate in clearing the claims in full or negotiating lesser payouts has been fairly consistent. On average, the Corporation avoided paying on 50% of claimed amounts during the 24-month period ended June 30, 2011 (52% during the 24-month period ended December 31, 2010). On the remaining 50% of claimed amounts, the Corporation either repurchased the balance in full or negotiated settlements. For the accounts where the Corporation settled, it averaged paying 61% of claimed amounts during the 24-month period ended June 30, 2011 (62% during the 24-month period ended December 31, 2010). In total, during the 24-month period ended June 30, 2011, the Corporation paid an average of 35% of claimed amounts (24-month period ended December 31, 2010 – 34%).
E-LOAN’s outstanding unresolved claims related to representation and warranty obligations from mortgage loan sales prior to 2009 were as follows at June 30, 2011 and December 31, 2010:
By Counterparty
GSEs
Whole loan and private-label securitization investors
Total outstanding claims by counterparty
By Product Type
1st lien (Prime loans)
2nd lien (Prime loans)
Total outstanding claims by product type
The outstanding claims balance from private-label investors is comprised of four different counterparties at June 30, 2011 and three at December 31, 2010.
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In the case of E-LOAN, the Corporation indemnifies the lender, repurchases the loan, or settles the claim, generally for less than the full amount. Each repurchase case is different and each lender / servicer has different requirements. The large majority of the loans repurchased have been greater than 90 days past due at the time of repurchase and are included in the corporation’s non-performing loans. During the quarter and six months ended June 30, 2011, charge-offs recorded by E-LOAN against this representation and warranty reserve associated with loan repurchases, indemnification or make-whole events and settlement / closure of certain agreements with counterparties to reduce the exposure to future claims were minimal. Make-whole events are typically defaulted cases in which the investor attempts to recover by collateral or guarantees, and the seller is obligated to cover any impaired or unrecovered portion of the loan. Historically, claims have been predominantly for first mortgage agency loans and principally consist of underwriting errors related to undisclosed debt or missing documentation. The table that follows presents the changes in the Corporation’s liability for estimated losses associated with customary representations and warranties related to loans sold by E-LOAN, included in the consolidated statement of condition for the quarters and six months ended June 30, 2011 and 2010.
During 2008, the Corporation provided indemnifications for the breach of certain representations or warranties in connection with certain sales of assets by the discontinued operations of Popular Financial Holdings (“PFH”). The sales were on a non-credit recourse basis. At June 30, 2011, the agreements primarily include indemnification for breaches of certain key representations and warranties, some of which expire within a definite time period; others survive until the expiration of the applicable statute of limitations, and others do not expire. Certain of the indemnifications are subject to a cap or maximum aggregate liability defined as a percentage of the purchase price. The indemnification agreements outstanding at June 30, 2011 are related principally to make-whole arrangements. At June 30, 2011, the Corporation’s reserve related to PFH’s indemnity arrangements amounted to $4 million, compared with $8 million at December 31, 2010, and is included as other liabilities in the consolidated statement of condition. The reserve balance at June 30, 2011 contemplates historical indemnity payments. Popular, Inc. and Popular North America have agreed to guarantee certain obligations of PFH with respect to the indemnification obligations. The following table presents the changes in the Corporation’s liability for estimated losses associated to loans sold by the discontinued operations of PFH, included in the consolidated statement of condition for the quarters and six months ended June 30, 2011 and 2010.
PIHC fully and unconditionally guarantees certain borrowing obligations issued by certain of its wholly-owned consolidated subsidiaries amounting to $0.7 billion at June 30, 2011 (December 31, 2010 and June 30, 2010 - $0.6 billion). In addition, at June 30, 2011, December 31, 2010 and June 30, 2010, PIHC fully and unconditionally guaranteed on a subordinated basis $1.4 billion of capital securities (trust preferred securities) issued by wholly-owned issuing trust entities to the extent set forth in the applicable guarantee agreement. Refer to Note 17 to the consolidated financial statements for further information on the trust preferred securities.
The Corporation is a defendant in a number of legal proceedings arising in the ordinary course of business as described in the Legal Proceedings section in Part II. Item 1 of this Form 10-Q and Note 20 to the consolidated financial statements. At this early stage, it is not possible for management to assess the probability of an adverse outcome, or reasonably estimate the amount of any potential loss. It is possible that the ultimate resolution of these matters, if unfavorable, may be material to our results of operations.
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MARKET RISK
The financial results and capital levels of Popular, Inc. are constantly exposed to market risk. Market risk represents the risk of loss due to adverse movements in market rates or prices, which include interest rates, foreign exchange rates and equity prices; the failure to meet financial obligations coming due because of the inability to liquidate assets or obtain adequate funding; and the inability to easily unwind or offset specific exposures without significantly lowering prices because of inadequate market depth or market disruptions.
While the Corporation is exposed to various business risks, the risks relating to interest rate risk and liquidity are major risks that can materially impact future results of operations and financial condition due to their complexity and dynamic nature.
The Asset Liability Management Committee (“ALCO”) and the Corporate Finance Group are responsible for measuring, monitoring, planning and executing the Corporation’s market, interest rate risk, funding activities and strategy, and for implementing the policies and procedures approved by the Corporation’s Risk Management Committee. In addition, the Risk Management Group independently monitors and reports adherence with established market and liquidity policies and recommends actions to enhance and strengthen controls surrounding interest, liquidity, and market risks. The ALCO meets on a weekly basis and reviews the Corporation’s current and forecasted asset and liability position as well as desired pricing strategies and other relevant topics to the business. Also on a monthly basis, the ALCO reviews various interest rate risk metrics, ratios and portfolio information, including but not limited to, the Corporation’s liquidity positions, projected sources and uses of funds, interest rate risk positions and economic conditions.
Interest rate risk (“IRR”), a component of market risk, is considered by management as a predominant market risk in terms of its potential impact on profitability or market value. The techniques for measuring the potential impact of the Corporation’s exposure to market risk from changing interest rates that were described in the 2010 Annual Report are the same as those applied by the Corporation at June 30, 2011.
Net interest income simulation analysis performed by legal entity and on a consolidated basis is a tool used by the Corporation in estimating the potential change in net interest income resulting from hypothetical changes in interest rates. Sensitivity analysis is calculated using a simulation model which incorporates actual balance sheet figures detailed by maturity and interest yields or costs. It also incorporates assumptions on balance sheet growth and expected changes in its composition, estimated prepayments in accordance with projected interest rates, pricing and maturity expectations on new volumes and other non-interest related data. It is a dynamic process, emphasizing future performance under diverse economic conditions.
Management assesses interest rate risk using various interest rate scenarios that differ in magnitude and direction, the speed of change and the projected shape of the yield curve. For example, the types of interest rate scenarios processed include most likely economic scenarios, flat or unchanged rates, yield curve twists, +/- 200 and + 400 basis points parallel ramps and +/- 200 basis points parallel shocks. Management also performs analyses to isolate and measure basis and prepayment risk exposures. The asset and liability management group also evaluates the reasonableness of assumptions used and results obtained in the monthly sensitivity analyses. Due to the importance of critical assumptions in measuring market risk, the risk models incorporate third-party developed data for critical assumptions such as prepayment speeds on mortgage loans and mortgage-backed securities, estimates on the duration of the Corporation’s deposits and interest rate scenarios.
The Corporation runs net interest income simulations under interest rate scenarios in which the yield curve is assumed to rise and decline gradually by the same amount. The rising rate scenarios considered in these market risk disclosures reflect gradual parallel changes of 200 and 400 basis points during the twelve-month period ending June 30, 2012. Under a 200 basis points rising rate scenario, projected net interest income increases by $35.4 million, while under a 400 basis points rising rate scenario, projected net interest income increases by $60.0 million, when compared against the Corporation’s flat or unchanged interest rates forecast scenario. Given the fact that at June 30, 2011 some market interest rates continued to be close to zero, management has focused on measuring the risk on net interest income in rising rate scenarios. These interest rate simulations exclude the impact on loans accounted pursuant to ASC Subtopic 310-30, whose yields are based on management’s current expectation of future cash flows.
Simulation analyses are based on many assumptions, including relative levels of market interest rates, interest rate spreads, loan prepayments and deposit decay. They should not be relied upon as indicative of actual results. Further, the estimates 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 may actually occur in the future.
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The Corporation estimates the sensitivity of economic value of equity (“EVE”) to changes in interest rates. EVE is equal to the estimated present value of the Corporation’s assets minus the estimated present value of the liabilities. This sensitivity analysis is a useful tool to measure long-term IRR because it captures the impact of up or down rate changes in expected cash flows, including principal and interest, from all future periods.
EVE sensitivity calculated using interest rate shock scenarios is estimated on a quarterly basis. The shock scenarios consist of +/- 200 basis points parallel shocks. Management has defined limits for the increases / decreases in EVE sensitivity resulting from the shock scenarios.
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 or market value that are caused by interest rate volatility. The market value of these derivatives is subject to interest rate fluctuations and counterparty credit risk adjustments which could have a positive or negative effect in the Corporation’s earnings.
Trading
Popular, Inc. engages in trading activities in the ordinary course of business at its subsidiaries, Popular Securities and Popular Mortgage. Popular Securities’ trading activities consist primarily of market-making activities to meet expected customers’ needs related to its retail brokerage business and purchases and sales of U.S. Government and government sponsored securities with the objective of realizing gains from expected short-term price movements. Popular Mortgage’s trading activities consist primarily of holding U.S. Government sponsored mortgage-backed securities classified as “trading” and hedging the related market risk with “TBA” (to-be-announced) market transactions. The objective is to derive spread income from the portfolio and not to benefit from short-term market movements.
At June 30, 2011, the Corporation held trading account securities with a fair value of $786 million, representing 2% of the Corporation’s total assets. Mortgage-backed securities represented 95% of the trading portfolio at June 30, 2011, compared with 90% at the end of 2010. The mortgage-backed securities are investment grade securities. A significant portion of the trading portfolio is hedged against market risk by positions that offset the risk assumed. Trading instruments are recognized at fair value, with changes resulting from fluctuations in market prices, interest rates or exchange rates reported in current period income. The Corporation recognized net trading account profits of $375 thousand for the six months ended June 30, 2011.
The Corporation’s trading activities are limited by internal policies. For each of the two subsidiaries, the market risk assumed under trading activities is measured by the 5-day net value-at-risk, with a confidence level of 99%. The VAR measures the maximum estimated loss that may occur over a 5-day holding period, given a 99% probability. Under the Corporation’s current policies, trading exposures cannot exceed 2% of the trading portfolio market value of each subsidiary, subject to a cap.
The Corporation’s trading portfolio had a 5-day value at risk (VAR) of approximately $3.1 million, assuming a confidence level of 99%, for the last week in June 2011. There are numerous assumptions and estimates associated with VAR modeling, and actual results could differ from these assumptions and estimates. Backtesting is performed to compare actual results against maximum estimated losses, in order to evaluate model and assumptions accuracy.
In the opinion of management, the size and composition of the trading portfolio does not represent a significant source of market risk for the Corporation.
FAIR VALUE MEASUREMENT OF FINANCIAL INSTRUMENTS
The Corporation currently measures at fair value on a recurring basis its trading assets, available-for-sale securities, derivatives, and mortgage servicing rights. Occasionally, the Corporation may be required to record at fair value other assets on a nonrecurring basis, such as loans held-for-sale, impaired loans held-in-portfolio that are collateral dependent and certain other assets. These nonrecurring fair value adjustments typically result from the application of lower of cost or fair value accounting or write-downs of individual assets.
The Corporation categorizes its assets and liabilities measured at fair value under the three-level hierarchy. The level within the hierarchy is based on whether the inputs to the valuation methodology used for fair value measurement are observable.
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Refer to Note 22 to the consolidated financial statements for information on the Corporation’s fair value measurement disclosures required by the applicable accounting standard. At June 30, 2011, approximately $6.2 billion, or 97%, of the assets measured at fair value on a recurring basis used market-based or market-derived valuation inputs in their valuation methodology and, therefore, were classified as Level 1 or Level 2. The majority of instruments measured at fair value were classified as Level 2, including U.S. Treasury securities, obligations of U.S. Government sponsored entities, obligations of Puerto Rico, States and political subdivisions, most mortgage-backed securities (“MBS”) and collateralized mortgage obligations (“CMOs”), and derivative instruments.
At June 30, 2011, the remaining 3% of assets measured at fair value on a recurring basis were classified as Level 3 since their valuation methodology considered significant unobservable inputs. The financial assets measured as Level 3 included mostly tax-exempt GNMA mortgage-backed securities and mortgage servicing rights (“MSRs”). Additionally, the Corporation reported $164 million of financial assets that were measured at fair value on a nonrecurring basis at June 30, 2011, all of which were classified as Level 3 in the hierarchy.
Broker quotes used for fair value measurements inherently reflect any lack of liquidity in the market since they represent an exit price from the perspective of the market participants. Financial assets that were fair valued using broker quotes amounted to $59 million at June 30, 2011, of which $41 million were Level 3 assets and $ 18 million were Level 2 assets. These assets consisted principally of tax-exempt GNMA mortgage-backed securities. Fair value for these securities was based on an internally-prepared matrix derived from an average of two indicative local broker quotes. The main input used in the matrix pricing was non-binding local broker quotes obtained from limited trade activity. Therefore, these securities were classified as Level 3.
During the quarter and six months ended June 30, 2011, there were no transfers in and/or out of Level 3 for financial instruments measured at fair value on a recurring basis. Also, there were no transfers in and / or out of Level 1 and Level 2 during the quarter and six months ended June 30, 2011. Refer to Note 22 to the consolidated financial statements for a description of the Corporation’s valuation methodologies used for the assets and liabilities measured at fair value at June 30, 2011. Also, refer to the Critical Accounting Policies / Estimates in the 2010 Annual Report for additional information on the accounting guidance and the Corporation’s policies or procedures related to fair value measurements.
The majority of the values for trading account securities and investment securities available-for-sale are obtained from third-party pricing services and are validated with alternate pricing sources when available. Securities not priced by a secondary pricing source are documented and validated internally according to their significance to the Corporation’s financial statements. Management has established materiality thresholds according to the investment class to monitor and investigate material deviations in prices obtained from the primary pricing service provider and the secondary pricing source used as support for the valuation results. During the quarter and six months ended June 30, 2011, the Corporation did not adjust any prices obtained from pricing service providers or broker dealers.
Inputs are evaluated to ascertain that they consider current market conditions, including the relative liquidity of the market. When a market quote for a specific security is not available, the pricing service provider generally uses observable data to derive an exit price for the instrument, such as benchmark yield curves and trade data for similar products. To the extent trading data is not available, the pricing service provider relies on specific information including dialogue with brokers, buy side clients, credit ratings, spreads to established benchmarks and transactions on similar securities, to draw correlations based on the characteristics of the evaluated instrument. If for any reason the pricing service provider cannot observe data required to feed its model, it discontinues pricing the instrument. During the quarter and six months ended June 30, 2011, none of the Corporation’s investment securities were subject to pricing discontinuance by the pricing service providers. The pricing methodology and approach of our primary pricing service providers is concluded to be consistent with the fair value measurement guidance.
Furthermore, management assesses the fair value of its portfolio of investment securities at least on a quarterly basis, which includes analyzing changes in fair value that have resulted in losses that may be considered other-than-temporary. Factors considered include, for example, the nature of the investment, severity and duration of possible impairments, industry reports, sector credit ratings, economic environment, creditworthiness of the issuers and any guarantees.
Securities are classified in the fair value hierarchy according to product type, characteristics and market liquidity. At the end of each period, management assesses the valuation hierarchy for each asset or liability measured. The fair value measurement analysis performed by the Corporation includes validation procedures and review of market changes, pricing methodology, assumption and level hierarchy changes, and evaluation of distressed transactions.
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At June 30, 2011, the Corporation’s portfolio of trading and investment securities available-for-sale amounted to $6.2 billion and represented 96% of the Corporation’s assets measured at fair value on a recurring basis. At June 30, 2011, net unrealized gains on the trading and available-for-sale investment securities portfolios approximated $60 million and $215 million, respectively. Fair values for most of the Corporation’s trading and investment securities available-for-sale were classified as Level 2. Trading and investment securities available-for-sale classified as Level 3, which were the securities that involved the highest degree of judgment, represented less than 1% of the Corporation’s total portfolio of trading and investment securities available-for-sale.
Mortgage Servicing Rights
Mortgage servicing rights (“MSRs”), which amounted to $163 million at June 30, 2011, do not trade in an active, open market with readily observable prices. Fair value is estimated based upon discounted net cash flows calculated from a combination of loan level data and market assumptions. The valuation model combines loans with common characteristics that impact servicing cash flows (e.g. investor, remittance cycle, interest rate, product type, etc.) in order to project net cash flows. Market valuation assumptions include prepayment speeds, discount rate, cost to service, escrow account earnings, and contractual servicing fee income, among other considerations. Prepayment speeds are derived from market data that is more relevant to the U.S. mainland loan portfolios and, thus, are adjusted for the Corporation’s loan characteristics and portfolio behavior since prepayment rates in Puerto Rico have been historically lower. Other assumptions are, in the most part, directly obtained from third-party providers. Disclosure of two of the key economic assumptions used to measure MSRs, which are prepayment speed and discount rate, and a sensitivity analysis to adverse changes to these assumptions, is included in Note 12 to the consolidated financial statements.
Derivatives, such as interest rate swaps, interest rate caps and indexed options, are traded in over-the-counter active markets. These derivatives are indexed to an observable interest rate benchmark, such as LIBOR or equity indexes, and are priced using an income approach based on present value and option pricing models using observable inputs. Other derivatives are liquid and have quoted prices, such as forward contracts or “to be announced securities” (“TBAs”). All of these derivatives held by the Corporation were classified as Level 2. Valuations of derivative assets and liabilities reflect the values associated with counterparty risk and nonperformance risk, respectively. The non-performance risk, which measures the Corporation’s own credit risk, is determined using internally-developed models that consider the net realizable value of the collateral posted, remaining term, and the creditworthiness or credit standing of the Corporation. The counterparty risk is also determined using internally-developed models which incorporate the creditworthiness of the entity that bears the risk, net realizable value of the collateral received, and available public data or internally-developed data to determine their probability of default. To manage the level of credit risk, the Corporation employs procedures for credit approvals and credit limits, monitors the counterparties’ credit condition, enters into master netting agreements whenever possible and, when appropriate, requests additional collateral. During the quarter and six months ended June 30, 2011, inclusion of credit risk in the fair value of the derivatives resulted in a net gain of $0.6 million and $2.4 million, respectively, recorded in the other operating income and interest expense captions of the consolidated statement of operations, which consisted of a gain of $1.3 million and $1.5 million, respectively, resulting from the Corporation’s own credit standing adjustment and a loss of $(0.7) million and a gain of $0.9 million, respectively, from the assessment of the counterparties’ credit risk.
The impairment is based on the fair value of the collateral, which is derived from appraisals that take into consideration prices in observed transactions involving similar assets in similar locations, size and supply and demand. Continued deterioration of the housing markets and the economy in general have adversely impacted and continue to affect the market activity related to real estate properties. These collateral dependent impaired loans are classified as Level 3 and are reported as a nonrecurring fair value measurement.
LIQUIDITY
The objective of effective liquidity management is to ensure that the Corporation has sufficient liquidity to meet all of its financial obligations, finance expected future growth and maintain a reasonable safety margin for cash commitments under both normal and stressed market conditions. An institution’s liquidity may be pressured if, for example, its credit rating is downgraded, it experiences a sudden and unexpected substantial cash outflow, or some other event causes counterparties to avoid exposure to the institution. An institution is also exposed to liquidity risk if the markets on which it depends are subject to occasional disruptions.
Factors that the Corporation does not control, such as the economic outlook of its principal markets and regulatory changes, could affect its ability to obtain funding. In order to prepare for the possibility of such scenario, management has adopted contingency plans for raising financing under stress scenarios when important sources of funds that are usually fully available are temporarily
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unavailable. These plans call for using alternate funding mechanisms such as the pledging of certain asset classes and accessing secured credit lines and loan facilities put in place with the FHLB and the Fed, in addition to maintaining unpledged U.S. Government securities available for pledging in the repo markets. The Corporation has a significant amount of assets available for raising funds through these channels.
Liquidity is managed by the Corporation at the level of the holding companies that own the banking and non-banking subsidiaries. Also, it is managed at the level of the banking and non-banking subsidiaries. The Corporation has adopted policies and limits to monitor more effectively the Corporation’s liquidity position and that of the banking subsidiaries. Additionally, contingency funding plans are used to model various stress events of different magnitudes and affecting different time horizons that assist management in evaluating the size of the liquidity buffers needed if those stress events occur. However, such models may not predict accurately how the market and customers might react to every event, and are dependent on many assumptions.
Deposits, including customer deposits, brokered certificates of deposit, and public funds deposits, continue to be the most significant source of funds for the Corporation, funding 72% of the Corporation’s total assets at June 30, 2011, compared with 69% at December 31, 2010.
In addition to traditional deposits, the Corporation maintains borrowing arrangements. At June 30, 2011, these borrowings consisted primarily of the note issued to the FDIC as part of the Westernbank FDIC-assisted transaction with a carrying amount of $1.5 billion, advances with the FHLB of $855 million, securities sold under agreement to repurchase of $2.6 billion, junior subordinated deferrable interest debentures of $897 million (net of discount) and term notes of $279 million. A detailed description of the Corporation’s borrowings, including their terms, is included in Note 16 to the consolidated financial statements. Also, the consolidated statements of cash flows in the accompanying consolidated financial statements provide information on the Corporation’s cash inflows and outflows.
During 2010, the Corporation took steps to deleverage its balance sheet and prepay certain high cost debt to benefit its cost of funds going forward. These actions were possible in part due to the excess liquidity derived from the Corporation’s 2010 capital raise, paydowns from the loan portfolio coupled with weak loan demand, from maturities of investment securities and funds received from the sale of the majority interest in EVERTEC. During 2011, the Corporation’s liquidity position remains strong. The following strategies were executed by the Corporation during the six months ended June 30, 2011 to deploy excess liquidity at its banking subsidiaries and improve the Corporation’s net interest margin.
During the six months ended June 30, 2011, the Corporation reduced the note issued to the FDIC by $975 million. Apart from the repayment of the note from collections on covered loans and payments received from claims made to the FDIC under the loss sharing agreements, the Corporation also prepaid $480 million of the note during the six months ended June 30, 2011. The prepayments were made with proceeds from maturities of securities. The note carries a 2.50% annual rate. The Corporation expects to pay down the note issued to the FDIC by the end of 2011.
The Corporation received cash proceeds of $291 million on loan sales, principally related to the sale of $457 million (legal balance) in non-conventional mortgage loans at the BPNA reportable segment during the first quarter of 2011. In order to deploy excess liquidity at the BPNA reportable segment, these funds, as well as other excess liquidity at this reportable segment, were used to purchase $753 million in securities by BPNA during the first quarter of 2011, primarily U.S. Agencies securities and U.S. Government agency-issued collateralized mortgage obligations. Funds were invested in longer-term securities to improve the net interest margin. These securities can be pledged to other counterparties in the repo market and continue to serve as a source to manage the Corporation’s liquidity needs.
The BHC repaid $100 million of medium-term notes during the first quarter of 2011, which was accounted for as an early extinguishment of debt.
Also, during the second quarter of 2011, and as indicated previously, the Corporation exchanged $233.2 million in aggregate principal amount of the $275 million 6.85% Senior Notes due 2012, in order to issue new debt with a later maturity. The modified notes are as follows: (1) $78.0 million aggregate principal amount of 7.47% Senior Notes due 2014, (2) $35.2 million aggregate principal amount of 7.66% Senior Notes due 2015 and (3) $120.0 million aggregate principal amount of 7.86% Senior Notes due 2016.
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Banking Subsidiaries
Primary sources of funding for the Corporation’s banking subsidiaries (BPPR and BPNA), or “the banking subsidiaries,” include retail and commercial deposits, brokered deposits, collateralized borrowings, unpledged investment securities, and, to a lesser extent, loan sales. In addition, the Corporation maintains borrowing facilities with the FHLB and at the Discount Window of the Fed, and have a considerable amount of collateral pledged that can be used to quickly raise funds under these facilities.
The principal uses of funds for the banking subsidiaries include loan originations, investment portfolio purchases, loan purchases and repurchases, repayment of outstanding obligations (including deposits), and operational expenses. Also, the banking subsidiaries assume liquidity risk related to collateral posting requirements for off-balance sheet activities mainly in connection with contractual commitments; recourse provisions; servicing advances; derivatives, credit card licensing agreements and support to several mutual funds administered by BPPR.
Note 32 to the consolidated financial statements provides a consolidating statement of cash flows which includes the Corporation’s banking subsidiaries as part of the “All other subsidiaries and eliminations” column. The banking subsidiaries’ liquidity and funding activities during the first six months 2011 included changes in loans, securities, deposits and borrowings in the normal course of business. Main cash flow transactions at the Corporation’s subsidiaries, excluding the holding companies, that are not in the normal course of business or are part of strategies during the period included: (1) acquisition of loans held-in-portfolio for $744 million, mainly related to two large bulk purchases of performing mortgage loans, which were principally funded with FHLB advances (notes payable) and cash flows from loan repayments; (2) cash proceeds on the loan sales at BPNA, which were used to purchase investment securities available-for-sale; (3) a reduction in the pension and other postretirement benefit obligation of $123 million due to a large payment in the first quarter of 2011; and (4) special tax payment of $89.4 million in the second quarter of 2011 related to the tax ruling and closing agreement with the P.R. Treasury.
The bank operating subsidiaries maintain sufficient funding capacity to address large increases in funding requirements such as deposit outflows. This capacity is comprised mainly of available liquidity derived from secured funding sources, as well as on-balance sheet liquidity in the form of cash balances maintained at the Fed and unused secured lines held at the Fed and FHLB, in addition to liquid unpledged securities. The Corporation has established liquidity guidelines that require the banking subsidiaries to have sufficient liquidity to cover all short-term borrowings and a portion of deposits. In addition, the total loan portfolio is funded with deposits with the exception of the loans acquired in the Westernbank FDIC-assisted transaction which are partially funded with the note issued to the FDIC.
The Corporation’s ability to compete successfully in the marketplace for deposits, excluding brokered deposits, depends on various factors, including pricing, service, convenience and financial stability as reflected by operating results, credit ratings (by nationally recognized credit rating agencies), and importantly, FDIC deposit insurance. Although a downgrade in the credit ratings of the Corporation’s banking subsidiaries may impact their ability to raise retail and commercial deposits or the rate that it is required to pay on such deposits, management does not believe that the impact should be material. Deposits at all of the Corporation’s banking subsidiaries are federally insured (subject to FDIC limits) and this is expected to mitigate the effect of a downgrade in the credit ratings.
Deposits are a key source of funding as they tend to be less volatile than institutional borrowings and their cost is less sensitive to changes in market rates. Refer to Table I for a breakdown of deposits by major types. Core deposits are generated from a large base of consumer, corporate and institutional customers. For purposes of defining core deposits, the Corporation excludes brokered deposits with denominations under $100,000. Core deposits have historically provided the Corporation with a sizable source of relatively stable and low-cost funds. Core deposits totaled $21.6 billion, or 77% of total deposits, at June 30, 2011, compared with $20.6 billion, or 77% of total deposits, at December 31, 2010. Core deposits financed 64% of the Corporation’s earning assets at June 30, 2011, compared to 61% at December 31, 2010.
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Certificates of deposit with denominations of $100,000 and over at June 30, 2011 totaled $4.4 billion, or 16% of total deposits, compared with $4.7 billion, or 17%, at December 31, 2010. Their distribution by maturity at June 30, 2011 was as follows:
3 months or less
3 to 6 months
6 to 12 months
Over 12 months
At June 30, 2011, approximately 7% of the Corporation’s assets were financed by brokered deposits, compared with 6% at December 31, 2010. The Corporation had $2.7 billion in brokered deposits at June 30, 2011, compared with $2.3 billion at December 31, 2010. Brokered certificates of deposit, which are typically sold through an intermediary to retail investors, provide access to longer-term funds and provide the ability to raise additional funds without pressuring retail deposit pricing in the Corporation’s local markets. An unforeseen disruption in the brokered deposits market, stemming from factors such as legal, regulatory or financial risks, could adversely affect the Corporation’s ability to fund a portion of the Corporation’s operations and/or meet its obligations.
In the event that any of the Corporation’s banking subsidiaries’ regulatory capital ratios fall below those required by a well-capitalized institution or are subject to capital restrictions by the regulators, that banking subsidiary faces the risk of not being able to raise or maintain brokered deposits and faces limitations on the rate paid on deposits, which may hinder the Corporation’s ability to effectively compete in its retail markets and could affect its deposit raising efforts.
To the extent that the banking subsidiaries are unable to obtain sufficient liquidity through core deposits, the Corporation may meet its liquidity needs through short-term borrowings by pledging securities for borrowings under repurchase agreements, by pledging additional loans and securities through the available secured lending facilities, or by selling liquid assets. These measures are subject to availability of collateral.
The Corporation’s banking subsidiaries have the ability to borrow funds from the FHLB. At June 30, 2011 and December 31, 2010, the banking subsidiaries had credit facilities authorized with the FHLB aggregating $1.7 billion and $1.6 billion, respectively, based on assets pledged with the FHLB at those dates. Outstanding borrowings under these credit facilities totaled $0.9 billion at June 30, 2011 and $0.7 billion at December 31, 2010. Such advances are collateralized by loans held-in-portfolio, do not have restrictive covenants and do not have any callable features. At June 30, 2011, the credit facilities authorized with the FHLB were collateralized by $4.9 billion in loans held-in-portfolio, compared with $3.8 billion at December 31, 2010. Refer to Note 16 to the consolidated financial statements for additional information on the terms of FHLB advances outstanding.
At June 30, 2011, BPPR had a borrowing capacity at the Fed’s Discount Window of approximately $2.5 billion, compared with $2.7 billion at December 31, 2010, which remained unused as of both dates. This facility is a collateralized source of credit that is highly reliable even under difficult market conditions. The amount available under this borrowing facility is dependent upon the balance of performing loans and securities pledged as collateral and the haircuts assigned to such collateral. At June 30, 2011, this credit facility with the Fed was collateralized by $3.8 billion in loans held-in-portfolio, compared with $4.2 billion at December 31, 2010.
During the six months ended June 30, 2011, the BHCs did not make any capital contributions to BPNA and BPPR.
At June 30, 2011, management believes that the banking subsidiaries had sufficient current and projected liquidity sources to meet their anticipated cash flow obligations, as well as special needs and off-balance sheet commitments, during the ordinary course of business and have sufficient liquidity resources to address a stress event. Although the banking subsidiaries have historically been able to replace maturing deposits and advances if desired, no assurance can be given that they would be able to replace those funds in the future if the Corporation’s financial condition or general market conditions were to change. The Corporation’s financial flexibility will be severely constrained if its banking subsidiaries are unable to maintain access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates. The banking subsidiaries also are required to deposit cash or qualifying securities to meet margin requirements. To the extent that the value of securities previously pledged as collateral declines because of changes in interest rates, a liquidity crisis or any other factors, the Corporation will be required to deposit additional cash or securities to meet its margin requirements, thereby adversely affecting its liquidity. Finally, if management is required to rely more heavily on more expensive funding sources to support future growth, revenues may not increase proportionately to cover costs. In this case, profitability would be adversely affected.
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Bank Holding Companies
The principal sources of funding for the holding companies include cash on hand, investment securities, dividends received from banking and non-banking subsidiaries (subject to regulatory limits and authorizations), asset sales, credit facilities available from affiliate banking subsidiaries and proceeds from new borrowings or stock issuances. The principal source of cash flows for the parent holding company during 2010 was a capital issuance and proceeds from the sale of the 51% ownership interest in EVERTEC. The principal source of cash flows for the parent holding company during 2011 has been the repayment of loans made to subsidiaries and affiliates. Proceeds from the repayment of these loans, net of new advances, amounted to $185 million for the six months ended June 30, 2011.
As noted in the Overview section under the caption “Certain Regulatory Matters”, the Corporation’s banking subsidiaries are required to obtain approval from the Federal Reserve System and their respective applicable state banking regulator prior to declaring or paying dividends to the Corporation.
The principal use of these funds include capitalizing its banking subsidiaries, the repayment of debt, and interest payments to holders of senior debt and junior subordinated deferrable interest debentures (related to trust preferred securities). During 2011, the main cash outflows of the holding companies have been for the prepayment of $100 million in medium-term notes and payments of interest on debt of approximately $67.2 million, mainly associated with trust preferred securities and medium term notes.
Another use of liquidity at the parent holding company is the payment of dividends on preferred stock. At the end of 2010, the Corporation resumed paying dividends on its Series A and B preferred stock. The preferred stock dividends amounted to $1.9 million for the six months ended June 30, 2011. The preferred stock dividends paid were financed by issuing new shares of common stock to the participants of the Corporation’s qualified employee savings plans. As indicated in the Overview section under the caption “Certain Regulatory Matters”, the Corporation is required to obtain approval from the Federal Reserve System prior to declaring or paying dividends, incurring, increasing or guaranteeing debt or making any distributions on its trust preferred securities or subordinated debt. The Corporation anticipates that any future preferred stock dividend payments would continue to be financed with the issuance of new common stock in connection with its qualified employee savings plans. The Corporation is not paying dividends to holders of its common stock.
The Corporation’s bank holding companies ( Popular, Inc., Popular North America, Inc. and Popular International Bank, Inc. (“BHCs”)) have in the past borrowed in the money markets and in the corporate debt market primarily to finance their non-banking subsidiaries. These sources of funding have become more costly due to the reductions in the Corporation’s credit ratings together with higher credit spreads in general. The Corporation’s principal credit ratings are below “investment grade” which affects the Corporation’s ability to raise funds in the capital markets. However, the cash needs of the Corporation’s non-banking subsidiaries other than to repay indebtedness and interest are now minimal. The Corporation has an open-ended, automatic shelf registration statement filed and effective with the SEC, which permits us to issue an unspecified amount of debt or equity securities.
A principal use of liquidity at the BHCs is to ensure its subsidiaries are adequately capitalized. Operating losses at the BPNA banking subsidiary required the BHCs to contribute equity capital during 2009 and 2010 to ensure that it continued to meet the regulatory guidelines for “well-capitalized” institutions. There were no capital contributions made to BPNA during the six months ended June 30, 2011. Management does not expect either of the banking subsidiaries to require additional capitalizations for the foreseeable future.
Note 32 to the consolidated financial statements provides a statement of condition, of operations and of cash flows for the three BHCs. The loans held-in-portfolio in such financial statements are principally associated with intercompany transactions. The investment securities held-to-maturity at the parent holding company, amounting to $197 million at June 30, 2011, consisted principally of $185 million of subordinated notes from BPPR.
The outstanding balance of notes payable at the BHCs amounted to $1.2 billion at June 30, 2011, compared with $1.3 billion at December 31, 2010. These borrowings are principally junior subordinated debentures (related to trust preferred securities), including those issued to the U.S. Treasury as part of the TARP, and unsecured senior debt (term notes). The repayment of the BHCs obligations represents a potential cash need which is expected to be met with internal liquidity resources and new borrowings. As indicated previously, increasing or guaranteeing new debt would be subject to the prior approval from the Fed.
The BHCs liquidity position continues to be adequate with sufficient cash on hand, investments and other sources of liquidity which are expected to be enough to meet all BHCs obligations during the foreseeable future. Also, as indicated previously, the modification performed during the second quarter of 2011 to the term notes in order to extend their maturity provided enhanced liquidity at the BHCs.
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Risks to Liquidity
Total lines of credit outstanding are not necessarily a measure of the total credit available on a continuing basis. Some of these lines could be subject to collateral requirements, standards of creditworthiness, leverage ratios and other regulatory requirements, among other factors. Derivatives, such as those embedded in long-term repurchase transactions or interest rate swaps, and off-balance sheet exposures, such as recourse, are subject to collateral requirements. As their fair value increases, the collateral requirements may increase, thereby reducing the balance of unpledged securities.
Reductions of the Corporation’s credit ratings by the rating agencies could also affect its ability to borrow funds, and could substantially raise the cost of our borrowings. In addition, changes in the Corporation’s ratings could lead creditors and business counterparties to raise the collateral requirements, which could reduce available unpledged securities, reducing excess liquidity. Refer to Part II – Other Information, Item 1A-Risk Factors of the Corporation’s Form 10-K for the year ended December 31, 2010 for additional information on factors that could impact liquidity.
The importance of the Puerto Rico market for the Corporation is a risk factor that could affect its financing activities. In the case of a further deterioration of the Puerto Rico economy, the credit quality of the Corporation could be further affected and result in higher credit costs. Even though the U.S. economy is currently expanding, it is not certain that the Puerto Rico economy will benefit materially from the U.S. cycle. The Puerto Rico economy faces various challenges including a public-sector deficit, high unemployment and a residential real estate sector under pressure.
Factors that the Corporation does not control, such as the economic outlook of its principal markets and regulatory changes, could also affect its ability to obtain funding. In order to prepare for the possibility of such scenario, management has adopted contingency plans for raising financing under stress scenarios when important sources of funds that are usually fully available are temporarily unavailable. These plans call for using alternate funding mechanisms, such as the pledging of certain asset classes and accessing secured credit lines and loan facilities put in place with the FHLB and the Fed.
Credit ratings of Popular’s debt obligations are an important factor for liquidity because they impact the Corporation’s ability to borrow in the capital markets, its cost and access to funding sources. Credit ratings are based on the financial strength, credit quality and concentrations in the loan portfolio, the level and volatility of earnings, capital adequacy, the quality of management, the liquidity of the balance sheet, the availability of a significant base of core retail and commercial deposits, and the Corporation’s ability to access a broad array of wholesale funding sources, among other factors. At June 30, 2011, the Corporation’s senior unsecured debt ratings continued to be “non-investment grade” with the three major rating agencies. This may make it more difficult for the Corporation to borrow in the capital markets and at a higher cost. The Corporation’s counterparties are sensitive to the risk of a rating downgrade. In addition, the ability of the Corporation to raise new funds or renew maturing debt may be more difficult. Some of the Corporation’s or its subsidiaries’ counterparty contracts include close-out provisions if the credit ratings fall below certain levels.
The Corporation’s banking subsidiaries have historically not used unsecured capital market borrowings to finance its operations, and therefore are less sensitive to the level and changes in the Corporation’s overall credit ratings. Their main funding sources are currently deposits and secured borrowings. At the BHCs, the volume of capital market borrowings has declined substantially, as the non-banking lending businesses that it had historically funded have been shut down and outstanding unsecured senior debt has been reduced.
The Corporation’s banking subsidiaries currently do not use borrowings that are rated by the major rating agencies, as these banking subsidiaries are funded primarily with deposits and secured borrowings. The banking subsidiaries had $18 million in deposits at June 30, 2011 that are subject to rating triggers. At June 30, 2011, the Corporation had repurchase agreements amounting to $279 million that were subject to rating triggers or the maintenance of well-capitalized regulatory capital ratios, and were collateralized with securities with a fair value of $301 million.
Some of the Corporation’s derivative instruments include financial covenants tied to the bank’s well-capitalized status, credit ratings and certain formal regulatory actions. These agreements could require exposure collateralization, early termination or both. The fair value of derivative instruments in a liability position subject to financial covenants approximated $60 million at June 30, 2011, with the Corporation providing collateral totaling $72 million to cover the net liability position with counterparties on these derivative instruments.
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In addition, certain mortgage servicing and custodial agreements that BPPR has with third parties include rating covenants. Based on BPPR’s failure to maintain the required credit ratings, the third parties could have the right to require the institution to engage a substitute cash custodian for escrow deposits and/or increase collateral levels securing the recourse obligations. Also, as discussed in the Contractual Obligations and Commercial Commitments section of this MD&A, the Corporation services residential mortgage loans subject to credit recourse provisions. Certain contractual agreements require the Corporation to post collateral to secure such recourse obligations if the institution’s required credit ratings are not maintained. Collateral pledged by the Corporation to secure recourse obligations approximated $155 million at June 30, 2011. The Corporation could be required to post additional collateral under the agreements. Management expects that it would be able to meet additional collateral requirements if and when needed. The requirements to post collateral under certain agreements or the loss of escrow deposits could reduce the Corporation’s liquidity resources and impact its operating results.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Quantitative and qualitative disclosures for the current period can be found in the Market Risk section of this report, which includes changes in market risk exposures from disclosures presented in the Corporation’s 2010 Annual Report.
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 and such information is accumulated and communicated to management, as appropriate, to allow timely decisions regarding required disclosures.
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 quarter ended on June 30, 2011 that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.
Part II - Other Information
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Between May 14, 2009 and September 9, 2009, five putative class actions and two derivative claims were filed in the United States District Court for the District of Puerto Rico and the Puerto Rico Court of First Instance, San Juan Part, against Popular, Inc., and certain of its directors and officers, among others. The five class actions were consolidated into two separate actions: a securities class action captioned Hoff v. Popular, Inc., et al. (consolidated with Otero v. Popular, Inc., et al.) and an Employee Retirement Income Security Act (ERISA) class action entitledIn re Popular, Inc. ERISA Litigation (comprised of the consolidated cases of Walsh v. Popular, Inc., et al.; Montañez v. Popular, Inc., et al.; and Dougan v. Popular, Inc., et al.).
On October 19, 2009, plaintiffs in the Hoff case filed a consolidated class action complaint which included as defendants the underwriters in the May 2008 offering of Series B Preferred Stock, among others. The consolidated action purported to be on behalf of purchasers of Popular’s securities between January 24, 2008 and February 19, 2009 and alleged that the defendants violated Section 10(b) of the Exchange Act, and Rule 10b-5 promulgated thereunder, and Section 20(a) of the Exchange Act by issuing a series of allegedly false and/or misleading statements and/or omitting to disclose material facts necessary to make statements made by the Corporation not false and misleading. The consolidated action also alleged that the defendants violated Section 11, Section 12(a)(2) and Section 15 of the Securities Act by making allegedly untrue statements and/or omitting to disclose material facts necessary to make statements made by the Corporation not false and misleading in connection with the May 2008 offering of Series B Preferred Stock. The consolidated securities class action complaint sought class certification, an award of compensatory damages and reasonable costs and expenses, including counsel fees. On January 11, 2010, Popular, the underwriter defendants and the individual defendants moved to dismiss the consolidated securities class action complaint. On August 2, 2010, the U.S. District Court for the District of Puerto Rico granted the motion to dismiss filed by the underwriter defendants on statute of limitations grounds. The Court also dismissed the Section 11 claim brought against Popular’s directors on statute of limitations grounds and the Section 12(a)(2) claim brought against Popular because plaintiffs lacked standing. The Court declined to dismiss the claims brought against Popular and certain of its officers under Section 10(b) of the Exchange Act (and Rule 10b-5 promulgated thereunder), Section 20(a) of the Exchange Act, and Sections 11 and 15 of the Securities Act, holding that plaintiffs had adequately alleged that defendants made materially false and misleading statements with the requisite state of mind.
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The derivative actions (García v. Carrión, et al. and Díaz v. Carrión, et al.) were brought purportedly for the benefit of nominal defendant Popular, Inc. against certain executive officers and directors and alleged breaches of fiduciary duty, waste of assets and abuse of control in connection with Popular’s issuance of allegedly false and misleading financial statements and financial reports and the offering of the Series B Preferred Stock. The derivative complaints sought a judgment that the action was a proper derivative action, an award of damages, restitution, costs and disbursements, including reasonable attorneys’ fees, costs and expenses. On October 9, 2009, the Court coordinated for purposes of discovery the García action and the consolidated securities class action. On October 15, 2009, Popular and the individual defendants moved to dismiss the García complaint for failure to make a demand on the Board of Directors prior to initiating litigation. On November 20, 2009, plaintiffs filed an amended complaint, and on December 21, 2009, Popular and the individual defendants moved to dismiss the García amended complaint. At a scheduling conference held on January 14, 2010, the Court stayed discovery in both the Hoff and García matters pending resolution of their respective motions to dismiss. On August 11, 2010, the Court granted in part and denied in part the motion to dismiss the Garcia action. The Court dismissed the gross mismanagement and corporate waste claims, but declined to dismiss the breach of fiduciary duty claim. The Díaz case, filed in the Puerto Rico Court of First Instance, San Juan, was removed to the U.S. District Court for the District of Puerto Rico. On October 13, 2009, Popular and the individual defendants moved to consolidate the García and Díaz actions. On October 26, 2009, plaintiff moved to remand the Diaz case to the Puerto Rico Court of First Instance and to stay defendants’ consolidation motion pending the outcome of the remand proceedings. On September 30, 2010, the Court issued an order without opinion remanding the Diaz case to the Puerto Rico Court of First Instance. On October 13, 2010, the Court issued a Statement of Reasons In Support of Remand Order. On October 28, 2010, Popular and the individual defendants moved for reconsideration of the remand order. The court denied Popular’s request for reconsideration shortly thereafter.
At the Court’s request, the parties to the Hoff and García cases discussed the prospect of mediation and agreed to nonbinding mediation in an attempt to determine whether the cases could be settled. On January 18 and 19, 2011, the parties to the Hoff and García cases engaged in nonbinding mediation before the Honorable Nicholas Politan. As a result of the mediation, the Corporation and the other named defendants to the Hoff matter entered into a memorandum of understanding to settle this matter. Under the terms of the memorandum of understanding, subject to certain customary conditions including court approval of a final settlement agreement in consideration for the full settlement and release of all defendants, the parties agreed that the amount of $37.5 million would be paid by or on behalf of defendants. On June 17, 2011, the parties filed a stipulation of settlement and a joint motion for preliminary approval of such settlement. On June 20, 2011, the Court entered an order granting preliminary approval of the settlement and set a settlement conference for November 1, 2011, which was subsequently moved to November 2, 2011. On or before July 5, 2011, the amount of $37.5 million was paid to the settlement fund by or on behalf of defendants. Specifically, the amount of $26 million was paid by insurers and the amount of $11.5 million was paid by Popular (after which approximately $4.7 million was reimbursed by insurers per the terms of the relevant insurance agreement).
A separate memorandum of understanding was subsequently entered by the parties to the García and Diaz actions in April 2011. Under the terms of this memorandum of understanding, subject to certain customary conditions, including court approval of a final settlement agreement, and in consideration for the full and final settlement and release of all defendants, Popular agreed, for a period of three years, to maintain or implement certain corporate governance practices, measures and policies, as set forth in the memorandum of understanding. Aside from the payment by or on behalf of Popular of approximately $2.1 million of attorneys’ fees and expenses of counsel for the plaintiffs (of which management expects $1.6 million will be covered by insurance), the settlement does not require any cash payments by or on behalf of Popular or the defendants. On June 14, 2011, a motion for preliminary approval of settlement was filed. On July 8, 2011, the Court granted preliminary approval of such settlement and set the final approval hearing date for September 12, 2011.
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On December 13, 2010, Popular was served with a class action complaint captioned García Lamadrid, et al. v. Banco Popular, et al. which was filed in the Puerto Rico Court of First Instance. The complaint generally seeks damages against Banco Popular de Puerto Rico, other defendants and their respective insurance companies for their alleged breach of certain fiduciary duties, breach of contract, and alleged violations of local tort law. Plaintiffs seek in excess of $600 million in damages, plus costs and attorneys fees.
In addition to the other information set forth in this report, you should carefully consider the factors discussed under “Part I-Item 1A - Risk Factors” in our 2010 Annual Report. These factors could materially adversely affect our business, financial condition, liquidity, results of operations and capital position, and could cause our actual results to differ materially from our historical results or the results contemplated by the forward-looking statements contained in this report. Also refer to the discussion in “Part I - Item 2- Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report for additional information that may supplement or update the discussion of risk factors in our 2010 Annual Report.
There have been no material changes to the risk factors previously disclosed under Item 1A. of the Corporation’s 2010 Annual Report.
The risks described in our 2010 Annual Report and in this report are not the only risks facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition or results of operations.
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Issuer Purchases of Equity Securities
In April 2004, the Corporation’s shareholders adopted the Popular, Inc. 2004 Omnibus Incentive Plan. The Corporation has to date used shares purchased in the market to make grants under the Plan. The maximum number of shares of common stock that may be granted under this plan is 10,000,000.
In connection with the Corporation’s participation in the Capital Purchase Program under the Troubled Asset Relief Program, the consent of the U.S. Department of the Treasury will be required for the Corporation to repurchase its common stock other than in connection with benefit plans consistent with past practice and certain other specified circumstances.
The following table sets forth the details of purchases of Common Stock during the quarter ended June 30, 2011 under the 2004 Omnibus Incentive Plan.
Period
May 1 – May 31
June 1 – June 30
Total June 30, 2011
Exhibit No.
Exhibit Description
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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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