UNITED STATESSECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Mark One
For the quarterly period ended September 30, 2001or
For the transition period from to .
Commission file number 000-24939
EAST WEST BANCORP, INC.
(Exact name of registrant as specified in its charter)
Registrant's telephone number, including area code: (626) 799-5700
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.001 Par Value
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /x/ No / /
Number of shares of common stock of the registrant outstanding as of October 31, 2001: 23,392,638 shares
TABLE OF CONTENTS
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PART I—FINANCIAL INFORMATION ITEM 1. INTERIM CONSOLIDATED FINANCIAL STATEMENTS
EAST WEST BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except per share data)
See accompanying notes to interim consolidated financial statements.
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EAST WEST BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Dollars in thousands) (Unaudited)
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EAST WEST BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
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EAST WEST BANCORP, INC. AND SUBSIDIARIES NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS For the Nine Months Ended September 30, 2001 and 2000 (Unaudited)
1. BASIS OF PRESENTATION
The consolidated financial statements include the accounts of East West Bancorp, Inc. (the "Company") and its wholly owned subsidiaries, East West Bank and subsidiaries (the "Bank") and Risk Services, Inc. Intercompany transactions and accounts have been eliminated in consolidation.
The interim consolidated financial statements, presented in accordance with accounting principles generally accepted in the United States of America ("GAAP"), are unaudited and reflect all adjustments which, in the opinion of management, are necessary for a fair statement of financial condition and results of operations for the interim periods. All adjustments are of a normal and recurring nature. Results for the period ended September 30, 2001 are not necessarily indicative of results which may be expected for any other interim period or for the year as a whole. Certain information and note disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted. The unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in the Company's annual report on Form 10K for the year ended December 31, 2000.
Certain reclassifications have been made to the prior period financial statements to conform to the current period presentation.
2. ACCOUNTING CHANGE
Effective January 1, 2001, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. All derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value. If the derivative is designated as a fair value hedge, the changes in fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. If the derivative is designated as a cash flow hedge, the effective portions of changes in the fair value of the derivative are recorded in other comprehensive income ("OCI") and are recognized in the income statement when the hedged item affects earnings. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings.
The adoption of SFAS No. 133 on January 1, 2001 resulted in a cumulative pre-tax reduction to income of $149 thousand ($87 thousand after-tax) as a result of the fair valuation of two interest rate swap agreements with a combined notional amount of $30.0 million. These swap agreements were used to hedge fixed rate brokered certificates of deposit totaling $30.0 million. Pursuant to the adoption of SFAS No. 133, the Company records these interest rate swap agreements at their estimated fair values, with resulting gains or losses recorded in current earnings. For the nine months ended September 30, 2001, the total amount of net gains recorded in current earnings amounted to $215 thousand. No interest rate swap agreements were outstanding at September 30, 2001.
3. OTHER DERIVATIVES
The Company has also entered into interest rate cap agreements which are primarily linked to the three-month LIBOR. Prior to October 1, 1999, the Company used interest rate caps for purposes of hedging against market fluctuations in the Bank's available-for-sale securities portfolio. Due to the volatility of the correlation between the Treasury yield curve and fixed rate mortgage-backed securities, the Company ceased using interest rate caps to hedge against fluctuations in the investment securities available for sale portfolio, effective October 1, 1999. The Company continues to record these interest
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rate caps at their estimated fair values, with resulting gains or losses recorded in current earnings. The unrealized gains and losses reflected in accumulated other comprehensive income (loss) in stockholders' equity as of September 30, 1999 are amortized into interest income or expense over the expected remaining lives of these interest rate cap agreements. One of these interest rate cap agreements, with a notional amount of $18.0 million, matured in April 2001. Only one interest cap agreement is outstanding at September 30, 2001. This remaining interest rate cap agreement, with a notional amount of $18.0 million, will mature in October 2002.
At September 30, 2001, the Company also has outstanding warrants to purchase common stock of various companies. The warrants were received by the Company in connection with certain lending relationships. The estimated fair value of the warrants, if any, is not material at September 30, 2001.
4. ACQUISITION OF PRIME BANK
On January 16, 2001, the Company completed its acquisition of Prime Bank in a combination of shares and cash valued at $16.6 million. The acquisition was accounted for under the purchase method of accounting and, accordingly, all assets and liabilities of Prime Bank were adjusted to and recorded at their estimated fair values as of the acquisition date. The estimated tax effect of differences between tax bases and fair values has been reflected in deferred income taxes. The Company recorded total goodwill of approximately $5.6 million and core deposit premium of $3.9 million, which are being amortized using the straight-line method over 15 years and 7 years, respectively. At December 31, 2000, Prime Bank had total assets of $128.4 million and total stockholders' equity of $9.0 million.
5. IN-STORE BANKING PROGRAM
On August 30, 2001, the Company entered into an exclusive ten-year agreement with 99 Ranch Market to provide supermarket banking in their stores throughout California. The initial introduction of the program is expected to include the opening of branches in targeted locations in Southern California during the first quarter of 2002. 99 Ranch is the largest Asian-focused chain of supermarkets on the West Coast, with twenty full service stores in California, one in Seattle, and affiliated licensee stores in Hawaii, Nevada, Georgia and Arizona. Tawa Supermarket Companies is the parent company of 99 Ranch Market. Tawa's property development division owns and operates many of the shopping centers where 99 Ranch stores are located.
In conjunction with the agreement with 99 Ranch Market, the Company has issued 300,000 warrants to senior executives of 99 Ranch Market to purchase common stock of the Company at a price of $26.67 per share. These warrants will vest over six years and are intended to provide direct benefit to 99 Ranch executives that make a significant contribution to the success of the in-store banking operations. The estimated total fair value of the issued warrants is $2.7 million.
To further align the interests of both parties, senior executives of 99 Ranch Market have also made a significant investment in the Company, including the purchase of 400,000 newly issued shares of East West Bancorp, Inc. common stock totaling $7.9 million. The shares were sold for cash at a price of $19.71 per share. No underwriting discounts or commissions were paid in connection with this transaction. The proceeds from the sale of the shares will be used for working capital and the repurchase of shares. The shares are restricted and unregistered, and will become registered two years from the transaction date of August 30, 2001. Upon the two-year anniversary, 40% of the shares will become available for sale. After each of the next three anniversaries, 20% of the total shares will become available for sale. All shares can be freely traded on the fifth year anniversary. The total estimated fair value of the purchased shares is $6.9 million.
The excess of the combined fair values of the issued warrants and the purchased shares over the total consideration paid by the senior executives of 99 Ranch Market for the newly issued shares will be treated as an intangible asset and will be amortized over the life of the agreement.
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6. LOANS HELD FOR SALE
Loans held for sale were $8.1 million and $1.1 million at September 30, 2001 and December 31, 2000, respectively. Loans held for sale are recorded at the lower of cost or market.
7. COMMITMENTS AND CONTINGENCIES
Credit Extensions—In the normal course of business, there are various outstanding commitments to extend credit which are not reflected in the accompanying interim consolidated financial statements. As of September 30, 2001, undisbursed loan commitments, commercial and standby letters of credit, and commitments to fund mortgage loan applications in process amounted to $430.3 million, $227.2 million, and $127.3 million, respectively.
Litigation—The Company is a party to various legal proceedings arising in the normal course of business. While it is difficult to predict the outcome of such litigation, the Company does not expect that such litigation will have a material adverse effect on its financial position and results of operations.
Regulated Investment Company—The Company realizes state tax benefits through East West Securities Company, Inc., a regulated investment company formed and funded in July 2000. The continued realization of state tax benefits through this entity is dependent on its continuing qualification as a registered investment company under the Investment Company Act of 1940, as amended.
8. STOCKHOLDERS' EQUITY
Earnings Per Share—The actual number of shares outstanding at September 30, 2001 was 23,348,603. Basic earnings per share are calculated on the basis of the weighted average number of shares outstanding during the period. Diluted earnings per share are calculated on the basis of the weighted average number of shares outstanding during the period plus shares issuable upon the assumed exercise of outstanding common stock options and warrants.
The following tables set forth the Company's earnings per share calculations for the three and nine months ended September 30, 2001 and 2000:
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Quarterly Dividends—During 2001, the Company's Board of Directors declared regular quarterly common stock cash dividends of $0.03 per share. Quarterly cash dividends were paid on or about February 14, 2001, May 16, 2001 and August 14, 2001 to shareholders of record on February 1, 2001, May 4, 2001 and July 31, 2001, respectively. For the nine months ended September 30, 2001, cash dividends totaling $2.1 million have been paid to the Company's shareholders.
Stock Repurchase Programs—On January 16, 2001, the Company's Board of Directors authorized the repurchase of up to $7.0 million of its common stock. The Company has completed this repurchase program repurchasing 302,500 shares for a total of $7.0 million. On March 21, 2001, the Company's Board of Directors initiated another share repurchase program, authorizing the repurchase of up to an additional $7.0 million of its common stock. As of September 30, 2001, the Company has repurchased 156,000 shares of its common stock for approximately $3.6 million in conjunction with this most recent stock repurchase program.
9. BUSINESS SEGMENTS
Management utilizes an internal reporting system to measure the performance of various operating segments within the Company and the Company overall. Four principal operating segments have been identified by the Company for purposes of management reporting: retail banking, commercial lending, treasury, and residential lending. Information related to the Company's remaining centralized functions and eliminations of intersegment amounts have been aggregated and included in "Other." Although all four operating segments offer financial products and services, they are managed separately based on each segment's strategic focus. While the retail banking segment focuses primarily on retail operations through the Company's branch network, certain designated branches have responsibility for generating commercial deposits and loans. The commercial lending segment primarily generates commercial loans and deposits through the efforts of commercial lending officers located in the Company's northern and southern California production offices. The treasury department's primary focus is managing the Company's investments, liquidity, and interest rate risk; the residential lending segment is mainly responsible for the Company's portfolio of single family and multifamily residential loans.
Operating segment results are based on the Company's internal management reporting process, which reflects assignments and allocations of capital, certain operating and administrative costs and the provision for loan losses. Net interest income is based on the Company's internal funds transfer pricing system which assigns a cost of funds or a credit for funds to assets or liabilities based on their type, maturity or repricing characteristics. Noninterest income and noninterest expense, including depreciation and amortization, directly attributable to a segment are assigned to that business. Indirect costs, including overhead expense, are allocated to the segments based on several factors, including, but not limited to, full-time equivalent employees, loan volume and deposit volume. The provision for credit losses is allocated based on new loan originations for the period. The Company evaluates overall performance based on profit or loss from operations before income taxes not including nonrecurring gains and losses.
Future changes in the Company's management structure or reporting methodologies may result in changes in the measurement of operating segment results. Results for prior periods have been restated for comparability for changes in management structure or reporting methodologies.
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The following tables present the operating results and other key financial measures for the individual operating segments for the three and nine months ended September 30, 2001 and 2000:
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10. RECENT ACCOUNTING PRONOUNCEMENTS
In June 2001 the Financial Accounting Standards Board approved Statement of Financial Accounting Standard ("SFAS") No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 prospectively prohibits the pooling of interest method of accounting for business combinations initiated after June 30, 2001. SFAS No. 142 requires companies to cease amortizing goodwill that existed at June 30, 2001. The amortization of existing goodwill will cease on December 31, 2001. Any goodwill resulting from acquisitions completed after June 30, 2001 will not be amortized. SFAS No. 142 also establishes a new method of testing goodwill for impairment on an annual basis or on an interim basis if an event occurs or circumstances change that would reduce the fair value of a reporting unit below its carrying value. The adoption of SFAS 142 will result in the Bank's discontinuation of the amortization of positive goodwill effective January 1, 2002. The total expected annual amortization expense for positive goodwill is $1.5 million for 2001. Positive goodwill will continue to be reviewed for impairment on an annual basis. Further, as a consequence of adopting SFAS 142, the expected remaining balance of negative goodwill of $1.4 million at December 31, 2001 will be recorded as a cumulative effect of a change in accounting principle effective January 1, 2002. The total expected annual amortization expense for negative goodwill is $94 thousand for 2001.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion provides information about the results of operations, financial condition, liquidity, and capital resources of East West Bancorp, Inc. and its subsidiaries (the "Company"). This information is intended to facilitate the understanding and assessment of significant changes and trends related to the financial condition of the Company and the results of its operations. This discussion and analysis should be read in conjunction with the Company's 2000 annual report on Form 10-K for the year ended December 31, 2000, and the accompanying interim unaudited consolidated financial statements and notes thereto.
In addition to historical information, this discussion includes certain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 which involve inherent risks and uncertainties. A number of important factors could cause the Company's actual results and performance in future periods to differ materially from those discussed in such forward-looking statements. These factors include, but are not limited to, the effect of interest rate and currency exchange fluctuations; competition in the financial services market for both deposits and loans; the Company's ability to efficiently incorporate acquisitions into its operations; the ability of the Company to increase its customer base; and regional and general economic conditions. Given these uncertainties, the reader is cautioned not to place undue reliance on such forward-looking statements. The Company expressly disclaims any obligation to update or revise any forward-looking statements contained herein to reflect any changes in the Company's expectations of results or any change in events.
Results of Operations
The Company reported third quarter 2001 net income of $9.8 million, or $0.43 per basic share and $0.41 per diluted share, compared with $8.8 million, or $0.39 per basic share and $0.38 per diluted share, reported during the third quarter of 2000. The 11% increase in net earnings is primarily attributable to higher net interest income and noninterest-related revenues and a lower provision for income taxes, partially offset by higher operating expenses and provision for loan losses. The Company's annualized return on average total assets decreased to 1.46% for the quarter ended September 30, 2001, from 1.50% for the same period in 2000. The annualized return on average stockholders' equity decreased to 17.47% for the third quarter of 2001, compared with 20.97% for the third quarter of 2000.
Net income for the nine months ended September 30, 2001 increased to $29.3 million, or $1.27 per basic share and $1.21 per diluted share, from $25.9 million, or $1.16 per basic share and $1.12 per diluted share, for the first nine months of 2000. The annualized return on average total assets increased to 1.51% for the first three quarters of 2001, compared with 1.48% for the same period in 2000. The annualized return on average stockholders' equity decreased to 18.42% for the first three quarters of 2001, compared with 21.70% for the same period in 2000.
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Components of Net Income
Net Interest Income
The Bank's primary source of revenue is net interest income, which is the difference between interest income on earning assets and interest expense on interest-bearing liabilities. Net interest income for the third quarter of 2001 totaled $24.8 million, a 10% increase over net interest income of $22.6 million for the same period in 2000.
Total interest and dividend income during the quarter ended September 30, 2001 decreased 6% to $44.4 million compared with $47.3 million during the same period in 2000 primarily due to lower yields and reduced volume of the Company's investment securities portfolio. Year-to-date interest and dividend income increased 2% to $140.3 million, from $137.7 million during the first three quarters of 2000. The increase in interest and dividend income during the first nine months of 2001 is attributable primarily to a 10% growth in average earning assets, partially offset by lower yields on every category of earning assets resulting from the continued decline in overall interest rates. Growth in the Bank's average loan and short-term investments portfolio, partially offset by decreases in investment securities and FHLB stock, triggered the growth in average earning assets. The net growth in average earning assets was funded largely by increases in time deposits, noninterest-bearing demand deposits, interest-bearing checking accounts, and money market accounts.
Total interest expense during the third quarter of 2001 decreased 21% to $19.6 million compared with $24.7 million for the same period a year ago. For the nine months ended September 30, 2001, total interest expense decreased 5% to $67.5 million, from $70.7 million for the first nine months of 2000. The decrease in interest expense during the third quarter and first nine months of 2001 is predominantly attributable to lower rates paid on substantially all categories of interest-bearing liabilities compounded by a lower volume of FHLB advances. Despite several progressive cuts in interest rates during the year, the decline in interest expense for the nine months ended September 30, 2001 has been tempered by the lag in the repricing of the Company's substantial portfolio of time deposits.
Net interest margin, defined as taxable equivalent net interest income divided by average earning assets, decreased 15 basis points to 3.94% for the third quarter of 2001, compared with 4.09% for the third quarter of 2000. For the first nine months of 2001, the Company's net interest margin decreased 6 basis points to 3.98%, from 4.04% for the same period a year ago. Overall yields on earning assets are significantly lower during the quarter and nine months ended September 30, 2001, when compared to the same periods in the prior year, primarily due to several progressive declines in interest rates since the beginning of the year. The reduction in prevailing interest rates had a particularly sharp impact during the third quarter of 2001, which evidenced a 151 basis point decline in the Company's overall yield on earning assets to 7.05%, compared to 8.56% for the third quarter of 2000. Similarly, the
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overall yield on average earning assets for the first nine months of 2001 declined 64 basis points to 7.67%, compared to 8.31% for the same period a year ago.
The Company's cost of funds for the third quarter of 2001 decreased 126 basis points to 3.82% in response to the declining interest rate environment, compared to 5.08% for the third quarter of 2000. Similarly, for the nine months ended September 30, 2001, the Company's cost of funds decreased 38 basis points to 4.42%, compared to 4.80% for the first three quarters of 2000. Despite the continued usage of noninterest demand deposits as a considerable funding source, the Company is not immune to the unfavorable impact of significant declines in market interest rates. The recent interest rate decreases had a disproportional effect on asset yields and differences in the timing of deposit repricing have resulted in a contraction of the Company's net interest spread and net interest margin. Management anticipates that the Company's net interest margin will continue to be negatively impacted by interest rate cuts.
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The following table presents the net interest spread, net interest margin, average balances, interest income and expense, and the average yields and rates by asset and liability component for the three months ended September 30, 2001 and 2000:
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The following table presents the net interest spread, net interest margin, average balances, interest income and expense, and the average yields and rates by asset and liability component for the nine months ended September 30, 2001 and 2000:
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Analysis of Changes in Net Interest Margin
Changes in the Bank's net interest income are a function of changes in rates and volumes of both interest-earning assets and interest-bearing liabilities. The following table sets forth information regarding changes in interest income and interest expense for the years indicated. The total change for each category of interest-earning asset and interest-bearing liability is segmented into the change attributable to variations in volume (changes in volume multiplied by old rate) and the change attributable to variations in interest rates (changes in rates multiplied by old volume). Nonaccrual loans are included in average loans used to compute this table.
Provision for Loan Losses
The provision for loan losses amounted to $1.5 million for the third quarter of 2001 compared to $1.3 million for the same period in 2000. For the first nine months of 2001, the provision for loan losses totaled $3.7 million, compared to $4.1 million for the same period in 2000. Provisions for loan losses are charged to income to bring the allowance for credit losses to a level deemed appropriate by management based on the factors discussed under the "Allowance for Loan Losses" section of this report.
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Noninterest Income
Components of Noninterest Income
Noninterest income includes revenues earned from sources other than interest income. These sources include: ancillary fees on loans, service charges and fees on deposit accounts, fees and commissions generated from trade finance activities and the issuance of letters of credit, net gains on sales of loans, investment securities available for sale and affordable housing investments, net gains on trading securities and disposals of fixed assets.
Noninterest income increased 27% to $4.7 million during the three months ended September 30, 2001 primarily due to higher loan fees, net gain on sales of available for sale securities, net gain on disposals of fixed assets, and higher other noninterest income. Included in noninterest income for the third quarter of 2001 are $387 thousand in net gains on sales of investment securities available for sale and $131 thousand in net gains from the sale of a building and associated leasehold improvements. This building previously housed a branch that has since been relocated. There were no such gains recorded during the same period in 2000. Noninterest income for the first three quarters of 2001 increased 40% to $16.2 million, from $11.5 million for the first three quarters of 2000, primarily due to higher loan fees, net gains on sales of loans and available for sale securities, net gain on trading securities and disposals of fixed assets and other noninterest-related revenues.
Partially offsetting these increases to noninterest income during the third quarter and first nine months of 2001 is the absence of gains on sales of affordable housing investments. This compares to $374 thousand and $1.3 million in such gains recorded during the third quarter and first nine months of 2000, respectively. Further offsetting increases to noninterest income is a reduction in the amortization of negative intangibles to $23 thousand for the third quarter of 2001, from $104 thousand for the same quarter in 2000. For the nine months ended September 30, 2001, the amortization of negative intangibles decreased 26% to $231 thousand, from $312 thousand for the corresponding period in 2000. The decrease is due to the full amortization of negative core deposit intangibles in June 2001.
Ancillary fees on loans include fees and service charges related to appraisal services, loan documentation, processing and underwriting, and secondary market-related activities. Ancillary loan fees increased 129% to $957 thousand during the third quarter of 2001, compared to $418 thousand for the same period in 2000. For the first three quarters of 2001, ancillary loan fee income increased 106% to $2.8 million, from $1.4 million for the first three quarters of 2000. The increase in ancillary loan fees is primarily due to a significant increase in residential mortgage and commercial loan origination
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activity during the third quarter and first nine months of 2001 in comparison to the same periods in 2000.
Other contributions to noninterest income include other operating income, which includes insurance commissions and insurance-related service fees, interest earned on officer life insurance policies, branch rental income, and income from operating leases. Other operating income increased to $917 thousand, or 68%, during the third quarter of 2001, from $545 thousand recorded during the third quarter of 2000. For the nine months ended September 30, 2001, other operating income increased to $2.8 million, or 104%, from $1.4 million recorded during the first three quarters of 2000. The increase in noninterest income is primarily due to insurance commissions and other insurance-related service fee income totaling $292 thousand and $787 thousand for the third quarter and first three quarters of 2001, respectively, resulting from the acquisition of Risk Services, Inc. in August 2000. In comparison, total insurance commissions and other insurance-related fee income totaled $145 thousand during both the third quarter and first nine months of 2000. In addition, the Company also recorded interest income on officer life insurance policies totaling $322 thousand and $969 thousand for the third quarter and first three quarters of 2001, respectively, compared to $232 thousand and $537 thousand earned during the same periods in 2000. At September 30, 2001, the aggregate cash surrender value of the Company's officer life insurance policies amounted to $26.4 million compared to $22.9 million at December 31, 2000. Further contributing to other noninterest income are revenues from leased equipment totaling $178 thousand and $593 thousand during the third quarter and first nine months of 2001, respectively. These revenues represent income from equipment leased to third parties in connection with $2.1 million in operating leases entered into by the Company. In comparison, the Company recorded $67 thousand and $195 thousand in leased equipment revenues for the third quarter and first three quarters of 2000, respectively.
Noninterest Expense
Components of Noninterest Expense
Noninterest expense, which is comprised primarily of compensation and employee benefits, occupancy and other operating expenses increased 25% to $15.3 million during the third quarter of 2001, from $12.3 million for the same period in 2000. Noninterest expense for the nine months ended September 30, 2001 increased 26% to $45.6 million, compared to $36.2 million for the first three quarters of 2000.
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Compensation and employee benefits increased 18% to $6.0 million during the third quarter of 2001, compared to $5.1 million for the same period last year. For the first nine months of 2001, compensation and employee benefits increased 24% to $18.3 million, compared to $14.8 million for the same period in 2000. The rise in compensation and employee benefits is primarily due to the acquisition of Prime Bank in mid-January 2001 and the Company's continued investment in its operating infrastructure, predominantly in the lending area.
Occupancy expenses increased 38% to $2.6 million during the third quarter of 2001, compared to $1.9 million for the same period in 2000. For the first nine months of 2001, occupancy expenses increased 32% to $7.4 million, from $5.6 million for the same period in 2000. The increase in occupancy expenses reflects the operations for the Century City, California branch location of Prime Bank which was acquired by the Company in mid-January 2001 and increased rent expense attributed to the Company's new Oakland and Milbrae, California branch locations which were both opened during 2001. As such, these overhead factors were not present during the third quarter and first nine months of 2000. Additionally, the impact of normal rent adjustments in existing leases further contributed to the rise in occupancy expenses.
The amortization of positive intangibles, which include premiums on deposits acquired and excess of purchase price over fair value of net assets acquired ("goodwill"), decreased 2% to $847 thousand during the third quarter of 2001, compared to $865 thousand for the third quarter of 2000. The decrease in the amortization of positive intangibles reflects the full amortization of certain core deposit intangibles during the second quarter of 2001 partially offset by the addition of positive intangibles related to the Prime Bank acquisition in mid-January 2001. For the nine months ended September 30, 2001, the amortization of positive intangibles increased 17% to $2.9 million, from $2.5 million for the same period a year ago. The increase in the amortization of positive intangibles is primarily due to the acquisition of Prime Bank. Goodwill of $5.6 million and deposit premium of $3.9 million were recorded by the Company for this transaction which are being amortized straight line over 15 and 7 years, respectively.
Deposit insurance premiums and regulatory assessments increased 19% to $142 thousand for the three months ended September 30, 2001, compared with $119 thousand for the same period in 2000. For the nine months ended September 30, 2001, deposit insurance premiums and regulatory assessments increased 20% to $408 thousand, compared with $339 thousand for the same period in 2000. Although there was a decrease in the Savings Association Insurance Fund ("SAIF") annualized Financing Corporation ("FICO") assessment rate to 1.96 basis points, 1.90 basis points and 1.88 basis points for the first, second and third quarters of 2001, respectively, from 2.12 basis points, 2.08 basis points and 2.06 baisis points for the same periods in 2000, deposit insurance premiums increased during the three and nine months ended September 30, 2001 as a result of the significant growth in the Bank's assessable deposit base.
Net income related to OREO operations, which include net rental income collected from OREO properties and net gains or losses on subsequent sales, totaled $3 thousand for the third quarter of 2001, compared to net income of $108 thousand for the prior year period. For the nine months ended September 30, 2001, net expenses related to OREO operations totaled $30 thousand compared to net income of $115 thousand for the corresponding period in 2000. The decrease in OREO net income for both the third quarter and first nine months of 2001 is primarily due to lower gain on sales of OREO properties.
The amortization of investments in affordable housing partnerships decreased 20% to $764 thousand during the third quarter of 2001, from $958 thousand for the third quarter of 2000. For the nine months ended September 30, 2001, the amortization of investments in affordable housing partnerships decreased 4% to $2.8 million, from $2.9 million for the first three quarters of 2000. The
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decrease in amortization reflects the impact of two sale transactions totaling $9.3 million in February 2000 and September 2000.
Other operating expenses include advertising and public relations, telephone and postage, stationery and supplies, bank and item processing charges, insurance, legal and other professional fees. Other operating expenses increased 49% to $4.5 million during the three months ended September 30, 2001, compared with $3.0 million for the same period in 2000. For the nine months ended September 30, 2001, other operating expenses increased 41% to $12.4 million, from $8.8 million for the first three quarters of 2000. The increase in other operating expenses is due primarily to the Company's continued expansion, which includes the recent acquisition of Prime Bank, as well as its continued investment in its operating infrastructure.
The Company's efficiency ratio, which represents noninterest expense (excluding the amortization of intangibles and investments in affordable housing partnerships) divided by the aggregate of net interest income before provision for loan losses and noninterest income (excluding the amortization of intangibles), increased to 46% for the quarter ended September 30, 2001, compared to 40% for the corresponding period in 2000. For the first nine months of 2001, the Company's efficiency ratio increased to 45% from 39% for the same period a year ago. The increase in efficiency ratio is primarily due to the acquisition of Prime Bank, the Company's continued investment in its operating infrastructure, and slower growth in the Bank's net interest income and margin as a result of several progressive interest rate cuts during 2001. Management anticipates the Company's efficiency ratio to remain in the mid 40% range for the remainder of the year.
Provision for Income Taxes
The provision for income taxes decreased 25% to $2.9 million for the third quarter of 2001, compared with $3.9 million for the same period in 2000. For the nine months ended September 30, 2001, the provision for income taxes totaled $10.3 million, a 16% decrease from the $12.3 million income tax expense recorded for the same period a year ago. Despite increases in pretax income during the third quarter and first three quarters of 2001, the provision for income taxes decreased primarily as a result of state tax benefits achieved through East West Securities Company, Inc., a regulated investment company formed and funded in July 2000. The continued realization of state tax benefits through this entity is dependent on its continuing qualification as a registered investment company under the Investment Company Act of 1940, as amended.
The provision for income taxes for the third quarter of 2001 also reflects the utilization of tax credits totaling $855 thousand, compared to $987 thousand utilized during the same period in 2000. The third quarter 2001 provision reflects an effective tax rate of 23.0%, compared with 30.8% for the third quarter of 2000. For the first nine months of 2001, the effective tax rate of 26.0% reflects tax credits of $2.7 million, compared with an effective tax rate of 32.3% for the first three quarters of 2000 reflecting tax credits of $3.0 million.
Balance Sheet Analysis
The Company's total assets increased $330.5 million, or 13%, to $2.82 billion, as of September 30, 2001, relative to total assets at December 31, 2000. The increase in total assets was due primarily to a $258.8 million growth in net loans receivable and a $205.5 million increase in short-term investments, partially offset by a decrease in investment securities available for sale of $136.9 million. The increase in total assets was funded by increases of $511.8 million in deposits, partially offset by decreases in short-term borrowings of $38.0 million and FHLB advances of $199.0 million.
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Investment Securities Available for Sale
Total investment securities available for sale decreased 28% to $351.3 million as of September 30, 2001, compared to total available for sale investment securities of $488.3 million at December 31, 2000. Investment securities with a net carrying value of $37.0 million were acquired from Prime Bank during the first quarter of 2001, substantially all of which were sold during the same period. Total repayments and proceeds from sales of available for sale securities amounted to $127.9 million and $176.2 million, respectively, during the nine months ended September 30, 2001. Proceeds from repayments and sales were applied towards the repayment of short-term borrowings and FHLB advances as well as funding a portion of the loan originations made during the first three quarters of 2001. The Bank recorded net gains totaling $2.0 million on sales of available for sale securities during the nine months ended September 30, 2001.
The following table sets forth the amortized cost and the estimated fair values of investment securities available for sale as of September 30, 2001 and December 31, 2000:
Loans
Net loans receivable increased $258.8 million, or 15% to $2.05 billion at September 30, 2001. Excluding the $43.3 million of net loans acquired from Prime Bank, loan growth during the first three quarters of 2001 amounted to $215.5 million, or 12% compared to year-end 2000 levels. The growth in loan volume during the nine months ended September 30, 2001 was funded primarily through deposit growth and through repayments and sales of investment securities available for sale.
The growth in loans, excluding loans acquired from Prime Bank, is comprised of increases in multifamily loans of $37.5 million or 12%, commercial real estate loans of $183.9 million or 29%, construction loans of $20.1 million or 17%, automobile loans of $5.5 million or 86%, and consumer loans, including home equity lines of credit, of $10.7 million or 26%. Approximately 60%, or $129.0 million, of the growth in loans can be attributed to whole loan purchases from various financial institutions. Whole loan purchases during the first nine months of 2001 were comprised of $13.4 million in single family loans, $60.1 million in multifamily loans, and $55.5 million in commercial real estate loans.
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Partially offsetting the growth in the aforementioned loan categories was a decrease in single family loans of $35.9 million or 11% and commercial business loans, including trade finance products, of $5.7 million or 2%. The decrease in single family loans was primarily due to loan sales of $64.8 million and FNMA securitizations totaling $13.3 million during the first three quarters of 2001.
The following table sets forth the composition of the loan portfolio as of the dates indicated:
Nonperforming Assets
Nonperforming assets are comprised of nonaccrual loans, loans past due 90 days or more but not on nonaccrual, restructured loans and other real estate owned, net. Nonperforming assets as a percentage of total assets were 0.26% and 0.30% at September 30, 2001 and December 31, 2000, respectively. Nonaccrual loans, which include loans 90 days or more past due, totaled $5.1 million at September 30, 2001, compared with $3.7 million at year-end 2000. Loans totaling $1.2 million were placed on nonaccrual status during the third quarter of 2001. These additions to nonaccrual loans were offset by $922 in gross chargeoffs, $181 in principal paydowns and a $59 thousand loan that was brought current. Additions to nonaccrual loans during the third quarter of 2001 were comprised of a $123 thousand multifamily loan, $850 thousand in commercial business loans, and a $180 thousand trade finance loan. For the nine months ended September 30, 2001, nonaccrual loans increased $1.5 million due to $4.4 million additions to nonaccrual loans, partially offset by payoffs totaling $1.8 million, gross chargeoffs totaling $703 thousand and loans brought current totaling $464 thousand.
Restructured loans and loans that have had their original terms modified totaled $2.1 million at September 30, 2001, compared with $3.0 million at year-end 2000. The decrease in restructured loans is due to $627 thousand in payoffs, $31 thousand in chargeoffs and $178 thousand in principal payments received during the first nine months of 2001.
Other real estate owned ("OREO") includes properties acquired through foreclosure or through full or partial satisfaction of loans. Other real estate owned totaled $801 thousand at December 31, 2000. The Bank had no OREO properties at September 30, 2001. There were no additions to OREO during the first nine months of 2001. Two single family residential OREO properties were sold during the nine months ended September 30, 2001 for a combined gain of $20 thousand.
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The following table sets forth information regarding nonaccrual loans, loans past due 90 days or more but not on nonaccrual, restructured loans and other real estate owned as of the dates indicated:
The Company evaluates impairment of loans according to the provisions of SFAS No. 114, Accounting by Creditors for Impairment of a Loan, as amended. Under SFAS No. 114, loans are considered impaired when it is probable that the Company will be unable to collect all amounts due according the contractual terms of the loan agreement, including scheduled interest payments. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as an expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent, less costs to sell.
At September 30, 2001, the Bank had classified $10.5 million of its loans as impaired, compared with $12.4 million at December 31, 2000. Specific reserves on impaired loans totaled $3.1 million at September 30, 2001 and $1.3 million at December 31, 2000. The Bank's average recorded investment in impaired loans for the nine months ended September 30, 2001 and 2000 were $13.5 million and $16.8 million, respectively. During the nine months ended September 30, 2001 and 2000, gross interest income that would have been recorded on impaired loans, had they performed in accordance with their original terms, totaled $1.0 million and $1.5 million, respectively. Of this amount, actual interest recognized on impaired loans, on a cash basis, was $789 thousand and $915 thousand, respectively.
Allowance for Loan Losses
Management of the Bank is committed to maintaining the allowance for loan losses at a level that is considered to be commensurate with estimated and known risks in the portfolio. Although the adequacy of the allowance is reviewed quarterly, management performs an ongoing assessment of the risks inherent in the portfolio. While management believes that the allowance for loan losses is adequate at September 30, 2001, future additions to the allowance will be subject to continuing evaluation of estimated and known, as well as inherent, risks in the loan portfolio.
The allowance for loan losses is increased by the provision for loan losses which is charged against current period operating results, and is decreased by the amount of net chargeoffs during the period. At September 30, 2001, the allowance for loan losses amounted to $26.0 million, or 1.25% of total loans, compared with $23.8 million, or 1.31% of total loans, at December 31, 2000, and $24.7 million, or 1.43% of total loans, at September 30, 2000. The $2.2 million increase in the allowance for loan losses at September 30, 2001, from year-end 2000, results from a $1.6 million in allowance for losses
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acquired from Prime Bank, $3.7 million in additional loss provisions, and $3.1 million in net chargeoffs recorded during the period.
The provision for loan losses of $1.5 million for the third quarter of 2001 represents a 15% increase from the $1.3 million in loss provisions recorded during the third quarter of 2000. Third quarter 2001 net chargeoffs amounting to $1.3 million represent 0.26% of average loans outstanding for the three months ended September 30, 2001. This compares to net chargeoffs of $1.2 million, or 0.29% of average loans outstanding for the same period in 2000. For the nine months ended September 30, 2001, the provision for loan losses totaled $3.7 million, a 9% decrease from the $4.1 million provision recorded during the same period in 2000. Net chargeoffs for the first three quarters of 2001 totaling $3.1 million represent 0.21% of average loans outstanding for the nine months ended September 30, 2001. This compares to net chargeoffs of $2.5 million for the first three quarters of 2000, or 0.20% of average loans outstanding. The Bank continues to record loss provisions to compensate for both the continued growth of the Bank's loan portfolio, which grew 14% during the first nine months of 2001, and the changing composition of the overall loan portfolio, reflecting a shift toward commercial real estate and commercial business loans. At September 30, 2001, the combined volume of commercial real estate and commercial business loans represented approximately 58% of the total loan portfolio, compared to 55% at December 31, 2000 and 53% at September 30, 2000.
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The following table summarizes activity in the allowance for loan losses for the three and nine months ended September 30, 2001 and 2000:
The Bank's total allowance for loan losses is comprised of two components—allocated and unallocated. The Bank utilizes several methodologies to determine the allocated portion of the allowance and to test overall adequacy. The two primary methodologies, the classification migration model and the individual loan review analysis methodology, provide the basis for determining allocations between the various loan categories as well as the overall adequacy of the allowance. These methodologies are augmented by ancillary analyses, which include historical loss analyses, peer group comparisons, and analyses based on the federal regulatory interagency policy for loan and lease losses.
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The following table reflects management's allocation of the allowance for loan losses by loan category and the ratio of each loan category to total loans as of the dates indicated:
Allocated reserves on single family loans decreased $28 thousand, or 20%, to $114 thousand at September 30, 2001 partly due to a 9% decrease in the volume of loans in this loan category since year-end 2000. Further, the loss factor for single family loans that are not classified (i.e. rated "pass") declined to 2 basis points at September 30, 2001 compared to 3 basis points at December 31, 2000. At September 30, 2001, approximately 99% of the loans within this category were rated "pass."
Allocated reserves on multifamily loans increased $69 thousand, or 4%, to $1.8 million at September 30, 2001 primarily due to a 12% increase in the volume of multifamily loans from year-end 2000 levels. The increase in loan volume was partially offset by a decrease in criticized (i.e. rated "special mention") loans relative to December 31, 2000. Multifamily loans rated special mention totaled $1.0 million at September 30, 2001, compared to $4.8 million at December 31, 2000.
Similarly, allocated reserves on commercial real estate loans increased $77 thousand, or 2%, to $4.5 million primarily due to a 31% increase in the volume of commercial real estate loans at September 30, 2001, in comparison to year-end 2000 levels. This volume increase was offset in part by the reversal of a $350 thousand specific allocation on a commercial real estate loan that paid off in April 2001. There were no specific allocations on commercial real estate loans at September 30, 2001. Further counterbalancing the significant volume growth in this loan category is a decrease in criticized and classified (i.e. rated "substandard" or "doubtful") loans relative to December 31, 2000. Commercial real estate loans rated special mention totaled $2.0 million at September 30, 2001, compared to $8.9 million at December 31, 2000 while substandard commercial real estate loans decreased to $1.2 million at September 30, 2001, compared to $2.9 million at December 31, 2000.
Allocated reserves on construction loans decreased $325 thousand, or 14%, to $2.0 million at September 30, 2001 primarily due to a decrease in criticized loans partially offset by an increase in classified loans relative to December 31, 2000. Construction loans rated special mention totaled $1.3 million at September 30, 2001 compared to $7.2 million at December 31, 2000.
Allocated reserves on commercial business loans increased $3.3 million, or 31%, to $13.7 million at September 30, 2001 for two reasons. First, specific allocations on commercial loans increased to $3.4 million at September 30, 2001 compared to $968 thousand at December 31, 2000, primarily due to one loan. The other factor contributing to the increase in allocated reserves on commercial business loans is an increase in classified loans, partially offset by a decrease in criticized loans relative to December 31, 2000. Commercial business loans rated special mention totaled $2.9 million at September 30, 2001 compared to $41.3 million at December 31, 2000. On the other hand, commercial business loans rated substandard and doubtful totaled $17.4 million at September 30, 2001, compared to $9.0 million at December 31, 2000.
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The allowance for loan losses of $26.0 million at September 30, 2001 exceeded the Bank's allocated allowance by $3.7 million, or 14% of the total allowance. This compares to an unallocated allowance of $4.6 million, or 19%, as of December 31, 2000. The $3.7 million unallocated allowance at September 30, 2001 is comprised of three elements. First, the Bank has set aside $2.2 million, or approximately 10% of the allocated allowance amount of $22.3 million at September 30, 2001, to compensate for the modeling risk associated with the classification migration and individual loan review analysis methodologies. The second element, which accounts for approximately $244 thousand of the unallocated allowance, has been established for the foreign transaction risk associated with credit lines totaling $82.7 million extended to financial institutions in foreign countries. Loss factors, ranging from 0.1% to 5.0% of the total credit facility, are multiplied by anticipated usage volumes to determine the loss exposure on this type of credit offering. These loss factors are internally determined based on the sovereign risk ratings of the various countries which range from BBB+ to AAA. The total amount of the allowance set aside for foreign transaction risk associated with such credit lines totaled $1.4 million for December 31, 2000. The decrease in this element as of September 30, 2001 reflects the Bank's more refined calculation of the allowance with respect to loan commitments and foreign credit facilities. The third and final element, which accounts for approximately $1.1 million of the unallocated allowance, represents a 5% economic risk factor to compensate for the slowing of the national economy, as evidenced by rising unemployment rates and energy costs, eroding consumer confidence, and substantial shortfalls in sales and earnings. Management of the Bank has deemed it prudent to set aside a portion of the unallocated allowance to compensate for this current economic risk.
Deposits
Deposits increased $511.8 million, or 26%, to $2.46 billion at September 30, 2001. The increase in deposits reflects $98.1 million in deposits acquired from Prime Bank in January 2001. Excluding this transaction, internal deposit growth amounted to $413.8 million, or 21%, over December 31, 2000. This internal deposit growth was comprised primarily of increases in non-interest bearing demand accounts of $201.0 million, or 100%, interest-bearing checking accounts of $50.9 million, or 46%, money market accounts of $104.5 million, or 86% and time deposits of $108.3 million, or 11%. The increases can be attributed to continued momentum from various promotions associated with the Chinese New Year holiday, as well as carryover benefits from the Prime Bank acquisition.
Included in time deposits at September 30, 2001 are $69.2 million of brokered deposits, compared with $154.5 million as of December 31, 2000. The decrease of $85.2 million reflects the replacement of brokered deposits with the increasing volume of commercial and retail deposit accounts.
Although the Company occasionally promotes certain time deposit products, its efforts are largely concentrated in increasing the volume of low-cost transaction accounts which generate higher fee income and are a less costly source of funds in comparison to time deposits.
Borrowings
The Bank regularly uses short-term borrowings and FHLB advances to manage its liquidity position. Short-term borrowings consist of federal funds purchased and securities sold under agreements to repurchase. There were no outstanding short-term borrowings at September 30, 2001. This compares to $38.0 million in short-term borrowings at December 31, 2000. The decrease in short-term borrowings during the nine months ended September 30, 2001 was primarily due to the growth in core deposits.
FHLB advances decreased 74% to $69.0 million as of September 30, 2001, a decrease of $199.0 million from December 31, 2000. The decrease in FHLB advances resulted primarily from the application of sales proceeds on investment securities and loans receivable to partially pay down outstanding advances. The growth in core deposits, cash acquired from Prime Bank and runoffs on
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investment securities available for sale as an alternate source of funding further contributed to the decrease in FHLB advances during the first nine months of 2001.
Capital Resources
The primary source of capital for the Company is the retention of net after tax earnings. At September 30, 2001, stockholders' equity totaled $235.9 million, a 27% increase from $186.1 million as of December 31, 2000. The increase is due primarily to: (1) net income of $29.3 million during the first nine months of 2001; (2) net issuance of common stock totaling $2.2 million, representing 220,903 shares, from the exercise of stock options and stock warrants; (3) net issuance of common stock totaling $300 thousand, or 18,631 shares, in connection with the Company's Employee Stock Purchase Program; (4) net issuance of common stock totaling $12.3 million, representing 512,707 shares, in connection with the acquisition of Prime Bank; (5) issuance of unregistered restricted common stock totaling $7.0 million, representing 400,000 shares, in connection with the Company's recent in-store banking agreement with 99 Ranch Market; (6) issuance of warrants totaling $2.7 million, representing 300,000 shares, also in connection with the Company's in-store banking agreement with 99 Ranch Market; (7) release from escrow of 13,147 shares totaling $221 thousand as stipulated in the earn-out agreement related to the acquisition of Risk Services, Inc.; (8) stock compensation costs amounting to $299 thousand related to the Company's Restricted Stock Award Program; (9) tax benefits of $1.1 million resulting from the exercise of nonqualified stock options; and (10) a decrease of $7.2 million in unrealized losses on available-for-sale securities. These transactions were offset by (1) repurchases of $10.7 million or 464,228 shares of common stock in connection with the Company's stock repurchase programs, and to a much lesser degree, from forfeitures of restricted stock awards; and (2) payment of regular quarterly cash dividends totaling $2.1 million.
Management is committed to maintaining capital at a level sufficient to assure shareholders, customers and regulators that the Company and its bank subsidiary are financially sound. The Company and its bank subsidiary are subject to risk-based capital regulations adopted by the federal banking regulators in January 1990. These guidelines are used to evaluate capital adequacy and are based on an institution's asset risk profile and off-balance sheet exposures. According to the regulations, institutions whose Tier 1 and total capital ratios meet or exceed 6% and 10%, respectively, are deemed to be "well-capitalized." At September 30, 2001, the Bank's Tier 1 and total capital ratios were 9.6% and 10.8%, respectively, compared to 9.5% and 10.7%, respectively, at December 31, 2000.
The following table compares the Company's and the Bank's actual capital ratios at September 30, 2001, to those required by regulatory agencies for capital adequacy and well-capitalized classification purposes:
ASSET LIABILITY AND MARKET RISK MANAGEMENT
Liquidity
Liquidity management involves the Bank's ability to meet cash flow requirements arising from fluctuations in deposit levels and demands of daily operations, which include funding of securities purchases, providing for customers' credit needs and ongoing repayment of borrowings. The Bank's liquidity is actively managed on a daily basis and reviewed periodically by the Asset/Liability Committee
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and the Board of Directors. This process is intended to ensure the maintenance of sufficient funds to meet the needs of the Bank, including adequate cash flow for off-balance sheet instruments.
The Bank's primary sources of liquidity are derived from financing activities which include the acceptance of customer and broker deposits, federal funds facilities, repurchase agreement facilities and advances from the Federal Home Loan Bank of San Francisco. These funding sources are augmented by payments of principal and interest on loans, the routine liquidation of securities from the available-for-sale portfolio and securitizations of eligible loans. Primary uses of funds include withdrawal of and interest payments on deposits, originations and purchases of loans, purchases of investment securities, and payment of operating expenses.
During the nine months ended September 30, 2001 and 2000, the Company experienced net cash inflows of $51.0 million and $39.8 million, respectively, from operating activities. Cash inflows from operating activities for the first three quarters of 2001 and 2000 were primarily due to net income earned during the period. Moreover, proceeds from the sale of securitized loans also contributed to operating cash inflows for the nine months ended September 30, 2001. There were no sales of securitized loans during the same period in 2000. Net cash outflows from investing activities totaled $14.9 million and $218.5 million for the nine months ended September 30, 2001 and 2000, respectively. Net cash outflows from investing activities for both periods can be attributed primarily to the growth in the Bank's loan portfolio and purchases of available for sale securities. These activities were partially offset by net proceeds from the sale and repayments of investment securities available for sale and proceeds from the sale of loans receivable. Cash acquired through the purchase of Prime Bank in January 2001 also contributed to cash from investing activities during the first nine months of 2001. The Company experienced net cash inflows from financing activities of $174.4 million for the nine months ended September 30, 2001 primarily due to the growth in deposits partially offset by repayments of FHLB advances and short-term borrowings. During the first nine months of 2000, the growth in deposits and short-term borrowings largely accounted for net cash inflows from financing activities of $186.8 million.
As a means of augmenting its liquidity, the Bank has established federal funds lines with four correspondent banks and several master repurchase agreements with major brokerage companies. At September 30, 2001, the Bank's available borrowing capacity includes approximately $97.7 million in repurchase arrangements, $92.0 million in federal funds line facilities, and $169.9 million in unused FHLB advances. Management believes its liquidity sources to be stable and adequate. At September 30, 2001, management was not aware of any information that was reasonably likely to have a material effect on the Bank's liquidity position.
The liquidity of the parent company, East West Bancorp, Inc. is primarily dependent on the payment of cash dividends by its subsidiary, East West Bank, subject to limitations imposed by the Financial Code of the State of California. For the nine months ended September 30, 2001, total dividends paid by the Bank to East West Bancorp, Inc. totaled $6.9 million, compared with $2.8 million for the same period in 2000. As of September 30, 2001, approximately $47.5 million of undivided profits of the Bank were available for dividends to the Company.
Interest Rate Sensitivity Management
The Bank's success is largely dependent upon its ability to manage interest rate risk, which is the impact of adverse fluctuations in interest rates on the Bank's net interest income and net portfolio value. Although in the normal course of business the Bank manages other risks, such as credit and liquidity risk, management considers interest rate risk to be its most significant market risk and could potentially have the largest material effect on the Bank's financial condition and results of operations.
The fundamental objective of the asset liability management process is to manage the Bank's exposure to interest rate fluctuations while maintaining adequate levels of liquidity and capital. The
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Bank's strategy is formulated by the Asset/Liability Committee, which coordinates with the Board of Directors to monitor the Bank's overall asset and liability composition. The Committee meets regularly to evaluate, among other things, the sensitivity of the Bank's assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses on its available-for-sale portfolio (including those attributable to hedging transactions), purchase and securitization activity, and maturities of investments and borrowings.
The Bank's overall strategy is to minimize the adverse impact of immediate incremental changes in market interest rates (rate shock) on net interest income and net portfolio value. Net portfolio value is defined as the present value of assets, minus the present value of liabilities and off-balance sheet instruments. The attainment of this goal requires a balance between profitability, liquidity and interest rate risk exposure. To minimize the adverse impact of changes in market interest rates, the Bank simulates the effect of instantaneous interest rate changes on net interest income and net portfolio value on a monthly basis. The table below shows the estimated impact of changes in interest rates on net interest income and market value of equity as of September 30, 2001 and December 31, 2000, assuming a parallel shift of 100 to 200 basis points in both directions:
All interest-earning assets, interest-bearing liabilities and related derivative contracts are included in the interest rate sensitivity analysis at September 30, 2001 and December 31, 2000. At September 30, 2001 and December 31, 2000, the Bank's estimated changes in net interest income and net portfolio value were within the ranges established by the Board of Directors.
The primary analytical tool used by the Bank to gauge interest rate sensitivity is a simulation model used by many major banks and bank regulators, and is based on the actual maturity and repricing characteristics of interest-rate sensitive assets and liabilities. The model attempts to predict changes in the yields earned on assets and the rates paid on liabilities in relation to changes in market interest rates. As an enhancement to the primary simulation model, prepayment assumptions and market rates of interest provided by independent broker/dealer quotations, an independent pricing model and other available public sources are incorporated into the model. Adjustments are made to reflect the shift in the Treasury and other appropriate yield curves. The model also factors in projections of anticipated activity levels by Bank product line and takes into account the Bank's increased ability to control rates offered on deposit products in comparison to its ability to control rates on adjustable-rate loans tied to published indices.
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The following tables provide the outstanding principal balances and the weighted average interest rates of the Bank's non-derivative financial instruments as of September 30, 2001 and December 31, 2000. Historically, the balances of these financial instruments have remained fairly constant over various economic conditions. The information presented below is based on the repricing date for variable rate instruments and the expected maturity date for fixed rate instruments.
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Expected maturities of assets are contractual maturities adjusted for projected payment based on contractual amortization and unscheduled prepayments of principal as well as repricing frequency. Expected maturities for deposits are based on contractual maturities adjusted for projected rollover rates and changes in pricing for deposits with no stated maturity dates. The Bank utilizes assumptions supported by documented analyses for the expected maturities of its loans and repricing of its deposits. It also relies on third party data providers for prepayment projections for amortizing securities. The actual maturities of these instruments could vary significantly if future prepayments and repricing differ from the Bank's expectations based on historical experience.
The fair values of short-term investments approximate their book values due to their short maturities. The fair values of available for sale securities are based on bid quotations from third party data providers. The fair values of loans are estimated for portfolios with similar financial characteristics and takes into consideration discounted cash flows based on expected maturities or repricing dates utilizing estimated market discount rates as projected by third party data providers.
Transaction deposit accounts, which include checking, money market and savings accounts, are presumed to have equal book and fair values because the interest rates paid on these accounts are based on prevailing market rates. The fair value of time deposits is based upon the discounted value of contractual cash flows, which is estimated using current rates offered for deposits of similar remaining terms. The fair value of short-term borrowings approximates book value due to their short maturities. The fair value of FHLB advances is estimated by discounting the cash flows through maturity or the next repricing date based on current rates offered by the FHLB for borrowings with similar maturities. The fair value of junior subordinated debt securities is estimated by discounting the cash flows through maturity based on current rates offered on the 30-year Treasury bond.
The Asset/Liability Committee is authorized to utilize a wide variety of off-balance sheet financial techniques to assist in the management of interest rate risk. Derivative positions are integral
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components of the Bank's asset/liability management strategy. Therefore, the Bank does not believe it is meaningful to separately analyze the derivatives components of its risk management activities in isolation from their related positions. The Bank uses derivative instruments, primarily interest rate swap and cap agreements, as part of its management of asset and liability positions in connection with its overall goal of minimizing the impact of interest rate fluctuations on the Bank's net interest margin or its stockholders' equity. These contracts are entered into for purposes of reducing the Bank's interest rate risk and not for trading purposes.
The Bank entered into interest rate swap agreements for the purpose of converting fixed rate brokered certificates of deposits to floating rate liabilities. The gross notional amount of interest rate swap agreements totaled $30.0 million at December 31, 2000. There were no interest rate swap agreements outstanding at June 30, 2001. The Bank adopted SFAS No. 133 effective January 1, 2001. The adoption of this standard resulted in a cumulative pre-tax reduction to earnings of $149 thousand ($87 thousand after-tax) as a result of the fair valuation of the interest rate swap agreements. Pursuant to the adoption of SFAS No. 133, the Company recorded these interest rate swap agreements at their estimated fair values, with resulting gains or losses recorded in current earnings.
The Bank has also entered into interest rate cap agreements which are primarily linked to the three-month LIBOR. Prior to October 1, 1999, the Bank used interest rate caps for purposes of hedging against market fluctuations in the Bank's available-for-sale securities portfolio. Due to the volatility of the correlation between the Treasury yield curve and fixed rate mortgage-backed securities, the Bank ceased using interest rate caps to hedge against fluctuations in the investment securities available for sale portfolio, effective October 1, 1999. The Bank continues to record these interest rate caps at their estimated fair values, with resulting gains or losses recorded in current earnings. The unrealized gains and losses reflected in accumulated other comprehensive income (loss) in stockholders' equity as of September 30, 1999 are amortized into interest income or expense over the expected remaining lives of these interest rate cap agreements. One of these interest rate cap agreements, with a notional amount of $18.0 million, matured in April 2001. Only one interest cap agreement is outstanding at September 30, 2001. This remaining interest rate cap agreement, with a notional amount of $18.0 million, will mature in October 2002.
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The following table summarizes the expected maturities, weighted average pay and receive rates, and the unrealized gains and losses of the Bank's interest rate contracts as of September 30, 2001 and December 31, 2000. The fair values reflected in the table are based on quoted market prices from broker dealers making a market for these derivatives.
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES OF MARKET RISKS
For quantitative and qualitative disclosures regarding market risks in the Bank's portfolio, see "Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations—Asset Liability and Market Risk Management."
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PART II—OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Neither the Bank nor the Company is involved in any material legal proceedings. The Bank, from time to time is party to litigation which arises in the ordinary course of business, such as claims to enforce liens, claims involving the origination and servicing of loans, and other issues related to the business of the Bank. In the opinion of management, based upon the advice of legal counsel, the resolution of any such issues would not have a material adverse impact on the financial position, results of operations, or liquidity of the Bank or the Company.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
On August 30, 2001, the Company entered into a ten-year agreement with 99 Ranch Market to provide supermarket banking in their stores throughout California. 99 Ranch is the largest Asian-focused chain of supermarkets on the West Coast, with twenty full service stores in California, one in Seattle, and affiliated licensee stores in Hawaii, Nevada, Georgia and Arizona. In conjunction with this agreement, the Company has issued 300,000 warrants to senior executives of 99 Ranch Market to purchase common stock of the Company at a price of $26.67 per share. These warrants will vest over six years and are intended to provide direct benefit to 99 Ranch executives that make a significant contribution to the success of the in-store banking operations. The estimated total fair value of the issued warrants is $2.7 million.
In order to further align the interests of both parties, senior executives of 99 Ranch Market have also made a significant investment in the Company, including the purchase of 400,000 newly issued shares of East West Bancorp, Inc. common stock totaling $7.9 million. The shares were sold for cash at a price of $19.71 per share. No underwriting discounts or commissions were paid in connection with this transaction. The proceeds from the sale of the shares will be used for working capital and the repurchase of shares. The shares are restricted and unregistered, and will become registered two years from the transaction date of August 30, 2001. Upon the two-year anniversary, 40% of the shares will become available for sale. After each of the next three anniversaries, 20% of the total shares will become available for sale. All shares can be freely traded on the fifth year anniversary. The total estimated fair value of the purchased shares is $6.9 million.
The warrants and the restricted shares were issued in reliance upon the exemption for private sales to accredited investors.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
No events have transpired which would make response to this item appropriate.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 5. OTHER INFORMATION
ITEM 6. ITEM EXHIBITS AND REPORTS ON FORM 8-K
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All other material referenced in this report which is required to be filed as an exhibit hereto has previously been submitted.
The Company filed no reports on Form 8-K during the third quarter of 2001.
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SIGNATURE
Pursuant to the requirements of Section 13 or 15(d) 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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