East West Bancorp - 10-Q quarterly report FY

EAST WEST BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
For the Six Months Ended June 30, 2004 and 2003
(Unaudited)

1. BASIS OF PRESENTATION

Our consolidated financial statements include the accounts of East West Bancorp, Inc. and our wholly owned subsidiaries, East West Bank and its subsidiaries and East West Insurance 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 six months ended June 30, 2004 are not necessarily indicative of results that may be expected for any other interim period or for the year as a whole. Certain information and note disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted. The unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in our annual report on Form 10-K for the year ended December 31, 2003.

Certain reclassifications have been made to the prior period financial statements to conform to the current period presentation. Information related to share volume and per share amounts have been adjusted to reflect the two-for-one stock split that became effective on or about June 21, 2004 (see Note 6).

2. SIGNIFICANT ACCOUNTING POLICIES

New Accounting Standards

In January 2003, the Financial Accounting Standards Board (“FASB”) issued Financial Accounting Standards Interpretation No. 46,Consolidation of Variable Interest Entities (“FIN No. 46”), an interpretation of Accounting Research Bulletin No. 51. FIN No. 46, which was revised in December 2003, requires that variable interest entities be consolidated by a company if that company is subject to a majority of expected loss from the variable interest entity’s activities or is entitled to receive a majority of the entity’s expected residual returns or both. FIN No. 46 also requires disclosures about variable interest entities that companies are not required to consolidate but in which a company has a significant variable interest. The consolidation requirements of FIN No. 46 applied immediately to variable interest entities created after January 31, 2003. The consolidation requirements applied to entities established prior to January 31, 2003 in the first fiscal year or interim period beginning after December 15, 2003. The Company adopted the consolidation requirements of FIN No. 46 effective December 31, 2003. As previously reported, the adoption of FIN No. 46 primarily resulted in the reclassification of certain liabilities due to the deconsolidation of statutory business trusts previously consolidated by the Company. FIN No. 46 had no effect on reported net income and cash flows.

In December 2003, the Accounting Standards Executive Committee of the AICPA issued Statement of Position No. 03-3 (“SOP 03-3”), Accounting for Certain Loans or Debt Securities Acquired in a Transfer. SOP 03-3 addresses the accounting for differences between contractual cash flows and the cash flows expected to be collected from purchased loans or debt securities if those differences are attributable, in part, to credit quality. SOP 03-3 requires purchased loans and debt securities to be recorded initially at fair value based on the present value of the cash flows expected to be collected with no carryover of any

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valuation allowance previously recognized by the seller. Interest income should be recognized based on the effective yield from the cash flows expected to be collected. To the extent that the purchased loans or debt securities experience subsequent deterioration in credit quality, a valuation allowance would be established for any additional cash flows that are not expected to be received. However, if more cash flows subsequently are expected to be received than originally estimated, the effective yield would be adjusted on a prospective basis. SOP 03-3 will be effective for loans and debt securities acquired after December 31, 2004. Management does not expect the adoption of this statement to have a material impact on the Company’s financial position, results of operations, or cash flows.

In March 2004, the Emerging Issues Task Force (EITF) reached consensus on the guidance provided in EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments (EITF 03-1) as applicable to debt and equity securities that are within the scope of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities and equity securities that are accounted for using the cost method specified in Accounting Policy Board Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. An investment is impaired if the fair value of the investment is less than its cost. EITF 03-1 outlines that an impairment would be considered other-than-temporary unless: a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment, and b) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. Although not presumptive, a pattern of selling investments prior to the forecasted recovery of fair value may call into question the investor’s intent. In addition, the severity and duration of the impairment should also be considered in determining whether the impairment is other-than-temporary. This new guidance for determining whether impairment is other-than-temporary is effective for reporting periods beginning after June 15, 2004. Adoption of EITF 03-1 may cause the Company to recognize impairment losses in the Consolidated Statements of Income which would not have been recognized under the current guidance or to recognize such losses in earlier periods, especially those due to increases in interest rates. Since fluctuations in the fair value for available-for-sale securities are already recorded in accumulated other comprehensive income, adoption of this standard is not expected to have a significant impact on stockholders’ equity.

Stock-Based Compensation

The Company issues fixed stock options to certain employees, officers, and directors. SFAS No. 123,Accounting for Stock-based Compensation,encourages, but does not require, companies to account for stock options using the fair value method, which generally results in compensation expense recognition. As also permitted by SFAS No. 123, the Company accounts for its fixed stock options using the intrinsic-value method, prescribed in APB Opinion No. 25, Accounting for Stock Issued to Employees, which generally does not result in compensation expense recognition. Under the intrinsic value method, compensation cost for stock options is measured at the date of grant as the excess, if any, of the quoted market price of the Company’s stock over the exercise price of the options. Had compensation cost for the Company’s stock-based compensation plans been determined based on the fair value at the grant dates of options consistent with the method defined in SFAS No. 123, the Company’s net income and earnings per share would have

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been reduced to the pro forma amounts indicated below for the three and six months ended June 30, 2004 and 2003:

The weighted average fair value for options granted during the six months ended June 30, 2004 and 2003 was $6.41 and $4.23, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:

In addition to stock options, the Company also grants restricted stock awards to directors, certain officers and employees. The Company records the cost of the restricted shares at market value. The restricted stock grants are reflected as a component of common stock and additional paid-in capital with an offsetting amount of deferred compensation in the consolidated statements of changes in stockholders’ equity. The restricted shares awarded become fully vested after three years of continued employment from the date of grant. The Company becomes entitled to an income tax deduction in an amount equal to the taxable income reported by the holders of the restricted shares when the restrictions are released and the shares are issued. The deferred compensation cost reflected in stockholders’ equity is being amortized as compensation expense over three years using the straight-line method. Restricted shares are forfeited if officers and employees terminate prior to the lapsing of restrictions. The Company records forfeitures of restricted stock as treasury share repurchases and any compensation cost previously recognized is reversed in the period of forfeiture.

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3. ACQUISITION OF TRUST BANCORP

On June 3, 2004, the Company announced that it has entered into a definitive agreement to acquire Trust Bancorp, parent company of Trust Bank, in an all-stock transaction valued at approximately $32.9 million. Trust Bank, which was founded in 1981, is headquartered in Monterey Park, California and provides community banking services to ethnic retail and commercial customers through four branches located in Monterey Park, Arcadia, Rowland Heights, and West Covina. At June 30, 2004, Trust Bank had total assets of $229.0 million, total loans of $161.2 million, and total deposits of $187.2 million. The acquisition has been approved by the Company’s primary regulators and is anticipated to be completed in the third quarter of 2004.

4. GOODWILL AND OTHER INTANGIBLES

Effective January 1, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 requires companies to cease amortizing goodwill that existed at June 30, 2001. The amortization of existing goodwill ceased on December 31, 2001. Goodwill resulting from acquisitions completed after June 30, 2001 is not 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 carrying amount of remaining goodwill amounted to $28.7 million at June 30, 2004 and December 31, 2003.

The Company also has premiums on acquired deposits which represent the intangible value of depositor relationships resulting from deposit liabilities assumed in various acquisitions. The Company amortizes premiums on acquired deposits using the straight-line method over 7 to 10 years. At June 30, 2004, the balance of deposit premiums totaled $6.5 million. The total amortization expense of deposit premiums totaled $1.0 million and $952 thousand for the six months ended June 30, 2004 and 2003, respectively. Estimated future amortization expense of premiums on acquired deposits is as follows: $1.0 million for the remaining two quarters of 2004, $2.1 million in 2005, $1.9 million in 2006, $885 thousand in 2007, $295 thousand in 2008 and 2009, and $74 thousand in 2010.

5. COMMITMENTS, GUARANTEES AND CONTINGENCIES

Credit Extensions—In the normal course of business, the Company has various outstanding commitments to extend credit that are not reflected in the accompanying interim consolidated financial statements. As of June 30, 2004, undisbursed loan commitments, commercial and standby letters of credit, and commitments to fund residential mortgage, commercial real estate and commercial business loan applications in process amounted to $907.6 million, $373.9 million, and $476.2 million, respectively.

Guarantees—From time to time, the Company sells loans with recourse in the ordinary course of business. For loans that have been sold with recourse, the recourse component is considered a guarantee. When the Company sells a loan with recourse, it commits to stand ready to perform, if the loan defaults, and to make payments to remedy the default. As of June 30, 2004 and December 31, 2003, loans sold with recourse, comprised entirely of residential single family mortgage loans, totaled $42.8 million and $53.0 million. The Company’s recourse reserve related to these loans totaled $64 thousand and $79 thousand as of June 30, 2004 and December 31, 2003.

The Company also sells loans without recourse that may have to be subsequently repurchased if a defect that occurred during the loans origination process results in a violation of a representation or warranty made in connection with the sale of the loan. When a loan sold to an investor without recourse fails to perform according to its contractual terms, the investor will typically review the loan file to determine whether defects in the origination process occurred and if such defects give rise to a violation of a representation or warranty made to the investor in connection with the sale. If such a defect is identified, the Company may be required to either repurchase the loan or indemnify the investor for losses sustained.

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If there are no such defects, the Company has no commitment to repurchase the loan. As of June 30, 2004 and December 31, 2003, the amount of loans sold without recourse totaled $477.0 million and $474.8 million, which substantially represents the unpaid principal balance of the Company’s loans serviced for others portfolio.

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—As previously reported, the California Franchise Tax Board (the “FTB”) announced that it is taking the position that certain tax deductions related to regulated investment companies (“RICs”) will be disallowed pursuant to California Senate Bill 614 and California Assembly Bill 1601, which were signed into law in the fourth quarter of 2003. East West Securities Company, Inc. (the “Fund”), a regulated investment company formed and funded in July 2000 to raise capital in an efficient and economical manner was dissolved on December 30, 2002 as a result of, among other reasons, proposed legislation to change the tax treatments of RICs. The Fund provided state tax benefits beginning in 2000 until the end of 2002, when the RIC was officially dissolved. While the Company’s management continues to believe that the tax benefits realized in previous years were appropriate and fully defensible under the existing tax codes at that time, the Company has deemed it prudent to participate in the voluntary compliance initiative (“VCI”) offered by the State of California to avoid certain potential penalties should the FTB choose to litigate its recently announced position about the tax treatment of RICs for periods prior to enactment of the legislation described above and should the FTB be successful in that litigation.

Pursuant to the VCI program, the Company filed amended California income tax returns on April 15, 2004 for all affected years and paid the resulting taxes and interest due to the FTB. This amounted to an aggregate payment of $14.2 million for tax years 2000, 2001, and 2002. The Company’s management continues to believe that the tax deductions are appropriate and, as such, refund claims have also been filed for the amounts paid with the amended returns. These refund claims are reflected as assets in the Company’s consolidated financial statements. As a result of these actions—amending the Company’s California income tax returns and subsequent related filing of refund claims—the Company retains its potential exposure for assertion of an accuracy-related penalty should the FTB prevail in its position, in addition to our risk of not being successful in our refund claim for taxes and interest. The Company’s potential exposure to all other penalties, however, has been eliminated through this course of action. Management will continue to work with counsel to follow the latest developments with regards to this matter as well as actively pursue the Company’s refund claims.

6. STOCKHOLDERS’ EQUITY

Stock Split—On May 18, 2004, the Company’s Board of Directors approved a two-for-one stock split effected in the form of a 100% stock dividend. Shareholders of record at the close of business on June 3, 2004 received one additional share of common stock for each share of common stock held by them on that date. The additional shares were distributed by the Company’s transfer agent on or about June 21, 2004. Prior to the stock split, the Company had 25,141,002 shares of common stock issued and outstanding. The stock dividend increased the number of shares issued and outstanding to 50,282,004.

Earnings Per Share—The actual number of shares outstanding at June 30, 2004 was 50,308,122. 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.

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The following tables set forth earnings per share calculations for the three and six months ended June 30, 2004 and 2003.

Quarterly Dividends—The Company’s Board of Directors declared and paid quarterly common stock cash dividends of $0.05 per share payable on or about February 11, 2004 to shareholders of record on January 28, 2004. On April 16, 2004, the Board of Directors declared another quarterly common stock cash dividend of $0.05 per share payable on or about May 12, 2004 to shareholders of record on April 28, 2004. Cash dividends totaling $5.0 million were paid to the Company’s shareholders during the first half of 2004.

7. PRIVATE PLACEMENT OFFERINGS

On March 1, 2004, the Company completed a private placement of common stock with two institutional investors amounting to approximately $30 million. The transaction involved the sale of 1,217,132 shares of common stock at a purchase price of approximately $24.65 per share. In addition, the Company granted the investors a right to purchase up to an additional 405,712 shares of common stock at approximately $24.65 per share, or up to an additional $10.0 million. The investors have until October 6, 2004 to exercise the option to purchase an additional $10.0 million of the Company’s common stock. Net proceeds from the offering were used to support the continued growth of the Company. During April 2004, the Company completed the registration of the common stock sold to the investors as well as the shares covered by the investors’ options with the Securities and Exchange Commission under the Securities Act of 1933.

On June 10, 2004, we issued another $10.0 million in junior subordinated debt securities in a separate private placement transaction. Similar to our previous offerings, these securities were issued through a newly formed statutory business trust, East West Capital Trust IV (“Trust IV”), which is a wholly-owned subsidiary of the Company. The proceeds from the debt securities are loaned by Trust IV to the Company and are reported in the consolidated balance sheet as junior subordinated debt. The securities have a scheduled maturity date of June 23, 2034 and bear an initial interest rate of 3.96% per annum. The interest rate adjusts quarterly based on the 3-Month Libor plus 2.55%. Interest payments are due quarterly on

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January 23, April 23, July 23, and October 23 of each year. This additional issuance of capital securities provides the Bank with a cost-effective means of obtaining Tier 1 capital for regulatory purposes.

8. BUSINESS SEGMENTS

The Company’s management utilizes an internal reporting system to measure the performance of its various operating segments. The Company has identified four principal operating segments 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 throughout 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 while 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. The Company allocates indirect costs, including overhead expense, to the various 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.

The following tables present the operating results and other key financial measures for the individual operating segments for the three and six months ended June 30, 2004 and 2003:

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ITEM 2.          MANAGEMENT’S DISCUSSION AND ANALYSIS OF 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. This information is intended to facilitate the understanding and assessment of significant changes and trends related to our financial condition and the results of our operations. This discussion and analysis should be read in conjunction with our 2003 annual report on Form 10-K for the year ended December 31, 2003, and the accompanying interim unaudited consolidated financial statements and notes thereto. Information related to share volume and per share amounts have been adjusted to reflect the two-for-one stock split that became effective on or about June 21, 2004.

Critical Accounting Policies

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in our consolidated financial statements and accompanying notes. We believe that the judgments, estimates and assumptions used in the preparation of our consolidated financial statements are appropriate given the factual circumstances as of June 30, 2004.

Various elements of our accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, we have identified four accounting policies that, due to judgments, estimates and assumptions inherent in those policies, are critical to an understanding of our consolidated financial statements. These policies relate to the classification and valuation of investment securities, the methodologies that determine our allowance for loan losses, the valuation of retained interests and mortgage servicing assets related to securitizations and sales of loans, and the calculation of accrued income taxes. In each area, we have identified the variables most important in the estimation process. We have used the best information available to make the estimations necessary to value the related assets and liabilities. Actual performance that differs from our estimates and future changes in the key variables could change future valuations and impact net income.

Our significant accounting principles are described in greater detail in our 2003 Annual Report on Form 10-K in the “Critical Accounting Policies” section of Management’s Discussion and Analysis and in Note 1 to the Consolidated Financial Statements—“Significant Accounting Policies” which are essential to understanding Management’s Discussion and Analysis of Results of Operations and Financial Condition.

Overview

During the second quarter of 2004, we again generated record earnings totaling $18.0 million, or $0.36 per basic share and $0.35 per diluted share, compared with $14.7 million, or $0.31 per basic share and $0.30 per diluted share, reported during the second quarter of 2003. Continued strong growth in loans, improved efficiencies in our operating platform, and continued solid asset quality contributed to our earnings performance for the second quarter of 2004. The annualized return on average assets during the second quarter of 2004 was 1.56%, compared with 1.67% for the same quarter in 2003. The annualized return on average equity decreased to 17.51% during the second quarter of 2004, compared to 18.56% during the same period in 2003. Based on the operating results for the first half of the year, the anticipated completion of the Trust Bancorp acquisition, and the recent 25 basis point increase in interest rates, management expects net income per diluted common share for the full year of 2004 to be in the range of approximately 18% to 19% higher than the net income per diluted common share for 2003. This updated guidance, which is slightly higher than previously reported, is based on a stable efficiency ratio and interest

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rate environment for the second half of the year, and projected annualized loan and deposit growth of approximately 25% and 15%, respectively, for the remainder of 2004.

During the second quarter of 2004, our Board of Directors approved a two-for-one split effected in the form of a 100% stock dividend. Shareholders of record at the close of business on June 3, 2004 received one additional share of common stock for each share of common stock held by them on that date. The additional stock was distributed to shareholders of record on or about June 21, 2004. We believe that the stock split will enhance the liquidity of the stock and make it more accessible to a broader range of investors.

As mentioned earlier, another major highlight of the second quarter of 2004 was the signing of a definitive agreement to acquire Trust Bancorp, parent company of Trust Bank. Trust Bank, which was founded in 1981, offers community banking services to a range of retail and commercial customers through four branches located in Monterey Park, Rowland Heights, West Covina, and Arcadia. The proposed transaction has received the requisite approvals from our primary regulators and we anticipate the acquisition to be completed sometime in the middle of the third quarter of 2004. Upon the completion of this merger, we will expand our already strong franchise in the ethnic Chinese-American retail and commercial sector and extend our market coverage in our primary niche markets. We estimate the acquisition to be accretive to 2004 earnings by approximately $0.02 per share.

Total consolidated assets at June 30, 2004 increased 21% to $4.91 billion, compared with $4.06 billion at December 31, 2003. A 24% growth in gross loans was the primary driver of this increase, rising to a record $4.07 billion at June 30, 2004. We attribute overall loan growth to the continued expansion of lending relationships with new as well as established customers, increased loan origination volume from our branch network, and the addition of personnel to enhance and support loan and deposit growth. Based on our current production levels and pipeline of quality lending opportunities, we project loan growth for the full year of 2004 to be approximately 36% over yearend 2003 levels, compared to our initial estimate of 18% to 20%. The increased growth projection reflects the favorable economic conditions in our markets, our expanded delivery platforms and loan origination capabilities at the branch level, as well as enhanced lending opportunities afforded by the Trust Bank acquisition.

Total deposits grew 15% to $3.82 billion at June 30, 2004, compared to $3.31 billion at December 31, 2003. Core deposits increased 17% to $2.09 billion at June 30, 2004 predominantly as a result of expanded commercial relationships, as well as programs and products in the retail branches that better align with the needs of both smaller businesses and retail customers. Time deposits increased 14% to $1.74 billion at June 30, 2004 relative to December 31, 2003, benefiting directly from the implementation of a retail promotional program that spanned the first and second quarters of 2004. We also took advantage of attractive market pricing for FHLB advances which increased 103% to $571.3 million at June 30, 2004, compared to $281.3 million at December 31, 2003. This will provide us with cost-effective longer-term financing to support our anticipated loan production activity throughout the year.

Total average assets increased 32% to $4.64 billion during the second quarter of 2004, compared to $3.51 billion for the same quarter in 2003, primarily due to growth in average loans partially offset by a moderate reduction in average investment securities. Proceeds from sales and repayments of investment securities were used to fund a portion of the Company’s loan growth. Total average loans grew to $3.84 billion during the quarter ended June 30, 2004, an increase of 45% over the prior year quarter. With the exception of trade finance loans, all loan categories experienced double-digit growth during the quarter, with the most significant contributions coming from residential multifamily and commercial real estate loans. Total average deposits rose 20% during the second quarter of 2004 to $3.63 billion, compared to $3.03 billion for the same quarter in 2003. Noninterest-bearing demand deposits, money market accounts, and time deposits had the most noteworthy impact on deposit growth during the period.

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