UNITED STATES SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
(Mark One)
Commission File Number: 000-50245
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 þ No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes þ No o
As of October 29, 2004, there were 23,323,338 outstanding shares of the issuer’s Common Stock, $0.001 par value.
Table of Contents
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PART I
FINANCIAL INFORMATION
NARA BANCORP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION(Unaudited)
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LIABILITIES AND STOCKHOLDERS’ EQUITY
See accompanying notes to condensed consolidated financial statements
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CONDENSED CONSOLIDATED STATEMENTS OF INCOMEFor the three and nine months ended September 30, 2004 and 2003(Unaudited)
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CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITYNINE MONTHS ENDED SEPTEMBER 30, 2004 and 2003(Unaudited)
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWSNINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003(Unaudited)
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See accompanying notes to consolidated financial statements
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Notes to unaudited Consolidated Financial Statements
Nara Bancorp, Inc. (“Nara Bancorp”, on a parent-only basis, and “we” or “our” on a consolidated basis), incorporated under the laws of the State of Delaware in 2000, is a bank holding company, headquartered in Los Angeles, California, offering a full range of commercial banking and consumer financial services through its wholly owned subsidiary, Nara Bank, N.A., a national bank (“Nara Bank”) with branches in California and New York as well as Loan Production Offices in California, Washington, Colorado, Georgia, Illinois, New Jersey, and Virginia.
Our condensed consolidated financial statements included herein have been prepared without an audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures, normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted pursuant to such SEC rules and regulations.
The condensed consolidated financial statements include the accounts of Nara Bancorp and its wholly owned subsidiaries, principally Nara Bank, N. A. (the “Bank”). All intercompany transactions and balances have been eliminated in consolidation.
Nara Bancorp also has five special-purpose subsidiaries that were formed for capital-raising transactions: Nara Capital Trust I, Nara Statutory Trust II, Nara Capital Trust III, Nara Statutory Trust IV, and Nara Statutory Trust V. With the adoption of FASB Interpretation No. 46 (“FIN 46), Nara Bancorp deconsolidated the five grantor trusts as of December 31, 2003. As a result, the junior subordinated debentures issued by Bancorp to the grantor trusts, totaling $39.3 million, are reflected in our consolidated balance sheet in the liabilities section at September 30, 2004 and December 31, 2003, under the caption as “junior subordinated debentures.” We also recorded $2.1 million in other assets in the consolidated statement of financial condition at September 30, 2004 and December 31, 2003 for the common capital securities issued by the issuer trusts.
We also believe that we have made all adjustments necessary to fairly present our financial position and the results of our operations for the interim period ended September 30, 2004. Certain reclassifications have been made to prior period figures in order to conform to the September 30, 2004 presentation. The results of operations for the interim period are not necessarily indicative of results for the full year.
These condensed consolidated financial statements should be read along with the audited consolidated financial statements and accompanying notes included in our 2003 Annual Report on Form 10-K/A.
Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, encourages, but does not require, companies to record compensation cost for stock-based employees compensation plans at fair value. We have elected to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees, and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the fair value of our stock at the date of grant over the grant price.
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We have adopted the disclosure only provisions of SFAS No. 123. Had compensation cost for our stock-based compensation plans been determined based on the fair value at the grant date for awards consistent with the provisions of SFAS No. 123, our net income and earnings per share would have been reduced to the pro forma amounts as follows:
The weighted-average fair values of options granted during the third quarter of 2004 were $6.76 and $4.63, respectively. The fair values of options granted under our stock option plans during the third quarter of 2004 and 2003 were estimated on the date of grant using the Black-Scholes option-pricing model, with the following weighted-average assumptions used: 0.57% dividends yield, volatility of 38.49% with risk-free interest rate of 4.0 % and expected lives of five years for 2004 and 0.5% dividend yield, volatility of 28.16%, risk-free interest rate of 2.8% and expected life of three years for 2003.
On September 3, 2004, we declared a $0.0275 per share cash dividend paid on October 14, 2004 to stockholders of record at the close of business on September 30, 2004. On May 17, 2004, we declared a $0.0275 per share cash dividend paid on July 14, 2004 to stockholders of record at the close of business on June 30, 2004. On March 11, 2004, we declared a $0.025 per share cash dividend paid on April 12, 2004 to stockholders of record at the close of business on March 31, 2004.
On May 17, 2004, Nara Bancorp announced that its Board of Directors approved a two-for-one stock split of its common stock, effected in the form of a 100% stock dividend, which was distributed on June 15, 2004 to stockholders of record on close of business on May 31, 2004. The effect of this dividend is that stockholders received one additional share of Nara Bancorp common stock for each share owned. All share and per share information have been restated to reflect the stock split.
Basic EPS excludes dilution and is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted to common stock that would then share in our earnings.
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The following table shows how we computed basic and diluted EPS for the periods ended September 30, 2004 and 2003.
Certain Small Business Administration (“SBA”) loans that we have the intent to sell prior to maturity have been designated as held for sale at origination and are recorded at the lower of cost or market value on an aggregate basis. A valuation allowance is established if the aggregate market value of such loans is lower than their cost and operations are charged or credited for valuation adjustments. A portion of the premium on sale of SBA loans is recognized as gain on sale of loans at the time of the sale. The remaining portion of the premium (relating to the portion of the loan retained) is deferred and amortized over the remaining life of the loan as an adjustment to yield. Servicing assets are recognized when loans are sold with servicing retained. Servicing assets are recorded based on the present value of the contractually specified servicing fee, net of servicing costs, over the estimated life of the loan, using a discount rate based on the related note rate, plus 1 to 2%. Servicing assets are amortized in proportion to and over the period of estimated future net servicing income.
We periodically evaluate servicing assets for impairment. At September 30, 2004, the fair value of servicing assets was determined using a weighted-average discount rate of 7.1% and a prepayment speed of 11.2%. At December 31, 2003, the fair value of servicing assets was determined using a weighted-average discount rate of 6.9% and a prepayment speed of 11.4%. For purposes of measuring impairment, servicing assets are stratified by loan type. An impairment is recognized if the carrying value of servicing assets exceeds the fair value of the stratum. The fair values of servicing assets exceeded the carrying amounts and were $4,290,000 and $3,376,000 at September 30, 2004 and December 31, 2003, respectively.
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An interest-only strip is recorded based on the present value of the excess of the total future income from serviced loans over the contractually specified servicing fee, calculated using the same assumptions as used to value the related servicing assets. Such interest-only strip is accounted for at estimated fair value, with unrealized gain or loss, net of tax, recorded as a component of accumulated other comprehensive income (loss).
EITF Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, contains accounting guidance regarding other-than-temporary impairment on securities that was to take effect for the quarter ended September 30, 2004. However, the effective date of portions of this guidance has been delayed, and more interpretive guidance is to be issued in the near future. The effect of this new and pending guidance on the Company’s financial statements is not known, but it is possible this guidance could change management’s assessment of other-than-temporary impairment in future periods.
As part of our asset and liability management strategy, we may engage in derivative financial instruments, such as interest rate swaps, with the overall goal of minimizing the impact of interest rate fluctuations on our net interest margin. During the second and fourth quarters of 2002, we entered into various interest rate swap agreements as summarized in the table below. Our objective for the interest rate swaps is to manage asset and liability positions in connection with our overall strategy of minimizing the impact of interest rate fluctuations on our interest rate margin. As part of our overall risk management, our Asset Liability Committee monitors and measures the interest rate risk and the sensitivity of our assets and liabilities to interest rate changes, including the impact of the interest rate swaps.
Under the swap agreements, we receive a fixed rate and pay a variable rate based on H.15 Prime. The swaps qualify as cash flow hedges under SFAS No. 133,Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted, and are designated as hedges of the variability of cash flows we receive from certain of our Prime-indexed loans. In accordance with SFAS No. 133, these interest rate swap agreements are measured at fair value and reported as assets or liabilities on the consolidated statement of financial condition. The portion of the change in the fair value of the interest rate swaps that is deemed effective in hedging the cash flows of the designated assets are recorded in accumulated other comprehensive income (“OCI”), net of tax and reclassified into interest income when such cash flows occur in the future. Any ineffectiveness resulting from the hedges is recorded as a gain or loss in the consolidated statement of income as a part of non-interest income. As of September 30, 2004, the amounts in accumulated OCI associated with these cash flows totaled a gain of $445,009 (net of tax of $296,672), of which $130,589 is expected to be reclassified into interest income within the next 12 months. As of September 30, 2004, the maximum length of time over which we are hedging our exposure to the variability of future cash flow is approximately 8 years.
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Interest rate swap information at September 30, 2004 is summarized as follows:
During the third quarter of 2004 and 2003, interest income received from swap counterparties were $723,562 and $893,278, respectively. For the nine months ended September 30, 2004 and 2003, interest income received from swap counterparties was approximately at $2.5 million. At September 30, 2004 and 2003, we pledged as collateral to the interest rate swap counterparties agency securities with a book value of $2.0 million and real estate loans of $2.1 million.
Our management utilizes an internal reporting system to measure the performance of our various operating segments. We have identified three principal operating segments for the purposes of management reporting: banking operation, trade finance (“TFS”), and small business administration (“SBA”). Information related to our remaining centralized functions and eliminations of intersegment amounts have been aggregated and included in banking operation. Although all three operating segments offer financial products and services, they are managed separately based on each segment’s strategic focus. The banking operation segment focuses primarily on commercial and consumer lending and deposit operations throughout our branch network. The TFS segment focuses primarily on allowing our import/export customers to handle their international transactions. Trade finance products include the issuance and collection of letters of credit, international collection, and import/export financing. The SBA segment provides our customers with the U.S. SBA guaranteed lending program.
Operating segment results are based on our internal management reporting process, which reflects assignments and allocations of capital, certain operating and administrative costs and the provision for loan losses. Non-interest income and non-interest expense, including depreciation and amortization, directly attributable to a segment are assigned to that business. We allocate 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. We allocate the provision for loan losses based on the origination of new loans for the period. We evaluate the overall performance based on profit or loss from operations before income taxes excluding nonrecurring gains and losses. Future changes in our management structure or reporting methodologies may result in changes to the measurement of operating segment results.
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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, 2004 and 2003.
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For the three months ended September 30, 2004, we recorded an additional impairment charge of $442,000 on floating rate agency preferred stocks as a result of decline in market value due to the interest rate environment. For the nine months ended September 30, 2004, we recorded total impairment charges of $2.2 million on these securities. Management determined that the unrealized losses on these securities should be considered other than temporary and therefore recorded as impairment charges as these investments have had significant unrealized loss positions for more than one year and it is difficult to forecast significant market value recovery in a reasonable time frame.
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The following is management’s discussion and analysis of the major factors that influenced our consolidated results of operations and financial condition for the three and nine months periods ended September 30, 2004 and September 30, 2003. This analysis should be read in conjunction with our Annual Report on Form 10-K/A for the year ended December 31, 2003 and with the unaudited consolidated financial statements and notes set forth in this report.
GENERAL
Selected Financial Data
The following table sets forth certain selected financial data concerning the periods indicated:
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Forward-Looking Information
Certain matters discussed in this report may constitute forward-looking statements under Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. There can be no assurance that the results described or implied in such forward-looking statements will, in fact, be achieved and actual results, performance, and achievements could differ materially because our business involves inherent risks and uncertainties. Risks and uncertainties include possible future deteriorating economic conditions in our areas of operation; interest rate risk associated with volatile interest rates and related asset-liability matching risk; liquidity risks; risk of significant non-earning assets, and net credit losses that could occur, particularly in times of weak economic conditions or times of rising interest rates; risks of available for sale securities declining significantly in value as interest rates rise; and regulatory risks associated with the variety of current and future regulations which we are subject to. For additional information concerning these factors, see “Item 1. Business — Factors That May Affect Business or the Value of Our Stock” contained in our Annual Report on Form 10-K/A for the year ended December 31, 2003.
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Critical Accounting Policies
The preparation of the condensed consolidated 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 September 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 six 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 treatment of non-accrual loans, the valuation of properties acquired through foreclosure, the valuation of retained interests and mortgage servicing assets related to the sales of Small Business Administration loans, and the valuation of derivative instruments. 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/A 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. There has been no material modification to these policies during the quarter ended September 30, 2004
RESULTS OF OPERATIONS
Net income
Our net income for the three months ended September 30, 2004 was $5.0 million or $0.20 per diluted share compared to $3.7 million or $0.16 per diluted share for the same quarter of 2003, which represented an increase of $1.3 million or 35%. The increase resulted primarily from an increase in net interest income due to growth in our loan portfolio. The annualized return on average assets was 1.42% for the third quarter of 2004 compared to 1.34% for the same period of 2003. The annualized return on average equity was 21.34 % for the third quarter of 2004 compared to 19.10% for the same period of 2003. The resulting efficiency ratio was 56.61% for the three months ended September 30, 2004 compared with 55.95% for the same period of 2003.
Our net income for the nine months ended September 30, 2004 was $13.7 million or $0.56 per diluted share compared to $10.4 million or $0.45 per diluted share for the same period of 2003, an increase of approximately $3.3 million or 32%. The increase resulted primarily from a growth in our loan portfolio, which in turn resulted in higher interest income, and from the sale of loans we originated offset by non-interest expense.
The annualized return on average assets was 1.37 % for the nine months ended September 30, 2004 compared to 1.32% for the same period of 2003. The annualized return on average equity was 19.83% for the nine months ended September 30, 2004 compared to 19.13% for the same period of 2003. The efficiency ratios were 54.78% for the nine months ended September 30, 2004 compared with 56.48% for the corresponding period of 2003. Excluding the one-time impairment charge on investment securities of $2.2 million, the efficiency ratio for the nine months ended September 30, 2004 was 52.78%.
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Net Interest Income and Net Interest Margin
Net Interest Income
The principal component of our earnings is net interest income, which is the difference between the interest and fees earned on loans, interest rate swaps and investments and the interest paid on deposits and borrowed funds. When net interest income is expressed as a percentage of average interest-earning assets, the result is the net interest margin. Net interest spread is the yield on average interest-earning assets less the cost of average interest-bearing deposits and borrowed funds. Net interest income is affected by changes in the volume of interest-earning assets and interest-bearing liabilities as well as by changes in yield earned on interest-earning assets and rates paid on interest-bearing liabilities.
Net interest income before provision for loan losses was $14.9 million for the three months ended September 30, 2004, an increase of $3.3 million, or 28% from net interest income of $11.6 million for the same quarter of 2003. This increase was primarily due to an increase in average earning assets, which increased $278.5 million or 27% to $1,304.6 million for the third quarter of 2004 from $1,026.1 million for the same quarter of 2003.
Interest income for the third quarter of 2004 was $19.9 million, which represented an increase of $4.3 million or 28% over interest income of $15.6 million for the same quarter of 2003. The increase was the net result of a $4.4 million increase in interest income due to an increase in volume of average interest-earning assets (volume change) off-set by a $91,000 decrease in interest income due to a decline in the yield earned on those average interest-earning assets (rate change). Interest expense for the third quarter of 2004 was $5.0 million, an increase of $1.1 million or 27% over interest expense of $3.9 million for the same quarter of 2003. The increase was primarily the result of a $1.0 million increase in interest expense due to an increase in volume of average interest-bearing liabilities (volume change) offset by a $ 35,000 increase in interest expense due to a decline in the rates paid on interest-bearing liabilities (rate change).
Net interest income before provision for loan losses was $42.3 million for the nine months ended September 30, 2004, which represented an increase of $9.7 million or 30% from net interest income of $32.5 million for the same period of 2003. The increase was the primarily due to an increase in average earning assets. Average earning assets increased $266.8 million or 27% to $1,238.0 million for the nine months ended September 30, 2004, from $971.2 million for the same period of 2003.
Interest income for the nine months ended September 30, 2004 was $55.4 million, an increase of $10.8 million or 24% over interest income of $44.6 million for the same period of 2003. The increase was the net result of a $13.5 million increase in interest income due to an increase in volume of average interest-earning assets (volume change) off-set by a $2.8 million decrease in interest income due to a decline in the yield earned on those average interest-earning assets (rate change). Interest expense for the nine months ended September 30, 2004 was $13.1 million, which represented an increase of $1.0 million or 8% over interest expense of $12.1 million for the same period of 2003. The increase was the net result of a $3.1 million increase in interest expense due to an increase in volume of average interest-bearing liabilities (volume change) offset by a $2.1 million decrease in interest expense due to a decline in the rates paid on interest-bearing liabilities (rate change).
Net Interest Margin
The yield on average interest-earning assets increased to 6.10% for the third quarter of 2004 compared with 6.07% for the same quarter of 2003. The increase was primarily due to an increase in market interest rates of our loans, including a 75 basis points increase by Federal Reserve Board in the prime rate during the third quarter of 2004. The average cost of interest-bearing liabilities decreased to 2.08% for the third quarter of 2004 from 2.11% for the same quarter of 2003. The net interest margin was 4.57% for the third quarter of 2004 compared with 4.54% for the same quarter of 2003. Despite the increase in prime rate during the third quarter of 2004, the
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net interest margin only increased by 3 basis points primarily because the rate increases have not been fully priced into the loan yield. The increase in cost of interest bearing demand deposits was a direct result of money market account promotion during the second quarter of 2004, which was fully priced during the third quarter with the cost of approximately 2%. The average balance of money market accounts, increased $254.4 million for the third quarter of 2004 to $345.6 million from $91.2 million for the same quarter of 2003.
The yield on average interest-earning assets decreased by 17 basis points to 5.96% for the nine months ended September 30, 2004 compared with 6.13% for the nine months ended September 30, 2003. The average cost of interest-bearing liabilities decreased by 34 basis points to 1.94% for the nine months ended September 30, 2004 from 2.28% for the nine months ended September 30, 2003. The net interest margin was 4.55% for the nine months ended September 30, 2004 compared with 4.47% for the same period of 2003.
The following table presents our condensed consolidated average balance sheet information, together with interest rates earned and paid on the various sources and uses of funds for the three and nine months periods indicated:
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The following table illustrates the changes in our interest income, interest expenses, amount attributable to variations in interest rates, and volumes for the periods indicated. The variances attributable to simultaneous volume and rate changes have been allocated to the changes due to volume and the changes due to rate categories in proportion to the relationship of the absolute dollar amount attributable solely to the change in volume and to the change in rate.
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Provision for Loan Losses
The provision for loan losses reflects our judgment of the current period cost associated with credit risk inherent in our loan portfolio. The loan loss provision for each period is dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, assessments by management, third parties’ and regulators’ examination of the quality of the loan portfolio, the value of the underlying collateral on problem loans and the general economic conditions in our market areas. Specifically, the provision for loan losses represents the amount charged against current period earnings to achieve an allowance for loan losses that, in our judgment, is adequate to absorb probable incurred losses in our loan portfolio. Periodic fluctuations in the provision for loan losses result from management’s assessment of the adequacy of the allowance for loan losses; however, actual loan losses may vary from current estimates.
We recorded a $900,000 in provision for loan losses in the third quarter of 2004 compared to $1.4 million in the same quarter of 2003. For the nine months ended September 30, 2004, we recorded $3.7 million in provision for loan losses compared to $3.8 million for the nine months ended September 30, 2003. These changes reflect the results of our review and analysis of the loan portfolio and the adequacy of our existing allowance for loan losses in light of the growth experienced in our loan portfolio. We believe that the allowance is sufficient for the probable incurred losses at September 30, 2004. Refer to Allowance for Loan Losses section for further discussion.
Non-interest Income
Non-interest income includes revenues earned from sources other than interest income. It is primarily comprised of service charges and fees on deposits accounts, fees received from letter of credit operations, gain or losses on interest rate swaps and gains on sale of SBA loans and investment securities.
Non-interest income for the third quarter of 2004 was $6.4 million compared to $5.2 million for the same quarter of 2003, an increase of $1.2 million, or 23%, primarily as a result of an increase in gain on sale of loans
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offset by the recognition of an additional impairment charges on the securities of $442,000. Gain on sale of SBA loans increased $974,000 or 86% to $2.1 million for the third quarter of 2004 from $1.1 million for the same quarter of 2003. During the third quarter of 2004 we originated $47.6 million in SBA loans and sold $26.6 million. During the third quarter of 2003, we originated $16.1 million in SBA loans and sold $13.9 million. During the third quarter of 2004 we recognized a gain of $196,000 from the sale of real estate loans. Detailed breakdown of other non-interest income components are in the table below.
Non-interest income for the nine months ended September 30, 2004 was $15.9 million compared to $14.9 million for the same period of 2003, which represented an increase of $997,000 or 7%, primarily as a result of increase in gains on sale of loans, service fee income on SBA loans, loan referral income, offset by decrease in valuation of interest rate swaps and the recognition of other than temporary impairment charges in U.S. Agency Preferred Stock . For the nine months ended September 30, 2004 we recorded an impairment charges of $2.2 million on floating rate agency preferred stocks as a result of decline in market value due to the interest rate environment. Gain on sale of SBA loans for the nine months ended September 30, 2004 was $4.8 million, increased $1.6 million or 51% from $3.2 million for the same period of 2003. We originated $95.2 million in SBA loans and sold $58.9 million during the first nine months of 2004. During the same period of 2003, we originated $56.5 million and sold $42.3 million. During the nine months ended September 30, 2004, we recognized loan referral income of $747,000 from the loan sale referral program entered into with GE Capital and Zion Bancorp. We also recognized a gain of $196,000 during the nine months of 2004 from the sale of real estate loans. Service fee income on SBA increased $147,000 or 80% to $330,000 for the nine months of 2004, compared to $183,000 for the same period of 2003. This increase is primarily due to increase in servicing assets from the increased sale of SBA loans. We recognized a loss of $194,000 from the valuation of interest rate hedge during the nine months ended September 30, 2004, compared to a gain of $437,000 during the same period of 2003.
The breakdown of changes in our non-interest income by category is illustrated below:
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Non-interest Expense
Non-interest expense for the third quarter of 2004 was $12.0 million compared to $9.4 million for the same quarter of 2003, an increase of $2.6 million or 28%, primarily due to increases in salaries and benefits, professional fees and advertising and marketing expenses. Salaries and benefits increased $1.2 million or 25% to $6.1 million for the third quarter of 2004 compared to $4.9 million for the same quarter of 2003. This increase is mainly due to an increase in staffs to support new branches such as Rowland Heights and an increase in compensation for those who are tied to their performances. Adverting and marketing expenses for the third quarter of 2004 increased $224,000 or 82% to $498,000 from $274,000 for the same quarter of 2003. These increases were due to our continued efforts to serve and market to our customers and community through advertisement, financial supports and events. Professional fees for the third quarter of 2004 also increased $277,000 or 56% to $769,000 from $492,000 for the same quarter of 2003. This increase was due to an expense incurred to comply with the Sarbanes-Oxley Act (“SOX”)
Non-interest expense for the nine months ended September 30, 2004 was $31.9 million compared to $26.8 million for the same period of 2003, an increase of $5.1 million or 19%, primarily due to the increases in salaries and benefits, occupancy expense and professional fees. Salaries and benefits increased primarily due to increase in staffs to support branch expansions such as Wilshire and Rowland Height branches. Occupancy expenses increased $619,000 or 18% to $4.0 million for the nine months of 2004 from $3.4 million for the corresponding period of 2003. This increase was due to the acquisition and opening of branches in additional to general increases in leases. Professional fees also increased $515,000 or 53% to $1.5 million for the nine months of 2004 from $973,000 for the corresponding period of 2003. This increase was primarily due to the expenses related to the compliance with Bank Secrecy Act and SOX.
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The breakdown of changes in our non-interest expense is illustrated below:
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Provision for Income Taxes
The provision for income taxes was $3.3 million and $2.4 million on income before taxes of $8.3 million and $6.1 million for the three months ended September 30, 2004 and 2003, respectively. The effective tax rate for the quarter ended September 30, 2004 was 40% compared with 39% for the quarter ended September 30, 2003.
The provision for income taxes was $8.9 million and $6.5 million on income before taxes of $22.6 million and $16.9 million for the nine months ended September 30, 2004 and 2003, respectively. The effective tax rate for the nine months ended September 30, 2003 was 40% compared with 39% for the nine months ended September 30, 2003.
Financial Condition
At September 30, 2004, our total assets were $1.4 billion, an increase of $159.0 million or 13% from $1.3 million at December 31, 2003. The growth was primarily due to increases in our loans funded by growth in deposits.
Loan Portfolio
We carry all loans (except for certain SBA loans held-for-sale) at face amount, less payments collected, net of deferred loan origination fees and costs and the allowance for loan losses. SBA loans held-for-sale are carried at the lower of cost or market in aggregate. Interest on all loans is accrued daily. Once a loan is placed on non-accrual status, accrual of interest is discontinued and previously accrued interest is reversed. Loans are placed on non-accrual status when principal and interest on a loan is past due 90 days or more, unless a loan is both well secured and in process of collection.
As of September 30, 2004, our gross loans (net of unearned fees) increased by $165.0 million or 17% to $1,162.3 million from $997.3 million at December 31, 2003. The commercial loans, which include domestic commercial, international trade finance, SBA loans, and equipment leasing, at September 30, 2004 increased by $66.5 million or 18 % to $426.7 million from $360.2 million at December 31, 2003. Real estate and construction loans increased by $96.1 million or 17% to $672.0 million from $575.9 million at December 31, 2003. Management continued to make efforts in maintaining balanced mix in the loan portfolio.
The following table illustrates our loan portfolio by amount and percentage of gross loans in each major loan category at the dates indicated:
We normally do not extend lines of credit and make loan commitments to business customers for periods in excess of one year. We use the same credit policies in making commitments and conditional obligations as we do for extending loan facilities to our customers. We perform annual reviews of such commitments prior to the renewal. The following table shows our loan commitments and letters of credit outstanding at the dates indicated:
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At September 30, 2004, our nonperforming assets (nonaccrual loans, loans 90 days or more past due and still accruing interest, restructured loans, and other real estate owned) were $3.2 million, a decrease from $5.6 million at December 31, 2003. As of September 30, 2004 restructured loans that are current totaled $325,000. Nonperforming assets to total assets was 0.23% and 0.44% at September 30, 2004 and December 31, 2003, respectively. At September 30, 2004, nonperforming loans were $2.9 million, a decrease from $5.1 million at December 31, 2003. Of the $2.9 million in nonperforming loans, $2.0 million are fully secured by commercial real estate. At September 30, 2004, nonperforming loans to total gross loans was 0.25% compared to 0.51% at December 31, 2003.
The following table illustrates the composition of our nonperforming assets as of the dates indicated.
Allowance for Loan Losses
We maintain an allowance for loan losses to absorb probable incurred losses our loan portfolio. The allowance is based on our regular quarterly assessments of the probable estimated losses in the loan portfolio. Our methodologies for measuring the appropriate level of the allowance includes the combination of: (1) Historical Loss of a Migration Analysis for pools of loan and (2) a Specific Allocation Method for individual loans.
The following table provides a breakdown of the allowance for loan losses by category at September 30, 2004 and December 31, 2003:
Allocation of Allowance for Loan Losses
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The adequacy of the allowance is determined by management based upon an evaluation and review of the credit quality of the loan portfolio, consideration of historical loan loss experience, all relevant internal and external factors that affect loan collectibility, and other pertinent factors.
The Migration Analysis is a formula method based on our actual historical net charge-off experience for each loan type pools and a loan risk grade (Pass (net of cash secured loans), Special Mention, Substandard, Doubtful).
Central to the migration analysis is our credit risk rating system. Both internal, external contracted credit review examinations, and regulatory examinations are used to determine and validate loan risk grades. Our credit review system takes into consideration factors such as: borrower’s background and experience; historical and current financial condition; credit history and payment performance; industry and the economy; type, market value, volatility of the market value of collateral, lien position; and the financial strength of the guarantors.
To calculate our various loss allocation factors, we use a twelve-quarter rolling average of historical losses detailing charge-offs, recoveries, by loan type pool balances to determine the estimated credit losses for each type of non-classified and classified loans. Also, in order to reflect the impact of recent events more heavily, the twelve-quarter rolling average has been weighted. The most recent four quarters have been assigned a 40% weighted average while the next four quarters have been assigned a 33% weighted average and the last four quarters have been assigned a 27% weighted average. Using a twelve-quarter rolling average of historical losses was implemented as of the quarter ended March 31, 2004. Management believed that the eight quarter time period was not sufficient to cover the resolution of all loans in the pool. Management determined that a rolling analysis time frame typically covers a longer time period and began to track on a quarterly average basis for the twelve-quarters. The changes in the time period had no material impact on the migration analysis calculation.
Additionally, in order to systematically quantify the credit risk impact of trends and changes within the loan portfolio, we make adjustments to the Migration Analysis within established parameters. Our parameters for making adjustments are established under a Credit Risk Matrix that provides seven possible scenarios for each of the factors below. The matrix allows for three positive/decrease (Major, Moderate, and Minor), three negative/increase (Major, Moderate, and Minor), and one neutral credit risk scenarios within each factor for each loan type pool. Generally, the factors are considered to have no impact (neutral) to our historical migration ratios. However, if information exists to warrant adjustment to the Migration Analysis, we make the changes in accordance with the established parameters supported by narrative and/or statistical analysis. Our Credit Risk Matrix and the seven possible scenarios enable us to adjust the Loss Migration Ratio as much as 50 basis points in either direction (positive or negative) for each loan type pool. The following 9 factors considered in this matrix are patterned after the guidelines provided under the Interagency Policy Statement on the Allowance for Loan and Lease Losses dated December 23, 1993.
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Under the Specific Allocation method, management establishes specific allowances for loans where management has identified significant conditions or circumstances related to a specific individual credit that are believed to indicate the probability that a loss may be incurred. The specific allowance amount is determined by a method prescribed by the Statement of Financial Accounting Standards (SFAS) No. 114, Accounting by Creditors for Impairment of a Loan. The loans identified as impaired will be accounted for in accordance with one of the three acceptable valuations: 1) the present value of future cash flows discounted a the loan’s effective interest rate; 2) the loan's observable market price; or 3) the fair value of the collateral, if the loan is collateral dependent. The calculated amount of loan impairment will be compared to the Migration Analysis risk factors, and the more conservative of the two risk factors shall be used. If the calculated impairment is greater than the Migration Analysis risk factor, an adjustment for the difference is made to the General Reserve.
We consider a loan as impaired when it is probable that it will be unable to collect all amounts due (principal and interest) according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed.
For commercial, real estate and certain consumer loans, we base the measurement of loan impairment on the present value of the expected future cash flows, discounted at the loan’s effective interest rate or on the fair value of the loan’s collateral if the loan is collateral dependent. We evaluate installment loans for impairment on a collective basis, because these loans are smaller balance, homogeneous loans. Impairment losses are included in the allowance for loan losses through a charge to the provision for loan losses.
The allowance for loan losses was $14.8 million at September 30, 2004, compared to $12.5 million at December 31, 2003 and $11.8 million at September 30, 2003. We recorded a provision for loan losses of $3.7 million during the nine months ended September 30, 2004 compared to $3.8 million for the same period of 2003. Despite the increase in loan portfolio, we were able to maintain the provision for loan losses at approximately the same level mainly due to decreases in nonperforming loans and classified loans. Average gross loans (net of deferred fees and cost) increased $248.3 million or 30% to $1,087.4 million for the nine months ended September 30, 2004, compared to $151.2 million or 25% increase for the same period of 2003. During the nine months ended September 30, 2004, we charged off $2.0 million and recovered $550,000. The allowance for loan losses was 1.27% of gross loans at September 30, 2004, compared to 1.25% at December 31, 2003 and 1.30% at September 30, 2003. The total classified loans at September 30, 2004 were $6.2 million, compared to $10.3 million at September 30, 2003.
We believe the level of allowance as of September 30, 2004 is adequate to absorb the estimated losses from any known or inherent risks in the loan portfolio and the loan growth for the quarter. However, no assurance can be given that economic conditions which adversely affect our service areas or other circumstances will not be reflected in increased provisions or loan losses in the future.
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The following table shows the provisions made for loan losses, the amount of loans charged off, the recoveries on loans previously charged off together with the balance in the allowance for loan losses at the beginning and end of each period, the amount of average and total loans outstanding, and other pertinent ratios as of the dates and for the periods indicated:
Total loans are net of unearned of $2,637 and $1,541 at September 30, 2004 an 2003, respectivly
Investment Securities Portfolio
We classify our securities as held-to-maturity or available-for-sale under SFAS No.115. Those securities that we have the ability and intent to hold to maturity are classified as “held-to-maturity securities”. All other securities are classified as “available-for-sale”. We did not own any trading securities at September 30, 2004 and December 31, 2003. Securities that are held to maturity are stated at cost, adjusted for amortization of premiums and accretion of discounts. Securities that are available for sale are stated at fair value. The securities we currently hold are government-sponsored agency bonds, corporate bonds, collateralized mortgage obligations, U.S. government agency preferred stocks, and municipal bonds.
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As of September 30, 2004, we had $2.0 million in held-to-maturity securities and $123.8 million in available-for-sale securities compared to $2.0 million and $126.4 million, respectively at December 31, 2003. The total net unrealized loss on the available-for sale securities at September 30, 2004 was $393,000 compared to net unrealized loss of $1.5 million at December 31, 2003. During the nine months of 2004, a total of $41.5 million in securities available-for-sale were purchased, $13.9 million was sold, and $16.0 million was called and total gross gains of $433,607 were recognized.
Securities with an amortized cost of $5.2 million were pledged to secure public deposits and for other purposes as required or permitted by law at September 30, 2004. Securities with a carrying value of $24.1 million and $68.5 million were pledged to FHLB of San Francisco and State of California Treasurer’s Office, respectively, at September 30, 2004.
The following table summarizes the book value, market value and distribution of our investment securities portfolio as of dates indicated:
Investment Portfolio
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Investment Maturities and Repricing Schedule
The amortized cost by contractual maturity at September 30, 2004 are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The following table shows our investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2004.
The unrealized losses were created due to what we believe is a temporary condition, mainly fluctuations in interest rates and do not reflect a deterioration of credit quality of the issuers. For the three and nine months ended September 30, 2004, we did not have any sales of investment securities resulting in realized losses. For investments in an unrealized loss position at September 30, 2004, we have the intent and ability to hold these investments until the full recovery. During the nine months ended September 30, 2004, as a result of an other than temporary decline in market value due to changes in interest rates, impairment charges of $2.2 million were recognized for floating rate agency preferred stocks.
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Deposits and Other Borrowings
Deposits. Deposits are our primary source of funds to use in our lending and investment activities. At September 30, 2004, our deposits increased by $191.7 million or 18% to $1,253.2 million from $1,061.4 million at December 31, 2003. Demand deposits totaled $333.8 million at September 30, 2004, an increase of $8.2 million or 3% from $325.6 million at December 31, 2003. Time deposits over $100,000 totaled $336.6 million, a decrease of $12.0 million or 3% from $348.6 million at December 31, 2003. Other interest-bearing demand deposits, including money market and super now accounts, totaled $381.6 million, an increase of $247.4 million or 184% from $134.1 million at December 31, 2003. The growth in deposits was the result of the deposit promotion on new money market products throughout all three regions as well as the direct result of several newly opened branches, such as Wilshire, Diamond Bar and Rowland Height branches.
At September 30, 2004, 27% of the total deposits were non-interest bearing demand deposits, 33% were time deposits, 10% were savings accounts, and 30% were interest bearing demand deposits. By comparison, at December 31, 2003, 31% of the total deposits were non-interest bearing demand deposits, 41% were time deposits, 15% were savings accounts, and 13% were interest bearing demand deposits. The increase in interest bearing demand deposits at September 30, 2004 was primarily due to bank-wide deposit campaign on new money market product we launched during the second quarter of 2004 to support the loan growth.
At September 30, 2004, we had a total of $37.3 million in time deposits issued through brokers and $60.0 million in time deposits from the State of California Treasurer’s Office. The deposits from the State of California Treasurer’s Office were collateralized with our securities with an amortized cost of $68.5 million. The detail of those deposits is shown on the table below.
Other Borrowings. Advances may be obtained from the FHLB of San Francisco to supplement our supply of lendable funds. Advances from the FHLB of San Francisco are typically secured by a pledge of mortgage loans and/or securities with a market value at least equal to outstanding advances plus investment in FHLB stocks. The following table shows our outstanding borrowings from FHLB at September 30, 2004. All FHLB advances carry fixed interest rates.
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At September 30, 2004 and December 31, 2003, five wholly-owned subsidiary grantor trusts established by Nara Bancorp had issued $38 million of pooled Trust Preferred Securities (“trust preferred securities”). Trust preferred securities accrue and pay distributions periodically at specified annual rates as provided in the indentures. The trusts used the net proceeds from the offering to purchase a like amount of junior subordinated debentures (the “Debentures”) of the Nara Bancorp. The Debentures are the sole assets of the trusts. Nara Bancorp’s obligations under the junior subordinated debentures and related documents, taken together, constitute a full and unconditional guarantee by Nara Bancorp of the obligations of the trusts. The trust preferred securities are mandatorily redeemable upon the maturity of the Debentures, or upon earlier redemption as provided in the indentures. Nara Bancorp has the right to redeem the Debentures in whole (but not in part) on or after specific dates, at a redemption price specified in the indentures plus any accrued but unpaid interest to the redemption date.
The following table is a summary of trust preferred securities and debentures at September 30, 2004:
The Junior Subordinated Debentures are not redeemable prior to June 8, 2011 with respect to Nara Bancorp Capital Trust I, March 26, 2007 with respect to Nara Statutory Trust II, June 15, 2008 with respect to Nara Capital Trust III, January 7, 2009 with respect to Nara Statutory Trust IV, and December 17, 2008 with respect to Nara Statutory Trust V unless certain events have occurred. During March of 2004, $10 million of the total proceeds from the issuance of the Trust Preferred Securities were injected into Nara Bank as permanent capital.
With the adoption of FIN No. 46R, Nara Bancorp deconsolidated the five grantor trusts. As a result, the junior subordinated debentures issued by Nara Bancorp to the grantor trusts, totaling $39.3 million, are reflected in the consolidated balance sheet in the liabilities section at September 30, 2004 and December 31, 2003, under the caption “junior subordinated debentures.” We also recorded $2.1 million in other assets in the consolidated balance sheet at September 30, 2004 and December 31, 2003 for the common capital securities issued by the issuer trusts.
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On July 2, 2003, the Federal Reserve Bank issued Supervisory Letter SR 03-13 clarifying that bank holding companies should continue to report trust preferred securities in accordance with current Federal Reserve Bank instructions which allows trust preferred securities to be counted in Tier 1 capital subject to certain limitations. As of September 30, 2004, $30.8 million of the trust preferred securities was included in the Tier I capital. The Federal Reserve has indicated it will review the implications of any accounting treatment changes and, if necessary or warranted, will provide appropriate guidance.
Off-Balance Sheet Activities And Contractual Obligations
We routinely engage in activities that involve, to varying degrees, elements of risk that are not reflected, in whole or in part, in the consolidated financial statements. These activities are part of our normal course of business and include traditional off-balance sheet credit-related financial instruments, interest rate swap contracts, operating leases and long-term debt.
Traditional off-balance sheet credit-related financial instruments are primarily commitments to extend credit and standby letters of credit. These activities could require us to make cash payments to third parties in the event certain specified future events have occurred. The contractual amounts represent the extent of our exposure in these off-balance sheet activities. However, since certain off-balance sheet commitments, particularly standby letters of credit, are expected to expire or be only partially used, the total amount of commitments does not necessarily represent future cash requirements. These activities are necessary to meet the financing needs of our customers.
We also entered into interest rate swap contracts where we are required to either receive cash from or pay cash to counter parties depending on changes in interest rates. We utilize interest rate swap contracts to help manage the risk of changing interest rates. Our accounting for interest rate swap contracts is discussed below under Item 3.
We do not anticipate that our current off-balance sheet activities will have a material impact on future results of operations and financial condition. Further information regarding our financial instruments with off-balance sheet risk can be found in Item 3— “Quantitative and Qualitative Disclosures of Market Risks”.
We continue to lease our banking facilities and equipment under non-cancelable operating leases with terms providing for fixed monthly payments over periods typically ranging from 2 to 30 years.
The following table shows our contractual obligation as of September 30, 2004.
Stockholders’ Equity and Regulatory Capital
In order to ensure adequate levels of capital, we conduct an ongoing assessment of projected sources and uses of capital in conjunction with projected increases in assets and levels of risk. We consider on an ongoing basis, among other things, cash generated from operations, access to capital from financial markets or the issuance of additional securities, including common stock or notes, to meet our capital needs. Total stockholders’ equity was $98.9 million at September 30, 2004. This represented an increase of $13.9 million or 16% over total stockholders’ equity of $85.0 million at December 31, 2003.
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The federal banking agencies require a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%. In addition to the risk-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage ratio. For a banking organization rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets must be 3%. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios.
At September 30, 2004, Tier 1 capital, stockholders’ equity less intangible assets, plus proceeds from the Trust Preferred Securities, was $123.3 million. This represented an increase of $16.7 million or 16% over total Tier 1 capital of $106.6 million at December 31, 2003. This increase was primarily due to a net income of $13.7 million reduced by the payments of cash dividends. At September 30, 2004, we had a ratio of total capital to total risk-weighted assets of 11.73% and a ratio of Tier 1 capital to total risk weighted assets of 9.86%. The Tier 1 leverage ratio was 8.76% at September 30, 2004.
As of September 30, 2004, the Bank has met the criteria as a “well capitalized institution” under the regulating framework for prompt corrective action. The following table presents the amounts of our regulatory capital and capital ratios, compared to regulatory capital requirements for adequacy purposes as of September 30, 2004 and December 31, 2003.
Liquidity Management
Liquidity risk is the risk to earnings or capital resulting from our inability to fund assets when needed and liability obligations when they come due without incurring unacceptable losses. Liquidity risk includes the ability to manage unplanned decreases or changes in funding sources and to recognize or address changes in market conditions that affect our ability to liquidate assets quickly and with a minimum loss of value. Factors considered in liquidity risk management are stability of the deposit base, marketability of our assets, maturity and availability of pledgeable investments, and customer demand for credits.
In general, our sources of liquidity are derived from financing activities, which include the acceptance of customer and broker deposits, federal funds 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 and the routine liquidation of securities from principal paydown, maturity and sales. Our primary uses of funds include withdrawal of and interest payments on deposits, originations of loans, purchases of investment securities, and payment of operating expenses.
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We manage liquidity risk by controlling the level of federal funds and by maintaining lines with correspondent banks, the Federal Reserve Bank, and Federal Home Loan Bank of San Francisco. The sale of investment securities available-for-sale can also serve as a contingent source of funds. Increasing the deposit rates is considered a last resort in raising funds to increase liquidity.
As a means of augmenting our liquidity, we have established federal funds lines with corresponding banks and Federal Home Loan Bank of San Francisco. At September 30, 2004, our borrowing capacity included $46.0 million in federal funds line facility from correspondent banks and $294.8 million in unused Federal Home Loan Bank of San Francisco advances. In addition to the lines, our liquid assets include cash and cash equivalents, federal funds sold and securities available for sale that are not pledged. The book value of the aggregate of these assets totaled $82.4 million at September 30, 2004 compared to $107.9 million at December 31, 2003. We believe our liquidity sources to be stable and adequate.
Because our primary sources and uses of funds are loans and deposits, the relationship between gross loans and total deposits provides a useful measure of our liquidity. Typically, higher the ratio of loans to deposits, the more we rely on our loan portfolio to provide for short-term liquidity needs. Because repayment of loans tends to be less predictable than the maturity of investments and other liquid resources, the higher the loan to deposit ratio, the less liquid are our assets. At September 30, 2004, our gross loan to deposit ratio was 94%.
The objective of our asset and liability management activities is to improve our earnings by adjusting the type and mix of assets and liabilities to effectively address changing condition and risks. Through overall management of our balance sheet and by controlling various risks, we seek to optimize our financial returns within safe and sound parameters. Our operating strategies for attaining this objective include managing net interest margin through appropriate risk/return pricing of asset and liabilities and emphasizing growth in retail deposits, as a percentage of interest-bearing liabilities, to reduce our cost of funds. We also seek to improve earnings by controlling non-interest expense, and enhancing non-interest income. We also use risk management instruments to modify interest rate characteristic of certain assets and liabilities to hedge against our exposure to interest rate fluctuations, reducing the effects these fluctuations might have on associated cash flows or values. Finally, we perform internal analyses to measure, evaluate and monitor risk.
Interest Rate Risk
Interest rate risk is the most significant market risk impacting us. Market risk is the risk of loss to future earnings, to fair values, or to future cash flow that may result from changes in the price of a financial instrument. Interest rate risk occurs when interest rate sensitive assets and liabilities do not reprice simultaneously and in equal volume. A key objective of asset and liability management is to manage interest rate risk associated with changing asset and liability cash flows and values and market interest rate movements. The management of interest risk is governed by policies reviewed and approved annually by the Board of Directors. Our Board delegates responsibility for interest risk management to the Asset and Liability Management Committee (“ALCO”), which is composed of Nara Bank’s senior executives and other designated officers.
The fundamental objective of the ALCO is to manage our exposure to interest rate fluctuations while maintaining adequate levels of liquidity and capital. The ALCO meets regularly to monitor the interest rate risk, the sensitivity of our assets and liabilities to interest rate changes, the book and market values of assets and liabilities, the investment activities and the changes in the composition of the balance sheet. Our strategy has been to reduce the sensitivity of our earnings to interest rate fluctuations by more closely matching the effective maturities or repricing characteristics of our assets and liabilities. Certain assets and liabilities, however, may react in different degrees to changes in market interest rates. Furthermore, interest rates on certain types of assets and liabilities may fluctuate prior to the changes in market interest rates, while the rates on other types may lag. We consider the anticipated effects of these factors when implementing our interest rate risk management objectives.
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Swaps
As part of our asset and liability management strategy, we may engage in derivative financial instruments, such as interest rate swaps, with the overall goal of minimizing the impact of interest rate fluctuations on our net interest margin. Interest rate swaps involve the exchange of fixed-rate and variable-rate interest payment obligations without the exchange of the underlying notional amounts. During 2002, we entered into eight different interest rate swap agreements.
Under the swap agreements, we receive a fixed rate and pay a variable rate based on H.15 Prime. The swaps qualify as cash flow hedges under SFAS No. 133,Accounting for Derivative Instruments and Hedging Activities, as amended, and are designated as hedges of the variability of cash flows we receive from certain of our Prime-indexed loans. In accordance with SFAS No. 133, these swap agreements are measured at fair value and reported as assets or liabilities on the consolidated statement of financial condition. The portion of the change in the fair value of the swaps that is deemed effective in hedging the cash flows of the designated assets are recorded in accumulated other comprehensive income (“OCI”) and reclassified into interest income when such cash flows occur in the future. Any ineffectiveness resulting from the hedges is recorded as a gain or loss in the consolidated statement of income as a part of non-interest income or loss. As of September 30, 2004, the amounts in accumulated OCI associated with these cash flows totaled a gain of $445,009 (net of tax of $296,672), of which $130,589 is expected to be reclassified into interest income within the next 12 months.
During the third quarter of 2004 and 2003, interest income received from swap counterparties were $723,562 and $893,278, respectively. During the nine months of 2004 and 2003, interest income received from swap counterparties were $2.5 million. At September 30, 2004 and 2003, we pledged as collateral to the interest rate swap counterparties agency securities with a book value of $2.0 million and real estate loans of $2.1 million.
Interest Rate Sensitivity
Our monitoring activities related to managing interest rate risk include both interest rate sensitivity “gap” analysis and the use of a simulation model. While traditional gap analysis provides a simple picture of the interest rate risk embedded in the balance sheet, it provides only a static view of interest rate sensitivity at a specific point in time and does not measure the potential volatility in forecasted results relating to changes in market interest rates over time. Accordingly, we combine the use of gap analysis with the use of a simulation model, which provides a dynamic assessment of interest rate sensitivity.
The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets anticipated to reprice within a specific time period and the amount of interest-bearing liabilities anticipated to reprice within that same time period. A gap is considered positive when the amount of interest rate sensitive assets repricing within a specific time period exceeds the amount of interest-bearing liabilities repricing within that same time period. Positive cumulative gaps suggest that earnings will increase when interest rates rise. Negative cumulative gap suggest that earnings will increase when interest rates fall.
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The following table shows our gap position as of September 30, 2004
The simulation model discussed above also provides our ALCO with the ability to simulate our net interest income. In order to measure, at September 30, 2004, the sensitivity of our forecasted net interest income to changing interest rates, both a rising and falling interest scenario were projected and compared to a base market interest rate forecasts. One application of our simulation model measures the impact of market interest rate changes on the net present value of estimated cash flows from our assets and liabilities, defined as our market value of equity. This analysis assesses the changes in market values of interest rate sensitive financial instruments that would occur in response to an instantaneous and sustained increase in market interest rates.
At September 30, 2004, our net interest income and market value of equity exposed to these hypothetical changes in market interest rates are illustrated in the following table.
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We carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our “disclosure controls and procedures” (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end of the period covered by this report. Based upon the evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective. Disclosure controls and procedures are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules.
There have been no significant changes in the our internal controls or in other factors that could significantly affect our internal controls subsequent to the date of the evaluation.
PART IIOTHER INFORMATION
We are a party to routine litigation incidental to our business, none of which is considered likely to have a material adverse effect on us.
The exhibits listed on the accompanying index to exhibits are filed or incorporated by reference (as stated herein) as part of this Quarterly Report on Form 10-Q.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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INDEX TO EXHIBITS
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