UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2003 or
For the transition period from to
Commission File Number: 000-50245
NARA BANCORP, INC.
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]
As of October 31, 2003, there were 11,525,089 outstanding shares of the issuer’s Common Stock, $0.001 par value.
TABLE OF CONTENTS
Table of Contents
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PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
NARA BANCORP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION(Unaudited)
ASSETS
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LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES:
See notes to condensed consolidated financial statements
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CONDENSED CONSOLIDATED STATEMENTS OF INCOMEFor the three and nine months ended September 30, 2003 and 2002(Unaudited)
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CONDENSED CONSOLIDATED STATEMENTS OF INCOMEFor the three and nine months ended, September 30, 2003 and 2002(Unaudited)
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CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITYNINE MONTHS ENDED SEPTEMBER 30, 2003 and 2002(Unaudited)
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWSNINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002(Unaudited)
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See notes to consolidated financial statements
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Notes to unaudited Condensed Consolidated Financial Statements
1. Nara Bancorp, Inc.
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 wide 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 Seattle, Chicago, New Jersey , Atlanta, and Virginia.
2. Basis of Presentation
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 subsidiary, Nara Bank. In addition, we have the following consolidated subsidiaries which issued trust preferred securities and purchased Nara Bancorp’s junior subordinated deferrable interest debentures: Nara Bancorp Capital Trust I, Nara Statutory Trust II, and Nara Capital Trust III. We also created Nara Real Estate Trust (“REIT”), a Maryland real estate investment trust and wholly owned second-tier operating subsidiary of Nara Bank. All intercompany transactions and balances have been eliminated in consolidation.
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, 2003. Certain reclassifications have been made to prior period amounts in order to conform to the September 30, 2003 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 2002 Annual Report on Form 10-K.
3. Stock-Based Compensation
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.
We have adopted the disclosure only provisions of SFAS No. 123. Had compensation cost for our stock-based compensation plans been determined base on the fair value at the grant date for awards consistent with the provisions of SFAS No. 123, our net income would have been reduced to the pro forma amounts as follows:
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4. Dividends
On August 25, 2003, we declared a $0.05 per share cash dividend paid on October 10, 2003 to stockholders of record at the close of business on September 30, 2003.
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5. Stock Splits
On February 14, 2003, 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 payable on March 17, 2003 to stockholders of record on close of business on March 3, 2003. The effect of this dividend is that Stockholders received one additional share of Nara Bancorp common stock for each share owned. All per share amounts and number of shares outstanding in this report have been retroactively restated for this stock split.
6. Earnings Per Share
Basic earnings-per-share excludes the number of shares of common stock that could be purchased from those who hold stock options or warrants and is computed by dividing our earnings for the period by the weighted-average number of common shares outstanding for the period. Diluted earnings-per-share includes the weighted-average number of common shares outstanding, plus the number of shares that could be issued upon the exercise of stock options and/or warrants where the exercise price is less than the period average market value of our common stock.
The following table shows how we computed basic and diluted earnings per share (“EPS”) for the periods ended September 30, 2003 and 2002.
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7. SBA
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 discounted 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, 2003, the fair value of servicing assets was determined using a weighted-average discount rate of 6.9% and a prepayment speed of 11.1%. At September 30, 2002, the fair value of servicing assets was determined using a weighted-average discount rate of 7.6% 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 were approximately $3,238,000 and $2,433,000 at September 30, 2003 and December 31, 2002, respectively.
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 the estimated fair value, with unrealized gain or loss, net of tax, recorded as a component of accumulated other comprehensive income (loss).
We offer direct financing leases to customers whereby the assets leased are acquired without additional financing from other sources. Direct financing leases are carried net of unearned income, unamortized nonrefundable fees and related direct costs associated with the origination or purchase of leases.
8. Goodwill and Other Intangible Assets
In July 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations completed after June 30, 2001 and also specifies the types of acquired intangible assets that are required to be recognized and reported separately from goodwill and those acquired intangible assets that are required to be included in goodwill. SFAS No. 142 requires that goodwill no longer be amortized, but instead be tested for impairment at least annually. Additionally, SFAS
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No. 142 requires recognized intangible assets to be amortized over their respective estimated useful lives and reviewed for impairment. Any recognized intangible asset determined to have an indefinite useful life will not be amortized, but instead it must be tested for impairment until its life is determined to no longer be indefinite. We adopted SFAS No. 142 on January 1, 2002.
In connection with the transitional impairment evaluation required by SFAS No. 142, we performed an assessment of whether there was an indication that goodwill was impaired as of January 1, 2002. We completed our evaluation of any transitional impairment of goodwill and determined that there was no impairment as of January 1, 2002. We also tested goodwill for impairment as of December 31, 2002, noting no impairment in the recorded goodwill of $874,968. No conditions indicated any further impairment as of September 30, 2003.
At December 31, 2001, we had negative goodwill (the amount by which the fair value of assets acquired and liabilities assumed exceeds the cost of an acquired company) of $4,192,334. In accordance with SFAS No. 142, such amount was recognized in the consolidated statement of income as the cumulative effect of a change in accounting principle on January 1, 2002. The recognition of negative goodwill is not tax effected, as no deferred taxes were allocated to it in the initial purchase accounting. We will continue to amortize its other intangible assets, representing core deposit intangibles, over the original estimated useful life of seven years.
In August 2003, we acquired Asiana Bank and recorded a core deposit intangible of $1.0 million, which we will amortize over an estimated useful life of seven years. We also recognized $1.0 million in goodwill, which will be tested for impairment on an annual basis. Refer to footnote 15 for more information.
As of September 30, 2003, intangible assets that continue to be subject to amortization include core deposits of $2,303,921 (net of $782,882 accumulated amortization) and servicing assets of $2,614,495 (net of $897,394 accumulated amortization). Amortization expense for such intangible asset was $576,932 for the nine months ended September 30, 2003. Estimated amortization expense for intangible assets for the remainder of 2003 and the five succeeding fiscal years are as follows:
9. Recent Accounting Pronouncements
FASB issued Interpretation (“FIN”) No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees and Indebtedness of Others, an interpretation of SFAS Nos. 5, 57 and 107, and rescission of FIN No. 34, Disclosure of Indirect Guarantees of Indebtedness of Others, in November 2002. FIN No. 45 elaborates on the disclosures to be made by the guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of the interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, while the provisions of the disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of such interpretation did not have a material impact on our results of operations, financial position or cash flows.
In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, which clarifies and amends financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. In general, SFAS No. 149 is effective for
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contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of such statement did not have a material impact on our results of operations, financial position or cash flows.
The FASB issued FIN 46, Consolidation of Variable Interest Entities - an interpretation of ARB No. 51, in January 2003. FIN 46 requires that variable interest entities be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or is entitled to receive a majority of the entity’s residual returns or both. FIN 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 46 will apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements will apply to entities established prior to January 31, 2003 in the first fiscal year or interim period beginning after December 15, 2003. We do not believe the adoption of such interpretation will have a material impact on our results of operations, financial position or cash flows.
10. Commitments and Contingencies
We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit, standby letters of credit, and commercial letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. Our exposure to credit loss in the event of nonperformance by the other party to commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we do for extending loan facilities to customers. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on our credit evaluation of the counterparty. Collateral held varies but may include accounts receivable; inventory; property, plant, and equipment; and income-producing properties.
Commitments at September 30, 2003 are summarized as follows:
In the normal course of business, we are involved in various legal claims. We have reviewed all legal claims against us with counsel and have taken into consideration the views of such counsel as to the outcome of the claims. In our opinion, the final disposition of all such claims will not have a material adverse effect on our financial position and results of operations.
11. Derivative Financial Instruments and Hedging Activities
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 interest rate fluctuations on our interest rate margin and equity.
Under the interest rate 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, 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
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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. As of September 30, 2003, the amounts in accumulated OCI associated with these cash flows totaled $1,625,504 (net of tax of $1,083,670), of which $211,763 is expected to be reclassified into interest income within the next 12 months. As of September 30, 2003, the maximum length of time over which we are hedging our exposure to the variability of future cash flow is approximately 9.5 years.
Interest rate swap information at September 30, 2003 is summarized as follows:
During the 3rd quarter of 2003, interest income received from the swap counterparties was $893,000 compared to $252,000 for the same quarter of 2003. During the first nine months of 2003, interest income received from swap counterparties was $2.5 million compared to $420,000 for the same period of 2002. At September 30, 2003, we pledged to the interest rate swap counterparty as collateral agency securities with a book value of $2.0 million and real estate loans of $1.0 million.
12. Business Segments
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.
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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. Noninterest income and noninterest 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.
The following tables present the operating results and other key financial measures for the individual operating segments for the nine and three months ended September 30, 2003 and 2002.
For the Nine Months Ended September 30
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For the Three Months Ended September 30
13. Other Comprehensive Income
The following table shows the reclassification of other comprehensive income as of September 30, 2003 and 2002.
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14. Trust preferred
On June 5, 2003, Nara Bancorp completed a $5.0 million offering of trust preferred securities, through Nara Capital Trust III, issued as part of a private placement pooled offering with several other financial institutions. Cohen Bros. & Company acted as placement agent for the pooled offering. For the period beginning on June 5, 2003 to September 15, 2003, the trust preferred securities bore the interest rate of 4.43 percent per annum with interest payable quarterly. Beginning September 15, 2003, the interest rate is adjusted quarterly on March 15, June 15, September 15, and December 15 during the 30-year term based on the 3-month LIBOR plus 3.15 percent. However, prior to June 15, 2008, the interest rate cannot exceed 12.0 percent.
The trust preferred securities mature on June 15, 2003 and are callable at par in whole or in part beginning June 15, 2008. Nara Capital Trust III used the proceeds from the sale of the trust preferred securities to purchase junior subordinate deferrable interest debentures of Nara Bancorp.
15. Business Combination
On August 25, 2003, we completed our acquisition of Asiana Bank (“Asiana”) at a price of $8.0 million in stocks. We have issued approximately 426,000 shares for this acquisition. The results of Asiana’s operations have been included in the consolidated financial statements since that date. The acquisition was accounted for under the purchase method of accounting, and accordingly, all assets and liabilities of Asiana were adjusted to and recorded at their estimated fair values as of the acquisition date. The estimated tax effect of differences between tax bases and market values has been reflected in deferred income taxes. The estimated fair values of assets, net loans, and deposits acquired were $37.7 million, $22.4 million, and $29.4 million, respectively. We recorded total goodwill of approximately $1.0 million and cored deposit premium of $1.0 million. Core deposit premium will be amortized using the straight-line method over 7 years.
16. Subsequent Event
On August 11, 2003, we announced that Nara Bank, N.A, a wholly owned subsidiary of Nara Bancorp, Inc. and Korea Exchange Bank, entered into an agreement for the assumption by Nara Bank of FDIC insured deposits and certain loans of Korea Exchange Bank’s Broadway branch in New York City. The acquisition was completed on October 31, 2003. Nara assumed approximately $46 million in deposits and approximately $37 million in loans.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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 ended September 30, 2003 and September 30, 2002. This analysis should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2002 and with the unaudited consolidated financial statements and notes as 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 under this caption may constitute forward-looking statements under Section 27A of the Securities Act 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 Form 10-K for the year ended December 31, 2002.
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RESULTS OF OPERATIONS
Net income
Our net income for the three months ended September 30, 2003 was $3.7 million or $0.32 per diluted share compared to $3.1 million or $0.27 per diluted shares for the same quarter of 2002, which represented an increase of approximately $0.6 million or 19.4%. The increase resulted primarily from an increase in net interest income. The annualized return on average assets was 1.34% for the third quarter or 2003 compared to 1.54% for the same period of 2002. The annualized return on average equity was 19.10 % for the third quarter of 2003 compared to 20.08% for the same period of 2002. The resulting efficiency ratio was 55.95% for the three months ended September 30, 2003 compared with 60.27% for the same period of 2002.
Our net income before cumulative effect of a change in accounting principle for the nine months ended September 30, 2003 was $10.4 million or $0.91 per diluted share compared to $8.2 million or $0.70 per diluted share for the same period of 2002, which represented an increase of approximately $1.5 million or 26.8%. The increase was primarily due to an increase in net interest income and noninterest income, provided primarily by the from a growth in loans as well as the sale of loans we originated, which was partially offset by higher loan loss provision and noninterest expense. During the first quarter of 2002, we recognized $4.2 million as the cumulative effect of a change in accounting principle. The cumulative effect of a change in accounting principle was related to the one-time recognition of all negative goodwill in the consolidated statement of income at January 1, 2002 in accordance with SFAS No. 142, Goodwill and Other Intangible Assets, which resulted in total net income for the nine months of $12.4 million or $1.06 per diluted share.
The annualized return on average assets was 1.32 % for the nine months ended September 30, 2003 compared to 1.45% for the same period of 2002. The annualized return on average equity was 19.13% for the nine months ended September 30, 2003 compared to 17.71% for the same period of 2002. The resulting efficiency ratios were 56.48% for the nine months ended September 30, 2003 compared with 62.24% for the corresponding period of the preceding year. This improvement was primarily due to the increase in net revenue. All 2002 ratios in this section exclude the cumulative effect of a change in accounting principle.
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, swaps and investments and the interest paid on deposits, trust preferreds and borrowed funds. When net interest income is expressed as a percentage of average interest-earning assets, the result is the net interest margin. The net interest spread is the yield on average interest-earning assets less the cost of average interest-bearing deposits and borrowed funds. The 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 $11.6 million for the three months ended September 30, 2003, which represented an increase of $2.4 million, or 26.1% from net interest income of $9.2 million for the same quarter of 2002. This increase was primarily due to an increase in the balance of average earning assets, which increased $284.1 million or 38.3% to $1,026.1 million for the third quarter of 2003, from $742.0 million for the same quarter of 2002.
Interest income for the third quarter of 2003 was $15.6 million, which represented an increase of $2.9 million or 22.8% over interest income of $12.7 million for the same quarter of 2002. The increase was the net result of a $4.4 million increase in average interest-earning assets (volume change) off-set by a $1.5 million decrease in the yield earned on those average interest-earning assets (rate change). Interest expense for the third
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quarter of 2003 was $3.9 million, which represented an increase of $0.4 million or 11.4% over the interest expense of $3.5 million for the same quarter of 2002. The increase was the net result of a $1.3 million increase in average interest-bearing liabilities (volume change) offset by an $846,000 decrease in the cost of those interest-bearing liabilities (rate change).
Net interest income before provision for loan losses was $32.5 million for the nine months ended September 30, 2003, which represented an increase of $8.4 million or 34.9% from net interest income of $24.1 million for the same period of 2002. The increase was the primarily due to an increase in average earning assets. Average earning assets increased $284.8 million or 41.5% to $971.2 million for the nine months ended September 30, 2003, from $686.4 million for the same period of 2002.
Interest income for the nine months ended September 30, 2003 was $44.6 million, which represented an increase of $9.5 million or 27.1% over interest income of $35.1 million for the same period of 2002. The increase was the net result of $13.0 million increase in average interest-bearing assets (volume change) offset by $3.5 million in the cost of those interest-bearing liabilities (rate change). Interest expense for the nine months ended September 30, 2003 was $12.1 million, which represented an increase of $2.5 million or 26.0% over interest expense of $9.6 million for the same period of 2002. The increase was the net result of a $4.2 million increase in average interest-bearing liabilities (volume change) offset by a $1.8 million decrease in the cost of those interest-bearing liabilities (rate change).
Net Interest Margin
The yield on average interest-earning assets decreased to 6.07% for the third quarter of 2003, from a yield of 6.87% for the same quarter of 2002. The decrease was primarily due to the two rate cuts in November of 2002 and June of 2003, a total of 75-basis. The average cost of interest-bearing liabilities decreased to 2.11 % for the third quarter of 2003 from 2.72% for the same quarter of 2002. The decrease was primarily due to the decreases in market interest rates. The net interest margin was 4.54% for the third quarter of 2003, down from 4.98% for the same quarter of 2002. The decrease in the net interest margin was primarily due to the decreases in interest rates.
The yield on average interest-earning assets decreased to 6.13% for the nine months ended September 30, 2003, from a yield of 6.82% for the nine months ended September 30, 2002. The average cost of interest-bearing liabilities decreased to 2.28% for the nine months ended September 30, 2003 from 2.74% for the nine months ended September 30, 2002. These decreases are mainly due to the decreases in market interest rates. The net interest margin was 4.47% for the nine months ended September 30, 2003, down from 4.95% for the same period of 2002. The decrease in the net interest margin resulted primarily from the decreases in market interest rates.
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The following table presents our condensed average balance sheet information, together with interest rates earned and paid on the various sources and uses of funds for the three month and six months periods indicated:
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The following table illustrates the changes in our interest income, interest expense, 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 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 losses inherent 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 $1.4 million in provision for loan losses in the third quarter of 2003 compared to $400,000 in the same quarter of 2002. For the nine months ended September 30, 2003, we recorded $3.8 million in provision for loan losses compared to $1.4 million for the nine months ended September 30, 2002. This increase reflects 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 known and inherent losses at September 30, 2003. Refer to Allowance and Provision 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, and gains on sale of SBA loans and investment securities.
Non-interest income for the third quarter of 2003 was $5.2 million compared to $4.5 million for the same quarter of 2002, which represented an increase of $652,000, or 14.4%, primarily as a result of increase in service charges on deposits and gain on sale of investment securities available for sale. Service charges on deposits increased $322,000 or 19.4% to $2.0 million for the third quarter of 2003, from $1.7 million for the same quarter of 2002. This increase is mainly due to the increase in average demand deposits. Average demand deposits increased $57.4 million or 30.41% to $270.7 million for the third quarter of 2003, from $213.3 million for the same quarter of 2002. Gain on sale of investment securities increased $290,000 or 414.3% to $220,000 for the third quarter of 2003, from a loss of $70,000 for the same quarter of 2002. We sold $7.4 million in investment securities during the third quarter of 2003, compared to $8.2 million during the third quarter of 2002.
Non-interest income for the nine months ended September 30, 2003 was $14.9 million compared to $12.4 million for the same period of 2002, which represented an increase of $2.5 million or 20.2%, primarily as a result of increase in service charges on deposits, gains on sale of SBA loans, and gain on interest rate swaps. Service charges on deposits increased $971,000 or 21.1% to $5.6 million for the nine months ended September 30, 2003, from $4.6 million for the same period of 2002. This increase is also due to an increase in average demand deposits. Average demand deposits increased $43.6 million or 21.2% to $249.5 million for the nine months ended September 30, 2003, from $205.9 million for the same period of 2002. Gain on sale of SBA loans for the nine months ended September 30, 2003 was $3.2 million, an increase of approximately $1.2 million or 60.9% from $2.0 million for the same period of 2002. We originated $56.5 million of SBA loans and sold $42.3 million during the nine months of 2003. During the same period of 2002, we originated $50.8 million and sold $34.6 million. Gain on sale of investment securities decreased $569 or 58.4% during the nine months of 2003 to $406,000, from $975,000 during the same period of 2002. We sold $11.0 million in securities during the nine months of 2003, compared to $39.2 million during the same period of 2002. We also recognized a gain of $437,000 from the interest rate swap transactions during the nine months of 2003, compared to $110,000 during the same period of 2002.
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The summary of our non-interest income by category is illustrated below:
Non-interest Expense
Non-interest expense for the third quarter of 2003 was $9.4 million compared to $8.3 million for the same quarter of 2002, which represented an increase of $1.1 million or 13.5%, primarily due to increase in salaries and employee benefit expenses and occupancy expenses. Salaries and employee benefits expenses for the third quarter of 2003 increased $629,000 or 14.7% to $4.9 million from $4.3 million for the same quarter of 2002. This increase is primarily due to the hiring of additional staff to support new branches and growth. Net occupancy expenses for the third quarter of 2003 increased $204,000 or 18.7% to $1.3 million from $1.1 million for the same quarter of 2002. This increase is also due to opening of new branches in Diamond Bar and Wilshire in Los Angeles. The advertising and marketing expenses for the third quarter of 2003 decreased $196,000 or 41.7% to $274,000 from $470,000 for the same quarter of 2002. During 2002, we broadcasted television advertising in
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California and began to broadcast in New York during the third quarter of 2002, which further increase the advertising expenses.
Non-interest expense for the nine months ended September 30, 2003 was $26.8 million, compared to $23.6 million for the same period of 2002, which represented an increase of $3.2 million or 13.7%, primarily due to an increase in salaries and employee benefit expenses, data processing expenses, and the amortization of intangible assets. Salaries and employee benefits expenses for the nine months ended September 30, 2003 increased $2.2 million or 17.7% to $14.7 million from $12.5 million for the same period of 2002. This increase is primarily due to the hiring of additional staff to support the new branches and internal growth. Data and item processing expenses for the nine months ended September 30, 2003 increased $278,000 or 22.3% to $1.5 million from $1.2 million for the same period of 2002. This increase is primarily due to an increase in number of accounts from the acquisition of deposits from Industrial Bank of Korea, New York (“IBKNY”) in December of 2002, and internal growth. The amortization expenses on intangible assets for the nine months ended December 30, 2003 increased $140,000 or 148.9% to $234,000 from $94,000. This increase is primarily due to the amortization of core deposit intangible recognized from the assumption of deposits from IBKNY.
The summary of our non-interest expenses is illustrated below:
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Provision for Income Taxes
The provision for income taxes was $2.4 million and $2.0 million on income before taxes of $6.1 million and $5.1 million for the three months ended September 30, 2003 and 2002, respectively. The effective tax rate for the quarter ended September 30, 2003 was 38.9%, compared with 38.6% for the quarter ended September 30, 2002.
The provision for income taxes was $6.5 million and $4.8 million on income before taxes and cumulative effect of a change in accounting principle of $16.9 million and $12.9 million for the nine months ended September 30, 2003 and 2002, respectively. The effective tax rate for the nine months ended September 30, 2003 was 38.6%, compared with 36.9% for the nine months ended September 30, 2002. The lower tax rate in 2002 was primarily due to a permanent differences recognized from loan recoveries relating to the charged-off loans of Korea First Bank of New York prior to our acquisition and also due to an one time tax benefit recognized from a California State tax law change in which one-half of the cumulative loan losses through December 31, 2002 taken for income tax purposes were forgiven.
Financial Condition
At September 30, 2003, our total assets were $1.1 billion, an increase of $161.4 million or 16.5%, from $979.2 million at December 31, 2002. The growth came primarily from the increases in the balance of our loans as a result of a continuing strong demand for loans in our market, funded by the growth in our deposits and other borrowings.
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
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securities are classified as “available-for-sale”. We did not own any trading securities at September 30, 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.
As of September 30, 2003, we had $2.0 million of held-to-maturity securities and $133.0 million of available-for-sale securities, compared to $2.8 million and $101.6 million at December 31, 2002, respectively. The total net unrealized loss on the available-for sale securities at September 30, 2003 was $1.3 million, compared to net unrealized gain of $1.1 million at December 31, 2002. During the nine months of 2003, we purchased a total of $81.3 million in available-for-sale securities, sold $11.0 million and $36.5 million in available-for-sale securities matured. We recognized total gross gains of $406,000 during the nine months of 2003 from the sale of securities available for sale.
Securities with an amortized cost of $14.5 million were pledged to Federal Reserve Bank to secure public deposits and for other purposes as required or permitted by law at September 30, 2003. Securities with an amortized cost of $41.4 million and $58.7 million were pledged to FHLB of San Francisco and State of California Treasurer’s Office, respectively, at September 30, 2003.
The following table summarizes the book value, market value and distribution of our investment securities portfolio as of dates indicated:
Investment Portfolio
The carrying value and the yield of investment securities as of September 30, 2003, by contractual maturity, 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.
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Investment Maturities and Repricing Schedule
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 the allowance for loan losses. SBA loans held-for-sale are carried at the lower of cost or market. 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 a 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 30,2003, our gross loans (net of unearned fees), including loans held for sale, increased by $185.7 million or 25.4% to $915.5 million from $ 729.8 million at December 31, 2002. Asiana loans accounted for $23.1 million or 12.4% of the increase, which were mostly commercial and real estate loans. At September 30, 2003, the commercial loans, which include domestic commercial, international trade finance, SBA loans, and equipment leasing, increased by $43.3 million or 14.5 % to $342.2 million from $298.9 million at December 31, 2002. Real estate and construction loans increased by $138.3 million or 36.8% to $514.0 million from $375.7 million at December 31, 2002. There has been a continued high demand for real estate loans during the past months; however, we continue to monitor and maintain well-balanced loan portfolio.
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The following table illustrates our loan portfolio by amount and percentage of gross loans in each major loan category at the dates indicated:
* Includes loans held for sale of $5,415,000 at September 30, 2003 and $6,338,000 at December 31, 2002
We do not normally 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:
At September 30, 2003, our nonperforming assets (nonaccrual loans, loans 90 days or more past due and still accruing interest, restructured loans, and other real estate owned) were $4.5 million, which represented an increase of $2.3 million or 104.5% from $2.2 million at December 31, 2002. As of September 30, 2003, the restructured loans totaled $496,000 and are all current. At September 30, 2003, nonperforming assets to total assets was 0.39%, compared to 0.22% at December 31, 2002. The non-performing loans were $4.0 million, which represented an increase of approximately $2.9 million or 263.6% from $1.1 million at December 31, 2002. The non-performing loans consists of the following: two borrowers totaling $1.5 million that are fully secured by real estate and business properties that are valued higher than the loan amounts, a loan in the amount of $312,000 that was transferred from the acquisition of Asiana Bank, a loan for $271,000 that was fully paid subsequent to September 30, 2003, and various loans totaling $1.9 million that are attributable to all branches and departments. At September 30, 2003, nonperforming loans to total gross loans was 0.43%, compared to 0.15% at December 31, 2002. At December 30, 2003, we had $4.0 million in impaired loans with a reserved amount of $1.9 million, compared to $1.8 million in impaired loans with a reserved amount of $743,000 at December 30, 20032.
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The following table illustrates the composition of our nonperforming assets as of the dates indicated.
Allowance for Loan Losses
We maintain an allowance for credit losses to absorb losses inherent in the loan portfolio. The allowance is based on our regular, quarterly assessments of the probable estimated losses inherent in the loan portfolio. Our methodology for measuring the appropriate level of the allowance relies on several key elements, which includes the formula allowance and specific allowances for identified problem loans.
The Migration Analysis is a formula method based on our actual historical net charge-off experience for each loan type pools and undisbursed commitments graded Pass (less cash secured loans), Special Mention, Substandard, and Doubtful.
Central to the migration analysis is our credit risk rating system. Both internal, contracted external, and regulatory credit reviews 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, and our lien position; and the financial strength of the guarantors
To calculate our various loan factors, we use an eight-quarter rolling average of historical losses detailing charge-offs, recoveries, and loan type pool balances to determine the estimated credit losses for non-classified and classified loans. Also, in order to reflect the impact of recent events, the eight-quarter rolling average has been weighted. The most recent four quarters have been assigned a 60% weighted average and the older four quarters have been assigned a 40% weighted average.
The resulting migration risk factors, or our established minimum risk factor for loan type pools that have no historical loss, whichever is greater, for each loan type pool is used to calculate our General Reserve. We have established a minimum risk factor for each loan grade Pass (0.40% - 1.00%), Special Mention (3.0%), Substandard (10.0% - 15.0%), Doubtful (50.0%), and Loss (100.0%).
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
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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 Migration Analysis as much as 50 basis points in either direction (positive or negative) for each loan type pool.
The effect of external factors such as competition and legal and regulatory requirements on the level of estimated losses in our loan portfolio.
Under the Specific Allocation method, management establishes specific allowances for loans where management has identified significant conditions or circumstances related to a 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. Our actual historical repayment experience and the borrower’s cash flow, together with an individual analysis of the collateral held on a loan, is taken into account in determining the allocated portion of the required Allowance under this method. As estimations and assumptions change, based on the most recent information available for a credit, the amount of the required specific allowance for a credit will increase or decrease.
Executive management reviews these conditions quarterly in discussion with our senior credit officers. To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s estimate of the effect of such conditions may be reflected as a specific allowance, applicable to such credit or portfolio segment. Where any of these conditions is not evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s evaluation of the probable loss related to such condition is reflected in the unallocated allowance.
The allowance for loan losses was $11.8 million at September 30, 2003, compared to $7.1 million at September 30, 2002. We recorded a provision of $3.8 million during the nine months ended September 30, 2003, mainly due to an increase in our loan portfolio and classified loans. Average gross loans (net of unearned) increased $220.1 million or 38.5% to $792.2 million for the nine months ended September 30, 2003, compared to $572.1 million for the same period of 2002. During the nine months of 2003, we charged off $1.4 million and recovered $267,000. The allowance for loan losses was 1.29% of gross loans at September 30, 2003, compared to 1.07% at September 30, 2002. The total classified loans at September 30, 2003 were $10.3 million, compared to $2.1 million at September 30, 2002.
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We believe the level of allowance as of September 30, 2003 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.
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 possible 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:
Deposits and Other Borrowings
Deposits are our primary source of funds to use in lending and investment activities. At September 30, 2003, our deposits increased by $132.5 million or 16.2% to $949.4 million from $816.9 million at December 31, 2002. Asiana deposits accounted for $29.3 million or 22.1% of the increase. Demand deposits totaled $295.4 million, which represented an increase of $58.5 million or 24.7% from $236.9 million at December 31, 2002. Time deposits over $100,000 totaled $306.2 million, which represented an increase of $38.0 million or 14.2% from $268.2 million at December 31, 2002. Other interest-bearing demand deposits, including money market and
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super now accounts, totaled $98.7 million, which represented an increase of $17.6 million or 17.6% from $83.9 million at December 31, 2002.
At September 30, 2003, 31.1% of the total deposits were non-interest bearing demand deposits, 42.2% were time deposits, 16.3% were savings accounts, and 10.4% were interest bearing demand deposits. By comparison, at December 31, 2002, 29.0% of the total deposits were non-interest bearing demand deposits, 43.4% were time deposits, 17.3% were savings accounts, and 10.3% were interest bearing demand deposits.
At September 30, 2003, we had a total of $40.9 million in time deposits brought in through brokers and $45.0 million in time deposits from the State of California Treasurer’s Office. The deposits from the Sate of California Treasurer’s Office were collateralized with our securities with an amortized cost of $58.7 million. The detail of those deposits is shown on the table below.
In October of 2000, we established a borrowing line with the FHLB of San Francisco. 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 loan 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, 2003. All FHLB advances were fixed rates.
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Nara Bancorp established special purpose trusts in 2001, 2002, and 2003 for the purpose of issuing Preferred Securities (the “Trust Securities”). The trusts exist for the sole purpose of issuing Trust Securities and investing the proceeds thereof in Junior Subordinated Debentures issued by Nara Bancorp. Payment of distributions out of the monies held by the trusts and payments on liquidation of the trusts or the redemption of the Junior Subordinated Debentures are guaranteed by Nara Bancorp to the extent the trusts have funds available thereof. The obligation of Nara Bancorp under the guarantees and the Junior Subordinated Debentures are subordinate and junior in right of payment to all indebtedness of Nara Bancorp and are structurally subordinated to all liabilities and obligations of Nara Bancorp’s subsidiaries. The table below summarizes the outstanding Junior Subordinated Debentures issued by each special purpose trust and the debentures issued by Nara Bancorp to each trust as of September 30, 2003.
(Dollars in Thousand)
The Junior Subordinate 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 and June 15, 2008 with respect to Nara Capital Trust III unless certain events have occurred. The proceeds from the issuance of the Trust Securities were used primarily for corporate purposes.
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The following table shows our contractual obligation as of September 30, 2003:
Stockholders’ Equity and Regulatory Capital
In order to ensure adequate capital level, 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 $81.9 million at September 30, 2003. This represented an increase of $16.5 million or 25.2% over total stockholders’ equity of $65.4 million at December 31, 2002.
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, 2003, Tier 1 capital, stockholders’ equity less intangible assets, plus proceeds from the Trust Securities, was $99.1 million. This represented an increase of $21.2 million or 27.2% over total Tier 1 capital of $77.9 million at December 31, 2002. This increase was due to an issuance of $4.7 million trust preferred during the second quarter, an issuance of $8.0 million in approximately 426,000 shares for purchase of Asiana Bank, and a net income of $10.4 million off-set by cash dividends of $1.6 million, of which $537,000, $540,000, and $569,000 were paid in April, July, and October of 2003, respectively. At September 30, 2003, we had a ratio of total capital to total risk-weighted assets of 11.4% and a ratio of Tier 1 capital to total risk weighted assets of 10.2%. The Tier 1 leverage ratio was 9.0% at September 30, 2003.
As of September 30, 2003, Management believed that the Bank has continued to meet 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, 2003 and December 31, 2002.
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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.
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. Increases in deposit rates are considered a last resort as a means of 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, 2003, our borrowing capacity included $30.0 million in federal funds line facility from correspondent banks and $91.2 million in unused FHLB advances. In addition to the lines, our liquid assets include cash and cash equivalents, interest bearing deposits in other banks, federal funds sold and securities available for sale that are not pledged. The book value of the aggregate of these assets totaled $57.4 million at September 30, 2003, compared to $138.1 million at December 31, 2002. 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 is to 100%, 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, 2003, our gross loan to deposit ratio was 96.4%.
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Item 3. Quantitative and qualitative disclosures about market risk
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 noninterest expense, and enhancing noninterest 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 of Nara Bank (“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, investment activities and directs 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. Further, interest rates on certain types of assets and liabilities may fluctuate prior to changes in market interest rates, while rate on other types may lag behind. We consider the anticipated effects of these factors when implementing our interest rate risk management objectives.
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 as summarized in the table below.
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. As of September 30, 2003, the amounts in
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accumulated OCI associated with these cash flows totaled $1,625,504 (net of tax of $1,083,670), of which $221,763 is expected to be reclassified into interest income within the next 12 months.
Interest rate swaps information at September 30, 2003 is summarized as follows:
1. Gain included in the consolidated statement of earnings for the nine months ended September 30, 2003, representing hedge ineffectiveness
2. Prime rate is based on Federal Reserve statistical release H.15
During the third quarter of 2003, interest income received from the swap counterparties was $893,000, compared to $252,000 for the same quarter of 2002. During the first nine months of 2003, interest income received from the swap counterparties was $2.5 million, compared to $420,000 for the first nine months of 2002. At September 30, 2003, we pledged to the interest rate swap counterparty as collateral 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.
The following table shows our gap position as of September 30, 2003
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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, 2003, 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, 2003, our net interest income and market value of equity expose related to these hypothetical changes in market interest rates are illustrated in the following table.
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Item 4. Controls and Procedures
Our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are sufficiently effective to ensure that the information we are required to be disclosed in the reports we file under the Exchange Act is gathered, analyzed and disclosed with adequate timeliness, accuracy and completeness, based on an evaluation of such controls and procedures conducted within 90 days prior to the date thereof.
There have been no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation referred to above.
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PART II
OTHER INFORMATION
Item 1. Legal Proceedings
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.
Item 2. Changes in Securities and Use of Proceeds
Item 3. Defaults upon Senior Securities
None
Item 4. Submission of Matters to a vote of Security Holders
Item 5. Other information
Item 6. Exhibits and Reports on Form 8-K
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
* Filed herein
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