Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
x Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended September 30, 2012
or
o Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from to
Commission File Number: 1-6887
BANK OF HAWAII CORPORATION
(Exact name of registrant as specified in its charter)
Delaware
99-0148992
(State of incorporation)
(I.R.S. Employer Identification No.)
130 Merchant Street, Honolulu, Hawaii
96813
(Address of principal executive offices)
(Zip Code)
1-888-643-3888
(Registrant’s telephone number, including area code)
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 o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o (Do not check if a smaller reporting company)
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No x
As of October 15, 2012, there were 44,950,484 shares of common stock outstanding.
Bank of Hawaii Corporation
Form 10-Q
Index
Page
Part I - Financial Information
Item 1.
Financial Statements (Unaudited)
Consolidated Statements of Income – Three and nine months ended September 30, 2012 and 2011
2
Consolidated Statements of Comprehensive Income – Three and nine months ended September 30, 2012 and 2011
3
Consolidated Statements of Condition – September 30, 2012 and December 31, 2011
4
Consolidated Statements of Shareholders’ Equity – Nine months ended September 30, 2012 and 2011
5
Consolidated Statements of Cash Flows – Nine months ended September 30, 2012 and 2011
6
Notes to Consolidated Financial Statements (Unaudited)
7
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
36
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
65
Item 4.
Controls and Procedures
Part II - Other Information
Item 1A.
Risk Factors
66
Unregistered Sales of Equity Securities and Use of Proceeds
Item 6.
Exhibits
Signatures
67
1
Bank of Hawaii Corporation and Subsidiaries
Consolidated Statements of Income (Unaudited)
Three Months Ended
Nine Months Ended
September 30,
(dollars in thousands, except per share amounts)
2012
2011
Interest Income
Interest and Fees on Loans and Leases
$
64,668
65,344
193,269
197,479
Income on Investment Securities
Available-for-Sale
15,922
23,097
50,623
84,256
Held-to-Maturity
23,232
20,344
74,699
48,530
Deposits
Funds Sold
105
160
353
708
Other
283
279
844
837
Total Interest Income
104,213
109,230
319,794
331,816
Interest Expense
2,931
4,561
9,623
14,585
Securities Sold Under Agreements to Repurchase
7,185
7,400
21,739
21,779
Funds Purchased
17
15
Long-Term Debt
458
499
1,454
1,475
Total Interest Expense
10,581
12,464
32,833
37,854
Net Interest Income
93,632
96,766
286,961
293,962
Provision for Credit Losses
-
2,180
979
10,471
Net Interest Income After Provision for Credit Losses
94,586
285,982
283,491
Noninterest Income
Trust and Asset Management
11,050
10,788
33,163
34,021
Mortgage Banking
11,745
5,480
24,376
11,263
Service Charges on Deposit Accounts
9,346
9,820
28,162
29,127
Fees, Exchange, and Other Service Charges
11,907
16,219
36,632
47,826
Investment Securities Gains (Losses), Net
13
(77
)
6,084
Insurance
2,326
2,664
7,003
8,645
5,987
5,892
18,045
17,282
Total Noninterest Income
52,374
50,863
147,304
154,248
Noninterest Expense
Salaries and Benefits
47,231
44,307
138,292
137,889
Net Occupancy
10,524
11,113
31,098
31,916
Net Equipment
4,523
4,662
15,018
14,101
Professional Fees
2,494
2,245
7,012
6,697
FDIC Insurance
1,822
2,065
5,981
7,319
18,284
19,563
53,431
65,889
Total Noninterest Expense
84,878
83,955
250,832
263,811
Income Before Provision for Income Taxes
61,128
61,494
182,454
173,928
Provision for Income Taxes
19,896
18,188
56,665
53,114
Net Income
41,232
43,306
125,789
120,814
Basic Earnings Per Share
0.92
0.93
2.78
2.55
Diluted Earnings Per Share
2.77
2.54
Dividends Declared Per Share
0.45
1.35
Basic Weighted Average Shares
44,913,348
46,806,439
45,280,541
47,358,049
Diluted Weighted Average Shares
45,050,638
46,934,140
45,421,624
47,531,066
The accompanying notes are an integral part of the Consolidated Financial Statements (Unaudited).
Consolidated Statements of Comprehensive Income (Unaudited)
(dollars in thousands)
Other Comprehensive Income, Net of Tax:
Net Unrealized Gains on Investment Securities
9,770
18,611
6,703
18,376
Defined Benefit Plans
152
365
1,413
Other Comprehensive Income
9,922
18,976
7,161
19,789
Comprehensive Income
51,154
62,282
132,950
140,603
Consolidated Statements of Condition (Unaudited)
December 31,
Assets
Interest-Bearing Deposits
4,673
3,036
251,664
512,384
Investment Securities
3,124,209
3,451,885
Held-to-Maturity (Fair Value of $3,587,997 and $3,754,206)
3,475,259
3,657,796
Loans Held for Sale
25,971
18,957
Loans and Leases
5,782,304
5,538,304
Allowance for Loan and Lease Losses
(130,971
(138,606
Net Loans and Leases
5,651,333
5,399,698
Total Earning Assets
12,533,109
13,043,756
Cash and Noninterest-Bearing Deposits
153,599
154,489
Premises and Equipment
107,144
103,550
Customers’ Acceptances
242
476
Accrued Interest Receivable
47,192
43,510
Foreclosed Real Estate
3,067
3,042
Mortgage Servicing Rights
23,980
24,279
Goodwill
31,517
Other Assets
482,575
441,772
Total Assets
13,382,425
13,846,391
Liabilities
Noninterest-Bearing Demand
2,985,561
2,850,923
Interest-Bearing Demand
2,034,319
2,005,983
Savings
4,480,733
4,398,638
Time
1,719,934
1,337,079
Total Deposits
11,220,547
10,592,623
10,942
10,791
818,080
1,925,998
28,065
30,696
Banker’s Acceptances
Retirement Benefits Payable
41,872
46,949
Accrued Interest Payable
5,997
5,330
Taxes Payable and Deferred Taxes
94,369
95,840
Other Liabilities
137,749
135,021
Total Liabilities
12,357,863
12,843,724
Shareholders’ Equity
Common Stock ($.01 par value; authorized 500,000,000 shares; issued / outstanding: September 30, 2012 - 57,315,093 / 45,004,813 and December 31, 2011 - 57,134,470 / 45,947,116)
571
Capital Surplus
513,758
507,558
Accumulated Other Comprehensive Income
42,424
35,263
Retained Earnings
1,065,245
1,003,938
Treasury Stock, at Cost (Shares: September 30, 2012 - 12,310,280 and December 31, 2011 - 11,187,354)
(597,436
(544,663
Total Shareholders’ Equity
1,024,562
1,002,667
Total Liabilities and Shareholders’ Equity
Consolidated Statements of Shareholders’ Equity (Unaudited)
Accum.
Common
Compre-
Shares
Capital
hensive
Retained
Treasury
Outstanding
Stock
Surplus
Income
Earnings
Total
Balance as of December 31, 2011
45,947,116
Share-Based Compensation
5,687
Common Stock Issued under Purchase and Equity Compensation Plans and Related Tax Benefits
471,104
513
(3,023
13,472
10,962
Common Stock Repurchased
(1,413,407
(66,245
Cash Dividends Paid ($1.35 per share)
(61,459
Balance as of September 30, 2012
45,004,813
Balance as of December 31, 2010
48,097,672
570
500,888
26,965
932,629
(449,919
1,011,133
2,001
309,108
366
(3,193
13,303
10,477
(1,836,367
(82,391
(64,048
Balance as of September 30, 2011
46,570,413
503,255
46,754
986,202
(519,007
1,017,775
Consolidated Statements of Cash Flows (Unaudited)
Operating Activities
Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:
Depreciation and Amortization
10,339
10,918
Amortization of Deferred Loan and Lease Fees
(2,493
(1,986
Amortization and Accretion of Premiums/Discounts on Investment Securities, Net
42,633
35,899
Benefit Plan Contributions
(5,888
(965
Deferred Income Taxes
(16,793
(8,277
Net Gain on Sale of Proprietary Mutual Funds
(1,956
Net Gains on Sales of Loans and Leases
(11,645
(4,658
Net Losses (Gains) on Investment Securities
77
(6,084
Proceeds from Sales of Loans Held for Sale
369,481
334,883
Originations of Loans Held for Sale
(367,965
(317,646
Tax Benefits from Share-Based Compensation
(712
(696
Net Change in Other Assets and Other Liabilities
(24,094
Net Cash Provided by Operating Activities
125,395
182,488
Investing Activities
Investment Securities Available-for-Sale:
Proceeds from Prepayments and Maturities
737,377
730,294
Proceeds from Sales
44,844
682,283
Purchases
(452,430
(1,535,348
Investment Securities Held-to-Maturity:
689,246
199,844
(540,472
(384,785
Proceeds from Sale of Proprietary Mutual Funds
1,956
Net Change in Loans and Leases
(253,521
(37,522
Premises and Equipment, Net
(13,933
(7,257
Net Cash Provided by (Used in) Investing Activities
211,111
(350,535
Financing Activities
Net Change in Deposits
627,924
120,018
Net Change in Short-Term Borrowings
(1,107,767
28,786
712
696
Proceeds from Issuance of Common Stock
10,356
9,919
Repurchase of Common Stock
Cash Dividends Paid
Net Cash Provided by (Used in) Financing Activities
(596,479
12,980
Net Change in Cash and Cash Equivalents
(259,973
(155,067
Cash and Cash Equivalents at Beginning of Period
669,909
607,547
Cash and Cash Equivalents at End of Period
409,936
452,480
Supplemental Information
Cash Paid for Interest
31,483
35,448
Cash Paid for Income Taxes
58,625
68,613
Non-Cash Investing Activities:
Transfer from Investment Securities Available-For-Sale to Investment Securities Held-To-Maturity
2,220,814
Transfer from Loans to Foreclosed Real Estate
3,230
2,067
Transfers from Loans to Loans Held for Sale
8,555
Notes to Consolidated Financial Statements
(Unaudited)
Note 1. Summary of Significant Accounting Policies
Basis of Presentation
Bank of Hawaii Corporation (the “Parent”) is a Delaware corporation and a bank holding company headquartered in Honolulu, Hawaii. Bank of Hawaii Corporation and its Subsidiaries (the “Company”) provide a broad range of financial products and services to customers in Hawaii, Guam, and other Pacific Islands. The Parent’s principal and only operating subsidiary is Bank of Hawaii (the “Bank”). All significant intercompany accounts and transactions have been eliminated in consolidation.
The accompanying unaudited consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and accompanying notes required by GAAP for complete financial statements. In the opinion of management, the consolidated financial statements reflect normal recurring adjustments necessary for a fair presentation of the results for the interim periods.
Certain prior period information has been reclassified to conform to the current period presentation.
These statements should be read in conjunction with the audited consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. Operating results for the interim periods disclosed herein are not necessarily indicative of the results that may be expected for the year ending December 31, 2012.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts in the financial statements and accompanying notes. Actual results may differ from those estimates and such differences could be material to the financial statements.
Realized gains and losses are recorded in noninterest income using the specific identification method.
In April 2011, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) No. 2011-03, “Reconsideration of Effective Control for Repurchase Agreements.” The provisions of ASU No. 2011-03 modify the criteria for determining when repurchase agreements would be accounted for as a secured borrowing rather than as a sale. ASU No. 2011-03 removes from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee. The FASB believes that contractual rights and obligations determine effective control and that there does not need to be a requirement to assess the ability to exercise those rights. ASU No. 2011-03 does not change the other existing criteria used in the assessment of effective control. The Company adopted the provisions of ASU No. 2011-03 prospectively for transactions or modifications of existing transactions that occurred on or after January 1, 2012. As the Company accounted for all of its repurchase agreements as collateralized financing arrangements prior to the adoption of ASU No. 2011-03, the adoption had no impact on the Company’s Consolidated Financial Statements.
Fair Value Measurements
In May 2011, the FASB issued ASU No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” The provisions of ASU No. 2011-04 result in a consistent definition of fair value and common requirements for the measurement of and disclosure about fair value between U.S. GAAP and International Financial Reporting Standards (“IFRS”). The changes to U.S. GAAP as a result of ASU No. 2011-04 are as follows: (1) The concepts of highest and best use and valuation premise are only relevant when measuring the fair value of nonfinancial assets (that is, it does not apply to financial assets or any liabilities); (2) U.S. GAAP currently prohibits application of a blockage factor in valuing financial instruments with quoted prices in active markets. ASU No. 2011-04 extends that prohibition to all fair value measurements; (3) An exception is provided to the basic fair value measurement principles for an entity that holds a group of financial assets and financial liabilities with offsetting positions in market risks or counterparty credit risk that are managed on the basis of the entity’s net exposure to either of those risks. This exception allows the entity, if certain criteria are met, to measure the fair value of the net asset or liability position in a manner consistent with how market participants would price the net risk position; (4) Aligns the fair value measurement of instruments classified within an entity’s shareholders’ equity with the guidance for liabilities; and (5) Disclosure requirements have been expanded for Level 3 fair value measurements to disclose quantitative information about unobservable inputs and assumptions used, to describe the valuation processes used by the entity, and to qualitatively describe the sensitivity of fair value measurements to changes in unobservable inputs and the interrelationships between those inputs. In addition, entities must report the level in the fair value hierarchy of items that are not measured at fair value in the statement of condition but whose fair value must be disclosed. The Company adopted the provisions of ASU No. 2011-04 effective January 1, 2012. The fair value measurement provisions of ASU No. 2011-04 had no impact on the Company’s statements of income and condition. See Note 12 to the Consolidated Financial Statements for the expanded disclosures required by ASU No. 2011-04.
In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income.” The provisions of ASU No. 2011-05 allow an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both options, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. Under either method, entities are required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. ASU No. 2011-05 also eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity but does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. ASU No. 2011-05 was effective for the Company’s interim reporting period beginning on or after January 1, 2012, with retrospective application required. In December 2011, the FASB issued ASU No. 2011-12, “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” The provisions of ASU No. 2011-12 defer indefinitely the requirement for entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. ASU No. 2011-12, which shares the same effective date as ASU No. 2011-05, does not defer the requirement for entities to present components of comprehensive income in either a single continuous statement of comprehensive income or in two separate but consecutive statements. The Company adopted the provisions of ASU No. 2011-05 and ASU No. 2011-12 which resulted in a new statement of comprehensive income for the interim period ended March 31, 2012. The adoption of ASU No. 2011-05 and ASU No. 2011-12 had no impact on the Company’s statements of income and condition.
Future Application of Accounting Pronouncements
In December 2011, the FASB issued ASU No. 2011-11, “Disclosures About Offsetting Assets and Liabilities.” This project began as an attempt to converge the offsetting requirements under U.S. GAAP and IFRS. However, as the FASB and International Accounting Standards Board were not able to reach a converged solution with regards to offsetting requirements, they each developed convergent disclosure requirements to assist in reconciling differences in the offsetting requirements under U.S. GAAP and IFRS. The new disclosure requirements mandate that entities disclose both gross and net information about instruments and transactions eligible for offset in the statement of financial position as well as instruments and transactions subject to an agreement similar to a master netting arrangement. ASU No. 2011-11 also requires disclosure of collateral received and posted in connection with master netting agreements or similar arrangements. ASU No. 2011-11 is effective for interim and annual reporting periods beginning on or after January 1, 2013. As the provisions of ASU No. 2011-11 only impact the disclosure requirements related to the offsetting of assets and liabilities, the adoption will have no impact on the Company’s statements of income and condition.
8
In July 2012, the FASB issued ASU No. 2012-02, “Testing Indefinite-Lived Intangible Assets for Impairment.” The provisions of ASU No. 2012-02 permit an entity to first assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform a quantitative impairment test, as is currently required by GAAP. ASU No. 2012-02 is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. As the Company does not have any indefinite-lived intangible assets, other than goodwill, the adoption of ASU No. 2012-02 is expected to have no impact on the Company’s Consolidated Financial Statements.
Note 2. Investment Securities
The amortized cost, gross unrealized gains and losses, and fair value of the Company’s investment securities as of September 30, 2012 and December 31, 2011 were as follows:
Gross
Amortized
Unrealized
Fair
Cost
Gains
Losses
Value
September 30, 2012
Available-for-Sale:
Debt Securities Issued by the U.S. Treasury and Government Agencies
990,957
15,193
(4
1,006,146
Debt Securities Issued by States and Political Subdivisions
682,054
32,990
(1
715,043
Debt Securities Issued by Corporations
82,567
2,341
(10
84,898
Mortgage-Backed Securities Issued by
Government Agencies
1,241,154
35,876
(615
1,276,415
U.S. Government-Sponsored Enterprises
39,327
2,380
41,707
Total Mortgage-Backed Securities
1,280,481
38,256
1,318,122
3,036,059
88,780
(630
Held-to-Maturity:
179,451
5,802
185,253
3,260,932
104,407
(22
3,365,317
34,876
2,551
37,427
3,295,808
106,958
3,402,744
112,760
3,587,997
December 31, 2011
1,220,282
11,204
(468
1,231,018
391,276
15,783
407,059
97,917
607
(2,137
96,387
1,618,913
38,066
(1,107
1,655,872
58,548
3,001
61,549
1,677,461
41,067
1,717,421
3,386,936
68,661
(3,712
179,474
6,704
186,178
3,429,038
89,801
(2,918
3,515,921
49,284
2,823
52,107
3,478,322
92,624
3,568,028
99,328
3,754,206
9
The table below presents an analysis of the contractual maturities of the Company’s investment securities as of September 30, 2012. Mortgage-backed securities are disclosed separately in the table below as these investment securities may prepay prior to their scheduled contractual maturity dates.
Amortized Cost
Fair Value
Due in One Year or Less
515,969
517,705
Due After One Year Through Five Years
234,406
242,906
Due After Five Years Through Ten Years
302,891
315,529
Due After Ten Years
702,312
729,947
1,755,578
1,806,087
Investment securities with carrying values of $2.9 billion and $3.6 billion as of September 30, 2012 and December 31, 2011, respectively, were pledged to secure deposits of governmental entities and securities sold under agreements to repurchase. As of September 30, 2012 and December 31, 2011, the Company did not have any investment securities pledged where the secured party had the right to sell or repledge the collateral.
Gross realized gains were less than $0.1 million and there were no gross realized losses on the sales of investment securities for the three months ended September 30, 2012. There were no sales of investment securities for the three months ended September 30, 2011. Gross realized gains on the sales of investment securities were $0.3 million and $10.3 million for the nine months ended September 30, 2012 and 2011, respectively. Gross realized losses on the sales of investment securities were $0.3 million and $4.2 million for the nine months ended September 30, 2012 and 2011, respectively.
The Company’s investment securities in an unrealized loss position, segregated by continuous length of impairment, were as follows:
Less Than 12 Months
12 Months or Longer
260
626
(3
886
100
9,990
Mortgage-Backed Securities Issued by Government Agencies
57,368
(533
12,663
(104
70,031
(637
57,728
(535
23,279
(117
81,007
(652
127,644
(464
920
128,564
38,059
727,726
(3,751
34,824
(274
762,550
(4,025
893,429
(6,352
35,744
(278
929,173
(6,630
10
The Company does not believe that the investment securities that were in an unrealized loss position as of September 30, 2012, which was comprised of 18 securities, represent an other-than-temporary impairment. Total gross unrealized losses were primarily attributable to changes in interest rates, relative to when the investment securities were purchased, and not due to the credit quality of the investment securities. The Company does not intend to sell the investment securities that were in an unrealized loss position and it is not more likely than not that the Company will be required to sell the investment securities before recovery of their amortized cost bases, which may be at maturity.
As of September 30, 2012 and December 31, 2011, the gross unrealized losses reported for mortgage-backed securities were attributable related to investment securities issued by the Government National Mortgage Association.
As of September 30, 2012, the carrying value of the Company’s Federal Home Loan Bank and Federal Reserve Bank stock was $60.7 million and $18.8 million, respectively. These securities can only be redeemed or sold at their par value and only to the respective issuing government-supported institution or to another member institution. The Company records these non-marketable equity securities as a component of other assets and periodically evaluates these securities for impairment. Management considers these non-marketable equity securities to be long-term investments. Accordingly, when evaluating these securities for impairment, management considers the ultimate recoverability of the par value rather than by recognizing temporary declines in value.
Note 3. Loans and Leases and the Allowance for Loan and Lease Losses
The Company’s loan and lease portfolio was comprised of the following as of September 30, 2012 and December 31, 2011:
Commercial
Commercial and Industrial
808,621
817,170
Commercial Mortgage
1,039,556
938,250
Construction
101,818
98,669
Lease Financing
277,328
311,928
Total Commercial
2,227,323
2,166,017
Consumer
Residential Mortgage
2,392,871
2,215,892
Home Equity
770,284
780,691
Automobile
200,788
192,506
Other 1
191,038
183,198
Total Consumer
3,554,981
3,372,287
Total Loans and Leases
1 Comprised of other revolving credit, installment, and lease financing.
11
Allowance for Loan and Lease Losses (the “Allowance”)
The following presents by portfolio segment, the activity in the Allowance for the three and nine months ended September 30, 2012 and 2011. The following also presents by portfolio segment, the balance in the Allowance disaggregated on the basis of the Company’s impairment measurement method and the related recorded investment in loans and leases as of September 30, 2012 and 2011.
Three Months Ended September 30, 2012
Allowance for Loan and Lease Losses:
Balance at Beginning of Period
78,012
54,431
132,443
Loans and Leases Charged-Off
(519
(4,515
(5,034
Recoveries on Loans and Leases Previously Charged-Off
678
2,884
3,562
Net Loans and Leases Charged-Off
159
(1,631
(1,472
1,647
(1,647
Balance at End of Period
79,818
51,153
130,971
Nine Months Ended September 30, 2012
80,562
58,044
138,606
(3,358
(15,371
(18,729
3,252
6,863
10,115
(106
(8,508
(8,614
(638
1,617
As of September 30, 2012
Individually Evaluated for Impairment
39
3,244
3,283
Collectively Evaluated for Impairment
79,779
47,909
127,688
Recorded Investment in Loans and Leases:
13,119
34,889
48,008
2,214,204
3,520,092
5,734,296
Three Months Ended September 30, 2011
88,985
55,991
144,976
(4,215
(6,556
(10,771
4,929
2,096
7,025
714
(4,460
(3,746
(7,024
9,204
82,675
60,735
143,410
Nine Months Ended September 30, 2011
80,977
66,381
147,358
(7,379
(19,773
(27,152
5,994
6,739
12,733
(1,385
(13,034
(14,419
3,083
7,388
As of September 30, 2011
4,179
56,556
139,231
8,602
26,400
35,002
2,085,561
3,227,909
5,313,470
2,094,163
3,254,309
5,348,472
12
Credit Quality Indicators
The Company uses several credit quality indicators to manage credit risk in an ongoing manner. The Company uses an internal credit risk rating system that categorizes loans and leases into pass, special mention, or classified categories. Credit risk ratings are applied individually to those classes of loans and leases that have significant or unique credit characteristics that benefit from a case-by-case evaluation. These are typically loans and leases to businesses or individuals in the classes which comprise the commercial portfolio segment. Groups of loans and leases that are underwritten and structured using standardized criteria and characteristics, such as statistical models (e.g., credit scoring or payment performance), are typically risk-rated and monitored collectively. These are typically loans and leases to individuals in the classes which comprise the consumer portfolio segment.
The following are the definitions of the Company’s credit quality indicators:
Pass:
Loans and leases in all classes within the commercial and consumer portfolio segments that are not adversely rated. Management believes that there is a low likelihood of loss related to those loans and leases that are considered pass.
Special Mention:
Loans and leases in the classes within the commercial portfolio segment that have potential weaknesses that deserve management’s close attention. If not addressed, these potential weaknesses may result in deterioration of the repayment prospects for the loan or lease. The special mention credit quality indicator is not used for classes of loans and leases that are included in the consumer portfolio segment. Management believes that there is a moderate likelihood of some loss related to those loans and leases that are considered special mention.
Classified:
Loans and leases in the classes within the commercial portfolio segment that are inadequately protected by the sound worth and paying capacity of the borrower or of the collateral pledged, if any. Classified loans and leases are also those in the classes within the consumer portfolio segment that are past due 90 days or more as to principal or interest. Residential mortgage loans that are past due 90 days or more as to principal or interest may be considered pass if the Company is in the process of collection and the current loan-to-value ratio is 60% or less. Home equity loans that are past due 90 days or more as to principal or interest may be considered pass if the Company is in the process of collection, the first mortgage is with the Company, and the current combined loan-to-value ratio is 60% or less. Residential mortgage and home equity loans may be current as to principal and interest, but may be considered classified for a period of up to six months following a loan modification. Following a period of demonstrated performance in accordance with the modified contractual terms, the loan may be removed from classified status. Management believes that there is a distinct possibility that the Company will sustain some loss if the deficiencies related to classified loans and leases are not corrected in a timely manner.
The Company’s credit quality indicators are periodically updated on a case-by-case basis. The following presents by class and by credit quality indicator, the recorded investment in the Company’s loans and leases as of September 30, 2012 and December 31, 2011.
Pass
752,688
956,582
86,050
249,734
2,045,054
Special Mention
23,640
30,851
11,684
26,282
92,457
Classified
32,293
52,123
4,084
1,312
89,812
2,367,353
766,462
200,634
190,459
3,524,908
25,518
3,822
154
579
30,073
Total Recorded Investment in Loans and Leases
765,339
859,891
83,722
282,081
1,991,033
30,316
43,805
370
26,257
100,748
21,515
34,554
14,577
3,590
74,236
2,186,063
776,473
192,336
182,431
3,337,303
29,829
4,218
170
767
34,984
14
Aging Analysis of Accruing and Non-Accruing Loans and Leases
The following presents by class, an aging analysis of the Company’s accruing and non-accruing loans and leases as of September 30, 2012 and December 31, 2011.
30 - 59 Days Past Due
60 - 89 Days Past Due
Past Due 90 Days or More
Non- Accrual
Total Past Due and Non-Accrual
Current
Non-Accrual Loans and Leases that are Current 2
1,197
1,342
5,635
8,174
800,447
5,014
542
2,671
3,213
1,036,343
2,446
953
100,865
1,884
9,259
12,340
2,214,983
8,413
10,123
5,221
3,988
25,456
44,788
2,348,083
5,202
4,012
2,293
2,755
2,502
11,562
758,722
477
3,412
541
4,107
196,681
2,029
1,192
578
3,799
187,239
19,576
9,247
7,475
27,958
64,256
3,490,725
5,679
20,773
11,131
37,217
76,596
5,705,708
14,092
As of December 31, 2011
2,959
743
6,243
9,946
807,224
5,661
2,140
2,818
935,432
959
2,080
96,589
311,923
3,637
10,468
14,849
2,151,168
6,625
8,878
9,258
6,422
25,256
49,814
2,166,078
1,856
5,310
2,694
2,194
2,024
12,222
768,469
97
4,095
839
5,104
187,402
1,679
1,528
435
3,642
179,556
19,962
14,319
9,221
27,280
70,782
3,301,505
1,953
23,599
15,062
9,222
37,748
85,631
5,452,673
8,578
2 Represents non-accrual loans that are not past due 30 days or more; however, full payment of principal and interest is still not expected.
Impaired Loans
The following presents by class, information related to the Company’s impaired loans as of September 30, 2012 and December 31, 2011.
Recorded Investment
Unpaid Principal Balance
Related Allowance for Loan Losses
Impaired Loans with No Related Allowance Recorded:
8,496
13,746
2,963
3,463
1,283
12,412
18,492
Total Impaired Loans with No Related Allowance Recorded
Impaired Loans with an Allowance Recorded:
707
28,983
35,166
3,195
5,621
31
285
18
41,072
Total Impaired Loans with an Allowance Recorded
35,596
41,779
Impaired Loans:
19,199
Total Impaired Loans
60,271
6,176
13,526
2,640
8,316
16,166
4,447
846
292
19
330
6,819
1,195
25,726
30,606
4,138
21
6,190
75
528
42
32,465
37,345
4,256
39,284
44,164
5,451
15,135
22,985
47,600
60,330
1 Comprised of other revolving credit and installment financing.
16
The following presents by class, information related to the average recorded investment and interest income recognized on impaired loans for the three and nine months ended September 30, 2012 and 2011.
September 30, 2011
Average Recorded Investment
Interest Income Recognized
8,765
4,019
2,996
2,693
1,068
144
12,829
6,856
–
797
26
3,030
27
311
30
3,341
28
27,826
25,374
78
5,675
140
5,837
150
287
601
33,788
241
31,833
236
34,585
271
35,174
264
13,626
10,197
47,414
42,030
8,215
2,665
2,561
3,022
904
192
11,680
5,879
1,748
90
3,873
116
146
351
520
96
2,414
102
4,320
126
26,244
254
23,662
252
5,854
443
5,841
438
404
22
32,507
711
30,037
34,921
813
34,357
838
14,094
10,199
46,601
40,236
For the three and nine months ended September 30, 2012 and 2011, the amount of interest income recognized by the Company within the periods that the loans were impaired were primarily related to loans modified in a troubled debt restructuring that remained on accrual status. For the three and nine months ended September 30, 2012 and 2011, the amount of interest income recognized using a cash-basis method of accounting during the periods that the loans were impaired was not material.
Modifications
A modification of a loan constitutes a troubled debt restructuring (“TDR”) when the Company for economic or legal reasons related to a borrower’s financial difficulties grants a concession to the borrower that it would not otherwise consider. Loans modified in a TDR were $41.3 million and $38.8 million as of September 30, 2012 and December 31, 2011, respectively. There were no commitments to lend additional funds on loans modified in a TDR as of September 30, 2012.
The Company offers various types of concessions when modifying a loan or lease, however, forgiveness of principal is rarely granted. Commercial and industrial loans modified in a TDR often involve temporary interest-only payments, term extensions, and converting revolving credit lines to term loans. Additional collateral, a co-borrower, or a guarantor is often requested. Commercial mortgage and construction loans modified in a TDR often involve reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor. Construction loans modified in a TDR may also involve extending the interest-only payment period. Lease financing modifications generally involve a short-term forbearance period, usually about three months, after which the missed payments are added to the end of the lease term, thereby extending the maturity date. Interest continues to accrue on the missed payments and as a result, the effective yield on the lease remains unchanged. As the forbearance period usually involves an insignificant payment delay, lease financing modifications typically do not meet the reporting criteria for a TDR. Residential mortgage loans modified in a TDR are primarily comprised of loans where monthly payments are lowered to accommodate the borrowers’ financial needs for a period of time, normally two years. During that time, the borrower’s entire monthly payment is applied to principal. After the lowered monthly payment period ends, the borrower reverts back to paying principal and interest per the original terms with the maturity date adjusted accordingly. Land loans are also included in the class of residential mortgage loans. Land loans are typically structured as interest-only monthly payments with a balloon payment due at maturity. Land loans modified in a TDR typically involve extending the balloon payment by one to three years, changing the monthly payments from interest-only to principal and interest, while leaving the interest rate unchanged. Home equity modifications are made infrequently and are offered to borrowers if the Company does not hold the first mortgage. Home equity modifications are uniquely designed to meet the specific needs of each borrower. Borrowers having both a first mortgage and home equity loan with the Company are offered a residential mortgage loan modification. Automobile loans modified in a TDR are primarily comprised of loans where the Company has lowered monthly payments by extending the term.
Loans modified in a TDR are typically already on non-accrual status and partial charge-offs have in some cases already been taken against the outstanding loan balance. As a result, loans modified in a TDR may have the financial effect of increasing the specific Allowance associated with the loan. An Allowance for impaired consumer and commercial loans that have been modified in a TDR is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the estimated fair value of the collateral, less any selling costs, if the loan is collateral dependent. Management exercises significant judgment in developing these estimates.
The following presents by class, information related to loans modified in a TDR during the three and nine months ended September 30, 2012.
Loans Modified as a TDR for the
Recorded
Increase in
Troubled Debt Restructurings 1
Number of
Investment
Allowance
Contracts
(as of period end)
2,757
7,106
957
60
635
1,516
3,392
516
157
8,622
965
158
9,575
1 The period end balances reflect all paydowns and charge-offs since the modification date. TDRs fully paid off, charged-off, or foreclosed upon by period end are not included.
The following presents by class, all loans modified in a TDR that defaulted during the three and nine months ended September 30, 2012, and within twelve months of their modification date. A TDR is considered to be in default once it becomes 60 days or more past due following a modification.
TDRs that Defaulted During the Period,
Within Twelve Months of their Modification Date
(as of period end) 1
702
32
734
There were no residential mortgage loans modified in a TDR that subsequently defaulted during the three months ended September 30, 2012. Of the two residential mortgage loans modified in a TDR that subsequently defaulted during the nine months ended September 30, 2012, one was modified by temporarily lowering monthly payments and applying all payments during this time to principal. The other residential mortgage loan in default pertained to a land loan which was modified from an interest-only loan to an amortizing loan, while granting a brief extension on the balloon payment. The automobile loans modified in a TDR that subsequently defaulted were primarily modified by lowering monthly payments by extending the term.
Commercial and consumer loans modified in a TDR are closely monitored for delinquency as an early indicator of possible future default. If loans modified in a TDR subsequently default, the Company evaluates the loan for possible further impairment. The specific Allowance associated with the loan may be increased, adjustments may be made in the allocation of the Allowance, or partial charge-offs may be taken to further write-down the carrying value of the loan.
Note 4. Mortgage Servicing Rights
The Company’s portfolio of residential mortgage loans serviced for third parties was $3.1 billion and $3.2 billion as of September 30, 2012 and December 31, 2011, respectively. Generally, the Company’s residential mortgage loans sold to third parties are sold on a non-recourse basis. The Company’s mortgage servicing activities include collecting principal, interest, and escrow payments from borrowers; making tax and insurance payments on behalf of borrowers; monitoring delinquencies and executing foreclosure proceedings; and accounting for and remitting principal and interest payments to investors. Servicing income, including late and ancillary fees, was $2.0 million and $2.2 million for the three months ended September 30, 2012 and 2011, respectively, and $6.0 million and $6.3 million for the nine months ended September 30, 2012 and 2011, respectively. Servicing income is recorded as a component of mortgage banking income in the Company’s consolidated statements of income. The Company’s residential mortgage investor loan servicing portfolio is primarily comprised of fixed rate loans concentrated in Hawaii.
For the three and nine months ended September 30, 2012 and 2011, the change in the carrying value of the Company’s mortgage servicing rights accounted for under the fair value measurement method was as follows:
5,459
8,852
7,131
10,226
Change in Fair Value:
Due to Change in Valuation Assumptions 1
(5
(1,162
(886
(1,649
Due to Payoffs
(338
(257
(1,129
(1,144
Total Changes in Fair Value of Mortgage Servicing Rights
(343
(1,419
(2,015
(2,793
5,116
7,433
1 Principally represents changes in discount rates and loan repayment rate assumptions, mostly due to changes in interest rates.
For the three and nine months ended September 30, 2012 and 2011, the change in the carrying value of the Company’s mortgage servicing rights accounted for under the amortization method was as follows:
17,795
16,220
17,148
15,153
Servicing Rights that Resulted From Asset Transfers
1,747
976
3,716
2,938
Amortization
(678
(639
(2,000
(1,534
18,864
16,557
Fair Value of Mortgage Servicing Rights Accounted for Under the Amortization Method
Beginning of Period
18,937
21,483
17,159
20,340
End of Period
20,241
17,156
The key data and assumptions used in estimating the fair value of the Company’s mortgage servicing rights as of September 30, 2012 and December 31, 2011 were as follows:
Weighted-Average Constant Prepayment Rate 1
13.74
%
15.56
Weighted-Average Life (in years)
5.65
5.03
Weighted-Average Note Rate
4.69
4.87
Weighted-Average Discount Rate 2
5.54
6.31
1 Represents annualized loan repayment rate assumption.
2 Derived from multiple interest rate scenarios that incorporate a spread to the London Interbank Offered Rate swap curve and market volatilities.
A sensitivity analysis of the Company’s fair value of mortgage servicing rights to changes in certain key assumptions as of September 30, 2012 and December 31, 2011 is presented in the following table.
Constant Prepayment Rate
Decrease in fair value from 25 basis points (“bps”) adverse change
(333
(295
Decrease in fair value from 50 bps adverse change
(657
(582
Discount Rate
Decrease in fair value from 25 bps adverse change
(386
(331
(760
This analysis generally cannot be extrapolated because the relationship of a change in one key assumption to the change in the fair value of the Company’s mortgage servicing rights usually is not linear. Also, the effect of changing one key assumption without changing other assumptions is not realistic.
20
Note 5. Securities Sold Under Agreements to Repurchase
The Company enters into agreements under which it sells securities subject to an obligation to repurchase the same or similar securities. Under these arrangements, the Company may transfer legal control over the assets but still retain effective control through an agreement that both entitles and obligates the Company to repurchase the assets. As a result, securities sold under agreements to repurchase are accounted for as collateralized financing arrangements and not as a sale and subsequent repurchase of securities. The obligation to repurchase the securities is reflected as a liability in the Company’s consolidated statements of condition, while the securities underlying the securities sold under agreements to repurchase remain in the respective asset accounts and are delivered to and held as collateral by third party trustees.
As of September 30, 2012, the contractual maturities of the Company’s securities sold under agreements to repurchase were as follows:
Amount
Overnight
2 to 30 Days
41,631
31 to 90 Days
13,599
Over 90 Days
762,850
Note 6. Other Comprehensive Income
The following table presents the components of other comprehensive income for the three and nine months ended September 30, 2012 and 2011:
Before Tax
Tax Effect
Net of Tax
Net Unrealized Gains on Investment Securities:
Net Unrealized Gains Arising During the Period
20,129
7,893
12,236
Less: Reclassification Adjustment for Gains Realized in Net Income
(4,099
(1,633
(2,466
16,030
6,260
Defined Benefit Plans:
Amortization of Prior Service Credit and Net Actuarial Losses During the Period
251
99
Defined Benefit Plans, Net
16,281
6,359
32,184
12,677
19,507
(1,508
(612
(896
30,676
12,065
777
412
31,453
12,477
23,125
9,111
14,014
(12,062
(4,751
(7,311
11,063
4,360
756
298
11,819
4,658
40,003
15,784
24,219
(9,640
(3,797
(5,843
30,363
11,987
2,331
918
32,694
12,905
Note 7. Earnings Per Share
There were no adjustments to net income, the numerator, for purposes of computing earnings per share. The following is a reconciliation of the weighted average number of common shares outstanding for computing diluted earnings per share and antidilutive stock options and restricted stock outstanding for the three and nine months ended September 30, 2012 and 2011:
Denominator for Basic Earnings Per Share
Dilutive Effect of Stock Options
99,270
110,617
115,516
156,226
Dilutive Effect of Restricted Stock
38,020
17,084
25,567
16,791
Denominator for Diluted Earnings Per Share
Antidilutive Shares Outstanding
529,050
253,052
217,209
Note 8. Business Segments
The Company’s business segments are defined as Retail Banking, Commercial Banking, Investment Services, and Treasury and Other. The Company’s internal management accounting process measures the performance of the business segments based on the management structure of the Company. This process, which is not necessarily comparable with similar information for any other financial institution, uses various techniques to assign balance sheet and income statement amounts to the business segments, including allocations of income, expense, the provision for credit losses, and capital. This process is dynamic and requires certain allocations based on judgment and other subjective factors. Unlike financial accounting, there is no comprehensive authoritative guidance for management accounting that is equivalent to GAAP. Previously reported results have been reclassified to conform to the current organizational reporting structure.
The net interest income of the business segments reflects the results of a funds transfer pricing process that matches assets and liabilities with similar interest rate sensitivity and maturity characteristics and reflects the allocation of net interest income related to the Company’s overall asset and liability management activities on a proportionate basis. The basis for the allocation of net interest income is a function of the Company’s assumptions that are subject to change based on changes in current interest rates and market conditions. Funds transfer pricing also serves to transfer interest rate risk to Treasury. However, the other business segments have some latitude to retain certain interest rate exposures related to customer pricing decisions within guidelines.
The provision for credit losses reflects the actual net charge-offs of the business segments. This may be adjusted periodically for changes in the risk profile of the business segment. The amount of the consolidated provision for loan and lease losses is based on the methodology that we use to estimate our consolidated Allowance. The residual provision for credit losses to arrive at the consolidated provision for credit losses is included in Treasury and Other.
Implicit in noninterest income and expense are allocations from support units to business units. These allocations are based on actual usage where practicably calculated or by management’s estimate of such usage.
The provision for income taxes is allocated to business segments using a 37% effective tax rate, with the exception of our Leasing business unit which is assigned its actual effective tax rate due to the unique relationship that income taxes have with their leasing products. The residual income tax expense or benefit to arrive at the consolidated effective tax rate is included in Treasury and Other.
Retail Banking
Retail Banking offers a broad range of financial products and services to consumers and small businesses. Loan and lease products include residential mortgage loans, home equity lines of credit, automobile loans and leases, installment loans, and small business loans and leases. Deposit products include checking, savings, and time deposit accounts. Retail Banking also offers retail life insurance products. Products and services from Retail Banking are delivered to customers through 66 Hawaii branch locations, 495 ATMs throughout Hawaii and the Pacific Islands, e-Bankoh (on-line banking service), a 24-hour customer service center, and a mobile banking service.
23
Commercial Banking
Commercial Banking offers products including corporate banking, commercial real estate loans, commercial lease financing, auto dealer financing, and deposit products. Commercial lending and deposit products are offered to middle-market and large companies in Hawaii. Commercial real estate mortgages focus on customers that include investors, developers, and builders predominantly domiciled in Hawaii. Commercial Banking also includes international banking and operations at the Bank’s 11 branches in the Pacific Islands and also provides merchant services to its small business customers.
Investment Services
Investment Services includes private banking, trust services, investment management, and institutional investment advisory services. A significant portion of this segment’s income is derived from fees, which are generally based on the market values of assets under management. The private banking and personal trust group assists individuals and families in building and preserving their wealth by providing investment, credit, and trust services to high-net-worth individuals. The investment management group manages portfolios and creates investment products. Institutional client services offer investment advice to corporations, government entities, and foundations. This segment also provides a full service brokerage offering equities, mutual funds, life insurance, and annuity products.
Treasury and Other
Treasury consists of corporate asset and liability management activities, including interest rate risk management and a foreign currency exchange business. This segment’s assets and liabilities (and related interest income and expense) consist of interest-bearing deposits, investment securities, federal funds sold and purchased, government deposits, and short and long-term borrowings. The primary sources of noninterest income are from bank-owned life insurance, net gains from the sale of investment securities, and foreign exchange income related to customer-driven currency requests from merchants and island visitors. The net residual effect of the transfer pricing of assets and liabilities is included in Treasury, along with the elimination of intercompany transactions.
Other organizational units (Technology, Operations, Marketing, Human Resources, Finance, Credit and Risk Management, and Corporate and Regulatory Administration) provide a wide-range of support to the Company’s other income earning segments. Expenses incurred by these support units are charged to the business segments through an internal cost allocation process.
24
Selected business segment financial information as of and for the three and nine months ended September 30, 2012 and 2011 were as follows:
Retail
Consolidated
Banking
Services
and Other
38,530
30,811
3,607
20,684
1,677
(180
(24
(1,473
36,853
30,991
3,631
22,157
24,918
8,687
15,350
3,419
(45,454
(22,120
(14,519
(2,785
(84,878
16,317
17,558
4,462
22,791
(6,038
(6,051
(1,651
(6,156
(19,896
10,279
11,507
2,811
16,635
Total Assets as of September 30, 2012
3,242,817
2,397,307
321,273
7,421,028
43,334
33,935
3,698
15,799
4,477
(935
205
(1,567
38,857
34,870
3,493
17,366
24,677
9,426
15,971
789
(45,026
(22,626
(14,615
(1,688
(83,955
18,508
21,670
4,849
16,467
(6,848
(7,468
(1,794
(2,078
(18,188
11,660
14,202
3,055
14,389
Total Assets as of September 30, 2011
3,050,418
2,249,890
212,914
7,791,536
13,304,758
117,179
93,069
10,738
65,975
9,041
(691
265
(7,636
108,138
93,760
10,473
73,611
65,443
28,816
44,482
8,563
(133,758
(67,247
(43,524
(6,303
(250,832
39,823
55,329
11,431
75,871
(14,735
(15,103
(4,229
(22,598
(56,665
25,088
40,226
7,202
53,273
131,648
103,624
11,353
47,337
15,105
(726
(3,973
116,543
104,350
11,288
51,310
66,494
28,224
46,256
13,274
(141,114
(71,363
(45,062
(6,272
(263,811
41,923
61,211
12,482
58,312
(15,512
(21,215
(4,618
(11,769
(53,114
26,411
39,996
7,864
46,543
25
Note 9. Pension Plans and Postretirement Benefit Plan
Components of net periodic benefit cost for the Company’s pension plans and the postretirement benefit plan are presented in the following table for the three and nine months ended September 30, 2012 and 2011.
Pension Benefits
Postretirement Benefits
Three Months Ended September 30,
Service Cost
145
123
Interest Cost
1,263
1,305
319
359
Expected Return on Plan Assets
(1,354
(1,612
Amortization of:
Prior Service Credit
(80
(53
Net Actuarial Losses
331
830
Net Periodic Benefit Cost
240
523
384
429
Nine Months Ended September 30,
369
3,789
3,914
958
1,078
(4,371
(4,837
(242
(160
Net Actuarial Losses (Gains)
998
2,492
416
1,569
1,151
1,286
The net periodic benefit cost for the Company’s pension plans and postretirement benefit plan are recorded as a component of salaries and benefits in the consolidated statements of income. For the three and nine months ended September 30, 2012, the Company contributed $0.1 million and $5.4 million, respectively, to the pension plans and $0.2 million and $0.5 million, respectively, to the postretirement benefit plan. The Company expects to contribute $5.5 million to the pension plans and $1.3 million to the postretirement benefit plan for the year ending December 31, 2012.
Note 10. Derivative Financial Instruments
The following table presents the Company’s derivative financial instruments, their fair values, and balance sheet location as of September 30, 2012 and December 31, 2011:
Derivative Financial Instruments Not Designated as Hedging Instruments1 (dollars in thousands)
Asset Derivatives
Liability Derivatives
Interest Rate Lock Commitments
13,037
2,344
Forward Commitments
53
3,331
946
Interest Rate Swap Agreements
34,991
35,260
35,503
35,779
Foreign Exchange Contracts
57
58
230
48,138
38,649
38,085
36,832
1 Asset derivatives are included in other assets and liability derivatives are included in other liabilities in the consolidated statements of condition.
The following table presents the Company’s derivative financial instruments and the amount and location of the net gains or losses recognized in the statements of income for the three and nine months ended September 30, 2012 and 2011:
Location of Net Gains
Derivative Financial Instruments Not Designated
(Losses) Recognized in the
as Hedging Instruments (dollars in thousands)
Statement of Income
15,219
8,809
28,286
12,197
(2,132
(4,206
(3,894
(4,311
Other Noninterest Income
(67
300
852
717
2,432
2,357
13,941
5,253
26,831
10,543
Management has received authorization from the Bank’s Board of Directors to use derivative financial instruments as an end-user in connection with its risk management activities and to accommodate the needs of its customers. As with any financial instrument, derivative financial instruments have inherent risks. Market risk is defined as the risk of adverse financial impact due to fluctuations in interest rates, foreign exchange rates, and equity prices. Market risks associated with derivative financial instruments are balanced with the expected returns to enhance earnings performance and shareholder value, while limiting the volatility of each. The Company uses various processes to monitor its overall market risk exposure, including sensitivity analysis, value-at-risk calculations, and other methodologies.
Derivative financial instruments are also subject to credit and counterparty risk, which is defined as the risk of financial loss if a borrower or counterparty is either unable or unwilling to repay borrowings or settle a transaction in accordance with the underlying contractual terms. Credit and counterparty risks associated with derivative financial instruments are similar to those relating to traditional financial instruments. The Company manages derivative credit and counterparty risk by evaluating the creditworthiness of each borrower or counterparty, adhering to the same credit approval process used for commercial lending activities.
Derivative financial instruments are required to be carried at their fair value on the Company’s consolidated statements of condition. As of September 30, 2012 and December 31, 2011, the Company did not designate any derivative financial instruments in formal hedging relationships. The Company’s free-standing derivative financial instruments have been recorded at fair value on the Company’s consolidated statements of condition. These financial instruments have been limited to interest rate lock commitments (“IRLCs”), forward commitments, interest rate swap agreements, and foreign exchange contracts.
The Company enters IRLCs for residential mortgage loans which commit us to lend funds to a potential borrower at a specific interest rate and within a specified period of time. IRLCs that relate to the origination of mortgage loans that will be held for sale are considered derivative financial instruments under applicable accounting guidance. Outstanding IRLCs expose the Company to the risk that the price of the mortgage loans underlying the commitments may decline due to increases in mortgage interest rates from inception of the rate lock to the funding of the loan. To mitigate this risk, the Company utilizes forward commitments as economic hedges against the potential decreases in the values of the loans held for sale. The IRLCs and forward commitments are free-standing derivatives which are carried at fair value with changes recorded in the mortgage banking component of noninterest income in the Company’s consolidated statements of income. Changes in the fair value of IRLCs and forward commitments subsequent to inception are based on changes in the fair value of the underlying loan resulting from the fulfillment of the commitment and changes in the probability that the loan will fund within the terms of the commitment, which is affected primarily by changes in interest rates and the passage of time.
The Company enters into interest rate swap agreements to facilitate the risk management strategies of a small number of commercial banking customers. The Company mitigates this risk by entering into equal and offsetting interest rate swap agreements with highly rated third party financial institutions. The interest rate swap agreements are free-standing derivatives which are carried at fair value with changes included in other noninterest income in the Company’s consolidated statements of income. The Company is party to master netting arrangements with its institutional counterparties; however, the Company does not offset assets and liabilities under these arrangements for financial statement presentation purposes. Collateral, usually in the form of marketable securities, is posted by the counterparty with liability positions in accordance with contract thresholds. The Company had net liability positions with its financial institution counterparties totaling $35.3 million and $35.8 million as of September 30, 2012 and December 31, 2011, respectively. The collateral posted by the Company for these net liability positions was $3.4 million and $3.6 million as of September 30, 2012 and December 31, 2011, respectively.
The Company’s interest rate swap agreements with institutional counterparties contain credit-risk-related contingent features tied to the Company’s debt ratings or capitalization levels. Under these provisions, if the Company’s debt rating falls below investment grade or if the Company’s capitalization levels fall below stipulated thresholds, certain counterparties may require immediate and ongoing collateralization on interest rate swaps in net liability positions, or may require immediate settlement of the contracts. As of September 30, 2012, the Company’s debt ratings and capital levels were in excess of these minimum requirements.
The Company utilizes foreign exchange contracts to offset risks related to transactions executed on behalf of customers. The foreign exchange contracts are free-standing derivatives which are carried at fair value with changes included in other noninterest income in the Company’s consolidated statements of income.
Note 11. Credit Commitments
The Company’s credit commitments as of September 30, 2012 and December 31, 2011 were as follows:
Unfunded Commitments to Extend Credit
2,017,086
1,975,327
Standby Letters of Credit
64,325
74,082
Commercial Letters of Credit
15,004
18,486
Total Credit Commitments
2,096,415
2,067,895
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of the terms or conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since commitments may expire without being drawn, the total commitment amount does not necessarily represent future cash requirements.
Standby and Commercial Letters of Credit
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Standby letters of credit generally become payable upon the failure of the customer to perform according to the terms of the underlying contract with the third party, while commercial letters of credit are issued specifically to facilitate commerce and typically result in the commitment being drawn on when the underlying transaction is consummated between the customer and a third party. The contractual amount of these letters of credit represents the maximum potential future payments guaranteed by the Company. The Company has recourse against the customer for any amount it is required to pay to a third party under a standby letter of credit, and holds cash and deposits as collateral on those standby letters of credit for which collateral is deemed necessary.
Note 12. Fair Value of Assets and Liabilities
Fair Value Hierarchy
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for an asset or liability in an orderly transaction between market participants at the measurement date. GAAP established a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following three levels:
Level 1: Inputs to the valuation methodology are quoted prices, unadjusted, for identical assets or liabilities in active markets. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available. A contractually binding sales price also provides reliable evidence of fair value.
Level 2: Inputs to the valuation methodology include quoted prices for similar assets or liabilities in active markets; inputs to the valuation methodology include quoted prices for identical or similar assets or liabilities in markets that are not active; or inputs to the valuation methodology that utilize model-based techniques for which all significant assumptions are observable in the market.
Level 3: Inputs to the valuation methodology are unobservable and significant to the fair value measurement; inputs to the valuation methodology that utilize model-based techniques for which significant assumptions are not observable in the market; or inputs to the valuation methodology that requires significant management judgment or estimation, some of which may be internally developed.
Management maximizes the use of observable inputs and minimizes the use of unobservable inputs when determining fair value measurements. Management reviews and updates the fair value hierarchy classifications of the Company’s assets and liabilities on a quarterly basis.
Assets and Liabilities Measured at Fair Value on a Recurring Basis
Investment Securities Available-for-Sale
Fair values of investment securities available-for-sale were primarily measured using information from a third-party pricing service. This service provides pricing information by utilizing evaluated pricing models supported with market data information. Standard inputs include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data from market research publications. Level 1 investment securities are comprised of debt securities issued by the U.S. Treasury. As quoted prices were available, unadjusted, for identical securities in active markets, these securities were classified as Level 1 measurements. Level 2 investment securities were primarily comprised of debt securities issued by the Small Business Administration, states and municipalities, corporations, as well as mortgage-backed securities issued by government agencies. Fair values were estimated primarily by obtaining quoted prices for similar assets in active markets or through the use of pricing models. In cases where there may be limited or less transparent information provided by the Company’s third-party pricing service, fair value may be estimated by the use of secondary pricing services or through the use of non-binding third-party broker quotes.
On a quarterly basis, management reviews the pricing information received from the Company’s third-party pricing service. This review process includes a comparison to non-binding third-party broker quotes, as well as a review of market-related conditions impacting the information provided by the Company’s third-party pricing service. Management primarily identifies investment securities which may have traded in illiquid or inactive markets by identifying instances of a significant decrease in the volume or frequency of trades, relative to historical levels, as well as instances of a significant widening of the bid-ask spread in the brokered markets. Investment securities that are deemed to have been trading in illiquid or inactive markets may require the use of significant unobservable inputs. As of September 30, 2012 and December 31, 2011, management did not make adjustments to prices provided by the third-party pricing service as a result of illiquid or inactive markets. On a quarterly basis, management also reviews a sample of securities priced by the Company’s third-party pricing service to review significant assumptions and valuation methodologies used. Based on this review, management determines whether the current placement of the security in the fair value hierarchy is appropriate or whether transfers may be warranted. The Company’s third-party pricing service has also established processes for us to submit inquiries regarding quoted prices. Periodically, we will challenge the quoted prices provided by our third-party pricing service. The Company’s third-party pricing service will review the inputs to the evaluation in light of the new market data presented by us. The Company’s third-party pricing service may then affirm the original quoted price or may update the evaluation on a going forward basis.
The fair value of the Company’s residential mortgage loans held for sale was determined based on quoted prices for similar loans in active markets, and therefore, is classified as a Level 2 measurement.
Mortgage servicing rights do not trade in an active market with readily observable market data. As a result, the Company estimates the fair value of mortgage servicing rights by using a discounted cash flow model to calculate the present value of estimated future net servicing income. The Company stratifies its mortgage servicing portfolio on the basis of loan type. The assumptions used in the discounted cash flow model are those that we believe market participants would use in estimating future net servicing income. Significant assumptions in the valuation of mortgage servicing rights include estimated loan repayment rates, the discount rate, servicing costs, and the timing of cash flows, among other factors. Mortgage servicing rights are classified as Level 3 measurements due to the use of significant unobservable inputs, as well as significant management judgment and estimation.
Other assets recorded at fair value on a recurring basis are primarily comprised of investments related to deferred compensation arrangements. Quoted prices for these investments, primarily in mutual funds, are available in active markets. Thus, the Company’s investments related to deferred compensation arrangements are classified as Level 1 measurements in the fair value hierarchy.
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Derivative Financial Instruments
Derivative financial instruments recorded at fair value on a recurring basis are comprised of interest rate lock commitments (“IRLCs”), forward commitments, interest rate swap agreements, and foreign exchange contracts. The fair values of IRLCs are calculated based on the value of the underlying loan, which in turn is based on quoted prices for similar loans in the secondary market. However, this value is adjusted by a factor which considers the likelihood that the loan in a lock position will ultimately close. This factor, the closing ratio, is derived from the Bank’s internal data and is adjusted using significant management judgment. As such, IRLCs are classified as Level 3 measurements. Forward commitments are classified as Level 2 measurements as they are primarily based on quoted prices from the secondary market based on the settlement date of the contracts, interpolated or extrapolated, if necessary, to estimate a fair value as of the end of the reporting period. The fair values of interest rate swap agreements are calculated using a discounted cash flow approach and utilize Level 2 observable inputs such as the LIBOR swap curve, effective date, maturity date, notional amount, and stated interest rate. In addition, the Company includes in its fair value calculation a credit factor adjustment which is based primarily on management judgment. Thus, interest rate swap agreements are classified as a Level 3 measurement. The fair values of foreign exchange contracts are calculated using the Bank’s multi-currency accounting system which utilizes contract specific information such as currency, maturity date, contractual amount, and strike price, along with market data information such as the spot rates of specific currency and yield curves. Foreign exchange contracts are classified as Level 2 measurements because while they are valued using the Bank’s multi-currency accounting system, significant management judgment or estimation is not required.
The Company is exposed to credit risk if borrowers or counterparties fail to perform. The Company seeks to minimize credit risk through credit approvals, limits, monitoring procedures, and collateral requirements. The Company generally enters into transactions with borrowers and counterparties that carry high quality credit ratings. Credit risk associated with borrowers or counterparties as well as the Company’s non-performance risk is factored into the determination of the fair value of derivative financial instruments.
The table below presents the balances of assets and liabilities measured at fair value on a recurring basis as of September 30, 2012 and December 31, 2011:
Quoted Prices in Active Markets for Identical Assets or Liabilities
Significant Other Observable Inputs
Significant Unobservable Inputs
(Level 1)
(Level 2)
(Level 3)
Assets:
592,065
414,081
Total Investment Securities Available-for-Sale
2,532,144
12,438
Derivatives 1
110
48,028
Total Assets Measured at Fair Value on a Recurring Basis as of September 30, 2012
604,503
2,558,225
53,144
3,215,872
Liabilities:
3,389
Total Liabilities Measured at Fair Value on a Recurring Basis as of September 30, 2012
822,508
408,510
2,629,377
11,082
238
37,847
Total Assets Measured at Fair Value on a Recurring Basis as of December 31, 2011
833,590
2,648,572
44,978
3,527,140
1,043
35,789
Total Liabilities Measured at Fair Value on a Recurring Basis as of December 31, 2011
1 The fair value of each class of derivatives is shown in Note 10 to the Consolidated Financial Statements.
For the three and nine months ended September 30, 2012 and 2011, the changes in Level 3 assets and liabilities measured at fair value on a recurring basis were as follows:
Mortgage Servicing Rights 1
Net Derivative Assets and Liabilities 2
Balance as of July 1, 2012
12,565
Realized and Unrealized Net Gains (Losses):
Included in Net Income
15,221
14,878
Transfers to Loans Held for Sale
(9,559
12,768
17,884
Total Unrealized Net Gains (Losses) Included in Net Income Related to Assets Still Held as of September 30, 2012
12,763
Balance as of July 1, 2011
432
9,284
8,742
7,323
(4,128
5,046
12,479
Total Unrealized Net Gains (Losses) Included in Net Income Related to Assets Still Held as of September 30, 2011
3,884
Balance as of January 1, 2012
2,058
9,189
28,293
26,278
(17,583
11,882
Balance as of January 1, 2011
(332
9,894
12,127
9,334
(6,749
3,397
1 Realized and unrealized gains and losses related to mortgage servicing rights are reported as a component of mortgage banking income in the Company’s consolidated statements of income.
2 Realized and unrealized gains and losses related to interest rate lock commitments are reported as a component of mortgage banking income in the Company’s consolidated statements of income. Realized and unrealized gains and losses related to interest rate swap agreements are reported as a component of other noninterest income in the Company’s consolidated statements of income.
For Level 3 assets and liabilities measured at fair value on a recurring or nonrecurring basis as of September 30, 2012, the significant unobservable inputs used in the fair value measurements were as follows:
Significant
Fair Value at
Unobservable
Valuation Technique
Input Value
25,357
Discounted Cash Flow
Weighted Average Constant Prepayment Rate 1
13.74 %
Weighted Average Discount Rate 2
5.54 %
Net Derivative Assets and Liabilities:
Pricing Model
Weighted Average Closing Ratio
87.37 %
(269
Weighted Average Credit Factor
0.76 %
The significant unobservable inputs used in the fair value measurement of the Company’s mortgage servicing rights are the weighted average constant prepayment rate and weighted average discount rate. Significant increases (decreases) in any of those inputs in isolation could result in a significantly lower (higher) fair value measurement. Although the constant prepayment rate and the discount rate are not directly interrelated, they will generally move in opposite directions of each other.
The Company estimates the fair value of mortgage servicing rights by using a discounted cash flow model to calculate the present value of estimated future net servicing income. The Company’s Treasury Division enters observable and unobservable inputs into the model to arrive at an estimated fair value. To assess the reasonableness of the fair value measurement, the Treasury Division performs a back-test by applying the model to historical prepayment data. The fair value and constant prepayment rate are also compared to forward-looking estimates to assess reasonableness. The Treasury Division also compares the fair value of the Company’s mortgage servicing rights to a value calculated by an independent third-party. Discussions are held with members from the Treasury, Mortgage Banking, and Controllers Divisions, along with the independent third-party to discuss and reconcile the fair value estimates and key assumptions used by the respective parties in arriving at those estimates. A subcommittee of the Company’s Asset/Liability Management Committee is responsible for providing oversight over the valuation methodology and key assumptions.
The significant unobservable input used in the fair value measurement of the Company’s IRLCs is the closing ratio, which represents the percentage of loans currently in a lock position which management estimates will ultimately close. Generally, the fair value of an IRLC is positive (negative) if the prevailing interest rate is lower (higher) than the IRLC rate. Therefore, an increase in the closing ratio (i.e., higher percentage of loans are estimated to close) will result in the fair value of the IRLC to increase if in a gain position, or decrease if in a loss position. The closing ratio is largely dependent on the loan processing stage that a loan is currently in and the change in prevailing interest rates from the time of the rate lock. The closing ratio is computed by our secondary marketing system using historical data and the ratio is periodically reviewed by the Company’s Secondary Marketing Department of the Mortgage Banking Division for reasonableness.
The unobservable input used in the fair value measurement of the Company’s interest rate swap agreements is the credit factor. This factor represents the risk that a counterparty is either unable or unwilling to settle a transaction in accordance with the underlying contractual terms. A significant increase (decrease) in the credit factor could result in a significantly lower (higher) fair value measurement. The credit factor is determined by the Treasury Division based on the risk rating assigned to each counterparty in which the Company holds a net asset position. The Company’s Credit Policy Committee periodically reviews and approves the Expected Default Frequency of the Economic Capital Model for Credit Risk. The Expected Default Frequency is used as the credit factor for the interest rate swap agreements.
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
The Company may be required periodically to measure certain assets and liabilities at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from the application of lower-of-cost-or-fair value accounting or impairment write-downs of individual assets. As of September 30, 2012 and 2011, there were no material adjustments to fair value for the Company’s assets and liabilities measured at fair value on a nonrecurring basis in accordance with GAAP.
33
Fair Value Option
The Company elected the fair value option for all residential mortgage loans held for sale originated on or after October 1, 2011. This election allows for a more effective offset of the changes in fair values of the loans held for sale and the derivative financial instruments used to economically hedge them without having to apply complex hedge accounting requirements. As noted above, the fair value of the Company’s residential mortgage loans held for sale was determined based on quoted prices for similar loans in active markets.
The following table reflects the difference between the aggregate fair value and the aggregate unpaid principal balance of the Company’s residential mortgage loans held for sale as of September 30, 2012 and December 31, 2011.
Aggregate Fair Value
Aggregate
Less Aggregate
Unpaid Principal
24,908
1,063
18,088
869
Changes in the estimated fair value of residential mortgage loans held for sale are reported as a component of mortgage banking income in the Company’s consolidated statements of income. For the three and nine months ended September 30, 2012, the Company recorded net losses of $3.3 million and $4.2 million, respectively, as a result of the change in fair value of the Company’s residential mortgage loans held for sale.
Disclosures about Fair Value of Financial Instruments
The assumptions used below are expected to approximate those that market participants would use in valuing these financial instruments.
Investment Securities Held-to-Maturity
The fair value of the Company’s investment securities held-to-maturity was primarily measured using information from a third-party pricing service. Level 1 investment securities are comprised of debt securities issued by the U.S. Treasury as quoted prices were available, unadjusted, for identical securities in active markets. If quoted prices were not available, fair values were estimated primarily by obtaining quoted prices for similar assets in active markets or through the use of pricing models. In cases where there may be limited or less transparent information provided by the Company’s third-party pricing service, fair value may be estimated by the use of secondary pricing services or through the use of non-binding third-party broker quotes.
Loans
The fair value of the Company’s loans was estimated by discounting the expected future cash flows using the current interest rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Loans were first segregated by type such as commercial, real estate, and consumer, and were then further segmented into fixed and variable rate and loan quality categories. Expected future cash flows were projected based on contractual cash flows, adjusted for estimated prepayments.
Time Deposits
The fair values of the Company’s time deposits were estimated using discounted cash flow analyses. The discount rates used were based on rates currently offered for deposits with similar remaining maturities. The fair values of the Company’s time deposit liabilities do not take into consideration the value of the Company’s long-term relationships with depositors, which may have significant value.
The fair value of the Company’s securities sold under agreements to repurchase was calculated using discounted cash flow analyses, applying discount rates currently offered for new agreements with similar remaining maturities and considering the Company’s non-performance risk.
34
The fair value of the Company’s long-term debt was calculated using a discounted cash flow approach and applying discount rates currently offered for new notes with similar remaining maturities and considering the Company’s non-performance risk.
The following presents the carrying amount, fair value, and placement in the fair value hierarchy of the Company’s financial instruments as of September 30, 2012 and December 31, 2011. This table excludes financial instruments for which the carrying amount approximates fair value. For short-term financial assets such as cash and cash equivalents, the carrying amount is a reasonable estimate of fair value due to the relatively short time between the origination of the instrument and its expected realization. For non-marketable equity securities such as Federal Home Loan Bank and Federal Reserve Bank stock, the carrying amount is a reasonable estimate of fair value as these securities can only be redeemed or sold at their par value and only to the respective issuing government supported institution or to another member institution. For financial liabilities such as noninterest-bearing demand, interest-bearing demand, and savings deposits, the carrying amount is a reasonable estimate of fair value due to these products having no stated maturity.
Carrying Amount
Financial Instruments - Assets
Loans1
5,383,152
5,737,168
Financial Instruments - Liabilities
1,730,848
934,477
Long-Term Debt2
19,184
22,076
5,098,681
5,373,777
1,347,576
2,031,057
21,787
24,076
1 Comprised of loans, net of unearned income and the Allowance related to loans.
2 Excludes capitalized lease obligations.
35
Item 2. Management’s Discussion and Analysis of
Financial Condition and Results of Operations
Forward-Looking Statements
This report contains forward-looking statements concerning, among other things, the economic and business environment in our service area and elsewhere, credit quality, and other financial and business matters in future periods. Our forward-looking statements are based on numerous assumptions, any of which could prove to be inaccurate and actual results may differ materially from those projected because of a variety of risks and uncertainties, including, but not limited to: 1) general economic conditions either nationally, internationally, or locally may be different than expected, and particularly, any event that negatively impacts the tourism industry in Hawaii; 2) unanticipated changes in the securities markets, public debt markets, and other capital markets in the U.S. and internationally; 3) the competitive pressure among financial services and products; 4) the impact of legislative and regulatory initiatives, particularly the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”); 5) changes in fiscal and monetary policies of the markets in which we operate; 6) the increased cost of maintaining or the Company’s ability to maintain adequate liquidity and capital, based on the requirements adopted by the Basel Committee on Banking Supervision and U.S. regulators; 7) actual or alleged conduct which could harm our reputation; 8) changes in accounting standards; 9) changes in tax laws or regulations or the interpretation of such laws and regulations; 10) changes in our credit quality or risk profile that may increase or decrease the required level of our reserve for credit losses; 11) changes in market interest rates that may affect credit markets and our ability to maintain our net interest margin; 12) the impact of litigation and regulatory investigations of the Company, including costs, expenses, settlements, and judgments; 13) any interruption or breach in security of our information systems resulting in failures or disruptions in customer account management, general ledger processing, and loan or deposit systems; 14) changes to the amount and timing of proposed common stock repurchases; and 15) natural disasters or adverse weather, public unrest, public health and other conditions that impact us and our customers’ operations. For a detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements, refer to the section entitled “Risk Factors” in Part II of this report and Part I of our Annual Report on Form 10-K for the year ended December 31, 2011, and subsequent periodic and current reports, filed with the U.S. Securities and Exchange Commission (the “SEC”). Words such as “believes,” “anticipates,” “expects,” “intends,” “targeted,” and similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. We do not undertake an obligation to update forward-looking statements to reflect later events or circumstances.
Reclassifications
Certain prior period information in Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) has been reclassified to conform to current period classifications.
Overview
Bank of Hawaii Corporation (the “Parent”) is a Delaware corporation and a bank holding company headquartered in Honolulu, Hawaii. The Parent’s principal and only operating subsidiary is Bank of Hawaii (the “Bank”).
The Bank, directly and through its subsidiaries, provides a broad range of financial services to businesses, consumers, and governments in Hawaii, Guam, and other Pacific Islands. References to “we,” “our,” “us,” or the “Company” refer to the Parent and its subsidiaries that are consolidated for financial reporting purposes.
Exceptional people working together are the foundation for our success and enable us to build exceptional value for our customers, communities, shareholders, and each other. Excellence, integrity, respect, innovation, commitment, and teamwork are the core values for the way we do business. Our business plan is balanced between growth and risk management, including the flexibility to adjust, given the uncertainties of the economy. We remain cautious about the economy, interest rates, and loan demand. We intend to continue to focus on providing customers with a competitive mix of products and services, improving expense management, and efficiently managing capital.
Hawaii Economy
Hawaii’s economy continued to improve during the third quarter of 2012 led by tourism, the State’s largest industry. For the first eight months of 2012, total visitor arrivals increased by 10.0% and visitor spending increased by 20.0% compared to the same period in 2011. The most significant growth continues to come from international markets. For the first eight months of 2012, hotel occupancy and revenue per available room also continued to improve. The statewide seasonally-adjusted unemployment rate declined to 5.7% in September 2012, compared to 7.8% nationally. For the first nine months of 2012, the volume of single-family home sales on Oahu was 3.5% higher compared to the same period in 2011. However, the median price of single-family homes sold was 8.8% higher for the first nine months of 2012 compared to the same period in 2011. As of September 30, 2012, months of inventory of single-family homes on Oahu remained low at approximately 3.3 months.
Earnings Summary
Net income for the third quarter of 2012 was $41.2 million, a decrease of $2.1 million or 5% compared to the same period in 2011. Diluted earnings per share were $0.92 for the third quarter of 2012, unchanged compared to the same period in 2011. The change in net income for the third quarter of 2012 compared to the same period in 2011 was primarily due to the following:
· Net interest income for the third quarter of 2012 was $93.6 million, a decrease of $3.1 million or 3% compared to the same period in 2011. The net interest margin was 2.98% in the third quarter of 2012, a decrease of 11 basis points compared to the same period in 2011. This decrease was primarily due to lower yields on loans and investments, a result of the low interest rate environment.
· We recorded no provision for credit losses (the “Provision”) in the third quarter of 2012, a decrease of $2.2 million compared to the same period in 2011. This decrease was primarily due to improving credit trends and the underlying risk profile of the loan portfolio as economic conditions in Hawaii continued to improve.
· Mortgage banking income for the third quarter of 2012 was $11.7 million, an increase of $6.3 million compared to the same period in 2011. This increase was primarily due to an increase in loan origination volume related to refinancing activity, a result of low interest rates.
· Debit card income was $3.7 million for the third quarter of 2012, a decrease of $3.9 million or 51% compared to the same period in 2011. This decrease was primarily due to changes in debit card interchange rules as a result of pricing restrictions imposed by the Durbin Amendment which was effective October 1, 2011.
Noninterest expense was $0.9 million higher in the third quarter of 2012 compared to the same period in 2011. This was primarily due to start-up expenses related to our new consumer credit card product, higher profit sharing and bonus accruals due to higher profitability, and higher separation expense. The provision for income taxes was also $1.7 million higher in the third quarter of 2012 compared to the same period in 2011. This was primarily due to the release of a valuation allowance in the third quarter of 2011.
Net income for the first nine months of 2012 was $125.8 million, an increase of $5.0 million or 4% compared to the same period in 2011. Diluted earnings per share were $2.77 for the first nine months of 2012, an increase of $0.23 or 9% compared to the same period in 2011. The change in net income for the first nine months of 2012 was primarily due to the following:
· Net interest income was $287.0 million for the first nine months of 2012, a decrease of $7.0 million or 2% compared to the same period in 2011. The net interest margin was 3.01% for the first nine months of 2012, a decrease of 15 basis points compared to the same period in 2011. This decrease was primarily due to lower yields on loans and investments, a result of the low interest rate environment, and investing conservatively.
· The Provision for the first nine months of 2012 was $1.0 million, a decrease of $9.5 million compared to the same period in 2011. Consistent with improvements in our credit quality, the Provision was $7.6 million less than net charge-offs of loans and leases for the first nine months of 2012.
· Mortgage banking income for the first nine months of 2012 was $24.4 million, an increase of $13.1 million compared to the same period in 2011. This was primarily due to increased loan refinancing activity as a result of low interest rates.
· Debit card income was $11.3 million for the first nine months of 2012, a decrease of $10.9 million or 49% compared to the same period in 2011. This decrease was primarily due to changes in debit card interchange rules as a result of pricing restrictions imposed by the Durbin Amendment which was effective October 1, 2011.
· Other noninterest expense for the first nine months of 2012 was $53.4 million, a decrease of $12.5 million or 19% compared to the same period in 2011. Our financial results in 2011 included a $9.0 million accrual related to the settlement of overdraft litigation recorded in the second quarter of 2011.
We also recorded lower net gains from the sales of investment securities for the first nine months of 2012. We recorded net losses from the sales of investment securities of $0.1 million for the first nine months of 2012 compared to net gains of $6.1 million for the same period in 2011. The amount and timing of our sale of investment securities are dependent on a number of factors, including our efforts to preserve capital levels while managing duration and extension risk. The provision for income taxes was also $3.6 million higher for the first nine months of 2012 compared to the same period in 2011. This was primarily due to the release of reserves in the second quarter of 2011 and the previously noted release of a valuation allowance in the third quarter of 2011.
37
Our results for the first nine months of 2012 were influenced by a generally improving economy in Hawaii. However, we remained cautious about the slow pace of economic recovery both in Hawaii and on the U.S. Mainland. We also continued to monitor regulatory changes and the associated costs of compliance as well as volatility in the financial markets. As a result of the uncertainties in the economic recovery, we continued to maintain adequate reserves for credit losses and high levels of liquidity and capital. In particular:
· The allowance for loan and lease losses (the “Allowance”) was $131.0 million as of September 30, 2012, a decrease of $7.6 million or 6% from December 31, 2011. The ratio of our Allowance to total loans and leases outstanding decreased to 2.27% as of September 30, 2012, compared to 2.50% as of December 31, 2011. Absent significant deterioration in the economy and assuming continued improvement and/or stability in credit quality, we may further reduce the Allowance in future periods.
· Total deposits were $11.2 billion as of September 30, 2012, an increase of $627.9 million or 6% from December 31, 2011. This increase was primarily due to local government entities transferring funds from repurchase agreements to time deposits. Commercial and consumer deposits also increased over this period as customers remain cautious about investing and spending.
· We continued to invest excess liquidity in high-grade investment securities. As of September 30, 2012, the total carrying value of our investment securities portfolio was $6.6 billion, a decrease of $510.2 million or 7% from December 31, 2011. During the first nine months of 2012, we continued to change the composition of our investment securities portfolio. We decreased our holdings in mortgage-backed securities to somewhat reduce extension risk and increased our state and municipal bond holdings.
· Total shareholders’ equity was $1.0 billion as of September 30, 2012, an increase of $21.9 million or 2% from December 31, 2011. We continued to return capital to our shareholders in the form of share repurchases and dividends. During the first nine months of 2012, we repurchased 1.4 million shares of common stock at a total cost of $64.5 million under our share repurchase program. We also paid cash dividends of $61.5 million during the first nine months of 2012. In the third quarter of 2012, we reduced our share repurchases to $14.5 million, compared to $20.0 million in the second quarter of 2012 and $30.0 million in the first quarter of 2012. This combined with a lower level of total assets, compared to the second quarter of 2012, produced a higher Tier 1 Leverage Ratio of 6.78% compared to 6.57% in the second quarter of 2012.
Should economic conditions continue to improve in Hawaii, we may see improving prospects for loan growth in certain portfolios. However, we remain cautious about interest rates, the uncertainties of increased government regulation, as well as increased pressure on fee-based revenues in future periods. In particular, we continue to monitor the pressure on our net interest margin in the current low interest rate environment, and the impact of compliance with the Durbin Amendment which has significantly reduced debit card income. We intend to continue to focus on controlling expenses and maintaining adequate levels of liquidity, reserves for credit losses, and capital.
38
Our financial highlights are presented in Table 1.
Financial Highlights
Table 1
For the Period:
Operating Results
Performance Ratios
Return on Average Assets
1.22
1.31
1.23
1.24
Return on Average Shareholders’ Equity
16.02
16.80
16.49
15.85
Efficiency Ratio 1
58.13
56.87
57.76
58.86
Net Interest Margin 2
2.98
3.09
3.01
3.16
Dividend Payout Ratio 3
48.91
48.39
48.56
52.94
Average Shareholders’ Equity to Average Assets
7.59
7.79
7.47
7.83
Average Balances
Average Loans and Leases
5,716,421
5,340,406
5,640,733
5,326,209
Average Assets
13,490,835
13,125,077
13,640,304
13,019,898
Average Deposits
11,301,668
9,871,750
10,786,654
9,845,269
Average Shareholders’ Equity
1,023,804
1,022,585
1,018,903
1,019,409
Market Price Per Share of Common Stock
Closing
45.62
36.40
High
48.92
47.10
49.99
49.26
Low
45.29
35.30
44.02
As of Period End:
Balance Sheet Totals
Asset Quality
Non-Performing Assets
40,284
40,790
Financial Ratios
Allowance to Loans and Leases Outstanding
2.27
2.50
Tier 1 Capital Ratio
16.12
16.68
Total Capital Ratio
17.39
17.95
Tier 1 Leverage Ratio
6.78
6.73
Total Shareholders’ Equity to Total Assets
7.66
7.24
Tangible Common Equity to Tangible Assets 4
7.44
7.03
Tangible Common Equity to Risk-Weighted Assets 4
17.43
17.93
Non-Financial Data
Full-Time Equivalent Employees
2,304
2,370
Branches and Offices
81
ATMs
495
506
1 Efficiency ratio is defined as noninterest expense divided by total revenue (net interest income and total noninterest income).
2 Net interest margin is defined as net interest income, on a taxable-equivalent basis, as a percentage of average earning assets.
3 Dividend payout ratio is defined as dividends declared per share divided by basic earnings per share.
4 Tangible common equity to tangible assets and tangible common equity to risk-weighted assets are Non-GAAP financial measures. See the “Use of Non-GAAP Financial Measures” section below.
Use of Non-GAAP Financial Measures
The ratios “tangible common equity to tangible assets” and “tangible common equity to risk-weighted assets” are Non-GAAP financial measures. The Company believes these measurements are useful for investors, regulators, management and others to evaluate capital adequacy relative to other financial institutions. Although these Non-GAAP financial measures are frequently used by stakeholders in the evaluation of a company, they have limitations as analytical tools, and should not be considered in isolation, or as a substitute for analyses of results as reported under GAAP. Table 2 provides a reconciliation of these Non-GAAP financial measures with financial measures defined by GAAP.
GAAP to Non-GAAP Reconciliation
Table 2
Less: Goodwill
Intangible Assets
46
83
Tangible Common Equity
992,999
971,067
Tangible Assets
13,350,862
13,814,791
Risk-Weighted Assets, determined in accordance with prescribed regulatory requirements
5,697,581
5,414,481
7.66%
7.24%
Tangible Common Equity to Tangible Assets (Non-GAAP)
7.44%
7.03%
16.12%
16.68%
Tangible Common Equity to Risk-Weighted Assets (Non-GAAP)
17.43%
17.93%
40
Analysis of Statements of Income
Average balances, related income and expenses, and resulting yields and rates are presented in Table 3. An analysis of the change in net interest income, on a taxable-equivalent basis, is presented in Table 4.
Average Balances and Interest Rates - Taxable-Equivalent Basis
Table 3
Average
Income/
Yield/
(dollars in millions)
Balance
Expense
Rate
Earning Assets
4.0
0.33
3.7
0.56
3.4
0.24
4.4
0.18
221.5
0.1
0.19
309.4
0.2
0.20
240.5
0.4
427.8
0.7
0.22
3,247.8
18.3
2.26
4,309.3
23.5
2.18
3,369.5
57.4
4,667.6
85.4
2.44
3,617.3
23.2
2.57
2,511.0
20.3
3.24
3,714.2
74.7
2.68
1,949.2
48.6
3.32
15.8
4.32
9.2
13.3
4.26
9.7
0.3
4.46
Loans and Leases 1
797.2
7.7
3.86
815.5
8.2
3.97
796.5
3.94
788.0
23.8
4.03
993.2
10.8
876.7
10.7
4.85
962.9
31.7
4.40
873.1
31.9
4.88
100.1
1.3
4.97
74.5
1.0
5.15
101.1
3.9
5.13
78.1
3.0
5.14
Commercial Lease Financing
278.5
1.7
2.42
314.6
2.0
2.61
285.7
5.1
2.37
325.8
6.6
2.72
2,391.8
28.1
4.70
2,129.8
27.8
5.23
2,342.8
83.8
4.77
2,114.7
84.2
5.31
770.2
8.3
4.28
780.5
9.3
4.72
773.8
25.2
4.35
787.2
28.4
4.82
194.9
2.9
5.90
191.4
3.2
6.66
193.9
8.8
6.05
195.7
10.1
6.91
Other 2
190.5
8.09
157.4
7.50
184.0
11.2
8.10
163.6
7.51
5,716.4
64.7
4.51
5,340.4
65.2
4.86
5,640.7
193.2
4.57
5,326.2
197.2
4.94
80.1
1.41
79.9
1.40
80.0
0.8
Total Earning Assets 3
12,902.9
106.8
3.30
12,562.9
109.6
3.48
13,061.6
326.9
3.34
12,464.8
333.0
3.56
134.9
135.1
134.6
133.0
453.0
427.1
444.1
422.1
13,490.8
13,125.1
13,640.3
13,019.9
Interest-Bearing Liabilities
Interest-Bearing Deposits Demand
1,968.8
0.03
1,772.5
0.04
1,914.2
1,782.2
0.6
4,456.2
0.09
4,497.1
1.8
0.16
4,446.6
3.5
0.10
4,518.9
5.9
1,823.2
0.38
1,069.4
2.6
0.96
1,447.1
5.8
0.53
1,041.7
8.1
1.04
Total Interest-Bearing Deposits
8,248.2
0.14
7,339.0
4.6
0.25
7,807.9
9.6
7,342.8
14.6
0.27
Short-Term Borrowings
18.5
0.15
19.0
0.08
16.4
17.4
0.12
853.0
7.2
1,908.9
7.4
1.52
1,523.4
21.8
1.88
1,844.7
1.56
28.0
0.5
6.52
30.7
6.50
29.8
1.5
6.51
32.0
6.15
Total Interest-Bearing Liabilities
9,147.7
10.6
0.46
9,297.6
12.5
9,377.5
32.9
9,236.9
37.9
0.54
96.2
97.1
294.0
295.1
Interest Rate Spread
2.84
2.95
2.88
3.02
Net Interest Margin
Noninterest-Bearing Demand Deposits
3,053.5
2,532.8
2,978.8
2,502.5
265.8
272.1
265.1
261.1
1,023.8
1,022.6
1,018.9
1,019.4
1 Non-performing loans and leases are included in the respective average loan and lease balances. Income, if any, on such loans and leases is recognized on a cash basis.
2 Comprised of other consumer revolving credit, installment, and consumer lease financing.
3 Interest income includes taxable-equivalent basis adjustments, based upon a federal statutory tax rate of 35%, of $2,529,000 and $364,000 for the three months ended September 30, 2012 and 2011, respectively, and $7,080,000 and $1,142,000 for the nine months ended September 30, 2012 and 2011, respectively.
41
Analysis of Change in Net Interest Income - Taxable-Equivalent Basis
Table 4
Compared to September 30, 2011
Volume 1
Rate 1
Change in Interest Income:
$ (0.2
$ (0.1
$ (0.3
(22.4
(5.6
(28.0
36.9
(10.8
26.1
(0.6
(0.3
3.1
(3.3
(0.2
0.9
(0.8
(0.7
(1.5
8.6
(9.0
(0.4
(0.5
(2.7
(3.2
(0.1
(1.2
(1.3
1.2
12.7
(16.7
(4.0
Total Change in Interest Income
27.1
(33.2
(6.1
Change in Interest Expense:
Demand
(2.3
(2.4
2.5
(4.8
2.4
(7.4
(5.0
(4.1
4.1
Total Change in Interest Expense
(1.8
Change in Net Interest Income
$ 28.9
$ (30.0
$ (1.1
1 The change in interest income and expense not solely due to changes in volume or rate has been allocated on a pro-rata basis to the volume and rate columns.
Net interest income is affected by the size and mix of our balance sheet components as well as the spread between interest earned on assets and interest paid on liabilities. Net interest margin is defined as net interest income, on a taxable-equivalent basis, as a percentage of average earning assets.
Net interest income was $93.6 million in the third quarter of 2012, a decrease of $3.1 million or 3% compared to the same period in 2011. On a taxable-equivalent basis, net interest income was $96.2 million in the third quarter of 2012, relatively unchanged compared to the same period in 2011. The net interest margin was 2.98% in the third quarter of 2012, a decrease of 11 basis points compared to the same period in 2011. Net interest income was $287.0 million for the first nine months of 2012, a decrease of $7.0 million or 2% compared to the same period in 2011. On a taxable-equivalent basis, net interest income was $294.0 million for the first nine months of 2012, relatively unchanged compared to the same period in 2011. The net interest margin was 3.01% for the first nine months of 2012, a decrease of 15 basis points compared to the same period in 2011. The lower margins in 2012 were primarily due to lower yields on investment securities and loans. As higher yielding assets continue to run-off, we expect pressure on our net interest margin as our assets re-price in the current low interest rate environment.
Yields on our earning assets decreased by 18 basis points in the third quarter of 2012 and by 22 basis points for the first nine months of 2012 compared to the same periods in 2011, reflective of lower yields on investment securities and loans. Yields on our investment securities portfolio decreased by 15 basis points in the third quarter of 2012 and by 21 basis points for the first nine months of 2012 compared to the same periods in 2011. Yields on our loans and leases decreased by 35 basis points in the third quarter of 2012 and by 37 basis points for the first nine months of 2012 compared to the same periods in 2011, with lower yields in nearly every category of loans and leases. Partially offsetting the lower yields on our earning assets were lower funding costs, primarily due to lower rates paid on our interest-bearing deposits, reflective of the re-pricing of our deposits at lower interest rates. Rates paid on our time deposits decreased by 58 basis points in the third quarter of 2012 and by 51 basis points for the first nine months of 2012 compared to the same periods in 2011.
Average balances of our earning assets increased by $340.0 million or 3% in the third quarter of 2012 compared to the same period in 2011, primarily due to a $262.1 million increase in our residential mortgage loan portfolio and a $116.5 million increase in our commercial mortgage loan portfolio. The increase in our residential mortgage portfolio was primarily due to higher origination volume related to strong refinancing activity, the result of low interest rates, as well as our decision to retain additional conforming saleable loans in our portfolio. The increase in our commercial mortgage loan portfolio was primarily due to increased demand from new and existing customers.
Average balances of our earning assets increased by $596.7 million or 5% for the first nine months of 2012 compared to the same period in 2011, primarily due to a $466.7 million increase in average balances of our investment securities portfolio. In 2011 and during the first nine months of 2012, we reduced our holdings in mortgage-backed securities issued by the Government National Mortgage Association (“Ginnie Mae”) to somewhat reduce extension risk. Average balances of our mortgage-backed securities issued by Ginnie Mae decreased by $309.1 million for the first nine months of 2012 compared to the same period in 2011. We invested our excess liquidity into state and municipal securities and securities issued by the Small Business Administration (the “SBA”). Average balances of our investments in state and municipal bond holdings increased by $520.5 million and average balances of our SBA securities increased by $336.3 million for the first nine months of 2012 compared to the same period in 2011. Also contributing to the increase in our average balances of earning assets was a $228.2 million increase in our residential mortgage loan portfolio primarily due to higher origination volume related to strong refinancing activity, the result of low interest rates, as well as our decision to retain additional conforming saleable loans in our portfolio, partially offset by a $187.3 million reduction in funds sold.
Average balances of our interest-bearing liabilities decreased by $149.9 million or 2% in the third quarter of 2012 compared to the same period in 2011 primarily due to a $1.1 billion decrease in average balances of our public repurchase agreements, partially offset by an $822.5 million increase in public time deposits of $100 thousand or more as a result of local government entities transferring their funds from repurchase agreements to time deposits. Average balances of our interest-bearing liabilities increased by $140.6 million or 2% for the first nine months of 2012 compared to the same period in 2011 primarily due to a $482.6 million increase in average balances of our public time deposits of $100 thousand or more, partially offset by a $321.3 million decrease in our public repurchase agreements.
The Provision reflects our judgment of the expense or benefit necessary to achieve the appropriate amount of the Allowance. We maintain the Allowance at levels adequate to cover our estimate of probable credit losses as of the end of the reporting period. The Allowance is determined through detailed quarterly analyses of the loan and lease portfolio. The Allowance is based on our loss experience and changes in the economic environment, as well as an ongoing assessment of credit quality. We recorded no Provision in the third quarter of 2012 and recorded a Provision of $1.0 million for the first nine months of 2012 compared to a Provision of $2.2 million in the third quarter of 2011 and $10.5 million for the first nine months of 2011. The lower Provision in 2012 reflected improving credit trends and the underlying risk profile of the loan and lease portfolio as economic conditions in Hawaii continued to improve. Net charge-offs were $1.5 million in the third quarter of 2012 and $8.6 million for the first nine months of 2012, a decrease of $2.3 million or 61% and $5.8 million or 40% compared to the same periods in 2011, respectively. Non-performing assets appear to have stabilized and were $40.3 million as of September 30, 2012, a decrease of $0.5 million from December 31, 2011. For further discussion, see the “Corporate Risk Profile - Reserve for Credit Losses” section in MD&A for information on net charge-offs, non-performing assets, and other factors considered by management in assessing the credit quality of the loan portfolio and establishing the Allowance.
Noninterest income increased by $1.5 million or 3% in the third quarter of 2012 and decreased by $6.9 million or 5% for the first nine months of 2012 compared to the same periods in 2011.
Trust and asset management income is comprised of fees earned from the management and administration of trusts and other customer assets. These fees are largely based upon the market value of the assets that we manage and the fee rate charged to customers. Total trust assets under administration were $10.1 billion as of September 30, 2012, $9.3 billion as of December 31, 2011, and $9.5 billion as of September 30, 2011. Trust and asset management income increased by $0.3 million or 2% in the third quarter of 2012 primarily due to higher agency fees. Trust and asset management income decreased by $0.9 million or 3% for the first nine months of 2012 compared to the same period in 2011. This decrease was primarily due to a $0.6 million decline in special service fees which were mainly the result of two large termination fees recorded in the first quarter of 2011. In addition, mutual fund investment management fees decreased by $0.3 million primarily due to our decision to liquidate our proprietary money market funds in November 2011.
43
Mortgage banking income is highly influenced by mortgage interest rates and the housing market. Mortgage banking income increased by $6.3 million or 114% in the third quarter of 2012 compared to the same period in 2011. This increase was primarily due to higher loan origination volume related to refinancing activity and an increase in loan sale margins. Residential mortgage loan originations were $287.5 million in the third quarter of 2012, a $92.4 million or 47% increase compared to the same period in 2011. Residential mortgage loan sales were $174.1 million in the third quarter of 2012, a $74.2 million or 74% increase compared to the same period in 2011. Mortgage banking income increased by $13.1 million or 116% for the first nine months of 2012 compared to the same period in 2011 primarily due to the aforementioned increases in loan origination volume and loan sale margins. Residential mortgage loan originations were $873.2 million for the first nine months of 2012, an increase of $270.2 million or 45% compared to the same period in 2011. Residential mortgage loan sales were $369.5 million for the first nine months of 2012, an increase of $58.2 million or 19% compared to the same period in 2011.
Service charges on deposit accounts decreased by $0.5 million or 5% in the third quarter of 2012 and by $1.0 million or 3% for the first nine months of 2012 compared to the same periods in 2011. These decreases were primarily due to a decline in account analysis fees as a result of reduced charges applied against the customers’ earnings credit rate.
Fees, exchange, and other service charges are primarily comprised of debit card income, fees from ATMs, merchant service activity, and other loan fees and service charges. Fees, exchange, and other service charges decreased by $4.3 million or 27% in the third quarter of 2012 and by $11.2 million or 23% for the first nine months of 2012 compared to the same periods in 2011. These decreases were primarily due to a decline in debit card income resulting mainly from the pricing restrictions imposed by the Durbin Amendment, which was effective October 1, 2011.
Sales of investment securities resulted in a net gain of less than $0.1 million in the third quarter of 2012 compared to no sales of investment securities during the same period in 2011. Sales of investment securities resulted in a net loss of $0.1 million for the first nine months of 2012 compared to a net gain of $6.1 million for the same period in 2011. The amount and timing of our sales of investments securities are dependent on a number of factors, including our efforts to preserve capital levels while managing duration and extension risk.
Insurance income decreased by $0.3 million or 13% in the third quarter of 2012 and by $1.6 million or 19% for the first nine months of 2012 compared to the same periods in 2011. These decreases were primarily due to lower sales of our annuity products. The low interest rate environment, in particular, continues to adversely affect sales of our fixed annuity products.
Other noninterest income increased by $0.1 million or 2% in the third quarter of 2012 and by $0.8 million or 4% for the first nine months of 2012 compared to the same periods in 2011. The year-to-date increase was primarily due to a lessee exercising its early buy-out option on two cargo ship leveraged leases which resulted in a pre-tax gain of $3.5 million in the first quarter of 2012. This increase was partially offset by a $2.0 million contingent payment received in the third quarter of 2011 related to the 2010 sale of our proprietary mutual funds, combined with a $1.0 million pre-tax loss related to the sale and termination of an aircraft lease in the first quarter of 2012.
Noninterest expense increased by $0.9 million or 1% in the third quarter of 2012 and decreased by $13.0 million or 5% for the first nine months of 2012 compared to the same periods in 2011.
44
Table 5 presents the components of salaries and benefits expense.
Table 5
Salaries
$ 29,312
$ 28,965
$ 85,830
$ 87,182
Incentive Compensation
4,492
4,777
12,678
12,486
Share-Based Compensation and Cash Grants for the Purchase of Company Stock
1,817
5,260
3,901
Commission Expense
1,750
1,572
5,040
4,788
Retirement and Other Benefits
4,322
3,634
12,193
12,400
Payroll Taxes
2,267
2,241
8,522
8,615
Medical, Dental, and Life Insurance
2,255
2,056
6,931
6,717
Separation Expense
1,016
1,838
1,800
Total Salaries and Benefits
$ 47,231
$ 44,307
$ 138,292
$ 137,889
Salaries and benefits expense increased by $2.9 million or 7% in the third quarter of 2012 compared to the same period in 2011. Share-based compensation increased by $1.1 million primarily due to a new stock option program introduced in the fourth quarter of 2011, coupled with an increase in amortization related to performance-based restricted stock granted in the first quarter of 2012. In addition, profit sharing accruals increased by $0.6 million due to higher Company profitability and separation expense increased by $0.7 million. Salaries and benefits expense increased by $0.4 million or less that 1% for the first nine months of 2012 compared to the same period in 2011. An increase in share-based compensation was largely offset by a decrease in salaries expense.
Net occupancy expense decreased by $0.6 million or 5% in the third quarter of 2012 and by $0.8 million or 3% for the first nine months of 2012 compared to the same periods in 2011. These decreases were primarily due to a decline in depreciation expense primarily related to the closure of two branches in April 2012.
Net equipment expense decreased by $0.1 million or 3% in the third quarter of 2012 and increased by $0.9 million or 7% for the first nine months of 2012 compared to the same periods in 2011. The increase for the first nine months of 2012 was primarily due to the purchase of technology equipment in the first quarter of 2012.
FDIC insurance expense decreased by $0.2 million or 12% in the third quarter of 2012 and by $1.3 million or 18% for the first nine months of 2012 compared to the same periods in 2011. The decrease for the first nine months of 2012 was primarily due to lower rate assessments as a result of new rules finalized by the FDIC. As required by the Dodd-Frank Act, on February 7, 2011, the FDIC finalized new rules which redefined the assessment base as “average consolidated total assets minus average tangible equity.” The new rate schedule and other revisions to the assessment rules became effective April 1, 2011. On October 9, 2012, the FDIC issued a final rule that revises the definitions of subprime consumer loans and leveraged commercial loans for banks with more than $10.0 billion in assets that are subject to the large-bank pricing assessment system. The final rule is effective April 1, 2013. As of the date of this filing, management is still assessing the potential impact that the provisions of this final rule may have on the Company’s FDIC assessments.
Other noninterest expense decreased by $1.3 million or 7% in the third quarter of 2012 compared to the same period in 2011. This decrease was primarily due to a $2.0 million reduction in donations, partially offset by $1.0 million of start-up expenses related to our new consumer credit card product. Other noninterest expense decreased by $12.5 million or 19% for the first nine months of 2012 compared to the same period in 2011. This decrease was primarily due to the accrual of $9.0 million related to the settlement of overdraft litigation recorded in the second quarter of 2011. In addition, operating losses, which include losses as a result of bank error, fraud, items processing, or theft, decreased by $1.3 million, while donations declined by $1.0 million.
45
Table 6 presents our provision for income taxes and effective tax rates.
Provision for Income Taxes and Effective Tax Rates
Table 6
$ 19,896
$ 18,188
$ 56,665
$ 53,114
Effective Tax Rates
32.55%
29.58%
31.06%
30.54%
The higher effective tax rate for the third quarter of 2012 compared to the same period in 2011 was primarily due to a $1.8 million credit to the provision for income taxes recorded in the third quarter of 2011 for the release of a valuation allowance related to low-income housing investments.
The slightly higher effective tax rate for the first nine months of 2012 compared to the same period in 2011 was primarily due to a $2.7 million credit to the provision for income taxes recorded in the second quarter of 2011 related to the release of reserves due to the closing of the Internal Revenue Service audit for tax years 2007 and 2008 as well as the previously noted release of the valuation allowance related to low-income housing investments. This was partially offset by a $2.7 million credit to the provision for income taxes recorded in the first quarter of 2012 related to the sale of our equity interest in two cargo ship leveraged leases.
Analysis of Statements of Condition
The carrying value of our investment securities was $6.6 billion as of September 30, 2012, a decrease of $510.2 million or 7% compared to December 31, 2011.
We continually evaluate our investment securities portfolio in response to established asset/liability management objectives, changing market conditions that could affect profitability, and the level of interest rate risk to which we are exposed. These evaluations may cause us to change the level of funds we deploy into investment securities, change the composition of our investment securities portfolio, and change the proportion of investments made into the available-for-sale and held-to-maturity investment categories.
During the third quarter of 2012, we continued to reduce our positions in mortgage-backed securities issued by the Government National Mortgage Corporation (“Ginnie Mae”) in an effort to manage extension risk related to our mortgage-backed securities. As of September 30, 2012, our portfolio of Ginnie Mae mortgage-backed securities were primarily comprised of securities issued between 2008 and 2011 and were all AAA-rated. As of September 30, 2012, our available-for-sale investment securities portfolio was comprised of securities with an average base duration of less than three years.
Gross unrealized gains in our investment securities portfolio were $201.5 million as of September 30, 2012 and $168.0 million as of December 31, 2011. Gross unrealized losses on our temporarily impaired investment securities were $0.7 million as of September 30, 2012 and $6.6 million as of December 31, 2011. As of September 30, 2012, the gross unrealized losses were primarily related to mortgage-backed securities issued by government agencies and were attributable primarily to changes in interest rates, relative to when the investment securities were purchased.
As of September 30, 2012, we did not own any subordinated debt, or preferred or common stock of the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation. See Note 2 to the Consolidated Financial Statements for more information.
Table 7 presents the composition of our loan and lease portfolio by major categories.
Loan and Lease Portfolio Balances
Table 7
Total loans and leases as of September 30, 2012 increased by $244.0 million or 4% from December 31, 2011.
Commercial loans and leases as of September 30, 2012 increased by $61.3 million or 3% from December 31, 2011. Commercial and industrial loans decreased by $8.5 million or 1% from December 31, 2011 primarily due to corporate customers that remained cautious as they continued to paydown their loan balances. Commercial mortgage loans increased by $101.3 million or 11% from December 31, 2011 primarily due to increased demand from new and existing customers. Construction loans increased by $3.1 million or 3% from December 31, 2011. However, demand for new development activity generally remains weak. Lease financing decreased by $34.6 million or 11% from December 31, 2011 primarily due to a $16.6 million decrease in balances related to a lessee’s decision to exercise its early buy-out option on two cargo ship leveraged leases in the first quarter of 2012. Also contributing to the decrease in lease financing balances was a $6.1 million decrease related to the sale and termination of an aircraft lease in the first quarter of 2012.
Consumer loans and leases as of September 30, 2012 increased by $182.7 million or 5% from December 31, 2011. Residential mortgage loans increased by $177.0 million or 8% from December 31, 2011 primarily due to strong refinancing activity, the result of low interest rates, as well as our decision to retain additional conforming saleable loans in our portfolio. Home equity loans decreased by $10.4 million or 1% from December 31, 2011 primarily due to continued paydowns and reduced line utilization. Automobile loans increased by $8.3 million or 4% from December 31, 2011 primarily due to increased customer demand and changes in our underwriting practices. Other consumer loans as of September 30, 2012 increased by $7.8 million or 4% from December 31, 2011 primarily due to the success of our installment loan product.
47
Table 8 presents the composition of our loan and lease portfolio by geographic area and by major categories.
Geographic Distribution of Loan and Lease Portfolio
Table 8
U.S.
Hawaii
Mainland 1
Guam
Pacific Islands
Foreign 2
704,525
34,726
66,611
2,148
611
942,977
33,441
63,138
99,059
2,759
30,733
207,292
16,008
23,295
1,777,294
275,459
148,516
23,906
2,246,673
141,573
4,625
740,307
8,477
19,518
1,982
142,399
4,977
50,728
2,684
Other 3
137,111
20,838
33,085
3,266,490
13,454
232,657
42,376
5,043,784
288,913
381,173
44,524
23,910
700,570
42,296
67,870
3,325
3,109
849,551
23,965
64,711
30,488
236,203
21,868
23,369
1,679,278
302,464
154,449
3,328
26,498
2,059,448
150,676
5,768
750,196
10,512
17,877
2,106
140,111
9,073
41,113
2,209
139,229
19,136
24,828
3,088,984
19,585
228,802
34,911
4,768,262
322,049
383,251
38,239
26,503
1 For secured loans and leases, classification as U.S. Mainland is made based on where the collateral is located. For unsecured loans and leases, classification as U.S. Mainland is made based on the location where the majority of the borrower’s business operations are conducted.
2 Loans classified as Foreign represent those which are recorded in the Company’s international business units. Lease financing classified as Foreign represent those with air transportation carriers based outside the United States.
3 Comprised of other revolving credit, installment, and lease financing.
Our commercial and consumer lending activities are concentrated primarily in Hawaii and the Pacific Islands. Our commercial loan and lease portfolio to borrowers based on the U.S. Mainland includes leveraged lease financing and participation in Shared National Credits. Our consumer loan and lease portfolio includes limited lending activities on the U.S. Mainland.
48
Table 9 presents the major components of other assets.
Table 9
Bank-Owned Life Insurance
217,247
213,113
Federal Home Loan Bank and Federal Reserve Bank Stock
79,586
79,946
Low-Income Housing and Other Equity Investments
42,786
35,860
Prepaid Expenses
24,875
28,979
Accounts Receivable
13,482
13,607
Federal and State Tax Deposits
6,069
50,392
26,113
Total Other Assets
Other assets increased by $40.8 million or 9% from December 31, 2011. The increase in other assets from December 31, 2011 was primarily due to a $19.3 million increase in receivables related to the settlement of investment securities that matured. Also contributing to the increase was a $10.1 million increase in the fair value of our derivative financial instruments, a $10.5 million increase in commitments to fund low-income housing investments, and a $4.1 million increase in the value of our bank-owned life insurance. This was partially offset by a $5.6 million decrease in prepaid FDIC assessments due to amortization recorded in the first nine months of 2012.
As of September 30, 2012, the carrying value of our Federal Home Loan Bank of Seattle (“FHLB”) stock was $60.7 million and consisted of 607,461 shares valued at a par value of $100 per share. Our investment in the FHLB is a condition of membership and, as such, is required to obtain credit and other services from the FHLB. As of June 30, 2012, the FHLB met all of its regulatory capital requirements, but remained classified as “undercapitalized” by its primary regulator, the Federal Housing Finance Agency (the “Finance Agency”), due to several factors including the possibility that further declines in the value of its private-label mortgage-backed securities could cause it to fall below its risk-based capital requirements. However, on September 7, 2012, the FHLB reported that its financial health has been steadily improving. As such, the Finance Agency upgraded the FHLB’s classification to “adequately capitalized,” which will allow it, conditions permitting, to repurchase a small amount of excess capital stock for the first time since December 2008. In 2007, the Company requested the redemption of 361,645 shares. On September 24, 2012, the FHLB redeemed 5,463 shares at par value of $100 per share for a total of $546,300. This redemption reduced our holdings in FHLB stock from $61.3 million to $60.7 million.
We consider our investment in the FHLB as a long-term investment and we value the investment based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. We understand that in addition to meeting all of its regulatory capital requirements, as of June 30, 2012, the FHLB met all minimum financial requirements stipulated under a Consent Order issued by the Finance Agency in October 2010. To our knowledge, the FHLB also continues to meet its debt obligations and if needed has an additional source of liquidity available to U.S. Government-Sponsored Enterprises through the U.S. Treasury. Based upon the foregoing, we have not recorded an impairment of the carrying value of our FHLB stock as of September 30, 2012.
Table 10 presents the composition of our deposits by major customer categories.
Table 10
5,369,724
5,241,827
4,394,745
4,320,712
Public and Other
1,456,078
1,030,084
Our strong brand continues to play a key role as we compete with other financial institutions for a share of the deposit market.
Customers continue to seek liquidity and safety in light of the slow pace of economic recovery both in Hawaii and on the U.S. Mainland. Deposit balances as of September 30, 2012 increased by $627.9 million or 6% from December 31, 2011. The increase was primarily due to a $486.0 million increase in public time deposits, mainly the result of local government entities transferring funds from repurchase agreements to time deposits. Consumer and commercial deposits also rose due to increases in demand and savings account balances, partially offset by a decrease in time deposits.
Table 11 presents the composition of our savings deposits.
Savings Deposits
Table 11
Money Market
1,726,186
1,732,999
Regular Savings
2,754,547
2,665,639
Total Savings Deposits
49
Table 12 presents our quarterly average balance of time deposits of $100,000 or more.
Average Time Deposits of $100,000 or More
Table 12
Average Time Deposits
1,477,636
769,024
Borrowings
Borrowings consisted of funds purchased as of September 30, 2012 and December 31, 2011. Borrowings were $10.9 million as of September 30, 2012, relatively unchanged from December 31, 2011. We manage the level of our borrowings to ensure that we have adequate sources of liquidity. Due to our successful deposit gathering efforts and our strong capital levels, our level of borrowings as a source of funds has remained low.
Table 13 presents the composition of our securities sold under agreements to repurchase.
Table 13
Government Entities
218,080
1,325,998
Private Institutions
600,000
Total Securities Sold Under Agreements to Repurchase
Securities sold under agreements to repurchase as of September 30, 2012 decreased by $1.1 billion or 58% from December 31, 2011. The decrease was primarily due to local government entities transferring funds from repurchase agreements to time deposits. As of September 30, 2012, the weighted average maturity was 207 days for our securities sold under agreements to repurchase with government entities and 5.2 years for securities sold under agreements to repurchase with private institutions, subject to the private institutions’ right to terminate agreements at earlier specified dates which could decrease the weighted average maturity to 2.6 years. As of September 30, 2012, all of our securities sold under agreements to repurchase were at fixed interest rates. As of September 30, 2012, the weighted average interest rate for outstanding agreements with government entities and private institutions was 0.11% and 4.63%, respectively. We have not entered into agreements in which the securities sold and the related liability were not recorded on the consolidated statements of condition.
Long-term debt was $28.1 million as of September 30, 2012, a $2.6 million or 9% decrease from December 31, 2011. Due to our strong liquidity position, we have not needed additional long-term funding in recent years.
50
Analysis of Business Segments
Our business segments are defined as Retail Banking, Commercial Banking, Investment Services, and Treasury and Other.
Table 14 summarizes net income from our business segments. Additional information about segment performance is presented in Note 8 to the Consolidated Financial Statements.
Business Segment Net Income
Table 14
24,597
28,917
72,516
74,271
Consolidated Total
Net income decreased by $1.4 million or 12% in the third quarter of 2012 compared to the same period in 2011 primarily due to a decrease in net interest income and an increase in noninterest expense, partially offset by a decrease in the Provision. The decrease in net interest income was primarily due to lower earnings credits on the segment’s deposit portfolio, partially offset by higher average deposit and loan balances. The increase in noninterest expense was primarily due to start-up costs related to the launch of our new consumer credit card product. The decrease in the Provision was primarily due to lower net charge-offs of loans and leases in the segment combined with improving credit trends and the underlying risk profile of the loan portfolio.
Net income decreased by $1.3 million or 5% during the first nine months of 2012 compared to the same period in 2011 primarily due to decreases in net interest income and noninterest income, partially offset by decreases in the Provision and noninterest expense. The decrease in net interest income was primarily due to lower earnings credits on the segment’s deposit portfolio, partially offset by higher average deposit and loan balances. The decrease in noninterest income was primarily due to lower debit card interchange income resulting from the pricing restrictions imposed by the Durbin Amendment, partially offset by higher mortgage banking income. The decrease in the Provision was primarily due to lower net charge-offs of loans and leases in the segment combined with improving credit trends and the underlying risk profile of the loan portfolio. The decrease in noninterest expense was primarily due to lower allocated expenses related to the overdraft litigation settlement accrued in the second quarter of 2011.
Net income decreased by $2.7 million or 19% in the third quarter of 2012 compared to the same period in 2011 primarily due to decreases in net interest income and noninterest income, partially offset by a decrease in noninterest expense. The decrease in net interest income was due to lower earnings credits on the segment’s deposit portfolio, partially offset by higher average deposit balances. The decrease in noninterest income was due to lower account analysis, merchant, signature debit and business check card fee income. The decrease in noninterest expense was primarily due to lower other operating and allocated expenses.
Net income increased by $0.2 million or 1% for the first nine months of 2012 compared to the same period in 2011 primarily due to decreases in the provision for income taxes and noninterest expense, coupled with an increase in noninterest income. These positive variances were partially offset by a decrease in net interest income. The decrease in the provision for income taxes and the increase in noninterest income were attributed to a gain recognized upon a lessee exercising its early buy-out option on two cargo ship leveraged leases. The decrease in noninterest expense was primarily due to lower other operating expense and lower allocated expenses related to the overdraft litigation settlement accrued in the second quarter of 2011. The decrease in net interest income was due to lower earnings credits on the segment’s deposit portfolio, partially offset by higher average deposit balances.
Net income decreased by $0.2 million or 8% in the third quarter of 2012 compared to the same period in 2011 primarily due to a decrease in noninterest income, partially offset by a decrease in the Provision. The decrease in noninterest income was primarily due to a contingent payment received in the third quarter of 2011 related to the 2010 sale of our proprietary mutual funds, partially offset by higher mortgage banking income. The decrease in the Provision reflects the improving credit trends and the underlying risk profile of the loan portfolio.
Net income decreased by $0.7 million or 8% for the first nine months of 2012 compared to the same period in 2011 primarily due to decreases in noninterest income and net interest income, partially offset by a decrease in noninterest expense. The decrease in noninterest income was primarily due to lower annuity and life insurance fee income from the segment’s full service brokerage, coupled with the aforementioned contingent payment received in the third quarter of 2011 related to the 2010 sale of our proprietary mutual funds. This decrease was partially offset by higher mortgage banking income. The decrease in net interest income was primarily due to lower earnings credits on the segment’s deposit portfolio. The decrease in noninterest expense was primarily due to lower salaries and other operating expense.
51
Net income increased by $2.2 million or 16% in the third quarter of 2012 compared to the same period in 2011 primarily due to an increase in net interest income and noninterest income. The increase in net interest income was primarily due to lower deposit funding costs. The increase in noninterest income was primarily due to a reduction in net fair value write-downs of mortgage servicing rights.
Net income increased by $6.7 million or 14% for the first nine months of 2012 compared to the same period in 2011 primarily due to an increase in net interest income coupled with a lower Provision. This was partially offset by a decrease in noninterest income. The increase in net interest income was primarily due to lower deposit funding costs. The decrease in the Provision represents a reduction in the Allowance due to improvements in credit quality. The decrease in noninterest income was primarily due to lower net investment securities gains and a reduction in net fair value write-downs of mortgage servicing rights.
Other organizational units (Technology, Operations, Marketing, Human Resources, Finance, Credit and Risk Management, and Corporate and Regulatory Administration) included in Treasury and Other provide a wide-range of support to the Company’s other income earning segments. Expenses incurred by these support units are charged to the business segments through an internal cost allocation process.
52
Corporate Risk Profile
Credit Risk
As of September 30, 2012, our overall credit risk position reflects a generally improving Hawaii economy. However, we remain cautious because of the slow pace of economic recovery both in Hawaii and the U.S. Mainland. We also remain concerned about U.S. and global economic volatility.
Although asset quality has improved over the past several years, we remain vigilant in light of the uncertainties in the U.S. economy as well as concerns related to specific segments of our lending portfolio that present a higher risk profile. As of September 30, 2012, the higher risk segments within our loan and lease portfolio were concentrated in residential land loans, home equity loans, and air transportation leases. In addition, loans and leases based on Hawaiian Islands other than Oahu (the “neighbor islands”) may present a higher risk profile as the neighbor islands have continued to experience higher levels of unemployment and have shown signs of slower economic recovery when compared to Oahu.
We continue to monitor our loan and lease portfolio to identify higher risk segments. We also actively manage exposures with deteriorating asset quality to reduce levels of potential loss exposure and have systematically built our reserves and capital base to address both anticipated and unforeseen issues. Risk management activities have included curtailing activities in some higher risk segments. We have also conducted detailed analysis of portfolio segments and stress tested those segments to ensure that reserve and capital levels are appropriate. We are also performing frequent loan and lease-level risk monitoring and risk rating review which provides opportunities for early interventions to allow for credit exits or restructuring, loan and lease sales, and voluntary workouts and liquidations.
Table 15 presents balances in our loan and lease portfolio which demonstrate a higher risk profile.
Higher Risk Loans and Leases Outstanding
Table 15
Residential Land Loans
16,513
18,163
Home Equity Loans
19,774
21,413
Air Transportation
27,765
36,144
64,052
75,720
As of September 30, 2012, our higher risk loans and leases outstanding decreased by $11.7 million or 15% from December 31, 2011.
We previously reported a segment of our residential home building loans as representing a higher risk profile. However, as of September 30, 2012, this segment of our residential home building loans has significantly decreased and now represents an exposure of less than $3.0 million due to paydowns and improved borrower financial performance. As such, we no longer consider this segment of our residential home building loans to be a reportable higher risk loan segment.
Residential land loans in our residential mortgage portfolio consist of consumer loans secured by unimproved lots. These loans often represent higher risk due to the volatility in the value of the underlying collateral. Our residential land loan portfolio was $16.5 million as of September 30, 2012, of which $14.1 million was related to properties on the neighbor islands. The decrease in our higher risk exposure in this portfolio segment for the first nine months of 2012 was primarily due to $1.4 million in paydowns and $0.3 million in charge-offs. Residential land loans that have not been modified in a troubled debt restructuring (“TDR”) are collectively evaluated for impairment in connection with the evaluation of our residential mortgage portfolio. As of September 30, 2012, there was a nominal specific Allowance associated with the remaining balance of our residential land loans and there were no residential land loans that were past due 90 days or more as to principal or interest.
The higher risk segment within our Hawaii home equity lending portfolio was $19.8 million or 3% of our total home equity loans outstanding as of September 30, 2012. The higher risk segment within our Hawaii home equity portfolio includes those loans originated in 2005 or later, with current monitoring credit scores below 600, and with original loan-to-value (“LTV”) ratios greater than 70%. Higher risk loans in our Hawaii home equity portfolio are collectively evaluated for impairment in connection with the evaluation of our entire home equity portfolio. As of September 30, 2012, there was no specific Allowance associated with the balance of our higher risk home equity loans. The higher risk home equity loans had a 90 day past due delinquency ratio of 2.9% and $2.4 million in gross charge-offs were recorded during the first nine months of 2012.
We consider all of our air transportation leases to be of higher risk due to the volatile financial profile of the industry. Domestic air transportation carriers continue to demonstrate a higher risk profile due to fuel costs, pension plan obligations, consumer demand, and marginal pricing power. Carriers are migrating to newer generations of more fuel efficient fleets which is negatively impacting older generation aircraft valuations. We believe that volatile fuel costs, coupled with a slowly recovering economy, could place additional pressure on the financial health of air transportation carriers for the foreseeable future. As of September 30, 2012, our air
transportation leasing portfolio was comprised of four leveraged leases on aircraft that were originated in the 1990’s and prior. In the first nine months of 2012, we sold one aircraft and terminated the lease and transferred one aircraft to equipment held for sale, a component of other assets, at the lease termination date. These two transactions decreased our higher risk air transportation exposure by $8.6 million, which had a related Allowance of $3.4 million. As of September 30, 2012, the Allowance associated with our air transportation leases was $20.5 million. For the first nine months of 2012, there were no delinquencies in our air transportation lease portfolio and no charge-offs were recorded.
All of these higher risk loans and leases have been considered in our quarterly evaluation of the adequacy of the Allowance.
54
Table 16 presents information on non-performing assets (“NPAs”) and accruing loans and leases past due 90 days or more.
Non-Performing Assets and Accruing Loans and Leases Past Due 90 Days or More
Table 16
Non-Accrual Loans and Leases
—
Total Non-Accrual Loans and Leases
Total Non-Performing Assets
Accruing Loans and Leases Past Due 90 Days or More
Total Accruing Loans and Leases Past Due 90 Days or More
Restructured Loans on Accrual Status and Not Past Due 90 Days or More
31,426
33,703
Ratio of Non-Accrual Loans and Leases to Total Loans and Leases
0.64%
0.68%
Ratio of Non-Performing Assets to Total Loans and Leases, and Foreclosed Real Estate
0.70%
0.74%
Ratio of Commercial Non-Performing Assets to Total Commercial Loans and Leases, and Commercial Foreclosed Real Estate
0.46%
0.56%
Ratio of Consumer Non-Performing Assets to Total Consumer Loans and Leases and Consumer Foreclosed Real Estate
0.84%
0.85%
Ratio of Non-Performing Assets and Accruing Loans and Leases Past Due 90 Days or More to Total Loans and Leases, and Foreclosed Real Estate
0.83%
0.90%
Changes in Non-Performing Assets
Balance at December 31, 2011
Additions
15,786
Reductions
Payments
(7,874
Return to Accrual Status
(3,703
Sales of Foreclosed Real Estate
(3,720
Charge-offs/Write-downs
(995
Total Reductions
(16,292
Balance at September 30, 2012
55
NPAs consist of non-accrual loans and leases, and foreclosed real estate. Changes in the level of non-accrual loans and leases typically represent increases for loans and leases that reach a specified past due status, offset by reductions for loans and leases that are charged-off, paid down, sold, transferred to foreclosed real estate, or are no longer classified as non-accrual because they have returned to accrual status.
Total NPAs were $40.3 million as of September 30, 2012, a decrease of $0.5 million or 1% from December 31, 2011. The ratio of our non-accrual loans and leases to total loans and leases was 0.64% as of September 30, 2012 and 0.68% as of December 31, 2011.
Commercial and industrial non-accrual loans decreased by $0.6 million or 10% from December 31, 2011 due to paydowns. As of September 30, 2012, three commercial borrowers comprised 99% of the non-accrual balance in this category. We individually evaluated these loans for impairment and have previously recorded partial charge-offs of $5.3 million on two of these loans.
Commercial mortgage non-accrual loans increased by $0.5 million from December 31, 2011 due to the addition of one loan. We have individually evaluated all four of these loans for impairment and have previously recorded a partial charge-off of $0.5 million on one of these loans.
There was one construction non-accrual loan as of September 30, 2012 and December 31, 2011. The $1.1 million decrease from December 31, 2011was due to a partial charge-off of $0.3 million and paydowns of $0.8 million.
Residential mortgage non-accrual loans increased by $0.2 million or 1% from December 31, 2011 primarily due to $8.5 million in additions with 15% representing Oahu owner-occupant properties. This increase was partially offset by $7.9 million in repayments. Residential mortgage non-accrual loans remain at elevated levels due mainly to the lengthy judiciary foreclosure process. As of September 30, 2012, our residential mortgage non-accrual loans were comprised of 64 loans with a weighted average current LTV ratio of 82%.
Foreclosed real estate represents property acquired as the result of borrower defaults on loans. Foreclosed real estate is recorded at fair value, less estimated selling costs, at the time of foreclosure. On an ongoing basis, properties are appraised as required by market conditions and applicable regulations. Foreclosed real estate remained relatively unchanged from December 31, 2011. During the first nine months of 2012, the addition of several residential properties was offset by the sales of one commercial property and several residential properties.
Included in NPAs are loans that we consider impaired. Impaired loans are defined as loans for which we believe it is probable we will not collect all amounts due according to the contractual terms of the loan agreement. Included in impaired loans are all classes of commercial non-accruing loans (except lease financing and small business loans), and all loans modified in a TDR. Impaired loans exclude lease financing and smaller balance homogeneous loans (consumer and small business non-accruing loans) that are collectively evaluated for impairment. Impaired loans were $48.0 million as of September 30, 2012 and $47.6 million as of December 31, 2011, and had a related Allowance of $3.3 million as of September 30, 2012 and $5.5 million as of December 31, 2011. As of September 30, 2012, we have recorded charge-offs of $12.3 million related to our impaired loans. As of September 30, 2012, our impaired loans have been included in management’s assessment of the overall adequacy of the Allowance.
Loans and Leases Past Due 90 Days or More and Still Accruing Interest
Loans and leases in this category are 90 days or more past due, as to principal or interest, and are still accruing interest because they are well secured and in the process of collection. Loans and leases past due 90 days or more and still accruing interest were $7.5 million as of September 30, 2012, a $1.7 million or 19% decrease from December 31, 2011. The decrease was primarily in our neighbor island residential mortgage portfolio.
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Table 17 presents information on loans with terms that have been modified in a TDR.
Loans Modified in a Troubled Debt Restructuring
Table 17
Restructured Loans Included in Non-Accrual Loans or Accruing Loans Past Due 90 Days or More
9,923
5,127
Total Restructured Loans
41,349
38,830
Loans modified in a TDR increased by $2.5 million or 6% from December 31, 2011. The majority of our TDRs are residential mortgage loans in which we lowered monthly payments to accommodate the borrowers’ financial needs for a period of time. Generally, loans modified in a TDR are returned to accrual status after the borrower has demonstrated
performance under the modified terms by making six consecutive payments. The increase in loans modified in a TDR from December 31, 2011 was primarily due to additional modifications of residential mortgage loans.
Reserve for Credit Losses
Table 18 presents the activity in our reserve for credit losses.
Table 18
137,862
150,395
144,025
152,777
(519)
(4,215)
(3,028)
(7,379)
(330)
(628)
(1,558)
(3,577)
(5,286)
(1,061)
(2,528)
(5,159)
(7,139)
(472)
(715)
(1,436)
(2,541)
(2,354)
(1,755)
(5,199)
(4,807)
Total Loans and Leases Charged-Off
(5,034)
(10,771)
(18,729)
(27,152)
994
3,035
1,965
530
3,405
166
3,499
739
740
1,781
1,621
258
137
993
1,226
433
650
1,453
1,951
569
2,636
1,941
Total Recoveries on Loans and Leases Previously Charged-Off
(1,472)
(3,746)
(8,614)
(14,419)
Balance at End of Period 2
136,390
148,829
Components
Reserve for Unfunded Commitments
5,419
Total Reserve for Credit Losses
Average Loans and Leases Outstanding
Ratio of Net Loans and Leases Charged-Off to Average Loans and Leases Outstanding (annualized)
0.10%
0.28%
0.20%
0.36%
Ratio of Allowance for Loan and Lease Losses to Loans and Leases Outstanding
2.27%
2.68%
2 Included in this analysis is activity related to the Company’s reserve for unfunded commitments, which is separately recorded in other liabilities in the Consolidated statements of condition.
We maintain a reserve for credit losses that consists of two components, the Allowance and a reserve for unfunded commitments (the “Unfunded Reserve”). The reserve for credit losses provides for the risk of credit losses inherent in the loan and lease portfolio and is based on loss estimates derived from a comprehensive quarterly evaluation. The evaluation reflects analyses of individual borrowers and historical loss experience, supplemented as necessary by credit judgment that considers observable trends, conditions, and other relevant environmental and economic factors. The level of the Allowance is adjusted by recording an expense or recovery through the Provision. The level of the Unfunded Reserve is adjusted by recording an expense or recovery in other noninterest expense.
As of September 30, 2012, the Allowance was $131.0 million or 2.27% of total loans and leases outstanding, compared with an Allowance of $138.6 million or 2.50% of total loans and leases outstanding as of December 31, 2011. The decrease in the Allowance was commensurate with improvements in credit quality and a generally improving economy in Hawaii. With continued improvement in the Hawaii economy and in our credit quality, including reductions in our higher risk loan segments, we may require a lower level of the Allowance in future periods.
The allocation of the Allowance between the commercial and consumer categories changed during the first nine months of 2012 based on management’s ongoing assessment of the Allowance. Factors contributing to the change in the allocation of the Allowance included management’s consideration of energy prices, economic uncertainty both domestically and globally, and the direct and indirect impact these items potentially have on Hawaii tourism, employment, and discretionary spending. We continue to see improvements in our credit quality, with most metrics showing positive trends through the first nine months of 2012.
Net charge-offs of loans and leases were $1.5 million or 0.10% of total average loans and leases, on an annualized basis, in the third quarter of 2012 compared to $3.7 million or 0.28% of total average loans and leases, on an annualized basis, in the third quarter of 2011. Net charge-offs of loans and leases were $8.6 million or 0.20% of total average loans and leases, on an annualized basis, for the first nine months of 2012 compared to $14.4 million or 0.36% of total average loans and leases, on an annualized basis, for the first nine months of 2011. All of our commercial portfolios were in net recovery positions for the third quarter of 2012. Net charge-offs in our commercial portfolios were $0.1 million for the first nine months of 2012 compared with $1.4 million for the same period in 2011. Net charge-offs of loans and leases in the third quarter of 2012 and for the first nine months of 2012 were lower in all of our consumer portfolios compared to the same periods in 2011. Net charge-offs of loans and leases in the third quarter of 2012 and for the first nine months of 2012 were primarily in our home equity and other consumer portfolios. The risk profile of our consumer loan portfolios continue to be negatively impacted by unemployment levels and neighbor island residential real estate prices.
Although we determine the amount of each component of the Allowance separately, the Allowance as a whole was considered appropriate by management as of September 30, 2012, based on our ongoing analysis of estimated probable credit losses, credit risk profiles, economic conditions, coverage ratios, and other relevant factors.
The Reserve for Unfunded Commitments
The Unfunded Reserve was $5.4 million as of September 30, 2012, unchanged from December 31, 2011. The process used to determine the Unfunded Reserve is consistent with the process for determining the Allowance, as adjusted for estimated funding probabilities or loan and lease equivalency factors.
Risks Related to Representation and Warranty Provisions
We sell residential mortgage loans in the secondary market primarily to Fannie Mae. We also pool Federal Housing Administration (“FHA”) insured and U.S. Department of Veterans Affairs (“VA”) guaranteed residential mortgage loans for sale to Ginnie Mae. These pools of FHA-insured and VA-guaranteed residential mortgage loans are securitized by Ginnie Mae. The agreements under which we sell residential mortgage loans to Fannie Mae or Ginnie Mae and the insurance or guaranty agreements with FHA and VA contain provisions that include various representations and warranties regarding the origination and characteristics of the residential mortgage loans. Although the specific representations and warranties vary among investors, insurance or guarantee agreements, they typically cover ownership of the loan, validity of the lien securing the loan, the absence of delinquent taxes or liens against the property securing the loan, compliance with loan criteria set forth in the applicable agreement, compliance with applicable federal, state, and local laws, and other matters.
As of September 30, 2012, the unpaid principal balance of our portfolio of residential mortgage loans sold was $2.9 billion. The agreements under which we sell residential mortgage loans require us to deliver various documents to the investor or its document custodian. Although these loans are primarily sold on a non-recourse basis, we may be obligated to repurchase residential mortgage loans where required documents are not delivered or are defective. Investors may require the immediate repurchase of a mortgage loan when an early payment default underwriting review reveals significant underwriting deficiencies, even if the mortgage loan has subsequently been brought current. Upon receipt of a repurchase request, we work with investors or insurers to arrive at a mutually agreeable resolution. Repurchase demands are typically reviewed on an individual loan by loan basis to validate the claims made by the investor or insurer and to determine if a contractually required repurchase event has occurred. We manage the risk associated with potential repurchases or other forms of settlement through our underwriting and quality assurance practices and by servicing mortgage loans to meet investor and secondary market standards. For the first nine months of 2012, we repurchased five residential mortgage loans with an unpaid principal balance totaling $1.9 million as a result of the representation and warranty provisions contained in these contracts. Three of these loans were delinquent as to principal and interest at the time of repurchase. However, no losses were incurred related to these repurchases. As of September 30, 2012, there were two pending repurchase requests totaling $0.4 million related to representation and warranty provisions.
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Risks Relating to Residential Mortgage Loan Servicing Activities
In addition to servicing loans in our portfolio, substantially all of the loans we sell to investors are sold with servicing rights retained. The loans we service were originated by us or by other mortgage loan originators. As servicer, our primary duties are to: (1) collect payments due from borrowers; (2) advance certain delinquent payments of principal and interest; (3) maintain and administer any hazard, title, or primary mortgage insurance policies relating to the mortgage loans; (4) maintain any required escrow accounts for payment of taxes and insurance and administer escrow payments; and (5) foreclose on defaulted mortgage loans or, to the extent consistent with the documents governing a securitization, consider alternatives to foreclosure, such as loan modifications or short sales.
Each agreement under which we act as servicer generally specifies a standard of responsibility for actions taken by us in such capacity and provides protection against expenses and liabilities incurred by us when acting in compliance with the respective servicing agreements. However, if we commit a material breach of our obligations as servicer, we may be subject to termination if the breach is not cured within a specified period following notice. The standards governing servicing and the possible remedies for violations of such standards vary by investor. These standards and remedies are determined by servicing guides issued by the investors as well as the contract provisions established between the investors and the Bank. Remedies could include repurchase of an affected loan. As of September 30, 2012, there were no pending repurchase requests related to loan servicing activities.
Although to date repurchase requests related to representation and warranty provisions, and servicing activities have been limited, it is possible that requests to repurchase mortgage loans may increase in frequency as investors more aggressively pursue all means of recovering losses on their purchased loans. However, as of September 30, 2012, we believe that this exposure is not material due to the historical level of repurchase requests and loss trends and thus have not established a liability for losses related to mortgage loan repurchases. As of September 30, 2012, 99% of our residential mortgage loans serviced for investors were current. We maintain ongoing communications with our investors and will continue to evaluate this exposure by monitoring the level and number of repurchase requests as well as the delinquency rates in our investor portfolios.
Market Risk
Market risk is the potential of loss arising from adverse changes in interest rates and prices. We are exposed to market risk as a consequence of the normal course of conducting our business activities. Our market risk management process involves measuring, monitoring, controlling, and mitigating risks that can significantly impact our statements of income and condition. In this management process, market risks are balanced with expected returns in an effort to enhance earnings performance, while limiting volatility.
Our primary market risk exposure is interest rate risk.
Interest Rate Risk
The objective of our interest rate risk management process is to maximize net interest income while operating within acceptable limits established for interest rate risk and maintaining adequate levels of funding and liquidity.
The potential cash flows, sales, or replacement value of many of our assets and liabilities, especially those that earn or pay interest, are sensitive to changes in the general level of interest rates. This interest rate risk arises primarily from our normal business activities of gathering deposits and extending loans. Many factors affect our exposure to changes in interest rates, such as general economic and financial conditions, customer preferences, historical pricing relationships, and repricing characteristics of financial instruments.
Our earnings are affected not only by general economic conditions, but also by the monetary and fiscal policies of the U.S. and its agencies, particularly the Federal Reserve Bank (the “FRB”). The monetary policies of the FRB can influence the overall growth of loans, investment securities, and deposits and the level of interest rates earned on assets and paid for liabilities. The nature and impact of future changes in monetary policies are generally not predictable.
In managing interest rate risk, we, through the Asset/Liability Management Committee (“ALCO”), measure short and long-term sensitivities to changes in interest rates. The ALCO, which is comprised of members of executive management, utilizes several techniques to manage interest rate risk, which include:
· adjusting balance sheet mix or altering the interest rate characteristics of assets and liabilities;
· changing product pricing strategies;
· modifying characteristics of the investment securities portfolio; or
· using derivative financial instruments.
The use of derivative financial instruments, as detailed in Note 10 to the Consolidated Financial Statements, has generally been limited. This is due to natural on-balance sheet hedges arising out of offsetting interest rate exposures from loans and investment securities with deposits and other interest-bearing liabilities. In particular, the investment securities portfolio is utilized to manage the interest rate exposure and sensitivity to within the guidelines and limits established by the ALCO. We utilize natural and offsetting economic hedges in an effort to reduce the need to employ off-balance sheet derivative financial instruments to hedge interest rate risk exposures. Expected movements in interest rates are also considered in managing interest rate risk. Thus, as interest rates change, we may use different techniques to manage interest rate risk.
A key element in our ongoing process to measure and monitor interest rate risk is the utilization of an asset/liability simulation model. The model is used to estimate and measure the balance sheet sensitivity to changes in interest rates. These estimates are based on assumptions on the behavior of loan and deposit pricing, repayment rates on mortgage-based assets, and principal amortization and maturities on other financial instruments. While such assumptions are inherently uncertain, we believe that these assumptions are reasonable. The model’s analytics include the effects of standard prepayment options on mortgages and customer withdrawal options for deposits. As a result, the simulation model attempts to capture the dynamic nature of the balance sheet.
We utilize net interest income simulations to analyze short-term income sensitivities to changes in interest rates. Table 19 presents, for the twelve months subsequent to September 30, 2012 and December 31, 2011, an estimate of the change in net interest income that would result from a gradual and immediate change in interest rates, moving in a parallel fashion over the entire yield curve, relative to the measured base case scenario. The base case scenario assumes the balance sheet and interest rates are generally unchanged. Based on the net interest income simulation as of September 30, 2012, net interest income sensitivity to changes in interest rates as of September 30, 2012 was more sensitive compared to the sensitivity profile as of December 31, 2011. As a result of our strategy to maintain a relatively short investment portfolio duration, net interest income is expected to increase as interest rates rise. Economic conditions and government intervention continue to result in interest rates remaining relatively low.
Net Interest Income Sensitivity Profile
Table 19
Impact on Future Annual Net Interest Income
Gradual Change in Interest Rates (basis points)
+200
7,422
2.1%
2,934
0.8%
+100
4,383
1.3%
2,036
0.5%
-100
(8,775
-2.5%
(7,900
-2.0%
Immediate Change in Interest Rates (basis points)
21,506
6.2%
10,086
2.6%
13,261
3.8%
7,226
1.9%
(27,243
-7.8%
(25,750
-6.7%
To analyze the impact of changes in interest rates in a more realistic manner, non-parallel interest rate scenarios are also simulated. These non-parallel interest rate scenarios indicate that net interest income may decrease from the base case scenario should the yield curve flatten or become inverted for a period of time. Conversely, if the yield curve should steepen, net interest income may increase.
Other Market Risks
In addition to interest rate risk, we are exposed to other forms of market risk in our normal business transactions. Foreign currency and foreign exchange contracts expose us to a small degree of foreign currency risk. These transactions are primarily executed on behalf of customers. Our trust and asset management income are at risk to fluctuations in the market values of underlying assets, particularly debt and equity securities. Also, our share-based compensation expense is dependent on the fair value of the stock options and restricted stock at the date of grant. The fair value of both stock options and restricted stock is impacted by the market price of the Parent’s common stock on the date of grant and is at risk to changes in equity markets, general economic conditions, and other factors.
Liquidity Risk Management
The objective of our liquidity risk management process is to manage cash flow and liquidity in an effort to provide continuous access to sufficient, reasonably priced funds. Funding requirements are impacted by loan originations and refinancings, deposit growth, liability issuances and settlements, and off-balance sheet funding commitments. We consider and comply with various regulatory guidelines regarding required liquidity levels and periodically monitor our liquidity position in light of the changing economic environment and customer activity. Based on periodic liquidity assessments, we may alter our asset, liability, and off-balance sheet positions. The ALCO monitors sources and uses of funds and modifies asset and liability positions as liquidity requirements change. This process, combined with our ability to raise funds in money and capital markets and through private placements, provides flexibility in managing the exposure to liquidity risk.
In an effort to satisfy our liquidity needs, we actively manage our assets and liabilities. We have immediate liquid resources in cash and noninterest-bearing deposits and funds sold. The potential sources of short-term liquidity include interest-bearing deposits as well as the ability to sell certain assets including available-for-sale investment securities. Short-term liquidity is further enhanced by our ability to sell loans in the secondary market and to secure borrowings from the FRB and FHLB. Short-term liquidity is also generated from securities sold under agreements to repurchase, funds purchased, and short-term borrowings. Deposits have historically provided us with a long-term source of stable and relatively lower cost source of funding. Additional funding is available through the issuance of long-term debt. In recent years, we have retired some long-term debt due to our strong liquidity position.
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We continued to maintain a strong liquidity position throughout the third quarter of 2012. As of September 30, 2012, cash and cash equivalents were $409.9 million, available-for-sale investment securities were $3.1 billion, and total deposits were $11.2 billion. As of September 30, 2012, we continued to maintain our excess liquidity primarily in mortgage-backed securities issued by Ginnie Mae, state and municipal securities, and in U.S. Treasury Notes. As of September 30, 2012, our available-for-sale investment securities portfolio was comprised of securities with an average base duration of less than three years.
Capital Management
In our ongoing efforts to maximize shareholder value over time, we regularly review our capital management activities including the amount of earnings we retain in excess of cash dividends paid and the amount and pace of common stock repurchases. We also seek to maintain capital levels for the Company and the Bank at amounts in excess of the regulatory “well-capitalized” thresholds by an amount commensurate with our risk profile. Periodically, we may respond to market conditions by implementing changes to our overall balance sheet positioning to manage our capital position.
The Company and the Bank are each subject to regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can cause certain mandatory and discretionary actions by regulators that, if undertaken, could have a material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative and qualitative measures. These measures were established by regulation to ensure capital adequacy. As of September 30, 2012, the Company and the Bank were “well capitalized” under this regulatory framework. The Company’s regulatory capital ratios are presented in Table 20 below. There have been no conditions or events since September 30, 2012 that management believes have changed either the Company’s or the Bank’s capital classifications.
As of September 30, 2012, shareholders’ equity was $1.0 billion, an increase of $21.9 million from December 31, 2011. Earnings for the first nine months of 2012 of $125.8 million, common stock issuances of $11.0 million, and a net increase in unrealized gains related to available-for-sale and held-to-maturity investment securities of $6.7 million were partially offset by cash dividends paid of $61.5 million. In the first nine months of 2012, we also repurchased 1.4 million shares of our common stock under our share repurchase program at an average cost per share of $46.87 and a total cost of $64.5 million. In the third quarter of 2012, we reduced our share repurchases to $14.5 million, compared to $20.0 million in the second quarter of 2012 and $30.0 million in the first quarter of 2012. This combined with a lower level of total assets, compared to the second quarter of 2012, produced a higher Tier 1 Leverage Ratio of 6.78% compared to 6.57% in the second quarter of 2012. From the beginning of our share repurchase program in July 2001 through September 30, 2012, we repurchased a total of 49.9 million shares of common stock and returned a total of $1.8 billion to our shareholders at an average cost of $36.28 per share. As of September 30, 2012, remaining buyback authority under our share repurchase program was $84.5 million of the total $1.9 billion repurchase amount authorized by our Board of Directors.
From October 1, 2012 through October 15, 2012, the Parent repurchased an additional 57,500 shares of common stock at an average cost of $45.33 per share for a total of $2.6 million. Remaining buyback authority was $81.9 million as of October 15, 2012. The actual amount and timing of future share repurchases, if any, will depend on market and economic conditions, regulatory rules, applicable SEC rules, and various other factors.
In October 2012, the Parent’s Board of Directors declared a quarterly cash dividend of $0.45 per share on the Parent’s outstanding shares. The dividend will be payable on December 14, 2012 to shareholders of record at the close of business on November 30, 2012.
We continue to evaluate the potential impact that regulatory proposals may have on our liquidity and capital management strategies, including Basel III and those required under the Dodd-Frank Act, as they continue to progress through the final rule-making process. See the “Regulatory Initiatives Related to Liquidity, Capital, and Stress Testing” section in MD&A for more information on the potential impact that these regulatory proposals may have on our liquidity and capital requirements.
Table 20 presents our regulatory capital and ratios as of September 30, 2012 and December 31, 2011.
Regulatory Capital and Ratios
Table 20
Regulatory Capital
Less:
Postretirement Benefit Liability Adjustments
2,668
2,815
69,635
62,932
2,200
2,230
Tier 1 Capital
918,542
903,173
Allowable Reserve for Credit Losses
72,024
68,624
Total Regulatory Capital
990,566
971,797
Risk-Weighted Assets
Key Regulatory Capital Ratios
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Regulatory Initiatives Related to Liquidity, Capital, and Stress Testing
Basel III
On December 16, 2010, the Basel Committee on Banking Supervision (the “BCBS”) released the final text of the Basel III package on capital, leverage, and liquidity reforms. Under Basel III, financial institutions are required to have more capital and a higher quality of capital. Accordingly, Basel III increases the minimum regulatory capital ratios, narrows the definition of capital, and requires capital buffers. In addition, Basel III imposes a leverage ratio requirement and liquidity standards.
On June 7, 2012, the Office of the Comptroller of the Currency (the “OCC”), the FRB, and the FDIC published notices of proposed rulemakings that would revise and replace the agencies’ current capital requirements to make them consistent with the above Basel III capital standards.
The new minimum capital requirements will be phased in between January 1, 2013 and January 1, 2015 as follows: (1) the minimum requirement for common equity to total risk-weighted assets will be increased from the current 2.0% to 4.5%; (2) the minimum requirement for the Tier 1 Capital Ratio to be considered “adequately capitalized” will be increased from the current 4.0% to 6.0%; (3) an additional 2.5% of common equity to total risk-weighted assets will be phased in between January 1, 2016 and January 1, 2019; and (4) a minimum Tier 1 Leverage Ratio of 3.0% will be tested under a stress scenario starting January 1, 2013.
The BCBS quantitative liquidity requirements are not part of the published notices of proposed rulemakings by the OCC, the FRB, and the FDIC. The liquidity proposals under Basel III include: (1) a liquidity coverage ratio (to become effective January 1, 2015); (2) a net stable funding ratio (to become effective January 1, 2018); and (3) a set of monitoring tools to establish minimum reporting requirements of financial institutions to their regulatory supervisors. The liquidity coverage ratio is intended to ensure that banks have sufficient high-quality liquid assets to sustain a significant liquidity stress scenario lasting 30 days. The net stable funding ratio, which has a one year time horizon, is intended to promote the use of more stable sources of funding on an ongoing basis. As of the date of this filing, final regulations have not been issued.
Stress Testing
The Dodd-Frank Act also requires federal banking agencies to issue regulations that require banks with total consolidated assets of more than $10.0 billion to conduct and publish self-administered annual stress tests to assess the potential impact of different scenarios on the consolidated earnings and capital of each bank and certain related items over a nine-quarter forward-looking planning horizon, taking into account all relevant exposures and activities. On October 9, 2012, the FRB published final rules implementing the Dodd-Frank Act stress testing requirements for banks with total consolidated assets of more than $10.0 billion. These banks, including the Company, will be required to perform their company-run stress tests after September 30, 2013, submit the required regulatory report to the FRB by March 31, 2014, but they will not be required to publicly disclose the results of this first stress test until June 2015.
Operational Risk
Operational risk represents the risk of loss resulting from our operations, including, but not limited to, the risk of fraud by employees or persons outside the Company, errors relating to transaction processing and technology, failure to adhere to compliance requirements, business continuation and disaster recovery, and the risk of cyber security attacks. We are also exposed to operational risk through our outsourcing arrangements, and the effect that changes in circumstances or capabilities of our outsourcing vendors can have on our ability to continue to perform operational functions necessary to our business. The risk of loss also includes the potential legal actions that could arise as a result of an operational deficiency or as a result of noncompliance with applicable regulatory standards, adverse business decisions or their implementation, and customer attrition due to potential negative publicity.
The Operating Risk Committee (the “ORC”) provides oversight and assesses the most significant operational risks facing the Company. We have developed a framework that provides for a centralized operating risk management function through the ORC, supplemented by business unit responsibility for managing operational risks specific to their business units.
We continuously strive to strengthen our system of internal controls to improve the oversight of operational risk. While we believe that internal controls have been designed to minimize operational risks, there is no assurance that business disruption or operational losses will not occur. On an ongoing basis, management reassesses operational risks, implements appropriate process changes, and invests in enhancements to its systems of internal controls. For example, we actively and continuously monitor cyber-attacks such as attempts related to fraud and loss of sensitive customer data. We evaluate internal systems, processes and controls to mitigate loss from cyber-attacks and, to date, have not experienced any material losses.
European Debt Crisis
We continue to monitor the debt crisis in Europe and the potential direct and indirect impact it may have on us. As of September 30, 2012, we had no direct exposure to sovereign European governments and our non-sovereign European exposures posed a low risk of loss to the Company. However, the U.S. and Hawaii economies and our customers may be adversely affected by future developments arising from the debt crisis in Europe.
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Off-Balance Sheet Arrangements, Credit Commitments, and Contractual Obligations
Off-Balance Sheet Arrangements
We hold interests in several unconsolidated variable interest entities (“VIEs”). These unconsolidated VIEs are primarily low-income housing partnerships. Variable interests are defined as contractual ownership or other interests in an entity that change with fluctuations in an entity’s net asset value.
The primary beneficiary consolidates the VIE. We have determined that the Company is not the primary beneficiary of these entities. As a result, we do not consolidate these VIEs.
Credit Commitments and Contractual Obligations
Our credit commitments and contractual obligations have not changed materially since previously reported in our Annual Report on Form 10-K for the year ended December 31, 2011.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
See the “Market Risk” section of MD&A.
Item 4. Controls and Procedures
Disclosure Controls and Procedures
The Company’s management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the Company’s 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 September 30, 2012. The Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2012.
Changes in Internal Control over Financial Reporting
There were no changes in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended September 30, 2012 that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.
Item 1A. Risk Factors
There are no material changes from the risk factors set forth under Part I, Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
The Parent’s repurchases of its common stock during the third quarter of 2012 were as follows:
Issuer Purchases of Equity Securities
Total Number of Shares
Approximate Dollar Value
Purchased as Part of
of Shares that May Yet Be
Total Number of
Average Price
Publicly Announced
Purchased Under the
Period
Shares Purchased 1
Paid Per Share
Plans or Programs
Plans or Programs 2
July 1 - 31, 2012
100,697
$ 46.17
100,000
$ 94,426,196
August 1 - 31, 2012
118,277
46.72
117,400
88,940,240
September 1 - 30, 2012
95,500
46.94
84,457,061
314,474
$ 46.61
312,900
1 During the third quarter of 2012, 1,574 shares were purchased for a deferred compensation plan. These shares were not purchased as part of the publicly announced program. The shares were purchased at the closing price of the Parent’s common stock on the dates of purchase.
2 The share repurchase program was first announced in July 2001. As of September 30, 2012, $84.5 million remained of the total $1.9 billion total repurchase amount authorized by the Parent’s Board of Directors under the share repurchase program. The program has no set expiration or termination date.
Item 6. Exhibits
A list of exhibits to this Form 10-Q is set forth on the Exhibit Index and is incorporated herein by reference.
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.
Date: October 22, 2012
By:
/s/ Peter S. Ho
Peter S. Ho
Chairman of the Board,
Chief Executive Officer, and
President
/s/ Kent T. Lucien
Kent T. Lucien
Chief Financial Officer
Exhibit Index
Exhibit Number
31.1
Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) Under the Securities Exchange Act of 1934
31.2
Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) Under the Securities Exchange Act of 1934
Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
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Interactive Data File