UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
(Mark One)
or
Commission File Number 001-12647
Oriental Financial Group Inc.
Principal Executive Offices:
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes [x] No [ ].
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes [x] No [ ] .
Number of shares outstanding of the registrant’s common stock, as of the latest practicable date:
21,921,949 common shares ($1.00 par value per share)outstanding as of March 31, 2004
TABLE OF CONTENTS
PART 1 - FINANCIAL INFORMATION
UNAUDITED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITIONMARCH 31, 2004 AND JUNE 30, 2003
See notes to consolidated financial statements.
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UNAUDITED CONSOLIDATED STATEMENTS OF INCOMEFOR THE QUARTER AND NINE-MONTH PERIODS ENDED MARCH 31, 2004 AND 2003
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UNAUDITED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITYFOR THE NINE-MONTH PERIODS ENDED MARCH 31, 2004 AND 2003
UNAUDITED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOMEFOR THE QUARTER AND NINE-MONTH PERIODS ENDED MARCH 31, 2004 AND 2003
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UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE NINE-MONTH PERIODS ENDED MARCH 31, 2004 AND 2003
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ORIENTAL FINANCIAL GROUP INC.
NOTE 1 – BASIS OF PRESENTATION:
The accounting and reporting policies of Oriental Financial Group Inc. (the “Group” or “Oriental”) conform with accounting principles generally accepted in the United States of America (“GAAP”) and to financial services industry practices.
The unaudited Consolidated Financial Statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). In the opinion of management, these financial statements include all adjustments (which consist of normal recurring accruals) necessary, to present fairly the consolidated financial condition as of March 31, 2004 and June 30, 2003, and the results of operations and cash flows for the nine-month periods ended March 31, 2004 and 2003. All significant intercompany balances and transactions have been eliminated in the accompanying unaudited consolidated financial statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such SEC rules and regulations. Management believes that the disclosures made are adequate to make the information presented not misleading. Financial information as of June 30, 2003 has been derived from the Group’s audited Consolidated Financial Statements. The results of operations and cash flows for the nine-month periods ended March 31, 2004 and 2003 are not necessarily indicative of the results to be expected for the full year. For further information, refer to the Consolidated Financial Statements and footnotes thereto for the year ended June 30, 2003, included in the Group’s Annual Report on Form 10-K.
Certain reclassifications have been made to prior periods financial statements to conform to the current period presentation.
Nature of Operations
Oriental is a financial holding company that provides a wide range of financial services such as retail and commercial banking, mortgage banking, and commercial and consumer lending, as well as financial planning, insurance sales, money management and investment brokerage services, and corporate and individual trust services. The Group focuses its marketing on attracting professional consumer and commercial customers. It operates through three major business segments, Retail Banking, Treasury, and Financial Services, which are comprised of four subsidiaries, Oriental Bank and Trust (the “Bank”), Oriental Financial Services Corp. (“Oriental Financial Services”), Oriental Insurance, Inc. (“Oriental Insurance”) and Caribbean Pension Consultants, Inc. The main offices of the Group and most of its subsidiaries are located in San Juan, Puerto Rico. Note 9 to the consolidated financial statements present further information about the operations of the Group’s business segments.
Oriental is incorporated under the laws of the Commonwealth of Puerto Rico and operates under U.S. and Puerto Rico banking laws and regulations. The Group is subject to examination, regulation and periodic reporting under the Bank Holding Company Act of 1956, as amended, which is administered by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). The Bank operates through twenty-three branches located throughout Puerto Rico and is subject to the supervision, examination and regulation of the Office of the Commissioner of Financial Institutions of Puerto Rico and the Federal Deposit Insurance Corporation (FDIC), which insures its deposits through the Savings Association Insurance Fund (SAIF). The Bank also operates an international banking entity, which is a unit of the Bank, named O.B.T. International Bank, pursuant to the International Banking Center Regulatory Act of Puerto Rico, as amended (the “IBE Act”). In November 2003, the Group organized a new international banking entity, named Oriental International Bank Inc., as a wholly owned subsidiary of the Bank. The Group transferred as of January 1, 2004 substantially all the assets and liabilities of O.B.T. International Bank to the new subsidiary. The international banking entity offers the Bank certain Puerto Rico tax advantages and its services are limited under Puerto Rico law to persons and assets located outside of Puerto Rico. Oriental Financial Services is subject to the supervision, examination and regulation of the National Association of Securities Dealers, Inc., the SEC, and the Office of the Commissioner of Financial Institutions of Puerto Rico. Oriental Insurance is subject to the supervision, examination and regulation of the Office of the Commissioner of Insurance of Puerto Rico.
Significant Accounting Policies
The consolidated financial statements of the Group are prepared in accordance with GAAP and with general practices within the financial services industry. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Group believes that of its significant accounting
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policies, the following may involve a higher degree of judgment and complexity.
Stock Option Plans
At March 31, 2004, the Group has four stock-based employee compensation plans: the 1988, 1996, 1998, and 2000 Incentive Stock Option Plans. These plans offer key officers, directors and employees an opportunity to purchase shares of the Group’s common stock. The Compensation Committee of the Board of Directors has sole authority and absolute discretion as to the number of stock options to be granted to any officer, director or employee, their vesting rights, and the options’ exercise prices. The plans provide for a proportionate adjustment in the exercise price and the number of shares that can be purchased in case of merger, consolidation, combination, exchange or shares, other reorganization, recapitalization, reclassification, stock dividend, stock split or reverse stock split in which the number of shares of common stock of the Group as a whole are increased, decreased, changed into or exchanged for a different number of kind of shares or securities stock options vest upon completion of specified years to service.
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The Group follows the intrinsic value-based method of accounting for measuring compensation expense, if any. Compensation expense is generally recognized for any excess of the quoted market price of the Group’s stock at measurement date over the amount an employee must pay to acquire the stock. No stock-based employee compensation cost is reflected in net income, as all options granted during the quarter and nine-month periods ended March 31, 2004 and 2003 under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Group had applied the fair value recognition provisions:
The fair value of each option granted during the nine-month periods ended March 31, 2004 and 2003 was $7.79 and $5.90 per option, respectively, as adjusted for the stock dividend effected on January 15, 2004. The fair value of each option granted during the nine-month periods ended March 31, 2004 and 2003 was estimated at the date of the grant using the Black-Scholes option pricing model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no restrictions and are fully transferable and negotiable in a free trading market. Black-Scholes does not consider the employment, transfer or vesting restrictions that are inherent in the Group’s employee options. Use of an option valuation model, as required by GAAP, includes highly subjective assumptions based on long-term predictions, including the expected stock price volatility and average life of each option grant. Because the Group’s employee options have characteristics significantly different from those of freely traded options, and because changes in the subjective input assumptions can materially affect the Group’s estimate of the fair value of those options, in the Group’s opinion, the existing valuation models, including Black-Scholes, are not reliable single measures and the use of other option pricing models may result in different fair values of the Group’s employee options.
The following assumptions were used in estimating the fair value of the options granted:
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NOTE 2 – INVESTMENT SECURITIES:
Short Term Investments
At March 31, 2004 and June 30, 2003 the Group’s short term investments were comprised of:
Trading Securities
A summary of trading securities owned by the Group at March 31, 2004 and June 30, 2003 is as follows:
As of March 31, 2004, the Group’s trading portfolio weighted average yield was 6.49% (June 30, 2003 – 6.35%).
Investment securities
The amortized cost, gross unrealized gains and losses, fair value, and weighted average yield of the investment securities as of March 31, 2004 and June 30, 2003, were as follows:
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At June 30, 2003, there were no held-to-maturity securities.
The amortized cost and fair value of the Group’s investment securities available-for-sale and held-to-maturity at March 31, 2004, by contractual maturity, are shown in the next table. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
Proceeds from the sale of investment securities available-for-sale during the nine-month period ended March 31, 2004 totaled $561,499,000 (2003 - $423,074,000). Gross realized gains and losses on those sales during the nine-month period ended March 31, 2004 were $11,932,000 and $2,423,000 respectively, (2003 – $10,227,000 and $1,818,000, respectively). During the quarters ended September 30, 2003 and March 31, 2004, the Group’s management reclassified, at fair value, $856,037,000 and $174,399,000, respectively, of its available-for-sale investment portfolio to the held-to-maturity investment category as management now intends to hold these securities to maturity.Unrealized loss on those securities transferred to held-to-maturity category amounted to $27.0 million at March 31, 2004, and is included as part of the accumulated other comprehensive loss in the unaudited consolidated statement of financial condition. This unrealized loss is amortized over the remaining life of the securities as a yield adjustment. For the nine-month periods ended March 31, 2004 and 2003, management concluded that there was no other-than-temporary impairment on its investment securities portfolio.
NOTE 3 - LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES:
Loans Receivable
The Group’s credit activity is mainly with customers located in Puerto Rico. Oriental’s loan transactions are encompassed within three main categories: mortgage, commercial and consumer. The composition of the Group’s loan portfolio at March 31, 2004 and June 30, 2003 was as follows:
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Allowance for Loan Losses
The Group maintains an allowance for loan losses at a level that management considers adequate to provide for probable losses based upon an evaluation of known and inherent risks. Oriental’s allowance for loan losses policy provides for a detailed quarterly analysis of probable losses. The analysis includes a review of historical loan loss experience, value of underlying collateral, current economic conditions, financial condition of borrowers and other pertinent factors.
While management uses available information in estimating probable loan losses, future additions to the allowance may be necessary based on factors beyond Oriental’s control, such as factors affecting Puerto Rico economic conditions. Refer to Table 4 of the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for the changes in the allowance for loan losses for the quarter and nine-month periods ended March 31, 2004 and 2003.
The Group evaluates all loans, some individually and other as homogeneous groups, for purposes of determining impairment. At March 31, 2004, the total investment in impaired commercial loans was $2,543,000. The impaired commercial loans were measured based on the fair value of collateral. The Group determined that no specific impairment allowance was required for such loans. The average investment in impaired commercial loans for the nine-month period ended March 31, 2004 amounted $2,529,000. At June 30, 2003 there were no impaired loans.
NOTE 4 - PLEDGED ASSETS:
At March 31, 2004, investment securities and residential mortgage loans with a carrying value of $2,139,090,000 and $449,853,000, respectively, were pledged to secure public fund deposits, securities sold under agreements to repurchase, letters of credit, advances and borrowings from the Federal Home Loan Bank of New York, term notes and interest rate swap agreements. As of March 31, 2004, investment securities available-for-sale and held-to-maturity not pledged amounted to $302,692,000 and $172,665,000 respectively. As of March 31, 2004, mortgage loans not pledged amounted to $132,888,000.
NOTE 5 – OTHER ASSETS
Other assets at March 31, 2004 and June 30, 2003 include the following:
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NOTE 6 – SUBORDINATED CAPITAL NOTES
Subordinated capital notes amounted to $72,166,000 and $36,083,000 at March 31, 2004 and June 30, 2003, respectively.
In October 2001 and August 2003, Oriental Financial (PR) Statutory Trust I (the “Statutory Trust I”) and Oriental Financial (PR) Statutory Trust II (the “Statutory Trust II”), respectively, wholly owned special purpose subsidiaries of the Group, were formed for the purpose of issuing trust redeemable preferred securities. In December 2001 and September 2003, $35 million of trust redeemable preferred securities were issued by the Statutory Trust I and by the Statutory Trust II, respectively, as part of pooled underwriting transactions. Pooled underwriting involves participating with other bank holding companies in issuing the securities through a special purpose pooling vehicle created by the underwriters.
The proceeds from these issuances were used by the Statutory Trust I and the Statutory Trust II to purchase a like amount of floating rate junior subordinated deferrable interest debentures (“subordinated capital notes”) issued by the Group. The first of these subordinated capital notes has a par value of $36.1 million, bear interest based on 3 months LIBOR plus 360 basis points (4.71% at March 31, 2004 and 4.72% at June 30, 2003) provided, however, that prior to December 18, 2006, this interest rate shall not exceed 12.5%, payable quarterly, and matures on December 23, 2031. The second one, has a par value of $36.1 million, bear interest based on 3 months LIBOR plus 295 basis points (4.06% at March 31, 2004), payable quarterly, and matures on September 17, 2033. Both subordinated capital notes may be called at par after five years. The trust redeemable preferred securities have the same maturity and call provisions as the subordinated capital notes.
In January 2003, the Financial Accounting Standards Board (“FASB”) Issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51.” FIN No. 46 addresses consolidation by business enterprises of variable interest entities. FIN No. 46 requires an enterprise to consolidate a variable interest entity if that enterprise has a variable interest that will absorb a majority of the entity’s expected losses if they occur, receive a majority of the entity’s expected residual returns if they occur, or both. A variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not issue voting interests (or other interests with similar rights) or (b) the total equity investment at risk is not sufficient to permit the entity to finance its activities. Qualifying Special Purpose Entities are exempt from the consolidation requirements.
The Group adopted FIN No. 46 in the second quarter of fiscal 2004. FIN No. 46 requires the Group to deconsolidate its investments in the Statutory Trust I and the Statutory Trust II, which were presented on a consolidated basis in previous financial statements. As a result of the adoption of FIN No. 46, the subordinated deferrable interest debentures issued by the Group are accounted for as a liability denominated as subordinated capital notes on the consolidated statements of financial condition. Interest on these subordinated capital notes and the amortization of related issuance costs are accounted for as interest expense on an accrual basis. FIN No. 46 was adopted by restating previously issued financial statements which resulted in increasing total assets and total liabilities by $2.2 million and $1.1 million as of December 31, 2003 and June 30, 2003, respectively, and did not had any effect on the Group’s net income for any period.
The trust redeemable preferred securities are treated as Tier-1 capital for regulatory purposes. In July 2003, the Federal Reserve Board issued a supervisory letter instructing bank holding companies to continue to include the trust preferred securities in their Tier 1 capital for regulatory capital purposes until notice is given to the contrary. The Federal Reserve Board intends to review the regulatory implications of any accounting treatment changes and, if necessary or warranted, provide further appropriate guidance.
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NOTE 7 – OTHER BORROWINGS
At March 31, 2004, securities underlying agreements to repurchase were delivered to, and are being held by, the counterparties with whom the repurchase agreements were transacted. The counterparties have agreed to resell to the Group the same or similar securities at the maturity of the agreements.
Securities sold under agreements to repurchase (“reverse repurchase agreements”) at March 31, 2004 mature as follows: within 30 days — $1,209,232,000; and between 31 to 90 days — $439,107,000.
At March 31, 2004, the contractual maturities of advances from the FHLB and term notes by fiscal year are as follows:
NOTE 8 – DERIVATIVES ACTIVITIES
The Group utilizes various derivative instruments for hedging purposes, such as asset/liability management. These transactions involve both credit and market risk. The notional amounts are amounts on which calculations and payments are based. Notional amounts do not represent direct credit exposures. Direct credit exposure is limited to the net difference between the calculated amounts to be received and paid, if any. The actual risk of loss is the cost of replacing, at market, these contracts in the event of default by the counterparties. The Group controls the credit risk of its derivative financial instrument agreements through credit approvals, limits, monitoring procedures and collateral, when considered necessary.
The Group generally uses interest rate swaps and interest rate options, such as caps and options, in managing its interest rate risk exposure. The swaps were entered into to convert short-term borrowings into fixed rate liabilities for longer periods and provide protection against increases in short-term interest rates. Under these swaps, the Group pays a fixed monthly or quarterly cost and receives a floating thirty or ninety-day payment based on LIBOR. Floating rate payments received from the swap counterparties correspond to the floating rate payments made on the short-term borrowings thus resulting in a net fixed rate cost to the Group. Under the caps, the Group pays an up front premium or fee for the right to receive cash flow payments in excess of the predetermined cap rate; thus, effectively capping its interest rate cost for the duration of the agreement.
Derivative instruments are recognized as assets and liabilities at fair value. If certain conditions are met, the derivative may qualify for hedge accounting treatment and be designated as one of the following types of hedges: (a) hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment (“fair value hedge”); (b) a hedge of the exposure to variability of cash flows of a recognized asset, liability or forecasted transaction (“cash flow hedge”) or (c) a hedge of foreign currency exposure (“foreign currency hedge”).
In the case of a qualifying fair value hedge, changes in the value of the derivative instruments that have been highly effective are recognized in current period earnings along with the change in value of the designated hedged item. In the case of a qualifying cash flow hedge, changes in the value of the derivative instruments that have been highly effective are recognized in other comprehensive income (loss), until such time as those earnings are affected by the variability of the cash flows of the underlying hedged item. In either a fair value hedge or a cash flow hedge, net earnings may be impacted to the extent the changes in the value of the derivative instruments do not perfectly offset changes in the value of the hedged items. If the derivative is not designated as a hedging instrument, the changes in fair value of the derivative are recorded in earnings.
Certain contracts contain embedded derivatives. When the embedded derivative possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract, it should be bifurcated, carried at fair value, and designated as a trading or non-hedging derivative instrument.
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The Group’s swaps, excluding those used to manage exposure to the stock market, and caps outstanding and their terms at March 31, 2004 and June 30, 2003 are set forth in the table below:
The Group offers its customers certificates of deposit with an option tied to the performance of the Standard & Poor’s 500 stock market index. At the end of five years, the depositor will receive a specified percentage of the average increase of the month-end value of the index. If the index decreases, the depositor receives the principal without any interest. The Group uses swap and option agreements with major money center banks and major broker-dealer companies to manage its exposure to changes in this index. Under the terms of the option agreements, the Group will receive the average increase in the month-end value of the index in exchange for a fixed premium. Under the term of the swap agreements, the Group will receive the average increase in the month-end value of the index in exchange for a quarterly fixed interest cost. The changes in fair value of the options purchased, the swap agreements and the options embedded in the certificates of deposit are recorded in earnings.
Derivatives instruments are generally negotiated over-the-counter (“OTC”) contracts. Negotiated OTC derivatives are generally entered into between two counterparties that negotiate specific agreement terms, including the underlying instrument, amount, exercise price and maturity.
Information pertaining to the notional amounts of the Group’s derivative financial instruments as of March 31, 2004 and June 30, 2003 is as follows:
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During the nine-month periods ended March 31, 2004 and 2003, $935,000 and $4.4 million respectively, of losses were charged to earnings and reflected as “Derivatives Activities” in the consolidated statements of income. During the nine-month periods ended March 31, 2004 and 2003, unrealized losses of $7.7 million and $26.9 million, respectively, on derivatives designated as cash flow hedges were included in other comprehensive income (loss). Ineffectiveness of $811,000 and $339,000 was charged to earnings during the nine-month periods ended March 31, 2004 and 2003, respectively.
At March 31, 2004 and June 30, 2003, the fair value of derivatives was recognized as either assets or liabilities in the consolidated statements of financial condition as follows: the fair value of the interest rate swaps used to manage the exposure to the stock market on stock indexed deposits represented a liability of $93,000 and $316,000, respectively; the purchased options used to manage the exposure to the stock market on stock indexed deposits represented an other asset of $14.5 million and $7.4 million, respectively, and the options sold to customers embedded in the certificates of deposit represented a liability of $14.3 million and $7.2 million, respectively, recorded in deposits. The fair value of the interest rate swaps represented a liability of $37.7 million and $42.8 million, respectively, presented in accrued expenses and other liabilities. The caps did not have carrying value as of March 31, 2004 and June 30, 2003.
NOTE 9 – STOCKHOLDERS’ EQUITY TRANSACTIONS:
Common Stock
On February 12, 2004, the Group filed a registration statement with the Securities and Exchange Commission (“SEC”) for an offering of 2,565,000 shares of common stock. The registration statement was amended on February 27, 2004. The offering consisted of 1,700,000 shares offered by the Group, and an aggregate of 865,000 shares offered by three stockholders of the Group. The offering also included an additional 384,750 shares subject to over-allotment options granted by the Group and the selling stockholders to the underwriters. The registration statement, as amended, was declared effective by the SEC on March 3, 2004.
On March 20, 2004, the underwriters exercised their options to purchase from the Group and the selling stockholders an aggregate of 384,750 shares of the Group’s common stock to cover over-allotments (255,000 of these shares were purchased from the Group and 129,750 from the three selling stockholders of the Group). Following such exercise, the total offering was for 2,949,750 shares at a public offering price of $28.00 per share, consisting of 1,955,000 shares offered by the Group and an aggregate of 994,750 shares by the three selling stockholders of the Group. Proceeds to the Group from issuance of common stock were approximately $51,534,000, net of $3,206,000 of issuance costs.
Stock Dividend
On October 28, 2002, the Group declared a twenty-five percent (25%) stock split effected in the form of a dividend on common stock held by shareholders of record as of December 30, 2002. As a result, 3,864,800 shares of common stock were issued and distributed on January 15, 2003. Also, on November 20, 2003, the Group declared a ten percent (10%) stock dividend on common stock held by shareholders of record as of December 31, 2003. As a result, 1,798,722 shares of common stock were distributed on January 15, 2004, from the Group’s treasury stock account. For purpose of the computation of income per common share, cash dividend and stock price, the stock dividends were retroactively recognized for the periods presented in the accompanying consolidated financial statements.
Preferred Stock
On September 30, 2003, the Group issued 1,380,000 shares of 7.0% Noncumulative Monthly Income Preferred Stock, Series B, at $25 per share. Proceeds from issuance of the Series B Preferred Stock, were approximately $33,057,000, net of $1,443,000 of issuance costs.
The Series B Preferred Stock has the following characteristics: (1) annual dividends of $1.75 per share, payable monthly, if declared by the Board of Directors; missed dividends are not cumulative, (2) redeemable at the Group’s option beginning on October 31, 2008, (3) no mandatory redemption or stated maturity date, and (4) liquidation value of $25 per share.
Treasury Stock
On March 26, 2003, the Group’s Board of Directors announced the authorization of a new program for the repurchase of up to $9.0 million of its outstanding shares of common stock. This program superseded the ongoing repurchase program established earlier. The Group makes such repurchases from time to time, depending on market conditions and prices. The Group repurchased 15,800 and 42,500 shares of its common stock, for $394,000 and $944,000, respectively, during the nine-month periods ended March 31, 2004 and 2003, respectively.
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NOTE 10 – SEGMENT REPORTING:
The Group segregates its businesses into the following major reportable segments of business: Retail Banking, Treasury and Financial Services. Management determined the reportable segments based on the internal reporting used to evaluate performance and to assess where to allocate resources. Other factors such as the Group’s organizational chart, nature of products, distribution channels and economic characteristics of the products were also considered in the determination of the reportable segments. The Group measures the performance of these reportable segments based on pre-established goals of different financial parameters such as net income, net interest income, loan production, and fees generated.
Retail Banking includes the Bank’s branches and mortgage banking, with traditional banking products such as deposits and mortgage, commercial and consumer loans. The mortgage banking activities are carried out by the Bank’s mortgage banking division, which principal activity is to originate and purchase mortgage loans for the Group’s own portfolio. From time to time, if conditions so warrant, it may sell loans to other financial institutions or securitize conforming loans into GNMA, FNMA and FHLMC certificates using another institution as issuer. The other institution services mortgages included in the resulting GNMA, FNMA, and FHLMC pools. The Group also sells the rights to service mortgage loans for others.
The Treasury segment encompasses all of the Group’s assets and liabilities management activities such as: purchases and sales of investment securities, interest rate risk management and funding derivatives and borrowings.
Financial services is comprised of the Bank’s trust division (Oriental Trust), the brokerage subsidiary (Oriental Financial Services Corp.), the insurance agency subsidiary (Oriental Insurance, Inc.), and the pension plan administration subsidiary (Caribbean Pension Consultants, Inc.). The core operations of this segment are financial planning, money management and investment brokerage services, insurance sales activity, corporate and individual trust services, as well as pension plan administration services.
Intersegment sales and transfers, if any, are accounted for as if the sales or transfers were to third parties, that is, at current market prices. The accounting policies of the segments are the same as those described in the “Summary of Significant Accounting Policies” included in the Group’s Annual Report on Form 10-K. Following are the results of operations and the selected financial information by operating segment for the quarter and nine-month periods ended March 31, 2004 and 2003:
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NOTE 11 – RECENT ACCOUNTING DEVELOPMENTS:
SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities
In April 2003, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities”. This Statement is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. Implementation of SFAS No. 149 did not have a significant effect on the Group’s financial condition or results of operations.
SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. This Statement establishes standards for how an issuer classifies and measures in its statement of financial condition certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. Implementation of SFAS No. 150 did not have a significant effect on the Group’s financial condition or results of operations.
EITF 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments
In March 2004, the Emerging Issues Task Force reached a consensus on Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“Issue 03-1”). The Task Force reached a consensus on an other-than-temporary impairment model for debt and equity securities accounted for under Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities” and cost method investments. The basic model developed by the Task Force in evaluating whether an investment within the scope of Issue 03-1 is other-than-temporary impaired must be applied on a security-by-security basis as follows: Step 1: Determine whether an investment is impaired. An investment is considered impaired if its fair value is less than its cost. Step 2: Evaluate whether an impairment is other-than-temporary. For equity securities and debt securities that can contractually be prepaid or otherwise settled in such a way that the investor would not recover substantially all of its cost, an impairment is presumed to be other-than-temporary unless: the investor has the ability and intent to hold the investment for a reasonable period of time sufficient for a forecasted market price recovery of the investment, and evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. For other debt securities, an impairment is deemed other-than-temporary if: the investor does not have the ability and intent to hold the investment until a forecasted market price recovery (may mean until maturity), or it is probable that the investor will be unable to collect all amounts due according to the contractual terms of the debt security. Step 3: If the impairment is other-than-temporary, recognize in earnings an impairment loss equal to the difference between the investment’s cost and its fair value. The fair value of the investment then becomes the new cost basis of the investment and cannot be adjusted for subsequent recoveries in fair value, unless required by other authoritative literature.
EITF 03-1 will be effective prospectively for all relevant current and future investments in reporting periods beginning after June 15, 2004. The implementation of EITF 03-1 is not expected to have a material effect on the Group’s financial condition or results of operations.
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Item 2 - Management’s Discussion and Analysis ofFinancial Condition and Results of Operations
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SELECTED FINANCIAL DATAFOR THE QUARTER AND NINE-MONTH PERIODS ENDED MARCH 31, 2004 AND 2003 (In thousands, except for per shares information)
PERIOD END BALANCES AND CAPITAL RATIOS:AS OF MARCH 31, 2004 and JUNE 30, 2003
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SELECTED FINANCIAL DATAFOR THE QUARTERS ENDED MARCH 31, 2004 AND 2003(Dollars in thousands)
TABLE 1 - QUARTERLY ANALYSIS OF NET INTEREST INCOME AND CHANGES DUE TO VOLUME/RATE:
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SELECTED FINANCIAL DATAFOR THE NINE-MONTH PERIODS ENDED MARCH 31, 2004 AND 2003(Dollars in thousands)TABLE 1A - FISCAL YEAR-TO-DATE ANALYSIS OF NET INTEREST INCOME AND CHANGES DUE TO VOLUME/RATE:
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SELECTED FINANCIAL DATAFOR THE QUARTER AND NINE-MONTH PERIODS ENDED MARCH 31, 2004 AND 2003 (Dollars in thousands)
(1) Excludes contracted services.
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SELECTED FINANCIAL DATAAS OF MARCH 31, 2004, 2003 and JUNE 30, 2003 (Dollars in thousands)
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SELECTED FINANCIAL DATAAS OF MARCH 31, 2004, 2003 and JUNE 30, 2003(Dollars in thousands)
(1) Includes loans held for sale.
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SELECTED FINANCIAL DATAAS OF MARCH 31, 2004, 2003 and JUNE 30, 2003(In thousands, except for per share data)
The following provides the high and low prices and dividend per share of the Group’s stock for each quarter of the last three fiscal periods. Common stock prices and cash dividend per share were adjusted to give retroactive effect to the stock split and stock dividends declared on the Group’s common stock.
(1) Adjusted to give retroactive effect to the 10% stock dividends declared on the Group’s common stock in November 20, 2003.
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OVERVIEW OF FINANCIAL PERFORMANCE
Introduction
The Group’s diversified mix of businesses produces both the interest income traditionally associated with a banking institution and non-interest income traditionally associated with a financial services institution (generated by such businesses as brokerage, fiduciary services, investment banking and insurance). Although all of these businesses, to varying degrees, are affected by interest rate and financial markets fluctuations and other external factors, the Group’s commitment is to produce a balanced and growing revenue stream.
Net Income
For the quarter ended March 31, 2004, the Group’s net income was $16.3 million, an increase of 25.5 percent from the $13.0 million reported in the third quarter ended March 31, 2003. Earnings per diluted share increased to $0.71, up 16.4 percent from $0.61. For the nine months ended March 31, 2004, the Group’s net income was $45.6 million, a 22.8 percent increase from the $37.1 million reported in the nine months ended March 31, 2003. Earnings per diluted share increased to $2.04, up 17.2 percent from $1.74. Performance in both periods reflects growth in net interest income and non-interest income.
Return on Assets & Common Equity
Return on assets (ROA) for the quarter ended March 31, 2004 increased to 1.93 percent from 1.83 percent in the prior year comparable quarter, and ROA for the nine-month period ended March 31, 2004 increased to 1.87 percent from 1.85 percent in the prior year comparable period. Return on common equity (ROE) for the quarter ended March 31, 2004 increased to 36.35 percent from 30.45 percent for the prior year comparable quarter, and ROE grew to 35.65 percent from 31.06 percent in the prior year comparable period.
Net Interest Income after Provision for Loan Losses
Net interest income after provision for loan losses increased 15.1 percent for the quarter ended March 31, 2004, reaching $21.7 million, compared with $18.9 million for the same period in the previous fiscal year. For the nine month period ended March 31, 2004, net interest income after provision for loan losses reached $61.2 million, against $53.5 million for the same nine-month period a year earlier, an increase of 14.4 percent. Performance in both periods reflected increases in average interest earning assets, partially offset by the decline in the interest rate spread.
Non-Interest Income
Total non-interest income reached $11.2 million in the quarter ended March 31, 2004, compared with $8.6 million in the same fiscal 2003 quarter, an increase of 29.9 percent. For the nine-month period, total non-interest income was $33.5 million in fiscal 2004, compared with $24.8 million in fiscal 2003, up 35.2 percent. Performance in both periods reflects increases in banking and financial service revenues and securities, derivatives and trading activities.
Banking Service Revenues
For the quarter, banking service revenues increased 32.3 percent, to $1.8 million, compared to $1.4 million in the year ago quarter. For the nine-month period, banking service revenues increased 20.0 percent to $5.2 million, from $4.4 million reported for the same period a year ago. Increases in both periods were principally driven by expanding consumer and professional retail and middle-market commercial business.
Financial Service Revenues
For the quarter, financial service revenues (trust, mortgage banking activities, brokerage and insurance fees) amounted to $6.3 million, compared with $5.6 million in the year-ago quarter, an increase of 11.7 percent. For the nine months, financial service revenues amount to $19.6 million, as compared to $16.1 million in the same period a year-ago, an increase of 21.8 percent. The improvement in both periods reflects increased securities brokerage fees. The increase for the nine months also reflected the addition of revenues from the January 2003 acquisition of Caribbean Pension Consultants, Inc. (CPC).
Securities, Derivatives and Trading Activities
For the quarter, securities, derivatives and trading activities amounted to $3.1 million, a 90.3 percent increase when compared to $1.6 million recorded in the year ago quarter. For the nine-months, securities, derivatives and trading activities amounted to $8.6 million, an 89.2 percent increase when compared to $4.5 million recorded in the same period a year ago. The increases in both periods primarily resulted from the Group’s strategy of selectively identifying favorable market opportunities to realize securities gains.
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Non-Interest Expenses
For the quarter ended March 31, 2004, non-interest expenses increased 8.9 percent, to $15.0 million as compared to $13.8 million in the quarter ended March 31, 2003. For the nine months ended March 31, 2004, non-interest expenses increased 15.1 percent, to $45.0 million as compared to $39.1 million in the nine-months ended March 31, 2003. The increase in both periods was the result of selected investments in human resources, new technology, marketing, and improvements to the current network of 23 branches, offset by selected cost-savings in outside professional services. The increase in the nine-month period also reflected additional expenses from CPC, which was acquired in January 2003. For the quarter, the efficiency ratio improved to 48.53 percent when compared to 51.54 percent in the year ago quarter, and for the nine months, the efficiency ratio improved to 50.25 percent when compared to 50.91 percent in the year ago period.
Total Group Financial Assets Managed and Owned
Total Group financial assets managed and owned (including assets managed by the trust department, the retirement plan administration subsidiary, and the broker-dealer subsidiary) increased 9.8 percent to $6.229 billion as of March 31, 2004, compared to $5.674 billion as of June 30, 2003. Assets managed by the Group’s trust department, the retirement plan administration subsidiary, and broker-dealer subsidiary increased 4.9 percent, to $2.763 billion, from $2.633 billion as of June 30, 2003, principally due to the effect that the equity market improvement had over the assets gathered by the broker-dealer. Assets owned increased 14.0 percent, reaching $3.466 billion as of March 31, 2004, versus $3.041 billion as of June 30, 2003, mainly due to increases in the investment and loan portfolios.
Interest Earning Assets
The investment portfolio amounted to $2.646 billion as of March 31, 2004, an 18.5 percent increase, when compared to $2.232 billion as of June 30, 2003, while the loan portfolio decreased by 1.4 percent to $718.1 million as of March 31, 2004, when compared to $728.5 million as of June 30, 2003. The change in the size of the loan portfolio reflects sales of mortgage loans in the secondary market, loan repayments, and growth of commercial loans.
Interest Bearing Liabilities
Deposits increased 1.3 percent from $1.044 billion as of June 30, 2003, to $1.058 billion as of March 31, 2004. This performance reflects the Group’s strategy of focusing on attracting longer-term checking, savings and IRA deposits from consumer, professional and commercial customers, based on the Group’s total capabilities to service their needs, rather than bidding for deposits based solely on rate. Total borrowings as of March 31, 2004 reached $2.046 billion, a 29.4 percent increase when compared to $1.582 billion as of June 30, 2003. This performance reflects the Group’s strategy of using borrowings as a cost effective source to fund the growth of interest earning assets.
Stockholders’ Equity
The Group continued strengthening its capital base during the third quarter and nine months ended March 31, 2004. Stockholders’ equity as of March 31, 2004 was $286.7 million, a 42.1 percent increase from $201.7 million as of June 30, 2003. This increase reflects the impact of earnings retention and proceeds of $34.5 million from the issuance of Preferred Series B shares in the first quarter of fiscal 2004 and $51.5 million, net of expenses, from the issuance of 1,955,000 shares of common stock in the third quarter of fiscal 2004, partially offset by the increase in the accumulated other comprehensive loss of $38.2 million, mostly associated with the decrease in unrealized gains on the securities available-for-sale portfolio from the fourth quarter of fiscal 2003 to the first quarter of fiscal 2004.
Dividends
In November 2003, the Group increased its quarterly cash dividend by 10 percent and also declared a 10 percent stock dividend on its common shares.
Net Interest Income
Net interest income is affected by the difference between rates earned on the Group’s interest-earning assets and rates paid on its interest-bearing liabilities (interest rate spread) and the relative amounts of its interest-earning assets and interest-bearing liabilities (interest rate margin). Typically bank liabilities reprice in tandem with changes in short-term rates, while many assets positions are influenced by longer-term rates. Our interest rate risk position generally benefits in a declining rate environment because liabilities reprice more quickly than assets. However, when long-term rates decline faster than short-term rates, this benefit is somewhat offset. The Group constantly monitors the composition and repricing of its assets and liabilities to maintain its net interest income at adequate levels.
For the third quarter ended March 31, 2004, net interest income amounted to $22.8 million, a 15.5 percent increase from $19.7 million in the same period of the previous fiscal year. The increase was due to a positive volume variance of $4.0 million, partially offset by a negative rate variance of $1.0 million. Interest rate spread dropped 25 basis points, to 2.68% from 2.93% in the year ago quarter. This was due principally to a decrease of 74 basis points in the combined average yield of investments and loans, partially offset by a 49 basis point decline in the average cost of funds.
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For the nine-months ended March 31, 2004, net interest income amounted to $64.6 million, a 14.7 percent increase from $56.3 million for the same period of the previous fiscal year. The increase was due to a positive volume variance of $21.7 million, partially offset by a negative rate variance of $13.4 million. Interest rate spread declined 29 basis points to 2.70% from 2.99% in the year ago nine months.
Tables 1 and 1A provide information on the major categories of interest-earning assets and interest-bearing liabilities, their respective interest income, expenses, yields and costs, and their impact on net interest income due to changes in volume and rates.
For the third quarter ended March 31, 2004, interest income totaled $42.4 million, an 8.5 percent increase from $39.1 million in the same period of the previous fiscal year. The increase resulted from a larger volume of average interest earning assets partially offset by a decline in their yield performance. For the third quarter ended March 31, 2004, the average balance of total interest-earning assets grew by 23.85 percent, to $3.240 billion versus $2.616 billion for the same period of the previous fiscal year, with the increase concentrated in both the investment and loan portfolios. The increase in the investment portfolio was concentrated in mortgage-backed securities and Puerto Rico government agencies obligations.
The average balance of total loans grew by 7.5 percent, to $736.7 million for the third quarter ended March 31, 2004 from $685.0 million for the third quarter ended March 31, 2003. The average balance of real estate mortgage loans increased 4.8 percent, to $658.6 million for the quarter ended March 31, 2004 from $628.6 million for the quarter ended March 31, 2003. The average balance of commercial loans increased 62.2 percent to $61.3 million for the quarter ended March 31, 2004 from $37.8 million for the quarter ended March 31, 2003. The increase in real estate mortgage loans reflects continued growth in that business while the increase in commercial loans reflects initial success of the Group’s expanded commercial lending effort. Most of the Group’s commercial loans are secured by real estate.
For the quarter ended March 31, 2004, the average yield on interest-earning assets was 5.24%, 74 basis points lower than the 5.98% reported in the same period a year ago. The decline in average yield was primarily due to: (i) expansion of the investment portfolio with securities that provide a lower yield at less risk than the loan portfolio as well as generating a significant amount of tax-exempt interest; and (ii) a decrease on the yield of the investment and loan portfolios, reflecting the decline in market rates (4.78% and 6.81%, respectively, for the third quarter ended March 31, 2004, versus 5.49% and 7.36%, respectively, for the corresponding period of the previous fiscal year).
For the nine months ended March 31, 2004, interest income totaled $121.9 million, a 6.3 percent increase from $114.7 million in the same period of the previous fiscal year. Similar to the third quarter, results reflect a larger volume of average interest earning assets partially offset by a decline in their yield. For the nine-month period ended March 31, 2004, total average investments were $2.346 billion, an increase of 30.84 percent from $1.793 billion in the same period of the previous fiscal year. For the nine-month period ended March 31, 2004, total average loans were $731.6 million, an increase of 12.56 percent from $650.0 million in the same period of the previous fiscal year. For the nine-month period ended March 31, 2004, the average yield on interest-earning assets was 5.28%, 98 basis points lower than the 6.26% reported in the same period a year ago. The decline was primarily due to a 102 basis point decline on the yield of the investment and loan portfolios.
For the quarter ended March 31, 2004, interest expense increased 1.4 percent, to $19.7 million from $19.4 million for the year ago quarter. A positive volume variance of $4.0 million accounted for this increase as average borrowing balances increased 30.73 percent to $2.005 billion when compared to $1.534 billion for the same period of the previous fiscal year. For the nine-month period ended March 31, 2004, interest expense declined 1.9 percent, to $57.3 million from $58.4 million for the year ago period. The average cost of funds was 2.58% or 69 basis points lower than the 3.27% in the year ago period.
Larger average balances of repurchase agreements, FHLB advances and subordinated capital notes were used to fund the growth of the Group’s loan and investment portfolios, accounting for both the increase in the average interest-bearing liabilities and the decline in costs of funds in the quarter and the nine months versus the comparable year ago periods.
For the quarter ended March 31, 2004, the cost of borrowings decreased 53 basis points to 2.38% as compared to 2.91% in the year ago quarter. The cost of FHLB funds and term notes declined 107 basis points and of subordinated capital notes declined 51 basis points (2.50% and 4.58% cost for the quarter ended March 31, 2004 versus 3.57% and 5.09% for the same quarter of the previous fiscal year, respectively). At the same time, the average cost of repurchase agreements declined 47 basis points to 2.26% from 2.73%. For the nine-month period ended March 31, 2004, the cost of borrowings decreased 78 basis points to 2.38% as compared to 3.16% in the year ago period. The cost of FHLB funds and term notes declined 114 basis points and of subordinated capital notes declined 81 basis points (from 3.70% and 5.45% to 2.56% and 4.64%, respectively). At the same time, the average cost of repurchase agreements decreased 73 basis points to 2.25% from 2.98%.
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Non-interest income, the second largest source of earnings, is affected by the level of trust assets under management, transactions generated by gathering of financial assets by the broker-dealer subsidiary, investment banking, the level of mortgage banking activities, and fees generated from loans, deposit accounts and insurance.
Non-interest income rose to $11.2 million or 29.9% in the third quarter ended March 31, 2004, compared to $8.6 million in the same quarter of the previous fiscal year. For the nine-month period ended March 31, 2004, non-interest income increased 35.2 percent, to $33.5 million from $24.8 million recorded for the same period of the prior fiscal year. Performance in both periods reflects increases in banking and financial service revenues and securities, derivatives and trading activities.
Revenues generated from trust, mortgage banking, brokerage and insurance activities, are one of the principal components of non-interest income. For the quarter ended March 31, 2004, these revenues increased 11.7 percent to $6.3 million from $5.6 million for the year ago quarter. This performance was driven by a 26.4 percent increase in revenues from the trust business and an 8.2 percent increase in revenues from brokerage, insurance, commissions, and other fees. For the nine-month period ended March 31, 2004, revenues from trust, mortgage banking, brokerage and insurance activities increased 21.8 percent to $19.6 million from $16.1 million in the year ago period. These increases are mainly due to increases in underwriting activities, the effect of new and revised service fees applied in fiduciary activities, and fee income generated by CPC, which was acquired in January 2003.
Mortgage banking revenues for the quarter ended March 31, 2004 amounted to $1.9 million, a 6.0 percent decrease when compared to $2.1 million in the year ago quarter. For the nine-month period ended March 31, 2004, mortgage banking revenues amounted to $6.4 million, an 11.9 percent increase when compared to the $5.7 million in the year ago period. The increase reflects the impact of greater volume of mortgage loans securitization and sales during the first quarter of fiscal 2004.
Banking service revenues, another major component of non-interest income, consist primarily of fees generated by deposit accounts, electronic banking services and bank service commissions. For the quarter ended March 31, 2004, these revenues increased 32.3 percent to $1.8 million from $1.4 million in the year-ago quarter. Fees on deposit accounts increased 28.7 percent to $1.3 million from $1.0 million and bank service charges and commissions increased 33.2 percent to $506,000 from $380,000. For the nine-month period ended March 31, 2004, banking service revenues increased 20.0 percent to $5.2 million from $4.4 million in the year ago period, mainly by fees on deposit accounts and bank service charges and commissions. Such increases were mainly driven by the strategy of strengthening the Group’s banking franchise by expanding its ability to attract deposits and build relationships with consumer, professional and commercial customers through aggressive marketing and the expansion of our sales force, innovative products like the Amiga checking account with overdraft privileges, investments in technology, and the remodeling and the expansion of our financial centers.
Securities, derivatives and trading activities is the third component of non-interest income. For the third quarter ended March 31, 2004, the net gain from these activities was $3.1 million, compared to $1.6 million for the year ago quarter. For the nine months ended March 31, 2004, the net gain from these activities was $8.6 million, an 89.2 percent increase compared to $4.5 million for the year ago period. For the quarter and nine months, securities net activity increased as the Group selectively identified favorable market opportunities to realize gains. For the quarter, derivatives net loss decreased $164,000 when compared with the same quarter of last year. The prior year’s loss was related to a decrease in the market value of derivatives, primarily due to the cancellation of interest rate caps, reflecting interest rate market conditions at that time.
Non-interest expenses for the quarter ended March 31, 2004 increased 8.9 percent to $15.0 million from $13.8 million in the comparable period of the previous fiscal year, with the efficiency ratio improving to 48.53 percent compared to 51.54 percent in the year ago quarter. For the nine-months ended March 31, 2004, non-interest expenses amounted to $45.0 million, 15.1 percent more than the $39.1 million reported for the same period of fiscal 2003, with the efficiency ratio improving to 50.25 percent from 50.91 percent in the year ago period. The efficiency ratio measures how much of a company’s revenue is used to pay operating expenses.
The dollar increase in non-interest expenses in the quarter and the nine months reflects the Group’s growth and spending related to “The Oriental Way” program, specifically for the expansion and improvement of the Group’s sales force, including additional experienced lenders, marketing, enhancing branch distribution and continuing investments in technology and infrastructure supporting risk management processes as well as recent and future growth. At the same time, expenses have been pared in other areas, consistent with management’s goal of maintaining operating expenses for upcoming quarters at approximately the same level as the third quarter. As a result, non-interest expenses, which peaked at $15.4 million in the first quarter, have trended lower the last two quarters.
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Employee compensation and benefits is the largest non-interest expense category. For the third quarter ended March 31, 2004, total compensation and benefits amounted to $6.4 million, a 4.6 percent increase compared to $6.1 million for the same period in the previous fiscal year. For the nine months of fiscal 2004, employee compensation and benefits amounted to $18.2 million, an 18.9 percent increase compared to the $15.3 million reported for the same period last year. Increases in both periods reflect the expansion of the sales force in order to generate a higher volume of business. Refer to Table 3 for more selected data regarding employee compensation and benefits.
Other non-interest expenses, which include occupancy and equipment, advertising and business promotion, professional and service fees, among other costs, for the quarter ended March 31, 2004, amounted to $8.6 million, a 12.3 percent increase compared to $7.7 million for the same period in the previous fiscal year. For the nine months of fiscal 2004, other non-interest expenses amounted to $26.8 million, a 12.7 percent increase compared to $23.8 million reported for the same period of fiscal 2003.
Occupancy and equipment expenses increased 2.6 percent, from $2.4 million in the quarter ended March 31, 2003, to $2.5 million in the third quarter of fiscal 2004. For the nine months of fiscal 2004, these expenses increased 4.8 percent from the $6.8 million recorded during the nine months of fiscal 2003. These increases are due to the relocation of existing financial centers and upgrading financial center technology and infrastructure.
Advertising and business promotion for the quarter ended March 31, 2004 increased 56.3 percent to $1.9 million versus $1.2 million reported in the year ago quarter. During the quarter, the Group continued its aggressive promotional campaign to enhance the market recognition of new and existing products, to increase our fee-based revenues and branding activity. For the nine months of fiscal 2004, advertising and business promotion increased 26.5 percent to $6.1 million from the $4.8 million in the year ago period.
Professional and service fees in the quarter ended March 31, 2004 decreased 5.0% to $1.4 million from $1.5 million in the year ago quarter. For the nine months ended March 31, 2004, professional and service fees decreased 7.1 percent to $4.5 million from $4.8 million in the year ago period. The decrease in both periods is due to specific cost control initiatives.
The rise in communication, municipal and other general taxes, insurance, printing, postage, stationery and supply, and other operating expenses are principally due to the general growth in the Group’s business activities, products and services offered.
Provision for Loan Losses
The provision for loan losses for the quarter ended March 31, 2004, totaled $1.1 million, a 23.5 percent increase from the $850,000 reported for the same period of the previous fiscal year. For the nine months of fiscal 2004, the provision amounted to $3.4 million, a 22.0 percent increase, when compared to $2.8 million reported a year earlier. The increase in the provision for loan losses reflects the required provisions needed to cover the increase of net credit losses on a year to date basis and any loss exposure in commercial and real estate non-performing loans as of March 31, 2004. During the quarter, no major increases in net credit losses were experienced, but the actual level of credit losses support the provision for the period to maintain an adequate reserve for possible loan losses. Net credit losses for the quarter decreased 35.2 percent, from $676,000 in the quarter ended March 31, 2003, to $438,000 in the quarter ended March 31, 2004. For the nine months of fiscal 2004, net credit losses amounted to $1.8 million, an increase of 2.8 percent from the $1.7 million reported for the same period of prior fiscal year.
Residential real estate loans net credit losses for the quarter and nine-month periods ended March 31, 2004, were $40,000 and $290,000, respectively. These amounts represent charge-offs on two real estate loans. The Group did not have any charge-offs on this portfolio last year.
For the quarter ended March 31, 2004, recoveries on the commercial loan portfolio amounted to $60,000. There were no credit losses. This is a positive variance of $67,000, compared to net credit losses of $7,000 for the quarter ended March 31, 2003. Commercial loans net credit losses increased to $166,000 for the nine-month period ended March 31, 2004, when compared to a recovery of $29,000 for the same period of the previous fiscal year. Management performed a review of the entire commercial loan portfolio and determined to recognize as losses during the quarter ended December 31, 2003 certain loans considered uncollectible or of such little value that their continuance as bankable assets was not warranted. This review reflects the Group’s strategy to expand its commercial loan portfolio. Almost all the commercial lending that the Group is originating is collateralized with real estate.
Net credit losses on consumer loans decreased when compared with the same quarter of last fiscal year. For the quarter ended March 31, 2004, net credit losses on consumer loans were $458,000, a decrease of 31.5 percent, when compared with the quarter ended March 31, 2003 in which the Group had a net credit loss of $669,000. For the nine-month period ended March 31, 2004, net credit losses on consumer loans were $1.3 million, a decrease of 24.5 percent when compared with the nine-month period ended March 31, 2003, in which the Group had a net credit loss of $1.8 million.
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Non-performing commercial loans, mainly collateralized by real estate, increased 170.9 percent, from $1.8 million as of June 30, 2003, to $4.9 million as of March 31, 2004. More stringent criteria have been implemented during this fiscal year in moving commercial loans to non-performing status. The Group is in the process of restructuring most of these loans. Non-performing residential real estate secured loans increased 8.2 percent, to $28.7 million as of March 31, 2004, when compared to the June 30, 2003 non-performing levels of $26.6 million. The commercial and residential real estate portfolios are well collateralized and the Group does not expect any major losses on such portfolios.
The Group evaluates all loans, some individually and other as homogeneous groups, for purposes of determining impairment. At March 31, 2004, the total investment in impaired commercial loans was $2.5 million. Impaired commercial loans are measured based on the fair value of collateral. The Group determined that no specific impairment allowance was required for such loans. The average investment in impaired commercial loans for the nine-month period ended March 31, 2004 amounted to $2.5 million. At June 30, 2003 there were no impaired loans.
Provision for Income Taxes
The Group recognized a provision for income taxes of $1.6 million for the quarter ended March 31, 2004, compared with a provision of $697,000 for the same period of the previous fiscal year. This is consistent with the increase in income before income taxes for the quarter ended March 31, 2004. For the nine months of fiscal 2004, the income tax provision amounted to $4.1 million or 95.2 percent higher than the $2.1 million reported for the same period of fiscal 2003. The current income tax provision is lower than the provision based on the statutory tax rate for the Group, which is 39%, due to the high level of tax-advantaged interest income earned on certain investments and loans, net of the disallowance of related expenses attributable to the exempt income. In addition, the Puerto Rico Internal Revenue Code, of 1994, as amended, provides a dividend received deduction of 100% on dividends received from wholly-owned subsidiaries subject to income taxation in Puerto Rico. Exempt interest relates principally to interest earned on obligations of the United States and Puerto Rico governments and certain mortgage-backed securities, including securities held by the Group’s international banking entities.
FINANCIAL CONDITION
Group’s Assets
At March 31, 2004, the Group’s total assets amounted to $3.466 billion, an increase of 14.0%, when compared to $3.041 billion at June 30, 2003.
At March 31, 2004, interest-earning assets were $3.376 billion, a 14.0% increase compared to $2.963 billion at June 30, 2003.
Investments are the Group’s largest interest-earning assets component. It principally consists of money market investments, U.S. government agencies bonds, mortgage-backed securities, CMO’s and P.R. government municipal bonds. The Group decided to reposition its investment portfolio during the quarters ended September 30, 2003 and March 31, 2004. As a result, management reclassified, at fair value, $856,037,000 and $174,399,000, respectively, of its available-for-sale investment portfolio to the held-to-maturity investment category. Management now intends to hold these securities to maturity. The investment portfolio increased 18.5%, to $2.646 billion, from $2.232 billion as of June 30, 2003. Most of the increase is principally due to the acquisition of additional high-rated mortgage-backed securities and Puerto Rico government and agency obligations (see Table 9 and Note 2 to the unaudited Consolidated Financial Statements).
At March 31, 2004, the Group’s loan portfolio, the second largest category of the Group’s interest-earning assets, decreased by 1.4 percent, to $718.1 million when compared to $728.5 million at June 30, 2003. This was principally due to a decrease in the residential and personal mortgage loans (including loans held for sale), the largest component of the Group’s loan portfolio, which decreased by 3.9 percent, to $643.6 million, when compared to $670.1 million at June 30, 2003. Such decrease was due to: (i) the Group selling residential mortgage loans in the secondary market during the nine months of fiscal 2004, which amounted to $199.6 million, or $115.8 million more than the $83.7 million sold during the same period of previous fiscal 2003, and (ii) increased loan repayments experienced during the first quarter. Most of this decrease was offset by a 47.3 percent increase in commercial loans. Commercial loans at March 31, 2004 and June 30, 2003 totaled $64.2 million and $43.6 million, respectively (8.0% and 5.3% of total gross loan portfolio, respectively). Such increase reflected the Group’s strategy to expand the commercial loan program. Table 9 and Note 3 of the unaudited Consolidated Financial Statements present the Group’s loan portfolio composition and mix at the end of the periods analyzed.
At March 31, 2004 and June 30, 2003, the consumer loan portfolio totaled $17.0 million and $19.9 million, respectively (2.4% and 2.7% of the Group’s total loan portfolio, respectively).
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Liabilities and Funding Sources
At March 31, 2004, the Group’s total liabilities reached $3.180 billion, 12.0 percent higher than the $2.839 billion reported at June 30, 2003. Deposits and borrowings, the Group’s funding sources, amounted to $3.118 billion at March 31, 2004, an increase of 12.2 percent, when compared to $2.778 billion recorded at June 30, 2003.
Borrowings are the Group’s largest interest-bearing liability component. They consist mainly of diversified funding sources through the use of Federal Home Loan Bank of New York (FHLB) advances and borrowings, repurchase agreements, term notes, subordinated capital notes, and lines of credit. At March 31, 2004, they amounted to $2.046 billion, 29.4 percent greater than the $1.582 billion at June 30, 2003. The increase, mainly in repurchase agreements and FHLB funds, reflects the funding needed to maintain the Group’s investment and loan portfolio growth.
The FHLB system functions as a source of credit to financial institutions that are members of a regional Federal Home Loan Bank. As a member of the FHLB, the Group can obtain advances from the FHLB, secured by the FHLB stock owned by the Group, as well as by certain of the Group’s mortgages and investment securities. FHLB funds reached $310.8 million as of March 31, 2004, an increase of 139.1 percent when compared to FHLB funds as of June 30, 2003. This increase is mainly due to the strategy of extending the maturity of our liabilities, to take advantage of alternative lower rate funding sources. Table 10 presents the composition of the Group’s borrowings at the end of the periods analyzed.
At March 31, 2004, deposits, the second largest category of the Group’s interest-bearing liabilities, reached $1.058 billion, up 1.3%, compared to the $1.044 billion reported as of June 30, 2003. A $17.8 million increase (or 5.1%) in individual retirement accounts (IRA) contributed to this rise in total deposits. Table 10 presents the composition of the Group’s deposits at the end of the periods analyzed.
At March 31, 2004, the Group’s total stockholders’ equity was $286.7 million, a 42.1% increase, when compared to $201.7 million at June 30, 2003. In addition to earnings from operations, this rise reflects an increase on outstanding preferred stocks of $34.5 million as a result of the issuance of Preferred Series B in the first quarter and an increase of $51.5 million, net of expenses, of the issuance of 1,965,000 shares of common stock in the third quarter, offset by an increase of $38.2 million in the other accumulated comprehensive loss (which occurred during the quarter ended September 30, 2003). Accumulated other comprehensive loss, net, consists of the unrealized loss on derivatives designated as cash flow hedges and the unrealized gain or loss on investment securities available-for-sale, net of deferred tax.
At March 31, 2004, accumulated unrealized loss, net of tax, on derivatives designated as cash flow hedges was $35.6 million, a $6.2 million decrease, when compared to an accumulated unrealized loss of $41.8 million at June 30, 2003. Accumulated unrealized loss, net of tax, on investment securities available-for-sale amounted to $2.9 million at March 31, 2004, after a $44.4 million negative change, when compared with an accumulated unrealized gain of $41.5 million at June 30, 2003. Accumulated unrealized loss, net of tax, on investment securities available-for-sale at March 31, 2004 includes an unrealized loss amounting to $28.0 million related to securities transferred to the held-to-maturity category, primarily in the first quarter. This unrealized loss is amortized over the remaining life of the securities as a yield adjustment.
On November 20, 2003, the Group declared a 10% common stock dividend payable from the treasury stock account on January 16, 2004 to holders of record as of December 31, 2003. This dividend brings to 242,441 shares the number of shares held by the Group as treasury stock. The Group’s common stock is traded on the New York Stock Exchange (NYSE) under the symbol OFG. At March 31, 2004, the Group’s market capitalization for its outstanding common stock was $698.2 million ($31.85 per common share).
Under the regulatory framework for prompt corrective action, banks that meet or exceed a Tier I risk-based ratio of 6%, a total capital risk-based ratio of 10% and a leverage ratio of 5% are considered well capitalized. The Bank exceeds those regulatory capital requirements. See Table 11 for the Group’s regulatory capital ratios.
Group’s Financial Assets
The Group’s total financial assets include the Group’s assets owned and the assets managed by the trust division, the broker-dealer subsidiary and the private pension plan administration subsidiary. At March 31, 2004, they reached $6.229 billion, an increase of 9.8 percent compared to $5.674 billion at June 30, 2003. The increase was largely due to an increase of 14.0 percent in the Group’s assets owned, when compared to June 30, 2003, and to the improvement in equity market values as broker-dealer assets gathered increased 13.9% when compared to June 30, 2003. The Group’s financial assets’ principal component is assets owned by the Group, of which approximately 98 percent are owned by the Group’s banking subsidiary. For more on this financial asset component, refer to “Group’s Assets” under “Financial Condition” herein above.
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The Group’s second largest financial assets component is assets managed by the trust division and the retirement plan administration subsidiary. The Group’s trust division offers various types of IRA products and manages 401(K) and Keogh retirement plans, custodian and corporate trust accounts, while Caribbean Pension Consultants, Inc. manages the administration of private pension plans. At March 31, 2004, total assets managed by the Group’s trust division and CPC amounted to $1.666 billion, 0.3% less than the $1.670 billion reported at June 30, 2003.
The other financial asset component is assets gathered by the securities broker-dealer. The Group’s securities broker-dealer subsidiary offers a wide array of investment alternatives to its client base such as tax-advantaged fixed income securities, mutual funds, stocks and bonds. At March 31, 2004, total assets gathered by the securities broker-dealer from its customer investment accounts reached $1.097 billion, up 13.9% from $963 million at June 30, 2003, as a result of the improvement in equity market values.
Allowance for Loan Losses and Non-Performing Assets:
At March 31, 2004, the Group’s allowance for loan losses amounted to $6.6 million (0.92% of total loans) a 31.8 percent increase from the $5.0 million (0.69% of total loans) reported at June 30, 2003. Residential real estate and commercial loans allowances represent the greatest increases of 79.6 percent and 104.4 percent, or $1.4 million and $452,000, respectively, when compared with balances recorded at June 30, 2003. The consumer loans allowance increased 20.6 percent, or $268,000, when compared to $1.3 million recorded at June 30, 2003.
The Group maintains an allowance for loan losses at a level that management considers adequate to provide for potential losses based upon an evaluation of known and inherent risks. The Group’s allowance for loan losses policy provides for a detailed quarterly analysis of possible losses.
The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.
The Group uses a methodology that follows a loan credit risk rating process that involves dividing loans into risk categories. The following are the credit risk categories (established by the FDIC Interagency Policy Statement of 1993) used:
Larger commercial loans that exhibit potential or observed credit weaknesses are subject to individual review and grading. Where appropriate, allowances are allocated to individual loans based on management’s estimate of the borrower’s ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to the Group.
Included in the review of individual loans are those that are impaired. A loan is considered impaired when, based on current information and events, it is probable that the Group will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or as a practical expedient, at the observable market price of the loan or the fair value of the collateral, if the loan is collateral dependent. Loans are individually evaluated for impairment, except large groups of small balance, homogeneous loans that are collectively evaluated for impairment.
The Group measures for impairment all commercial loans over $250,000. The portfolios of mortgages, consumer loans, and leases are considered homogeneous and are evaluated collectively for impairment.
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The Group, using an aged-based rating system, applies an overall allowance percentage to each loan portfolio category based on historical credit losses adjusted for current conditions and trends. This delinquency-based calculation is the starting point for management’s determination of the required level of the allowance for loan losses. Other data considered in this determination includes:
Loan loss ratios and credit risk categories are updated quarterly and are applied in the context of GAAP and the Joint Interagency Guidance on the importance of depository institutions having prudent, conservative, but not excessive loan loss allowances that fall within an acceptable range of estimated losses. While management uses available information in estimating possible loan losses, future changes to the allowance may be necessary based on factors beyond the Group’s control, such as factors affecting general economic conditions.
An unallocated allowance is established recognizing the estimation risk associated with the aged-based rating system and with the specific allowances. It is based upon management’s evaluation of various conditions, the effects of which are not directly measured in determining the aged-based rating system and the specific allowances. These conditions include then-existing general economic and business conditions affecting our key lending areas; credit quality trends, including trends in non-performing loans expected to result from existing conditions, collateral values, loan volumes and concentrations, seasoning of the loan portfolio, recent loss experience in particular segments of the portfolio, regulatory examination results, and findings by the Group’s management. The evaluation of the inherent loss regarding these conditions involves a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments.
Net credit losses for the quarter ended March 31, 2004, totaled $438,000 (0.24% of average loans) a decrease of 35.2 percent when compared to $676,000 (0.39% of average loans) for the same period of the previous fiscal year. Major decreases in net credit losses were recorded for commercial and consumer loans, which decreased $67,000 and $211,000, respectively, when compared to the same period of previous fiscal year 2003. For the nine months of fiscal 2004, net credit losses amounted to $1.8 million, a 2.8 percent increase when compared to $1.7 million reported for the nine months of fiscal 2003. On a year to date basis, these results reflect net credit losses increases in real estate of $290,000 and in commercial loans of $190,000, partially offset by a reduction of $436,000 in net credit losses related to consumer loans. Tables 4 through 6 set forth an analysis of activity in the allowance for loan losses and presents selected loan loss statistics.
At March 31, 2004, the Group’s non-performing assets totaled $34.4 million (0.99% of total assets) versus $29.4 million (0.97% of total assets) at the end of June 30, 2003. The increase was principally due to a 17.5 percent increase in non-performing loans. Foreclosed real estate properties decreased 16.6 percent when compared to $536,000 reported on June 30, 2003.
At March 31, 2004, the allowance for loan losses to non-performing loans coverage ratio was 19.55%. Excluding the lesser-risk real estate loans, the ratio is 127.78%. Detailed information concerning each of the items that comprise non-performing assets follows:
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Item – 3
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risk and Asset/Liability Management
The Group’s interest rate risk and asset/liability management is the responsibility of the Asset and Liability Management Committee (“ALCO”), which reports to the Board of Directors and is composed of members of the Group’s senior management. The principal objective of ALCO is to enhance profitability while maintaining an appropriate level of interest rate and liquidity risks. ALCO is also involved in formulating economic projections and strategies used by the Group in its planning and budgeting process and also, oversee the Group’s sources, uses and pricing of funds.
Interest rate risk can be defined as the exposure of the Group’s operating results or financial position to adverse movements in market interest rates which mainly occur when assets and liabilities reprice at different times and at different rates. This difference is commonly referred to as a “maturity mismatch” or “gap”. The Group employs various techniques to assess the degree of interest rate risk.
The Group is liability sensitive due to its fixed rate and medium to long-term asset composition being funded with shorter-term repricing liabilities. As a result, the Group utilizes various derivative instruments for hedging purposes, such as asset/liability management. These transactions involve both credit and market risk. The notional amounts are amounts from which calculations and payments are based. Notional amounts do not represent direct credit exposures. Direct credit exposure is limited to the net difference between the calculated amount to be received and paid, if any. The actual risk of loss is the cost of replacing, at market, these contracts in the event of default by the counterparties. The Group controls the credit risk of its derivative financial instrument agreements through credit approvals, limits, monitoring procedures and collateral, when considered necessary.
The Group generally uses interest rate swaps and interest rate options, such as caps and options, in managing its interest rate risk exposure. The swaps were entered into to convert short-term borrowings into fixed rate liabilities for longer periods and provide protection against increases in short-term interest rates. Under these swaps, the Group pays a fixed monthly or quarterly cost and receives a floating monthly or quarterly payment based on LIBOR. Floating rate payments received from the swap counterparties correspond to the floating rate payments made on the short-term borrowings thus resulting in a net fixed rate cost to the Group. Under the caps, the Group pays an upfront premium or fee for the right to receive cash flow payments in excess of the predetermined cap rate; thus, effectively capping its interest rate cost for the duration of the agreement.
The Group’s swaps, excluding those used to manage exposure to the stock market, and caps outstanding and their terms at March 31, 2004, and June 30, 2003 are set forth in the table below:
The Group offers its customers certificates of deposit with an option tied to the performance of the Standard & Poor’s 500 stock market index. At the end of five years, the depositor will receive a specified percentage of the average increase of the month-end value of the corresponding stock index. If such index decreases, the depositor receives the principal without any interest. The Group uses swap and option agreements with major money center banks and major broker dealer companies to manage its exposure to changes in those indexes. Under the terms of the option agreements, the Group will receive the average increase in the month-end value of the corresponding index in exchange for a fixed premium. Under
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the term of the swap agreements, the Group will receive the average increase in the month-end value of the corresponding index in exchange for a quarterly fixed interest cost. The changes in fair value of the options purchased, the swap agreements and the options embedded in the certificates of deposit are recorded in earnings.
Derivative instruments are generally negotiated over-the-counter (“OTC”) contracts. Negotiated OTC derivatives are generally entered into between two counterparties that negotiate specific agreement terms, including the underlying instrument, amount, exercise price and maturity.
During the quarters ended March 31, 2004 and 2003, $275,000 and $439,000 of losses, respectively, were charged to earnings and reflected as “Derivatives Activities” in the consolidated statements of income. For the nine months of fiscal 2004 and 2003 these losses amounted to $935,000 and $4.4 million, respectively. For the quarter ended March 31, 2004, unrealized losses of $13.2 million on derivatives designated as cash flow hedges were included in other comprehensive income. For the nine months of fiscal 2004, unrealized losses of $7.7 million on derivatives designated as cash flow hedges were included in other comprehensive income. Ineffectiveness of $254,000 was charged and $307,000 was credited to earnings during the quarters ended March 31, 2004 and 2003, respectively. During the nine-month periods ended March 31, 2004 and 2003, ineffectiveness of $811,000 and $339,000, respectively, were charged to earnings.
At March 31, 2004 and June 30, 2003, the fair value of derivatives was recognized as either assets or liabilities in the consolidated statements of financial condition as follows: the fair value of the interest rate swaps used to manage the exposure to the stock market on stock indexed deposits represented a liability of $93,000 and $316,000, respectively; the purchased options used to manage the exposure to the stock market on stock indexed deposits represented an other asset of $14.5 million and $7.4 million, respectively; and the options sold to customers embedded in the certificates of deposit represented a liability of $14.3 million and $7.2 million, respectively, recorded in deposits. The fair value of the interest rate swaps represented a liability of $37.7 million and $42.8 million, respectively, presented in accrued expenses and other liabilities. The caps did not have carrying value as of March 31, 2004 and June 30, 2003.
Rate changes expose the Group to changes in net interest income (NII). The result of the sensitivity analysis on NII of $91.8 million as of March 31, 2004, for the next twelve months is $11.1 million decrease, or -12.11% changes on a hypothetical 200 basis points rate increase. The change for the same period, utilizing a hypothetical declining rate scenario of 50 basis points, is an increase of $135,000 or 0.15%. Both hypothetical rate scenarios consider a gradual change of +200 and -50 basis points during the twelve-month period. The decreasing rate scenario has a floor of .25%. This floor causes liabilities (already around 1%) to have little cost reduction, while the assets do have a decrease in yields, causing a small loss in declining rate simulations. These estimated changes are within the policy guidelines established by the Board of Directors.
Liquidity Risk Management
The objective of the Group’s asset/liability management function is to maintain consistent growth in net interest income within the Group’s policy limits. This objective is accomplished through management of the Group’s Statement of Financial
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Condition composition, liquidity, and interest rate risk exposure arising from changing economic conditions, interest rates and customer preferences.
The goal of liquidity management is to provide adequate funds to meet changes in loan demand or unexpected deposit withdrawals. This is accomplished by maintaining liquid assets in the form of investment securities, maintaining sufficient unused borrowing capacity in the national money markets and delivering consistent growth in core deposits. As of March 31, 2004, the Group had approximately $475.4 million in securities and other short-term investments available to cover liquidity needs. Additional asset-driven liquidity is provided by securitizable loan assets. These sources, in addition to the Group’s 11.58% average equity capital base, provide a stable funding base.
In addition to core deposit funding, the Group also accesses a variety of other short-term and long-term funding sources. Short-term funding sources mainly include securities sold under agreements to repurchase. Borrowing funding source limits are determined annually by each counter-party and depend on the Group’s financial condition and delivery of acceptable collateral securities. The Bank may be required to provide additional collateral based on the fair value of the underlying securities. The Bank also uses the Federal Home Loan Bank of New York (FHLB) as a funding source, issuing notes payable, such as advances, through its FHLB member subsidiary, the Bank. This funding source requires the Bank to maintain a minimum amount of qualifying collateral with a fair value of at least 110% of the outstanding advances. At March 31, 2004, the Group has an additional borrowing capacity with the FHLB of $25.0 million.
In addition, the Bank utilizes the National Certificate of Deposit (“CD”) Market as a source of cost effective deposit funding in addition to local market deposit inflows. Depositors in this market consist of credit unions, banking institutions, CD brokers and some private corporations or non-profit organizations. The Bank’s ability to acquire brokered deposits can be restricted if it becomes in the future less than well-capitalized. An adequately-capitalized bank, by regulation, may not accept deposits from brokers unless it applies for and receives a waiver from the FDIC.
As of March 31, 2004, the Bank had line of credit agreements with other financial institutions permitting the Bank to borrow a maximum aggregate amount of $25.0 million. No borrowings were made during the nine-month period ended March 31, 2004 under such lines of credit. The agreements provide for unsecured advances to be used by the Bank on an overnight basis. Interest rate is negotiated at the time of the transaction. The credit agreements are renewable annually.
The Group’s liquidity targets are reviewed monthly by the ALCO Committee and are based on the Group’s commitment to make loans and investments and its ability to generate funds.
The Group’s investment portfolio at March 31, 2004 had an average maturity of 44 months. However, no assurance can be given that such levels will be maintained in future periods.
The principal source of funds for the Group is dividends from the Bank. The ability of the Bank to pay dividends is restricted by regulatory authorities. Primarily, through such dividends the Group meets its cash obligations and pays dividends to its common and preferred stockholders. Management believes that the Group will continue to meet its cash obligations as they become due and pay dividends as they are declared.
Changes in statutes and regulations, including tax laws and rules
The Group, as a Puerto Rico-chartered financial holding company, and its subsidiaries, are each subject to extensive federal and local governmental supervision and regulation relating to its banking, securities and insurance business. The Group also benefits from favorable tax treatment under regulations relating to the activities of its international banking entities. In addition, there are laws and other regulations that restrict transactions between the Group and its subsidiaries. Any change in such tax or other regulations, whether by applicable regulators or as a result of legislation subsequently enacted by the Congress of the United States or the Legislature of Puerto Rico, could adversely affect the Group’s profits and financial condition.
Puerto Rico international banking entities, or IBE’s, are currently exempt from taxation under Puerto Rico law. Recently, the Legislature of Puerto Rico and the Governor of Puerto Rico approved a law amending the IBE Act. This law imposes income taxes at normal statutory rates on each IBE that operates as a unit of a bank, if the IBE’s net income generated after December 31, 2003 exceeds 40 percent of the bank’s net income in the taxable year commenced on July 1, 2003, 30 percent of the bank’s net income in the taxable year commencing on July 1, 2004, and 20 percent of the bank’s net income in the taxable year commencing on July 1, 2005, and thereafter. It does not impose income taxation on an IBE that operates as a subsidiary of a bank.
The Group has an IBE that operates as a unit of the Bank. In November 2003, the Group organized a new IBE that operates as a subsidiary of the Bank. The Bank transferred as of January 1, 2004, substantially all of the Bank’s IBE assets to the new IBE subsidiary. Although this transfer of IBE assets allows the Group to continue enjoying tax benefits, there cannot be any assurance that the IBE Act will not be modified in the future in a manner to reduce the tax benefits available to the new IBE subsidiary.
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Item – 4
CONTROLS AND PROCEDURES
The Group’s management, including the Chief Executive Officer and the Acting Chief Financial Officer, evaluated the effectiveness of the design and operation of the Group’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 the end of the period covered by this report. Based upon that evaluation, the Group’s management, including the Chief Executive Officer and the Acting Chief Financial Officer, concluded that the Group’s disclosure controls and procedures are effective in timely alerting them to any material information relating to the Group and its subsidiaries required to be included in the Group’s Exchange Act filings.
There were no significant changes made in the Group’s internal controls over financial reporting that occurred during the Group’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Group’s internal control over financial reporting.
PART – 2 OTHER INFORMATION
Item – 1
LEGAL PROCEEDINGS
The Group and its subsidiaries are defendants in a number of legal proceedings incidental to their business. The Group is vigorously contesting such claims. Based upon a review by legal counsel and the development of these matters to date, management is of the opinion that the ultimate aggregate liability, if any, resulting from these claims will not have a material adverse effect on the Group’s financial condition or results of operations.
Item – 2
CHANGES IN SECURITIES AND USE OF PROCEEDS
None
DEFAULTS UPON SENIOR SECURITIES
SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
Item – 5
OTHER INFORMATION
Item – 6
EXHIBITS AND REPORTS ON FORM 8-K
A- Exhibits
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B – Reports on Form 8-K
Signatures
Pursuant to the requirements of Section 13 or 15(d ) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ORIENTAL FINANCIAL GROUP INC.(Registrant)
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