UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2013
or
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
For the transition period from ______________ to ______________
Commission File Number 001-12647
OFG Bancorp
Incorporated in the Commonwealth of Puerto Rico, IRS Employer Identification No. 66-0538893
Principal Executive Offices:
254 Muñoz Rivera Avenue
San Juan, Puerto Rico 00918
Telephone Number: (787) 771-6800
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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer ¨ Accelerated Filer x Non-Accelerated Filer ¨ Smaller Reporting Company ¨ (Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes¨ No x
Number of shares outstanding of the registrant’s common stock, as of the latest practicable date:
45,640,105 common shares ($1.00 par value per share) outstanding as of July 31, 2013
TABLE OF CONTENTS
PART I – FINANCIAL INFORMATION
Page
Item 1.
Financial Statements
Unaudited Consolidated Statements of Financial Condition
1
Unaudited Consolidated Statements of Operations
2
Unaudited Consolidated Statements of Comprehensive Income
3
Unaudited Consolidated Statements of Changes in Stockholders’ Equity
4
Unaudited Consolidated Statements of Cash Flows
5
Notes to Unaudited Consolidated Financial Statements
Note 1– Organization, Consolidation and Basis of Presentation
7
Note 2 – Business Combinations
10
Note 3 – Securities Purchased Under Agreements to Resell and Investments
13
Note 4 – Loans
19
Note 5 – Allowance for Loan and Lease Losses
26
Note 6 – Premises and Equipment
38
Note 7 – Derivative Activities
39
Note 8 – Accrued Interests Receivable and Other Assets
41
Note 9 – Deposits and Related Interests
42
Note 10 – Borrowings
43
Note 11 – Related Party Transactions
46
Note 12 – Income Taxes
47
Note 13 – Stockholders’ Equity and Earnings per Common Share
48
Note 14 – Commitments
53
Note 15 – Contingencies
55
Note 16 – Fair Value of Financial Instruments
Note 17 – Offsetting Arrangements
64
Note 18 – Business Segments
66
Note 19 – Subsequent Events
68
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Critical Accounting Policies and Estimates
69
Overview of Financial Performance
70
Selected Financial Data
Analysis of Results of Operations
78
Analysis of Financial Condition
87
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
108
Item 4.
Control and Procedures
112
PART II – OTHER INFORMATION
Legal Proceedings
113
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Default upon Senior Securities
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
SIGNATURES
114
EXHIBIT INDEX
FORWARD-LOOKING STATEMENTS
The information included in this quarterly report on Form 10-Q contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements may relate to the financial condition, results of operations, plans, objectives, future performance and business of OFG Bancorp, formerly known as Oriental Financial Group Inc. (“we,” “our,” “us” or the “Company”), including, but not limited to, statements with respect to the adequacy of the allowance for loan losses, delinquency trends, market risk and the impact of interest rate changes, capital markets conditions, capital adequacy and liquidity, and the effect of legal proceedings and new accounting standards on the Company’s financial condition and results of operations. All statements contained herein that are not clearly historical in nature are forward-looking, and the words “anticipate,” “believe,” “continues,” “expect,” “estimate,” “intend,” “project” and similar expressions and future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may,” or similar expressions are generally intended to identify forward-looking statements.
These statements are not guarantees of future performance and involve certain risks, uncertainties, estimates and assumptions by management that are difficult to predict. Various factors, some of which by their nature are beyond the Company’s control, could cause actual results to differ materially from those expressed in, or implied by, such forward-looking statements. Factors that might cause such a difference include, but are not limited to:
· the rate of growth in the economy and employment levels, as well as general business and economic conditions;
· changes in interest rates, as well as the magnitude of such changes;
· the fiscal and monetary policies of the federal government and its agencies;
· a credit default by the U.S. or Puerto Rico governments or a downgrade in the credit ratings of the U.S. or Puerto
Rico governments;
· changes in federal bank regulatory and supervisory policies, including required levels of capital;
· the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) on the
Company’s businesses, business practices and cost of operations;
· the relative strength or weakness of the consumer and commercial credit sectors and of the real estate market in
Puerto Rico;
· the performance of the stock and bond markets;
· competition in the financial services industry;
· additional Federal Deposit Insurance Corporation (“FDIC”) assessments;
· possible legislative, tax or regulatory changes; and
· difficulties in integrating the acquired Puerto Rico operations of Banco Bilbao Vizcaya Argentaria, S. A. (“BBVAPR”) into the Company’s operations.
Other possible events or factors that could cause results or performance to differ materially from those expressed in these forward-looking statements include the following: negative economic conditions that adversely affect the general economy, housing prices, the job market, consumer confidence and spending habits which may affect, among other things, the level of non-performing assets, charge-offs and provision expense; changes in interest rates and market liquidity which may reduce interest margins, impact funding sources and affect the ability to originate and distribute financial products in the primary and secondary markets; adverse movements and volatility in debt and equity capital markets; changes in market rates and prices which may adversely impact the value of financial assets and liabilities; liabilities resulting from litigation and regulatory investigations; changes in accounting standards, rules and interpretations; increased competition; the Company’s ability to grow its core businesses; decisions to downsize, sell or close units or otherwise change the Company’s business mix; and management’s ability to identify and manage these and other risks.
All forward-looking statements included in this quarterly report on Form 10-Q are based upon information available to the Company as of the date of this report, and other than as required by law, including the requirements of applicable securities laws, the Company assumes no obligation to update or revise any such forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.
Item 1. Financial Statements
OFG BANCORP
UNAUDITED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
AS OF JUNE 30, 2013 AND DECEMBER 31, 2012
June 30,
December 31,
2013
2012
(In thousands, except share data)
ASSETS
Cash and cash equivalents
Cash and due from banks
$
737,330
855,490
Money market investments
10,983
13,205
Total cash and cash equivalents
748,313
868,695
Securities purchased under agreements to resell
-
80,000
Investments:
Trading securities, at fair value, with amortized cost of $2,286 (December 31, 2012 - $508)
2,209
495
Investment securities available-for-sale, at fair value, with amortized cost of $1,807,335 (December 31, 2012 - $2,118,825)
1,836,229
2,194,286
Federal Home Loan Bank (FHLB) stock, at cost
22,156
38,411
Other investments
73
Total investments
1,860,660
2,233,265
Securities sold but not yet delivered
16,732
Loans:
Mortgage loans held-for-sale, at lower of cost or fair value
78,350
64,145
Loans not covered under shared-loss agreements with the FDIC, net of allowance for loan and lease losses of $46,625 (December 31, 2012 - $39,921)
4,543,299
4,709,778
Loans covered under shared-loss agreements with the FDIC, net of allowance for loan and lease losses of $53,992 (December 31, 2012 - $54,124)
369,380
395,307
Total loans, net
4,991,029
5,169,230
Other assets:
FDIC shared-loss indemnification asset
236,472
286,799
Foreclosed real estate covered under shared-loss agreements with the FDIC
25,193
22,283
Foreclosed real estate not covered under shared-loss agreements with the FDIC
56,496
51,233
Accrued interest receivable
17,508
17,554
Deferred tax asset, net
155,165
122,501
Premises and equipment, net
84,301
84,997
Customers' liability on acceptances
30,571
26,996
Servicing assets
12,994
10,795
Derivative assets
19,655
21,889
Goodwill
76,383
Other assets
104,462
123,642
Total assets
8,435,934
9,196,262
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits:
Demand deposits
2,294,635
2,447,152
Savings accounts
1,006,558
634,819
Certificates of deposit
2,363,845
2,607,588
Total deposits
5,665,038
5,689,559
Borrowings:
Short term borrowings
92,210
Securities sold under agreements to repurchase
1,313,870
1,695,247
Advances from FHLB and other borrowings
322,300
554,177
Subordinated capital notes
98,961
146,038
Total borrowings
1,735,131
2,487,672
Other liabilities:
Derivative liabilities
16,701
26,260
Acceptances executed and outstanding
Accrued expenses and other liabilities
117,569
102,169
Total liabilities
7,565,010
8,332,656
Commitments and contingencies (See Notes 14 and 15)
Stockholders’ equity:
Preferred stock; 10,000,000 shares authorized;
1,340,000 shares of Series A, 1,380,000 shares of Series B, and 960,000 shares of Series D
issued and outstanding, (December 31, 2012 - 1,340,000; 1,380,000; and 960,000) $25 liquidation value
92,000
84,000 shares of Series C issued and outstanding (December 31, 2012 - 84,000); $1,000 liquidation value
84,000
Common stock, $1 par value; 100,000,000 shares authorized; 52,688,584 shares issued;
45,640,105 shares outstanding (December 31, 2012 - 52,670,878; 45,580,281)
52,689
52,671
Additional paid-in capital
538,105
537,453
Legal surplus
57,906
52,143
Retained earnings
111,292
70,734
Treasury stock, at cost, 7,048,479 shares (December 31, 2012 - 7,090,597 shares)
(80,834)
(81,275)
Accumulated other comprehensive income, net of tax of -$174 (December 31, 2012 - $1,802)
15,766
55,880
Total stockholders’ equity
870,924
863,606
Total liabilities and stockholders’ equity
See notes to unaudited consolidated financial statements.
UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE QUARTERS AND SIX-MONTH PERIODS ENDED JUNE 30, 2013 AND 2012
Quarter Ended June 30,
Six-Month Period Ended June 30,
(In thousands, except per share data)
Interest income:
Loans not covered under shared-loss agreements with the FDIC
90,611
17,223
170,874
35,345
Loans covered under shared-loss agreements with the FDIC
23,999
20,342
44,228
41,884
Total interest income from loans
114,610
37,565
215,102
77,229
Mortgage-backed securities
9,080
21,573
19,898
49,636
Investment securities and other
2,118
1,650
4,436
3,843
Total interest income
125,808
60,788
239,436
130,708
Interest expense:
Deposits
9,973
7,885
20,451
17,008
7,109
16,500
14,357
34,070
2,187
2,926
3,847
5,930
FDIC-guaranteed term notes
909
1,170
321
2,830
649
Total interest expense
20,439
27,632
41,485
58,566
Net interest income
105,369
33,156
197,951
72,142
Provision for non-covered loan and lease losses
37,527
3,800
45,443
6,800
Provision for covered loan and lease losses, net
1,211
1,467
1,883
8,624
Total provision for loan and lease losses
38,738
5,267
47,326
15,424
Net interest income after provision for loan and lease losses
66,631
27,889
150,625
56,718
Non-interest income:
Financial service revenue
8,030
5,903
15,690
11,791
Banking service revenue
13,334
3,145
25,716
6,225
Mortgage banking activities
2,525
2,436
5,679
4,938
Total banking and financial service revenues
23,889
11,484
47,085
22,954
FDIC shared-loss expense, net
(19,965)
(5,583)
(32,836)
(10,410)
Net gain (loss) on:
Sale of securities
11,979
19,338
Derivatives
1,569
(107)
1,271
(108)
Early extinguishment of subordinated capital notes
1,061
Other
2,303
63
2,349
(779)
Total non-interest income, net
7,796
17,836
18,930
30,995
Non-interest expense:
Compensation and employee benefits
24,089
11,184
47,338
21,550
Professional and service fees
7,710
5,222
16,832
10,643
Occupancy and equipment
8,066
4,292
17,282
8,501
Insurance
2,723
1,442
5,401
3,262
Electronic banking charges
4,094
1,609
7,822
3,166
Advertising, business promotion, and strategic initiatives
1,670
1,564
3,079
2,412
Merger and restructuring charges
5,274
10,808
Foreclosure, repossession and other real estate expenses
2,156
936
3,661
1,686
Loan servicing and clearing expenses
1,884
955
3,360
1,923
Taxes, other than payroll and income taxes
5,132
7,754
1,067
Loss on sale of foreclosed real estate and other repossessed assets
1,696
886
3,573
1,282
Communication
835
392
1,699
781
Printing, postage, stationary and supplies
851
322
2,017
630
Director and investor relations
377
342
613
651
2,265
671
4,393
1,555
Total non-interest expense
68,822
29,710
135,632
59,109
Income before income taxes
5,605
16,015
33,923
28,604
Income tax expense (benefit)
(31,934)
1,057
(24,808)
2,994
Net income
37,539
14,958
58,731
25,610
Less: dividends on preferred stock
(3,466)
(1,201)
(6,931)
(2,401)
Income available to common shareholders
34,073
13,757
51,800
23,209
Earnings per common share:
Basic
0.75
0.34
1.14
0.57
Diluted
0.68
1.05
Average common shares outstanding and equivalents
52,968
40,808
52,929
40,986
Cash dividends per share of common stock
0.06
0.12
UNAUDITED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE QUARTERS AND SIX-MONTHS PERIODS ENDED JUNE 30, 2013 AND 2012
(In thousands)
Other comprehensive loss before tax:
Unrealized (gain) loss on securities available-for-sale
(35,576)
7,059
(46,568)
9,000
Realized gain on investment securities included in net income
(11,979)
(19,338)
Unrealized loss (gain) on cash flow hedges
3,016
(6,791)
4,477
(8,792)
Other comprehensive loss before taxes
(32,560)
(11,711)
(42,091)
(19,130)
Income tax effect
1,275
2,875
1,977
3,260
Other comprehensive loss after taxes
(31,285)
(8,836)
(40,114)
(15,870)
Comprehensive income
6,254
6,122
18,617
9,740
UNAUDITED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
FOR THE SIX-MONTH PERIODS ENDED JUNE 30, 2013 AND 2012
Preferred stock:
Balance at beginning and end of period
176,000
68,000
Common stock:
Balance at beginning of year
47,809
Exercised stock options
18
33
Balance at end of period
47,842
Additional paid-in capital:
499,096
Stock-based compensation expense
888
787
167
361
Lapsed restricted stock units
(364)
(392)
Common stock issuance costs
(16)
Preferred stock issuance costs
(23)
499,852
Legal surplus:
50,178
Transfer from retained earnings
5,763
2,490
52,668
Retained earnings:
68,149
Cash dividends declared on common stock
(5,479)
(4,886)
Cash dividends declared on preferred stock
Transfer to legal surplus
(5,763)
(2,490)
83,982
Treasury stock:
(74,808)
Stock repurchased
(7,022)
364
Stock used to match defined contribution plan
77
35
(81,403)
Accumulated other comprehensive income, net of tax:
37,131
Other comprehensive loss, net of tax
21,261
692,202
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of deferred loan origination fees, net of costs
486
297
Amortization of fair value discounts on acquired loans
3,504
Amortization of investment securities premiums, net of accretion of discounts
12,624
25,558
Amortization of core deposit and customer relationship intangibles
1,288
75
Amortization of fair value premiums on acquired deposits
9,649
32,836
10,410
Amortization of prepaid FDIC assessment
2,613
Other impairments on securities
Depreciation and amortization of premises and equipment
5,265
2,373
Deferred income taxes, net
(30,776)
(420)
Provision for covered and non-covered loan and lease losses, net
Stock-based compensation
(Gain) loss on:
Sale of mortgage loans held for sale
(1,771)
(2,898)
(1,271)
(1,061)
Foreclosed real estate
3,109
1,284
Sale of other repossessed assets
464
Sale of premises and equipment
(86)
Originations of loans held-for-sale
(179,127)
(93,940)
Proceeds from sale of loans held-for-sale
68,809
49,388
Net (increase) decrease in:
Trading securities
(1,714)
(34)
2,924
(2,199)
(322)
20,730
4,259
Net increase (decrease) in:
Accrued interest on deposits and borrowings
(995)
(4,498)
12,093
(13,167)
Net cash provided by operating activities
58,941
6,407
Cash flows from investing activities:
Purchases of:
Investment securities available-for-sale
(17,802)
(558,201)
Investment securities held-to-maturity
(119,025)
FHLB stock
(12,465)
Maturities and redemptions of:
313,866
378,144
102,251
28,720
911
Proceeds from sales of:
75,660
553,602
18,219
4,639
Other repossessed assets
12,912
1,941
Premises and equipment
1,667
368
Origination and purchase of loans, excluding loans held-for-sale
(422,590)
(112,974)
Principal repayment of loans, including covered loans
528,274
128,340
Reimbursements from the FDIC on shared-loss agreements
18,696
39,729
Additions to premises and equipment
(6,237)
(1,225)
Net change in securities purchased under agreements to resell
(225,000)
Net cash provided by investing activities
618,920
193,500
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS – (Continued)
Cash flows from financing activities:
(36,125)
(212,846)
(92,210)
(381,358)
FHLB advances
(231,617)
5,070
(46,017)
(105,000)
Exercise of stock options
185
394
Issuance of common stock costs
Issuance of preferred stock costs
Purchase of treasury stock
Termination of derivative instruments
1,348
(124)
Dividends paid on preferred stock
Dividends paid on common stock
Net cash used in financing activities
(798,243)
(326,815)
Net change in cash and cash equivalents
(120,382)
(126,908)
Cash and cash equivalents at beginning of period
591,487
Cash and cash equivalents at end of period
464,579
Supplemental Cash Flow Disclosure and Schedule of Non-cash Activities:
Interest paid
40,491
63,266
Income taxes paid
378
8,031
Mortgage loans securitized into mortgage-backed securities
89,590
37,730
Transfer from loans to foreclosed real estate and other repossessed assets
45,714
11,723
Reclassification of loans held for investment portfolio to held for sale portfolio
40,328
5,182
See notes to unaudited consolidated financial statements
6
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 – ORGANIZATION, CONSOLIDATION AND BASIS OF PRESENTATION
Nature of Operations
OFG Bancorp (the “Company”) is a publicly-owned financial holding company incorporated under the laws of the Commonwealth of Puerto Rico. The Company operates through various subsidiaries including, a commercial bank, Oriental Bank (or the “Bank”), two broker-dealers, Oriental Financial Services Corp. (“Oriental Financial Services”) and OFS Securities, Inc. (“OFS Securities”), an insurance agency, Oriental Insurance, Inc. (“Oriental Insurance”) and a retirement plan administrator, Caribbean Pension Consultants, Inc. (“CPC”). The Company also has a special purpose entity, Oriental Financial (PR) Statutory Trust II (the “Statutory Trust II”). Through these subsidiaries and their respective divisions, the Company provides a wide range of banking and financial services such as commercial, consumer and mortgage lending, leasing, auto loans, financial planning, insurance sales, money management and investment banking and brokerage services, as well as corporate and individual trust services. On April 25, 2013, the Company changed its corporate name from Oriental Financial Group Inc. to OFG Bancorp.
On December 18, 2012, the Company purchased from Banco Bilbao Vizcaya Argentaria, S. A. (“BBVA”), all of the outstanding common stock of each of (i) BBVAPR Holding Corporation (“BBVAPR Holding”), the sole shareholder of Banco Bilbao Vizcaya Argentaria Puerto Rico (“BBVAPR Bank”), a Puerto Rico chartered commercial bank, and BBVA Seguros, Inc. (“BBVA Seguros”), an insurance agency, and (ii) BBVA Securities of Puerto Rico, Inc. (“BBVA Securities,” now known as “OFS Securities”), a registered broker-dealer. This transaction is referred to as the BBVAPR Acquisition” and BBVAPR Holding, BBVAPR Bank, BBVA Seguros and BBVA Securities are collectively referred to as the “BBVAPR Companies” or “BBVAPR.”
Basis of Presentation and Use of Estimates
The accounting and reporting policies of the Company conform with U.S. generally accepted accounting principles (“GAAP”) and to banking industry practices.
The unaudited consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial information and should be read in conjunction with the audited consolidated financial statements in our annual report on Form 10-K for the year ended December 31, 2012 (“2012 Form 10-K”). All significant intercompany balances and transactions have been eliminated in consolidation. These unaudited statements are, in the opinion of management, a fair statement of the results for the periods reported and include all necessary adjustments, all of a normal recurring nature, for a fair statement of such results. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to SEC rules and regulations. Management believes that the disclosures made are adequate to make the information presented not misleading. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the unaudited consolidated financial statements and related disclosures. These estimates are based on information available as of the date of the consolidated financial statements. While management makes its best judgment, actual amounts or results could differ from these estimates. Interim period results are not necessarily indicative of the results to be expected for the full year.
Certain reclassifications have been made to 2012 unaudited consolidated financial statements and notes to the financial statements to conform to the 2013 presentation.
Significant Accounting Policies
We provide a summary of our significant accounting policies in our 2012 Form 10-K under “Notes to Consolidated Financial Statements—Note 1—Summary of Significant Accounting Policies.” Below we describe recent accounting changes.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income - In February 2013, the FASB issued an amendment to enhance current disclosure requirements of reclassifications out of accumulated other comprehensive income and their corresponding effect on net income to be presented, in one place, information about significant amounts reclassified and, in some cases, cross-reference to related footnote disclosures. Previously, this information was presented in different places throughout the financial statements. The amendments require disclosure of information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, they require the presentation, either on the face of the statement where net income is presented or in the notes, of significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under GAAP to be reclassified in their entirety to net income, the Company is required to cross-reference to other disclosures required under GAAP that provide additional detail about those amounts. The amended guidance was effective for annual and interim reporting periods beginning on or after December 15, 2012, prospectively. Our adoption of the guidance is presented in “Note 13 – Stockholders’ Equity and Earnings per Share.”
Testing Indefinite-Lived Intangible Assets for Impairment - In July 2012, the FASB issued ASU No. 2012-02, Intangibles—
Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment. The ASU is intended to simplify the guidance for testing the decline in the realizable value (impairment) of indefinite-lived intangible assets other than goodwill. Some examples of intangible assets subject to the guidance include indefinite-lived trademarks, licenses and distribution rights. The ASU allows companies to perform a qualitative assessment about the likelihood of impairment of an indefinite-lived intangible asset to determine whether further impairment testing is necessary, similar in approach to the goodwill impairment test. The ASU became effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Our adoption of the guidance had no effect on our unaudited consolidated financial statements.
Offsetting Financial Assets and Liabilities - In December 2011, the FASB issued ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities. The ASU is intended to enhance current disclosure requirements on offsetting financial assets and liabilities. The new disclosures enable financial statement users to compare balance sheets prepared under GAAP and IFRS, which are subject to different offsetting models. The guidance requires disclosure of both gross and net information about instruments and transactions eligible for offset in the balance sheet as well as instruments and transactions subject to an agreement similar to a master netting arrangement. The disclosures are required irrespective of whether such instruments are presented gross or net on the balance sheet. In January 2013, the FASB issued ASU No. 2013-01, Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities, which clarify that the scope of this guidance applies to derivatives accounted for in accordance with Topic 815, Derivatives and Hedging, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with Section 210-20-45 or Section 815-10-45 or subject to an enforceable master netting arrangement or similar agreement. The amended guidance was effective for annual and interim reporting periods beginning on or after January 1, 2013, with comparative retrospective disclosures required for all periods presented. We adopted the guidance in the first quarter of 2013. Our adoption of the guidance had no effect on our financial condition, results of operations or liquidity since it only impacts disclosures only. The new disclosures required by the amended guidance are included in “Note 17 – Offsetting Arrangements” hereto.
Subsequent Accounting for an Indemnification Asset Recognized at the Acquisition Date as a Result of a Government-Assisted Acquisition of a Financial Institution— FASB ASU 2012-06, “Business Combinations” (Topic 805) was issued in October 2012. This update addresses the diversity in practice about how to interpret the terms “on the same basis” and “contractual limitations” when subsequently measuring an indemnification asset recognized in a government-assisted (Federal Deposit Insurance Corporation) acquisition of a financial institution that includes a loss-sharing agreement (indemnification agreement). When a reporting entity recognizes an indemnification asset as a result of a government-assisted acquisition of a financial institution and subsequently the cash flows expected to be collected on the indemnification asset change as a result of a change in cash flows expected to be collected on the assets subject to indemnification, the reporting entity should subsequently account for the change in the measurement of the indemnification asset on the same basis as the change in the assets subject to indemnification. Any amortization of changes in value should be limited to the contractual term of the indemnification agreement, that is, the lesser of the term of the indemnification agreement and the remaining life of the indemnified assets. The amendments in this update are effective for fiscal years and interim periods within those years, beginning on or after December 15, 2012. The adoption of this guidance did not have a material effect on the unaudited consolidated financial statements, since the Company already followed the same basis approach.
8
Future Application of Accounting Standards
Accounting for Financial Instruments—Credit Losses - In December 2012, the FASB issued a proposed ASU, Financial Instruments—Credit Losses. This proposed ASU, or exposure draft, was issued for public comment in order to allow stakeholders the opportunity to review the proposal and provide comments to the FASB, and does not constitute accounting guidance until a final ASU is issued. The exposure draft contains proposed guidance developed by the FASB with the goal of improving financial reporting about expected credit losses on loans, securities and other financial assets held by banks, financial institutions, and other public and private organizations. The exposure draft proposes a new accounting model intended to require earlier recognition of credit losses, while also providing additional transparency about credit risk. The FASB’s proposed model would utilize a single “expected credit loss” measurement objective for the recognition of credit losses, replacing the multiple existing impairment models in GAAP which generally require that a loss be “incurred” before it is recognized. The FASB’s proposed model represents a significant departure from existing GAAP, and may result in material changes to the Company’s accounting for financial instruments. The impact of the FASB’s final ASU to the Company’s financial statements will be assessed when it is issued. The exposure draft does not contain a proposed effective date. This would be included in the final ASU, when issued.
Other Potential Amendments to Current Accounting Standards - The FASB and International Accounting Standards Board, either jointly or separately, are currently working on several major projects, including amendments to existing accounting standards governing financial instruments, leases, and consolidation and investment companies. As part of the joint financial instruments project, the FASB has issued a proposed ASU that would result in significant changes to the guidance for recognition and measurement of financial instruments, in addition to the proposed ASU that would change the accounting for credit losses on financial instruments discussed above. The FASB is also working on a joint project that would require substantially all leases to be capitalized on the balance sheet. Additionally, the FASB has issued a proposal on principal-agent considerations that would change the way the Company needs to evaluate whether to consolidate Variable Interest Entities (“VIE”) and non-VIE partnerships. Furthermore, the FASB has issued a proposed ASU that would change the criteria used to determine whether an entity is subject to the accounting and reporting requirements of an investment company. The principal-agent consolidation proposal would require all VIEs, including those that are investment companies, to be evaluated for consolidation under the same requirements. All of these projects may have significant impacts for the Company. Upon completion of the standards, the Company will need to reevaluate its accounting and disclosures. However, due to ongoing deliberations of the standard setters, the Company is currently unable to determine the effect of future amendments or proposals.
9
NOTE 2 – BUSINESS COMBINATIONS
BBVAPR Acquisition
On December 18, 2012, the Company purchased from BBVA, all of the outstanding common stock of each of BBVAPR Holding and BBVA Securities for an aggregate purchase price of $500 million. Immediately following the closing of the BBVAPR Acquisition, the Company merged BBVAPR Bank with and into Oriental Bank, with Oriental Bank continuing as the surviving entity.
The assets acquired and liabilities assumed as of December 18, 2012 were presented at their fair value. In many cases, the determination of these fair values required management to make estimates about discount rates, expected cash flows, market conditions and other future events that are highly subjective in nature and subject to change. The fair values initially assigned to the assets acquired and liabilities assumed were preliminary and subject to refinement for up to one year after the closing date of the acquisition as new information relative to closing date fair values became available. During the quarter ended June 30, 2013, the Company recorded retrospective adjustments to the preliminary estimated fair values of certain acquired loans, foreclosed real estate, deferred income taxes, and other assets acquired, to reflect new information obtained during the measurement period (as defined by ASC Topic 805), about facts and circumstances that existed as of the acquisition date that, if known, would have affected the acquisition-date fair value measurements. As detailed in the table below, the main adjustment occurred in the loans acquired. The adjustment resulted from in-depth reviews of the actual terms and amortization schedules. The original cash flows were revised to reflect the results of this review.
Net-assets acquired and their respective measurement period adjustments are reflected in the table below:
Measurement
Period
Fair Value
Adjustments,
as
Book Value
net
Remeasured
December 18, 2012
Adjustments, net
June 30, 2013
Assets
394,638
Investments
561,623
Loans
3,678,979
(118,913)
3,560,066
(12,798)
3,547,268
19,133
(18,252)
881
44,853
(8,896)
35,957
(1,932)
34,025
35,327
50,005
85,332
5,300
90,632
37,412
29,067
66,479
Legacy goodwill
116,353
(116,353)
Core deposit intangible
8,473
Customer relationship intangible
5,060
119,286
(7,663)
111,623
(2,936)
108,687
Total assets acquired
5,007,604
(177,472)
4,830,132
(12,366)
4,817,766
Liabilities
3,472,951
21,489
3,494,440
338,020
20,465
358,485
Other borrowings
348,624
1,108
349,732
117,000
(7,159)
109,841
80,392
(1,438)
78,954
Total liabilities assumed
4,356,987
34,465
4,391,452
Net assets acquired
650,617
(211,937)
438,680
426,314
Cash consideration
500,000
61,320
12,366
73,686
Merger and Restructuring Charges
Merger and restructuring charges are recorded in the unaudited consolidated statement of operations and include incremental costs to integrate the operations of the Company and BBVAPR. These charges represent costs associated with these one-time activities and do not represent ongoing costs of the fully integrated combined organization.
The following table presents severance and employee-related charges, systems integrations and other merger-related charges in connection with the BBVAPR Acquisition for the quarter and six-month period ended June 30, 2013:
Quarter Ended June 30, 2013
Six-Month Period Ended June 30, 2013
Severance and employee-related charges
400
1,150
Systems integrations and related charges
2,231
3,177
Other-contract cancellation fee
2,643
6,481
Total merger and restructuring charges
Restructuring Reserve
Restructuring reserves are established by a charge to merger and restructuring charges, and the restructuring charges are included in the merger and restructuring charges table.
The following table presents the changes in restructuring reserves for the quarter and six-month period ended June 30, 2013:
Balance at the beginning of the period
6,336
4,202
Cash payments and other
(11,334)
(14,734)
Balance at the end of the period
276
Payments under merger and restructuring reserves associated with the BBVAPR Acquisition are expected to continue in 2013 and will be accounted under applicable accounting guidance to the cost being incurred.
11
The FDIC-Assisted Acquisition and FDIC Shared-Loss Indemnification Asset
On April 30, 2010, the Bank acquired certain assets and assumed certain deposits and other liabilities in the FDIC-assisted acquisition of Eurobank. These assets acquired and liabilities assumed were recorded at fair value on the date of acquisition. As part of the Purchase and Assumption Agreement between the Bank and the FDIC (the “Purchase and Assumption Agreement”), the Bank and the FDIC entered into shared-loss agreements, whereby the FDIC covers a substantial portion of any losses on loans (and related unfunded loan commitments), foreclosed real estate and other repossessed properties.
The acquired loans, foreclosed real estate, and other repossessed property subject to the shared-loss agreements are collectively referred to as “covered assets.” Under the terms of the shared-loss agreements, the FDIC absorbs 80% of losses and shares in 80% of loss recoveries on covered assets. The term of the shared-loss agreement covering single family residential mortgage loans is ten years with respect to losses and loss recoveries, while the term of the shared-loss agreement covering commercial loans is five years with respect to losses and eight years with respect to loss recoveries, from the April 30, 2010 acquisition date. The shared-loss agreements also provide for certain costs directly related to the collection and preservation of covered assets to be reimbursed at an 80% level. The indemnification asset represents the portion of estimated losses covered by the shared-loss agreements between the Bank and the FDIC.
The Bank agreed to make a true-up payment, also known as clawback liability, to the FDIC on the date that is 45 days following the last day (such day, the “True-Up Measurement Date”) of the final shared-loss month, or upon the final disposition of all covered assets under the shared-loss agreements in the event losses thereunder fail to reach expected levels. Under the shared-loss agreements, the Bank will pay to the FDIC 50% of the excess, if any, of: (i) 20% of the Intrinsic Loss Estimate of $906.0 million (or $181.2 million) (as determined by the FDIC) less (ii) the sum of: (A) 25% of the asset discount (per bid) (or $227.5 million); plus (B) 25% of the cumulative shared-loss payments (defined as the aggregate of all of the payments made or payable to the Bank minus the aggregate of all of the payments made or payable to the FDIC); plus (C) the sum of the period servicing amounts for every consecutive twelve-month period prior to and ending on the True-Up Measurement Date in respect of each of the shared-loss agreements during which the shared-loss provisions of the applicable shared-loss agreement is in effect (defined as the product of the simple average of the principal amount of shared-loss loans and shared-loss assets at the beginning and end of such period times 1%). The true-up payment represents an estimated liability of $16.9 million and $15.5 million, net of discount, as of June 30, 2013 and December 31, 2012, respectively. This estimated liability is accounted for as a reduction of the indemnification asset.
The FDIC shared-loss indemnification asset activity for the six-month periods ended June 30, 2013 and 2012 follows:
Balance at beginning of period
392,367
Shared-loss agreements reimbursements from the FDIC
(18,696)
(39,729)
Increase (decrease) in expected credit losses to be
covered under shared-loss agreements, net
(2,015)
12,748
Incurred expenses to be reimbursed under shared-loss agreements
3,220
4,791
359,767
During the quarter ended June 30, 2013, the Company recorded $7.1 million in additional amortization of the FDIC indemnification asset from stepped up costs recoveries on certain construction and leasing pools.
12
NOTE 3 – SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL AND INVESTMENTS
Money Market Investments
The Company considers as cash equivalents all money market instruments that are not pledged and that have maturities of three months or less at the date of acquisition. At June 30, 2013 and December 31, 2012, money market instruments included as part of cash and cash equivalents amounted to $11.0 million and $13.2 million, respectively.
Securities Purchased Under Agreements to Resell
Securities purchased under agreements to resell consist of short-term investments and are carried at the amounts at which the assets will be subsequently resold as specified in the respective agreements. At December 31, 2012, securities purchased under agreements to resell amounted to $80.0 million. The fair value of the collateral securities held by the Company on these transactions as of December 31, 2012 was approximately $82.1 million. On June 30, 2013 the Company had no securities purchased under agreements to resell.
Investment Securities
The amortized cost, gross unrealized gains and losses, fair value, and weighted average yield of the securities owned by the Company at June 30, 2013 and December 31, 2012 were as follows:
Gross
Weighted
Amortized
Unrealized
Fair
Average
Cost
Gains
Losses
Value
Yield
Available-for-sale
FNMA and FHLMC certificates
1,358,834
36,112
4,324
1,390,622
2.92%
GNMA certificates
10,590
604
11,180
4.88%
CMOs issued by US Government sponsored agencies
250,806
85
2,528
248,363
1.81%
Total mortgage-backed securities
1,620,230
36,801
6,865
1,650,165
2.76%
Investment securities
US Treasury securities
26,499
26,501
0.08%
Obligations of US Government sponsored agencies
15,078
15,113
1.23%
Obligations of Puerto Rico Government and
political subdivisions
120,989
1,294
119,695
4.42%
Other debt securities
24,539
216
24,755
3.45%
Total investment securities
187,105
253
186,064
3.42%
Total securities available for sale
1,807,335
37,054
8,159
2.83%
December 31, 2012
1,622,037
71,411
1,693,447
3.06%
14,177
995
15,164
4.89%
288,409
3,784
793
291,400
1.85%
1,924,623
76,190
802
2,000,011
2.89%
US treasury securities
26,498
26,496
0.71%
21,623
224
21,847
1.35%
120,950
438
120,521
3.82%
25,131
280
25,411
3.46%
194,202
513
440
194,275
2.99%
Total securities available-for-sale
2,118,825
76,703
1,242
2.90%
14
The amortized cost and fair value of the Company’s investment securities at June 30, 2013, by contractual maturity, are shown in the next table. Securities not due on a single contractual maturity date, such as collateralized mortgage obligations, are classified in the period of final contractual maturity. 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.
Amortized Cost
Due after 5 to 10 years
32,779
33,345
Total due after 5 to 10 years
Due after 10 years
1,326,055
1,357,277
Total due after 10 years
1,587,451
1,616,820
Due in less than one year
20,000
20,058
Total due in less than one year
46,499
46,559
Due from 1 to 5 years
Obligations of Puerto Rico Government and political subdivisions
412
399
Total due from 1 to 5 years
11,425
11,053
Obligations of US Government and sponsored agencies
26,503
26,166
109,152
108,243
4,539
4,697
113,691
112,940
15
The BBVAPR Acquisition and the related deleverage of the investment securities portfolio that the Company completed during the second half of 2012 reduced the interest rate risk profile of the Company. During the six-month period ended June 30, 2013, the Company did not execute any sale of securities from its portfolio other than $92.4 million of available-for-sale GNMA certificates that were sold as part of its recurring mortgage loan origination and securitization activities. These sales produced a nominal gain during such period. During the six-month period ended June 30, 2012, there were certain sales of available-for-sale securities because the Company believed that gains could be realized and that there were good opportunities to invest the proceeds in other investment securities with attractive yields and terms that would allow the Company to continue protecting its net interest margin.
The Company, as part of its asset/liability management, may purchase U.S. Treasury securities and U.S. government sponsored agency discount notes close to their maturities as alternatives to cash deposits at correspondent banks or as a short term vehicle to reinvest the proceeds of sale transactions until investment securities with attractive yields can be purchased.
For the six-month period ended June 30, 2012, the Company recorded a net gain on sale of securities of $19.3 million. The table below presents the gross realized gains by category for such period:
Six-Month period Ended June 30, 2012
Description
Sale Price
at Sale
Gross Gains
Gross Losses
Sale of securities available-for-sale
Mortgage-backed securities and CMOs
367,971
349,400
18,581
39,484
39,483
19,725
18,372
1,353
Total mortgage-backed securities and CMOs
427,180
407,255
19,935
Obligations of U.S. Government sponsored agencies
35,882
36,478
31
628
Structured credit investments
10,530
126,412
127,008
Total
553,592
534,263
19,966
16
The following tables show the Company’s gross unrealized losses and fair value of investment securities available-for-sale, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2013 and December 31, 2012:
12 months or more
Loss
Securities available-for-sale
1,712
61
1,651
2,094
171
3,806
232
3,574
Less than 12 months
20,588
1,233
19,355
203,524
2,357
201,167
219,983
215,659
206
193
444,301
7,927
436,374
22,300
21,006
205,618
203,090
448,107
439,948
17
1,673
1,661
2,194
178
2,016
3,867
190
3,677
19,086
426
18,660
10,671
615
10,056
US Treasury Securities
11,498
11,496
84
76
67
41,407
1,052
40,355
20,759
20,321
12,865
12,072
45,274
44,032
The Company conducts quarterly reviews to identify and evaluate each investment in an unrealized loss position for other-than-temporary impairment. Any portion of a decline in value associated with credit loss is recognized in income with the remaining noncredit-related component recognized in other comprehensive income. A credit loss is determined by assessing whether the amortized cost basis of the security will be recovered by comparing the present value of cash flows expected to be collected from the security, discounted at the rate equal to the yield used to accrete current and prospective beneficial interest for the security. The shortfall of the present value of the cash flows expected to be collected in relation to the amortized cost basis is considered to be the “credit loss.” Other-than-temporary impairment analysis is based on estimates that depend on market conditions and are subject to further change over time. In addition, while the Company believes that the methodology used to value these exposures is reasonable, the methodology is subject to continuing refinement, including those made as a result of market developments. Consequently, it is reasonably possible that changes in estimates or conditions could result in the need to recognize additional other-than-temporary impairment charges in the future.
Securities in an unrealized loss position at June 30, 2013 are mainly composed of highly liquid securities that in most cases have a large and efficient secondary market. Valuations are performed on a monthly basis. The Company’s management believes that the unrealized losses of such securities at June 30, 2013 are temporary and are substantially related to market interest rate fluctuations and not to deterioration in the creditworthiness of the issuer or guarantor. At June 30, 2013, the Company does not have the intent to sell these investments in an unrealized loss position.
NOTE 4 - LOANS
The Company’s loan portfolio is composed of covered loans and non-covered loans. The Company presents loans subject to the loss sharing agreements as “covered loans” in the information below, and loans that are not subject to FDIC loss sharing agreements as “non-covered loans.” The risks of the Eurobank FDIC-assisted acquisition acquired loans are significantly different from those loans not covered under the FDIC loss sharing agreements because of the loss protection provided by the FDIC. Also, loans acquired in the BBVAPR Acquisition are included as non-covered loans in the unaudited consolidated statements of financial condition. Non-covered loans are further segregated between originated loans, acquired loans accounted for under ASC 310-20 (loans with revolving feature and/or acquired at a premium) and acquired loans accounted for under ASC 310-30 (loans acquired with deteriorated credit quality, including those by analogy).
For a summary of the accounting policy related to loans, interest recognition and allowance for loan and lease losses, please refer to the summary of significant accounting policies included in Note 1 of our 2012 Form 10-K under “Notes to Consolidated Financial Statements”.
The composition of the Company’s loan portfolio at June 30, 2013 and December 31, 2012 was as follows:
Loans not covered under shared-loss agreements with FDIC:
Originated and other loans and leases held for investment:
Mortgage
755,298
804,942
Commercial
702,074
353,930
Auto and leasing
233,092
50,720
Consumer
89,608
48,136
1,780,072
1,257,728
Acquired loans:
Accounted for under ASC 310-20 (Loans with revolving feature and/or
acquired at a premium)
140,234
317,244
Commercial secured by real estate
14,519
29,215
Auto
373,587
457,894
62,751
68,878
591,091
873,231
Accounted for under ASC 310-30 (Loans acquired with deteriorated
credit quality, including those by analogy)
747,077
942,267
Construction
140,060
196,692
781,389
810,135
462,691
554,938
88,375
118,171
2,219,592
2,622,203
4,590,755
4,753,162
Deferred loan fees, net
(831)
(3,463)
Loans receivable
4,589,924
4,749,699
Allowance for loan and lease losses on non-covered loans
(46,625)
(39,921)
Loans receivable, net
Mortgage loans held-for-sale
Total loans not covered under shared-loss agreements with FDIC, net
4,621,649
4,773,923
Loans covered under shared-loss agreements with FDIC:
Loans secured by 1-4 family residential properties
123,507
128,811
Construction and development secured by 1-4 family residential properties
16,478
15,969
Commercial and other construction
275,489
289,070
Leasing
943
7,088
6,955
8,493
Total loans covered under shared-loss agreements with FDIC
423,372
449,431
Allowance for loan and lease losses on covered loans
(53,992)
(54,124)
Total loans covered under shared-loss agreements with FDIC, net
Non-covered Loans
Originated and Other Loans and Leases Held for Investment
The Company’s originated and other held for investment loan transactions are encompassed within four portfolio segments: mortgage, commercial, consumer, and auto and leasing.
The following table presents the aging of the recorded investment in gross originated and other loans held for investment as of June 30, 2013 and December 31, 2012 by class of loans. Mortgage loans past due included delinquent loans in the GNMA buy-back option program. Servicers of loans underlying GNMA mortgage-backed securities must report as their own assets the defaulted loans that they have the option (but not the obligation) to repurchase, even when they elect not to exercise that option.
Loans 90+
Days Past
Due and
30-59 Days
60-89 Days
90+ Days
Total Past
Still
Past Due
Due
Current
Total Loans
Accruing
Traditional (by origination year):
Up to the year 2002
2,937
6,993
9,930
79,666
89,596
Years 2003 and 2004
5,413
3,429
8,842
117,754
126,596
Year 2005
2,136
1,431
3,567
65,196
68,763
Year 2006
3,369
2,838
6,207
87,614
93,821
Years 2007, 2008
and 2009
2,863
3,407
6,270
104,169
110,439
433
Years 2010, 2011, 2012
and 2013
391
2,115
2,506
96,270
98,776
17,109
20,213
37,322
550,669
587,991
515
Non-traditional
1,520
2,212
3,732
42,695
46,427
Loss mitigation program
4,993
14,287
19,280
68,335
87,615
1,606
23,622
36,712
60,334
661,699
722,033
2,121
Home equity secured personal loans
740
752
GNMA's buy-back option program
32,513
69,237
92,859
662,439
11,033
1,381
12,694
25,108
386,236
411,344
Other commercial and industrial
324
753
1,143
289,587
290,730
11,357
1,447
13,447
26,251
675,823
670
165
370
1,205
88,403
8,826
2,075
1,096
11,997
221,095
20,853
27,309
84,150
132,312
1,647,760
20
Traditional
(by origination year):
6,906
2,116
11,363
20,385
80,883
101,268
12,048
5,206
18,162
35,416
114,446
149,862
4,983
1,746
8,860
15,589
65,312
80,901
9,153
3,525
15,363
28,041
85,045
113,086
2,632
1,682
8,965
13,279
108,358
121,637
Years 2010, 2011 and 2012
and 2012
632
769
1,162
2,563
64,084
66,647
36,354
15,044
63,875
115,273
518,128
633,401
2,850
11,160
15,077
42,742
57,819
8,933
4,649
19,989
33,571
53,739
87,310
48,137
20,760
95,024
163,921
614,609
778,530
726
736
25,676
120,710
189,607
615,335
9,062
271
15,335
24,668
226,606
251,274
345
189
2,378
2,912
99,744
102,656
9,407
460
17,713
27,580
326,350
747
92
409
1,248
46,888
251
129
131
511
50,209
58,542
21,441
138,963
218,946
1,038,782
During the quarter ended June 30, 2013, the Company transferred $55.0 million of non-performing residential mortgage loans held-for-investment to held-for-sale at a fair value of $27.0 million. The difference between fair value and book value was recorded as charge-off to the mortgage portfolio. The provision for loan and lease losses during the quarter and six-month period ended June 30, 2013 increased to provide the coverage necessary under the allowance policy for the remaining mortgage loans, following the effects that the aforementioned reclassification had on the mortgage portfolio allowance level.
21
Acquired Loans Accounted for under ASC 310-20 (Loans with revolving feature and/or acquired at a premium)
Credit cards, retail and commercial revolving lines of credits, floor plans and performing auto loans with FICO scores over 660 acquired at a premium as part of the BBVAPR Acquisition are accounted for under the guidance of ASC 310-20, which requires that any contractually required loan payment receivable in excess of the Company’s initial investment in the loans be accreted into interest income on a level-yield basis over the life of the loan. Loans accounted for under ASC 310-20 are placed on non-accrual status when past due in accordance with the Company’s non-accrual policy and any accretion of discount or amortization of premium is discontinued. Loans acquired in the BBVAPR Acquisition that were accounted for under the provisions of ASC 310-20, which had fully amortized their premium or discount, recorded at the date of acquisition, are removed from the acquired loan category at the end of the reporting period.
The following table presents the aging of the recorded investment in gross acquired loans accounted for under ASC 310-20 as of June 30, 2013 and December 31, 2012 by class of loans:
291
134
493
918
139,316
14,510
8,849
1,892
674
11,415
362,172
1,767
1,069
2,843
59,908
10,916
2,033
2,236
15,185
575,906
715
984
316,260
315
28,900
6,753
1,023
275
8,051
449,843
982
1,095
2,077
66,801
8,765
1,099
1,563
11,427
861,804
22
Acquired Loans Accounted for under ASC 310-30 (including those accounted for under ASC 310-30 by analogy)
Loans acquired as part of the BBVAPR Acquisition, except for credit cards, retail and commercial revolving lines of credits, floor plans and performing auto loans with FICO scores over 660 acquired at a premium, are accounted for by the Company in accordance with ASC 310-30.
The carrying amount corresponding to non-covered loans acquired with deteriorated credit quality, including those accounted under ASC 310-30 by analogy, in the statement of financial condition at June 30, 2013 and December 31, 2012 is as follows:
Contractual required payments receivable
$ 3,429,294
$ 3,954,484
Less: Non-accretable discount
713,641
741,872
Cash expected to be collected
2,715,653
3,212,612
Less: Accretable yield
496,061
590,409
Carrying amount
$ 2,219,592
$ 2,622,203
The following tables describe the accretable yield and non-accretable discount activity of acquired loans accounted for under ASC 310-30 for the quarter and six-month period ended June 30, 2013, excluding covered loans:
Accretable Yield Activity
542,741
Accretion
(54,427)
(102,095)
Transfer from non-accretable discount
7,747
Non-Accretable Discount Activity
733,126
Principal losses
(11,738)
(20,484)
Transfer to accretable yield
(7,747)
23
Covered Loans
The carrying amount of covered loans at June 30, 2013 and December 31, 2012 is as follows:
782,763
874,994
192,259
237,555
590,504
637,439
167,132
188,008
Carrying amount, gross
Less: Allowance for covered loan and lease losses
53,992
54,124
Carrying amount, net
The following tables describe the accretable yield and non-accretable discount activity of covered loans for the quarters and six-month periods ended June 30, 2013 and 2012:
Accretable yield activity
174,107
174,878
188,822
(23,999)
(20,342)
(44,228)
(41,884)
17,024
22,712
23,352
30,310
177,248
Non-accretable discount activity
214,236
379,780
412,170
(4,953)
(42,664)
(21,944)
(67,456)
(17,024)
(22,712)
(23,352)
(30,310)
314,404
24
Non-accrual Loans
The following table presents the recorded investment in loans in non-accrual status by class of loans as of June 30, 2013 and December 31, 2012:
Originated and other loans and leases held for investment
6,987
11,362
3,465
1,481
8,859
Years 2007, 2008 and 2009
3,580
8,967
Years 2010, 2011, 2012 and 2013
3,988
22,376
2,287
28,450
39,957
53,113
114,992
53,125
115,002
29,491
26,517
2,939
2,989
32,430
29,506
442
Acquired loans accounted under ASC 310-20
Total non-accrual loans
89,257
146,644
Loans accounted for under ASC 310-30 are excluded from the above table as they are considered to be performing due to the application of the accretion method, in which these loans will accrete interest income over the remaining life of the loans using estimated cash flow analyses.
These loans do not include certain non-performing residential mortgage loans with a net book value of $55.0 million reclassified during the quarter ended June 30, 2013 to the loan held-for-sale category. Without this re-classification to loans held-for-sale, non-accruing loan balances would have been relatively consistent between December 31, 2012 and June 30, 2013.
Effective April 24, 2013, delinquent residential mortgage loans insured or guaranteed under applicable FHA and VA programs are placed in non-accrual when they become 18 months or more past due, since they are insured loans. Before that date, they were placed in non-accrual when they became 90 days or more past due.
At June 30, 2013 and December 31, 2012, loans whose terms have been extended and which are classified as troubled-debt restructurings that are not included in non-accrual loans amounted to $55.7 million and $52.0 million, respectively.
25
NOTE 5 - ALLOWANCE FOR LOAN AND LEASE LOSSES
Non-Covered Loans
The Company maintains an allowance for loan and lease losses at a level that management considers adequate to provide for probable losses based upon an evaluation of known and inherent risks. The Company’s allowance for loan and lease 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 required based on factors beyond the Company’s control. We also maintain an allowance for loan losses on acquired loans when: (i) for loans accounted for under ASC 310-30, there is deterioration in credit quality subsequent to acquisition, and (ii) for loans accounted for under ASC 310-20, the inherent losses in the loans exceed the remaining credit discount recorded at the time of acquisition.
The following tables present the activity in our allowance for loan and lease losses and the related recorded investment of the associated loans for our originated and other loans held for investment portfolio by segment for the periods indicated:
Auto and Leasing
Unallocated
Allowance for loan and lease losses:
22,889
16,314
1,313
1,741
42,334
Charge-offs
(29,120)
(2,886)
(323)
(709)
(33,038)
Recoveries
234
209
Provision for non-covered
loan and lease losses
27,606
3,961
1,309
2,400
643
35,919
21,375
17,623
2,342
3,641
720
45,701
Auto and
21,092
17,072
856
533
39,921
(31,707)
(3,444)
(569)
(800)
(36,520)
262
107
585
31,990
3,733
1,948
3,692
352
41,715
Ending allowance balance attributable
to loans:
Individually evaluated for impairment
8,879
5,795
14,674
Collectively evaluated for impairment
12,496
11,828
31,027
Total ending allowance balance
81,849
43,831
125,680
673,449
658,244
233,091
1,654,392
Total ending loan balance
702,075
27
Quarter Ended June 30, 2012
18,967
15,045
1,328
510
1,511
37,361
(1,948)
(1,721)
(184)
(3,853)
34
56
94
Provision for (recapture of) non-covered
2,769
2,620
(202)
(317)
(1,070)
19,788
15,978
998
197
441
37,402
Six-Month Period Ended June 30, 2012
21,652
12,548
1,423
845
542
37,010
(2,869)
(3,358)
(366)
(31)
(6,624)
101
1,005
6,687
(166)
(625)
(101)
Ending allowance balance attributable to loans:
5,334
4,121
9,455
15,758
12,951
30,466
74,783
46,199
120,982
730,159
307,731
1,136,746
Total ending loans balance
28
The following tables present the activity in our allowance for loan losses and related recorded investment of the associated loans in our non-covered acquired loan portfolio, excluding loans accounted for under ASC 310-30, for the quarter and six-month period ended June 30, 2013:
386
(25)
(1,158)
(1,410)
(2,593)
637
1,523
563
521
524
1,608
924
(2,614)
(3,125)
(5,764)
844
2,960
949
1,770
1,009
3,728
154,753
29
Impaired Loans
The Company evaluates all loans, some individually and others as homogeneous groups, for purposes of determining impairment. The total investment in impaired commercial loans was $43.8 million and $46.2 million at June 30, 2013 and December 31, 2012, respectively. The impaired commercial loans were measured based on the fair value of collateral or the present value of cash flows method, including those identified as troubled-debt restructurings. The valuation allowance for impaired commercial loans amounted to approximately $5.8 million and $4.1 million at June 30, 2013 and December 31, 2012, respectively. The total investment in impaired mortgage loans was $81.8 million and $74.8 million at June 30, 2013 and December 31, 2012, respectively. Impairment on mortgage loans assessed as troubled-debt restructurings was measured using the present value of cash flows. The valuation allowance for impaired mortgage loans amounted to approximately $8.9 million and $5.3 million at June 30, 2013 and December 31, 2012, respectively.
The Company’s recorded investment in commercial and mortgage loans that were individually evaluated for impairment, excluding loans accounted for under ASC 310-30, and the related allowance for loan and lease losses at June 30, 2013 and December 31, 2012 are as follows:
Unpaid
Recorded
Related
Principal
Investment
Allowance
Coverage
Impaired loans with specific allowance:
22,168
19,276
30%
Residential troubled-debt restructuring
85,271
11%
Impaired loans with no specific allowance:
31,334
24,555
N/A
Total investment in impaired loans
138,773
12%
Impaired loans with specific allowance
16,666
14,570
28%
76,859
7%
Impaired loans with no specific allowance
36,293
31,629
129,818
8%
Acquired Loans Accounted for under ASC-310-20 (Loans with revolving feature and/or acquired at a premium)
Specific
0%
30
The following table presents the interest recognized in commercial and mortgage loans that were individually evaluated for impairment, excluding loans accounted for under ASC 310-30, for the quarters and six-month periods ended June 30, 2013 and 2012:
Interest Income Recognized
Average Recorded Investment
255
17,049
132
16,105
682
83,081
461
62,548
226
23,304
49
25,031
Total interest income from impaired loans
1,163
123,434
642
103,684
17,789
264
20,516
1,273
80,914
874
59,466
25,304
104
21,864
1,959
124,007
101,846
Modifications
The following table presents the troubled-debt restructurings during the quarters and six-month periods ended June 30, 2013 and 2012:
Number of contracts
Pre Modification Outstanding Recorded Investment
Pre-Modification Weighted Average Rate
Pre-Modification Weighted Average Term (in Months)
Post-Modification Outstanding Recorded Investment
Post-Modification Weighted Average Rate
Post-Modification Weighted Average Term (in Months)
(Dollars in thousands)
Mortgage loans
5,372
6.47%
355
5,715
4.26%
420
Commercial loans
1,842
8.99%
4.00%
Consumer loans
13.67%
60
86
10,555
6.56%
11,288
4.59%
417
45
6,028
6.52%
290
6,380
4.95%
3,698
6.25%
65
3,968
6.08%
71
103
15,473
6.50%
313
16,419
4.96%
393
5,600
5.80%
5,407
6.22%
32
The following table presents troubled-debt restructurings for which there was a payment default during the twelve-month periods ended June 30, 2013 and 2012:
Twelve-Month Period Ended June 30,
Number of Contracts
Recorded Investment
6,414
4,110
Credit Quality Indicators
The Company categorizes non-covered originated and acquired loans accounted for under ASC 310-20 into risk categories based on relevant information about the ability of borrowers to service their debt, such as economic conditions, portfolio risk characteristics, prior loss experience, and the results of periodic credit reviews of individual loans.
The Company uses the following definitions for risk ratings:
Special Mention: Loans classified as “special mention” have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.
Substandard: Loans classified as “substandard” are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Doubtful: Loans classified as “doubtful” have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, questionable and improbable.
Loss: Loans classified as “loss” are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this worthless loan even though partial recovery may be affected in the future.
Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans.
As of June 30, 2013 and December 31, 2012, and based on the most recent analysis performed, the risk category of gross non-covered originated and acquired loans accounted for under ASC 310-20 subject to risk rating by class of loans is as follows:
Risk Ratings
Individually
Balance
Special
Measured for
Outstanding
Pass
Mention
Substandard
Doubtful
Impairment
Commercial - originated and other loans held for investment
Commercial secured
by real estate
412,958
346,115
29,355
1,293
282
35,913
Other commercial
and industrial
289,117
278,319
2,763
118
7,918
624,434
32,118
1,411
Commercial - acquired loans
(under ASC 310-20)
14,031
245
244
137,786
727
1,721
151,817
972
1,965
856,828
776,251
33,090
3,376
183,033
23,928
2,127
99
42,087
85,806
8,569
4,169
4,112
268,839
32,497
6,296
Construction and commercial
real estate
20,337
19,701
Commercial and industrial
317,632
315,085
213
2,334
337,969
334,786
458
2,725
691,899
603,625
32,955
9,021
For residential and consumer loan classes, the Company evaluates credit quality based on the delinquency status of the loan. As of June 30, 2013 and December 31, 2012, and based on the most recent analysis performed, the risk category of non-covered gross originated loans and acquired loans accounted for under ASC 310-20 not subject to risk rating by class of loans is as follows:
Delinquency
0-29 days
30-59 days
60-89 days
90-119 days
120-364 days
365+ days
(by origination year)
84,184
367
1,719
302
117,665
1,319
737
1,373
89
65,026
663
267
502
169
87,259
968
512
104,041
2,782
2,199
676
Years 2010, 2011,
2012 and 2013
94,271
951
800
365
1,998
552,446
17,028
4,610
4,530
5,908
3,469
807
160
1,152
93
7,980
98
969
78,287
603,121
18,646
5,464
4,924
8,029
Home equity secured
personal loans
5,782
15,775
10,956
603,861
11,246
20,699
18,997
88,218
660
156
199
208
759
337
1,077,998
913,174
9,486
20,877
12,172
21,235
82,057
Acquired loans (under ASC 310-20)
373,588
362,173
179
1,054
436,339
422,081
10,616
1,899
1,549
194
1,514,337
1,335,255
20,102
22,776
13,721
21,429
80,715
6,907
3,720
6,442
482
114,341
2,082
3,994
11,533
658
80,900
65,245
1,202
1,846
5,727
151
84,926
9,012
1,530
5,103
8,695
295
121,639
108,357
641
2,532
5,732
Years 2010, 2011
66,646
249
452
517,668
36,214
6,590
17,647
38,589
1,649
455
8,418
9,595
606
128
102
3,492
73,134
570,005
39,670
16,239
7,147
20,187
50,499
GNMA's buy back
option program
6,064
10,659
8,953
570,731
13,211
30,846
59,462
188
218
903,798
667,828
40,668
16,460
13,445
31,149
59,465
1,591
1,070
1,089
528,363
517,714
7,735
536
1,432,161
1,185,542
48,403
17,483
14,798
31,685
59,467
The reduction in mortgage loans over 90 days past due from December 31, 2012 is due to the reclassification of certain non-performing residential mortgage loans originated before 2010, ,with the a net book value of $55.0 million to the loan held-for-sale category.
Non-covered Acquired Loans Accounted under ASC 310-30
Loans acquired in the BBVAPR Acquisition accounted for under ASC 310-30 were recognized at fair value as of December 18, 2012, which included the impact of expected credit losses, and therefore, no allowance for credit losses was recorded at the acquisition date. To the extent credit deterioration occurs after the date of acquisition, the Company would record an allowance for loan and lease losses. Management determined that there was no need to record an allowance for loan and lease losses on loans acquired in the BBVAPR Acquisition accounted for under ASC 310-30 as of June 30, 2013 and December 31, 2012.
36
For covered loans, as part of the evaluation of actual versus expected cash flows, the Company assesses on a quarterly basis the credit quality of these loans based on delinquency, severity factors and risk ratings, among other assumptions. Migration and credit quality trends are assessed at the pool level, by comparing information from the latest evaluation period through the end of the reporting period.
The changes in the allowance for loan and lease losses on covered loans for the quarters and six-month periods ended June 30, 2013 and 2012 were as follows:
Balance at beginning of the period
52,974
56,437
37,256
1,210
1,882
FDIC shared-loss portion of provision for (recapture of)
covered loan and lease losses, net
(192)
724
(2,014)
Balance at end of the period
58,628
FDIC shared-loss portion of provision for (recapture of) covered loans and lease losses net, represents the credit impairment losses to be covered under the FDIC loss-share agreement which is increasing (decreasing) the FDIC loss-share indemnification asset.
Provision for covered loans and lease losses for the quarter and six-month period ended June 30, 2013 was $1.2 million and $1.9 million, respectively, reflecting the Company’s quarterly revision of the expected cash flows in the covered loan portfolio considering actual experiences and changes in the Company’s expectations for the remaining terms of the loan pools. During the quarter ended June 30, 2013, a commercial real estate loan pool underperformed, requiring additional allowance for the quarter. The six-month period ended June 30, 2013, is mainly affected by the aforementioned commercial real estate pool together with two pools of non-performing residential mortgage loans pools. The six-month period ended June 30, 2013 was benefited by the reversal of the allowance of pools of commercial and industrial loans and pools of commercial loans secured by real estate.
37
The Company’s recorded investment in covered loan pools that have recorded impairments and their related allowance for covered loan and lease losses as of June 30, 2013 and December 31, 2012 are as follows:
Impaired covered loan pools with specific allowance
51,613
36,483
7,072
19%
Construction and development secured by 1-4 family
residential properties
66,024
16,170
6,741
42%
242,054
75,941
39,504
52%
12,790
6,818
675
10%
Total investment in impaired covered loan pools
372,481
135,412
40%
45,208
29,482
4,986
17%
68,255
6,137
252,373
121,237
42,323
35%
14,494
678
380,330
174,397
31%
NOTE 6 — PREMISES AND EQUIPMENT
Premises and equipment at June 30, 2013 and December 31, 2012 are stated at cost less accumulated depreciation and amortization as follows:
Useful Life
(Years)
Land
—
5,677
2,876
Buildings and improvements
40
63,673
63,133
Leasehold improvements
5 — 10
23,637
23,602
Furniture and fixtures
3 — 7
11,685
10,441
Information technology and other
23,271
20,874
127,943
120,926
Less: accumulated depreciation and amortization
(43,642)
(35,929)
Depreciation and amortization of premises and equipment totaled $3.0 million and $6.1 million in the quarter and six-month period ended June 30, 2013, respectively, and $1.2 million and $2.4 million in the quarter and six-month period ended June 30, 2012, respectively. These are included in the unaudited consolidated statements of operations as part of occupancy and equipment expenses.
NOTE 7 — DERIVATIVE ACTIVITIES
During the quarter and six-month period ended June 30, 2013, gains of $1.6 million and $1.3 million, respectively, were recognized and reflected as “Derivative Activities” in the unaudited consolidated statements of operations, which were mainly related to the mortgage hedging activities. During the quarter and six-month period ended June 30, 2012, there were no significant transactions impacting the Company’s operations reflected as “Derivative Activities” in the unaudited consolidated statements of operations.
The following table details “Derivative Assets” and “Derivative Liabilities” as reflected in the unaudited consolidated statements of financial condition at June 30, 2013 and December 31, 2012:
Derivative assets:
Options tied to S&P 500 Index
16,020
13,233
Interest rate swaps not designated as hedges
3,245
8,426
Interest rate caps
270
230
120
Derivative liabilities:
Interest rate swaps designated as cash flow hedges
13,187
17,665
3,244
8,365
Interest Rate Swaps
The Company enters into interest rate swap contracts to hedge the variability of future interest cash flows of forecasted wholesale borrowings, attributable to changes in a predetermined variable index rate. The interest rate swaps effectively fix the Company’s interest payments on an amount of forecasted interest expense attributable to the variable index rate corresponding to the swap notional stated rate. These swaps are designated as cash flow hedges for the forecasted wholesale borrowings transactions and are properly documented as such, and therefore, qualify for cash flow hedge accounting. Any gain or loss associated with the effective portion of our cash flow hedges was recognized in other comprehensive income and is subsequently reclassified into earnings in the period during which the hedged forecasted transactions affect earnings. Changes in the fair value of these derivatives are recorded in accumulated other comprehensive income to the extent there is no significant ineffectiveness in the cash flow hedging relationships. Currently, the Company does not expect to reclassify any amount included in other comprehensive income related to these interest rate swaps to earnings in the next twelve months.
The following table shows a summary of these swaps and their terms at June 30, 2013:
Notional
Fixed
Variable
Trade
Settlement
Maturity
Type
Amount
Rate
Rate Index
Date
25,000
2.4365%
1-Month Libor
05/05/11
05/04/12
05/04/16
2.6200%
07/24/12
07/24/16
2.6350%
07/30/12
07/30/16
50,000
2.6590%
08/10/12
08/10/16
100,000
2.6750%
08/16/12
08/16/16
225,000
An unrealized loss of $13.2 million was recognized in accumulated other comprehensive income related to the valuation of these swaps at June 30, 2013, and the related liability is being reflected in the accompanying unaudited consolidated statements of financial condition.
At June 30, 2013 and December 31, 2012, interest rate swaps not designated as hedging instruments that were offered to clients represented an asset of $3.2 million and $8.4 million, respectively, and were included as part of derivative assets in the unaudited consolidated statements of financial position. The credit risk to these clients stemming from these derivatives, if any, is not material. At June 30, 2013 and December 31, 2012, interest rate swaps not designated as hedging instruments that are the mirror-images of the derivatives offered to clients represented a liability of $3.2 million and $8.4 million, respectively, and were included as part of derivative liabilities in the unaudited consolidated statements of financial condition.
The following table shows a summary of these interest rate swaps not designated as hedging instruments and their terms at June 30, 2013:
Interest Rate Swaps - Derivatives Offered to Clients
4,232
5.1300%
07/03/06
07/03/16
12,500
5.5050%
04/11/09
04/11/19
5.1500%
3-Month Libor
10/24/08
10/24/13
17,882
Interest Rate Swaps - Mirror Image Derivatives
4.9550%
Options Tied to Standard & Poor’s 500 Stock Market Index
The Company has offered its customers certificates of deposit with an option tied to the performance of the S&P 500 Index. The Company uses option agreements with major broker-dealers to manage its exposure to changes in this index. Under the terms of the option agreements, the Company receives the average increase in the month-end value of the index in exchange for a fixed premium. The changes in fair value of the option agreements used to manage the exposure in the stock market in the certificates of deposit are recorded in earnings. At June 30, 2013 and December 31, 2012, the purchased options used to manage exposure to the S&P 500 Index on stock indexed deposits represented an asset of $16.0 million (notional amount of $49.1 million) and $13.2 million (notional amount of $66.6 million), respectively, and the options sold to customers embedded in the certificates of deposit and recorded as deposits in the unaudited consolidated statements of financial condition, represented a liability of $15.3 million (notional amount of $42.9 million) and $12.7 million (notional amount of $62.3million), respectively.
The Company has entered into interest rate cap transactions with various clients with floating-rate debt who wish to protect their financial results against increases in interest rates. In these cases, the Company simultaneously enters into mirror-image interest rate cap transactions with financial counterparties. None of these cap transactions qualify for hedge accounting; therefore, they are marked to market through earnings. The outstanding total notional amount of interest rate caps was $94.0 million June 30, 2013 and December 31, 2012. At June 30, 2013, the interest rate caps sold to clients represented a liability of $270 thousand and were included as part of derivative liabilities in the unaudited consolidated statements of financial condition. At June 30, 2013, the interest rate caps purchased as mirror-images represented an asset of $270 thousand and were included as part of derivative assets in the unaudited consolidated statements of financial condition.
NOTE 8 — ACCRUED INTEREST RECEIVABLE AND OTHER ASSETS
Accrued interest receivable at June 30, 2013 and December 31, 2012 consists of the following:
Non-covered loans
11,459
10,533
6,049
7,021
Other assets at June 30, 2013 and December 31, 2012 consist of the following:
Prepaid FDIC insurance
6,451
Other prepaid expenses
23,568
19,674
Servicing advances
7,976
Mortgage tax credits
8,706
Core deposit and customer relationship intangibles
13,201
14,490
Investment in Statutory Trust
1,086
8,921
6,084
Accounts receivable and other assets
48,980
59,175
On November 12, 2009, the FDIC adopted a final rule requiring insured depository institutions to prepay on December 31, 2009 their estimated quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012, along with each institution’s risk-based deposit insurance assessment for the third quarter of 2009. The prepayment balance of the assessment amounted to $6.5 million at December 31, 2012. Pursuant to guidelines issued by the FDIC, the assessment due for the first quarter of 2013 paid on June 28, 2013 was offset by the amount of the credit for prepaid assessments.
Other prepaid expenses amounting to $23.6 million and $19.7 million at June 30, 2013 and December 31, 2012, respectively, include prepaid municipal, property and income taxes aggregating to $17.1 million and $12.0 million, respectively.
Servicing advances amounting to $8.0 million at December 31, 2012, represent the advances made to Bayview Loan Servicing, LLC in order to service some of the loans acquired in the FDIC-assisted acquisition of Eurobank. This servicing agreement was terminated effective May 31, 2013.
At June 30, 2013 and December 31, 2012, tax credits for the Company amounted $8.7 million. Mortgage loan tax credits acquired as part of the BBVAPR Acquisition amounted to $6.3 million and $7.4 million at June 30, 2013 and December 31, 2012, respectively. These tax credits do not have an expiration date.
As part of the FDIC-assisted acquisition of Eurobank and the recent BBVAPR Acquisition, the Company recorded a core deposit intangible representing the value of checking and savings deposits acquired. At June 30, 2013 and December 31, 2012, this core deposit intangible amounted to $8.6 million and $9.5 million, respectively. In addition, as part of the BBVAPR Acquisition on December 18, 2012, the Company recorded a customer relationship intangible amounting to $5.0 million representing the value of customer relationships acquired in the broker-dealer and insurance subsidiaries as of December 31, 2012. At June 30, 2013, this customer relationship intangible amounted to $4.6 million.
Other repossessed assets totaled $8.9 million and $6.1 million at June 30, 2013 and December 31, 2012, respectively. Repossessed auto loans acquired as part of the BBVAPR Acquisition amounted to $8.6 million and $5.9 million at June 30, 2013 and December 31, 2012, respectively.
NOTE 9 — DEPOSITS AND RELATED INTEREST
Total deposits as of June 30, 2013 and December 31, 2012 consist of the following:
Non-interest bearing demand deposits
872,806
799,667
Interest-bearing savings and demand deposits
2,331,589
2,282,305
Individual retirement accounts
352,637
376,611
Retail certificates of deposit
688,877
699,983
Institutional certificates of deposits
645,037
602,828
Total core deposits
4,890,946
4,761,394
Brokered deposits
774,092
928,165
The weighted average interest rate of the Company’s deposits was 0.73% at June 30, 2013 and 1.33% at December 31, 2012, inclusive of non-interest bearing deposits of $934.7 million and $799.7 million, respectively. Interest expense for the quarters and the six-month periods ended June 30, 2013 and 2012 was as follows:
Demand and savings deposits
5,435
2,848
11,397
6,024
4,538
5,037
9,054
10,984
At June 30, 2013 and December 31, 2012, demand and interest-bearing deposits and certificates of deposit included deposits of the Puerto Rico Cash & Money Market Fund Inc., which amounted to $93.3 million and $101.5 million, respectively, with a weighted average rate of 0.77% and 0.77%, and were collateralized with investment securities with a fair value of $68.3 million and $80.3 million, respectively.
At June 30, 2013 and December 31, 2012, time deposits in denominations of $100 thousand or higher, excluding accrued interest and unamortized discounts, amounted to $1.18 billion and $1.87 billion, including public fund time deposits from various Puerto Rico government municipalities, agencies, and corporations of $170.5 million and $78.3 million, respectively, at a weighted average rate of 0.48% at June 30, 2013 and 0.72% at December 31, 2012.
At June 30, 2013 and December 31, 2012, public fund deposits from various Puerto Rico government agencies were collateralized with investment securities with a fair value of $98.7million and $114.6 million, respectively, and with commercial loans amounting to $464.1 million at June 30, 2013 and $485.8 million at December 31, 2012.
Excluding equity indexed options in the amount of $15.3 million, which are used by the Company to manage its exposure to the S&P 500 Index, and also excluding accrued interest of $3.3 million and unamortized deposit discounts in the amount of $9.0 million, the scheduled maturities of certificates of deposit at June 30, 2013 are as follows:
Within one year:
Three (3) months or less
492,297
Over 3 months through 1 year
759,405
1,251,702
Over 1 through 2 years
634,600
Over 2 through 3 years
258,143
Over 3 through 4 years
143,128
Over 4 through 5 years
61,763
2,349,336
The aggregate amount of overdraft in demand deposit accounts that were reclassified to loans amounted to $1.0 million and $2.8 million as of June 30, 2013 and December 31, 2012, respectively.
NOTE 10 — BORROWINGS
At June 30, 2013, no short term borrowings were outstanding, compared to December 31, 2012 when these totaled $92.2 million and mainly consisted of unsecured fixed rate borrowings with a weighted average rate of 0.30%.
Securities Sold under Agreements to Repurchase
At June 30, 2013, 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 Company the same or similar securities at the maturity of the agreements.
At June 30, 2013 and December 31, 2012, securities sold under agreements to repurchase (classified by counterparty), excluding accrued interest in the amount of $2.3 million at both dates, were as follows:
Fair Value of
Borrowing
Underlying
Collateral
UBS Financial Services Inc.
597,126
616,751
JP Morgan Chase Bank NA
255,000
273,783
412,837
443,436
Credit Suisse Securities (USA) LLC
270,180
269,943
Deutsche Bank
271,702
273,288
Citigroup Global Markets Inc.
46,573
52,473
150,000
162,652
Barclays Bank
68,650
77,521
Wells Fargo
51,444
54,943
1,311,573
1,465,264
1,692,931
1,898,534
The following table shows a summary of the Company’s repurchase agreements and their terms, excluding accrued interest in the amount of $2.3 million, at June 30, 2013:
Weighted-
Year of Maturity
Coupon
Settlement Date
0.420%
6/25/2013
7/8/2013
2014
0.500%
12/13/2012
1/7/2014
0.550%
12/10/2012
6/13/2014
85,000
0.675%
12/3/2012
12/3/2014
170,000
12/6/2012
12/8/2014
765,000
2017
4.665%
3/2/2007
3/2/2017
2.129%
None of the structured repurchase agreements referred to above with maturity dates up to the date of this report were renewed.
Advances from the Federal Home Loan Bank
Advances are received from the FHLB under an agreement whereby the Company is required to maintain a minimum amount of qualifying collateral with a fair value of at least 110% of the outstanding advances. At June 30, 2013 and December 31, 2012, these advances were secured by mortgage and commercial loans amounting to $1.3 billion both periods. Also, at June 30, 2013, the Company had an additional borrowing capacity with the FHLB of $714.4 million. At June 30, 2013 and December 31, 2012, the weighted average remaining maturity of FHLB’s advances was 11.7 months and 3.5 months, respectively. The original terms of these advances range between one month and five years, and the FHLB does not have the right to exercise put options at par on any advances outstanding as of June 30, 2013.The following table shows a summary of these advances and their terms, excluding accrued interest in the amount of $294 thousand, at June 30, 2013:
0.360%
6/4/2013
7/5/2013
6/10/2013
7/10/2013
0.390%
6/17/2013
7/16/2013
0.400%
6/24/2013
7/24/2013
0.410%
6/28/2013
7/30/2013
4,844
1.240%
4/3/2012
4/3/2017
2018
30,000
2.187%
1/16/2013
1/16/2018
2.177%
55,000
284,844
0.745%
All of the advances referred to above with maturity dates up to the date of this report were renewed as one-month short-term advances.
44
Subordinated Capital Notes
Subordinated capital notes amounted to $99.0 million and $146.0 million at June 30, 2013 and December 31, 2012, respectively.
In August 2003, the Statutory Trust II, a special purpose entity of the Company, was formed for the purpose of issuing trust redeemable preferred securities. In September 2003, $35.0 million of trust redeemable preferred securities were issued by the Statutory Trust II as part of a pooled underwriting transaction. 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 this issuance were used by the Statutory Trust II to purchase a like amount of a floating rate junior subordinated deferrable interest debenture issued by the Company. The subordinated deferrable interest debenture has a par value of $36.1 million, bears interest based on 3-month LIBOR plus 295 basis points (3.22% at June 30, 2013; 3.26% at December 31, 2012), is payable quarterly, and matures on September 17, 2033. It may be called at par after five years and quarterly thereafter (next call date September 2013). The trust redeemable preferred securities have the same maturity and call provisions as the subordinated deferrable interest debenture. The subordinated deferrable interest debenture issued by the Company is accounted for as a liability denominated as a subordinated capital note on the unaudited consolidated statements of financial condition.
Under Federal Reserve Board rules, restricted core capital elements, which are qualifying trust preferred securities, qualifying cumulative perpetual preferred stock (and related surplus) and certain minority interests in consolidated subsidiaries, are limited in the aggregate to no more than 25% of a bank holding company’s core capital elements (including restricted core capital elements), net of goodwill less any associated deferred tax liability. However, under the Dodd-Frank Act, and the capital rules adopted in July 2013 by the federal banking regulators to implement the agreements reached by the Basel Committee on Banking Supervision in “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” and to make other changes consistent with the Dodd-Frank Act, which are scheduled to become effective January 1, 2015 (subject to certain phase-in periods through January 1, 2019), bank holding companies are prohibited from including in their Tier 1 capital hybrid debt and equity securities, including trust preferred securities, issued on or after May 19, 2010. Any such instruments issued before May 19, 2010 by a bank holding company, such as the Company, with total consolidated assets of less than $15 billion as of December 31, 2009, are permanently grandfathered under the new capital rules and may continue to be included as Tier 1 capital. Therefore, the Company is permitted to continue to include its existing trust preferred securities as Tier 1 capital.
As part of the BBVAPR Acquisition on December 18, 2012, the Company’s banking subsidiary assumed three subordinated capital notes issued by BBVAPR Bank consisting of the following:
· Subordinated capital notes issued in September 2004 amounting to $50.0 million at a variable rate of three-month LIBOR plus 1.44% (1.75% at December 31, 2012 ), that was due September 23, 2014. During the quarter ended March 31, 2013, the Bank repurchased and cancelled these subordinated capital notes in whole before maturity and realized a gain of $1.1 million in the Company’s unaudited consolidated statements of operations.
· Subordinated capital notes issued in September 2006 amounting to $37.0 million at a fixed rate of 5.76% through September 29, 2011, and three-month LIBOR plus 1.56% thereafter (1.83% at June 30, 2013; 1.87% at December 31, 2012), due September 29, 2016. Interest on these subordinated notes is payable quarterly during the floating-rate period. The Bank has the option to redeem these subordinated capital notes in whole or in part from time to time before maturity at 100% of the principal amount plus any accrued but unpaid interest to the date of redemption, beginning September 29, 2011, and at each payment date thereafter.
· Subordinated capital notes issued in September 2006 amounting to $30.0 million at a variable rate of three-month LIBOR plus 1.56% thereafter ( 1.83% at June 30, 2013; 1.87% at December 31, 2012), due September 29, 2016. Interest on these subordinated notes is payable quarterly. The Bank has the option to redeem these subordinated capital notes in whole or in part from time to time before maturity at 100% of the principal amount plus any accrued but unpaid interest to the date of redemption, beginning September 29, 2011, and at each payment date thereafter.
These notes qualify as Tier 2 capital at a discounted rate, which totals $40.2 million at June 30, 2013 and $50.2 million at December 31, 2012. Generally speaking, subordinated notes are included as Tier 2 capital if they have an original weighted average maturity of at least 5 years and comply with certain other requirements. As the notes approach maturity, they begin to take on characteristics of a short term obligation. For this reason, the outstanding amount eligible for inclusion in Tier 2 capital is reduced, or discounted, as the instruments approach maturity: one fifth of the outstanding amount is excluded each year during the instruments last five years before maturity. When the remaining maturity is less than one year, the instrument is excluded from Tier 2 capital.
Under the requirements of Puerto Rico Banking Act, the Bank must establish a redemption fund for the subordinated capital notes by transferring from undivided profits pre-established amounts as follows:
Redemption fund
48,575
6,700
2015
2016
5,025
67,000
Other borrowings, presented in the unaudited consolidated statements of financial condition within “Advances from FHLB and other borrowings”, amounted to $37.2 million and $17.6 million at June 30, 2013 and December 31, 2012, respectively. These borrowings mainly consists of federal funds purchased of $29.4 million and $9.9 million at June 30, 2013 and December 31, 2012, respectively, with a weighted average interest rate of 0.30% at both dates, and unsecured fixed-rate borrowings of $7.7 million at both June 30, 2013 and December 31, 2012, with a weighted average interest rate of 0.67% at both dates.
NOTE 11 — RELATED PARTY TRANSACTIONS
The Bank grants loans to its directors, executive officers and to certain related individuals or organizations in the ordinary course of business. These loans are offered at the same terms as loans to unrelated third parties. As of June 30, 2013 and December 31, 2012, these loan balances amounted to $8.0 million and $6.1 million, respectively. The activity and balance of these loans for the quarters and six-month periods ended June 30, 2013 and 2012 were as follows:
Balance at the beginning of period
8,688
5,238
6,055
3,772
New loans
4,234
1,505
Repayments
(657)
(180)
(2,026)
(219)
Credits of persons no longer
considered related parties
(232)
Balance at the end of period
5,058
NOTE 12 — INCOME TAXES
On June 30, 2013 the Governor signed Act No. 40 known as “Ley de Redistribución y Ajuste de la Carga Contributiva” (Act of Redistribution and Adjustment of Tax Burden). This Act, along with others signed by the Governor, comprises the budget of the Commonwealth of Puerto Rico for 2013-2014. The main purpose of the Act is to increase government collections in order to alleviate the structural deficit. The most relevant provisions of the Act, as applicable to the Company, and effective for taxable years beginning after December 31,2012 are as follows: (1) the maximum Corporate Income Tax rate was increased from 30% to 39%; (2) the allowance deduction for determining the income subject to surtax was reduced from $750,000 to $75,000 (which must be allocated among the members of a controlled group of corporations; (3) the allowable Net Operating Loss (“NOL”) deduction was reduced to (i) 90% of the corporation’s net income subject to regular tax, for purposes of computing the regular income tax and (ii) 80% of the alternative minimum taxable income for purposes of computing the alternative minimum tax (“AMT”); (4) the NOL carryover period was extended from 10 to 12 years for NOLs incurred after December 31, 2012; (5) a new special tax based on gross income (the “Special Tax”) was added to the Puerto Rico Internal Revenue Code of 2011, as further described below; and (6) a special tax of 1% on insurance premiums earned after June 30, 2013.
In the case of non-financial institutions, the Special Tax is paid as part of the AMT and thus is accounted for under the provisions of ASC 740. The applicable rate for non-financial institutions increases gradually from 0.2% for gross income in excess of $1.0 million up to 0.85% for gross income in excess of $1.5 billion. In the case of a controlled group of corporations, the tax rate for all members of the group is determined by the aggregate gross income of all members in the group. In the case of financial institutions, the Special Tax is not part of the AMT calculation thus is accounted for as other tax not subject to the provisions of ASC 740 since the same is based on gross income. The applicable rate for financial institutions is 1%, of which fifty percent (50%) may be claimed as a credit against the financial institution’s applicable income tax.
At June 30, 2013 and December 31, 2012, the Company’s net deferred tax asset amounted to $155.2 million and $122.5 million, respectively. Income tax benefit for the quarter and six-month periods ended June 30, 2013 totaled $31.9 million and $24.8 million, respectively. The benefit of both periods is related to the positive effect on the deferred tax asset of the increase in the enacted tax rate from 30% to 39%. Income tax expense for the quarter and six-month period ended June 30, 2012 totaled $1.1 million and $3.0 million, respectively.
At June 30, 2013 and December 31, 2012, OIB had $415 thousand and $504 thousand, respectively, in the income tax effect of unrecognized gain on available-for-sale securities included in other comprehensive income. Following the change in OIB’s applicable tax rate from 5% to 0% as a result of a Puerto Rico law adopted in 2011, this remaining tax balance will flow through income as these securities are repaid or sold in future periods. During the quarters ended June 30, 2013 and 2012, $43 thousand and $166 thousand, respectively, related to this residual tax effect from OIB was reclassified from accumulated other comprehensive income into income tax provision. During the six-month periods ended June 30, 2013 and 2012, $89 thousand and $724 thousand, respectively, related to this residual effect from OIB was reclassified from accumulated other comprehensive income to income tax provision.
The Company maintained an effective tax rate for the six-month period ended June 30, 2013 lower than the new maximum marginal statutory rate of 39.00%. The reconciliation of the enacted tax rate and the effective income tax rate for the six-month period ended June 30, 2013 follows:
Tax at statutory rates
13,230
39.00%
Tax effect of exempt income, net
(3,607)
-10.63%
Effect in deferred taxes due to increase in tax rates
from 30.00% to 39.00%
(36,928)
-108.85%
Other items, net
2,497
7.35%
Income tax benefit
-73.13%
The Company classifies unrecognized tax benefits in income taxes payable. These gross unrecognized tax benefits would affect the effective tax rate if realized. The balance of unrecognized tax benefits at June 30, 2013 was $5.6 million (December 31, 2012 - $5.3 million). The Company had accrued $1.7 million at June 30, 2013 (December 31, 2012 - $1.4 million) for the payment of interest and penalties relating to unrecognized tax benefits. As part of the BBVAPR Acquisition, there are unrecognized tax benefits amounting to $3.9 million at June 30, 2013 and December 31, 2012. There is also $812 thousand (December 31, 2012 - $665 thousand) in accrued payment of interest and penalties relating to unrecognized tax benefits.
NOTE 13 — STOCKHOLDERS’ EQUITY AND EARNINGS PER COMMON SHARE
Regulatory Capital Requirements
The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by federal and Puerto Rico banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Pursuant to the Dodd-Frank Act, federal banking regulators have adopted new capital rules that are scheduled to become effective January 1, 2015 (subject to certain phase-in periods through January 1, 2019) and that will replace their general risk-based capital rules, advanced approaches rule, market risk rule, and leverage rules.
Quantitative measures established by regulation to ensure capital adequacy currently require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined in the regulations) and of Tier 1 capital to average assets (as defined in the regulations). As of June 30, 2013 and December 31, 2012, the Company and the Bank met all capital adequacy requirements to which they are subject. As of June 30, 2013 and December 31, 2012, the Bank is “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well capitalized,” an institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following tables.
The Company’s and the Bank’s actual capital amounts and ratios as of June 30, 2013 and December 31, 2012 are as follows:
Minimum Capital
Actual
Requirement
Ratio
Company Ratios
As of June 30, 2013
Total capital to risk-weighted assets
807,190
15.83%
407,818
8.00%
Tier 1 capital to risk-weighted assets
702,801
13.79%
203,909
Tier 1 capital to total assets
8.54%
329,223
As of December 31, 2012
794,195
15.15%
419,269
678,127
12.94%
209,634
6.42%
422,307
Minimum to be Well
Capitalized Under Prompt
Corrective Action
Provisions
Bank Ratios
743,653
15.01%
396,291
495,363
10.00%
641,043
198,145
297,218
6.00%
7.84%
327,058
408,823
5.00%
719,675
14.03%
410,268
512,835
604,997
11.80%
205,134
307,701
5.76%
420,298
525,373
Additional paid-in capital represents contributed capital in excess of par value of common and preferred stock net of costs of the issuance. As of June 30, 2013, accumulated issuance costs charged against additional paid in capital amounted to $10.1 million and $13.6 million for preferred and common stock, respectively.
Legal Surplus
The Puerto Rico Banking Act requires that a minimum of 10% of the Bank’s net income for the year be transferred to a reserve fund until such fund (legal surplus) equals the total paid in capital on common and preferred stock. At June 30, 2013 and December 31, 2012, the Bank’s legal surplus amounted to $57.9 million and $52.1 million, respectively. The amount transferred to the legal surplus account is not available for the payment of dividends to shareholders.
Earnings per Common Share
The calculation of earnings per common share for the quarters and six-month periods ended June 30, 2013 and 2012 is as follows:
Less: Dividends on preferred stock
Non-Convertible Preferred Stock (Series A, B, and D)
(1,629)
(3,256)
Convertible preferred stock (Series C)
(1,837)
(3,675)
Effect of assumed conversion of the Convertible ' 'Preferred Stock
1,837
3,675
Income available to common shareholders assuming conversion
35,910
55,475
Weighted average common shares and share equivalents:
Average common shares outstanding
45,630
40,703
45,613
40,873
Effect of dilutive securities:
Average potential common shares-options
200
105
Average potential common shares-assuming ' 'conversion of convertible preferred stock
7,138
Total weighted average common shares ' 'outstanding and equivalents
Earnings per common share - basic
Earnings per common share - diluted
In computing diluted earnings per common share, the 84,000 shares of convertible preferred stock, which remained outstanding at June 30, 2013, with a conversion rate, subject to certain conditions, of 84.9798 shares of common stock per share, were included as average potential common shares from the date they were issued and outstanding. Moreover, in computing diluted earnings per common share, the dividends declared during the quarter and six-month period ended June 30, 2013 on the convertible preferred stock were added back as income available to common shareholders.
For the quarters ended June 30, 2013 and 2012, weighted-average stock options with an anti-dilutive effect on earnings per share not included in the calculation amounted to 243,721 and 708,976, respectively. For the six-month periods ended June 30, 2013 and 2012, weighted-average stock options with an anti-dilutive effect on earnings per share not included in the calculation amounted to 578,393 and 707,143, respectively.
50
Treasury Stock
Repurchased common stock is held by the Company as treasury shares. The Company records treasury stock purchases under the cost method whereby the entire cost of the acquired stock is recorded as treasury stock.
The activity in connection with common shares held in treasury by the Company for the six-month periods ended June 30, 2013 and 2012 is set forth below:
Dollar
Shares
(In thousands, except shares data)
Beginning of period
7,090,597
81,275
6,564,124
74,808
Common shares used upon lapse of restricted stock units
(34,800)
(37,446)
Common shares repurchased as part of the stock repurchase program
603,000
7,022
Common shares used to match defined
contribution plan, net
(7,318)
(77)
(18,898)
(35)
End of period
7,048,479
80,834
7,110,780
81,403
Accumulated Other Comprehensive Income
Accumulated other comprehensive income, net of income tax, as of June 30, 2013 and December 31, 2012 consisted of:
Unrealized gain on securities available-for-sale which are not
other-than-temporarily impaired
28,779
75,347
Income tax effect of unrealized gain on securities available-for-sale
(3,379)
(7,102)
Net unrealized gain on securities available-for-sale which are not
25,400
68,245
Unrealized loss on cash flow hedges
(13,187)
(17,664)
Income tax effect of unrealized loss on cash flow hedges
3,553
5,299
Net unrealized loss on cash flow hedges
(9,634)
(12,365)
51
The following table presents changes in accumulated other comprehensive income by component, net of taxes, for the quarter and the six-month period ended June 30, 2013:
Net unrealized
Accumulated
gains on
loss on
other
securities
cash flow
comprehensive
available-for-sale
hedges
income
Beginning balance
58,393
(11,342)
47,051
Other comprehensive income before reclassifications
(33,036)
292
(32,744)
(42,934)
(21)
(42,955)
Amounts reclassified out of accumulated other comprehensive income
1,416
1,459
2,752
2,841
Other comprehensive income (loss)
(32,993)
1,708
(42,845)
2,731
Ending balance
The following table presents reclassifications out of accumulated other comprehensive income for the quarter and six-month period ended June 30, 2013:
Six-Month Period
Affected Line Item in
Quarter Ended
Ended
Consolidated Statement
of Operations
Cash flow hedges:
Interest-rate contracts
Net interest expense
Available-for-sale securities:
Residual tax effect from OIB's change in applicable tax rate
Income tax expense
At June 30, 2013 and December 31, 2012, OIB had $415 thousand and $504 thousand, respectively, in the income tax effect of unrecognized gain on available-for-sale securities included in other comprehensive income. Following the change in OIB’s applicable tax rate from 5% to 0% as a result of a new Puerto Rico law adopted in 2011, this remaining tax balance will flow through income as these securities are repaid or sold in future periods.
52
NOTE 14 — COMMITMENTS
Loan Commitments
In the normal course of business, the Company becomes a party to credit-related financial instruments with off-balance-sheet risk to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby and commercial letters of credit, and financial guarantees. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the unaudited consolidated statements of financial condition. The contract or notional amount of those instruments reflects the extent of the Company’s involvement in particular types of financial instruments.
The Company’s exposure to credit losses in the event of nonperformance by the counterparty to the financial instrument for commitments to extend credit, including commitments under credit card arrangements, and commercial letters of credit is represented by the contractual notional amount of those instruments, which do not necessarily represent the amounts potentially subject to risk. In addition, the measurement of the risks associated with these instruments is meaningful only when all related and offsetting transactions are identified. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Summarized credit-related financial instruments at June 30, 2013 and December 31, 2012 were as follows:
Commitments to extend credit
445,411
591,679
Commercial letters of credit
2,918
Commitments from loans acquired as part of the BBVAPR Acquisition amounted to $337.1 million and $461.6 million at June 30, 2013 and December 31, 2012, respectively. Commitments to extend credit represent agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if it is deemed necessary by the Company upon the extension of credit, is based on management’s credit evaluation of the counterparty.
At June 30, 2013 and December 31, 2012, commitments to extend credit consisted mainly of undisbursed available amounts on commercial lines of credit, construction loans, and revolving credit card arrangements. Since many of the unused commitments are expected to expire unused or be only partially used, the total amount of these unused commitments does not necessarily represent future cash requirements. These lines of credit had a reserve of $900 thousand at both June 30, 2013 and December 31, 2012.
Commercial letters of credit are issued or confirmed to guarantee payment of customers’ payables or receivables in short-term international trade transactions. Generally, drafts will be drawn when the underlying transaction is consummated as intended. However, the short-term nature of this instrument serves to mitigate the risk associated with these contracts.
The summary of instruments that are considered financial guarantees in accordance with the authoritative guidance related to guarantor’s accounting and disclosure requirements for guarantees, including indirect guarantees of indebtedness of others, at June 30, 2013 and December 31, 2012, is as follows:
Standby letters of credit and financial guarantees
67,087
69,789
Loans sold with recourse
184,937
172,492
Commitments to sell or securitize mortgage loans
10,977
83,663
Standby letters of credit and financial guarantees are written conditional commitments issued by the Company to guarantee the payment and/or performance of a customer to a third party (“beneficiary”). If the customer fails to comply with the agreement, the beneficiary may draw on the standby letter of credit or financial guarantee as a remedy. The amount of credit risk involved in issuing letters of credit in the event of nonperformance is the face amount of the letter of credit or financial guarantee. These guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The amount of collateral obtained, if it is deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the customer. The Company does not expect any significant losses under these obligations. As of June 30, 2013 and December 31, 2012, no performance was required on any financial guarantees. As part of the BBVAPR Acquisition, the Company assumed $65.9 million of standby letters of credit and $169.3 million of loans sold without recourse commitments at December 31, 2012.
Lease Commitments
The Company has entered into various operating lease agreements for branch facilities and administrative offices. Rent expense for the quarters ended June 30, 2013 and 2012 amounted to $2.6 million and $1.6 million, respectively, and is included in the “occupancy and equipment” caption in the unaudited consolidated statements of operations. For the six-month periods ended June 30, 2013 and 2012, rent expense amounted to $5.2 million and $3.3 million, respectively. Future rental commitments under leases in effect at June 30, 2013, exclusive of taxes, insurance, and maintenance expenses payable by the Company, are summarized as follows:
Year Ending June 30,
Minimum Rent
5,332
8,402
8,116
7,492
7,965
Thereafter
62,062
54
NOTE 15 — CONTINGENCIES
The Company and its subsidiaries are defendants in a number of legal proceedings incidental to their business. In the ordinary course of business, the Company and its subsidiaries are also subject to governmental and regulatory examinations. Certain subsidiaries of the Company, including the Bank (and its subsidiary OIB), Oriental Financial Services, OFS Securities and Oriental Insurance, are subject to regulation by various U.S., Puerto Rico and other regulators.
The Company seeks to resolve all litigation and regulatory matters in the manner management believes is in the best interests of the Company and its shareholders, and contests allegations of liability or wrongdoing and, where applicable, the amount of damages or scope of any penalties or other relief sought as appropriate in each pending matter.
Subject to the accounting and disclosure framework under the provisions of ASC 450, it is the opinion of the Company’s management, based on current knowledge and after taking into account its current legal accruals, that the eventual outcome of all matters would not be likely to have a material adverse effect on the unaudited consolidated statements of financial condition of the Company. Nonetheless, given the substantial or indeterminate amounts sought in certain of these matters, and the inherent unpredictability of such matters, an adverse outcome in certain of these matters could, from time to time, have a material adverse effect on the Company’s unaudited consolidated results of operations or cash flows in particular quarterly or annual periods. The Company has evaluated all litigation and regulatory matters where the likelihood of a potential loss is deemed reasonably possible. The Company has determined that the estimate of the reasonably possible loss is not significant.
NOTE 16 - FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company follows the fair value measurement framework under GAAP.
Fair Value Measurement
The fair value measurement framework defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. This framework also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs previously described that may be used to measure fair value.
The fair value of money market investments is based on the carrying amounts reflected in the unaudited consolidated statements of financial condition as these are reasonable estimates of fair value given the short-term nature of the instruments.
The fair value of investment securities is based on quoted market prices, when available, or market prices provided by recognized broker-dealers. If listed prices or quotes are not available, fair value is based upon externally developed models that use both observable and unobservable inputs depending on the market activity of the instrument. The Company holds two securities categorized as other debt that are classified as Level 3. The estimated fair value of the other debt securities is determined by using a third-party model to calculate the present value of projected future cash flows. The assumptions are highly uncertain and include primarily market discount rates, current spreads, and an indicative pricing. The assumptions used are drawn from similar securities that are actively traded in the market and have similar characteristics as the collateral underlying the debt securities being evaluated. The valuation is performed on a monthly basis.
Derivative instruments
The fair value of the interest rate swaps is largely a function of the financial market’s expectations regarding the future direction of interest rates. Accordingly, current market values are not necessarily indicative of the future impact of derivative instruments on earnings. This will depend, for the most part, on the shape of the yield curve, the level of interest rates, as well as the expectations for rates in the future. The fair value of most of these derivative instruments is based on observable market parameters, which include discounting the instruments’ cash flows using the U.S. dollar LIBOR-based discount rates, and also applying yield curves that account for the industry sector and the credit rating of the counterparty and/or the Company.
Certain other derivative instruments with limited market activity are valued using externally developed models that consider unobservable market parameters. Based on their valuation methodology, derivative instruments are classified as Level 2 or Level 3. The Company has offered its customers certificates of deposit with an option tied to the performance of the S&P Index and uses equity indexed option agreements with major broker-dealers to manage its exposure to changes in this index. Their fair value is obtained through the use of an external based valuation that was thoroughly evaluated and adopted by management as its measurement tool for these options. The payoff of these options is linked to the average value of the S&P Index on a specific set of dates during the life of the option. The methodology uses an average rate option or a cash-settled option whose payoff is based on the difference between the expected average value of the S&P Index during the remaining life of the option and the strike price at inception. The assumptions, which are uncertain and require a degree of judgment, include primarily S&P Index volatility, forward interest rate projections, estimated index dividend payout, and leverage.
Servicing assets do not trade in an active market with readily observable prices. Servicing assets are priced using a discounted cash flow model. The valuation model considers servicing fees, portfolio characteristics, prepayment assumptions, delinquency rates, late charges, other ancillary revenues, cost to service and other economic factors. Due to the unobservable nature of certain valuation inputs, the servicing rights are classified as Level 3.
Loans receivable considered impaired that are collateral dependent
The impairment is measured based on the fair value of the collateral, which is derived from appraisals that take into consideration prices in observed transactions involving similar assets in similar locations, in accordance with the provisions of ASC 310-10-35. Currently, the associated loans considered impaired are classified as Level 3.
Foreclosed real estate includes real estate properties securing residential mortgage and commercial loans. The fair value of foreclosed real estate may be determined using an external appraisal, broker price option or an internal valuation. These foreclosed assets are classified as Level 3 given certain internal adjustments that may be made to external appraisals.
Assets and liabilities measured at fair value on a recurring and non-recurring basis, including financial liabilities for which the Company has elected the fair value option, are summarized below:
Fair Value Measurements
Level 1
Level 2
Level 3
Recurring fair value measurements:
1,816,172
20,057
3,635
(16,701)
(15,315)
(32,016)
1,803,106
33,756
1,847,845
Non-recurring fair value measurements:
Impaired commercial loans
81,689
125,520
2,174,274
20,012
8,656
(26,260)
(12,707)
(38,967)
2,236,670
31,333
2,281,208
75,447
121,646
57
The table below presents a reconciliation of all assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the quarters and the six-month periods ended June 30, 2013 and 2012:
Derivative
asset
liability
debt
(S&P
Purchased
Servicing
Embedded
Level 3 Instruments Only
Options)
assets
20,042
15,404
11,543
(14,839)
32,150
Gains (losses) included in earnings
616
(516)
100
Changes in fair value of investment
securities available for sale included
in other comprehensive income
New instruments acquired
1,301
Principal repayments
(489)
Amortization
Changes in fair value of servicing assets
639
33,757
CLOs
29,643
9,882
12,515
10,725
(12,138)
50,627
(1,148)
1,119
(29)
(2,381)
(2,247)
499
(241)
(223)
(207)
27,280
10,016
11,367
10,776
(10,912)
48,527
58
2,787
(2,923)
(136)
1,994
(557)
762
CDOs
26,758
10,024
9,317
10,454
(9,362)
57,721
2,050
(2,035)
488
(7)
481
919
(476)
(442)
(1)
485
484
Sales of instruments
(10,530)
(121)
During the quarters and the six-month periods ended June 30, 2013 and 2012, there were purchases and sales of assets and liabilities measured at fair value on a recurring basis. There were no transfers into and out of Level 1 and Level 2 fair value measurements during such periods.
59
The table below presents quantitative information for all assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at June 30, 2013:
Valuation Technique
Unobservable Input
Range
available-for-sale:
Market comparable bonds
Indicative pricing
97.50% - 100.50%
Option adjusted spread
289.1% - 469.2%
Yield to maturity
3.060% - 5.101%
Spread to maturity
288.7% - 470.2%
Derivative assets (S&P
Purchased Options)
Option pricing model
Implied option volatility
24.82% - 39.16%
Counterparty credit risk
(based on 5-year credit
default swap ("CDS")
spread)
100.28% - 174.12%
Cash flow valuation
Constant prepayment rate
8.41% - 26.96%
Discount rate
10.50% - 13.50%
Derivative liability (S&P
Embedded Options)
Counterparty credit risk (based on 5-year CDS spread)
Collateral dependant
impaired loans
Fair value of property
or collateral
Appraised value
Not meaningful
Information about Sensitivity to Changes in Significant Unobservable Inputs
Other debt securities – The significant unobservable inputs used in the fair value measurement of one of the Company’s other debt securities are indicative comparable pricing, option adjusted spread (“OAS”), yield to maturity, and spread to maturity. Significant changes in any of those inputs in isolation would result in a significantly different fair value measurement. Generally, a change in the assumption used for indicative comparable pricing is accompanied by a directionally opposite change in the assumption used for OAS and a directionally, although not equally proportional, opposite change in the assumptions used for yield to maturity and spread to maturity.
Derivative asset (S&P Purchased Options) – The significant unobservable inputs used in the fair value measurement of Company’s derivative assets related to S&P purchased options are implied option volatility and counterparty credit risk. Significant changes in any of those inputs in isolation would result in a significantly different fair value measurement. Generally, a change in the assumption used for implied option volatility is not necessarily accompanied by directionally similar or opposite changes in the assumption used for counterparty credit risk.
Servicing assets – The significant unobservable inputs used in the fair value measurement of the Company’s servicing assets are constant prepayment rates and discount rates. Changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments), which may magnify or offset the sensitivities. Mortgage banking activities, a component of total banking and financial service revenue in the unaudited consolidated statements of operations, include the changes from period to period in the fair value of the mortgage loan servicing rights, which may result from changes in the valuation model inputs or assumptions (principally reflecting changes in discount rates and prepayment speed assumptions) and other changes, including changes due to collection/realization of expected cash flows.
Derivative liability (S&P Embedded Options)– The significant unobservable inputs used in the fair value measurement of the Company’s derivative liability related to S&P purchased options are implied option volatility and counterparty credit risk. Significant changes in any of those inputs in isolation would result in a significantly different fair value measurement. Generally, a change in the assumption used for implied option volatility is not necessarily accompanied by directionally similar or opposite changes in the assumption used for counterparty credit risk.
The table below presents a detail of investment securities available-for-sale classified as Level 3 at June 30, 2013:
Gains (Losses)
Protection
3.50%
Fair Value of Financial Instruments
The information about the estimated fair value of financial instruments required by GAAP is presented hereunder. The aggregate fair value amounts presented do not necessarily represent management’s estimate of the underlying value of the Company.
The estimated fair value is subjective in nature, involves uncertainties and matters of significant judgment, and therefore, cannot be determined with precision. Changes in assumptions could affect these fair value estimates. The fair value estimates do not take into consideration the value of future business and the value of assets and liabilities that are not financial instruments. Other significant tangible and intangible assets that are not considered financial instruments are the value of long-term customer relationships of retail deposits, and premises and equipment.
The estimated fair value and carrying value of the Company’s financial instruments at June 30, 2013 and December 31, 2012 is as follows:
Carrying
Financial Assets:
1,816,171
Federal Home Loan Bank (FHLB) stock
Financial Liabilities:
Total loans (including loans held-for-sale)
Non-covered loans, net
4,600,628
4,766,179
Covered loans, net
449,113
489,885
173,442
204,646
5,688,574
5,797,097
1,353,970
1,741,272
Advances from FHLB
283,443
285,135
538,355
536,542
Federal funds purchased
29,431
9,901
Term notes
7,734
7,912
98,008
146,415
62
The following methods and assumptions were used to estimate the fair values of significant financial instruments at June 30, 2013 and December 31, 2012:
• Cash and cash equivalents (including money market investments and time deposits with other banks), accrued interest receivable, securities purchased under agreements to resell, securities sold but not yet delivered, accrued expenses and other liabilities have been valued at the carrying amounts reflected in the unaudited consolidated statements of financial condition as these are reasonable estimates of fair value given the short-term nature of the instruments.
• Investments in FHLB stock are valued at their redemption value.
• The fair value of investment securities, including trading securities, is based on quoted market prices, when available, or market prices provided by recognized broker-dealers. If listed prices or quotes are not available, fair value is based upon externally developed models that use both observable and unobservable inputs depending on the market activity of the instrument. The estimated fair value of the structured credit investments is determined by using a third-party cash flow valuation model to calculate the present value of projected future cash flows. The assumptions used which are highly uncertain and require a high degree of judgment, include primarily market discount rates, current spreads, duration, leverage, default, home price depreciation, and loss rates. The assumptions used are drawn from a wide array of data sources, including the performance of the collateral underlying each deal. The external-based valuation, which is obtained at least on a quarterly basis, is analyzed and its assumptions are evaluated and incorporated in either an internal-based valuation model when deemed necessary, or compared to counterparties’ prices and agreed by management.
• The fair value of the FDIC shared-loss indemnification asset represents the present value of the estimated cash payments (net of amounts owed to the FDIC) expected to be received from the FDIC for future losses on covered assets based on the credit assumptions on estimated cash flows for each covered asset pool and the loss sharing percentages. The ultimate collectability of the FDIC shared-loss indemnification asset is dependent upon the performance of the underlying covered loans, the passage of time and claims paid by the FDIC which are impacted by the Bank’s adherence to certain guidelines established by the FDIC.
• The fair value of servicing assets is estimated by using a cash flow valuation model which calculates the present value of estimated future net servicing cash flows, taking into consideration actual and expected loan prepayment rates, discount rates, servicing costs, and other economic factors, which are determined based on current market conditions.
• The fair values of the derivative instruments are provided by valuation experts and counterparties. Certain derivatives with limited market activity are valued using externally developed models that consider unobservable market parameters. The Company has offered its customers certificates of deposit with an option tied to the performance of the S&P Index, and uses equity indexed option agreements with major broker-dealers to manage its exposure to changes in this index. Their fair value is obtained through the use of an external based valuation that was thoroughly evaluated and adopted by management as its measurement tool for these options. The payoff of these options is linked to the average value of the S&P Index on a specific set of dates during the life of the option. The methodology uses an average rate option or a cash-settled option whose payoff is based on the difference between the expected average value of the S&P Index during the remaining life of the option and the strike price at inception. The assumptions, which are uncertain and require a degree of judgment, include primarily S&P Index volatility, forward interest rate projections, estimated index dividend payout, and leverage.
• Fair value of derivative liabilities, which include interest rate swaps and forward-settlement swaps, are based on the net discounted value of the contractual projected cash flows of both the pay-fixed receive-variable legs of the contracts. The projected cash flows are based on the forward yield curve, and discounted using current estimated market rates.
• The fair value of the covered and non-covered loan portfolio (including loans held-for-sale) is estimated by segregating by type, such as mortgage, commercial, consumer, and leasing. Each loan segment is further segmented into fixed and adjustable interest rates and by performing and non-performing categories. The fair value of performing loans is calculated by discounting contractual cash flows, adjusted for prepayment estimates (voluntary and involuntary), if any, using estimated current market discount rates that reflect the credit and interest rate risk inherent in the loan. This fair value is not currently an indication of an exit price as that type of assumption could result in a different fair value estimate.
• The fair value of demand deposits and savings accounts is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is based on the discounted value of the contractual cash flows, using estimated current market discount rates for deposits of similar remaining maturities.
• For short term borrowings and federal funds purchased, the carrying amount is considered a reasonable estimate of fair value. The fair value of long-term borrowings, which include securities sold under agreements to repurchase, advances from FHLB, FDIC-guaranteed term notes, other term notes, and subordinated capital notes, is based on the discounted value of the contractual cash flows using current estimated market discount rates for borrowings with similar terms, remaining maturities and put dates.
• The fair value of commitments to extend credit and unused lines of credit is based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standings.
NOTE 17 — OFFSETTING ARRANGEMENTS
The Company manages credit and counterparty risk by entering into enforceable netting agreements and other collateral arrangements with counterparties to derivative financial instruments and secured financing transactions, including resale and repurchase agreements, and principal securities borrowing and lending agreements. These netting agreements mitigate counterparty credit risk by providing for a single net settlement with a counterparty of all financial transactions covered by the agreement in an event of default as defined under such agreement. In limited cases, a netting agreement may also provide for the periodic netting of settlement payments with respect to multiple different transaction types in the normal course of business.
Certain of the Company derivative contracts are executed under either standardized netting agreements or, for exchange-traded derivatives, the relevant contracts for a particular exchange which contain enforceable netting provisions. In certain cases, the Company may have cross-product netting arrangements which allow for netting and set-off of a variety of types of derivatives with a single counterparty. A derivative netting arrangement creates an enforceable right of set-off that becomes effective, and affects the realization or settlement of individual financial assets and liabilities, only following a specified event of default. Collateral requirements associated with the derivative contracts are determined after a review of the creditworthiness of each counterparty, and the requirements are monitored and adjusted daily, typically based on net exposure by counterparty. Collateral is generally in the form of cash or highly liquid U.S. government securities.
In connection with the Company’s secured financing activities, the Company enters into netting agreements and other collateral arrangements with counterparties, which provide for the right to liquidate collateral upon an event of default. Required collateral is generally in the form of cash, equities or fixed-income securities. Default events may include the failure to timely make payments or deliver securities, material adverse changes in financial condition or insolvency, the breach of minimum regulatory capital requirements, or loss of license, charter or other legal authorization necessary to perform under the contract.
In order for an arrangement to be eligible for netting, the Company must have a basis to conclude that such netting arrangements are legally enforceable. The analysis of the legal enforceability of an arrangement differs by jurisdiction, depending on the laws of that jurisdiction. In many jurisdictions, specific legislation exists that provides for the enforceability in bankruptcy of close-out netting under a netting agreement, typically by way of specific exception from more general prohibitions on the exercise of creditor rights.
Even though the Company has enforceable netting arrangements, they do not meet the applicable offsetting criteria, and therefore are not offset in the unaudited consolidated statements of financial condition. In addition, the Company does not offset secured financing assets and liabilities.
The following table presents derivative financial instruments and secured financing transactions that are subject to enforceable netting arrangements, but do not meet the applicable offsetting criteria and therefore were not offset in our unaudited consolidated statements of financial condition, as of the dates indicated:
Net amount of
Assets Presented
in Statement
Cash
of Financial
Financial
Net
Condition
Instruments
Received
Resale agreements and securities borrowings
101,889
(1) Excludes the impact of non-cash collateral. These secured financing transactions are fully collateralized.
The following table presents derivative financial instruments and secured financing transactions subject to enforceable netting arrangements that do not meet the applicable offsetting criteria and therefore were not offset in our unaudited consolidated statements of financial condition, as of the dates indicated:
Presented
Provided
19,534
Repurchase agreements and securities lending
1,331,107
21,302
1,714,233
NOTE 18 – BUSINESS SEGMENTS
The Company segregates its businesses into the following major reportable segments of business: Banking, Financial Services, and Treasury. Management established the reportable segments based on the internal reporting used to evaluate performance and to assess where to allocate resources. Other factors such as the Company’s organization, nature of its products, distribution channels and economic characteristics of the products were also considered in the determination of the reportable segments. The Company 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. The Company’s methodology for allocating non-interest expenses among segments is based on several factors such as revenue, employee headcount, occupied space, dedicated services or time, among others. These factors are reviewed on a periodical basis and may change if the conditions warrant.
Banking includes the Bank’s branches and traditional banking products such as deposits and commercial, consumer and mortgage loans. Mortgage banking activities are carried out by the Bank’s mortgage banking division, whose principal activity is to originate mortgage loans for the Company’s own portfolio. As part of its mortgage banking activities, the Company may sell loans directly into the secondary market or securitize conforming loans into mortgage-backed securities.
Financial Services is comprised of the Bank’s trust division, Oriental Financial Services, OFS Securities, Oriental Insurance, and CPC. The core operations of this segment are financial planning, money management and investment banking, brokerage services, insurance sales activity, corporate and individual trust and retirement services, as well as pension plan administration services.
The Treasury segment encompasses all of the Company’s asset/liability management activities, such as purchases and sales of investment securities, interest rate risk management, derivatives, and borrowings. 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.
Following are the results of operations and the selected financial information by operating segment as of and for the quarters and the six-month periods ended June 30, 2013 and 2012:
Total Major
Consolidated
Banking
Services
Treasury
Segments
Eliminations
Interest income
115,047
96
10,665
Interest expense
(10,272)
(10,167)
(20,439)
104,775
498
(37,527)
Provision for covered
(1,211)
Non-interest income (loss)
(4,197)
8,100
3,893
Non-interest expenses
(57,918)
(6,650)
(4,254)
(68,822)
Intersegment revenue
579
(579)
Intersegment expenses
(485)
(94)
4,501
6,746,902
39,960
2,527,039
9,313,901
(877,967)
23,223
(5,685)
(21,947)
(27,632)
31,880
1,276
(3,800)
(1,467)
Non-interest income
5,941
11,862
(24,365)
(3,611)
(1,734)
(29,710)
(440)
(296)
(144)
2,721
2,034
11,260
3,116,655
15,143
3,951,720
7,083,518
(707,240)
6,376,278
216,571
182
22,683
(21,417)
(20,068)
(41,485)
195,154
2,615
(45,443)
(1,883)
(901)
15,801
4,030
(115,834)
(12,777)
(7,020)
(135,631)
(624)
624
(786)
1,410
30,469
2,420
1,035
33,924
53,479
(12,094)
(46,472)
(58,566)
65,135
7,007
(6,800)
(8,624)
701
11,731
18,563
(46,952)
(8,500)
(3,657)
(59,109)
(844)
(605)
(239)
4,304
2,626
21,674
NOTE 19 – SUBSEQUENT EVENTS
On August 1, 2013, upon receipt of the required approval of the Financial Industry Authority, OFS Securities merged with and into Oriental Financial Services.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
The following discussion of the Company’s financial condition and results of operations should be read in conjunction with the “Selected Financial Data” and the Company’s unaudited consolidated financial statements and related notes. This discussion and analysis contains forward-looking statements. Please see “Forward-Looking Statements” and the risk factors set forth in our 2012 Form 10-K for discussion of the uncertainties, risks and assumptions associated with these statements.
The Company is a publicly-owned financial holding company that provides a full range of banking and financial services through its subsidiaries, including commercial, consumer , auto and mortgage lending; checking and savings accounts; financial planning, insurance and securities brokerage services; and corporate and individual trust and retirement services. The Company operates through three major business segments: Banking, Financial Services, and Treasury, and distinguishes itself based on quality service. The Company has 56 branches in Puerto Rico and a subsidiary in Boca Raton, Florida. The Company’s long-term goal is to strengthen its banking and financial services franchise by expanding its lending businesses, increasing the level of integration in the marketing and delivery of banking and financial services, maintaining effective asset-liability management, growing non-interest revenue from banking and financial services, and improving operating efficiencies.
The Company’s diversified mix of businesses and products generates 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 securities brokerage, fiduciary services, investment banking, insurance agency, and retirement plan administration). Although all of these businesses, to varying degrees, are affected by interest rate and financial market fluctuations and other external factors, the Company’s commitment is to continue producing a balanced and growing revenue stream.
The BBVAPR Acquisition, the deleveraging of the Company’s investment securities portfolio, and the continued organic growth of its banking operations have transformed the profitability of the Company in line with its strategic direction. The Company has begun to realize the anticipated benefits of the BBVAPR Acquisition as reflected by its significantly larger and higher yielding loan assets, a significantly larger deposit base and balances, and a sharply reduced size of its investment securities portfolio. It expects to continue to benefit from a more diverse business portfolio as well as increased scale and leadership in its market.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”) requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the consolidated financial statements. Understanding our accounting policies and the extent to which we use management judgment and estimates in applying these policies is integral to understanding our financial statements. We provide a summary of our significant accounting policies in “Note 1—Summary of Significant Accounting Policies” of our annual report on 2012 Form 10-K for the year ended December 31, 2012 (the “2012 Form 10-K”).
In the “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” section of our 2012 Form 10-K, we identified the following accounting policies as critical because they require significant judgments and assumptions about highly complex and inherently uncertain matters and the use of reasonably different estimates and assumptions could have a material impact on our reported results of operations or financial condition:
•
Business combination
Allowance for loan and lease losses
Financial instruments
We evaluate our critical accounting estimates and judgments on an ongoing basis and update them as necessary based on changing conditions. Management has reviewed and approved these critical accounting policies and has discussed its judgments and assumptions with the Audit and Compliance Committee of our Board of Directors. There have been no material changes in the methods used to formulate these critical accounting estimates from those discussed in our 2012 Form 10-K.
OVERVIEW OF FINANCIAL PERFORMANCE
SELECTED FINANCIAL DATA
Variance
%
EARNINGS DATA:
107.0%
83.2%
-26.0%
-29.2%
217.8%
174.4%
887.6%
568.3%
-17.5%
-78.2%
Total provision for loan and lease losses, net
635.5%
206.8%
Net interest income after provision for loan
and lease losses
138.9%
165.6%
-56.3%
-38.9%
131.6%
129.5%
Income before taxes
-65.0%
18.6%
-3121.2%
-928.6%
151.0%
129.3%
153.0%
-188.7%
147.7%
123.2%
PER SHARE DATA:
120.9%
100.0%
101.1%
84.8%
12.1%
11.6%
29.8%
29.1%
Cash dividends declared per common share
20.0%
0.0%
Cash dividends declared on common shares
2,742
2,444
12.2%
5,479
4,887
PERFORMANCE RATIOS:
Return on average assets (ROA)
1.77%
0.91%
94.5%
1.36%
0.79%
72.2%
Return on average common equity (ROE)
18.56%
8.69%
113.6%
14.29%
7.38%
93.6%
Equity-to-assets ratio
10.34%
10.86%
-4.8%
Efficiency ratio
53.24%
66.55%
-20.0%
55.35%
62.16%
-10.9%
Interest rate spread
5.55%
2.24%
147.8%
5.11%
2.38%
114.7%
Interest rate margin
5.56%
2.29%
142.8%
5.13%
2.45%
109.4%
SELECTED FINANCIAL DATA - (Continued)
PERIOD END BALANCES AND CAPITAL RATIOS:
Investments and loans
Investments securities
-16.7%
Loans and leases not covered under shared-loss
agreements with the FDIC, net
-3.2%
Loans and leases covered under shared-loss
-6.6%
Total investments and loans
6,868,421
7,402,495
-7.2%
Deposits and borrowings
-0.4%
-22.5%
421,261
792,425
-46.8%
Total deposits and borrowings
7,400,169
8,177,231
-9.5%
Stockholders’ equity
Preferred stock
Common stock
0.1%
11.1%
57.3%
Treasury stock, at cost
0.5%
Accumulated other comprehensive income
-71.8%
Total stockholders' equity
0.8%
Per share data
Book value per common share
15.45
15.31
0.9%
Tangible book value per common share
13.49
13.31
1.4%
Market price at end of period
18.11
13.35
35.7%
Capital ratios
Leverage capital
33.0%
Tier 1 risk-based capital
13.96%
7.9%
Total risk-based capital
16.02%
5.7%
Tier 1 common equity to risk-weighted assets
9.97%
9.11%
9.5%
Financial assets managed
Trust assets managed
2,638,787
2,514,401
4.9%
Broker-dealer assets gathered
2,822,395
2,722,196
3.7%
Financial Highlights
Income available to common shareholders for the quarter and six-month period ended June 30, 2013, increased to $34.1 million and $51.8 million, or $0.68 and $1.05 per diluted share, respectively. The income available to common shareholders are a significant improvement over the $13.8 million and $23.2 million for the quarter and six-month period ended June 30, 2012, respectively.
Interest income from loans for the quarter and six-month period ended June 30, 2013, increased 205.1% and 178.5% when compared with the same periods in 2012, while net interest margin expanded to 5.56% from 2.29% in the second quarter of 2012, and to 5.13% for the six-month period ended June 30, 2013, from 2.45% for the same period in 2012.
During the quarter ended June 30, 2013, the Company’s return on assets was 1.77%, and its return on equity was 18.56%, all of which represent improvements from the second quarter of 2012. The Company improved its efficiency ratio, which decreased to 53.24% from 66.55% when compared with the same quarter in 2012. For the six-month period ended June 30, 2013, the Company’s return on assets was 1.36% and its return on equity was 14.29%, both of which also represent improvements from the same period in 2012. The efficiency ratio decreased to 55.35% from 62.16% when compared with the same period in 2012.
Operating revenues for the quarter ended June 30, 2013 increased 121.9%, or $62.2 million, to $113.2 million when compared to the same period in 2012. Operating revenues for the six-month period ended June 30, 2013 increased 110.3%, or $113.7 million, to $216.9 million when compared to the same period in 2012.
OPERATING REVENUE
105,368
72,141
Non-interest income, net
Total operating revenue
113,164
50,992
216,881
103,136
Interest Income
Total interest income for the quarter and six-month period ended June 30, 2013 increased 107.0% to $125.8 million and 83.2% to $239.4 million, respectively, as compared to the same periods in 2012. This was a result of an increase in interest income from loans of $77.0 million, or 205.1%, and $137.8 million, or 178.5%, when compared to the quarter and six-month period ended June 30, 2012, respectively. This increase was partially offset by a decrease in interest income from investments of $12.0 million, or 51.8%, and $29.1 million, or 54.5%, compared to the quarter and six-month period ended June 30, 2012, respectively. This result was related to the BBVAPR Acquisition in which the non-covered loans portfolio increased by approximately $3.4 billion when compared to same period in 2012. In addition, the yield on covered loans increased from 17.75% and 17.64% for the quarter and six-month period ended June 30, 2012, respectively, to 25.62% and 23.10% for the quarter and six-month period ended June 30, 2013. This increase in yield is the result of higher projected cash flows on certain pools of covered loans, as credit losses have been lower than initially estimated for these loan pools. The covered portfolio is beginning to have cost recoveries on pools with lower carrying amounts, and these have the effect of increasing net interest income. Such cost recoveries for the quarter ended June 30, 2013 amounted to $6.2 million in the leasing and the construction loan pools. The accretable yield amounted to $167.1 million at June 30, 2013 compared to $188.0 million at December 31, 2012.
Interest income from investments reflects a 51.8% and 54.5% decrease for the quarter and six-month period ended June 30, 2013, as compared to the same period in 2012, primarily related to the lower balance in the investment securities portfolio due to the sale of investments securities as part of the deleverage executed during the third and fourth quarters of 2012 in connection with the BBVAPR Acquisition
72
Interest Expense
Total interest expense for the quarter and six-month period ended June 30, 2013 decreased 26.0% to $20.4 million and 29.2% to $41.5 million, respectively, as compared to the same periods in 2012. This reflects the lower cost of both securities sold under agreements to repurchase (2.10% vs. 2.16%; 1.99% vs. 2.23%) and deposits (0.71% vs. 1.40%; 0.73% vs. 1.48%) for the quarter and six-month period ended June 30, 2013, respectively, as compared to the same periods in 2012, which reflects continuing progress in the repricing of the Group’s core retail deposits and further reductions in its cost of funds, in addition to the reduction in the repurchase agreements as a result of the deleverage executed during the third and fourth quarters of 2012 in connection with the BBVAPR Acquisition.
Net Interest Income
Net interest income for the quarter and six-month period ended June 30, 2013 was $105.4 million and $198.0 million, respectively, an increase of 217.8% and 174.4%, respectively, when compared with the same periods in 2012. The increase was mostly due to the net effect of an increase of 426.1% and 383.4% for the quarter and six-month period ended June 30, 2013, respectively, in interest income from non-covered loans as a result of higher loan balances following the BBVAPR Acquisition. It is also due to a decrease of 26.0% and 29.2% in interest expense for the same respective periods due to lower cost of funds, partially offset by a decrease of 51.8% and 54.5% for the same respective periods on interest income from investments, related to lower balances from aforementioned deleverage transactions and a lower yield in the investment securities portfolio.
Net interest margin of 5.56% and 5.13% for the quarter and six-month period ended June 30,2013, respectively, increased 327 basis points and 268 basis points when compared to the quarter and six-month period ended June 30, 2012.
Provision for Loan and Lease Losses
Provision for non-covered loans losses for the quarter and six-month period ended June 30, 2013 increased $33.7 million and $38.6 million, respectively, when compared to the same periods in 2012. The increased is mostly due to the net impact of $21.0 million in additional provision for loan and lease losses due to reclassification to held-for-sale of non-performing residential mortgage loans with unpaid principal balance of $59 million and the increase in loan averages balances in 2013. Provision for covered loans losses for the quarter and six-month period ended June 30, 2013 decreased $56 thousand and $6.7 million when compared to the same periods ended June 30, 2012, as some covered construction and development and commercial real estate loan pools underperformed during the second quarter of 2012, which required a provision amounting to $7.2 million, net of the estimated reimbursement from the FDIC , compared to the recorded net provision of $1.2 million resulting from this quarter’s assessment of actual versus expected cash flows on the covered portfolio accounted for under the provisions of ASC 310-30.
Non-Interest Income
During the quarter and six-month period ended June 30, 2013, core banking and financial services revenues increased 108.0% to $23.9 million and 105.1% to $47.1 million, respectively, as compared to the same periods in 2012, primarily reflecting a $10.2 million and $19.5 million increase in banking services revenue to $13.3 million and $25.7 million for the quarter and six-month period ended June 30, 2013, respectively, attributed to an increase of 157.6% in deposits from June 30, 2012, which is principally attributed to the BBVAPR Acquisition.
Net FDIC shared-loss expense of $20.0 million and $32.8 million for the quarter and six-month period ended June 30, 2013, respectively, compared to $5.6 million and $10.4 million for the same periods in 2012. Such increase resulted from the ongoing evaluation of expected cash flows of the loan portfolio acquired in the FDIC-assisted acquisition. As a result of such evaluation, the Company expects a decrease in losses to be collected from the FDIC and the improved re-yielding of the accretable yield on the covered loans. This reduction in claimable losses amortizes the shared-loss indemnification asset through the life of the shared-loss agreements. This amortization is net of the accretion of the discount recorded to reflect the expected claimable loss at its net present value. During the quarter ended June 30, 2013 the net amortization included $7.1 million of additional amortization of the FDIC indemnification asset from stepped up cost recoveries on certain construction and leasing loan pools.
There was no gain or loss on the sale of securities in the quarter and six-month period ended June 30, 2013 as compared to gains of $12.0 million and $19.3 million in the same periods in 2012.
Non-Interest Expense
Non-interest expense increased to $68.8 million and $135.6 million for the quarter and six-month period ended June 30, 2013, respectively, compared to $29.7 million and $59.1 million in the same periods of the previous year, due to the Company’s expanded operations as a result of the BBVAPR Acquisition, including merger and restructuring costs of $5.3 million and $10.8 million for the quarter and six-month period, respectively. Also, the quarter and six-month period ended June 30, 2013 reflects a $2.0 million impact of the new 1.0% tax on gross revenues, recently enacted in the amendments to the Puerto Rico tax code.
The efficiency ratio for the quarter and six-month period ended June 30, 2013 was 53.24% and 55.35%, respectively, compared to 66.55% and 62.16% for the quarter and six-month period ended June 30, 2012, respectively.
Income Tax Expense
Income tax benefit was $31.9 million and $24.8 million for the quarter and six-month period ended June 30, 2013, respectively, compared to an expense of $1.1 million and $3.0 million for the same periods in 2012. The income tax benefit of $31.9 million for the quarter ended June 30, 2013 includes three items resulting from the recent amendment to the Puerto Rico tax code: (i) a $37.0 million benefit from an increase in the Company’s deferred tax asset as a result of the increase in corporate income taxes to 39% from 30%; (ii) the Company’s income tax expense at the Company’s higher effective rate of 35.5% for the second quarter of 2013; and (iii) the increase in the Company’s income tax expense for the first quarter of 2013 as a result of the increase in the effective tax rate to 35.5% from the previously reported 25.2%.
Income Available to Common Shareholders
For the quarter and six-month period ended June 30, 2013, the Group’s income available to common shareholders amounted to $34.1 million and $51.8 million, respectively, compared to $13.8 million and $23.2 million for the same periods in 2012. Earnings per basic common share and fully diluted common share were $0.75 and $0.68 for the quarter ended June 30, 2013, respectively, compared to earnings per basic and fully diluted common share of $0.34 for the quarter ended June 30, 2012. Income per basic common share and fully diluted common share were $1.14 and $1.04, respectively, for the six-month period ended June 30, 2013, compared to income per basic and fully diluted common share of $0.57 for the six-month period ended June 30, 2012.
Interest Earning Assets
The loan portfolio declined to $4.991 billion at June 30, 2013 compared to $5.169 billion at December 31, 2012 primarily due to the early pay down of some commercial loans and the reclassification of non-performing residential mortgage loans with a book value of $55 million to held-for-sale, at fair value. The investment portfolio of $1.861 billion at June 30, 2013 decreased 9.2% compared to $2.233 billion at December 31, 2012. The decrease in the investment portfolio is mainly due to redemptions and maturities of investments securities available for sale.
Interest Bearing Liabilities
Total deposits decreased slightly to $5.665 billion at June 30, 2013, compared to $5.690 billion at December 31, 2012. Core deposits, including brokered deposits, increased 2.7% compared to December 31, 2012, while brokered certificate of deposits decreased 16.6%. Securities sold under agreements to repurchase decreased 22.5%, or $381.4 million, as the Company used available cash to pay off $380 million repurchase agreements at maturity. During the six-month period ended June 30, 2013, the Company settled, prior to maturity, a former BBVAPR subordinated note of $50 million.
Stockholders’ Equity
Stockholders’ equity at June 30, 2013 was $870.9 million compared to $863.6 million at December 31, 2012, an increase of 0.8%. This increase reflects the net income for the quarter, partially offset by the change in other comprehensive income.
Book value per share was $15.45 at June 30, 2013 compared to $15.31 at December 31, 2012.
The Company maintains capital ratios in excess of regulatory requirements. At June 30, 2013, Tier 1 Leverage Capital Ratio was 8.54%, Tier 1 Risk-Based Capital Ratio was 13.96%, and Total Risk-Based Capital Ratio was 16.02%.
74
Return on Average Assets and Common Equity
Return on average common equity (“ROE”) for the quarter and six-month period ended June 30, 2013 was 18.56% and 14.29%, respectively, up from 8.69% and 7.38% for the quarter and six-month period ended June 30, 2012, respectively. Return on average assets (“ROA”) for the quarter and six-month period ended June 30, 2013 was 1.77% and 1.36%, respectively, up from 0.91% and 0.79% for the same periods in 2012. The increases in ROE and ROA is mostly due to a 151.0% and 129.3% increase in net income from $15.0 million and $25.6 million in the quarter and six-month period ended June 30, 2012, respectively, to $37.5 million and $58.7 million in the quarter and six-month period ended June 30, 2013, respectively.
Assets under Management
Assets managed by the Company’s trust division, the retirement plan administration subsidiary (CPC), and the broker-dealer subsidiaries increased from December 31, 2012. The trust division offers various types of individual retirement accounts (“IRA”) and manages 401(k) and Keogh retirement plans and custodian and corporate trust accounts, while CPC manages the administration of private retirement plans. At June 30, 2013, total assets managed by the Company’s trust division and CPC increased 1.7% to $2.639 billion, compared to $2.514 billion at December 31, 2012, mainly related to employer and employee account contributions and capital market appreciation. At June 30, 2013, total assets managed by the broker-dealer subsidiaries from its customer investment accounts increased 1.1% to $2.822 billion, compared to $2.722 billion at December 31, 2012.
Lending
Total loan production of $601.7 million for the six-month period ended June 30, 2013 increased 190.8% year over year, including $327.0 million in the quarter ended June 30, 2013. Total commercial loan production of $178.3 million for the six-month period ended June 30, 2013, increased 95.5% from the same period in 2012, including $104.3 million in the quarter ended June 30, 2013. These increases are directly related to the BBVAPR Acquisition as the Company continue building a strong institutional pipeline.
Mortgage loan production and purchases of $101.3 million and $178.4 million for the quarter and six-month period ended June 30, 2013, respectively, increased 107.1% and 89.9% from the same periods in 2012. The Company sells most of its conforming mortgages in the secondary market and retains the servicing rights. The increase in mortgage loan production is also the result of the benefits of the completion during this quarter, of the integration of the BBVPR and Oriental mortgage operations.
Consumer loans production for the quarter and six-month period ended June 30, 2013 totaled $26.6 million and $49.2, up 247.0% and 283.3% when compared with the same periods in 2012. The increase in consumer lending is the result of the benefits of a larger branch network and origination platform following the BBVAPR Acquisition.
Auto and leasing production for the quarter and six-month period ended June 30, 2013 totaled $94.7 million and $195.7 million, respectively, up from $4.4 million and $8.9 million in the quarter and six-month period ended June 30, 2012, respectively. The increase is mainly attributed to the auto loan business newly entered into by the Company following the BBVAPR Acquisition.
While the loan portfolio remains far greater than it was a year ago and loan production for the quarter and six-month period ended June 30, 2013 has increased considerably from the same periods in 2012, total loan portfolio have declined slightly by $178.2 million from $5.169 billion at December 31, 2012 to $4.991 billion at June 30, 2013, mostly as the result of scheduled pay downs and maturities in both the non-covered and covered portfolios, a scheduled pay down of a PR government obligation of about $125 million, and the reclassification of residential non-performing loans to held-for-sale.
Credit Quality on Non-Covered Loans
Net credit losses, excluding acquired loans, increased $28.8 million to $32.6 million, and $29.5 million to $35.9 million during the quarter and six-month period ended June 30, 2013, respectively, representing 8.86% and 5.11% of average non-covered loans outstanding, versus 1.25% and 1.07% in the same periods in 2012. The credit losses for the quarter and six-month periods ended June 30, 2013 include a $27 million charge-off from nonperforming mortgage loans transferred into the loan held-for-sale category. The allowance for loan and lease losses on non-covered loans increased to $46.6 million (2.62% of total non-covered loans) at June 30, 2013, compared to $39.9 million (3.21% of total non-covered loans) at December 31, 2012.
Non-performing loans (“NPLs”), which exclude loans covered under shared-loss agreements with the FDIC and loans acquired in the BBVAPR Acquisition accounted under ASC 310-30, decreased to $88.5 million at June 30, 2013 compared to $145.1 million at December 31, 2012 primarily due to the reclassification of certain non-performing residential mortgage loans with a net book value of $55.0 million, to the loan held-for-sale category. Without this re-class to loans held-for-sale, NPL balances would have been relatively consistent between December 31, 2012 and June 31, 2013.
Non-GAAP Measures
The Company uses certain non-GAAP measures of financial performance to supplement the consolidated financial statements presented in accordance with GAAP. The Company presents non-GAAP measures that management believes are useful and meaningful to investors. Non-GAAP measures do not have any standardized meaning, are not required to be uniformly applied, and are not audited. Therefore, they are unlikely to be comparable to similar measures presented by other companies. The presentation of non-GAAP measures is not intended to be a substitute for, and should not be considered in isolation from, the financial measures reported in accordance with GAAP.
The Company’s management has reported and discussed the results of operations herein both on a GAAP basis and on a pre-tax pre-provision operating income basis (defined as net interest income, plus banking and financial services revenue, less non-interest expenses, as calculated on the table below). The Company’s management believes that, given the nature of the items excluded from the definition of pre-tax pre-provision operating income, it is useful to state what the results of operations would have been without them so that investors can see the financial trends from the Company’s continuing business.
During the quarter and six-month period ended June 30, 2013, the Company’s pre-tax pre-provision operating income was approximately $65.7 million and $120.2 million, respectively, an increase of 340.1% and 234.0% from $14.9 million and $36.0 million in the same periods of last year. Pre-tax pre-provision operating income is calculated as follows:
PRE-TAX PRE-PROVISION OPERATING INCOME
Core non-interest income:
Total core non-interest income
(135,632)
Less merger and restructuring charges
(63,548)
(124,824)
Total pre-tax pre-provision operating income
65,710
14,930
120,212
35,987
Tangible common equity consists of common equity less goodwill and core deposit intangibles. Tier 1 common equity consists of common equity less goodwill, core deposit intangibles, net unrealized gains on available for sale securities, net unrealized losses on cash flow hedges, and disallowed deferred tax asset and servicing assets. Ratios of tangible common equity to total assets, tangible common equity to risk-weighted assets, total equity to risk-weighted assets and Tier 1 common equity to risk-weighted assets are non-GAAP measures.
At June 30, 2013, tangible common equity to total assets and tangible common equity to risk-weighted assets increased to 7.30% and 12.22%, respectively, from 6.73% and 11.82% at December 31, 2012. Total equity to risk-weighted assets and Tier 1 common equity to risk-weighted assets at June 30, 2013 increased to 17.30% and 9.97%, respectively, from 16.48% and 9.11% at December 31, 2012
Ratios calculated based upon Tier 1 common equity have become a focus of regulators and investors, and management believes ratios based on Tier 1 common equity assist investors in analyzing the Company’s capital position. Furthermore, management and many stock analysts use tangible common equity in conjunction with more traditional bank capital ratios to compare the capital adequacy of banking organizations. Neither Tier 1 common equity nor tangible common equity or related measures should be considered in isolation or as a substitute for stockholders’ equity, total assets or any other measure calculated in accordance with GAAP.
ANALYSIS OF RESULTS OF OPERATIONS
The following tables show 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 quarters
and six-month periods ended June 30, 2013 and 2012:
TABLE 1 - QUARTERLY ANALYSIS OF NET INTEREST INCOME AND CHANGES DUE TO VOLUME/RATE
FOR THE QUARTERS ENDED JUNE 30, 2013 AND 2012
Interest
Average rate
Average balance
June
A - TAX EQUIVALENT SPREAD
Interest-earning assets
6.64%
4.20%
7,580,468
5,794,684
Tax equivalent adjustment
1,743
13,675
0.09%
0.94%
Interest-earning assets - tax equivalent
127,551
74,463
6.73%
5.14%
Interest-bearing liabilities
1.09%
1.96%
7,481,718
5,626,256
Tax equivalent net interest income / spread
107,112
46,831
5.65%
3.18%
98,750
168,428
Tax equivalent interest rate margin
5.64%
3.23%
B - NORMAL SPREAD
Interest-earning assets:
10,925
22,842
2.26%
2.61%
1,936,849
3,501,015
7.62%
0.00%
1,574
243
0.18%
0.24%
538,920
634,707
11,198
2.25%
2,477,343
4,135,722
Loans not covered under shared-loss agreements
with the FDIC:
Originated and Other loans held-for-investment
10,494
11,803
5.18%
5.74%
809,898
821,807
5,083
4,054
5.10%
5.21%
398,456
311,299
795
9.47%
8.03%
73,776
39,623
5,075
570
10.68%
8.17%
190,129
27,908
Total originated non-covered loans
22,398
17,222
6.09%
1,472,259
1,200,637
Acquired
11,138
5.46%
816,483
36,446
10.45%
1,394,769
5,101
12.36%
165,053
15,528
7.06%
879,936
Total acquired non-covered loans
68,213
8.38%
3,256,241
Total non-covered loans
7.67%
4,728,500
Loans covered under shared-loss agreements
25.62%
17.75%
374,625
458,325
Total loans
37,564
8.98%
9.06%
5,103,125
1,658,962
Total interest earning assets
60,787
Interest-bearing liabilities:
Non-interest bearing deposits
766,574
172,615
NOW accounts
1,966
2,268
0.57%
1.04%
1,388,689
876,041
Savings and money market accounts
3,014
544
0.93%
895,377
234,762
1,552
2,080
1.71%
362,839
369,519
2,898
1.68%
2.02%
690,229
330,644
9,430
6,559
0.92%
1.32%
4,103,708
1,983,581
Institutional certificates of deposit
2,664
506
1.63%
2.12%
653,270
95,382
1,790
0.83%
2.04%
858,769
167,207
4,454
1,357
1.18%
2.07%
1,512,039
262,589
Deposits fair value premium amortization
(4,326)
(67)
Core deposit intangible amortization
415
1.40%
5,615,747
2,246,170
2.10%
2.16%
1,356,856
3,057,598
2.14%
4.09%
409,742
286,405
4.74%
3.56%
98,644
36,083
10,466
19,747
2.34%
1,865,242
3,380,086
Total interest bearing liabilities
7,480,989
Net interest income / spread
Excess of average interest-earning assets over
average interest-bearing liabilities
99,479
Average interest-earning assets to average
interest-bearing liabilities ratio
101.33%
102.99%
C - CHANGES IN NET INTEREST INCOME DUE TO:
Volume
Interest Income:
(9,312)
(2,713)
(12,025)
46,890
30,155
77,045
37,578
27,442
65,020
Interest Expense:
11,831
(9,743)
2,088
(9,178)
(213)
(9,391)
1,872
(1,762)
110
4,525
(11,718)
(7,193)
33,053
39,160
72,213
79
TABLE 1/A - YEAR-TO-DATE ANALYSIS OF NET INTEREST INCOME AND CHANGES DUE TO VOLUME/RATE
FOR THE SIX-MONTH PERIOD ENDED JUNE 30, 2013 AND 2012
6.20%
4.43%
7,721,878
5,900,367
12,336
0.32%
0.46%
251,772
144,383
2.05%
7,641,470
5,724,700
210,287
85,817
5.43%
2.84%
80,408
175,667
5.45%
2.91%
23,734
52,696
2.35%
2,022,072
3,611,510
8.51%
1,175
550
779
0.20%
0.25%
544,502
614,517
24,334
1.90%
2.53%
2,567,749
4,226,027
Originated
21,938
24,516
5.41%
5.92%
810,441
828,700
9,978
8,150
5.16%
5.34%
386,882
305,116
2,942
1,561
9.13%
8.05%
64,412
38,798
7,921
1,118
10.97%
8.37%
144,441
26,719
42,779
5.89%
1,406,176
1,199,333
22,308
5.40%
826,101
62,816
8.72%
1,441,540
10,648
12.37%
172,178
32,323
6.99%
925,246
128,095
7.61%
3,365,065
7.16%
4,771,241
23.10%
17.64%
382,888
475,007
8.35%
9.23%
5,154,129
1,674,340
80
766,601
174,497
5,707
4,817
0.80%
1.11%
1,421,481
869,525
4,820
1,134
1.10%
0.97%
877,109
235,019
3,356
4,368
1.83%
367,490
367,009
6,141
3,795
1.78%
2.20%
691,668
345,644
20,024
14,114
1.42%
4,124,349
1,991,694
Institutional deposits
5,359
1,105
2.11%
627,157
104,648
3,779
1,893
0.88%
1.84%
857,454
206,049
Total wholesale deposits
9,138
2,998
1.93%
1,484,611
310,697
829
(9,540)
(175)
0.73%
1.48%
5,608,960
2,302,391
1.99%
2.23%
1,440,866
3,057,858
1.64%
4.17%
469,620
284,188
4.11%
44,180
4.65%
3.60%
121,659
21,034
41,558
2.43%
2,032,145
3,422,309
7,641,105
Excess of average interest-earning assets
over average interest-bearing liabilities
80,773
101.06%
103.07%
(20,985)
(8,160)
(29,145)
97,144
40,729
137,873
76,159
32,569
108,728
24,429
(20,986)
3,443
(18,016)
(1,697)
(19,713)
4,660
(5,471)
(811)
11,073
(28,154)
(17,081)
65,086
60,723
125,809
81
Net interest income amounted to $105.4 million and $198.0 million for the quarter and the six-month period ended June 30, 2013, respectively, a 217.8% and 174.4% increase from $33.2 million and $72.1 million for the same periods in 2012. These changes reflect a decrease of 26.0% and 29.2% in interest expense and an increase of 205.1% and 178.5% in interest income from loans, partially offset by a 51.8% and 54.5% decrease in interest income from investments when comparing the quarter and six-month period ended June 30, 2013 and 2012, respectively.
Interest rate spread for the quarter ended June 30, 2013 increased 331 basis points to 5.55% from 2.24% in the same period of 2012. This increase is mainly due to the net effect of a 87 basis point decrease in the average cost of funds from 1.96% to 1.09%, and a 244 basis point increase in the average yield of interest-earning assets from 4.20% to 6.64%. For the six-month period ended June 30, 2013, interest rate spread increased 273 basis point to 5.11% from 2.38% in the same period of 2012. This increase is mainly due to the net effect of a 96 basis point decrease in the average cost of funds from 2.05% to 1.09%, and a 177 basis point increase in the average yield of interest-earning assets from 4.43% to 6.20%.
The increase in interest income for the quarter was primarily the result of an increase of $37.6 million in interest-earning assets volume variance, and a $27.4 million increase in interest rate variance. The six-month period increase in interest income was primarily the result of an increase of $76.2 million in interest earning assets volume variance, and a $32.6 million increase in interest rate variance. Interest income from loans increased 205.1% to $114.6 million and 178.5% to $215.1 million for the quarter and six-month period ended June 30, 2013, respectively, mainly due to the loan portfolio acquired as part of the BBVAPR Acquisition. This was mitigated by the fact that interest income on investments decreased 51.8% to $11.2 million and 54.5% to $24.3 million in the quarter and six-month period ended June 30, 2013, respectively, compared to the same periods in 2012, reflecting a lower balance in the investment securities portfolio due to the sale of investments securities as part of the deleverage executed during the third and fourth quarters of 2012 in connection with the BBVAPR Acquisition.
Interest expense decreased 26.0% to $20.4 million and 29.2% to $41.5 million for the quarter and six-month period ended June 30, 2013, respectively. The decrease for the quarter was primarily the result of an $11.7 million decrease in interest rate variance, partially offset by a $4.5 million increase in interest-bearing liabilities volume variance. The six-month period decrease was primarily the result of a $28.2 million decrease in interest rate variance, partially offset by an $11.1 million increase in interest-bearing liabilities volume variance. The decrease in interest rate variance is due to a reduction in the cost of funds and the increase in the volume variance is due to the increase in the balance of deposits, which reflected a decrease in cost of funds of 87 basis points to 1.09% and 96 basis points to 1.09% for the quarter and six-month period ended June 30, 2013, respectively, compared to the same periods in 2012. The cost of deposits decreased 69 basis points to 0.71% and 75 basis points to 0.73% for the quarter and six-month period ended June 30, 2013, respectively, compared to 1.40% and 1.48% for the same periods in 2012, primarily due to continuing progress in repricing core deposits and to the maturity of higher cost brokered deposits during the periods. The cost of borrowings decreased by 10 basis points to 2.24% and 36 basis points to 2.07% in the quarter and six-month period ended June 30, 2013, respectively, compared to 2.34% and 2.43% for the same periods in 2012.
For the quarter and six-month period ended June 30, 2013, the average balance of total interest-earning assets was $7.580 billion and $7.722 billion, respectively, an increase of 30.8% for both periods compared to 2012. The increase in average balance of interest-earning assets was mainly attributable to an increase in average loans for the quarter and six-month period ended June 30, 2013 of 207.6% and 207.8% , respectively, resulting from the loan acquisition of the portfolio from BBVAPR, mitigated by a reduction of 40.9% and 39.2% in the average investments for the quarter and the six-month period ended June 30, 2013 as a result of the aforementioned sale of investments as part of the deleverage plan in connection with the BBVAPR Acquisition. For the quarter ended June 30, 2013, the average yield on interest-earning assets was 6.64% compared to 4.20% for the same quarter in 2012, and for the six-month period ended June 30, 2013, was 6.20% compared to 4.43% for the same period in 2012. This was mainly due to the increase in average balance and higher average yields in the non-covered loan portfolio, which their average yield increased to 7.67% from 5.74% and to 7.16% from 5.89% for quarter and six-month period ended June 30, 2013, respectively, compared to the same periods in 2012.
82
TABLE 2 - NON-INTEREST INCOME SUMMARY
36.0%
33.1%
324.0%
313.1%
15.0%
Total banking and financial service revenue
108.0%
105.1%
-257.6%
-215.4%
Sale of securities available for sale
-100.0%
1566.4%
1276.9%
3555.6%
401.5%
(16,093)
6,352
-353.4%
(28,155)
8,041
-450.1%
Non-interest income is affected by the amount of securities, derivatives and trading transactions, the level of trust assets under management, transactions generated by clients’ financial assets serviced by the securities broker-dealer and insurance subsidiaries, the level of mortgage banking activities, and the fees generated from loans and deposit accounts. It is also affected by the FDIC shared-loss expense ,which varies depending on the results of the on-going evaluation of expected cash flows of the loan portfolio acquired in the FDIC-assisted acquisition.
As shown in Table 2 above, the Company recorded non-interest income in the amount of $7.8 million and $18.9 million for the quarter and six-month period ended June 30, 2013, respectively, compared to $17.8 million and $31.0 million for the same period in 2012, a decrease of $10.0 million and $12.1 million, respectively.
During the quarter and six-month period ended June 30, 2013, the Company did not have any gain or loss on sale of securities as compared to the quarter and six-month period ended June 30, 2012, in which the Company had gains of $12.0 million and $19.3 million on sale of securities, respectively.
Also, the increase in the FDIC shared-loss expense to $20.0 million and $32.8 million for the quarter and the six-month period ended June 30, 2013, respectively, compared to $5.6 million and $10.4 million for the same periods in 2012, resulted from the ongoing evaluation of expected cash flows of the covered loan portfolio, which resulted in reduced losses expected to be collected from the FDIC and the improved re-yielding of the accretable yield on the covered loans. The reduction in claimable losses amortizes the shared-loss indemnification asset through the life of the shared loss agreement. This amortization is net of the accretion of the discount recorded to reflect the expected claimable loss at its net present value. During the quarter ended June 30, 2013, the Company recorded $7.1 million in additional amortization of the FDIC indemnification asset from stepped up cost recoveries on certain construction and leasing loan pools.
During the quarter ended June 30, 2013, the Company recognized a realized gain of $2.1 million, included as “Net gain (loss) on other” in the Statement of Operations, corresponding to the recovery from the sale of a claim in the Lehman Brothers bankruptcy.
Banking service revenue, which consists primarily of fees generated by deposit accounts, electronic banking services, and customer services, increased 324.0% to $13.3 million and 313.1% to $25.7 million in the quarter and six-month period ended June 30, 2013, respectively, from $3.1 million and $6.2 million for the same periods in 2012. This increase for the quarter and six-month period ended June 30, 2013, is attributable to an increase in transaction volume due to larger the deposit portfolio, as a result of the BBVAPR Acquisition.
83
Financial service revenue, which consists of commissions and fees from fiduciary activities, and securities brokerage and insurance activities, increased 36.0% to $8.0 million and 33.1% to $15.7 million, for the quarter and six-month period ended June 30, 2013, respectively, compared to $5.9 million and $11.8 million for the same periods in 2012. This increase is mainly due to increased brokerage, trust and insurance business and transactions as a result of the BBVAPR Acquisition.
Income generated from mortgage banking activities increased 3.7% to $2.5 million and 15.0% to $5.7 million for the quarter and six-month period ended June 30, 2013, respectively, compared to $2.4 million and $4.9 million for the same periods in 2012. Such increase is mainly a result of an increase in mortgage loan production for the quarter and six-month period ended June 30, 2013 when compared to the same periods in 2012, as the Company sells the majority of the loans produced into secondary markets. This increase in loan production is partially offset by the effect of the steep rise in interest rate during the later part of the quarter ended June 30, 2013 , resulting in decreased profit margins from the sale of mortgage loans.
TABLE 3 - NON-INTEREST EXPENSES SUMMARY
Variance %
115.4%
119.7%
87.9%
103.3%
47.6%
58.2%
4896.3%
626.7%
154.4%
147.1%
88.8%
65.6%
130.3%
117.1%
91.4%
178.7%
97.3%
74.7%
6.8%
27.7%
Printing, postage, stationery and supplies
164.3%
220.2%
113.0%
117.5%
10.2%
-5.8%
Other operating expenses
237.6%
182.5%
Total non-interest expenses
Relevant ratios and data:
Compensation and benefits to
non-interest expense
35.00%
37.64%
34.90%
36.46%
Compensation to total assets owned
1.14%
0.70%
1.12%
0.68%
Average number of employees
1,559
751
1,573
748
Average compensation per employee
61.81
59.57
60.19
57.62
Assets owned per average employee
5,412
8,490
5,364
8,524
Non-Interest Expenses
Non-interest expense for the quarter ended June 30, 2013 reached $68.8 million, representing an increase of 131.6% compared to $29.7 million for the quarter ended June 30, 2012. For the six-month period ended June 30, 2013, non-interest expense reached $135.6 million, representing an increase of 129.5% compared to $59.1 million for the same periods in 2012, due to the Company’s expanded operations as a result of the BBVAPR Acquisition.
Compensation and employee benefits increased 115.4% and 119.7% to $24.1 million and $47.3 million for the quarter and six-month period ended June 30, 2013, respectively, from $11.2 million and $21.6 million for the same periods in 2012.These increase are mainly driven by the integration of the employees of BBVAPR.
Professional and service fees increased 47.6% to $7.7 million and 58.2% to $16.8 million for the quarter and six-month period ended June 30, 2013, respectively, as compared to $5.2 million and $10.6 million for the same periods in 2012, mainly due to professional expenses related to the BBVAPR integration.
Occupancy and equipment expenses increased 87.9% to $8.1 million and 103.3% to $17.3 million for the quarter and six-month period ended June 30, 2013, as compared to $4.3 million and $8.5 million for the same periods in 2012, as a result of the BBVAPR Acquisition in which the Bank acquired 36 branches and the building where our new headquarters are located. During the quarter ended June 30, 2013, the Company consolidated 8 branches.
Electronic banking charges increased 154.4% to $4.1 million and 147.1% to $7.8 million for the quarter and six-month period ended June 30, 2013, respectively, as compared to $1.6 million and $3.2 million for the same periods in 2012, mostly due to the increase in expenses related to merchant business and card interchange transactions resulting from our banking business growth.
During the quarter and six-month period ended June 30, 2013, the Company incurred $5.3 million and $10.8 million, respectively, in expenses related to the merger and restructuring charges. This amount includes a $3.7 million charge related to an early termination of a contract with a third party servicer of certain loan portfolios acquired in the FDIC-assisted transaction and $3.2 million related to systems integration. These charges represent costs associated with these one-time activities and do not represent ongoing costs of the fully integrated combined organization.
Taxes, other than payroll and income taxes, for the quarter and six-month period ended June 30, 2013 increased to $5.1 million and to $7.8 million, respectively, as compared to a benefit of $107 thousand and an expense of $1.1 million for the same periods in 2012. The increase primarily reflects a $2.0 million impact from the application of the new 1.0% tax on gross revenues which was part of the recently enacted amendments to the Puerto Rico tax code. Also, included in the benefit of $107 thousand during the quarter ended June 30, 2012 was the reversal of an accrual resulting from a municipal license tax settlement.
Foreclosure, repossession and other real estate expenses for the quarter and six-month period ended June 30, 2013 increased 130.3% to $2.2 million and 117.1% to $3.7 million, respectively, as compared to $936 thousand and $1.7 million for the same periods in 2012, principally due to the increase in foreclosures during the six-month period ended June 30, 2013 as compared to the same periods in 2012.
Advertising, business promotion, and strategic initiatives for the quarter and six-month period ended June 30, 2013 increased 6.8% and 27.7%, respectively, as compared to the same periods in 2012, primarily to support the Company’s expansion of commercial banking and it’s rebranding.
The increase in the Company’s net-interest income resulted in a decrease in the efficiency ratio to 53.24% for the quarter ended June 30, 2013 compared to 66.55% for the quarter ended June 30, 2012, and a decrease to 55.35% for the six-month period ended June 30, 2013 from 62.16% from the same period in the prior year. The efficiency ratio measures how much of a company’s revenue is used to pay operating expenses. The Company computes its efficiency ratio by dividing non-interest expenses by the sum of its net interest income and non-interest income, but excluding gains on the sale of investments securities, derivatives gains or losses, credit-related other-than-temporary impairment losses, FDIC shared-loss expense, losses on the early extinguishment of repurchase agreements, other gains and losses, and other income that may be considered volatile in nature. Management believes that the exclusion of those items permits greater comparability. Amounts presented as part of non-interest income that are excluded from the efficiency ratio computation amounted to losses of $16.1 million and $28.2 million for the quarter and six-month period ended June 30, 2013, respectively, compared to gains of $6.4 million and $8.0 million for the same period in 2012 . Revenue for purposes of the efficiency ratio for the quarter and six-month period ended June 30, 2013 amounted to $129.3 million and $245.0 million, respectively, compared to $44.6 million and $95.1 million for the same periods in 2012 .
The provision for non-covered loan and lease losses for the quarter and six-month period ended June 30, 2013 totaled $37.5million and $45.4 million, respectively, an increase of $33.7 million and $38.6 million from the same periods in 2012, mostly due to the net impact of $21.0 million in additional provision for loan and lease losses from the reclassification to held-for-sale of non-performing residential mortgage loans with an unpaid principal balance of $59.0 million. Based on an analysis of the credit quality and the composition of the Company’s loan portfolio, management determined that the provision for the quarter ended June 30, 2013 was
adequate in order to maintain the allowance for loan and lease losses at an adequate level to provide for probable losses based upon an evaluation of known and inherent risks.
During the quarter and six-month period ended June 30, 2013, net credit losses amounted to $32.6 million and $35.9 million, respectively, a n increase of 766.0% and 460.8% when compared to $3.8 million and $6.4 million reported for the same periods in 2012. The increase was primarily due to an increase of $27.2 million and a $28.8 million in net credit losses for mortgage loans during the quarter and the six-month period ended June 30, 2013, respectively, compared to the same periods in 2012. These include $27.0 million in charge-offs due to the aforementioned reclassification to held-for-sale of non-performing residential loans with an unpaid principal balance of $59.0 million.
Total charge-offs on originated and other loans held-for-investment increased 757.5% to $33.0 million and 451.3% to $36.5 million for the quarter and six-month period ended June 30, 2013, respectively, as compared to the same periods in 2012, and total recoveries increased from $94 thousand and $216 thousand in the quarter and six-month period ended June 30, 2012, respectively, to $486 thousand and $585 thousand in the quarter and the six-month period ended June 30, 2013, respectively. As a result, the recoveries to charge-offs ratio decreased from 2.44% and 3.26% in the quarter and six-month period ended June 30, 2012 to 1.47% and 1.60% in the quarter and six-month period ended June 30, 2013.
The loans acquired in the BBVAPR Acquisition accounted for under ASC 310-20 (loans with revolving feature and/or acquired at a premium) were recognized at fair value as of December 18, 2012, which included the impact of expected credit losses. Provision for loan and lease losses on these loans for the quarter and the six-month period ended June 30, 2013 was $1.6 million and $3.7 million, respectively. Loans acquired in the BBVAPR Acquisition accounted for under ASC 310-30 (loans acquired with deteriorated credit quality, including those by analogy) were also recognized at fair value as of December 18, 2012, which included the impact of expected credit losses. This portfolio did not require provision for loan and lease losses for the quarter and the six-month period ended June 30, 2013.
The loans covered by the FDIC shared-loss agreement were recognized at fair value as of April 30, 2010, which included the impact of expected credit losses. To the extent credit deterioration occurs in covered loans after the date of acquisition, the Company records an allowance for loan and lease losses. Also, the Company records an increase in the FDIC shared-loss indemnification asset for the expected reimbursement from the FDIC under the shared-loss agreements. Provision for covered loans and lease losses for the quarter and six-month period ended June 30, 2013 was $1.2 million and $1.9 million, reflecting the Company’s quarterly revision of the expected cash flows in the covered loan portfolio considering actual experiences and changes in the Company’s expectations for the remaining terms of the loan pools. During the quarter and six-month period ended June 30, 2012, some covered construction and development and commercial real estate loan pools underperformed, which required a provision amounting to $7.2 million, net of the estimated reimbursement from the FDIC.
Please refer to the “Allowance for Loan and Lease Losses and Non-Performing Assets” section in this MD&A and Table 8 through Table 13 below for more detailed information concerning the allowances for loan and lease losses, net credit losses and credit quality statistics.
Income Taxes
The Company had an income tax benefit of $31.9 million and $24.8 million for the quarter and six-month period ended June 30, 2013, respectively, compared to an expense of $1.1 million and $3.0 million for the same period in 2012. The income tax benefit of $31.9 million for the quarter ended June 30, 2013 includes three items resulting from the recent amendment to the Puerto Rico tax code: (i) a $37.0 million benefit from an increase in the Company’s deferred tax asset as a result of the increase in corporate income taxes to 39% from 30%; (ii) the Company’s income tax expense at the Company’s higher effective rate of 35.4% for the second quarter of 2013; and (iii) the increase in the Company’s income tax expense for the first quarter of 2013 as a result of the increase in the effective tax rate to 35.4% from the previously reported 25.2%.
ANALYSIS OF FINANCIAL CONDITION
TABLE 4 - ASSETS SUMMARY AND COMPOSITION
-17.9%
-30.8%
-14.8%
-26.3%
Puerto Rico Government and agency obligations
120,520
-0.7%
-42.3%
-2.6%
2,275
568
300.5%
4,749,300
-3.4%
Allowance for loan and lease losses on non covered loans
-16.8%
Non covered loans receivable, net
4,709,379
-3.5%
Mortgage loans held for sale
64,544
21.4%
Total loans not covered under shared-loss agreements with the FDIC, net
0.2%
Total loans covered under shared-loss agreements with the FDIC, net
Total securities and loans
7,482,495
-8.2%
-13.8%
73,516
-0.3%
26.7%
-0.8%
20.4%
-10.2%
135,033
150,638
-10.4%
Total other assets
1,567,513
1,713,767
-8.5%
-8.3%
Investments portfolio composition:
74.9%
75.8%
1.0%
1.2%
13.3%
13.0%
0.6%
0.7%
6.4%
5.4%
1.7%
Other debt securities and other investments
Assets Owned
At June 30, 2013, the Company’s total assets amounted to $8.436 billion, a decrease of 8.3% when compared to $9.196 billion at December 31, 2012, and interest-earning assets decreased 8.2% from $7.482 billion at December 31, 2012 to $6.868 billion at June 30, 2013.
At June 30, 2013, loans represented 73% of total interest-earning assets while investments represented 27%, compared to 70% and 30%, respectively, at December 31, 2012.
The Company’s loan portfolio is comprised of residential mortgage loans, commercial loans collateralized by mortgages on real estate located in Puerto Rico, other commercial and industrial loans, consumer loans, leases, and auto loans. Auto loans were added as part of the recent BBVAPR Acquisition. At June 30, 2013, the Company’s loan portfolio decreased 3.4% to $4.991 billion compared to $5.169 billion at December 31, 2012. The covered loan portfolio decreased $25.9 million, or 6.6%, from December 31, 2012. The non-covered loan portfolio decreased $152.3 million, or 3.2%.
The FDIC shared-loss indemnification asset amounted to $236.5 million as of June 30, 2013 and $286.8 million as of December 31, 2012 ,representing a 17% reduction .The FDIC shared-loss indemnification asset is reduced as claims over losses recognized on covered loans are collected from the FDIC. Realized credit losses in excess of previously forecasted estimates result in an increase in the FDIC shared-loss indemnification asset. Conversely, if realized credit losses are less than previously forecasted estimates, the FDIC shared-loss indemnification asset is amortized through the term of the shared-loss agreements. The decrease in the FDIC shared-loss indemnification asset is mainly related to reimbursements of $18.7 million received from the FDIC during the six-month period ended June 30, 2013, net amortization of $32.8 million and a decrease of $2.1 million in expected net credit impairment losses to be covered under shared-loss agreements, partially offset by $3.2 million in incurred expenses to be reimbursed under the shared-loss agreements.
Investments principally consist of U.S. treasury securities, U.S. government and agency bonds, mortgage-backed securities and Puerto Rico government and agency bonds. At June 30, 2013, the investment portfolio decreased 16.7% to $1.861 billion from $2.233 billion at December 31, 2012. This decrease is mostly due to the effect of a decrease of $302.8 million in FNMA and FHLMC certificates. During the quarter and six-month period ended June 30, 2013, the Company did not have realized gains or losses due to the sale of securities.
88
TABLE 5 — LOANS RECEIVABLE COMPOSITION
-6.2%
98.4%
359.6%
86.2%
Total originated and other loans and leases held for investment
41.5%
Accounted for under ASC 310-20
-55.8%
Construction and commercial real estate
-50.3%
-18.4%
-8.9%
-32.3%
Accounted for under ASC 310-30
-20.7%
-28.8%
-16.6%
-25.2%
-15.4%
2,810,683
3,495,434
-19.6%
Deferred loans fees, net
76.0%
22.1%
-4.1%
3.2%
-4.7%
-86.7%
-18.1%
Total loans receivable, net
As shown in Table 5 above, total loans receivable net amounted to $5.0 billion at June 30, 2013 compared to $5.2 billion at December 31, 2013.
The Company’s originated and other loans held-for-investment portfolio composition and trends were as follows:
· Mortgage loan portfolio amounted to $755.3 million (42.4% of the gross originated loan portfolio) compared to $804.9 million (64.1% of the gross originated loan portfolio) at December 31, 2012. Mortgage loan production totaled $101.3 million and $178.4 million for the quarter and the six-month period ended June 30, 2013, respectively, increase of 107.2% and 90.0% from $48.9 million and $93.9 million in the previous year quarter and six-month period, respectively.
· Commercial loan portfolio amounted to $702.1 million (39.4% of the gross originated loan portfolio) compared to $353.9 million (28.1% of the gross originated loan portfolio) at December 31, 2012. Commercial loan production increased 193.8% to $104.3 million for the second quarter ended June 30, 2013 and increased 95.5% to $178.3 for the six-month period ended June 30, 2013 from $35.5 million and $91.2 million for the same period in 2012.
· Consumer loan portfolio amounted to $89.6 million (5.0% of the gross originated loan portfolio) compared to $48.1 million (3.8% of the gross originated loan portfolio) at December 31, 2012. Consumer loan production increased 245.5% to $26.6 million for the quarter ended June 30, 2013 and 284.4% to $49.2 million for the six-month period ended June 30, 2013 from $7.7 million and $12.8 million for the same period in 2012.
· Auto and leasing portfolio amounted to $233.1 million (13.0% of the gross originated loan portfolio) compared to $50.7 million (4.0% of the gross originated loan portfolio) at December 31, 2012. Auto and leasing production was $94.7 million for the quarter ended June 30, 2013 and $195.7 million for the six-month period ended June 30, 2013, compared to $4.4 million and $8.9 million for the same period in 2012 in which the Company only originated leases. The auto business line was added as part of the BBVAPR Acquisition on December 18, 2012.
At June 30, 2013 the Company's non-covered BBVAPR acquired loan portfolio composition was as follows :
Portfolio Type
Carrying Amounts
% of Gross Non-Covered Acquired Portfolio
27.80%
1,041,888
37.07%
151,124
5.38%
836,282
29.75%
100.00%
90
TABLE 6 - LIABILITIES SUMMARY AND COMPOSITION
9.1%
1,421,563
1,647,072
-13.7%
909,258
634,133
43.4%
2,457,384
2,603,693
-5.6%
5,661,011
5,684,565
Accrued interest payable
4,027
4,994
-19.4%
Total deposits and accrued interest payable
-46.9%
197.3%
Other term notes
-32.2%
-30.3%
-36.4%
Acceptances outstanding
13.2%
Other liabilities
15.1%
-9.2%
Deposits portfolio composition percentages:
15.4%
14.1%
25.1%
29.0%
16.1%
11.2%
45.7%
Borrowings portfolio composition percentages:
68.1%
16.4%
21.6%
0.4%
0.3%
5.9%
Amount outstanding at period-end
Daily average outstanding balance
2,888,558
Maximum outstanding balance at any month-end
3,060,578
91
Liabilities and Funding Sources
As shown in Table 6 above, at June 30, 2013, the Company’s total liabilities were $7.565 billion, 9.2% less than the $8.333 billion reported at December 31, 2012. Deposits and borrowings, the Company’s funding sources, amounted to $7.400 billion at June 30, 2013 versus $8.177 billion at December 31, 2012, an 9.5% decrease.
At June 30, 2013, deposits represented 77% and borrowings represented 23% of interest-bearing liabilities, compared to 70% and 30%, respectively, at December 31, 2012. At June 30, 2013, deposits and accrued interest payable, the largest category of the Company’s interest-bearing liabilities, were $5.665 billion, down 0.4% from $5.690 billion at December 31, 2012. Core deposits increased 2.7% to $4.891 billion at June 30, 2013 from December 31, 2012, and brokered deposits decreased 16.6% to $774.1 million as of June 30, 2013 from $928.2 million at December 31, 2012.
Borrowings consist mainly of funding sources through the use of repurchase agreements, FHLB advances, subordinated capital notes, and short-term borrowings. At June 30, 2013, borrowings amounted to $1.735 billion, 30.3% lower than the $2.488 billion reported at December 31, 2012. Repurchase agreements as of June 30, 2013 decreased $381.4 million to $1.314 billion from $1.695 billion at December 31, 2012, as the Company used available cash to pay off repurchase agreements at maturity.
As a member of the FHLB, the Bank can obtain advances from the FHLB, secured by the FHLB stock owned by the Bank, as well as by certain of the Bank’s mortgage loans and investment securities. Advances from FHLB amounted to $285.1 million and $536.5 million as of June 30, 2013 and December 31, 2012, respectively. These advances mature from July 2013 through January 2018.
At June 30, 2013, the Company’s total stockholders’ equity was $870.9 million, a 0.8% increase when compared to $863.6 million at December 31, 2012. Increase in stockholders’ equity was mainly driven by the income for the six-month period, partially offset by changes to other comprehensive income.
Tangible common equity to total assets increased to 7.30% from 6.74% at the end of the last year. Tier 1 Leverage Capital Ratio increased to 8.54% from 6.42%, Tier 1 Risk-Based Capital Ratio increased to 13.96% from 12.94%, and Total Risk-Based Capital Ratio increased to 16.02% from 15.15% on December 31, 2012.
The Company maintains capital ratios in excess of regulatory requirements. At June 30, 2013, Tier 1 Leverage Capital Ratio was 2.14 times the minimum requirement of 4.00%, Tier 1 Risk-Based Capital Ratio was 3.49 times the minimum requirement of 4.00%, and Total Risk-Based Capital Ratio was 2.00 times the minimum requirement of 8.00%.
The following are the consolidated capital ratios of the Company at June 30, 2013 and December 31, 2012:
TABLE 7 — CAPITAL, DIVIDENDS AND STOCK DATA
(Dollars in thousands, except per share data)
Capital data:
Regulatory Capital Ratios data:
Leverage capital ratio
32.9%
Minimum leverage capital ratio required
Actual tier 1 capital
3.6%
Minimum tier 1 capital required
329,225
-22.0%
Excess over regulatory requirement
373,576
255,820
46.0%
Tier 1 risk-based capital ratio
Minimum tier 1 risk-based capital ratio required
Actual tier 1 risk-based capital
Minimum tier 1 risk-based capital required
201,409
-3.9%
501,392
468,493
7.0%
Risk-weighted assets
5,035,233
5,240,861
Total risk-based capital ratio
Minimum total risk-based capital ratio required
Actual total risk-based capital
806,418
1.5%
Minimum total risk-based capital required
402,819
403,599
374,926
7.6%
Tangible common equity to total assets
7.30%
8.5%
Tangible common equity to risk-weighted assets
12.22%
11.82%
3.4%
Total equity to total assets
10.32%
9.39%
9.9%
Total equity to risk-weighted assets
17.30%
16.48%
5.0%
9.4%
Tier 1 common equity capital
501,932
477,241
5.2%
Stock data:
Outstanding common shares
45,640,105
45,580,281
Market capitalization at end of period
826,542
608,497
35.8%
Common dividend data:
Cash dividends declared
4,886
Cash dividends declared per share
Payout ratio
11.54%
21.19%
-45.5%
Dividend yield
1.33%
2.17%
The following table presents a reconciliation of the Company’s total stockholders’ equity to tangible common equity and total assets to tangible assets at June 30, 2013 and December 31, 2012:
(In thousands, except share or per
share information)
(176,000)
10,130
10,115
(76,383)
(8,633)
(9,463)
(4,568)
(5,027)
Total tangible common equity
615,470
606,848
9,196,261
Total tangible assets
8,346,350
9,105,388
Tangible common equity to tangible assets
7.37%
6.66%
Common shares outstanding at end of period
The tangible common equity ratio and tangible book value per common share are non-GAAP measures. Management and many stock analysts use the tangible common equity ratio and tangible book value per common share in conjunction with more traditional bank capital ratios to compare the capital adequacy of banking organizations. Neither tangible common equity nor tangible assets or related measures should be considered in isolation or as a substitute for stockholders’ equity, total assets or any other measure calculated in accordance with GAAP. Moreover, the manner in which the Company calculates its tangible common equity, tangible assets and any other related measures may differ from that of other companies reporting measures with similar names.
The Tier 1 common equity to risk-weighted assets ratio is another non-GAAP measure. Ratios calculated based upon Tier 1 common equity have become a focus of regulators and investors, and management believes ratios based on Tier 1 common equity assist investors in analyzing the Company’s capital position. In connection with the Supervisory Capital Assessment Program, the Federal Reserve Board began supplementing its assessment of the capital adequacy of a large bank holding company based on a variation of Tier 1 capital, known as Tier 1 common equity.
Because Tier 1 common equity is not formally defined by GAAP or, unlike Tier 1 capital, codified in the federal banking regulations, this measure is considered to be a non-GAAP financial measure. Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied and are not audited. To mitigate these limitations, the Company has procedures in place to calculate these measures using the appropriate GAAP or regulatory components. Although these non-GAAP financial measures are frequently used by stakeholders in the evaluation of a company, they have limitations as analytical tools and should not be considered in isolation or as a substitute for analyses of results as reported under GAAP.
The table below presents a reconciliation of the Company’s total common equity (GAAP) at June 30, 2013 and December 31, 2012 to Tier 1 common equity (non-GAAP):
December 31
Common stockholders' equity
705,054
697,721
Unrealized gains on available-for-sale securities, net of income tax
(25,400)
(68,245)
Unrealized losses on cash flow hedges, net of income tax
9,634
12,365
Disallowed deferred tax assets
(96,473)
(85,010)
Disallowed servicing assets
(1,299)
(1,079)
Intangible assets:
Other disallowed intangibles
(13,201)
(14,490)
Total Tier 1 common equity
464,879
8.87%
The following table presents the Company’s capital adequacy information at June 30, 2013 and December 31, 2012:
Risk-based capital:
Tier 1 capital
Supplementary (Tier 2) capital
103,616
116,068
806,417
Risk-weighted assets:
Balance sheet items
4,715,273
4,927,919
Off-balance sheet items
319,960
312,942
Total risk-weighted assets
Ratios:
Tier 1 capital (minimum required - 4%)
Total capital (minimum required - 8%)
Leverage ratio
Equity to assets
Tangible common equity to assets
The Federal Reserve Board has risk-based capital guidelines for bank holding companies. Under the guidelines, the minimum ratio of qualifying total capital to risk-weighted assets is 8%. At least half of the total capital is to be comprised of qualifying common stockholders’ equity, qualifying noncumulative perpetual preferred stock (including related surplus), minority interests related to qualifying common or noncumulative perpetual preferred stock directly issued by a consolidated U.S. depository institution or foreign bank subsidiary, and restricted core capital elements (collectively, “Tier 1 Capital”). Banking organizations are expected to maintain at least 50% of their Tier 1 Capital as common equity. Except as otherwise discussed below in light of the Dodd-Frank Act in connection with certain debt or equity instruments issued on or after May 19, 2010, not more than 25% of qualifying Tier 1 Capital may consist of qualifying cumulative perpetual preferred stock, trust preferred securities or other so-called restricted core capital elements. “Tier 2 Capital” may consist, subject to certain limitations, of allowance for loan and lease losses; perpetual preferred stock and related surplus; hybrid capital instruments, perpetual debt, and mandatory convertible debt securities; term subordinated debt and intermediate-term preferred stock, including related surplus; and unrealized holding gains on equity securities. “Tier 3 Capital” consists of qualifying unsecured subordinated debt.
The sum of Tier 2 and Tier 3 Capital may not exceed the amount of Tier 1 Capital. At June 30, 2013 and December 31, 2012, the Company was a “well capitalized” institution for regulatory purposes.
95
The Federal Reserve Board has regulations with respect to risk-based and leverage capital ratios that require most intangibles, including goodwill and core deposit intangibles, to be deducted from Tier 1 Capital. The only types of identifiable intangible assets that may be included in, that is, not deducted from, an organization’s capital are readily marketable mortgage servicing assets, nonmortgage servicing assets, and purchased credit card relationships.
In addition, the Federal Reserve Board has established minimum leverage ratio (Tier 1 Capital to total assets) guidelines for bank holding companies and member banks. These guidelines provide for a minimum leverage ratio of 3% for bank holding companies and member banks that meet certain specified criteria, including that they have the highest regulatory rating. All other bank holding companies and member banks are required to maintain a minimum ratio of Tier 1 Capital to total assets of 4%. The guidelines also provide that banking organizations experiencing internal growth or making acquisitions are expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the guidelines state that the Federal Reserve Board will continue to consider a “tangible Tier 1 leverage ratio” and other indicators of capital strength in evaluating proposals for expansion or new activities.
Under the Dodd-Frank Act, federal banking regulators are required to establish minimum leverage and risk-based capital requirements on a consolidated basis for insured institutions, depository institution holding companies, and non-bank financial companies supervised by the Federal Reserve Board. The minimum leverage and risk-based capital requirements are to be determined based on the minimum ratios established for insured depository institutions under prompt corrective action regulations. In effect, such provision of the Dodd-Frank Act (i.e., Section 171), which is commonly known as the Collins Amendment, applies to bank holding companies the same leverage and risk based capital requirements that apply to insured depository institutions. Because the capital requirements must be the same for insured depository institutions and their holding companies, the Collins Amendment generally excludes certain debt or equity instruments, such as cumulative perpetual preferred stock and trust preferred securities, from Tier 1 Capital, subject to a three-year phase-out from Tier 1 qualification for such instruments issued before May 19, 2010, with the phase-out commencing on January 1, 2014 for advanced approaches banking organizations and January 1, 2015 for other bank holding companies with consolidated assets of $15 billion or more as of December 31, 2009. However, such instruments issued before May 19, 2010 by a bank holding company, such as the Company, with total consolidated assets of less than $15 billion as of December 31, 2009, are not affected by the Collins Amendment and may continue to be included in Tier 1 Capital as a restricted core capital element.
In July 2013, the Office of the Comptroller of the Currency (the “OCC”), the Federal Reserve Board, and the FDIC adopted new rules that revise and replace the agencies’ current capital rules. The new capital rules revise the agencies’ risk-based and leverage capital requirements for banking organizations, and consolidate three separate notices of proposed rulemaking that the OCC, Federal Reserve Board and FDIC published in the Federal Register on August 30, 2012, with selected changes. These rules implement a revised definition of regulatory capital, a new common equity Tier 1 minimum capital requirement, a higher minimum Tier 1 capital requirement, and, for banking organizations subject to the advanced approaches risk-based capital rules, a supplementary leverage ratio that incorporates a broader set of exposures in the denominator. The rules incorporate these new requirements into the agencies’ prompt corrective action framework. In addition, the rules establish limits on a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a specified amount of common equity Tier 1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements. Further, the rules amend the methodologies for determining risk-weighted assets for all banking organizations; introduce disclosure requirements that would apply to top-tier banking organizations domiciled in the United States with $50 billion or more in total assets; and adopt changes to the agencies’ regulatory capital requirements that meet the requirements of Section 171 and Section 939A of the Dodd-Frank Act. These rules also codify the agencies’ current capital rules, which have previously resided in various appendices to their respective regulations, into a harmonized integrated regulatory framework.
The Company’s common stock is traded on the New York Stock Exchange (“NYSE”) under the symbol “OFG.” At June 30, 2013 and December 31, 2012, the Company’s market capitalization for its outstanding common stock was $826.5 million ($18.11 per share) and $608.5 million ($13.35 per share), respectively.
The following table provides the high and low prices and dividends per share of the Company’s common stock for each quarter in 2013, 2012 and 2011:
Price
Dividend
High
Low
Per share
14.26
March 31, 2013
15.83
13.85
9.98
September 30, 2012
11.49
10.02
June 30, 2012
12.37
9.87
March 31, 2012
12.69
11.25
2011
December 31, 2011
12.35
9.19
September 30, 2011
13.20
9.18
0.05
June 30, 2011
13.07
11.26
March 31, 2011
12.84
11.40
The Bank is considered “well capitalized” under the regulatory framework for prompt corrective action. The table below shows the Bank’s regulatory capital ratios at June 30, 2013 and at December 31, 2012:
Oriental Bank Regulatory Capital Ratios:
Total Tier 1 Capital to Total Assets
36.2%
6.0%
Minimum capital requirement (4%)
-22.2%
Minimum to be well capitalized (5%)
Tier 1 Capital to Risk-Weighted Assets
9.7%
Minimum to be well capitalized (6%)
Total Capital to Risk-Weighted Assets
3.3%
Minimum capital requirement (8%)
Minimum to be well capitalized (10%)
97
Company’s Financial Assets Managed
The Company’s financial assets managed include those managed by the Company’s trust division, retirement plan administration subsidiary, and its broker-dealer subsidiaries. Assets managed by the trust division and the broker-dealer subsidiaries increased from December 31, 2012, mainly as a result of an increase in employer and employee account contributions and capital market appreciation.
The Company’s trust division offers various types of IRAs and manages 401(k) and Keogh retirement plans and custodian and corporate trust accounts, while the retirement plan administration subsidiary, CPC, manages private retirement plans. At June 30, 2013, total assets managed by the Company’s trust division and CPC amounted to $2.639 billion, compared to $2.514 billion at December 31, 2012. Oriental Financial Services and OFS Securities offer a wide array of investment alternatives to their client base, such as tax-advantaged fixed income securities, mutual funds, stocks, bonds and money management wrap-fee programs. At June 30, 2013, total assets gathered by Oriental Financial Services and OFS Securities from their customer investment accounts increased to $2.822 billion, compared to $2.722 billion in assets gathered at December 31, 2012.
Allowance for Loan and Lease Losses and Non-Performing Assets
The Company maintains an allowance for loan and lease losses at a level that management considers adequate to provide for probable losses based upon an evaluation of known and inherent risks. The Company’s allowance for loan and lease losses policy provides for a detailed quarterly analysis of probable losses. Tables 8 through 13 set forth an analysis of activity in the allowance for loan and lease losses and present selected loan loss statistics. In addition, refer to Table 5 for the composition of the loan portfolio.
At June 30, 2013, the Company’s allowance for non-covered loan and lease losses amounted to $46.6 million, $41.2 million of such allowance corresponded to originated and other loans held for investment, or 2.91% of total non-covered originated and other loans held for investment at June 30, 2013, compared to $39.9 million or 3.17% of total non-covered originated and other loans held for investment at December 31, 2012. The allowance for residential mortgage loans, consumer loans, and auto and leases increased by 8.5% (or $1.8 million), 53.4% (or $457 thousand), and 226.6% (or $1.2 million), respectively, when compared with balances recorded at December 31, 2012. The allowance for commercial loans decreased by 4.4%, or $758 thousand, when compared with balances recorded at December 31, 2012. The unallocated allowance at June 30, 2013 decreased by 79.1%, or $291 thousand, when compared with balances recorded at December 31, 2012.
Please refer to the “Provision for Loan and Lease Losses” section in this MD&A for a more detailed analysis of provisions for loan and lease losses.
Loans acquired in a business acquisition are recorded at their fair value at the acquisition date. Credit cards, floor plans, revolving lines of credit, and auto loans with FICO scores over 660, acquired as part of the BBVAPR Acquisition are accounted for under the guidance of ASC 310-20, which requires that any differences between contractually required loan payment receivable in excess of the Company’s initial investment in the loans be accreted into interest income on a level-yield basis over the life of the loan. Loans acquired in the BBVAPR Acquisition that were accounted for under the provisions of ASC 310-20 which had fully amortized their premium or discount, recorded at the date of acquisition, at the end of the reporting period are removed from the acquired loan category. Allowance for loan and lease losses recorded for acquired loans as of June 30, 2013 was $924 thousand.
The remaining loans acquired in the BBVAPR Acquisition are accounted for under ASC-310-30 and were recognized at fair value as of December 18, 2012. The Company does not believe differences between cash flows collected on the loans acquired in the BBVAPR Acquisition accounted for under ASC-310-30 and those anticipated at December 18, 2012 are the result of credit deterioration from our original estimates, and thus no allowance for these loans was recorded as of June 30, 2013.
There have been no material changes in criteria or estimation techniques as compared to prior periods that impacted the determination of the current period allowance for loan and lease losses, except for the inclusion of the loans acquired under BBVAPR Acquisition.
The Company’s non-performing assets include non-performing loans and foreclosed real estate (see Tables 11 and 12). At June 30, 2013 and December 31, 2012, the Company had $132.2 million and $146.6 million, respectively, of non-accrual non-covered loans, including acquired loans accounted under ASC 310-20 (loans with revolving feature and/or acquired at a premium). Covered loans
and loans acquired from BBVAPR with credit deterioration are considered to be performing due to the application of the accretion method under ASC 310-30. At June 30, 2013 and December 31, 2012, loans whose terms have been extended and which are classified as troubled-debt restructuring that are not included in non-performing assets amounted to $48.3 million and $52.0 million, respectively.
At June 30, 2013, the Company’s non-performing assets decreased 3.2% to $221.3 million (3.84% of total assets, excluding covered assets and acquired loans with deteriorated credit quality) from $228.5 million (3.72% of total assets, excluding covered assets and acquired loans with deteriorated credit quality) at December 31, 2012. The Company does not expect non-performing loans to result in significantly higher losses as most are well-collateralized with adequate loan-to-value ratios. At June 30, 2013, the allowance for non-covered originated loans and lease losses to non-performing loans coverage ratio was 32.45% (27.13% at December 31, 2012).
The Company follows a conservative residential mortgage lending policy, with more than 90% of its residential mortgage portfolio consisting of fixed-rate, fully amortizing, fully documented loans that do not have the level of risk associated with subprime loans offered by certain major U.S. mortgage loan originators. Furthermore, the Company has never been active in negative amortization loans or adjustable rate mortgage loans, including those with teaser rates, and does not originate construction and development loans.
The following items comprise non-performing assets:
1. Originated and other loans held for investment:
· Mortgage loans — are placed on non-accrual status when they become 90 days or more past due and are written-down, if necessary, based on the specific evaluation of the collateral underlying the loan, except for FHA and VA insured mortgage loans which are placed in non-accrual when they become 18 months or more past due. At June 30, 2013, the Company’s originated non-performing mortgage loans totaled $99.1 million (75.0% of the Company’s non-performing loans), a 13.8% decrease from $115.0 million (78.4% of the Company’s non-performing loans) at December 31, 2012. Non-performing loans in this category are primarily residential mortgage loans. Non-performing loans decrease is primarily due to the reclassification of certain non-performing residential mortgage loans with a net book value of $53.6 million, to the loan held-for-sale category. Without this re-class to loans held-for-sale, non-performing loan balances would have been relatively consistent between December 31, 2012 and June 31, 2013.
· Commercial loans — are placed on non-accrual status when they become 90 days or more past due and are written-down, if necessary, based on the specific evaluation of the underlying collateral, if any. At June 30, 2013, the Company’s originated non-performing commercial loans amounted to $30.8 million (23.3% of the Company’s non-performing loans), a 4.2% increase when compared to non-performing commercial loans of $29.5 million at December 31, 2012 (20.1% of the Company’s non-performing loans). Most of this portfolio is collateralized by commercial real estate properties.
· Consumer loans — are placed on non-accrual status when they become 90 days past due and written-off when payments are delinquent 120 days in personal loans and 180 days in credit cards and personal lines of credit. At June 30, 2013, the Company’s originated non-performing consumer loans amounted to $371 thousand (0.3% of the Company’s total non-performing loans), a 16.1% decrease from $442 thousand at December 31, 2012 (0.3% of the Company’s total non-performing loans).
· Auto and leases — are placed on non-accrual status when they become 90 days past due and partially written-off to collateral value when payments are delinquent 120 days, and fully written-off when payments are delinquent 180 days. At June 30, 2013, the Company’s originated non-performing auto and leases amounted to $219 thousand (0.2% of the Company’s total non-performing loans), an increase of 67.2% from $131 thousand at December 31, 2012 (0.1% of the Company’s total non-performing loans).
2. Acquired loans accounted for under ASC 310-20 (loans with revolving features and/or acquired at premium):
· Commercial revolving lines of credit and credit cards - are placed on non-accrual status when they become 90 days or more past due and are written-down, if necessary, based on the specific evaluation of the underlying collateral, if any. At June 30, 2013, the Company’s acquired non-performing commercial lines of credit accounted for under ASC 310-20 amounted to $153 thousand (0.1% of the Company’s non-performing loans), a 20.7% decrease when compared to non-
performing commercial lines of credit accounted for under ASC 310-20 of $193 thousand at December 31, 2012 (0.1% of the Company’s non-performing loans).
· Auto loans acquired at premium - are placed on non-accrual status when they become 90 days past due and written-off when payments are delinquent 120 days. At June 30, 2013, the Company’s acquired non-performing auto loans accounted for under ASC 310-20 totaled $605 thousand (0.5% of the Company’s non-performing loans), a 120.0% increase when compared to non-performing auto loans accounted for under ASC 310-20 of $275 thousand at December 31, 2012 (0.2% of the Company’s non-performing loans).
· Consumer revolving lines of credit and credit cards — are placed on non-accrual status when they become 90 days past due and written-off when payments are delinquent 180 days. At June 30, 2013, the Company’s acquired non-performing consumer lines of credit and credit cards accounted for under ASC 310-20 totaled $1.0 million (0.8% of the Company’s non-performing loans), an 8.6% decrease when compared to non-performing consumer lines of credit and credit cards accounted for under ASC 310-20 of $1.1 million at December 31, 2012 (0.7% of the Company’s non-performing loans).
3. Acquired loans accounted for under ASC 310-30 are considered to be performing due to the application of the accretion method, in which these loans will accrete interest income over the remaining life of the loans using estimated cash flow analyses.
4. Foreclosed real estate is initially recorded at the lower of the related loan balance or fair value less cost to sell as of the date of foreclosure. Any excess of the loan balance over the fair value of the property is charged against the allowance for loan and lease losses. Subsequently, any excess of the carrying value over the estimated fair value less disposition cost is charged to operations. Net losses on the sale of foreclosed real estate for the quarter and six-month period ended June 30, 2013 amounted to $1.7 million and $3.6 million, respectively, compared to $886 thousand and $1.3 million for the same quarter in 2012.
The Company has two mortgage loan modification programs. These are the Loss Mitigation Program and the Non-traditional Mortgage Loan Program. Both programs are intended to help responsible homeowners to remain in their homes and avoid foreclosure, while also reducing the Company’s losses on non-performing mortgage loans.
The Loss Mitigation Program helps mortgage borrowers who are or will become financially unable to meet the current or scheduled mortgage payments. Loans that qualify under this program are those guaranteed by FHA, VA, RHS, “Banco de la Vivienda de Puerto Rico,” conventional loans guaranteed by Mortgage Guaranty Insurance Corporation (MGIC), conventional loans sold to the FNMA and FHLMC, and conventional loans retained by the Company. The program offers diversified alternatives such as regular or reduced payment plans, payment moratorium, mortgage loan modification, partial claims (only FHA), short sale, and payment in lieu of foreclosure.
The Non-traditional Mortgage Loan Program is for non-traditional mortgages, including balloon payment, interest only/interest first, variable interest rate, adjustable interest rate and other qualified loans. Non-traditional mortgage loan portfolios are segregated into the following categories: performing loans that meet secondary market requirement and are refinanced by the credit underwriting guidelines of FHA/VA/FNMA/FMAC, and performing loans not meeting secondary market guidelines, processed by the Company’s current credit and underwriting guidelines. The Company achieved an affordable and sustainable monthly payment by taking specific, sequential, and necessary steps such as reducing the interest rate, extending the loan term, capitalizing arrearages, deferring the payment of principal or, if the borrower qualifies, refinancing the loan.
There may not be a foreclosure sale scheduled within 60 days prior to a loan modification under any such programs. This requirement does not apply to loans where the foreclosure process has been stopped by the Company. In order to apply for any of the loan modification programs, the borrower may not be in active bankruptcy or have been discharged from Chapter 7 bankruptcy since the loan was originated. Loans in these programs will be evaluated by management for troubled debt restructuring classification if the Company grants a concession for legal or economic reasons due to the debtor’s financial difficulties.
The allowance for loan and lease losses on covered loans acquired in the FDIC-assisted acquisition of Eurobank is accounted under the provisions of ASC 310-30. Under this accounting guidance, the allowance for loan and lease losses on covered loans is evaluated at each financial reporting period, based on forecasted cash flows. Credit related decreases in expected cash flows, compared to those previously forecasted, are recognized by recording a provision for credit losses on covered loans when it is probable that all cash flows
expected at acquisition will not be collected. The portion of the loss on covered loans reimbursable from the FDIC is recorded as an offset to the provision for credit losses and increases the FDIC shared-loss indemnification asset.
During the quarter ended June 30, 2013, the assessment of actual versus expected cash flows resulted in a net provision of $1.2 million, principally because certain pools of commercial real estate backed loans underperformed. The pools in which an additional allowance was recognized had no offsetting adjustment to the FDIC shared-loss indemnification asset as these losses were not covered by a loss share agreement and were mainly attributed to delay timing in the expected cash flows rather than additional forecasted losses.
For the six-month period ended June 30, 2013, the net provision for covered loans amounted to $1.9 million. The allowance for covered loans decreased from $54.1 million at December 31, 2012 to $53.0 million at June 30, 2013. The decrease in the allowance balance is mainly attributable to the fact that during the first quarter of this period, the assessment of actual versus expected cash flows included the reversal of previously recorded allowance in certain commercial real estate and commercial and industrial pools whose loans the Company has managed to workout with better outcomes than forecasted.
TABLE 8 — ALLOWANCE FOR LOAN AND LEASE LOSSES SUMMARY
Originated loans:
845.2%
513.5%
757.5%
(36,521)
451.3%
417.0%
586
171.3%
22.2%
Acquired loans accounted for
under ASC 310-20:
Total non-covered loans balance
at end of period
46,625
24.7%
Allowance for loans and lease
losses on originated loans to:
Total originated loans
2.57%
3.17%
-19.0%
3.03%
-15.2%
Non-performing originated loans
51.03%
31.03%
64.4%
30.54%
67.1%
losses on acquired loans
accounted for under ASC 310-20:
Total acquired loans accounted
for under ASC 310-20
0.16%
0.07%
Non-performing acquired loans
accounted for under ASC 310-20
41.32%
Covered loans
45.3%
loan and lease losses, net
672
-54.2%
-92.2%
FDIC shared-loss portion on
(provision for) recapture of loan
(1,822)
-351.7%
-114.3%
-9.6%
TABLE 9 — ALLOWANCE FOR NON-COVERED LOAN AND LEASE LOSSES BREAKDOWN
Originated and other loans held for investment
Allowance balance:
1.3%
583.1%
173.6%
Unallocated allowance
95.7%
Total allowance balance
14.5%
Allowance composition:
46.77%
52.83%
-11.5%
38.56%
42.76%
-9.8%
7.97%
1.34%
494.8%
5.12%
139.3%
1.58%
69.9%
Allowance coverage ratio at end of period applicable to:
2.62%
8.0%
2.51%
4.82%
-48.0%
1.56%
1.05%
48.6%
47.0%
Unallocated allowance to total originated loans
0.04%
0.03%
38.2%
Total allowance to total originated loans
-19.1%
Allowance coverage ratio to non-performing loans:
38.40%
18.34%
54.34%
57.86%
-6.1%
332.21%
406.87%
631.27%
193.67%
226.0%
27.52%
85.4%
Acquired loans accounted for under ASC 310-20
0.60%
Total allowance to total acquired loans
0.11%
187.42%
TABLE 10 — NET CREDIT LOSSES STATISTICS ON NON-COVERED ORIGINATED LOAN AND LEASES
(29,119)
1394.8%
(31,708)
1005.2%
(2,887)
67.8%
2.6%
588.2%
159.4%
(2,653)
(1,687)
(3,182)
(3,257)
-2.3%
75.5%
55.5%
-23.2%
(280)
(128)
118.8%
(461)
(259)
78.0%
2480.6%
5125.0%
2600.0%
(500)
-12600%
(584)
2439.1%
Net credit losses
Total charge-offs
Total recoveries
(32,552)
(3,759)
766.0%
(35,935)
(6,408)
460.8%
Net credit losses to average
loans outstanding:
14.38%
0.95%
1413.7%
7.82%
0.69%
1033.3%
2.66%
22.6%
2.13%
-23.0%
1.52%
1.29%
17.8%
1.43%
6.7%
-0.06%
-1850.0%
0.81%
0.17%
376.5%
8.84%
1.25%
607.2%
1.07%
377.6%
Recoveries to charge-offs
1.47%
2.44%
-39.7%
1.60%
3.26%
-50.8%
Average originated loans:
-1.4%
-2.2%
28.0%
26.8%
66.0%
581.3%
440.6%
17.2%
TABLE 11 — NON-PERFORMING ASSETS
(%)
Non-performing assets:
Non-accruing loans
Troubled Debt Restructuring loans
35,566
50,468
-29.5%
Other loans
52,762
96,176
-45.1%
Accruing loans
2,821
652
Total non-performing loans
91,801
-37.4%
Foreclosed real estate not covered under the
shared-loss agreements with the FDIC
8.3%
Other repossessed asset
46.6%
26,586
319
8234.2%
208,997
228,494
Non-performing assets to total assets, excluding covered assets and acquired loans with deteriorated credit quality (including those by analogy)
3.59%
3.72%
Non-performing assets to total capital
24.00%
26.46%
-9.3%
Interest that would have been recorded in the period if the
loans had not been classified as non-accruing loans
530
1,642
991
3,075
TABLE 12 — NON-PERFORMING LOANS
Non-performing loans:
55,668
-51.6%
371
-16.1%
736.6%
Acquired loans accounted for under ASC 310-20 (Loans with
revolving feature and/or acquired at a premium)
155.4%
Auto loans
145.1%
-2.4%
Non-performing loans composition percentages:
Originated loans
60.6%
78.4%
35.3%
20.1%
Non-performing loans to:
Total loans, excluding covered loans and loans accounted for
under ASC 310-30 (including those by analogy)
3.87%
6.90%
-43.9%
Total assets, excluding covered assets and loans accounted for
2.39%
-34.0%
Total capital
10.54%
16.98%
-37.9%
Non-performing loans with partial charge-offs to:
1.26%
2.01%
-37.2%
Non-performing loans
32.49%
29.17%
11.4%
Other non-performing loans ratios:
Charge-off rate on non-performing loans to non-performing loans
on which charge-offs have been taken
40.25%
27.86%
44.5%
Allowance for loan and lease losses to non-performing
loans on which no charge-offs have been taken
75.23%
37.81%
99.0%
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TABLE 13 — HIGHER RISK RESIDENTIAL MORTGAGE LOANS
Higher-Risk Residential Mortgage Loans*
High Loan-to-Value Ratio Mortgages
Junior Lien Mortgages
Interest Only Loans
LTV 90% and over
Delinquency:
0 - 89 days
14,555
353
26,680
4.62%
86,279
3,003
3.48%
90 - 119 days
153
5.88%
1,783
5.05%
120 - 179 days
124
13.71%
8.60%
180 - 364 days
6.82%
1,375
330
176
10.30%
1,787
349
19.53%
2,512
928
36.94%
1,871
266
14.22%
16,998
756
4.45%
30,720
2,500
8.14%
91,734
3,543
3.86%
Percentage of total loans excluding
acquired loans accounted for under ASC 310-30
3.75%
Refinanced or Modified Loans:
2,680
10.82%
19,758
2,066
10.46%
Percentage of Higher-Risk Loan
Category
15.77%
21.54%
Loan-to-Value Ratio:
Under 70%
12,835
612
4.77%
5,599
1,243
22.20%
70% - 79%
2,834
2.36%
3,942
80% - 89%
1,019
3.53%
8,535
489
5.73%
90% and over
310
13.23%
12,644
4.63%
* Loans may be included in more than one higher-risk loan category and excludes acquired residential mortgage loans.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Background
The Company’s risk management policies are established by its Board of Directors (the “Board”) and implemented by management through the adoption of a risk management program, which is overseen and monitored by the Chief Risk Officer and the Risk Management and Compliance Committee. The Company has continued to refine and enhance its risk management program by strengthening policies, processes and procedures necessary to maintain effective risk management.
All aspects of the Company’s business activities are susceptible to risk. Consequently, risk identification and monitoring are essential to risk management. As more fully discussed below, the Company’s primary risk exposures include, market, interest rate, credit, liquidity, operational and concentration risks.
Market Risk
Market risk is the risk to earnings or capital arising from adverse movements in market rates or prices, such as interest rates or prices. The Company evaluates market risk together with interest rate risk. The Company’s financial results and capital levels are constantly exposed to market risk. The Board and management are primarily responsible for ensuring that the market risk assumed by the Company complies with the guidelines established by policies approved by the Board. The Board has delegated the management of this riskto the Asset/Liability Management Committee (“ALCO”) which is composed of certain executive officers from the business, treasury and finance areas. One of ALCO’s primary goals is to ensure that the market risk assumed by the Company is within the parameters established in such policies.
Interest Rate Risk
Interest rate risk is the exposure of the Company’s earnings or capital to adverse movements in interest rates. It is a predominant market risk in terms of its potential impact on earnings. The Company manages its asset/liability position in order to limit the effects of changes in interest rates on net interest income. ALCO oversees interest rate risk, liquidity management and other related matters.
In discharging its responsibilities, ALCO examines current and expected conditions in global financial markets, competition and prevailing rates in the local deposit market, liquidity, unrealized gains and losses in securities, recent or proposed changes to the investment portfolio, alternative funding sources and their costs, hedging and the possible purchase of derivatives such as swaps, and any tax or regulatory issues which may be pertinent to these areas.
On a monthly basis, the Company performs a net interest income simulation analysis on a consolidated basis to estimate the potential change in future earnings from projected changes in interest rates. These simulations are carried out over a one-year time horizon, assuming certain gradual upward and downward interest rate movements, achieved during a twelve-month period. Simulations are carried out in two ways:
(i) using a static balance sheet as the Company had on the simulation date, and
(ii) using a dynamic balance sheet based on recent growth patterns and business strategies.
The balance sheet is divided into groups of assets and liabilities detailed by maturity or re-pricing and their corresponding interest yields and costs. As interest rates rise or fall, these simulations incorporate expected future lending rates, current and expected future funding sources and costs, the possible exercise of options, changes in prepayment rates, deposits decay and other factors which may be important in projecting the future growth of net interest income.
The Company uses a software application to project future movements in the Company’s balance sheet and income statement. The starting point of the projections generally corresponds to the actual values of the balance sheet on the date of the simulations.
These simulations are highly complex, and use many simplifying assumptions that are intended to reflect the general behavior of the Company over the period in question. There can be no assurance that actual events will match these assumptions in all cases. For this reason, the results of these simulations are only approximations of the true sensitivity of net interest income to changes in market interest rates. The following table presents the results of the simulations at June 30, 2013 for the most likely scenario, assuming a one-year time horizon:
Net Interest Income Risk (one year projection)
Static Balance Sheet
Growing Simulation
Percent
Change
Change in interest rate
+ 200 Basis points
8,494
2.08%
11,596
+ 100 Basis points
5,441
7,067
- 50 Basis points
(273)
-0.07%
(93)
-0.02%
The impact of -100 and -200 basis point reductions in interest rates is not presented in view of current level of the federal funds rate and other short-term interest rates.
Future net interest income could be affected by the Company’s investments in callable securities, prepayment risk related to mortgage loans and mortgage-backed securities, and its structured repurchase agreements and advances from the FHLB. As part of the strategy to limit the interest rate risk and reduce the re-pricing gaps of the Company’s assets and liabilities, the maturity and the re-pricing frequency of the liabilities have been extended to longer terms and the amounts of its structured repurchase agreements and advances from the FHLB been reduced.
The Company maintains an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility. The Company’s goal is to manage interest rate sensitivity by modifying the repricing or maturity characteristics of certain balance sheet assets and liabilities so that the net interest margin is not, on a material basis, adversely affected by movements in interest rates. As a result of interest rate fluctuations, hedged fixed-rate assets and liabilities will appreciate or depreciate in market value. Also, for some fixed-rate assets or liabilities, the effect of this variability in earnings is expected to be substantially offset by the Company’s gains and losses on the derivative instruments that are linked to the forecasted cash flows of these hedged assets and liabilities. The Company considers its strategic use of derivatives to be a prudent method of managing interest-rate sensitivity as it reduces the exposure of earnings and the market value of its equity to undue risk posed by changes in interest rates. The effect of this unrealized appreciation or depreciation is expected to be substantially offset by the Company’s gains or losses on the derivative instruments that are linked to these hedged assets and liabilities. Another result of interest rate fluctuations is that the contractual interest income and interest expense of hedged variable-rate assets and liabilities, respectively, will increase or decrease.
Derivative instruments that are used as part of the Company’s interest risk management strategy include interest rate swaps, forward-settlement swaps, futures contracts, and option contracts that have indices related to the pricing of specific balance sheet assets and liabilities. Interest rate swaps generally involve the exchange of fixed and variable-rate interest payments between two parties based on a common notional principal amount and maturity date. Interest rate futures generally involve exchanged-traded contracts to buy or sell U.S. Treasury bonds and notes in the future at specified prices. Interest rate options represent contracts that allow the holder of the option to (i) receive cash or (ii) purchase, sell, or enter into a financial instrument at a specified price within a specified period. Some purchased option contracts give the Company the right to enter into interest rate swaps and cap and floor agreements with the writer of the option. In addition, the Company enters into certain transactions that 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 is bifurcated and carried at fair value. Please refer to Note 7 to the accompanying unaudited consolidated financial statements for further information concerning the Company’s derivative activities.
Following is a summary of certain strategies, including derivative activities, currently used by the Company to manage interest rate risk:
Interest rate swaps — The Company entered into hedge-designated swaps to hedge the variability of future interest cash flows of forecasted wholesale borrowings, attributable to changes in the one-month LIBOR rate. Once the forecasted wholesale borrowings transactions occurred, the interest rate swap effectively fixes the Company’s interest payments on an amount of forecasted interest
109
expense attributable to the one-month LIBOR rate corresponding to the swap notional stated rate. A derivative liability of $13.2 million was recognized at June 30, 2013, related to the valuation of these swaps. Refer to Note 7 of the unaudited consolidated financial statements for a description of these swaps.
As part of the BBVAPR Acquisition, the Company assumed certain derivative contracts from BBVAPR, including interest rate swaps not designated as hedging instruments which are utilized to convert certain fixed-rate loans to variable rates, and the mirror-images of these interest rate swaps in which BBVAPR entered into to minimize its interest rate risk exposure that results from offering the derivatives to clients. These interest rate swaps are marked to market through earnings. At June 30, 2013, interest rate swaps offered to clients not designated as hedging instruments represented a derivative asset of $3.2 million, and the mirror-image interest rate swaps in which BBVAPR entered into represented a derivative liability of $3.2 million. Refer to Note 7 of the unaudited consolidated financial statements for a description of these swaps.
S&P options — The Company has offered its customers certificates of deposit with an option tied to the performance of the S&P 500 Index. At the end of five years, the depositor receives a minimum return or a specified percentage of the average increase of the month-end value of the S&P 500 Index. The Company uses option agreements with major money center banks and major broker-dealer companies to manage its exposure to changes in that index. Under the terms of the option agreements, the Company receives the average increase in the month-end value of S&P 500 Index in exchange for a fixed premium. The changes in fair value of the options purchased and the options embedded in the certificates of deposit are recorded in earnings.
At June 30, 2013 and December 31, 2012, the fair value of the purchased options used to manage the exposure to the S&P 500 Index on stock-indexed certificates of deposit represented an asset of $16.0 million and $13.2 million, respectively, and the options sold to customers embedded in the certificates of deposit represented a liability of $15.3 million and $12.7 million, respectively.
Wholesale borrowings — The Company uses interest rate swaps to hedge the variability of interest cash flows of certain advances from FHLB that are tied to a variable rate index. The interest rate swaps effectively fix the Company’s interest payments on these borrowings. As of June 30, 2013, the Company had $225 million in interest rate swaps at an average rate of 2.63% designated as cash flow hedges for $225 million in advances from FHLB that reprice or are being rolled over on a monthly basis.
Credit Risk
Credit risk is the possibility of loss arising from a borrower or counterparty in a credit-related contract failing to perform in accordance with its terms. The principal source of credit risk for the Company is its lending activities. In Puerto Rico, the Company’s principal market, economic growth remains a challenge due to the lack of significant employment growth, a housing sector that remains under pressure and the Puerto Rico government’s large structural deficit.
The Company manages its credit risk through a comprehensive credit policy which establishes sound underwriting standards by monitoring and evaluating loan portfolio quality, and by the constant assessment of reserves and loan concentrations. The Company also employs proactive collection and loss mitigation practices.
The Company may also encounter risk of default in relation to its securities portfolio. The securities held by the Company are principally agency mortgage-backed securities. Thus, a substantial portion of these instruments are guaranteed by mortgages, a U.S. government-sponsored entity, or the full faith and credit of the U.S. government.
The Company’s Executive Credit Committee, composed of its Chief Executive Officer, Chief Credit Risk Officer and other senior executives, has primary responsibility for setting strategies to achieve the Company’s credit risk goals and objectives. Those goals and objectives are set forth in the Company’s Credit Policy as approved by the Board.
Liquidity Risk
Liquidity risk is the risk of the Company not being able to generate sufficient cash from either assets or liabilities to meet obligations as they become due without incurring substantial losses. The Board has established a policy tomanage this risk. The Company’s cash requirements principally consist of deposit withdrawals, contractual loan funding, repayment of borrowings as these mature, and funding of new and existing investments as required.
The Company’s business requires continuous access to various funding sources. While the Company is able to fund its operations through deposits as well as through advances from the FHLB of New York and other alternative sources, the Company’s business is dependent upon other wholesale funding sources. Although the Company has selectively reduced its use of wholesale funding sources, such as repurchase agreements and brokered deposits, it is still significantly dependent on repurchase agreements. The Company’s repurchase agreements have been structured with initial terms that mature from one month to two years for five repurchase agreements amounting to $811.6 million, and a $500 million repurchase agreement that matures on March 2, 2017.
Brokered deposits are typically offered through an intermediary to small retail investors. The Company’s ability to continue to attract brokered deposits is subject to variability based upon a number of factors, including volume and volatility in the global securities markets, the Company’s credit rating, and the relative interest rates that it is prepared to pay for these liabilities. Brokered deposits are generally considered a less stable source of funding than core deposits obtained through retail bank branches. Investors in brokered deposits are generally more sensitive to interest rates and will generally move funds from one depository institution to another based on small differences in interest rates offered on deposits.
The Company participates in the Federal Reserve Bank’s Borrower-In Custody Program which allows it to pledge certain type of loans while keeping physical control of the collateral.
Although the Company expects to have continued access to credit from the foregoing sources of funds, there can be no assurance that such financing sources will continue to be available or will be available on favorable terms. In a period of financial disruption or if negative developments occur with respect to the Company, the availability and cost of the Company’s funding sources could be adversely affected. In that event, the Company’s cost of funds may increase, thereby reducing its net interest income, or the Company may need to dispose of a portion of its investment portfolio, which depending upon market conditions, could result in realizing a loss or experiencing other adverse accounting consequences upon the dispositions. The Company’s efforts to monitor and manage liquidity risk may not be successful to deal with dramatic or unanticipated changes in the global securities markets or other reductions in liquidity driven by the Company or market-related events. In the event that such sources of funds are reduced or eliminated and the Company is not able to replace these on a cost-effective basis, the Company may be forced to curtail or cease its loan origination business and treasury activities, which would have a material adverse effect on its operations and financial condition.
As of June 30, 2013, the Company had approximately $748.3 million in cash and cash equivalents, $183 million in investment securities, $714 million in borrowing capacity at the FHLB of New York and $885 million in borrowing capacity at the Federal Reserve’s discount window available to cover liquidity needs.
111
Operational Risk
Operational risk is the risk of loss from inadequate or failed internal processes, personnel and systems or from external events. All functions, products and services of the Company are susceptible to operational risk.
The Company faces ongoing and emerging risk and regulatory pressure related to the activities that surround the delivery of banking and financial products. Coupled with external influences such as market conditions, security risks, and legal risk, the potential for operational and reputational loss has increased. In order to mitigate and control operational risk, the Company has developed, and continues to enhance, specific internal controls, policies and procedures that are designed to identify and manage operational risk at appropriate levels throughout the organization. The purpose of these policies and procedures is to provide reasonable assurance that the Company’s business operations are functioning within established limits.
The Company classifies operational risk into two major categories: business specific and corporate-wide affecting all business lines. For business specific risks, a risk assessment group works with the various business units to ensure consistency in policies, processes and assessments. With respect to corporate-wide risks, such as information security, business recovery, legal and compliance, the Company has specialized groups, such as Information Security, Enterprise Risk Management, Corporate Compliance, Information Technology and Operations. These groups assist the lines of business in the development and implementation of risk management practices specific to the needs of the business groups. All these matters are reviewed and discussed in the Information Technology Steering Committee, and the Risk Management and Compliance Committee.
The Company is subject to extensive United States federal and Puerto Rico regulation, and this regulatory scrutiny has been significantly increasing over the last several years. The Company has established and continues to enhance procedures based on legal and regulatory requirements that are reasonably designed to ensure compliance with all applicable statutory and regulatory requirements. The Company has a corporate compliance function headed by a Compliance Director who reports to the Chief Risk Officer and is responsible for the oversight of regulatory compliance and implementation of a company-wide compliance program.
Concentration Risk
Substantially all of the Company’s business activities and a significant portion of its credit exposure are concentrated in Puerto Rico. As a consequence, the Company’s profitability and financial condition may be adversely affected by an extended economic slowdown, adverse political or economic developments in Puerto Rico or the effects of a natural disaster, all of which could result in a reduction in loan originations, an increase in non-performing assets, an increase in foreclosure losses on mortgage loans, and a reduction in the value of its loans and loan servicing portfolio.
ITEM 4. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
As of the end of the period covered by this quarterly report on Form 10-Q, an evaluation was carried out under the supervision and with the participation of the Company’s management, including the Chief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based upon such evaluation, the CEO and the CFO have concluded that, as of the end of such period, the Company’s disclosure controls and procedures provided reasonable assurance of effectiveness in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act. Notwithstanding the foregoing, a control system, no matter how well designed and operated, can provide only reasonable, not absolute assurance that it will detect or uncover failures within the Company to disclose material information otherwise required to be set forth in the Company’s periodic reports.
Internal Control over Financial Reporting
There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d -15 (f) under the Exchange Act) during the quarter ended June 30, 2013, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART – II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company and its subsidiaries are defendants in a number of legal proceedings incidental to their business. The Company 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 Company’s financial condition or results of operations.
ITEM 1A. RISK FACTORS
There have been no material changes to the risk factors previously disclosed in the Company’s annual report on Form 10-K for the year ended December 31, 2012. In addition to other information set forth in this report, you should carefully consider the risk factors included in the Company’s annual report on Form 10-K, as updated by this report or other filings the Company makes with the SEC under the Exchange Act. Additional risks and uncertainties not presently known to the Company at this time or that the Company currently deems immaterial may also adversely affect the Company’s business, financial condition or results of operations.
Item 2. UNREGISTERED SALES OF EQUITY SECURITES AND USE OF PROCEEDS
None
Item 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
ITEM 5. OTHER INFORMATION
Item 6. Exhibits
Exhibit No. Description of Document:
10 Amendment and Termination Agreement, dated April 16, 2013, of Omnibus Asset Servicing Agreement between Oriental Bank and Bayview Loan Servicing, LLC.
31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101 The following materials from OFG Bancorp’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2013, formatted in XBRL (eXtensible Business Reporting Language): (i) Unaudited Consolidated Statements of Financial Condition, (ii) Unaudited Consolidated Statements of Operations, (iii) Unaudited Consolidated Statements of Comprehensive Income, (iv) Unaudited Consolidated Statements of Changes in Stockholders’ Equity, (v) Unaudited Consolidated Statements of Cash Flows, and (vi) Notes to Unaudited Consolidated Financial Statements.
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
(Registrant)
By:
/s/ José Rafael Fernández
Date: August 8, 2013
José Rafael Fernández
President and Chief Executive Officer
/s/ Ganesh Kumar
Ganesh Kumar
Executive Vice President and Chief Financial Officer