UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2017
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 ý Non-Accelerated Filer ☐ Smaller Reporting Company ☐ (Do not check if a smaller reporting company)
Emerging Growth Company ☐
If an Emerging Growth Company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act ☐
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:
43,947,442 common shares ($1.00 par value per share) outstanding as of October 31, 2017
TABLE OF CONTENTS
PART I – FINANCIAL INFORMATION
Page
Item 1.
Financial Statements
Unaudited Consolidated Statements of Financial Condition
1
Unaudited Consolidated Statements of Operations
4
Unaudited Consolidated Statements of Comprehensive Income
6
Unaudited Consolidated Statements of Changes in Stockholders’ Equity
7
Unaudited Consolidated Statements of Cash Flows
8
Notes to Unaudited Consolidated Financial Statements
Note 1 – Organization, Consolidation and Basis of Presentation
11
Note 2 – Significant Events
13
Note 3 – Restricted Cash
Note 4 – Investment Securities
15
Note 5 – Loans
22
Note 6 – Allowance for Loan and Lease Losses
50
Note 7 – FDIC Indemnification Asset and True-Up Payment Obligation
62
Note 8 – Foreclosed Real Estate
61
Note 9 – Derivatives
63
Note 10 – Accrued Interest Receivable and Other Assets
66
Note 11 – Deposits and Related Interest
67
Note 12 – Borrowings and Related Interest
68
Note 13 – Offsetting of Financial Assets and Liabilities
71
Note 14 – Income Taxes
73
Note 15 – Regulatory Capital Requirements
74
Note 16 – Stockholders’ Equity
76
Note 17 – Accumulated Other Comprehensive Income
77
Note 18 – Earnings per Common Share
80
Note 19 – Guarantees
81
Note 20 – Commitments and Contingencies
82
Note 21 – Fair Value of Financial Instruments
84
Note 22 – Business Segments
92
Note 23 – Subsequent Events
94
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
95
Critical Accounting Policies and Estimates
Overview of Financial Performance:
Selected Financial Data
97
Financial Highlights of the Third Quarter of 2017
99
Analysis of Results of Operations
100
Analysis of Financial Condition
116
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
144
Item 4.
Controls and Procedures
148
PART II – OTHER INFORMATION
Legal Proceedings
149
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
150
Default upon Senior Securities
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
151
SIGNATURES
152
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 (“we,” “our,” “us” or “Oriental”), 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 Oriental’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 Oriental’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 credit default by the government of Puerto Rico;
· amendments to the fiscal plan approved by the Financial Oversight and Management Board of Puerto Rico;
· determinations in the court-supervised debt-restructuring process under Title III of PROMESA for the Puerto Rico government and all of its agencies, including some of its public corporations;
· the impact of property, credit and other losses in Puerto Rico as a result of hurricanes Irma and Maria;
· the amount of government, private and philanthropic financial assistance for the reconstruction of Puerto Rico’s critical infrastructure, which suffered catastrophic damages caused by hurricane Maria;
· the pace and magnitude of Puerto Rico’s economic recovery;
· the potential impact of damages from future hurricanes and natural disasters in Puerto Rico;
· the fiscal and monetary policies of the federal government and its agencies;
· changes in federal bank regulatory and supervisory policies, including required levels of capital;
· the relative strength or weakness of the commercial and consumer credit sectors and the real estate market in Puerto Rico;
· the performance of the stock and bond markets;
· competition in the financial services industry; and
· possible legislative, tax or regulatory changes.
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; Oriental’s ability to grow its core businesses; decisions to downsize, sell or close units or otherwise change Oriental’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 Oriental as of the date of this report, and other than as required by law, including the requirements of applicable securities laws, Oriental 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 SEPTEMBER 30, 2017 AND DECEMBER 31, 2016
September 30,
December 31,
2017
2016
(In thousands)
ASSETS
Cash and cash equivalents:
Cash and due from banks
$
714,196
504,833
Money market investments
6,530
5,606
Total cash and cash equivalents
720,726
510,439
Restricted cash
3,030
Investments:
Trading securities, at fair value, with amortized cost of $667 (December 31, 2016 - $667)
284
347
Investment securities available-for-sale, at fair value, with amortized cost of $611,936 (December 31, 2016 - $749,867)
613,423
751,484
Investment securities held-to-maturity, at amortized cost, with fair value of $525,830 (December 31, 2016 - $592,763)
530,178
599,884
Federal Home Loan Bank (FHLB) stock, at cost
14,016
10,793
Other investments
3
Total investments
1,157,904
1,362,511
Loans:
Loans held-for-sale, at lower of cost or fair value
12,114
12,499
Loans held for investment, net of allowance for loan and lease losses of $154,161 (December 31, 2016 - $115,937)
3,952,458
4,135,193
Total loans
3,964,572
4,147,692
Other assets:
FDIC indemnification asset
-
14,411
Foreclosed real estate
47,275
47,520
Accrued interest receivable
22,736
20,227
Deferred tax asset, net
126,041
124,200
Premises and equipment, net
67,994
70,407
Customers' liability on acceptances
16,486
23,765
Servicing assets
9,818
9,858
Derivative assets
809
1,330
Goodwill
86,069
Other assets
64,757
80,365
Total assets
6,288,217
6,501,824
See notes to unaudited financial statements
AS OF SEPTEMBER 30, 2017 AND DECEMBER 31, 2016 (CONTINUED)
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits:
Demand deposits
1,925,721
1,939,764
Savings accounts
1,360,080
1,196,232
Time deposits
1,540,603
1,528,491
Total deposits
4,826,404
4,664,487
Borrowings:
Securities sold under agreements to repurchase
283,080
653,756
Advances from FHLB
100,091
105,454
Subordinated capital notes
36,083
Other borrowings
Total borrowings
419,254
795,354
Other liabilities:
Derivative liabilities
1,677
2,437
Acceptances executed and outstanding
Accrued expenses and other liabilities
86,766
95,370
Total liabilities
5,350,587
5,581,413
Commitments and contingencies (See Note 20)
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, 2016 - 1,340,000 shares; 1,380,000 shares; and 960,000
shares) $25 liquidation value
92,000
84,000 shares of Series C issued and outstanding (December 31, 2016 -
84,000 shares); $1,000 liquidation value
84,000
Common stock, $1 par value; 100,000,000 shares authorized; 52,625,869 shares
issued: 43,947,442 shares outstanding (December 31, 2016 - 52,625,869;
43,914,844)
52,626
Additional paid-in capital
541,302
540,948
Legal surplus
79,795
76,293
Retained earnings
191,567
177,808
Treasury stock, at cost, 8,678,427 shares (December 31, 2016 - 8,711,025
shares)
(104,502)
(104,860)
Accumulated other comprehensive income, net of tax of $223
(December 31, 2016 $983)
842
1,596
Total stockholders’ equity
937,630
920,411
Total liabilities and stockholders’ equity
2
UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE QUARTERS AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2017 AND 2016
Quarter Ended September 30,
Nine-Month Period Ended September 30,
(In thousands, except per share data)
Interest income:
Loans
82,467
82,604
237,355
243,431
Mortgage-backed securities
6,245
6,997
20,728
23,215
Investment securities and other
1,643
983
4,390
3,152
Total interest income
90,355
90,584
262,473
269,798
Interest expense:
Deposits
7,601
7,331
22,606
21,822
1,282
4,272
6,260
14,629
Advances from FHLB and other borrowings
596
1,237
1,799
5,574
398
817
1,149
2,559
Total interest expense
9,877
13,657
31,814
44,584
Net interest income
80,478
76,927
230,659
225,214
Provision for loan and lease losses, net
44,042
23,469
88,232
51,703
Net interest income after provision for loan and lease losses
36,436
53,458
142,427
173,511
Non-interest income:
Banking service revenue
9,923
10,330
31,007
30,667
Wealth management revenue
6,016
6,526
18,747
19,719
Mortgage banking activities
1,274
1,421
2,820
3,300
Total banking and financial service revenues
17,213
18,277
52,574
53,686
FDIC shared-loss benefit (expense), net
(3,296)
1,403
(10,745)
Net gain (loss) on:
Sale of securities
6,896
12,207
Derivatives
17
103
Early extinguishment of debt
(80)
(12,000)
Other non-interest income
695
5,217
976
5,721
Total non-interest income, net
17,912
20,215
61,872
48,873
FOR THE QUARTERS AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2017 AND 2016 (CONTINUED)
Non-interest expense:
Compensation and employee benefits
19,882
19,168
59,546
57,864
Professional and service fees
3,113
2,889
9,575
8,685
Occupancy and equipment
8,276
7,353
24,012
22,995
Insurance
1,052
1,242
3,834
7,547
Electronic banking charges
5,021
5,077
15,373
15,613
Information technology expenses
2,046
1,862
6,114
5,124
Advertising, business promotion, and strategic initiatives
1,405
1,347
4,205
4,133
Loss on sale of foreclosed real estate and other repossessed assets
1,395
2,970
4,508
9,063
Loan servicing and clearing expenses
1,134
2,844
3,592
6,940
Taxes, other than payroll and income taxes
2,243
2,385
7,007
7,386
Communication
855
748
2,682
2,434
Printing, postage, stationary and supplies
586
602
1,889
1,927
Director and investor relations
221
233
775
812
Credit related expenses
1,714
3,719
6,557
8,177
Other
1,526
2,487
5,300
4,908
Total non-interest expense
50,469
54,926
154,969
163,608
Income before income taxes
3,879
49,330
58,776
Income tax expense
560
3,627
13,757
15,146
Net income
3,319
15,120
35,573
43,630
Less: dividends on preferred stock
(3,465)
(10,396)
(Loss) income available to common shareholders
(146)
11,655
25,177
33,234
Earnings per common share:
Basic
0.27
0.57
0.76
Diluted
0.26
0.56
Average common shares outstanding and equivalents
51,102
51,111
51,095
51,091
Cash dividends per share of common stock
0.06
0.18
See notes to unaudited consolidated financial statements
5
UNAUDITED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Other comprehensive income before tax:
Unrealized gain (loss) on securities available-for-sale
1,445
(315)
6,766
12,049
Realized gain on investment securities included in net income
(4)
(6,896)
(12,207)
Unrealized gain on cash flow hedges
56
853
136
1,504
Other comprehensive income before taxes
1,497
538
1,346
Income tax effect
(348)
(499)
(760)
501
Other comprehensive (loss) income after taxes
39
(754)
1,847
Comprehensive income
4,468
15,159
34,819
45,477
UNAUDITED CONSOLIDATED STATEMENTS OF CHANGES
IN STOCKHOLDERS’ EQUITY
FOR THE NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2017 AND 2016
Preferred stock:
Balance at beginning of period
176,000
Balance at end of period
Common stock:
Additional paid-in capital:
540,512
Stock-based compensation expense
811
1,014
Stock-based compensation excess tax benefit recognized in income
(99)
Lapsed restricted stock units
(358)
(834)
540,692
Legal surplus:
70,435
Transfer from retained earnings
3,502
4,353
74,788
Retained earnings:
148,886
Cash dividends declared on common stock
(7,916)
(7,909)
Cash dividends declared on preferred stock
Transfer to legal surplus
(3,502)
(4,353)
169,858
Treasury stock:
(105,379)
358
505
(104,874)
Accumulated other comprehensive income, net of tax:
13,997
Other comprehensive (loss) income, net of tax
15,844
924,934
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
2,526
2,849
Amortization of fair value premiums, net of discounts, on acquired loans
Amortization of investment securities premiums, net of accretion of discounts
6,108
6,541
Amortization of core deposit and customer relationship intangibles
1,105
1,258
Amortization of fair value premiums on acquired deposits
268
FDIC shared-loss (benefit) expense, net
(1,403)
10,745
Depreciation and amortization of premises and equipment
6,654
7,229
Deferred income tax expense, net
(2,619)
15,176
Stock-based compensation
(Gain) loss on:
Sale of mortgage loans held-for-sale
(792)
(1,294)
(103)
78
12,000
4,938
10,580
Sale of other repossessed assets
146
(1,498)
Sale of premises and equipment
(539)
12
Originations of loans held-for-sale
(103,194)
(134,189)
Proceeds from sale of mortgage loans held-for-sale
68,758
51,238
Net (increase) decrease in:
Trading securities
(92)
(2,509)
2,671
40
(938)
14,260
(13,394)
Net increase (decrease) in:
Accrued interest on deposits and borrowings
(345)
(1,013)
(4,745)
(5,594)
Net cash provided by operating activities
106,055
46,812
FOR THE NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2017 AND 2016 (CONTINUED)
Cash flows from investing activities:
Purchases of:
Investment securities available-for-sale
(128,969)
(676)
Investment securities held-to-maturity
(81,261)
FHLB stock
(26,730)
(20,398)
Maturities and redemptions of:
83,669
112,444
65,877
56,058
23,507
28,469
Proceeds from sales of:
256,996
300,483
Foreclosed real estate and other repossessed assets, including write-offs
31,829
36,983
Proceeds from sale of loans held-for-sale
Premises and equipment
569
48
Origination and purchase of loans, excluding loans held-for-sale
(546,616)
(555,658)
Principal repayment of loans, including covered loans
571,098
616,518
(Repayments to) reimbursements from the FDIC on shared-loss agreements, net
(10,125)
824
Additions to premises and equipment
(4,271)
(3,804)
Net change in restricted cash
319
Net cash provided by investing activities
316,834
491,498
9
FOR THE NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2017 AND 2016 – (CONTINUED)
Cash flows from financing activities:
180,958
35,449
(369,816)
(287,865)
FHLB advances, federal funds purchased, and other borrowings
(5,436)
(228,157)
(66,550)
Exercise of stock options and restricted units lapsed, net
(329)
Dividends paid on preferred stock
Dividends paid on common stock
(7,912)
(7,906)
Net cash used in financing activities
(212,602)
(565,754)
Net change in cash and cash equivalents
210,287
(27,444)
Cash and cash equivalents at beginning of period
536,709
Cash and cash equivalents at end of period
509,265
Supplemental Cash Flow Disclosure and Schedule of Non-cash Activities:
Interest paid
30,777
44,316
Income taxes paid
23
7,389
Mortgage loans securitized into mortgage-backed securities
69,148
71,315
Transfer from loans to foreclosed real estate and other repossessed assets
37,852
32,535
Reclassification of loans held-for-investment portfolio to held-for-sale portfolio
33,647
123,137
Reclassification of loans held-for-sale portfolio to held-for-investment portfolio
112
182
10
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 – ORGANIZATION, CONSOLIDATION AND BASIS OF PRESENTATION
Nature of Operations
OFG Bancorp (“Oriental”) is a publicly-owned financial holding company incorporated under the laws of the Commonwealth of Puerto Rico. Oriental operates through various subsidiaries including, a commercial bank, Oriental Bank (the “Bank”), a securities broker-dealer, Oriental Financial Services Corp. (“Oriental Financial Services”), an insurance agency, Oriental Insurance, LLC. (“Oriental Insurance”) and a retirement plan administrator, Oriental Pension Consultants, Inc. (“OPC”). Through these subsidiaries and their respective divisions, Oriental provides a wide range of banking and financial services such as commercial, consumer and mortgage lending, auto loans, financial planning, insurance sales, money management and investment banking and brokerage services, as well as corporate and individual trust services.
On April 30, 2010, the Bank acquired certain assets and assumed certain deposits and other liabilities of Eurobank, a Puerto Rico commercial bank, in an FDIC-assisted acquisition. On February 6, 2017, the Bank and the FDIC agreed to terminate the shared-loss agreements related to the Eurobank Acquisition. On December 18, 2012, Oriental acquired a group of Puerto Rico-based entities that included Banco Bilbao Vizcaya Argentaria Puerto Rico (“BBVAPR”), a Puerto Rico commercial bank, as well as a securities broker-dealer and an insurance agency, which is referred to herein as the “BBVAPR Acquisition.” The businesses acquired in these acquisitions have been integrated with Oriental’s existing business.
Recent Accounting Developments
Scope of Modification Accounting. In May 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2017-09 that clarifies when changes to the terms or conditions of a share-based payment award must be accounted for as modifications. Entities will apply the modification accounting guidance if the value, vesting conditions or classification of the award changes. ASU No. 2017-08 is effective for fiscal years, and interim periods, beginning after December 15, 2018, with early adoption permitted. Oriental's Omnibus Plan provides for equity-based compensation incentives through the grant of stock options, stock appreciation rights, restricted stock, restricted stock units, and dividend equivalents, as well as equity-based performance awards. If any change occurs in the future to the Omnibus Plan, Oriental will evaluate it under this guideline.
Premium Amortization on Purchased Callable Debt Securities Receivables. In March 2017, the FASB issued ASU No. 2017-08, which requires the amortization of the premium on callable debt securities to the earliest call date. The amortization period for callable debt securities purchased at a discount would not be impacted by the ASU. This ASU will be applied prospectively for annual and interim periods in fiscal years beginning after December 15, 2018. The ASU is not expected to have a material impact on Oriental's consolidated financial position or results of operations. At September 30, 2017, Oriental does not have callable debt securities.
Plan Accounting: Defined Benefit Pension Plans (Topic 960), Defined Contribution Pension Plans (Topic 962), Health and Welfare Benefit Plans (Topic 965): Employee Benefit Plan Master Trust Reporting (a consensus of the Emerging Issues Task Force). In February 2017, the FASB issued ASU No. 2017-06, which intended to reduce diversity and improve the usefulness of information provided by employee benefit plans that hold interests in master trusts. This ASU will be applied prospectively for annual and interim periods in fiscal years beginning after December 15, 2018. The ASU is not expected to have a material impact on Oriental's consolidated financial position or results of operations.
Simplifying the Test for Goodwill Impairment. In January 2017, the FASB issued ASU No. 2017-04, which simplifies the measurement of goodwill impairment. An entity will no longer perform a hypothetical purchase price allocation to measure goodwill impairment. Instead, impairment will be measured using the difference between the carrying amount and the fair value of the reporting unit. This ASU will be applied prospectively for annual and interim periods in fiscal years beginning after December 15, 2019. We will assess the impact that the adoption of ASU 2017-04 will have on our consolidated financial statements and related disclosures before implementation.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
Restricted Cash. In November 2016, the FASB issued ASU No. 2016-18, which amends Topic 230 (Statement of Cash Flows) and requires that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. ASU No. 2016-18 is intended to reduce diversity in practice in how restricted cash or restricted cash equivalents are presented and classified in the statement of cash flows. ASU No. 2016-18 is effective for fiscal years, and interim periods, beginning after December 15, 2017, with early adoption permitted. The standard requires application using a retrospective transition method. The adoption of ASU No. 2016-18 will change the presentation and classification of restricted cash and restricted cash equivalents in our consolidated statements of cash flows.
Measurement of Credit Losses on Financial Instruments. In June 2016, the FASB issued ASU No. 2016-13, which includes an impairment model (known as the current expected credit loss (CECL) model) that is based on expected losses rather than incurred losses. Under the new guidance, an entity recognizes as an allowance its estimate of expected credit losses. ASU No. 2016-13 is effective for fiscal years, and interim periods, beginning after December 15, 2019. While we continue to assess the impact of ASU No. 2016-13, we have developed a roadmap with time schedules in place from 2016 to implementation date. Oriental is in the process of assessing the methodology and the software to be used.
Leases. In February 2016, the FASB issued ASU No. 2016-02, which requires lessees to recognize a right-of-use asset and related lease liability for leases classified as operating leases at the commencement date that have lease terms of more than 12 months. This ASU retains the classification distinction between finance leases and operating leases. ASU No. 2016-02 is effective for fiscal years, and interim periods, beginning after December 15, 2018. We are currently assessing the impact the adoption of ASU 2016-02 will have on our consolidated financial statements and related disclosures.
Revenue from Contracts with Customers. In May 2014, the FASB issued ASU No. 2014-09, which supersedes the revenue recognition requirements Topic 605 (Revenue Recognition), and most industry-specific guidance. ASU No. 2014-09 is based on the principle that revenue is recognized to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU No. 2014-09 also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. ASU No. 2014-09 permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method), or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (modified retrospective method). In August 2015, the FASB issued ASU No. 2015-14 to defer the effective date of ASU No. 2014-09 by one year to fiscal years beginning after December 15, 2017. ASU No. 2015-14 also permits early adoption of ASU No. 2014-09, but not before the original effective date, which was for fiscal years beginning after December 15, 2016. While the new guidance does not apply to revenue associated with loans or securities, Oriental identified the customer contracts within the scope of the new guidance, assessed the related revenues, and has determined that it will not materially impact its consolidated financial position or results of operations. There will not be any accounting or significant internal control changes as a result of the new provisions. The timing of Oriental’s revenue recognition is not expected to materially change.
Other than the accounting pronouncements disclosed above, there are no other new accounting pronouncements issued during the first quarter of 2017 that could have a material impact on Oriental's financial position, operating results or financial statements disclosures.
NOTE 2 – SIGNIFICANT EVENTS
Hurricanes Irma and Maria
During the third quarter of 2017, Oriental was impacted by Hurricanes Irma and Maria, which struck the island on September 7, 2017 and September 20, 2017, respectively. Hurricane Maria caused catastrophic damages throughout Puerto Rico, including homes, businesses, roads, bridges, power lines, commercial establishments, and public facilities. It caused an unprecedented crisis when it ravaged the Island’s electric power grid less than two weeks after hurricane Irma left over a million Puerto Rico residents without power. Over a month after the hurricanes, most of Puerto Rico remains without electricity, many businesses are unable to operate, and government authorities are still struggling to deliver emergency supplies and clean drinking water to many communities outside the San Juan metropolitan area. Further, payment and delivery systems, including the U.S. Post Office, were unable to operate for weeks after hurricane Maria and some are still subject to significant delays.
Almost all of Oriental’s operations and clients are located in Puerto Rico. Although Oriental’s business operations were disrupted by major damages to Puerto Rico’s critical infrastructure, including its electric power grid and telecommunications network, Oriental’s digital channels, core banking and electronic funds transfer systems continued to function uninterrupted during and after the hurricanes. Within days after hurricane Maria, and upon securing a continuing supply of diesel fuel for its electric power generators, Oriental was able to open its main offices and many of its branches and ATMs in addition to its digital and phone trade channels.
As a result of this event, and based on current assessments of information available for the impact of the hurricanes on our credit portfolio, third quarter 2017 results included an additional $27.0 million in loan loss provision, pre-tax. Refer to footnotes for further disclosure associated to this significant event.
NOTE 3 – RESTRICTED CASH
The following table includes the composition of Oriental’s restricted cash:
Cash pledged as collateral to other financial institutions to secure:
1,980
Obligations under agreement of loans sold with recourse
1,050
At September 30, 2017, the Bank’s international banking entities, Oriental International Bank Inc. (“OIB”) and Oriental Overseas, a division of the Bank, held an unencumbered certificate of deposit and other short-term highly liquid securities in the amount of $300 thousand and $325 thousand, respectively, as the legal reserve required for international banking entities under Puerto Rico law. At December 31, 2016, they held an unencumbered certificate of deposit and other short-term highly liquid securities in the amount of $300 thousand as the required legal reserve. The certificate of deposit and other securities cannot be withdrawn or sold by OIB or Oriental Overseas without prior written approval of the Office of the Commissioner of Financial Institutions ("OCFI").
As part of its derivative activities, Oriental has entered into collateral agreements with certain financial counterparties. At both September 30, 2017 and December 31, 2016, Oriental had delivered approximately $2.0 million of cash as collateral for such derivatives activities.
As part of the BBVA Acquisition, Oriental assumed a contract with FNMA which required collateral to guarantee the repurchase, if necessary, of loans sold with recourse. At both September 30, 2017 and December 31, 2016, Oriental delivered as collateral cash amounting to approximately $1.1 million.
The Bank is required by Puerto Rico law to maintain average weekly reserve balances to cover demand deposits. The amount of those minimum average reserve balances for the week that covered September 30, 2017 was $167.3 million (December 31, 2016 - $161.0
million). At September 30, 2017 and December 31, 2016, the Bank complied with the requirement. Cash and due from bank as well as other short-term, highly liquid securities are used to cover the required average reserve balances.
14
NOTE 4 – INVESTMENT SECURITIES
Money Market Investments
Oriental 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 September 30, 2017 and December 31, 2016, money market instruments included as part of cash and cash equivalents amounted to $6.5 million and $5.6 million, respectively.
Investment Securities
The amortized cost, gross unrealized gains and losses, fair value, and weighted average yield of the securities owned by Oriental at September 30, 2017 and December 31, 2016 were as follows:
September 30, 2017
Gross
Weighted
Amortized
Unrealized
Fair
Average
Cost
Gains
Losses
Value
Yield
Available-for-sale
FNMA and FHLMC certificates
344,581
2,464
1,462
345,583
2.36%
GNMA certificates
162,993
2,197
423
164,767
2.94%
CMOs issued by US government-sponsored agencies
86,905
1,038
85,873
1.90%
Total mortgage-backed securities
594,479
4,667
2,923
596,223
2.45%
Investment securities
US Treasury securities
10,269
51
10,218
1.26%
Obligations of US government-sponsored agencies
3,121
29
3,092
1.38%
Obligations of Puerto Rico government and
public instrumentalities
2,455
249
2,206
5.55%
Other debt securities
1,612
72
1,684
3.00%
Total investment securities
17,457
329
17,200
2.42%
Total securities available for sale
611,936
4,739
3,252
2.44%
Held-to-maturity
367
4,715
525,830
2.09%
December 31, 2016
422,168
6,354
3,036
425,486
2.59%
163,614
2,241
620
165,235
2.95%
103,990
64
2,223
101,831
1.88%
689,772
8,659
5,879
692,552
2.57%
49,672
618
49,054
1.73%
3,903
19
3,884
4,680
607
4,073
1,840
1,921
60,095
1,244
58,932
2.04%
Total securities available-for-sale
749,867
8,740
7,123
2.53%
145
7,266
592,763
2.15%
The amortized cost and fair value of Oriental’s investment securities at September 30, 2017, 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.
16
Amortized Cost
Fair Value
Due from 1 to 5 years
7,160
7,246
Total due from 1 to 5 years
Due after 5 to 10 years
76,877
75,884
132,716
132,163
Total due after 5 to 10 years
209,593
208,047
Due after 10 years
204,705
206,174
10,028
9,989
Total due after 10 years
377,726
380,930
Due less than one year
324
323
Total due in less than one year
2,779
2,529
9,945
9,895
Obligations of US government and sponsored agencies
13,066
12,987
Due from 5 to 10 years
Total
During the nine-month period ended September 30, 2017 Oriental retained securitized GNMA pools totaling $69.3 million amortized cost, at a yield of 3.14% from its own originations while during the nine-month period ended September 30, 2016 that amount totaled $71.8 million, amortized cost, at a yield of 2.99%.
During the nine-month period ended September 30, 2017, Oriental sold $166.0 million of mortgage-backed securities and $84.1 million of US Treasury securities, and recorded a net gain on sale of securities of $6.9 million. During the nine-month period ended September 30, 2016, Oriental sold $277.2 million on mortgage-backed securities and $11.1 million of Puerto Rico government bonds, and recorded a net gain on sale of securities of $12.2 million.
Nine-Month Period Ended September 30, 2017
Book Value
Description
Sale Price
at Sale
Gross Gains
Gross Losses
Sale of securities available-for-sale
107,510
102,311
5,199
65,284
63,704
1,580
84,202
84,085
117
250,100
Nine-Month Period Ended September 30, 2016
293,505
277,181
16,324
Obligations of PR government and public instrumentalities
6,978
11,095
4,117
288,276
The following tables show Oriental’s gross unrealized losses and fair value of investment securities available-for-sale and held-to-maturity, aggregated by investment category and the length of time that individual securities have been in a continuous unrealized loss position at September 30, 2017 and December 31, 2016:
18
12 months or more
Loss
Securities available-for-sale
58,328
869
57,459
8,196
175
8,021
Obligations of Puerto Rico government and public instrumentalities
72,100
1,322
70,778
Securities held to maturity
44,759
884
43,875
Less than 12 months
27,413
169
27,244
146,578
1,287
145,291
29,243
28,820
US Treasury Securities
213,503
1,930
211,573
Securities held-to-maturity
FNMA and FHLMC Certificates
386,995
3,831
383,164
85,741
84,703
154,774
153,312
285,603
282,351
431,754
427,039
33,883
793
33,090
38,563
1,400
37,163
67,777
1,430
66,347
184,782
181,746
29,445
28,825
49,172
48,554
335,079
5,723
329,356
525,258
517,992
101,660
99,437
373,642
366,519
20
Oriental performs valuations of the investment securities on a monthly basis. Moreover, Oriental 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 the statements of operations with the remaining noncredit-related component recognized in other comprehensive income (loss). 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 Oriental 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.
Most of the investments ($714.9 million, amortized cost, or 99.7%) with an unrealized loss position at September 30, 2017 consist of securities issued or guaranteed by the U.S. Treasury or U.S. government-sponsored agencies, all of which are highly liquid securities that have a large and efficient secondary market. Their aggregate losses and their variability from period to period are the result of changes in market conditions, and not due to the repayment capacity or creditworthiness of the issuers or guarantors of such securities.
The sole exposure to PR bond ($2.5 million, amortized cost, or 0.3%) with an unrealized loss position at September 30, 2017 consists of an obligation issued by the Puerto Rico Highways and Transportation Authority ("PRHTA") secured by a pledge of toll revenues from the Teodoro Moscoso Bridge operated through a public-private partnership. The decline in the market value of this security is mainly attributed to the significant economic and fiscal challenges that Puerto Rico is facing, which is expected to result in a significant restructuring of the government under the supervision of a federally created Fiscal Oversight Board. All other Puerto Rico government securities were sold during the first quarter of 2016. The PRHTA bond had an aggregate fair value of $2.2 million at September 30, 2017 (90% of the bond's amortized cost) and matures on July 1, 2018. The discounted cash flow analysis for the investment showed a cumulative default probability at maturity of 6.6%, thus reflecting that it is more likely than not that the bond will not default during its remaining term. Based on this analysis, Oriental determined that it is more likely than not that it will recover all interest and principal invested in this Puerto Rico government bond and is, therefore, not required to recognize a credit loss as of September 30, 2017. Also, Oriental’s conclusion is based on the assessment of the specific source of repayment of the outstanding bond, which continues to perform. PRHTA started principal repayments on July 1, 2014. All scheduled principal and interest payments to date have been collected. As a result of the aforementioned analysis, no other-than-temporary losses were recorded during the period ended September 30, 2017.
As of September 30, 2017, Oriental performed a cash flow analysis of its Puerto Rico government bond to calculate the cash flows expected to be collected and determine if any portion of the decline in market value of this investment was considered an other-than-temporary impairment. The analysis derives an estimate of value based on the present value of risk-adjusted future cash flows of the underlying investment, and included the following components:
· The contractual future cash flows of the bond are projected based on the key terms as set forth in the official statements for the investment. Such key terms include among others the interest rate, amortization schedule, if any, and maturity date.
· The risk-adjusted cash flows are calculated based on a monthly default probability and recovery rate assumptions based on the credit rating of the investment. Constant monthly default rates are assumed throughout the life of the bond which is based on the respective security’s credit rating as of the date of the analysis.
· The adjusted future cash flows are then discounted at the original effective yield of the investment based on the purchase price and expected risk-adjusted future cash flows as of the purchase date of the investment.
The following table presents a rollforward of credit-related impairment losses recognized in earnings for the nine-month periods ended September 30, 2017 and 2016 on available-for-sale securities:
1,490
Reductions for securities sold during the period (realized)
(1,490)
21
NOTE 5 -LOANS
Oriental’s loan portfolio is composed of two segments, loans initially accounted for under the amortized cost method (referred to as "originated and other" loans) and loans acquired (referred to as "acquired" loans). Acquired loans are further segregated between acquired BBVAPR loans and acquired Eurobank loans. Acquired Eurobank loans were purchased subject to loss-sharing agreements with the FDIC, which were terminated on February 6, 2017.
As a result of the devastation caused by hurricanes Irma and Maria, Oriental offered an automatic three-month forbearance for the payment due on auto and personal loans for customers whose payments were not over 89 days past due at August 31, 2017. These payments, together with any additional accrued interest, will be paid in three installments after the original maturity of the loans. Residential mortgage loans will have the same forbearance, but the payments subject to the forbearance on non-conforming loans will be payable in aggregate as a balloon payment at the maturity of the loan and on conforming mortgage loans the repayment terms will be established on a case by case basis at the end of the forbearance period. For credit cards, that were not over 29 days past due at August 31, 2017, the minimum payment amount will be skipped until December 31, 2017. Oriental also offered an automatic one-month forbearance for the payment of principal and interest for commercial loans, for customers whose payments were not over 30 days past due at August 31, 2017, and the flexibility of extending it up to two additional months, based on the customer's needs. Oriental had approximately 100 thousand loans under the automatic three-month forbearance program with a UPB of $3.7 billion at September 30, 2017.
The composition of Oriental’s loan portfolio atSeptember 30, 2017 and December 31, 2016 was as follows:
Originated and other loans and leases held for investment:
Mortgage
694,476
721,494
Commercial
1,245,711
1,277,866
Consumer
316,357
290,515
Auto and leasing
831,437
756,395
3,087,981
3,046,270
Allowance for loan and lease losses on originated and other loans and leases
(87,541)
(59,300)
3,000,440
2,986,970
Deferred loan costs, net
6,592
5,766
Total originated and other loans loans held for investment, net
3,007,032
2,992,736
Acquired loans:
Acquired BBVAPR loans:
Accounted for under ASC 310-20 (Loans with revolving feature and/or
acquired at a premium)
4,612
5,562
29,464
32,862
Auto
26,562
53,026
60,638
91,450
Allowance for loan and lease losses on acquired BBVAPR loans accounted for under ASC 310-20
(3,363)
(4,300)
57,275
87,150
Accounted for under ASC 310-30 (Loans acquired with deteriorated
credit quality, including those by analogy)
532,948
569,253
244,359
292,564
1,598
4,301
49,258
85,676
828,163
951,794
Allowance for loan and lease losses on acquired BBVAPR loans accounted for under ASC 310-30
(40,110)
(31,056)
788,053
920,738
Total acquired BBVAPR loans, net
845,328
1,007,888
Acquired Eurobank loans:
Loans secured by 1-4 family residential properties
68,996
73,018
53,028
81,460
1,220
1,372
Total acquired Eurobank loans
123,244
155,850
Allowance for loan and lease losses on Eurobank loans
(23,146)
(21,281)
Total acquired Eurobank loans, net
100,098
134,569
Total acquired loans, net
945,426
1,142,457
Total held for investment, net
Mortgage loans held-for-sale
Total loans, net
Originated and Other Loans and Leases Held for Investment
Oriental’s originated and other loans held for investment are encompassed within four portfolio segments: mortgage, commercial, consumer, and auto and leasing.
The following tables present the aging of the recorded investment in gross originated and other loans held for investment at September 30, 2017 and December 31, 2016, by class of loans. Mortgage loans past due include 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
278
1,469
3,074
4,821
42,086
46,907
283
Years 2003 and 2004
242
3,388
5,963
9,593
74,405
83,998
Year 2005
2,465
3,231
5,696
39,363
45,059
Year 2006
179
1,965
5,536
7,680
55,883
63,563
Years 2007, 2008
and 2009
252
1,706
7,859
9,817
59,451
69,268
98
Years 2010, 2011, 2012, 2013
349
2,213
7,274
9,836
118,409
128,245
414
Years 2014, 2015, 2016 and 2017
184
1,247
1,431
120,538
121,969
1,300
13,390
34,184
48,874
510,135
559,009
795
Non-traditional
506
3,529
4,035
14,670
18,705
Loss mitigation program
12,621
7,456
15,941
36,018
67,472
103,490
2,576
13,921
21,352
53,654
88,927
592,277
681,204
3,371
Home equity secured personal loans
261
273
GNMA's buy-back option program
12,999
66,665
101,938
592,538
Commercial secured by real estate:
Corporate
209,000
Institutional
254
45,922
46,176
Middle market
303
3,545
3,848
233,829
237,677
Retail
292
461
9,471
10,224
233,701
243,925
Floor plan
3,607
Real estate
15,473
764
13,270
14,326
741,532
755,858
Other commercial and industrial:
163,192
118,091
881
883
81,061
81,944
608
1,053
1,219
2,880
85,289
88,169
53
38,396
38,457
2,153
3,824
486,029
489,853
910
1,817
15,423
18,150
1,227,561
24
25
Credit cards
1,000
363
565
1,928
26,082
28,010
Overdrafts
45
189
265
Personal lines of credit
31
143
2,201
2,344
Personal loans
3,777
1,694
732
6,203
264,691
270,894
Cash collateral personal loans
447
32
497
14,347
14,844
5,372
2,132
1,343
8,847
307,510
43,331
28,275
10,831
82,437
749,000
63,534
53,576
94,262
211,372
2,876,609
26
196
2,176
5,743
44,542
50,285
158
156
3,872
7,272
11,300
79,407
90,707
1,952
4,306
6,258
43,751
50,009
2,905
6,261
9,672
59,628
69,300
409
1,439
11,732
13,580
63,149
76,729
1,772
10,417
12,538
127,322
139,860
583
Years 2014, 2015 and 2016
47
123
1,357
1,527
106,672
108,199
1,663
14,239
44,716
60,618
524,471
585,089
1,139
498
4,730
5,228
17,631
22,859
8,911
7,205
16,541
32,657
70,871
103,528
1,724
10,574
21,942
65,987
98,503
612,973
711,476
2,863
337
9,681
75,668
108,184
613,310
242,770
26,546
26,800
60
3,379
231,602
234,981
154
350
6,594
7,098
242,630
249,728
2,989
16,395
410
10,167
10,731
762,932
773,663
136,438
180,285
81,633
930
969
1,999
71,706
73,705
69
32,073
32,142
938
1,030
2,068
502,135
504,203
1,092
510
11,197
12,799
1,265,067
27
527
525
1,335
25,023
26,358
33
174
207
41
2,327
2,404
2,474
1,489
1,081
5,044
241,228
246,272
240
264
15,010
15,274
3,298
1,808
1,647
6,753
283,762
42,714
19,014
8,173
69,901
686,494
57,678
43,274
96,685
197,637
2,848,633
At September 30, 2017 and December 31, 2016, Oriental had carrying balance of $94.9 million and $136.6million, respectively, in originated and other loans held for investment granted to the Puerto Rico government, including its instrumentalities, public corporations and municipalities as part of the institutional commercial loan segment. All originated and other loans granted to the Puerto Rico government are general obligations of municipalities secured by ad valorem taxation, without limitation as to rate or amount, on all taxable property within the issuing municipalities. The good faith, credit and unlimited taxing power of each issuing municipality are pledged for the payment of its general obligations. On June 30, 2017, Oriental entered into an agreement to sell a performing originated municipal loan, which was due in July 2018, for $28.8 million. The sale reduced near-term risk associated with a likely refinancing. The loan was moved to other loans held-for-sale at June 30, 2017 with a balance of $33.7 million, and included a principal payment of $4.8 million received by Oriental on July 1, 2017. The sale transaction settled on July 5, 2017.
28
Acquired Loans
Acquired loans were initially measured at fair value and subsequently accounted for under either ASC 310-30 or ASC 310-20 (Non-refundable fees and Other Costs). We have acquired loans in two acquisitions, BBVAPR and Eurobank.
Acquired BBVAPR 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 are accounted for under the guidance of ASC 310-20, which requires that any contractually required loan payment receivable in excess of Oriental’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 Oriental’s non-accrual policy, and any accretion of discount or amortization of premium is discontinued. Acquired BBVAPR loans that were accounted for under the provisions of ASC 310-20 are removed from the acquired loan category at the end of the reporting period upon refinancing, renewal or normal re-underwriting.
The following tables present the aging of the recorded investment in gross acquired BBVAPR loans accounted for under ASC 310-20 as of September 30, 2017 and December 31, 2016, by class of loans:
Commercial secured by real estate
121
936
393
1,329
1,031
419
1,450
Other commercial and industrial
296
449
2,711
3,160
451
3,162
1,115
1,482
3,130
977
567
467
2,011
24,797
26,808
75
122
2,534
2,656
575
2,133
27,331
1,635
1,141
453
3,229
23,333
2,983
1,787
2,074
6,844
53,794
110
219
2,171
2,390
362
2,533
34
2,775
3,027
3,029
130
452
616
4,946
736
369
708
1,813
28,280
30,093
120
2,587
2,769
784
383
828
1,995
30,867
3,652
1,355
517
5,524
47,502
4,566
1,797
8,135
83,315
Acquired BBVAPR Loans Accounted for under ASC 310-30 (including those accounted for under ASC 310-30 by analogy)
Acquired BBVAPR loans, 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 Oriental in accordance with ASC 310-30.
The carrying amount corresponding to acquired BBVAPR loans with deteriorated credit quality, including those accounted under ASC 310-30 by analogy, in the statements of financial condition at September 30, 2017 and December 31, 2016 is as follows:
Contractual required payments receivable:
1,503,630
1,669,602
Less: Non-accretable discount
364,548
363,107
Cash expected to be collected
1,139,082
1,306,495
Less: Accretable yield
310,919
354,701
Carrying amount, gross
Less: allowance for loan and lease losses
40,110
31,056
Carrying amount, net
30
At September 30, 2017 and December 31, 2016, Oriental had $49.7 million and $66.2 million, respectively, in loans granted to the Puerto Rico government, including its instrumentalities, public corporations and municipalities as part of its acquired BBVAPR loans accounted for under ASC 310-30. These loans are primarily secured municipal general obligations and funds recovered under a Puerto Rico escheat law. During the third quarter of 2017, Oriental received the scheduled payments of principal from the municipal general obligations and settled the loan payable from funds recovered under the escheat law that was in default.
The following tables describe the accretable yield and non-accretable discount activity of acquired BBVAPR loans accounted for under ASC 310-30 for the quarters and nine-month periods ended September 30, 2017, and 2016:
Quarter Ended September 30, 2017
Accretable Yield Activity:
270,148
56,038
4,853
1,486
332,525
Accretion
(7,434)
(7,114)
(1,350)
(384)
(16,282)
Change in expected cash flows
3,716
37
3,766
Transfer (to) from non-accretable discount
(6,158)
(2,950)
(8)
(9,090)
256,556
49,690
3,508
1,165
Non-Accretable Discount Activity:
306,504
16,867
23,960
19,431
366,762
Change in actual and expected losses
(2,310)
(8,679)
(191)
(124)
(11,304)
Transfer from (to) accretable yield
6,158
2,950
(26)
9,090
310,352
11,138
23,777
19,281
292,115
50,366
8,538
3,682
(23,018)
(16,608)
(5,273)
(1,542)
(46,441)
19,907
163
20,195
(12,543)
(3,975)
(1,098)
(17,536)
305,615
16,965
22,407
18,120
(7,806)
(9,802)
(16,095)
12,543
3,975
1,098
17,536
Quarter Ended September 30, 2016
283,823
52,307
14,103
4,885
355,118
(8,197)
(6,686)
(3,107)
(662)
(18,652)
(1)
1,763
(241)
2,139
Transfer from (to) non-accretable discount
24,056
(525)
22,751
299,681
46,371
11,089
4,215
361,356
336,153
18,001
22,121
18,225
394,500
(2,591)
(1,216)
(309)
(3,995)
Transfer (to) from accretable yield
(24,056)
1,013
(233)
(22,751)
309,506
17,798
22,337
18,113
367,754
268,794
65,026
21,578
6,290
361,688
(24,798)
(20,973)
(10,934)
(2,470)
(59,175)
4,745
1,249
(242)
5,751
55,686
(2,427)
(804)
637
53,092
374,772
18,545
22,039
18,834
434,190
(9,580)
(3,174)
(506)
(84)
(13,344)
(55,686)
2,427
804
(637)
(53,092)
Acquired Eurobank Loans
The carrying amount of acquired Eurobank loans at September 30, 2017 and December 31, 2016 is as follows:
September 30
December 31
182,562
232,698
6,935
12,340
175,627
220,358
52,383
64,508
Less: Allowance for loan and lease losses
23,146
21,281
The following tables describe the accretable yield and non-accretable discount activity of acquired Eurobank loans for the quarters and nine-month periods ended September 30, 2017, and 2016:
Loans Secured by 1-4 Family Residential Properties
Construction & Development Secured by 1-4 Family Residential Properties
Leasing
43,012
9,157
1,906
54,075
(1,736)
(2,480)
(39)
(11)
(73)
(4,339)
106
(49)
346
460
1,094
1,448
(142)
(273)
2,187
42,388
8,231
1,764
6,687
2,010
299
9,010
126
(55)
(1,094)
(1,448)
142
(60)
(2,187)
5,613
688
402
232
45,839
16,475
2,194
(5,564)
(11,051)
(82)
(22)
(268)
(16,987)
119
1,427
(214)
730
2,144
1,994
1,380
(430)
236
(462)
2,718
8,441
3,880
(1,812)
(238)
(2,687)
(1,994)
(1,380)
430
(236)
462
(2,718)
48,336
29,142
2,204
79,682
(2,217)
(6,570)
(62)
(490)
(9,339)
646
1,719
490
2,909
3,737
(188)
3,403
50,502
24,103
2,050
76,655
11,555
(845)
617
(218)
(3,737)
188
(3,403)
6,973
805
7,934
35
51,954
26,970
2,255
3,212
84,391
(6,746)
(15,193)
(47)
(1,751)
(23,797)
1,432
14,431
(31)
(15)
(1,456)
14,361
3,862
(2,105)
(127)
(5)
1,700
12,869
8,287
21,156
Change in actual and expected cash flows
(2,034)
(1,300)
(8,292)
(11,522)
(3,862)
2,105
127
(75)
(1,700)
36
Non-accrual Loans
The following table presents the recorded investment in loans in non-accrual status by class of loans as of September 30, 2017 and December 31, 2016:
Originated and other loans and leases held for investment
2,789
3,336
6,107
7,668
3,367
4,487
5,537
6,746
Years 2007, 2008 and 2009
8,110
11,526
6,858
10,089
1,248
1,404
34,016
45,256
17,365
20,744
54,910
70,730
54,922
4,682
14,358
11,561
18,460
16,243
968
1,278
2,220
1,950
3,241
3,289
21,701
19,532
1,834
1,420
2,445
1,981
11,811
9,052
Total non-accrual originated loans
90,879
101,295
Acquired BBVAPR loans accounted for under ASC 310-20
1,057
1,292
1,415
481
552
Total non-accrual acquired BBVAPR loans accounted for under ASC 310-20
2,128
2,795
Total non-accrual loans
93,007
104,090
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 or are accounted under the cost recovery method.
Delinquent residential mortgage loans insured or guaranteed under applicable FHA and VA programs are classified as non-performing loans when they become 90 days or more past due, but are not placed in non-accrual status until they become 18 months or more past due, since they are insured loans. Therefore, these loans are included as non-performing loans but excluded from non-accrual loans. In addition, these loans are excluded from the impairment analysis.
At September 30, 2017 and December 31, 2016, loans whose terms have been extended and which are classified as troubled-debt restructurings that are not included in non-accrual loans amounted to $109.8 million and $98.1 million, respectively, as they are performing under their new terms.
38
Impaired Loans
Oriental evaluates all loans, some individually and others as homogeneous groups, for purposes of determining impairment. The total investment in impaired commercial loans that were individually evaluated for impairment was $67.8 million and $54.3 million at September 30, 2017 and December 31, 2016, respectively. The impairments on these commercial loans were measured based on the fair value of collateral or the present value of cash flows, including those identified as troubled-debt restructurings. The allowance for loan and lease losses for these impaired commercial loans amounted to $5.2 million and $1.8 million at September 30, 2017 and December 31, 2016, respectively. The total investment in impaired mortgage loans that were individually evaluated for impairment was $86.5 million and $91.6 million at September 30, 2017 and December 31, 2016, respectively. Impairment on mortgage loans assessed as troubled-debt restructurings was measured using the present value of cash flows. The allowance for loan losses for these impaired mortgage loans amounted to $9.5 million and $7.8 million at September 30, 2017 and December 31, 2016, respectively.
Oriental’s recorded investment in commercial and mortgage loans categorized as originated and other loans and leases held for investment that were individually evaluated for impairment and the related allowance for loan and lease losses at September 30, 2017 and December 31, 2016 are as follows:
Unpaid
Recorded
Related
Principal
Investment
Allowance
Coverage
Impaired loans with specific allowance:
33,159
30,465
5,223
17%
Residential impaired and troubled-debt restructuring
95,680
86,511
9,524
11%
Impaired loans with no specific allowance:
42,520
36,574
N/A
0%
Total investment in impaired loans
171,359
153,550
14,747
10%
13,183
11,698
1,626
14%
100,101
91,650
7,761
8%
Impaired loans with no specific allowance
49,038
41,441
162,322
144,789
9,387
6%
Acquired BBVAPR Loans Accounted for under ASC 310-20 (Loans with revolving feature and/or acquired at a premium)
Oriental’s recorded investment in acquired BBVAPR commercial loans accounted for under ASC 310-20 that were individually evaluated for impairment and the related allowance for loan and lease losses at September 30, 2017 and December 31, 2016 are as follows:
Impaired loans with specific allowance
926
2%
Specific
944
929
141
15%
1,184
1,150
12%
Oriental’s recorded investment in acquired BBVAPR loan pools accounted for under ASC 310-30 that have recorded impairments and their related allowance for loan and lease losses at September 30, 2017 and December 31, 2016 are as follows:
to Recorded
Impaired loan pools with specific allowance:
554,175
8,931
254,006
242,334
23,941
49,347
7,238
Total investment in impaired loan pools
857,528
824,540
5%
December 31 , 2016
595,757
569,250
199,092
195,528
23,452
92,797
4,922
887,646
850,454
4%
The tables above only present information with respect to acquired BBVAPR loan pools accounted for under ASC 310-30 if there is a recorded impairment to such loan pools and a specific allowance for loan losses.
Oriental’s recorded investment in acquired Eurobank loan pools that have recorded impairments and their related allowance for loan and lease losses as of September 30, 2017 and December 31, 2016 are as follows:
81,679
14,219
21%
58,043
51,523
8,922
139,737
121,739
19%
Impaired loan pools with specific allowance
88,017
11,947
16%
81,992
72,140
9,328
13%
170,038
146,530
The tables above only present information with respect to acquired Eurobank loan pools accounted for under ASC 310-30 if there is a recorded impairment to such loan pools and a specific allowance for loan losses.
The following table presents the interest recognized in commercial and mortgage loans that were individually evaluated for impairment, which excludes loans accounted for under ASC 310-30, for the quarters and nine-month periods ended September 30, 2017 and 2016:
Interest Income Recognized
Average Recorded Investment
Originated and other loans held for investment:
306
24,178
162
73,729
Residential troubled-debt restructuring
576
86,694
765
91,345
675
36,133
259
62,946
1,557
147,005
1,186
228,020
Acquired loans accounted for under ASC 310-20:
751
952
Total interest income from impaired loans
147,756
1,201
229,295
612
17,298
202
155,094
1,685
87,951
2,321
90,881
1,350
41,519
749
42,050
3,647
146,768
3,272
288,025
810
108
147,578
3,317
288,869
42
Modifications
The following tables present the troubled-debt restructurings in all loan portfolios during the quarters and nine-month periods ended September 30, 2017 and 2016.
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)
1,796
6.18%
401
1,804
4.28%
7.99%
8.45%
11.52%
11.21%
6.42%
8.13%
9,149
6.27%
390
9,132
4.26%
384
3,527
6.51%
55
3,528
93
1,262
11.87%
1,301
10.79%
70
134
7.24%
135
11.75%
43
2,737
6.28%
297
2,768
4.72%
387
7,352
5.31%
65
5.89%
183
14.73%
210
12.72%
54
9,558
6.00%
9,284
4.69%
8,675
5.53%
8,676
5.95%
739
13.63%
813
11.12%
The following table presents troubled-debt restructurings for which there was a payment default during the twelve month periods ended September 30, 2017 and 2016:
Twelve Month Period Ended September 30,
Number of Contracts
Recorded Investment
2,663
3,437
868
157
248
44
Credit Quality Indicators
Oriental categorizes originated and other loans 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.
Oriental uses the following definitions for risk ratings:
Pass: Loans classified as “pass” have a well-defined primary source of repayment very likely to be sufficient, with no apparent risk, strong financial position, minimal operating risk, profitability, liquidity and capitalization better than industry standards.
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 effected 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 September 30, 2017 and December 31, 2016, and based on the most recent analysis performed, the risk category of gross originated and other loans and BBVAPR acquired loans accounted for under ASC 310-20 subject to risk rating by class of loans is as follows:
Risk Ratings
Balance
Special
Outstanding
Pass
Mention
Substandard
Doubtful
Commercial - originated and other loans held for investment
192,513
14,550
1,937
34,348
11,828
198,479
11,020
28,178
214,924
7,585
21,416
2,287
1,320
658,024
34,475
63,359
65,530
8,618
7,796
83,729
891
3,549
35,368
465,910
12,545
11,398
1,123,934
47,020
74,757
Commercial - acquired loans
(under ASC 310-20)
3,154
3,547
1,065
46
Retail - originated and other loans held for investment
Mortgage:
Traditional
524,825
87,549
627,811
Consumer:
27,445
190
Unsecured personal lines of credit
2,335
Unsecured personal loans
270,160
734
14,826
314,956
1,401
Auto and Leasing
820,606
1,842,270
1,763,373
78,897
Retail - acquired loans (accounted for under ASC 310-20)
26,342
466
2,617
28,959
26,109
56,026
55,068
958
3,148,619
2,945,922
155,677
226,768
16,002
16,067
194,913
11,689
28,379
222,205
8,559
18,964
679,337
45,340
48,986
180,185
63,556
16,150
68,743
731
4,231
29,267
2,814
478,189
19,795
6,219
1,157,526
65,135
55,205
905
1,148
1,291
3,014
3,919
1,306
540,373
18,129
86,987
645,826
25,833
2,372
245,190
1,082
15,270
288,839
1,676
748,221
8,174
1,768,404
1,682,886
85,518
Retail - acquired loans
29,386
707
2,649
32,035
827
52,510
516
85,888
84,545
3,137,720
2,928,876
65,472
143,372
49
NOTE 6 – ALLOWANCE FOR LOAN AND LEASE LOSSES
The composition of Oriental’s allowance for loan and lease losses at September 30, 2017 and December 31, 2016 was as follows:
Allowance for loans and lease losses:
22,308
17,344
24,278
8,995
15,793
13,067
25,162
19,463
Unallocated
431
Total allowance for originated and other loans and lease losses
87,541
59,300
2,591
3,028
1,103
3,363
4,300
Total allowance for acquired BBVAPR loans and lease losses
43,473
35,356
Total allowance for acquired Eurobank loan and lease losses
Total allowance for loan and lease losses
154,160
115,937
Oriental 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. Oriental’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 Oriental’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.
During the third quarter of 2017, in the span of two weeks in September, hurricanes Irma and Maria caused catastrophic damages throughout Puerto Rico. Although the effect of the hurricanes on Oriental's loan portfolio is difficult to predict at this time,
management performed an evaluation of the loan portfolios in order to assess the impact on repayment sources and underlying collateral that could result in additional losses.
The framework for the analysis was based on our current ALLL methodology with additional considerations according to the estimated impact categorized as low, medium or high. From this impact assessment, additional reserve levels were estimated by increasing default probabilities (“PD”) and loss given default expectations (“LGD”) of each allowance segment.
For commercial portfolios, Oriental contacted its clients to evaluate the impact of the hurricanes on their business operations and collateral. The impact was then categorized as follows: (i) low risk, for clients that had no business impact or relatively insignificant impact; (ii) medium risk, for clients that had a business impact on their primary or secondary sources of repayment, but had adequate cash flow to cover operations and to satisfy their obligations; or (iii) high risk, for clients that had potentially significant problems that affected primary, secondary and tertiary (collateral) sources of repayment. This criterion was used to model adjusted PDs and LGDs considering internal and external sources of information available to support our estimation process and output. For retail portfolios (residential mortgage, consumer and auto), management established assumptions based on the historical losses of each ALLL segment and then further adjusted based on parameters used as key risk indicators, such as the industry of employment (for all portfolios) and the location of the collateral (for residential loans).
Based on our assessment of the facts related to these hurricanes, we have increased our provision for loan losses $27.0 million. The increase in the allowance corresponding to our originated loan portfolio was $16.8 million: $3.8 million in mortgage loans, $7.6 million in commercial loans, $800 thousand in consumer loans, and $4.6 million in auto loans. The increase in the allowance corresponding to our acquired loan portfolio was $10.2 million: $2.7 million in mortgage loans, $7.0 million in commercial loans, $100 thousand in consumer loans, and $400 thousand in auto loans.
The documentation for the assessment considers all information available at the moment; gathered through visits or interviews with our clients, inspections of collaterals, identification of most affected areas and industries. Oriental will continue to assess the impact to our customers and our businesses as a result of the hurricanes and refine our estimates as more information becomes available.
Allowance for Originated and Other Loan and Lease Losses Held for Investment
The following tables presents the activity in our allowance for loan and lease losses and the related recorded investment of the originated and other loans held for investment portfolio by segment for the periods indicated:
Allowance for loan and lease losses for originated and other loans:
18,664
17,279
14,981
18,742
69,666
Charge-offs
(727)
(4,424)
(9,387)
(15,372)
Recoveries
341
654
168
2,394
3,557
Provision for originated and other loans and lease losses
4,137
7,072
5,068
13,413
29,690
(5,375)
(6,424)
(11,792)
(24,726)
(48,317)
458
880
1,113
9,864
12,315
9,881
20,827
13,405
20,561
(431)
64,243
Allowance for loan and lease losses on originated and other loans:
Ending allowance balance attributable
to loans:
Individually evaluated for impairment
Collectively evaluated for impairment
12,784
19,055
72,794
Total ending allowance balance
67,039
607,965
1,178,672
2,934,431
Total ending loan balance
52
18,537
63,144
11,771
19,259
101
112,812
(1,656)
(56,700)
(3,173)
(7,804)
(69,333)
3,747
3,981
Provision (recapture) for originated and other loan and lease losses
1,625
5,770
3,571
3,800
(58)
14,708
18,527
12,307
12,289
19,002
62,168
18,352
64,791
18,261
112,626
(4,692)
(58,544)
(8,310)
(24,267)
(95,813)
204
407
355
9,969
10,935
4,663
5,653
9,047
15,039
34,420
9,583
7,369
49,913
53,139
629,844
1,224,727
2,901,481
Allowance for BBVAPR Acquired Loan Losses
Loans accounted for under ASC 310-20 (Loans with revolving feature and/or acquired at a premium)
The following tables present the activity in our allowance for loan losses and related recorded investment of the associated loans in our BBVAPR acquired loan portfolio accounted for under ASC 310-20, for the periods indicated:
Allowance for loan and lease losses
for acquired BBVAPR loans
accounted for under ASC 310-20:
2,623
684
3,348
(711)
(222)
(933)
Provision (recapture) for acquired BBVAPR
loan and lease losses accounted for
under ASC 310-20
712
Balance at beginning of year
(132)
(2,367)
(705)
(3,204)
392
1,251
1,649
(2)
1,538
(918)
Balance at end of year
3,351
3,864
59,890
3,002
1,464
(889)
(475)
(1,366)
544
Provision (recapture) for acquired
(17)
766
(201)
548
2,946
4,213
3,429
2,087
5,542
(21)
(2,714)
(1,783)
(4,518)
1,505
(43)
(560)
1,392
4,159
4,412
90,300
Loans Accounted for under ASC 310-30 (including those accounted for under ASC 310-30 by analogy)
For loans accounted for under ASC 310- 30, as part of the evaluation of actual versus expected cash flows, Oriental 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 following tables present the activity in our allowance for loan losses and related recorded investment of the acquired BBVAPR loan portfolio accounted for under ASC 310-30 for the periods indicated:
Allowance for loan and lease losses for acquired BBVAPR loans accounted for under ASC 310-30:
4,141
25,614
7,739
37,494
Provision for BBVAPR loans and
lease losses accounted for
under ASC 310-30
4,790
6,810
- 501
11,099
Allowance de-recognition
(8,483)
Provision (recapture) for BBVAPR loans
and lease losses accounted for
6,345
9,768
2,685
18,798
(96)
(9,279)
(369)
(9,744)
57
1,585
15,863
5,353
22,801
Provision (recapture) for acquired BBVAPR loans and lease losses accounted for under ASC 310-30
1,079
6,324
7,403
(189)
(196)
(385)
2,664
21,998
5,157
29,819
1,678
21,245
2,862
25,785
Provision for acquired BBVAPR loans and lease losses accounted for under ASC 310-30
9,552
2,693
13,245
Loan pools fully charged-off
(14)
(66)
(202)
(282)
Allowance de-recogntion
(8,733)
(8,929)
58
Allowance for Acquired Eurobank Loan Losses
The changes in the allowance for loan and lease losses on acquired Eurobank loans for the quarters and nine-month periods ended September 30, 2017 and 2016 were as follows:
Allowance for loan and lease losses for acquired Eurobank loans:
13,651
8,131
21,787
Provision for (recapture) acquired Eurobank loans and lease losses, net
1,402
2,541
(571)
(611)
(1,182)
4,011
562
4,573
(1,739)
(968)
(2,708)
59
Loans secured by 1-4 Family Residential Properties
11,016
11,096
22,116
Provision for (recapture) acquired Eurobank loan and lease losses, net
893
(74)
819
818
(459)
(478)
(941)
12,268
10,544
22,812
Allowance for loan and lease losses for Eurobank loans:
22,570
67,365
243
90,178
1,077
(7)
2,655
FDIC shared-loss portion of provision for covered loan and lease losses, net
3,213
(134)
(14,592)
(58,272)
(73,100)
NOTE 7- FDIC INDEMNIFICATION ASSET, TRUE-UP PAYMENT OBLIGATION, AND FDIC SHARED-LOSS EXPENSE
On February 6, 2017, the Bank and the FDIC agreed to terminate the single family and commercial shared-loss agreements related to the FDIC assisted acquisition of Eurobank on April 30, 2010. As part of the loss share termination transaction, the Bank made a payment of $10.1 million to the FDIC and recorded a net benefit of $1.4 million. Such termination payment took into account the anticipated reimbursements over the life of the shared-loss agreements and the true-up payment liability of the Bank anticipated at the end of the ten year term of the single family shared-loss agreement. All rights and obligations of the parties under the shared-loss agreements terminated as of the closing date of the agreement.
Pursuant to the terms of the shared-loss agreements, the FDIC would reimburse the Bank for 80% of all qualifying losses with respect to assets covered by such agreements, and the Bank would reimburse the FDIC for 80% of qualifying recoveries with respect to losses for which the FDIC reimbursed the Bank. The single family shared-loss agreement provided for FDIC loss sharing and the Bank’s reimbursement to the FDIC to last for ten years, and the commercial shared-loss agreement provided for FDIC loss sharing and the Bank’s reimbursement to the FDIC to last for five years, with additional recovery sharing for three years thereafter.
The following table presents the activity in the FDIC indemnification asset and true-up payment obligation for the quarters and nine-month periods ended September 30, 2017 and 2016:
FDIC indemnification asset:
18,426
22,599
Shared-loss agreements reimbursements from the FDIC
(87)
(824)
Increase in expected credit losses to be
covered under shared-loss agreements, net
FDIC indemnification asset benefit (expense)
(1,910)
(6,179)
Net expenses incurred under shared-loss agreements
(577)
(2,139)
Shared-loss termination settlement
(15,814)
16,670
True-up payment obligation:
25,771
26,786
24,658
Change in true-up payment obligation
508
1,621
(26,786)
26,279
Oriental recognized an FDIC shared-loss (benefit) expense, net in the consolidated statements of operations, which consists of the following, for the quarters and nine-month periods ended September 30, 2017 and 2016:
FDIC indemnification asset expense (benefit)
1,910
6,179
Reimbursement to FDIC for recoveries
878
2,945
Total FDIC shared-loss expense (benefit), net
3,296
NOTE 8 — FORECLOSED REAL ESTATE
The following tables present the activity related to foreclosed real estate for the quarters and nine month periods endedSeptember 30, 2017 and 2016:
Acquired BBVAPR loans
Acquired Eurobank loans
15,842
21,671
12,710
50,223
Decline in value
(592)
(680)
(340)
(1,612)
Additions
2,122
665
4,269
Sales
(1,996)
(2,410)
(1,108)
(5,514)
Other adjustments
(59)
(32)
(91)
14,677
20,671
11,927
12,389
21,379
13,752
(1,672)
(2,309)
(1,610)
(5,591)
9,338
9,210
2,597
21,145
(5,235)
(7,464)
(2,812)
(15,511)
(143)
(145)
(288)
10,401
23,894
16,925
51,220
(794)
(1,662)
(1,036)
(3,492)
1,866
1,800
692
4,358
(1,717)
(3,191)
(1,440)
(6,348)
9,758
20,841
15,141
45,740
9,738
26,757
21,681
58,176
(1,442)
(5,566)
(11,526)
6,295
4,855
2,399
13,549
(4,836)
(5,205)
(4,421)
(14,462)
During the third quarter of 2017, hurricanes Irma and Maria caused catastrophic damages throughout Puerto Rico. Management is evaluating the potential impact these two events brought to Oriental’s foreclosed real estate, considering the related underlying insurance coverage. Taking into consideration all available information and the status of the analysis to date, we believed the fair value of these properties will not be materially impacted.
NOTE 9 —DERIVATIVES
The following table presents Oriental’s derivative assets and liabilities at September 30, 2017 and December 31, 2016:
Derivative assets:
Interest rate swaps not designated as hedges
757
1,187
Interest rate caps
Derivative liabilities:
Interest rate swaps designated as cash flow hedges
1,004
139
107
Interest Rate Swaps
Oriental 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 Oriental’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 borrowing transactions, are properly documented as such, and therefore, qualify for cash flow hedge accounting. Any gain or loss associated with the effective portion of the cash flow hedges is recognized in other comprehensive income (loss) and is subsequently reclassified into operations 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, Oriental does not expect to reclassify any amount included in other comprehensive income (loss) related to these interest rate swaps to operations in the next twelve months.
The following table shows a summary of these swaps and their terms at September 30, 2017:
Notional
Fixed
Variable
Trade
Settlement
Maturity
Type
Amount
Rate
Rate Index
Date
35,487
2.4210%
1-Month LIBOR
07/03/13
08/01/23
An accumulated unrealized loss of $868 thousand and $1.0million was recognized in accumulated other comprehensive income (loss) related to the valuation of these swaps at September 30, 2017 and December 31, 2016, respectively, and the related liability is being reflected in the consolidated statements of financial condition.
At September 30, 2017 and December 31, 2016, interest rate swaps not designated as hedging instruments that were offered to clients represented an asset of $757 thousand and $1.2 million, respectively, and were included as part of derivative assets in the consolidated statements of financial position. The credit risk to these clients stemming from these derivatives, if any, is not material. At September 30, 2017 and December 31, 2016, interest rate swaps not designated as hedging instruments that are the mirror-images of the derivatives offered to clients represented a liability of $757 thousand and $1.2 million, respectively, and were included as part of derivative liabilities in the 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 September 30, 2017:
Interest Rate Swaps - Derivatives Offered to Clients
12,500
5.5050%
04/11/09
04/11/19
Interest Rate Swaps - Mirror Image Derivatives
Interest Rate Caps
Oriental 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, Oriental simultaneously enters into mirror-image interest rate cap transactions with financial counterparties. None of these cap transactions qualify for hedge accounting, and therefore, they are marked to market through earnings. As of September 30, 2017 and December 31, 2016, the outstanding total notional amount of interest rate caps was $135.3 million and $136.1 million, respectively. At September 30, 2017 and December 31, 2016, the interest rate caps sold to clients represented a liability of $52 thousand and $139 thousand, respectively, and were included as part of derivative liabilities in the consolidated statements of financial condition. At September 30, 2017 and December 31, 2016, the interest rate caps purchased as mirror-images represented an asset of $52 thousand and $143 thousand, respectively, and were included as part of derivative assets in the consolidated statements of financial condition.
NOTE 10 —ACCRUED INTEREST RECEIVABLE AND OTHER ASSETS
Accrued interest receivable at September 30, 2017 and December 31, 2016 consists of the following:
Loans, excluding acquired loans
19,768
16,706
Investments
2,968
3,521
Other assets at September 30, 2017 and December 31, 2016 consist of the following:
Prepaid expenses
13,070
17,096
Other repossessed assets
3,829
3,224
Core deposit and customer relationship intangibles
5,055
6,160
Mortgage tax credits
4,277
6,277
Investment in Statutory Trust
1,083
Accounts receivable and other assets
37,443
46,525
Prepaid expenses amounting to $13.1 million and $17.1 million at September 30, 2017 and December 31, 2016, respectively, include prepaid municipal, state accident insurance fund, property and income taxes aggregating to $7.5 million and $12.5 million, respectively.
In connection with the FDIC-assisted acquisition and the BBVAPR Acquisition, Oriental recorded a core deposit intangible representing the value of checking and savings deposits acquired. At September 30, 2017 and December 31, 2016 this core deposit intangible amounted to $3.6 million and $4.3 million, respectively. In addition, Oriental recorded a customer relationship intangible representing the value of customer relationships acquired with the acquisition of the securities broker-dealer and insurance agency in the BBVAPR Acquisition. At September 30, 2017 and December 31, 2016, this customer relationship intangible amounted to $1.5 million and $1.9 million, respectively.
Other repossessed assets totaled $3.8 million and $3.2 million at September 30, 2017 and December 31, 2016, respectively, include repossessed automobiles amounting to $3.6 million and $3.0 million, respectively, which are recorded at their net realizable value.
At September 30, 2017 and December 31, 2016, tax credits for Oriental totaled $4.3 million and $6.3 million, respectively. These tax credits do not have an expiration date.
NOTE 11—DEPOSITS AND RELATED INTEREST
Total deposits, including related accrued interest payable, as of September 30, 2017 and December 31, 2016 consist of the following:
Non-interest bearing demand deposits
900,063
848,502
Interest-bearing savings and demand deposits
2,337,174
2,219,452
Individual retirement accounts
235,265
265,754
Retail certificates of deposit
596,854
563,965
Institutional certificates of deposit
221,448
190,419
Total core deposits
4,290,804
4,088,092
Brokered deposits
535,600
576,395
Brokered deposits include $487.0 million in certificates of deposits and $48.6 million in money market accounts at September 30, 2017, and $508.4million in certificates of deposits and $68.0 million in money market accounts at December 31, 2016.
The weighted average interest rate of Oriental’s deposits was 0.65% and 0.62% at September 30, 2017 and December 31, 2016 respectively. Interest expense for the quarters and nine-month periods ended September 30, 2017 and 2016 was as follows:
Demand and savings deposits
2,715
3,035
8,563
9,061
Certificates of deposit
4,886
4,296
14,043
12,761
At December 31, 2016, demand and interest-bearing deposits and certificates of deposit included uncollateralized deposits of Puerto Rico Cash & Money Market Fund, Inc. ("the Fund”), which amounted to $15.3 million, with a weighted average rate of 0.77%. On April 3, 2017, the Fund was liquidated in anticipation of its dissolution.
At September 30, 2017 and December 31, 2016, time deposits in denominations of $250 thousand or higher, excluding accrued interest and unamortized discounts, amounted to $364.7 million and $344.0 million, respectively. Such amounts include public funds time deposits from various Puerto Rico government municipalities, agencies, and corporations of $13.3 million and $2.1 million at a weighted average rate of 0.67% and 0.50% at September 30, 2017 and December 31, 2016, respectively.
At September 30, 2017 and December 31, 2016, total public fund deposits from various Puerto Rico government municipalities, agencies, and corporations amounted to $135.8 million and $170.7 million, respectively. These public funds were collateralized with commercial loans amounting to $174.3 million and $209.2 million at September 30, 2017 and December 31, 2016, respectively.
Excluding accrued interest of approximately $2.1 million, the scheduled maturities of certificates of deposit at September 30, 2017 and December 31, 2016 are as follows:
Within one year:
Three (3) months or less
271,981
277,621
Over 3 months through 1 year
577,067
534,548
849,048
812,169
Over 1 through 2 years
448,068
488,440
Over 2 through 3 years
168,084
154,545
Over 3 through 4 years
37,303
29,701
Over 4 through 5 years
35,981
41,949
1,538,484
1,526,804
The table of scheduled maturities of certificates of deposits above includes brokered-deposits and individual retirement accounts.
The aggregate amount of overdrafts in demand deposit accounts that were reclassified to loans amounted to $593 thousand and $575 thousand as of September 30, 2017 and December 31, 2016, respectively.
NOTE 12 —BORROWINGS AND RELATED INTEREST
Securities Sold under Agreements to Repurchase
At September 30, 2017, 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 Oriental the same or similar securities at the maturity of these agreements. The purpose of these transactions is to provide financing for Oriental’s securities portfolio.
At September 30, 2017 and December 31, 2016, securities sold under agreements to repurchase (classified by counterparty), excluding accrued interest in the amount of $581 thousand and $1.5 million, respectively, were as follows:
Fair Value of
Borrowing
Underlying
Collateral
PR Cash and Money Market Fund
70,010
74,538
JP Morgan Chase Bank NA
172,500
185,848
350,219
376,674
Credit Suisse Securities (USA) LLC
232,000
249,286
Federal Home Loan Bank
110,000
115,836
282,500
301,684
652,229
700,498
The following table shows a summary of Oriental’s repurchase agreements and their terms, excluding accrued interest in the amount of $581 thousand, at September 30, 2017:
Weighted-
Year of Maturity
Coupon
Settlement Date
2018
1.42%
12/10/2012
4/29/2018
2019
50,000
1.72%
3/2/2017
9/3/2019
2020
60,000
1.85%
3/2/2020
1.56%
A repurchase agreement in the original amount of $500 million with an original term of ten years was modified in February 2016 to partially terminate, before maturity, $268.0 million at a cost of $12.0 million included as a loss on early extinguishment of debt in the consolidated statements of operations. The remaining balance of this repurchase agreement of $232.0 million matured on March 2, 2017. During the second quarter of 2017, repurchase agreements in the original amounts of $25.0 million and $75.0 million, respectively, with original terms of June 2019 and December 2019, respectively, were terminated before maturity at a cost of $80 thousand included as a loss on early extinguishment of debt in consolidated statement of operations.
The following table presents the repurchase liability associated with the repurchase agreement transactions (excluding accrued interest) by maturity. Also, it includes the carrying value and approximate market value of collateral (excluding accrued interest) at September 30, 2017 and December 31, 2016. There was no cash collateral at September 30, 2017 and December 31, 2016.
Market Value of Underlying Collateral
FNMA and
Repurchase
FHLMC
Liability
Certificates
Over 90 days
US Treasury
GNMA
Treasury
Notes
Less than 90 days
349,729
3.35%
248,288
75,536
48,954
372,778
302,500
1.44%
327,627
327,720
2.47%
575,915
75,629
Advances from the Federal Home Loan Bank of New York
Advances are received from the Federal Home Loan Bank of New York (the “FHLB-NY”) under an agreement whereby Oriental is required to maintain a minimum amount of qualifying collateral with a fair value of at least 110% of the outstanding advances. At September 30, 2017 and December 31, 2016, these advances were secured by mortgage and commercial loans amounting to $1.3 billion and $1.4 billion, respectively. Also, at September 30, 2017 and December 31, 2016, Oriental had an additional borrowing capacity with the FHLB-NY of $849.5 million and $1.2 billion, respectively. At September 30, 2017 and December 31, 2016, the weighted average remaining maturity of FHLB’s advances was 5.1 months and 10.6 months, respectively. The original terms of these advances range between one month and seven years, and the FHLB-NY does not have the right to exercise put options at par on any advances outstanding as of September 30, 2017.
The following table shows a summary of these advances and their terms, excluding accrued interest in the amount of $312 thousand, at September 30, 2017:
1.29%
9/1/2017
10/2/2017
30,000
2.19%
1/16/2013
1/16/2018
25,000
2.18%
55,000
9,292
7/19/2013
7/20/2020
99,779
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.
Subordinated Capital Notes
Subordinated capital notes amounted to $36.1 million at September 30, 2017 and December 31, 2016, for both periods.
NOTE 13 – OFFSETTING OF FINANCIAL ASSETS AND LIABILITIES
Oriental’s derivatives are subject to agreements which allow a right of set-off with each respective counterparty. In addition, Oriental’s securities purchased under agreements to resell and securities sold under agreements to repurchase have a right of set-off with the respective counterparty under the supplemental terms of the master repurchase agreements. In an event of default, each party has a right of set-off against the other party for amounts owed in the related agreements and any other amount or obligation owed in respect of any other agreement or transaction between them. Security collateral posted to open and maintain a master netting agreement with a counterparty, in the form of cash and securities, may from time to time be segregated in an account at a third-party custodian pursuant to a an account control agreement.
The following table presents the potential effect of rights of set-off associated with Oriental’s recognized financial assets and liabilities at September 30, 2017 and December 31, 2016:
Gross Amounts Not Offset in the Statement of Financial Condition
Gross Amounts
Net Amount of
Offset in the
Assets Presented
Gross Amount
Statement of
in Statement
Cash
of Recognized
Financial
of Financial
Net
Assets
Condition
Instruments
Received
2,021
(1,212)
Net amount of
2,003
(673)
Liabilities
Presented
Provided
(303)
(19,184)
284,177
(19,487)
457
(48,269)
654,666
(47,812)
NOTE 14 — INCOME TAXES
At September 30, 2017 and December 31, 2016, Oriental’s net deferred tax asset amounted to $126.0 million and $124.2 million, respectively. In assessing the realizability of the deferred tax asset, management considers whether it is more likely than not that some portion or the entire deferred tax asset will not be realized. The ultimate realization of the deferred tax asset is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax asset are deductible, management believes it is more likely than not that Oriental will realize the deferred tax asset, net of the existing valuation allowances recorded at September 30, 2017 and December 31, 2016. The amount of the deferred tax asset that is considered realizable could be reduced in the near term if estimates of future taxable income during the carry forward period are reduced.
At September 30, 2017 and December 31, 2016, Oriental International Bank Inc. (“OIB”), the Bank’s international banking entity subsidiary, had $5 thousand and $117 thousand, respectively, in 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 September 30, 2017 and 2016, $1 thousand and $9 thousand, respectively, related to this residual tax effect from OIB was reclassified from accumulated other comprehensive income (loss) into income tax provision. During the nine-month period ended September 30, 2017 and 2016, $103 thousand and $24 thousand, respectively, related to this residual tax effect from OIB was reclassified from accumulated other comprehensive income (loss) into income tax provision.
Oriental classifies unrecognized tax benefits in other liabilities. These gross unrecognized tax benefits would affect the effective tax rate if realized. At September 30, 2017 the amount of unrecognized tax benefits was $1.2 million (December 31, 2016 - $2.0 million). Oriental had accrued $73 thousand at September 30, 2017 (December 31, 2016 - $229 thousand) for the payment of interest and penalties relating to unrecognized tax benefits and released $877 thousand related to amounts accrued for periods whose statute of limitation expired.
Oriental is subject to the dispositions of the 2011 Puerto Rico Internal Revenue Code, as amended (the "Code"). The Code imposes a maximum corporate tax rate of 39%. Oriental maintained a lower effective tax rate for the nine-month periods ended September 30, 2017 and 2016 of 29.8% and 28.8%, respectively.
Income tax expense for the quarters ended September 30, 2017 and 2016 was $560 thousand and $3.6 million, respectively. Income tax expense for the nine-month periods ended September 30, 2017 and 2016 was $13.8 million and $15.1 million, respectively.
NOTE 15 — REGULATORY CAPITAL REQUIREMENTS
Regulatory Capital Requirements
Oriental (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 Oriental’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Oriental 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 adopted capital rules that became effective January 1, 2015 for Oriental and the Bank (subject to certain phase-in periods through January 1, 2019) and that replaced their general risk-based capital rules, advanced approaches rule, market risk rule, and leverage rules. Among other matters, the new capital rules: (i) introduce a new capital measure called “Common Equity Tier 1” (“CET1”) and related regulatory capital ratio of CET1 to risk-weighted assets; (ii) specify that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting certain revised requirements; (iii) mandate that most deductions/adjustments to regulatory capital measures be made to CET1 and not to the other components of capital; and (iv) expand the scope of the deductions from and adjustments to capital as compared to prior regulations. The current capital rules prescribe a new standardized approach for risk weightings that expand the risk-weighting categories from the current four Basel I-derived categories (0%, 20%, 50% and 100%) to a larger and more risk-sensitive number of categories, depending on the nature of the assets, and resulting in higher risk weights for a variety of asset classes.
Pursuant to the current capital rules, the minimum capital ratios requirements are as follows:
4.5% CET1 to risk-weighted assets;
6.0% Tier 1 capital (that is, CET1 plus Additional Tier 1 capital) to risk-weighted assets;
8.0% Total capital (that is, Tier 1 capital plus Tier 2 capital) to risk-weighted assets; and
4.0% Tier 1 capital to average consolidated assets as reported on consolidated financial statements (known
as the “leverage ratio”).
As of September 30, 2017 and December 31, 2016, Oriental and the Bank met all capital adequacy requirements to which they are subject. As of September 30, 2017 and December 31, 2016, the Bank is “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well capitalized,” an institution must maintain minimum CET1 risk-based, Tier 1 risk-based, total risk-based, and Tier 1 leverage ratios as set forth in the tables presented below.
OFG Bancorp’s and the Bank’s actual capital amounts and ratios as of September 30, 2017 and December 31, 2016are as follows:
Minimum Capital
Minimum to be Well
Actual
Requirement
Capitalized
Ratio
OFG Bancorp Ratios
As of September 30, 2017
Total capital to risk-weighted assets
885,523
20.82%
340,208
8.00%
425,260
10.00%
Tier 1 capital to risk-weighted assets
830,640
19.53%
255,156
Common equity tier 1 capital to risk-weighted assets
633,401
14.89%
191,367
4.50%
276,419
6.50%
Tier 1 capital to average total assets
14.07%
236,105
4.00%
295,131
5.00%
As of December 31, 2016
876,657
19.62%
357,404
446,756
819,662
18.35%
268,053
627,733
14.05%
201,040
290,391
12.99%
252,344
315,430
Bank Ratios
867,538
20.39%
340,304
425,380
812,833
19.11%
255,228
191,421
276,497
13.81%
235,364
294,204
857,259
19.23%
356,596
445,745
800,544
17.96%
267,447
200,585
289,734
12.75%
251,200
314,000
NOTE 16 – STOCKHOLDERS’ EQUITY
Additional Paid-in Capital
Additional paid-in capital represents contributed capital in excess of par value of common and preferred stock net of the costs of issuance. As of both periods, September 30, 2017 and December 31, 2016 accumulated issuance costs charged against additional paid in capital amounted to $13.6 million and $10.1 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 or loss 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 September 30, 2017 and December 31, 2016, the Bank’s legal surplus amounted to $79.8 million and $76.3 million, respectively. The amount transferred to the legal surplus account is not available for the payment of dividends to shareholders.
Treasury Stock
Under Oriental’s current stock repurchase program it is authorized to purchase in the open market up $7.7 million of its outstanding shares of common stock. The shares of common stock repurchased are to be held by Oriental as treasury shares. During the nine-month periods ended September 30, 2017 and 2016, Oriental did not purchase any shares under the program.
At September 30, 2017 the number of shares that may yet be purchased under the $70 million program is estimated at 844,902 and was calculated by dividing the remaining balance of $7.7 million by $9.15 (closing price of Oriental's common stock at September 30, 2017).
The activity in connection with common shares held in treasury by Oriental for the nine-month periods ended September 30, 2017 and 2016 is set forth below:
Dollar
Shares
(In thousands, except shares data)
Beginning of period
8,711,025
104,860
8,757,960
105,379
Common shares used upon lapse of restricted stock units
(32,598)
(45,810)
(505)
End of period
8,678,427
104,502
8,712,150
104,874
NOTE 17 - ACCUMULATED OTHER COMPREHENSIVE INCOME
Accumulated other comprehensive income, net of income taxes, as of September 30, 2017 and December 31, 2016 consisted of:
Unrealized gain on securities available-for-sale which are not
other-than-temporarily impaired
1,487
1,617
Income tax effect of unrealized gain on securities available-for-sale
(116)
592
Net unrealized gain on securities available-for-sale which are not
1,371
2,209
Unrealized loss on cash flow hedges
(868)
(1,004)
Income tax effect of unrealized loss on cash flow hedges
339
391
Net unrealized loss on cash flow hedges
(529)
(613)
Accumulated other comprehensive (loss) income, net of income taxes
The following table presents changes in accumulated other comprehensive income by component, net of taxes, for the quarters and nine-month periods ended September 30, 2017 and 2016:
Net unrealized
Accumulated
gains on
loss on
other
securities
cash flow
comprehensive
available-for-sale
hedges
(loss) income
income
Beginning balance
256
(563)
(307)
18,085
(2,280)
15,805
Other comprehensive loss before reclassifications
1,185
1,111
(469)
(144)
Amounts reclassified out of accumulated other comprehensive income (loss)
(70)
(63)
715
652
Other comprehensive income (loss)
(532)
571
Ending balance
17,553
(1,709)
16,924
(2,927)
Other comprehensive income (loss) before reclassifications
(726)
(301)
(1,027)
(1,732)
(2,550)
(4,282)
Other-than-temporary impairment amount reclassified from accumulated other comprehensive income
2,557
(112)
385
3,768
3,572
(838)
629
1,218
The following table presents reclassifications out of accumulated other comprehensive income for the quarters and nine-month periods ended September 30, 2017 and 2016:
Amount reclassified out of accumulated other
comprehensive (loss) income
Affected Line Item in
Consolidated Statement
of Operations
Cash flow hedges:
Interest-rate contracts
664
Net interest expense
Tax effect from increase in capital gains tax rate
Available-for-sale securities:
Residual tax effect from OIB's change in applicable tax rate
(71)
(72)
3,468
300
104
(216)
(220)
79
NOTE 18 – EARNINGS PER COMMON SHARE
The calculation of earnings per common share for the quarters and nine-month periods ended September 30, 2017 and 2016 is as follows:
Less: Dividends on preferred stock
Non-convertible preferred stock (Series A, B, and D)
(1,627)
(4,883)
Convertible preferred stock (Series C)
(1,838)
(5,513)
(Loss) Income available to common shareholders
Effect of assumed conversion of the convertible ' ' preferred stock
1,838
5,513
Income available to common shareholders assuming conversion
1,692
13,493
30,690
38,747
Weighted average common shares and share equivalents:
Average common shares outstanding
43,947
43,926
43,937
43,913
Effect of dilutive securities:
Average potential common shares-options
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 remain outstanding at September 30, 2017, with a conversion rate, subject to certain conditions, of 86.4225 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 quarters and nine-month periods ended September 30, 2017 and 2016 on the convertible preferred stock were added back as income available to common shareholders.
For the quarters ended September 30, 2017 and 2016, weighted-average stock options with an anti-dilutive effect on earnings per share not included in the calculation amounted to 922,601 and 927,069, respectively. For the nine-month period ended September 30, 2017 and 2016, weighted-average stock options with an anti-dilutive effect on earnings per share not included in the calculation amounted to 935,740 and 957,670, respectively.
NOTE 19 – GUARANTEES
At September 30, 2017 and December 31, 2016 , the unamortized balance of the obligations undertaken in issuing the guarantees under standby letters of credit represented a liability of $18.2 million and $4.0 million, respectively.
As a result of the BBVAPR Acquisition, Oriental assumed a liability for residential mortgage loans sold subject to credit recourse, pursuant to FNMA’s residential mortgage loan sales and securitization programs. At September 30, 2017 and December 31, 2016, the unpaid principal balance of residential mortgage loans sold subject to credit recourse was $6.6 million and $20.1 million, respectively.
The following table shows the changes in Oriental’s liability for estimated losses from these credit recourse agreements, included in the consolidated statements of financial condition during the quarters and nine-month periods ended September 30, 2017 and 2016.
570
710
439
Net (charge-offs/terminations) recoveries
(118)
(258)
(248)
191
The estimated losses to be absorbed under the credit recourse arrangements were recorded as a liability when the credit recourse was assumed, and are updated on a quarterly basis. The expected loss, which represents the amount expected to be lost on a given loan, considers the probability of default and loss severity. The probability of default represents the probability that a loan in good standing would become 120 days delinquent, in which case Oriental is obligated to repurchase the loan. The recourse obligation will be fully extinguished before the end of 2017.
If a borrower defaults, pursuant to the credit recourse provided, Oriental is required to repurchase the loan or reimburse the third party investor for the incurred loss. The maximum potential amount of future payments that Oriental would be required to make under the recourse arrangements is equivalent to the total outstanding balance of the residential mortgage loans serviced with recourse and interest, if applicable. During the quarter ended September 30, 2017, Oriental did not repurchase any unpaid principal balance in mortgage loans subject to credit recourse provisions. During the quarter ended 2016, Oriental repurchased approximately $133 thousand of unpaid principal balance in mortgage loans subject to the credit recourse provisions. During the nine-month periods ended September 30, 2017 and 2016, Oriental repurchased approximately $107 thousand and $421 thousand, respectively of unpaid principal balance in mortgage loans subject to the credit recourse provisions. If a borrower defaults, Oriental has rights to the underlying collateral securing the mortgage loan. Oriental suffers losses on these mortgage loans when the proceeds from a foreclosure sale of the collateral property are less than the outstanding principal balance of the loan, any uncollected interest advanced, and the costs of holding and disposing the related property. At September 30, 2017, Oriental’s liability for estimated credit losses related to loans sold with credit recourse amounted to $452 thousand (December 31, 2016– $710 thousand).
When Oriental sells or securitizes mortgage loans, it generally makes customary representations and warranties regarding the characteristics of the loans sold. Oriental's mortgage operations division groups conforming mortgage loans into pools which are exchanged for FNMA and GNMA mortgage-backed securities, which are generally sold to private investors, or are sold directly to FNMA or other private investors for cash. As required under such mortgage backed securities programs, quality review procedures are performed by Oriental to ensure that asset guideline qualifications are met. To the extent the loans do not meet specified characteristics, Oriental may be required to repurchase such loans or indemnify for losses and bear any subsequent loss related to the loans. During the quarter ended September 30, 2017, Oriental repurchased $625 thousand (September 30, 2016 – $791 thousand) of unpaid principal balance in mortgage loans, excluding mortgage loans subject to credit recourse provision referred above. During the nine-month periods ended September 30, 2017 and September 30, 2016, Oriental repurchased $3.0 million and $3.1 million, respectively, of unpaid principal balance in mortgage loans, excluding mortgage loans subject to credit recourse provision referred before.
During the quarter ended September 30, 2017, Oriental did not recognize any gains or losses from the repurchase of residential mortgage loans sold subject to credit recourse. During the quarter ended September 30, 2016, Oriental recognized $202 thousand, in
losses from the repurchase of residential mortgage loans sold subject to credit recourse. During the quarters ended September 30, 2017 and September 30, 2016, Oriental recognized $74 thousand and $208 thousand, respectively, in losses from the repurchase of residential mortgage loans as a result of breaches of the customary representations and warranties. During the nine-month periods ended September 30, 2017 and 2016, Oriental recognized $354 thousand and $313 thousand, respectively, in losses from the repurchase of residential mortgage loans sold subject to credit recourse, and $517 thousand and $1.0 million, respectively, from the repurchase of residential mortgage loans as a result of breaches of the customary representations and warranties.
Servicing agreements relating to the mortgage-backed securities programs of FNMA and GNMA, and to mortgage loans sold or serviced to certain other investors, including the FHLMC, require Oriental to advance funds to make scheduled payments of principal, interest, taxes and insurance, if such payments have not been received from the borrowers. At September 30, 2017, Oriental serviced $862.7 million in mortgage loans for third-parties. Oriental generally recovers funds advanced pursuant to these arrangements from the mortgage owner, from liquidation proceeds when the mortgage loan is foreclosed or, in the case of FHA/VA loans, under the applicable FHA and VA insurance and guarantees programs. However, in the meantime, Oriental must absorb the cost of the funds it advances during the time the advance is outstanding. Oriental must also bear the costs of attempting to collect on delinquent and defaulted mortgage loans. In addition, if a defaulted loan is not cured, the mortgage loan would be canceled as part of the foreclosure proceedings and Oriental would not receive any future servicing income with respect to that loan. At September 30, 2017, the outstanding balance of funds advanced by Oriental under such mortgage loan servicing agreements was approximately $402 thousand (December 31, 2016 - $334 thousand). To the extent the mortgage loans underlying Oriental's servicing portfolio experience increased delinquencies, Oriental would be required to dedicate additional cash resources to comply with its obligation to advance funds as well as incur additional administrative costs related to increases in collection efforts.
NOTE 20—COMMITMENTS AND CONTINGENCIES
Loan Commitments
In the normal course of business, Oriental 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 consolidated statements of financial condition. The contract or notional amount of those instruments reflects the extent of Oriental’s involvement in particular types of financial instruments.
Oriental’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 amounts 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. Oriental uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Credit-related financial instruments at September 30, 2017 and December 31, 2016 were as follows:
Commitments to extend credit
457,104
492,885
Commercial letters of credit
2,721
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. Oriental evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if it is deemed necessary by Oriental upon the extension of credit, is based on management’s credit evaluation of the counterparty.
At September 30, 2017 and December 31, 2016, 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 $667 thousand at September 30, 2017 and December 31, 2016.
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 September 30, 2017 and December 31, 2016, is as follows:
Standby letters of credit and financial guarantees
18,215
4,041
Loans sold with recourse
6,568
20,126
Standby letters of credit and financial guarantees are written conditional commitments issued by Oriental 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 Oriental upon extension of credit, is based on management’s credit evaluation of the customer.
Lease Commitments
Oriental has entered into various operating lease agreements for branch facilities and administrative offices. Rent expense for the quarters ended September 30, 2017 and 2016, amounted to $2.0 million, respectively. For the nine-month periods ended September 30, 2017 and 2016, rent expense amounted to $6.5 million, respectively, and is included in the "occupancy and equipment" caption in the unaudited consolidated statements of operations. Future rental commitments under leases in effect at September 30, 2017, exclusive of taxes, insurance, and maintenance expenses payable by Oriental, are summarized as follows:
Minimum Rent
Year Ending December 31,
2,027
7,085
6,928
6,201
2021
5,371
Thereafter
7,881
35,493
83
Contingencies
Oriental and its subsidiaries are defendants in a number of legal proceedings incidental to their business. In the ordinary course of business, Oriental and its subsidiaries are also subject to governmental and regulatory examinations. Certain subsidiaries of Oriental, including the Bank (and its subsidiary OIB), Oriental Financial Services, and Oriental Insurance, are subject to regulation by various U.S., Puerto Rico and other regulators.
Oriental seeks to resolve all litigation and regulatory matters in the manner management believes is in the best interests of Oriental 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 Oriental’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 consolidated statements of financial condition of Oriental. 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 Oriental’s consolidated results of operations or cash flows in particular quarterly or annual periods. Oriental has evaluated all litigation and regulatory matters where the likelihood of a potential loss is deemed reasonably possible. Oriental has determined that the estimate of the reasonably possible loss is not significant.
NOTE 21 -FAIR VALUE OF FINANCIAL INSTRUMENTS
Oriental follows the fair value measurement framework under U.S. Generally Accepted Accounting Principles (“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 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 fair value of money market investments is based on the carrying amounts reflected in the 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 Interactive Data Corporation ("IDC"), and independent, well-recognized pricing company. Such securities are classified as Level 1 or Level 2 depending on the basis for determining fair value. 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, and such securities are classified as Level 3. At September 30, 2017 and December 31, 2016, Oriental did not have investment securities classified as Level 3.
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 Oriental.
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. In the past, Oriental offered its customers certificates of deposit with an option tied to the performance of the S&P Index and used equity indexed option agreements with major broker-dealers to manage its exposure to changes in this index. Their fair value was 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 was linked to the average value of the S&P Index on a specific set of dates during the life of the option. The methodology used an average rate option or a cash-settled option whose payoff was 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 were uncertain and required a degree of judgment, included primarily S&P Index volatility, forward interest rate projections, estimated index dividend payout, and leverage. At September 30, 2017 and December 31, 2016, there were no options tied to the S&P Index outstanding.
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.
Impaired loans are carried at the present value of expected future cash flows using the loan’s existing rate in a discounted cash flow calculation, or the fair value of the collateral if the loan is collateral-dependent. Expected cash flows are based on internal inputs reflecting expected default rates on contractual cash flows. This method of estimating fair value does not incorporate the exit-price concept of fair value described in ASC 820-10 and would generally result in a higher value than the exit-price approach. For loans measured using the estimated fair value of collateral less costs to sell, fair value is generally determined 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 less disposition costs. 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.
85
Other repossessed assets include repossessed automobiles. The fair value of the repossessed automobiles may be determined using internal valuation and an external appraisal. These repossessed 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 are summarized below:
Fair Value Measurements
Level 1
Level 2
Level 3
Recurring fair value measurements:
(1,677)
612,839
629,187
Non-recurring fair value measurements:
Impaired commercial loans
67,788
118,892
(2,437)
750,724
766,188
54,289
105,033
86
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 ine-month periods ended September 30, 2017 and 2016:
Servicing
Level 3 Instruments Only
assets
9,866
New instruments acquired
429
Principal repayments
(152)
Changes in fair value of servicing assets
(325)
1,503
(1,065)
87
Quarter Ended September, 2016
Derivative
asset
liability
(S&P
Purchased
Embedded
Options)
187
7,932
(181)
7,938
Gains (losses) included in earnings
(187)
181
(6)
(123)
Amortization
118
8,393
Nine-Month Period Ended September, 2016
1,170
7,455
(1,095)
7,530
(1,170)
1,067
1,740
(347)
(455)
During the quarters and nine-month periods ended September 30, 2017 and 2016, 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.
88
The table below presents quantitative information for all assets and liabilities measured at fair value on a recurring and non-recurring basis using significant unobservable inputs (Level 3) at September 30, 2017:
Valuation Technique
Unobservable Input
Range
Cash flow valuation
Constant prepayment rate
4.22% - 9.11%
Discount rate
10.00% - 12.00%
Collateral dependant
impaired loans
24,025
Fair value of property
or collateral
Appraised value less disposition costs
22.20% - 36.20%
Other non-collateral dependant impaired loans
43,763
4.15% - 10.50%
Estimated net realizable value less disposition costs
34.00% - 66.00%
Information about Sensitivity to Changes in Significant Unobservable Inputs
Servicing assets – The significant unobservable inputs used in the fair value measurement of Oriental’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 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.
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 Oriental.
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.
89
The estimated fair value and carrying value of Oriental’s financial instruments at September 30, 2017 and December 31, 2016 is as follows:
Carrying
Financial Assets:
Cash and cash equivalents
Federal Home Loan Bank (FHLB) stock
Financial Liabilities:
Total loans (including loans held-for-sale)
3,854,106
3,917,340
8,669
4,809,945
4,644,629
281,786
651,898
100,249
106,422
31,938
30,230
90
The following methods and assumptions were used to estimate the fair values of significant financial instruments at September 30, 2017 and December 31, 2016:
• Cash and cash equivalents (including money market investments and time deposits with other banks), restricted cash, accrued interest receivable, accounts receivable and other assets and accrued expenses and other liabilities have been valued at the carrying amounts reflected in the consolidated statements of financial condition as these are reasonable estimates of fair value given the short-term nature of the instruments.
• Investments in FHLB-NY stock are valued at their redemption value.
• The fair value of investment securities, including trading securities and other investments, is based on quoted market prices, when available or prices provided from contracted pricing providers, 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 fair value of the FDIC indemnification asset represented the present value of the net estimated cash payments 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 and the loss sharing percentages. The FDIC shared-loss agreements were terminated on February 6, 2017. Such termination takes into account the anticipated reimbursements over the life of the shared-loss agreements and the true-up payment liability of the Bank anticipated at the end of the ten year term of the single family shared-loss agreement. Therefore, at June 30, 2017, Oriental had no FDIC indemnification asset.
• The fair value of servicing asset 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.
• 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 loan portfolio (including loans held-for-sale) is estimated by segregating by type, such as mortgage, commercial, consumer, auto 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. Non-performing loans have been valued at the carrying amounts.
• 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.
• The fair value of long-term borrowings, which include securities sold under agreements to repurchase, advances from FHLB, 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.
91
NOTE 22 – BUSINESS SEGMENTS
Oriental segregates its businesses into the following major reportable segments of business: Banking, Wealth Management, 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 Oriental’s organization, nature of its products, distribution channels and economic characteristics of the products were also considered in the determination of the reportable segments. Oriental 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. Oriental’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 Oriental’s own portfolio. As part of its mortgage banking activities, Oriental may sell loans directly into the secondary market or securitize conforming loans into mortgage-backed securities.
Wealth Management is comprised of the Bank’s trust division, Oriental Financial Services, Oriental Insurance, and OPC. 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 retirement plan administration services.
The Treasury segment encompasses all of Oriental’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 for the quarters and nine-month periods ended September 30, 2017 and 2016:
Wealth
Total Major
Consolidated
Banking
Management
Segments
Eliminations
Interest income
82,162
8,180
Interest expense
(6,342)
(3,535)
(9,877)
75,820
4,645
Provision for loan and lease losses
(44,042)
Non-interest income
10,384
6,695
833
Non-interest expenses
(43,819)
(5,048)
(1,602)
(50,469)
Intersegment revenue
Intersegment expenses
(324)
(107)
(1,226)
1,336
3,769
Income tax expenses (benefit)
521
514
(751)
815
3,255
5,605,922
23,148
1,620,919
7,249,989
(961,772)
82,564
8,005
(6,733)
(6,924)
(13,657)
75,831
(23,469)
8,918
6,379
4,918
(50,095)
(3,757)
(1,074)
(54,926)
375
(461)
(86)
(272)
11,474
2,365
4,475
922
(1,770)
6,999
1,443
6,678
5,715,958
19,433
1,801,752
7,537,143
(945,030)
6,592,113
236,754
25,676
(19,976)
(11,838)
(31,814)
216,778
13,838
(88,210)
(88,232)
Non-interest income, net
35,387
18,952
7,533
(137,275)
(13,368)
(4,326)
(154,969)
1,243
140
1,383
(1,383)
(140)
(354)
27,783
4,738
16,809
10,836
1,848
1,073
13,756
16,947
2,890
15,736
35,574
243,389
26,360
(20,840)
(23,744)
(44,584)
222,549
2,616
(51,703)
24,927
19,309
4,637
(147,881)
(11,610)
(4,117)
(163,608)
1,162
235
1,397
(1,397)
(235)
(849)
(313)
Income (loss) before income taxes
48,819
6,899
3,058
19,039
2,691
(6,584)
29,780
4,208
9,642
NOTE 23 – SUBSEQUENT EVENTS
On October 6, 2017, the Bank organized and began operating a new entity, OFG USA LLC ("OFG USA"), to provide commercial lending in the US mainland. The Bank made a capital contribution to OFG USA of $50.0 million on October 23, 2017.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
The following discussion of Oriental’s financial condition and results of operations should be read in conjunction with the “Selected Financial Data” and Oriental’s 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 Form 10-K for the year ended December 31, 2016 (the “2016 Form 10-K”), for discussion of the uncertainties, risks and assumptions associated with these statements.
Oriental 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. Oriental operates through three major business segments: Banking, Wealth Management, and Treasury, and distinguishes itself based on quality service. Oriental has 48 branches in Puerto Rico and a subsidiary in Boca Raton, Florida. Oriental’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.
Oriental’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, Oriental’s commitment is to continue producing a balanced and growing revenue stream.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in accordance with 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 2016 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 2016 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:
· Loans and lease receivables
· 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 Committee of our Board of Directors. During the third quarter of 2017, in the span of two weeks in September, hurricanes Irma and Maria caused catastrophic damages throughout Puerto Rico. Although the effect of the hurricanes on Oriental's loan portfolio is difficult to predict at this time, management performed an evaluation of the loan portfolios in order to assess the impact on repayment sources and underlying collateral that could result in additional losses. The framework for the analysis was based on our current ALLL methodology with additional considerations according to the estimated impact categorized as low, medium or high. From this impact assessment, additional reserve levels were estimated by increasing default probabilities (“PD”) and loss given default expectations (“LGD”) of each allowance segment. For commercial portfolios, Oriental contacted its clients to evaluate the impact of the hurricanes on their business operations and collateral. The impact was then categorized as follows: (i) low risk, for clients that had no business impact or relatively insignificant impact; (ii) medium risk, for clients that had a business impact on their primary or secondary sources of repayment, but had adequate cash flow to cover operations and to satisfy their obligations; or (iii) high risk, for clients that had potentially significant problems that affected primary, secondary and tertiary (collateral) sources of
repayment. This criterion was used to model adjusted PDs and LGDs considering internal and external sources of information available to support our estimation process and output. For retail portfolios (residential mortgage, consumer and auto), management established assumptions based on the historical losses of each ALLL segment and then further adjusted based on parameters used as key risk indicators, such as the industry of employment (for all portfolios) and the location of the collateral (for residential loans). The documentation for the assessment considers all information available at the moment; gathered through visits or interviews with our clients, inspections of collaterals, identification of most affected areas and industries. Oriental will continue to assess the impact to our customers and our businesses as a result of the hurricanes and refine our estimates as more information becomes available. Other than these changes, there have been no material changes in the methods used to formulate these critical accounting estimates from those discussed in our 2016 Form 10-K.
96
OVERVIEW OF FINANCIAL PERFORMANCE
SELECTED FINANCIAL DATA
Variance
%
EARNINGS DATA:
-0.3%
-2.7%
-27.7%
-28.6%
4.6%
2.4%
87.7%
70.7%
Net interest income after provision for loan
and lease losses
-31.8%
-17.9%
-11.4%
26.6%
-8.1%
-5.3%
Income before taxes
-79.3%
-16.1%
-84.6%
-9.2%
-78.0%
-18.5%
0.0%
Income available to common shareholders
-101.3%
-24.2%
PER SHARE DATA:
-100.0%
-25.0%
-26.3%
0.1%
Cash dividends declared per common share
Cash dividends declared on common shares
2,638
2,637
7,915
7,909
PERFORMANCE RATIOS:
Return on average assets (ROA)
0.22%
0.91%
-75.8%
0.76%
0.85%
-10.6%
Return on average tangible common equity
-0.08%
7.06%
-101.1%
4.94%
6.82%
-27.6%
Return on average common equity (ROE)
-0.07%
6.19%
4.35%
5.96%
-27.0%
Equity-to-assets ratio
14.91%
14.03%
6.3%
Efficiency ratio
51.66%
57.69%
-10.5%
54.71%
58.66%
-6.7%
Interest rate spread
5.56%
4.87%
14.2%
5.16%
4.68%
10.3%
Interest rate margin
5.64%
4.95%
13.9%
5.25%
4.77%
10.1%
SELECTED FINANCIAL DATA - (Continued)
PERIOD END BALANCES AND CAPITAL RATIOS:
Investments and loans
-15.0%
Loans and leases, net
-4.4%
Total investments and loans
5,122,476
5,510,203
-7.0%
Deposits and borrowings
3.5%
-56.7%
136,174
141,598
-3.8%
Total deposits and borrowings
5,245,658
5,459,841
-3.9%
Stockholders’ equity
Preferred stock
Common stock
7.7%
Treasury stock, at cost
0.3%
Accumulated other comprehensive (loss) income
-47.2%
Total stockholders' equity
1.9%
Per share data
Book value per common share
17.56
17.18
2.2%
Tangible book value per common share
15.49
15.08
2.7%
Market price at end of period
9.15
13.10
-30.2%
Capital ratios
Leverage capital
8.3%
Common equity Tier 1 capital ratio
6.0%
Tier 1 risk-based capital
6.4%
Total risk-based capital
6.1%
Financial assets managed
Trust assets managed
2,956,684
2,850,494
3.7%
Broker-dealer assets gathered
2,272,284
2,350,718
-3.3%
FINANCIAL HIGHLIGHTS OF THE THIRD QUARTER OF 2017
Our results for the third quarter of 2017 were significantly impacted by hurricanes Irma and Maria. The intensity and extent of damages caused by hurricane Maria, less than two weeks after hurricane Irma left over a million Puerto Rico residents without electric power, is unprecedented in Puerto Rico. Many areas and towns throughout Puerto Rico were devastated by hurricane Maria and at least 51 fatalities are attributed to this natural disaster. Over a month after the hurricanes, most of Puerto Rico remains without electricity, many businesses are unable to operate, and government authorities are still struggling to deliver emergency supplies and clean drinking water to many communities outside the San Juan metropolitan area. Further, payment and delivery systems, including the U.S. Post Office, were unable to operate for weeks after hurricane Maria and some are still subject to significant delays.
In response to the magnitude of this natural disaster and its general adverse effects on our customers, we offered a moratorium to defer payments on our personal, auto, mortgage and commercial loan portfolios. Any eligible customer may decline the deferment by continuing to make its regularly scheduled loan payments.
Our moratorium covers all personal and auto loan customers that are not over 89 days delinquent in their loans. It consists of an optional automatic deferment of three scheduled monthly payments of principal and interest. For any customer that does not opt out, the deferred payments are due and payable in three consecutive installments after the loan’s maturity date. Such loans continue to accrue interest on their principal balances during the moratorium at their respective rates, and such customers are not charged late payment fees in connection with the deferment, nor is their credit history affected thereby.
For commercial loans, we offered a one-month optional deferment in the payment of principal and interest for loans that are not over 30 days past due, and up to two additional one-month deferrals in certain cases. For conforming mortgage loans (Rural, VA, FNMA, FHA and FHLMC), we offered a three-month optional deferment of principal and interest due and payable in January 2018, and for credit card balances that were not over 29 days past due as of August 31, 2017, we offered a waiver of minimum payments for October, November and December 2017.
· Net loss available to shareholders totaled $146 thousand. This compares to $13.6 million, or $0.30 per share fully diluted, in the second quarter of 2017 and $11.7 million, or $0.26 per share fully diluted, in the year ago quarter.
· Based on preliminary assessments of the impact of the hurricanes on its credit portfolio, third quarter 2017 results included an additional loan loss provision of $27.0 million.
· Tangible book value per common share was $15.92 and tangible common equity ratio was 11.26%, with common equity Tier 1 capital ratio of 15.48%, Tier 1 risk-based capital ratio of 20.09%, and total risk-based capital ratio of 21.37%.
Adjusted results of operations – Non-GAAP financial measures
Oriental prepares its consolidated financial statements using accounting principles generally accepted in the United States (“U.S. GAAP” or the “reported basis”). In addition to analyzing Oriental’s results on a reported basis, management monitors “Adjusted net income” of Oriental and excludes the impact of certain transactions
on the results of its operations. During the third quarter of 2017, in the span of two weeks in September, hurricanes Irma and Maria caused catastrophic damages throughout Puerto Rico. Oriental has excluded the impact of these events for its "Adjusted net income". Adjusted net income is a non-GAAP financial measure. Management believes that Adjusted net income and other non-GAAP financial measures provides meaningful information about the underlying performance of Oriental’s ongoing operations.
Refer to the following table for a reconciliation of the reported results to the Adjusted net income and other non-GAAP financial measures for the quarter and nine-month period ended September 30, 2017. Non-GAAP financial measures used by Oriental may not be comparable to similarly named Non-GAAP financial measures used by other companies.
Reconciliation to Non-GAAP Financial Measures adjusted to exclude the effect of hurricanes Irma and Maria:
U.S GAAP Net income
Non-GAAP adjustments:
Additional loan loss provision from Hurricanes Irma and María
27,000
(8,038)
Adjusted net income (Non-GAAAP)
22,281
54,535
Adjusted income available to common shareholders (Non-GAAAP)
18,816
44,139
Plus: Effect of assumed conversion of the convertible preferred stock
20,654
45,977
Adjusted earnings per common share - diluted (Non-GAAP)
0.40
0.90
Average assets, excluding hurricane loan provision
6,048,021
6,231,725
Return on average assets, excluding hurricane loan provision (Non-GAAP)
1.47%
1.17%
Average tangible common stockholders' equity, excluding hurricane loan provision
690,203
679,867
Return on average tangible common stockholders' equity, excluding hurricane loan provision (Non-GAAP)
10.90%
8.66%
· Excluding the aforementioned impact of the hurricanes (Non-GAAP):
☐ Adjusted net income available to shareholders totaled $18.8 million or $0.40 per share fully diluted. That’s an increase of $0.10 per share or 33.0% from the second quarter of 2017 and of $0.14 or 53.8% from the year ago quarter.
☐ Return on average assets was 1.47% and return on average tangible common equity was 10.90% – 38 and 289 basis points higher, respectively, than the second quarter of 2017.
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 nine-month periods ended September 30, 2017 and 2016:
TABLE 1 - ANALYSIS OF NET INTEREST INCOME AND CHANGES DUE TO VOLUME/RATE
FOR THE QUARTERS ENDED SEPTEMBER 30, 2017 AND 2016
Interest
Average rate
Average balance
September
A - TAX EQUIVALENT SPREAD
Interest-earning assets
90,585
6.33%
5.83%
5,658,953
6,169,251
Tax equivalent adjustment
1,084
1,163
0.08%
0.07%
Interest-earning assets - tax equivalent
91,439
91,748
6.41%
5.90%
Interest-bearing liabilities
13,658
0.77%
0.96%
5,071,668
5,639,609
Tax equivalent net interest income / spread
81,562
78,090
587,285
529,642
Tax equivalent interest rate margin
5.72%
5.02%
B - NORMAL SPREAD
Interest-earning assets:
6,584
7,319
2.23%
2.25%
1,170,714
1,293,251
Interest bearing cash and money market investments
1,304
661
1.21%
0.55%
426,197
477,968
7,888
7,980
1.96%
1.79%
1,596,911
1,771,219
Non-acquired loans
9,303
10,159
5.33%
5.40%
692,782
746,613
21,337
15,976
6.83%
4.44%
1,239,390
1,426,216
8,423
7,044
11.10%
10.77%
301,121
259,535
19,876
17,390
9.51%
9.48%
829,446
727,727
Total non-acquired loans
58,939
50,569
7.63%
6.35%
3,062,739
3,160,091
Acquired BBVAPR
7,434
8,197
5.54%
5.60%
532,664
580,786
7,084
6,732
12.60%
9.40%
222,978
284,225
2,602
2,993
17.32%
18.02%
59,596
65,902
2,069
4,801
10.48%
11.24%
78,358
169,423
Total acquired BBVAPR loans
19,189
22,723
8.52%
8.19%
893,596
1,100,336
Acquired Eurobank
4,339
9,313
16.29%
26.85%
105,707
137,605
82,605
8.05%
7.45%
4,062,042
4,398,032
Total interest earning assets
Interest-bearing liabilities:
NOW Accounts
1,314
0.34%
0.42%
1,024,480
1,243,640
Savings and money market
1,426
1,351
0.50%
0.48%
1,142,338
1,113,649
482
0.66%
0.71%
236,385
268,467
Retail certificates of deposits
2,482
1,632
1.67%
1.30%
590,057
497,917
5,179
4,779
0.70%
0.62%
2,993,260
3,123,673
Institutional deposits
621
0.05%
1.00%
226,468
247,521
2,163
1,751
1.55%
554,650
549,371
Total wholesale deposits
2,192
1.14%
1.20%
781,118
796,892
7,371
7,151
0.72%
3,774,378
3,920,565
Non-interest bearing deposits
0.00%
835,255
801,833
Deposits fair value premium amortization
(78)
Core deposit intangible amortization
230
258
0.65%
4,609,633
4,722,398
2.73%
325,201
620,353
2.35%
2.51%
100,751
195,278
4.38%
3.19%
101,581
2,276
6,327
1.95%
2.74%
462,035
917,212
Total interest bearing liabilities
5,639,610
Net interest income / spread
Excess of average interest-earning assets
over average interest-bearing liabilities
587,284
529,641
Average interest-earning assets to average
interest-bearing liabilities ratio
111.58%
109.39%
C - CHANGES IN NET INTEREST INCOME DUE TO:
Volume
Interest Income:
(785)
693
(7,986)
7,848
(138)
(8,771)
8,541
(230)
Interest Expense:
(175)
445
270
Repurchase agreements
(2,033)
(958)
(2,991)
(1,060)
(3,316)
(465)
(3,781)
Net Interest Income
(5,455)
9,006
3,551
102
TABLE 1A - ANALYSIS OF NET INTEREST INCOME AND CHANGES DUE TO VOLUME/RATE
262,472
269,799
5.97%
5.71%
5,875,783
6,290,862
3,661
3,499
266,133
273,298
6.05%
5.78%
31,813
44,585
0.81%
1.03%
5,253,584
5,786,977
234,320
228,713
5.24%
4.75%
622,199
503,885
4.84%
21,996
24,420
2.29%
2.41%
1,287,594
1,351,078
7.40%
11.51%
325
3,104
1,919
0.99%
0.51%
417,892
497,795
25,118
26,367
1.97%
1,705,811
1,849,197
28,298
29,615
5.27%
701,039
748,755
54,023
47,214
5.79%
4.40%
1,247,249
1,428,499
24,146
19,778
11.09%
10.68%
291,140
246,641
57,940
50,985
9.64%
9.62%
803,821
705,956
164,407
147,592
7.22%
3,043,249
3,129,851
22,921
24,798
5.05%
5.59%
606,636
591,401
16,617
20,985
9.14%
8.94%
243,183
312,571
8,381
9,283
18.47%
18.17%
60,669
68,076
8,043
16,976
11.04%
11.37%
97,383
198,845
55,962
72,042
7.42%
8.20%
1,007,871
1,170,893
16,986
23,798
22.50%
118,854
140,921
243,432
7.61%
7.30%
4,169,973
4,441,665
5,875,784
2,972
3,914
0.37%
0.43%
1,065,419
1,208,943
4,392
4,057
0.49%
1,152,597
1,111,012
1,196
243,944
268,315
5,902
4,446
1.39%
1.28%
567,853
461,685
14,462
13,865
0.64%
3,029,813
3,049,955
1,895
0.79%
224,826
253,618
6,132
5,555
568,207
631,643
7,454
7,450
1.70%
793,033
885,261
21,916
21,315
3,822,846
3,935,216
-0.06%
834,325
784,099
690
4,657,171
4,719,315
1.83%
2.86%
456,523
682,326
2.32%
2.62%
103,807
282,957
2,560
3.33%
102,379
9,208
22,763
2.06%
2.84%
596,413
1,067,662
Excess of average interest-earning assets over
average interest-bearing liabilities
111.84%
108.71%
(2,044)
(1,249)
(16,473)
10,395
(6,078)
(18,517)
11,190
(7,327)
(287)
1,070
783
(4,841)
(3,528)
(8,369)
(5,181)
(5,186)
(10,309)
(2,463)
(12,772)
(8,208)
13,653
5,445
Net interest income is a function of the difference between rates earned on Oriental’s interest-earning assets and rates paid on its interest-bearing liabilities (interest rate spread) and the relative amounts of its interest earning assets and interest-bearing liabilities (interest rate margin). Oriental constantly monitors the composition and re-pricing of its assets and liabilities to maintain its net interest income at adequate levels.
Comparison of quarters ended September 30, 2017 and 2016
Net interest income of $80.5 million increased $3.6 million from $76.9 million. Both interest rate spread and net interest margin increased 69 basis points to 5.56% and 5.64%, respectively, from 4.87% and 4.95%, respectively. These increases are mainly due to the net effect of a 50 basis point increase in the average yield of interest-earning assets from 5.83% to 6.33% and to a 19 basis point decrease in average costs of interest-bearing liabilities from 0.96% to 0.77%.
Net interest income was positively impacted by:
· Higher interest income from originated loans of $8.4 million reflecting the recognition of $4.8 million from the pay-off before maturity of a commercial loan previously classified as non-accrual, and from higher yields in the commercial and retail loan portfolios;
· The recognition of $3.1 million in cost recoveries from the pay-off of the Puerto Rico Housing Finance Authority (PRHFA) included as interest income from acquired BBVAPR loans;
· A decrease in interest expenses from securities sold under agreements to repurchase due to decreases in volume an interest rate of $2.0 million and $1.0 million, respectively, mainly as a result of the repayment at maturity of (i) a $232.0 million repurchase agreement at 4.78% in March 2017 and of (ii) $160.4 million short-term repurchase agreements which were not renewed during the third quarter of 2017; and
· A decrease in interest expenses from a decrease in other borrowings volume of $1.1 million as a result of the repayment at maturity of $72.9 million of short term FHLB advances during the third quarter of 2017.
Net interest income was adversely impacted by:
· A decrease of $8.5 million in the interest income from the acquired BBVAPR and Eurobank loan portfolios as such loans continue to be repaid;
· A slight increase in interest expenses from deposits of 3.7% to $7.6 million, reflecting lower volume balances by $175 thousand, offset by $445 thousand more in interest rates; and
· A slight decrease in interest income from investments of 1.2% to $7.9 million, reflecting lower volume balances offset by higher yields on cash balances.
Comparison of nine-month periods ended September 30, 2017 and 2016
Net interest income of $230.7 million increased $5.5 million from $225.2 million. Both interest rate spread and net interest margin increased 48 basis points, both, to 5.16% and 5.25%, respectively, from 4.68% and 4.77%, respectively. These increases are mainly due to the net effect of a 26 basis point increase in the average yield of interest-earning assets from 5.71% to 5.97% and to a 22 basis point decrease in average costs of interest-bearing liabilities from 1.03% to 0.81%.
· Higher interest income from originated loans of $16.8 million; and
105
· Lower interest expenses on repurchases agreements and other borrowings of $13.6 million as a result of the repayment of high cost repurchase agreements.
· A decrease of $22.9 million in interest income from acquired loans as such loans continue to be repaid;
· A decrease in interest income from investments by $1.2 million due to lower volume; and
· A slight increase in interest expenses from deposits by $784 thousand.
TABLE 2 - NON-INTEREST INCOME SUMMARY
30,662
1.1%
-7.8%
-4.9%
-10.3%
-14.5%
Total banking and financial service revenue
-5.8%
53,681
-2.1%
100.0%
113.1%
Sale of securities available for sale
-43.5%
2475.0%
99.3%
-86.7%
-82.9%
699
1,938
-63.9%
9,298
(4,813)
293.2%
48,868
Non-Interest Income
Non-interest income is affected by the level of trust assets under management, transactions generated by clients’ financial assets serviced by the securities broker-dealer and insurance agency subsidiaries, the level of mortgage banking activities, and the fees generated from loans and deposit accounts.
Oriental recorded non-interest income, net, in the amount of $17.9 million, compared to $20.2 million, a decrease of 11.4%, or $2.3 million. The decrease in non-interest income was mainly due to:
· A decrease in banking service and financial service revenue of 5.8% to $17.2 million from $18.3 million. Oriental had lower banking, mortgage banking and wealth management activity levels in September, because of the hurricanes Irma and María; and
· A decrease in other non-interest income of $4.5 million reflects the receipt of $5.0 million during the quarter ended September 30, 2016 from a loss in 2009 related to a private label collateralized mortgage obligation, partially offset by $571 thousand received as final settlement during the quarter ended September 30, 2017.
The decrease in non-interest income was partially offset by the elimination of the FDIC shared-loss expense as Oriental entered into an agreement with the FDIC to terminate the shared-loss agreements covering certain assets during the first quarter of 2017. During the third quarter of 2016, Oriental recorded expenses of $3.3 million related to such agreement.
Oriental recorded non-interest income, net, in the amount of $61.9 million, compared to $48.9 million, an increase of 26.6%, or $13.0 million. The increase in non-interest income was mainly due to:
· The termination of the FDIC shared-loss agreement during the first quarter of 2017 resulting in the recognition of a $1.4 million gain during such period, compared to $10.7 million expenses related to the aforementioned agreement in the year ago period; and
· The sale of $166.0 million of its mortgage-backed securities, generating a gain of $6.9 million. As a result of this sale, Oriental unwound $100 million of repurchase agreements at a cost of $80 thousand, included as a loss on early extinguishment of debt in the consolidated statements of operations. The transaction resulted in a net benefit of $6.8 million. In the same period in 2016, Oriental sold $277.2 million in mortgage-backed securities and $11.1 million in Puerto Rico government bonds, resulting in a gain of $12.2 million. This transaction resulted in the repayment before maturity of $268.0 million of a repurchase agreement at a cost of $12.0 million, included as a loss on the early extinguishment of debt in the consolidated statements of operations. The transaction resulted in a net benefit of $207 thousand.
Increase in non-interest income was partially offset by a decrease in other non-interest income due to the aforementioned $5.0 million recognized in 2016 from a recovery of a previous loss related to a private label collateralized mortgage obligation.
TABLE 3 - NON-INTEREST EXPENSES SUMMARY
Variance %
2.9%
7.8%
10.2%
12.6%
4.4%
-15.3%
-49.2%
-1.1%
-1.5%
9.9%
19.3%
4.3%
1.7%
-53.0%
-50.3%
-60.1%
-48.2%
-6.0%
-5.1%
14.3%
Printing, postage, stationery and supplies
-2.0%
-5.2%
-4.6%
3,718
-53.9%
-19.8%
Other operating expenses
2,488
-38.7%
8.0%
Total non-interest expenses
Relevant ratios and data:
Compensation and benefits to
non-interest expense
39.39%
34.94%
38.42%
35.45%
Compensation to average total assets owned (annualized)
1.32%
1.15%
1.91%
Average number of employees
1,435
1,451
Average compensation per employee
13.58
13.40
40.7
40.0
Average loans per average employee
3,065
2,848
3,061
Non-Interest Expenses
Non-interest expense was $50.5 million, representing a decrease of 8.1% compared to $54.9 million.
The decrease in non-interest expenses was driven by:
· Lower credit related expenses by $2.0 million mainly from lower foreclosures when compared to the same quarter of 2016;
· Lower loan servicing and clearing expenses by $1.7 million, mainly due to a reduction of $1.1 million in mortgage servicing expense from the migration to in-house servicing during 2016; and
· Lower losses on the sale of foreclosed real estate and other repossessed assets by $1.6 million due to lower write-downs on the valuation of mortgage properties, mainly in the acquired loan portfolios.
The decreases in the foregoing non-interest expenses were partially offset by:
· Higher occupancy and equipment expenses by $923 thousand, primarily due to an increase in rent expenses driven by less rent income and to an increase in internet services; and
· Higher compensation and employee benefits by $714 thousand, mainly due to an increase in average employees.
The efficiency ratio improved to 51.66% from 57.69%. The efficiency ratio measures how much of Oriental’s revenues is used to pay operating expenses. Oriental 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 investment securities, derivatives gains or losses, FDIC shared-loss benefit/expense, losses on the early extinguishment of debt, other gains and losses, and other income that may be considered volatile in nature. Management believes that the exclusion of those items permits consistent comparability. Amounts presented as part of non-interest income that are excluded from efficiency ratio computation for the quarters ended September 30, 2017 and 2016 amounted to $699 thousand income and a $1.9 million loss, respectively.
Non-interest expense for the nine-month period ended September 30, 2017 was $155.0 million, representing a decrease of 5.3% compared to $163.6 million.
· Lower losses on sale of foreclosed real estate and other repossessed assets by $4.6 million due to lower write-downs on valuations of mortgage properties;
· Lower insurance expense by $3.7 million as a result of a change in the calculation method of the FDIC Savings Association Insurance Fund (SAIF) insurance. The change was effective beginning with the June 30, 2016 invoice, which was received during the third quarter of 2016; and
· Lower loan servicing and clearing expenses by $3.3 million mainly due to a reduction in mortgage servicing expense from the migration to in-house servicing during 2016.
As in the quarterly variances, the decreases in the foregoing non-interest expenses were partially offset by increases in occupancy and equipment expenses, mainly in rent expense, and in compensation and employee benefits of $1.0 million and $1.7 million, respectively.
109
The efficiency ratio was 54.71% compared to 58.66% for the same period in 2016. Amounts presented as part of non-interest income that are excluded from the efficiency ratio computation for the nine-month period ended September 30, 2017 amounted to income of $9.3 million, compared to a loss of $4.8 million for the nine-month period ended September 30, 2016.
Provision for Loan and Lease Losses
Comparison of quarters ended September, 2017 and 2016
Provision for loan and lease losses increased 87.7%, or $20.6 million, to $44.0 million. Based on an analysis of the credit quality and the composition of Oriental’s loan portfolio, management determined that the provision for the quarter was adequate to maintain the allowance for loan and lease losses at an appropriate level to provide for probable losses based upon an evaluation of known and inherent risks.
During the third quarter of 2017, Oriental was impacted by hurricanes Irma and Maria, which struck the island on September 7, 2017 and September 20, 2017, respectively. Based on our assessment of the facts related to these hurricanes, we have increased our provision for loan losses $27.0 million. The provision corresponding to our originated loan portfolio was $16.8 million, $3.8 million in mortgage loans, $7.6 million in commercial loans, $0.8 million in consumer loans, and $4.6 million in auto loans. The provision corresponding to our acquired loan portfolio was $10.2 million, $2.7 million in mortgage loans, $7.0 million in commercial loans, $0.1 million in consumer loans, and $0.4 million in auto loans.
Please refer to the "Allowance for Loan and Lease Losses" in the "Credit Risk Management" section of this MD&A for a more detailed analysis of the allowance for loan and lease losses.
Excluding the special provision made because of the hurricanes during the third quarter of 2017, the total provision decreased $6.4 million. The decrease in the provision was mostly due to:
· A decrease in the provision for acquired BBVAPR loan and lease losses of $5.4 million, mainly due to an additional provision recognized during the year ago quarter of $4.4 million for the Puerto Rico Housing Financing Authority loan; and
· A decrease in the provision for originated and other loan and lease losses of $1.8 million, mainly due to an additional provision recognized during the year ago quarter of $2.9 million for the classification to held for sale of the Puerto Rico Electric Power Authority (“PREPA”) line of credit, partially offset by the growth of originated loan portfolio.
Total net charge-offs on originated and other loans decreased 81.9%, or $53.5 million, as a result of the PREPA line of credit sold in the third quarter of 2016, in which a $56.2 million charge-off was recognized. The net charge-off rate decreased 673 basis points to 1.54%.
Provision for loan and lease losses increased 70.7% or $36.5 million, to $88.2 million. Excluding the special provision of $27.0 million because of the hurricanes during the third quarter of 2017, the total provision increased $9.5 million. The increase in the provision was mostly due to an increase in the provision for originated and other loan and lease losses by $13.0 million, mainly from the increase in the provision for commercial loans. Such provision includes $4.3 million recorded to charge-off the loss on sale of a municipal loan and another provision of $5.9 million recorded for the general allowance on the municipal loan portfolio during the second quarter of 2017.
The increase in provision was partially offset by a decrease in the provision for acquired BBVAPR loan and lease losses of $4.4 million mainly due to an additional provision recognized during the year ago period of $4.4 million for the Puerto Rico Housing Financing Authority loan.
Income Taxes
Income tax expense was $560 thousand, compared to $3.6 million, reflecting the effective income tax rate of 29.77% and the net income before income taxes of $3.9 million for the third quarter of 2017.
Income tax expense was $13.8 million, compared to $15.1 million for the same period in 2016. Income tax expense reflects the effective income tax rate of 29.77% and the net income before income taxes of $49.3 million for the nine-month period ended September 30, 2017.
Business Segments
Oriental segregates its businesses into the following major reportable segments: Banking, Wealth Management, 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 Oriental’s organization, nature of its products, distribution channels and economic characteristics of the products were also considered in the determination of the reportable segments. Oriental 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. Oriental’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. Following are the results of operations and the selected financial information by operating segment for the quarters and nine-month periods ended September 30, 2017 and 2016.
111
Net (loss) income
(945,029)
6,592,114
Provision for
loan and lease losses
Non-interest income (loss)
5,715,957
7,537,142
113
Oriental's banking segment net income decreased $7.8 million to a net loss of $751 thousand, reflecting:
· An increase in the provision for loan and lease losses of $20.6 million mainly due to the $27.0 million special provision ($19.0 million, net of tax) related to hurricanes Irma and Maria in the third quarter of 2017;
· A decrease in non-interest expenses of $6.3 million mainly as a result of lower credit related expenses by $2.0 million mainly from lower foreclosures, lower loan servicing and clearing expenses by $1.7 million, mainly due to a reduction of $1.1 million in mortgage servicing expense from the migration to in-house servicing during 2016, and lower losses on sale of foreclosed real estate and other repossessed assets by $1.6 million due to lower write-downs on valuation of mortgage properties, mainly in the acquired loan portfolios; and
· An increase in non-interest income of $1.5 million to $10.4 million, mainly because of the elimination of FDIC shared-loss expense during the first quarter of 2017.
Wealth Management
Wealth management segment revenue, which consists of commissions and fees from fiduciary activities, and securities brokerage and insurance activities, decreased to $628 thousand from a net income of $1.4 million in the same quarter of 2016 due to lower activity levels in September 2017 related to hurricanes Irma and Maria.
Treasury segment net income, which consists of Oriental's asset/liability management activities, such as purchase and sale of investment securities, interest rate risk management, derivatives, and borrowings, decreased to $3.3 million, compared to $6.7 million, reflecting:
· Lower non-interest income by $4.1 million reflects the receipt of $5.0 million during the quarter ended September 30, 2016 from a loss in 2009 related to a private label collateralized mortgage obligation, partially offset by $571 thousand received as final settlement during the quarter ended September 30, 2017;
· A decrease in lower interest expenses from securities sold under agreements to repurchase of $3.0 million from the repayment at maturity of (i) a $232.0 million repurchase agreement at 4.78% in March 2017 and (ii) a $160.4 million short-term repurchase agreements which were not renewed during the third quarter of 2017; and
· Higher non-interest expenses by $528 thousand from $1.1 million to $1.6 million, mainly from general operating expenses.
Oriental's banking segment net income decreased $12.8 million to $29.8 million, reflecting:
· A decrease in net interest income by $5.8 million, mainly from the acquired BBVAPR and Eurobank loan portfolios as such loans continue to be repaid.
· The special provision for loan and lease losses of $27.0 million ($19.0 million, net of tax) placed during the period related to hurricanes Irma and Maria;
· An increase in the regular provision for originated and other loan and lease losses of $13.0 million, which includes $4.3 million recorded to charge-off the loss on sale of a municipal loan and another provision of $5.9 million recorded for the
114
general allowance on the municipal loan portfolio during the second quarter of 2017, partially offset by a decrease in the provision for acquired BBVAPR loan and lease losses of $4.4 million, mainly due to an additional provision recognized during the year ago period of $4.4 million for the Puerto Rico Housing Financing Authority loan;
· Higher non-interest income by $10.5 million, reflecting the termination of the FDIC shared-loss agreement in the first quarter of 2017.
· Lower interest expenses by $10.6 million due to lower losses on the sale of foreclosed real estate and other repossessed assets by $4.6 million due to lower write-downs on valuations of mortgage properties, lower insurance expense by $3.7 million as a result of a change in the calculation method of the FDIC Savings Association Insurance Fund (SAIF) insurance, and lower loan servicing and clearing expenses by $3.3 million mainly due to a reduction in mortgage servicing expense from the migration to in-house servicing during 2016.
Wealth management segment revenue decreased $1.3 million to $2.9 million, mainly from changes in volume and market rates and lower activity levels in September 2017 related to hurricanes Irma and Maria.
Treasury segment income before taxes increased to $16.8 million, compared to $3.1 million, reflecting lower interest expenses by $11.9 million related to:
· The partial unwinding of a $268.0 million repurchase agreement at 4.78% in February 2016 and the repayment at maturity of the remaining $232.0 million balance in March 2017;
· The decrease in other borrowings balances that resulted from the repayment at maturity of $227.0 million of short term FHLB advances during the second quarter of 2016; and
· The repayment at maturity of $72.9 million in short-term repurchase agreements which were not renewed during the third quarter of 2017.
115
ANALYSIS OF FINANCIAL CONDITION
Assets Owned
At September 30, 2017, Oriental’s total assets amounted to $6.288 billion representing a decrease of 3.3% when compared to $6.502 billion at December 31, 2016. This reduction is mainly due to a decrease in the investment portfolio of $204.6 million and a decrease in the loan portfolio of $183.1 million, partially offset by an increase in cash and due from banks of $209.4 million.
Oriental's investment portfolio decreased 15.0% from $1.363 billion at December 31, 2016 to $1.158 billion at September 30, 2017, mainly attributed to the sale of $166.0 million mortgage-backed securities available-for-sale during the second quarter of 2017, and to paydowns in the investment securities held-to-maturity portfolio of $65.9 million.
Oriental’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, and auto loans. At September 30, 2017, Oriental’s loan portfolio decreased 4.4%. Our loan portfolio is transitioning as originated loans grow at a slower pace than acquired loans decrease, due to repayments and maturities. The BBVAPR acquired loan portfolio decreased $162.6 million from December 31, 2016 to $845.3 million. The Eurobank acquired loan portfolio decreased $34.5 million from December 31, 2016 to $100.1 million at September 30, 2017.
Cash and due from banks increased 41.2% to $717.2 million, due to increased deposits and lower transaction outflows toward the end of the quarter from commercial customers.
Financial Assets Managed
Oriental’s financial assets include those managed by Oriental’s trust division, retirement plan administration subsidiary, and assets gathered by its broker-dealer and insurance subsidiaries. Oriental’s trust division offers various types of individual retirement accounts ("IRA"s) and manages 401(k) and Keogh retirement plans and custodian and corporate trust accounts, while the retirement plan administration subsidiary, OPC, manages private retirement plans. At September 30, 2017, total assets managed by Oriental’s trust division and OPC amounted to $2.957 billion, compared to $2.850 billion at December 31, 2016. Oriental Financial Services offers a wide array of investment alternatives to its client base, such as tax-advantaged fixed income securities, mutual funds, stocks, bonds and money management wrap-fee programs. At September 30, 2017, total assets gathered by Oriental Financial Services and Oriental Insurance from its customer investment accounts amounted to $2.272 billion, compared to $2.351 billion at December 31, 2016. Changes in trust and broker-dealer related assets primarily reflect changes in portfolio balances and differences in market values.
Goodwill recorded in connection with the BBVAPR Acquisition and the FDIC-assisted Eurobank acquisition is not amortized to expense, but is tested at least annually for impairment. A quantitative annual impairment test is not required if, based on a qualitative analysis, Oriental determines that the existence of events and circumstances indicate that it is more likely than not that goodwill is not impaired. Oriental completes its annual goodwill impairment test as of October 31 of each year. Oriental tests for impairment by first allocating its goodwill and other assets and liabilities, as necessary, to defined reporting units. A fair value is then determined for each reporting unit. If the fair values of the reporting units exceed their book values, no write-down of the recorded goodwill is necessary. If the fair values are less than the book values, an additional valuation procedure is necessary to assess the proper carrying value of the goodwill.
Reporting unit valuation is inherently subjective, with a number of factors based on assumptions and management judgments or estimates. Actual values may differ significantly from such estimates. Among these are future growth rates for the reporting units, selection of comparable market transactions, discount rates and earnings capitalization rates. Changes in assumptions and results due to economic conditions, industry factors, and reporting unit performance and cash flow projections could result in different assessments of the fair values of reporting units and could result in impairment charges. If an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount, an interim impairment test is required.
Relevant events and circumstances for evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount may include macroeconomic conditions (such as a further deterioration of the Puerto Rico economy or the liquidity for Puerto Rico securities or loans secured by assets in Puerto Rico), adverse changes in legal factors or in the business climate, adverse actions by a regulator, unanticipated competition, the loss of key employees, or similar events. Oriental’s loan portfolio, which is the largest component of its interest-earning assets, is concentrated in Puerto Rico and is directly affected by adverse local economic and fiscal conditions. Such conditions have generally affected the market demand for non-conforming loans secured by assets in Puerto Rico and, therefore, affect the valuation of Oriental’s assets.
As of September 30, 2017, Oriental had $86.1 million of goodwill allocated as follows: $84.1 million to the Banking unit and $2.0 million to the Wealth Management unit. During the last quarter of 2016, based on its annual goodwill impairment test, Oriental determined that the Banking unit failed step one of the two-step impairment test and that the Wealth Management unit passed such step. As a result of step one; the Banking unit’s adjusted net book value exceeded its fair value by approximately $145.0 million, or 15%. Accordingly, Oriental proceeded to perform step two of the analysis. Based on the results of step two, Oriental determined that the carrying value of the goodwill allocated to the Banking unit was not impaired as of the valuation date. During the nine-month period ended September 30, 2017, Oriental performed an assessment of events or circumstances that could trigger reductions in the book value of the goodwill. Based on this assessment, no events were identified that triggered changes in the book value of goodwill at September 30, 2017.
TABLE 4 - ASSETS SUMMARY AND COMPOSITION
875,760
1,025,370
-14.6%
-20.4%
-79.2%
-15.7%
Puerto Rico government and public instrumentalities
-45.8%
29.9%
-12.3%
287
-18.0%
Cash and due from banks (including restricted cash)
717,226
507,863
41.2%
16.5%
-0.5%
12.4%
1.5%
-3.4%
-0.4%
-39.2%
Other assets and customers' liability on acceptances
81,243
104,130
-22.0%
Total other assets
1,165,741
991,621
17.6%
Investment portfolio composition:
75.6%
75.2%
0.9%
3.6%
7.4%
7.5%
12.1%
0.2%
1.2%
0.8%
Other debt securities and other investments
TABLE 5 — LOANS RECEIVABLE COMPOSITION
-3.7%
-2.5%
8.9%
1.4%
-47.6%
0.5%
-17.1%
-49.9%
-33.7%
21.8%
-34.3%
-6.4%
-16.5%
-62.8%
-42.5%
-13.0%
-29.2%
-14.4%
-5.5%
-34.9%
-11.1%
-20.9%
-8.8%
-25.6%
-17.2%
Mortgage loans held for sale
-3.1%
As shown in Table 5 above, total loans, net, amounted to $3.965 billion at September 30, 2017 and $4.148 billion at December 31, 2016. Oriental’s originated and other loans held-for-investment portfolio composition and trends were as follows:
· Mortgage loan portfolio amounted to $694.5 million (22.5% of the gross originated loan portfolio) compared to $721.5 million (23.7% of the gross originated loan portfolio) at December 31, 2016. Mortgage loan production totaled $32.6 million and $121.9 million for the quarter and nine-month period ended September 30, 2017, which represents a decrease of 36.2% and 22.3%, from $51.0 million and $157.0 million, respectively, for the same periods in 2016. Mortgage loans included delinquent loans in the GNMA buy-back option program amounting to $13.0 million and $9.7 million at September 30, 2017 and December 31, 2016, respectively. 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.
· Commercial loan portfolio amounted to $1.246 billion (40.3% of the gross originated loan portfolio) compared to $1.278 billion (42.0% of the gross originated loan portfolio) at December 31, 2016. Commercial loan production decreased 26.3% to $46.2 million for the quarter ended September 30, 2017, from $62.6 million for the same period in 2016. Also, for the nine-month period ended September 30, 2017, the production decreased 16.9% to $173.0 million from $208.2 million for the same period in 2016.
· Consumer loan portfolio amounted to $316.4 million (10.3% of the gross originated loan portfolio) compared to $290.5 million (9.5% of the gross originated loan portfolio) at December 31, 2016. Consumer loan production decreased 22.7% to $33.7 million for the quarter ended September 30, 2017 from $43.6 million for the same periods in 2016. However, for the nine-month period ended September 30, 2017, the production increased 6.9% to $125.5 million from $117.5 million for the same period in 2016.
· Auto and leasing portfolio amounted to $831.4 million (26.9% of the gross originated loan portfolio) compared to $756.4 million (24.8% of the gross originated loan portfolio) at December 31, 2016. Auto and leasing production increased by 12.6% and 17.6% to $78.3 million and $243.7 million for the quarter and nine-month period ended September 30, 2017, respectively, compared to $69.5 million and $207.2 million for the same periods in 2016.
TABLE 6 — 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
9,977
321
3.22%
9,970
801
8.03%
72,168
1,819
2.52%
90 - 119 days
11.76%
2,051
1.41%
120 - 179 days
15.69%
473
180 - 364 days
8.97%
209
24.88%
1,749
8.92%
365+ days
438
16.44%
2,311
24.92%
8,347
790
9.46%
10,561
3.88%
12,490
1,429
11.44%
84,788
2,803
3.31%
Percentage of total loans excluding
acquired loans accounted for under ASC 310-30
0.40%
2.69%
Refinanced or Modified Loans:
2,077
223
10.74%
540
9.63%
16,390
1,215
7.41%
Percentage of Higher-Risk Loan
Category
19.67%
4.32%
19.33%
Loan-to-Value Ratio:
Under 70%
3.73%
770
7.92%
70% - 79%
1,542
3,290
9.21%
80% - 89%
4.65%
2,538
11.66%
90% and over
2.26%
5,892
769
13.05%
* Loans may be included in more than one higher-risk loan category and excludes acquired residential mortgage loans.
The following table includes Oriental's lending and investment exposure to the Puerto Rico government, including its agencies, instrumentalities, municipalities and public corporations:
TABLE 7 - PUERTO RICO GOVERNMENT RELATED LOANS AND SECURITIES
Loans and Securities:
Carrying Value
Less than 1 Year
1 to 3 Years
More than 3 Years
Comments
Municipalities
144,529
5,265
95,622
43,642
Secured by ad valorem taxation, without limitation as to rate or amount, on all taxable property within the issuing municipalities. The good faith, credit and unlimited taxing power of each issuing
municipality are pledged for the payment of its general obligations.
The remaining position is a PRHTA security maturing July 1, 2018 issued for P3 Project Teodoro Moscoso Bridge operated by private companies that have the payment obligation.
146,735
7,471
Some highlights follow regarding the data included above:
· Deposits from the Puerto Rico government totaled $135.8 million at September 30, 2017.
Credit Risk Management
Allowance for Loan and Lease Losses
Oriental 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. Oriental’s allowance for loan and lease losses policy provides for a detailed quarterly analysis of probable losses. At September 30, 2017, Oriental’s allowance for loan and lease losses amounted to $154.2 million, a $38.2 million increase from $115.9 million at December 31, 2016.
During the third quarter of 2017, in the span of two weeks in September, hurricanes Irma and Maria caused catastrophic damages throughout Puerto Rico. Although the effect of the hurricanes on Oriental's loan portfolio is difficult to predict at this time, management performed an evaluation of the loan portfolios in order to assess the impact on repayment sources and underlying collateral that could result in additional losses.
Tables 8 through 10 set forth an analysis of activity in the allowance for loan and lease losses and present selected loan loss statistics. In addition, Table 5 sets forth the composition of the loan portfolio.
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.
124
Non-performing Assets
Oriental’s non-performing assets include non-performing loans and foreclosed real estate (see Tables 11 and 12). At September 30, 2017 and December 31, 2016, Oriental had $93.0 million and $104.1 million, respectively, of non-accrual loans, including acquired BBVAPR loans accounted for under ASC 310-20 (loans with revolving feature and/or acquired at a premium).
At September 30, 2017 and December 31, 2016, loans whose terms have been extended and which are classified as troubled-debt restructuring that are not included in non-performing assets amounted to $109.8 million and $98.1 million, respectively.
Delinquent residential mortgage loans insured or guaranteed under applicable FHA and VA programs are classified as non-performing loans when they become 90 days or more past due, but are not placed in non-accrual status until they become 18 months or more past due, since they are insured loans. Therefore, these loans are included as non-performing loans but excluded from non-accrual loans.
Acquired loans with credit deterioration are considered to be performing due to the application of the accretion method under ASC 310-30, in which these loans will accrete interest income over the remaining life of the loans using estimated cash flow analyses. Credit related decreases in expected cash flows, compared to those previously forecasted are recognized by recording a provision for credit losses on these loans when it is probable that all cash flows expected at acquisition will not be collected.
At September 30, 2017, Oriental’s non-performing assets decreased by 5.1% to $148.9 million (2.76% of total assets, excluding acquired loans with deteriorated credit quality) from $156.9 million (2.88% of total assets, excluding acquired loans with deteriorated credit quality) at December 31, 2016. Oriental does not expect non-performing loans to result in significantly higher losses. At September 30, 2017, the allowance for originated loan and lease losses to non-performing loans coverage ratio was 91.55% (56.30% at December 31, 2016).
Oriental 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, Oriental has never been active in negative amortization loans or adjustable rate mortgage loans, including those with teaser rates.
The following items comprise non-performing assets:
· Originated and other loans held for investment:
Residential 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 September 30, 2017, Oriental’s originated non-performing mortgage loans totaled $59.7 million (61.0% of Oriental’s non-performing loans), a 19.9% decrease from $74.5 million (68.9% of Oriental’s non-performing loans) at December 31, 2016.
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 September 30, 2017, Oriental’s originated non-performing commercial loans amounted to $21.7 million (22.2% of Oriental’s non-performing loans), an 9.7% increase from $19.8 million at December 31, 2016 (18.3% of Oriental’s non-performing loans).
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 September 30, 2017, Oriental’s originated non-performing consumer loans amounted to $2.4 million (2.5% of Oriental’s non-performing loans), a 23.1% increase from $2.0 million at December 31, 2016 (1.8% of Oriental’s non-performing loans).
Auto loans and leases — are placed on non-accrual status when they become 90 days past due, partially written-off to collateral value when payments are delinquent 120 days, and fully written-off when payments are delinquent 180 days. At September 30, 2017, Oriental’s originated non-performing auto loans and leases amounted to $11.8 million (12.1% of Oriental’s total non-performing loans), an increase of 30.5% from $9.1 million at December 31, 2016 (8.4% of Oriental’s total non-performing loans).
· Acquired BBVAPR loans accounted for under ASC 310-20 (loans with revolving features and/or acquired at premium):
125
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 September 30, 2017, Oriental’s acquired non-performing commercial lines of credit accounted for under ASC 310-20 amounted to $1.1 million (1.2% of Oriental’s non-performing loans), a 19.4% decrease from $1.4 million at December 31, 2016 (1.3% of Oriental’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 September 30, 2017, Oriental’s acquired non-performing consumer lines of credit and credit cards accounted for under ASC 310-20 totaled $506 thousand (0.5% of Oriental’s non-performing loans), a 38.9% decrease from $828 thousand at December 31, 2016 (0.8% of Oriental’s non-performing loans).
Auto loans acquired at premium - are placed on non-accrual status when they become 90 days past due, partially written-off to collateral value when payments are delinquent 120 days, and fully written-off when payments are delinquent 180 days. At September 30, 2017, Oriental’s acquired non-performing auto loans accounted for under ASC 310-20 totaled $481 thousand (0.5% of Oriental’s non-performing loans), a 12.9% decrease from $552 thousand at December 31, 2016 (0.5% of Oriental’s non-performing loans).
Oriental 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 Oriental’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, PRHFA, conventional loans guaranteed by Mortgage Guaranty Insurance Corporation (MGIC), conventional loans sold to FNMA and FHLMC, and conventional loans retained by Oriental. 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/interests 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 under the credit underwriting guidelines of FHA/VA/FNMA/ FHLMC, and performing loans not meeting secondary market guidelines processed by Oriental’s current credit and underwriting guidelines. Oriental 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.
In order to apply for any of the loan modification programs, if the borrower is active in Chapter 13 bankruptcy, they must request an authorization from the bankruptcy trustee to allow for the loan modification. Borrowers with discharged Chapter 7 bankruptcies may also apply. Loans in these programs are evaluated by designated underwriters for troubled-debt restructuring classification if Oriental grants a concession for legal or economic reasons due to the debtor’s financial difficulties.
TABLE 8 — ALLOWANCE FOR LOAN AND LEASE LOSSES BREAKDOWN
Originated and other loans held for investment
Allowance balance:
28.6%
169.9%
20.9%
29.3%
Unallocated allowance
Total allowance balance
47.6%
Allowance composition:
25.49%
29.24%
-12.8%
27.73%
15.17%
82.8%
18.04%
22.04%
-18.1%
28.74%
32.82%
-12.4%
0.73%
100.00%
Allowance coverage ratio at end of period applicable to:
3.21%
2.40%
33.8%
178.6%
4.99%
10.9%
3.03%
17.9%
Total allowance to total originated loans
2.83%
45.1%
Allowance coverage ratio to non-performing loans:
37.39%
23.28%
60.6%
111.88%
45.46%
146.1%
645.93%
657.96%
-1.8%
213.04%
215.01%
-0.9%
91.55%
56.30%
62.6%
TABLE 8 — ALLOWANCE FOR LOAN AND LEASE LOSSES BREAKDOWN (CONTINUED)
-75.7%
-21.8%
1.22%
3.93%
-69.0%
77.04%
70.42%
9.4%
21.74%
25.65%
-15.2%
0.89%
3.04%
-70.7%
8.79%
2.75%
2.08%
32.2%
Total allowance to total acquired loans
4.70%
18.1%
3.59%
11.94%
-69.9%
512.06%
365.70%
40.0%
151.98%
199.82%
-23.9%
158.04%
153.85%
128
Acquired BBVAPR loans accounted for under ASC 310-30
233.0%
2.1%
47.1%
29.2%
22.27%
8.64%
157.8%
59.68%
75.51%
-21.0%
18.05%
15.85%
Acquired Eurobank loans accounted for under ASC 310-30
19.0%
-16.7%
8.8%
61.43%
56.14%
38.54%
43.83%
-12.1%
0.02%
0.03%
-33.3%
129
TABLE 9 — ALLOWANCE FOR LOAN AND LEASE LOSSES SUMMARY
Originated and other loans:
-38.2%
-47.3%
101.9%
86.6%
-77.8%
-49.6%
-10.7%
40.8%
BBVAPR loans
Acquired loans accounted for
under ASC 310-20:
-25.4%
-22.4%
-55.6%
-31.7%
-29.1%
-56.6%
-8.2%
-20.2%
under ASC 310-30:
64.4%
20.4%
49.9%
41.9%
Loan pools fully charged off
2103.4%
9.1%
34.5%
Eurobank loans
-76.4%
210.3%
72.2%
FDIC shared-loss portion on
recapture of loan
25.6%
-96.3%
TABLE 9 — ALLOWANCE FOR LOAN AND LEASE LOSSES SUMMARY (CONTINUED)
Allowance for loans and lease losses on
originated and other loans to:
Total originated loans
37.4%
Non-performing originated loans
56.06%
63.3%
acquired loans accounted for under
ASC 310-20 to:
Total acquired loans accounted
for under ASC 310-20
4.04%
Non-performing acquired loans
accounted for under ASC 310-20
217.39%
-27.3%
131
TABLE 10 — NET CREDIT LOSSES STATISTICS ON LOAN AND LEASES, EXCLUDING LOANS ACCOUNTED FOR UNDER ASC 310-30
(Dollar in thousands)
Originated and other loans and leases:
14.6%
1523.8%
124.5%
(493)
(1,635)
-69.8%
(4,917)
(4,488)
9.6%
-98.7%
-89.0%
603.2%
116.2%
(56,607)
-99.9%
(5,544)
(58,137)
-90.5%
39.4%
213.5%
(4,256)
(3,053)
(10,679)
(7,955)
34.2%
20.3%
-36.1%
(6,993)
(4,057)
72.4%
(14,862)
(14,298)
3.9%
Net credit losses
Total charge-offs
Total recoveries
(11,815)
(65,352)
-81.9%
(36,002)
(84,878)
-57.6%
Net credit losses to average
loans outstanding:
0.28%
0.88%
-68.2%
0.94%
0.80%
15.88%
0.59%
5.43%
-89.1%
5.65%
4.71%
20.0%
4.89%
4.30%
13.7%
3.37%
51.1%
2.70%
-8.5%
1.54%
8.27%
-81.4%
1.58%
3.62%
-56.3%
Recoveries to charge-offs
23.14%
5.74%
303.1%
11.41%
123.3%
Average originated loans:
-7.2%
-13.1%
-12.7%
16.0%
18.0%
14.0%
-2.8%
132
TABLE 10 — NET CREDIT LOSSES STATISTICS ON LOAN AND LEASES, EXCLUDING LOANS ACCOUNTED FOR UNDER ASC 310-30 (CONTINUED)
528.6%
-93.8%
-89.3%
-92.9%
(126)
-460.0%
-20.0%
-50.7%
66.1%
(678)
(822)
-17.5%
(1,975)
(2,478)
-20.3%
-53.3%
-60.5%
-56.2%
-16.9%
(20)
42.9%
546
(278)
-296.4%
(697)
(1,555)
(2,721)
-42.9%
-1.06%
-10.65%
-90.1%
42.64%
-8.22%
-619.0%
5.52%
6.91%
5.51%
25.4%
0.23%
183.7%
-1.75%
0.46%
-477.1%
3.01%
2.56%
2.58%
25.29%
39.82%
-36.5%
51.47%
39.77%
29.4%
Average loans accounted for under ASC 310-20:
378
526
-28.1%
394
568
-30.6%
57,839
59,617
-3.0%
38,088
59,930
-36.4%
34,334
68,178
41,632
79,936
-47.9%
92,551
128,321
-27.9%
80,114
140,434
-43.0%
133
TABLE 11 — NON-PERFORMING ASSETS
(%)
Non-performing assets:
Non-accruing loans
Troubled-Debt Restructuring loans
25,257
32,408
-22.1%
Other loans
67,750
71,941
Accruing loans
4,103
2,706
51.6%
642
-39.8%
Total non-performing loans
97,752
108,122
-9.6%
45,587
18.8%
148,856
156,933
Non-performing assets to total assets, excluding acquired loans with deteriorated credit quality (including those by analogy)
2.76%
2.88%
-4.2%
Non-performing assets to total capital
17.05%
-6.9%
Interest that would have been recorded in the period if the
loans had not been classified as non-accruing loans
1,037
760
2,459
TABLE 12 — NON-PERFORMING LOANS
Non-performing loans:
59,667
74,503
-19.9%
19,786
9.7%
1,986
23.1%
30.5%
95,624
105,327
Acquired loans accounted for under ASC 310-20 (Loans with
revolving feature and/or acquired at a premium)
-19.4%
-38.9%
-12.9%
Non-performing loans composition percentages:
Originated loans
61.0%
68.9%
22.2%
18.3%
2.5%
1.8%
8.4%
1.3%
Non-performing loans to:
Total loans, excluding loans accounted for
under ASC 310-30 (including those by analogy)
3.10%
3.45%
-10.1%
Total assets, excluding loans accounted for
1.81%
1.99%
-9.0%
Total capital
10.43%
-11.2%
Non-performing loans with partial charge-offs to:
7.69%
Non-performing loans
40.45%
34.09%
18.7%
Other non-performing loans ratios:
Charge-off rate on non-performing loans to non-performing loans
on which charge-offs have been taken
60.64%
63.58%
Allowance for loan and lease losses to non-performing
loans on which no charge-offs have been taken
126.88%
89.25%
42.2%
FDIC Indemnification Asset
Oriental recorded the FDIC indemnification asset, measured separately from the covered loans, as part of the Eurobank FDIC-assisted transaction. On February 6, 2017, the Bank and the FDIC agreed to terminate the single family and commercial shared-loss agreements related to the FDIC assisted acquisition.
TABLE 13 - ACTIVITY OF FDIC INDEMNIFICATION ASSET
TABLE 14 - LIABILITIES SUMMARY AND COMPOSITION
NOW accounts
1,025,632
1,091,237
Savings and money market accounts
1,196,231
1,538,483
1,526,805
4,824,258
4,662,775
Accrued interest payable
2,146
1,712
Total deposits and accrued interest payable
Other term notes
Other Liabilities:
-31.2%
Acceptances outstanding
Other liabilities
-4.1%
Deposits portfolio composition percentages:
18.2%
21.3%
23.4%
28.1%
25.7%
31.9%
32.7%
Borrowings portfolio composition percentages:
67.5%
82.2%
23.9%
13.3%
8.6%
4.5%
Securities sold under agreements to repurchase (excluding accrued interest)
Amount outstanding at period-end
Daily average outstanding balance
445,911
663,845
Maximum outstanding balance at any month-end
655,790
902,500
137
Liabilities and Funding Sources
As shown in Table 14 above, at September 30, 2017, Oriental’s total liabilities were $5.351 billion, 4.1% less than the $5.581 billion reported at December 31, 2016. Deposits and borrowings, Oriental’s funding sources, amounted to $5.246 billion at September 30, 2017 versus $5.460 billion at December 31, 2016, a 3.9% decrease.
Borrowings consist mainly of repurchase agreements, FHLB-NY advances and subordinated capital notes. At September 30, 2017, borrowings amounted to $419.3 million, representing a decrease of 47.3% when compared with the $795.4 million reported at December 31, 2016. The decrease in borrowings is mainly attributed to a decrease in repurchase agreements of $370.7 million, reflecting:
· The maturity of a repurchase agreement amounting to $232.0 million with a rate of 4.78% on March 2, 2017;
· An unwinding of $100.0 million in repurchase agreements during the second quarter of 2017; and
· The repayment at maturity of $160.4 million of short-term repurchase agreement during the third quarter of 2017 that were not renewed.
At September 30, 2017, deposits represented 92% and borrowings represented 8% of interest-bearing liabilities. At September 30, 2017, deposits, the largest category of Oriental’s interest-bearing liabilities, were $4.826 billion, an increase of 3.5% from $4.664 billion at December 31, 2016.
Stockholders’ Equity
At September 30, 2017, Oriental’s total stockholders’ equity was $937.6 million, a 1.9% increase when compared to $920.4 million at December 31, 2016. This increase in stockholders’ equity reflects increases in retained earnings of $13.8 million and legal surplus of $3.5 million. Book value per share was $17.56 at September 30, 2017 compared to $17.18 at December 31, 2016.
From December 31, 2016 to September 30, 2017, tangible common equity to total assets increased to 10.82% from 10.19%, Leverage capital ratio increased to 14.07% from 12.99%, Common Equity Tier 1 capital ratio increased to 14.89% from 14.05%, Tier 1 Risk-Based capital ratio increased to 19.53% from 18.35%, and Total Risk-Based capital ratio increased to 20.82% from 19.62%.
New Capital Rules to Implement Basel III Capital Requirements
OFG Bancorp and the Bank are subject to regulatory capital requirements established by the Federal Reserve Board. The current risk-based capital standards applicable to OFG Bancorp and the Bank (“Basel III capital rules”), which have been effective since January 1, 2015, are based on the final capital framework for strengthening international capital standards, known as Basel III, of the Basel Committee on Banking Supervision. As of September 30, 2017, OFG Bancorp's and the Bank’s capital ratios
continue to exceed the minimum requirements for being “well-capitalized” under the Basel III capital rules.
The risk-based capital ratios presented in Table 15, which include common equity tier 1, Tier 1 capital, total capital and leverage capital as of September 30, 2017 and December 31, 2016, are calculated based on the Basel III capital rules related to the measurement of capital, risk-weighted assets and average assets.
138
The following are the consolidated capital ratios of Oriental under the New Capital Rules at September 30, 2017 and December 31, 2016:
TABLE 15 — CAPITAL, DIVIDENDS AND STOCK DATA
(Dollars in thousands, except per share data)
Capital data:
Regulatory Capital Ratios data:
Common equity tier 1 capital ratio
Minimum common equity tier 1 capital ratio required
Actual common equity tier 1 capital
Minimum common equity tier 1 capital required
-4.8%
Minimum capital conservation buffer required
53,158
27,922
90.4%
Excess over regulatory requirement
388,876
398,770
Risk-weighted assets
4,252,605
4,467,556
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
575,484
551,608
Total risk-based capital ratio
Minimum total risk-based capital ratio required
Actual total risk-based capital
1.0%
Minimum total risk-based capital required
545,315
519,252
5.0%
Leverage capital ratio
Minimum leverage capital ratio required
Actual tier 1 capital
Minimum tier 1 capital required
594,535
567,318
4.8%
Tangible common equity to total assets
10.82%
10.19%
6.2%
Tangible common equity to risk-weighted assets
16.01%
14.82%
Total equity to total assets
14.16%
5.3%
Total equity to risk-weighted assets
22.05%
20.60%
7.0%
Stock data:
Outstanding common shares
43,947,442
43,914,844
Market capitalization at end of period
402,119
575,284
-30.1%
The following table presents a reconciliation of Oriental’s total stockholders’ equity to tangible common equity and total assets to tangible assets at September 30, 2017, and December 31, 2016:
(In thousands, except share or per
share information)
(176,000)
Preferred stock issuance costs
10,130
(86,069)
Core deposit intangible
(3,569)
(4,260)
Customer relationship intangible
(1,486)
(1,900)
Total tangible common equity
680,636
662,312
Total tangible assets
6,197,093
6,409,595
Tangible common equity to tangible assets
10.98%
10.33%
Common shares outstanding at end of period
The tangible common equity ratio and tangible book value per common share are non-GAAP measures and, unlike Tier 1 capital and Common Equity Tier 1 capital, are not codified in the federal banking regulations. 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 Oriental calculates its tangible common equity, tangible assets and any other related measures may differ from that of other companies reporting measures with similar names.
Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied and are not audited. To mitigate these limitations, Oriental 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 following table presents Oriental’s capital adequacy information under the New Capital Rules:
Risk-based capital:
Common equity tier 1 capital
Additional tier 1 capital
197,239
191,929
2.8%
Tier 1 capital
Additional Tier 2 capital
54,883
56,995
Risk-weighted assets:
Balance sheet items
4,093,252
4,307,817
-5.0%
Off-balance sheet items
159,353
159,739
-0.2%
Total risk-weighted assets
Ratios:
Common equity tier 1 capital (minimum required - 4.5%)
Tier 1 capital (minimum required - 6%)
Total capital (minimum required - 8%)
Leverage ratio
Equity to assets
Tangible common equity to assets
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 September 30, 2017 and December 31, 2016:
Oriental Bank Regulatory Capital Ratios:
Common Equity Tier 1 Capital to Risk-Weighted Assets
812,831
Minimum capital requirement (4.5%)
Minimum capital conservation buffer requirement (1.25% at June 30, 2017 - 0.625% at December 31, 2016)
53,173
27,859
90.9%
Minimum to be well capitalized (6.5%)
Tier 1 Capital to Risk-Weighted Assets
Minimum capital requirement (6%)
Minimum to be well capitalized (8%)
Total Capital to Risk-Weighted Assets
867,535
Minimum capital requirement (8%)
Minimum to be well capitalized (10%)
Total Tier 1 Capital to Average Total Assets
0.14%
-98.9%
Minimum capital requirement (4%)
-6.3%
Minimum to be well capitalized (5%)
Oriental’s common stock is traded on the New York Stock Exchange (“NYSE”) under the symbol “OFG.” At September 30, 2017 and December 31, 2016, Oriental’s market capitalization for its outstanding common stock was $402.1 million ($9.15 per share) and $575.3 million ($13.10 per share), respectively.
The following table provides the high and low prices and dividends per share of Oriental’s common stock for each quarter of the last two calendar years:
Price
Dividend
High
Low
Per share
10.40
8.40
June 30, 2017
12.03
9.19
March 31, 2017
13.80
10.90
14.30
9.56
September 30, 2016
11.09
8.07
June 30, 2016
9.14
6.32
March 31, 2016
7.32
4.77
2015
December 31, 2015
10.52
6.39
September 30, 2015
10.20
6.63
0.10
June 30, 2015
17.04
10.67
March 31, 2015
17.70
14.88
Under Oriental’s current stock repurchase program, it is authorized to purchase in the open market up to $7.7 million of its outstanding shares of common stock. The shares of common stock repurchased are to be held by Oriental as treasury shares. There were no repurchases during the quarter ended September 30, 2017.
At September 30, 2017, the number of shares that may yet be purchased under such program is estimated at 844,902 and was calculated by dividing the remaining balance of $7.7 million by $9.15 (closing price of Oriental's common stock at September 30, 2017).
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Background
Oriental’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. Oriental 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 Oriental’s business activities are susceptible to risk. Consequently, risk identification and monitoring are essential to risk management. As more fully discussed below, Oriental’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. Oriental evaluates market risk together with interest rate risk. Oriental’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 Oriental complies with the guidelines established by policies approved by the Board. The Board has delegated the management of this risk to 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 Oriental is within the parameters established in such policies.
Interest Rate Risk
Interest rate risk is the exposure of Oriental’s earnings or capital to adverse movements in interest rates. It is a predominant market risk in terms of its potential impact on earnings. Oriental 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 executing 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 quarterly basis, Oriental 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 five-year time horizon, assuming certain gradual upward and downward interest rate movements, achieved during a twelve-month period. Instantaneous interest rate movements are also modeled. Simulations are carried out in two ways:
(i) using a static balance sheet as Oriental 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.
Oriental uses a software application to project future movements in Oriental’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 complex, and use many assumptions that are intended to reflect the general behavior of Oriental 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 September 30, 2017 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
12,085
8,772
+ 100 Basis points
6,077
2.20%
4,420
- 50 Basis points
(2,957)
-1.07%
(2,030)
-0.72%
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 Oriental’s investments in callable securities, prepayment risk related to mortgage loans and mortgage-backed securities, and any structured repurchase agreements and advances from the FHLB-NY in which it may enter into from time to time. As part of the strategy to limit the interest rate risk and reduce the re-pricing gaps of Oriental’s assets and liabilities, Oriental has executed certain transactions which include extending the maturity and the re-pricing frequency of the liabilities to longer terms reducing the amounts of its structured repurchase agreements and entering into hedge-designated swaps to hedge the variability of future interest cash flows of forecasted wholesale borrowings that only consist of advances from the FHLB-NY as of September 30, 2017.
Oriental 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. Oriental’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 Oriental’s gains and losses on the derivative instruments that are linked to the forecasted cash flows of these hedged assets and liabilities. Oriental 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 Oriental’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 Oriental’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 Oriental the right to enter into interest rate swaps and cap and floor agreements with the writer of the option. In addition, Oriental 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 9 to the accompanying consolidated financial statements for further information concerning Oriental’s derivative activities.
Following is a summary of certain strategies, including derivative activities, currently used by Oriental to manage interest rate risk:
Interest rate swaps — Oriental 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 Oriental’s interest payments on an amount of forecasted interest expense attributable to the one-month LIBOR rate corresponding to the swap notional stated rate. A derivative liability of $868 thousand (notional amount of $35.5 million) was recognized at September 30, 2017 related to the valuation of these swaps.
In addition, Oriental has certain derivative contracts, including interest rate swaps not designated as hedging instruments, which are utilized to convert certain variable rate loans to fixed-rate loans, and the mirror-images of these interest rate swaps in which Oriental enters 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 September 30, 2017, interest rate swaps offered to clients not designated as hedging instruments represented a derivative asset of $757 thousand (notional amounts of $12.5 million), and the mirror-image interest rate swaps in which Oriental entered into represented a derivative liability of $757 thousand (notional amounts of $12.5 million).
Wholesale borrowings — Oriental uses interest rate swaps to hedge the variability of interest cash flows of certain advances from the FHLB-NY that are tied to a variable rate index. The interest rate swaps effectively fix Oriental’s interest payments on these borrowings. As of September 30, 2017, Oriental had $35.5 million in interest rate swaps at an average rate of 2.4% designated as cash flow hedges for $35.5 million in advances from the FHLB-NY 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 Oriental is its lending activities. In Puerto Rico, Oriental’s principal market, economic conditions are challenging, as they have been for the last ten years, due to a shrinking population, a protracted economic recession, a housing sector that remains under pressure, the Puerto Rico government’s fiscal and liquidity crisis, and the payment defaults on various Puerto Rico government bonds, with severe austerity measures expected for the Puerto Rico government to be able to restructure its debts under the supervision of a federally created Fiscal Oversight Board. In addition, as was demonstrated with hurricanes Irma and Maria during the month of September 2017, Puerto Rico is an island in the Caribbean susceptible to natural disasters such as hurricanes and earthquakes. Such disasters can have a disproportionate impact on Puerto Rico because of the logistical difficulties of bringing relief to an island. Moreover, the Puerto Rico government's fiscal challenges and Puerto Rico's unique relationship with the United States additionally complicate any relief efforts after a natural disaster. These events increase credit risk as debtors may no longer be capable of operating their business and the collateral may suffer significant damage.
Oriental 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. Oriental also employs proactive collection and loss mitigation practices.
Oriental may also encounter risk of default in relation to its securities portfolio. The securities held by Oriental 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.
Oriental’s executive Credit Risk Committee, composed of its Chief Executive Officer, Chief Operating Officer, Chief Credit Officer, Chief Risk Officer, and other senior executives, has primary responsibility for setting strategies to achieve Oriental’s credit risk goals and objectives. Those goals and objectives are set forth in Oriental’s Credit Policy as approved by the Board.
Liquidity Risk
Liquidity risk is the risk of Oriental 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 to manage this risk. Oriental’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.
Oriental’s business requires continuous access to various funding sources. While Oriental is able to fund its operations through deposits as well as through advances from the FHLB-NY and other alternative sources, Oriental’s business is dependent upon other
external wholesale funding sources. Oriental has selectively reduced its use of certain wholesale funding sources, such as repurchase agreements and brokered deposits. As of September 30, 2017, Oriental had $282.5 million in repurchase agreements, excluding accrued interest, and $535.6 million in brokered deposits.
Brokered deposits are typically offered through an intermediary to small retail investors. Oriental’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, Oriental’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.
Although Oriental 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 Oriental, the availability and cost of Oriental’s funding sources could be adversely affected. In that event, Oriental’s cost of funds may increase, thereby reducing its net interest income, or Oriental 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 any such dispositions. Oriental’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 Oriental or market-related events. In the event that such sources of funds are reduced or eliminated and Oriental is not able to replace these on a cost-effective basis, Oriental 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 September 30, 2017, Oriental had approximately $720.7 million in unrestricted cash and cash equivalents, $810.3 million in investment securities that are not pledged as collateral, $849.5 million in borrowing capacity at the FHLB-NY.
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 Oriental are susceptible to operational risk.
Oriental faces ongoing and emerging risk and regulatory pressure related to the activities that surround the delivery of banking and financial products and services. Coupled with external influences such as the risk of natural disasters, market conditions, security risks, and legal risks, the potential for operational and reputational loss has increased. In order to mitigate and control operational risk, Oriental 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 Oriental’s business operations are functioning within established limits.
Oriental 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, Oriental has specialized groups, such as Information Security, Enterprise Risk Management, Corporate Compliance, Information Technology, Legal 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 Executive Risk and Compliance Committee. Oriental also has a Business Continuity Plan to address situations where its capacity to perform critical functions is affected. Under such circumstances, a Crisis Management Team is activated to restore such critical functions within established timeframes.
Oriental is subject to extensive United States federal and Puerto Rico regulations, and this regulatory scrutiny has been significantly increasing over the last several years. Oriental 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. Oriental has a corporate compliance function headed by a Chief Compliance Officer who reports to the Chief Executive Officer and supervises the BSA Officer and Regulatory Compliance Officer. The Chief Compliance Officer is responsible for the oversight of regulatory compliance and implementation of a company-wide compliance program, including the Bank Secrecy Act/Anti-Money Laundering compliance program.
147
Concentration Risk
Substantially all of Oriental’s business activities and a significant portion of its credit exposure are concentrated in Puerto Rico. As a consequence, Oriental’s profitability and financial condition may be adversely affected by an extended economic slowdown, adverse political, fiscal 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 Oriental’s management, including the Chief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of Oriental’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, Oriental’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 Oriental 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 Oriental to disclose material information otherwise required to be set forth in Oriental’s periodic reports.
Internal Control over Financial Reporting
During the third quarter of 2017, Oriental’s internal control measures were modified to accommodate the operational changes that were required in the aftermath of hurricanes Irma and Maria. Alternate and mitigating controls were implemented to provide continued assurance of proper internal control over activities affecting financial reporting. These modifications of internal controls over financial reporting have not materially affected, and are not reasonably likely to materially affect, the Company’s internal control over financial reporting.
During the third quarter of 2017, we completed the migration of our accounting and financial reporting systems to a new platform. This implementation impacts various internal processes and controls for business activities within accounting, as well as financial reporting. Oriental believes that this new system and the related changes to internal controls will ultimately strengthen its internal controls over financial reporting. However, there are inherent risks in implementing any new accounting and financial reporting system, and Oriental will continue to evaluate and test control changes to provide certification on the effectiveness, in all material respects, of its internal controls over financial reporting for the year ending December 31, 2017.
Except for the implementation described above, there were no changes in our internal control over financial reporting that occurred during the third quarter ended September 30, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART - II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Oriental and its subsidiaries are defendants in a number of legal proceedings incidental to their business. Oriental 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 Oriental’s financial condition or results of operations.
ITEM 1A. RISK FACTORS
Except as set forth below, there have been no material changes to the risk factors previously disclosed in Oriental’s annual report on Form 10-K for the year ended December 31, 2016. In addition to other information set forth in this report, you should carefully consider the risk factors included in Oriental’s annual report on Form 10-K, as updated by this report or other filings Oriental makes with the SEC under the Exchange Act. Additional risks and uncertainties not presently known to Oriental at this time or that Oriental currently deems immaterial may also adversely affect Oriental’s business, financial condition or results of operations.
Hurricanes Irma and Maria caused unprecedented catastrophic damages throughout Puerto Rico, our principal market area.
Puerto Rico is our principal market area, which is susceptible to hurricanes and tropical storms. Hurricane Maria, a category 4 storm, made landfall in Puerto Rico on September 20, 2017, less than two weeks after hurricane Irma, a category 5 storm, passed north of Puerto Rico leaving over a million local residents without electric power. Over a month after the hurricanes, most of Puerto Rico remains without electricity, many businesses are unable to operate, and government authorities are still struggling to deliver emergency supplies and clean drinking water to many communities outside the San Juan metropolitan area. Further, payment and delivery systems, including the U.S. Post Office, were unable to operate for weeks after hurricane Maria and some are still subject to significant delays. Hurricane Maria caused catastrophic property damages throughout Puerto Rico, including homes, businesses, roads, bridges, power lines, commercial establishments, and public facilities. In addition, it caused flooding in some areas, displaced many local residents, and severely disrupted business operations and economic activities. Although the hurricanes did not permanently affect our facilities, they affected our loan originations and impacted our deposit and customer base. Further, many properties and structures in Puerto Rico suffered extensive flood or wind damages, which may adversely affect the value of collateral securing our loans and, potentially, the ability of borrowers to repay their obligations to us. Approximately 99.7% of our $4.1 billion loan portfolio as of September 30, 2017, consists of Puerto Rico-based borrowers, and 56.1% of such portfolio is secured by Puerto Rico real estate assets. Therefore, it is likely that loan delinquencies and restructurings will increase, particularly in the near term, as borrowers undertake recovery and clean-up efforts, including the pursuit of insurance claims. Our borrowers may also experience disruptions in their business or employment status. Such increases in delinquencies and restructurings would negatively affect our cash flows and, if not timely cured, would increase our non-performing assets and reduce our net interest income. We may also experience increases in total loan losses as loan delinquencies and restructurings increase if insurance proceeds and collateral values are insufficient to cover balances of loans in default.
We evaluated the impact of hurricanes Irma and Maria on our loan portfolios relative to the adequacy of the allowance for loan losses at September 30, 2017, and recorded an additional provision for loan losses of $27 million (pre-tax). However, the amount of loan losses relating to these hurricanes remains uncertain and the additional loan loss provision may not be sufficient to cover our actual loan losses. Alternatively, loan losses may not materialize due to adequate insurance coverage or the financial resources of borrowers, which may result in a reduction to the loan loss provision in a future period.
Collection and foreclosure court proceedings on our loans in default were also affected or delayed as a result of the impact that hurricane Maria had on the infrastructure of the Puerto Rico judiciary branch. The Office of the Administrator of the Courts (known by its Spanish acronym as “OAT”) announced that all deadlines between September 19 and November 30, 2017, would be reset for December 1, 2017. OAT also stated that except for specific instances in which a court reschedules a hearing or conference, all settings from November 1, 2017 onward will remain as scheduled. The hearings and conferences set to be held in courthouses that were significantly damaged by the hurricane, such as in the municipalities of Aguadilla, Bayamon and Utuado, have had to be relocated to nearby courthouses.
The severity and duration of the effects of these hurricanes will depend on a number of factors that are beyond our control, including the amount and timing of government, private and philanthropic financial assistance for the reconstruction of Puerto Rico’s critical infrastructure, the pace and magnitude of Puerto Rico’s economic recovery, and the extent to which property damages and business
interruption losses caused by these natural disasters is covered by insurance. Also, changes to the Commonwealth’s fiscal plan, as mandated by the Financial Oversight and Management Board under PROMESA, increases in local unemployment, population decline due to migration, and further declines in Puerto Rico real estate values as a result of these hurricanes may be generally expected. Therefore, a significant uncertainty remains regarding the impact of these hurricanes on our business, financial condition, and results of operations.
Puerto Rico is susceptible to hurricanes and major storms, which could further deteriorate Puerto Rico’s economy and infrastructure.
Our branch network and most of our business is concentrated in Puerto Rico, which is susceptible to hurricanes and major storms that affect the local economy and the demand for our loans and financial services, as well as the ability of our customers to repay their loans. Any such natural disasters may further adversely affect Puerto Rico’s critical infrastructure, which is generally weak. This makes us vulnerable to downturns in Puerto Rico’s economy as a result of natural disasters, such as hurricanes Irma and Maria. Any subsequent hurricanes, major storms or similar natural disasters could further deteriorate Puerto Rico’s economy and infrastructure and negatively affect or disrupt our operations and customer base.
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:
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 September 30, 2017, 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: November 8, 2017
José Rafael Fernández
President and Chief Executive Officer
/s/ Maritza Arizmendi
Maritza Arizmendi
Executive Vice President and Chief Financial Officer
/s/ Vanessa de Armas
Vanessa de Armas
Controller