OFG Bancorp - 10-Q quarterly report FY

Washington, D.C. 20549

Form 10-Q

For the Quarter Ended March 31, 2003

Commission File No. 001-12647

Oriental Financial Group Inc.

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  ýNo  o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes  ýNo  o

TABLE OF CONTENTS

PART 1 - FINANCIAL INFORMATION

Item 1 -  Financial Statements

UNAUDITED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

March 31, 2003 AND JUNE 30, 2002

(In thousands, except shares information)

See notes to consolidated financial statements.

1

UNAUDITED CONSOLIDATED STATEMENTS OF INCOME

FOR THE QUARTER AND NINE-MONTH PERIODS ENDED MARCH 31, 2003 AND 2002

(In thousands, except for per share data)

See notes to consolidated financial statements.

2

UNAUDITED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

FOR THE NINE-MONTH PERIODS ENDED MARCH 31, 2003 AND 2002

(In thousands)

UNAUDITED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

FOR THE QUARTER AND NINE-MONTH PERIODS ENDED MARCH 31, 2003 AND 2002

(In thousands)

See notes to consolidated financial statements.

3

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINE-MONTH PERIODS ENDED MARCH 31, 2003 AND 2002

(In thousands)

See notes to consolidated financial statements.

4

ORIENTAL FINANCIAL GROUP INC.

Notes to Unaudited Consolidated Financial Statements

NOTE 1 - BASIS OF PRESENTATION:

The accounting and reporting policies of Oriental Financial Group Inc. (the “Group” or “Oriental”) conform with accounting principles generally accepted in the United States of America (“GAAP”) and to financial services industry practices.

The unaudited Consolidated Financial Statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). In the opinion of management, these financial statements include all adjustments (which consist of normal recurring accruals) necessary, to present fairly the consolidated financial condition as of March 31, 2003 and June 30, 2002, and the results of operations and cash flows for the quarter and nine-month periods ended March 31, 2003 and 2002. All significant intercompany balances and transactions have been eliminated in the accompanying unaudited consolidated financial statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such SEC rules and regulations. Management believes that the disclosures made are adequate to make the information presented not misleading. Financial information as of June 30, 2002 has been derived from the Group’s audited Consolidated Financial Statements. The results of operations and cash flows for the nine-month periods ended March 31, 2003 and 2002 are not necessarily indicative of the results to be expected for the full year. For further information, refer to the Consolidated Financial Statements and footnotes thereto for the year ended June 30, 2002, included in the Group’s Annual Report on Form 10-K.

Certain reclassifications have been made to prior periods financial statements to conform to the current period presentation.

Nature of Operations

Oriental is a financial holding company incorporated under the laws of the Commonwealth of Puerto Rico. It has five subsidiaries, Oriental Bank and Trust (the “Bank”), Oriental Financial Services Corp. (“Oriental Financial Services”), Oriental Insurance, Inc., Caribbean Pension Consultants, Inc. and Oriental Financial Group Inc. Statutory Trust I (the “Trust”). Through these subsidiaries, the Group provides a wide range of financial services such as mortgage, commercial and consumer lending, financial planning, insurance sales, money management and investment brokerage services, as well as corporate and individual trust services. Note 7 to the consolidated financial statements presents further information about the operations of the Group’s business segments.

Main offices for the Group and most of its subsidiaries are located in San Juan, Puerto Rico. The Group is subject to examination, regulation and periodic reporting under the Bank Holding Company Act of 1956, as amended, which is administered by the Board of Governors of the Federal Reserve System. The Bank operates through twenty-three branches located throughout the island and is subject to the supervision, examination and regulation of the Office of the Commissioner of Financial Institutions of Puerto Rico and the Federal Deposit Insurance Corporation (FDIC), which insures its deposits through the Savings Association Insurance Fund (SAIF). Oriental Financial Services is subject to the supervision, examination and regulation of the National Association of Securities Dealers, Inc., the SEC, and the Office of the Commissioner of Financial Institutions of Puerto Rico. Oriental Insurance, Inc. is subject to the supervision, examination and regulation of the Office of the Commissioner of Insurance of Puerto Rico.

Critical Accounting Policies

The consolidated financial statements of the Group are prepared in accordance with GAAP and with general practices within the financial industry.  In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amount of revenues and expenses during the reporting period.   Actual results could differ from those estimates. The Group believes that of its significant accounting policies, the following may involve a higher degree of judgement and complexity.

•                  Allowance for Loan Losses.  The Group assesses the overall risks in its loan portfolio and establishes and maintains a reserve for probable losses thereon.  The allowance for loan losses is maintained at a level sufficient to provide for estimated loan losses based on the evaluation of known and inherent risks in the Group’s loan portfolio.  The Group’s management evaluates the adequacy of the allowance for loan losses on a quarterly basis.  Based on current and expected economic conditions, the expected level on net loan losses and the methodology established to evaluate the adequacy of the allowance for loan losses, management considers that the allowance for loan losses is adequate to absorb probable losses on its loan portfolio.  In determining the allowance, management considers the portfolio risk characteristics, prior loss experience, prevailing and projected economic conditions and loan impairment measurements. Any significant changes in these considerations would have an impact on the allowance for loan losses.

5

•                  Financial Instruments. Certain financial instruments including derivatives, hedged items and investment securities available-for-sale are recorded at fair value and unrealized gains and losses are recorded in other comprehensive income or other gains and losses as appropriate.  Fair values are based on listed market prices, if available.  If listed market prices are not available, fair value is determined based on other relevant factors including price quotations for similar instruments.  Fair value for certain derivative contracts are derived from pricing models that consider current market and contractual prices for the underlying financial instruments as well as time valued and yield curve or volatility factors underlying the positions.

NOTE 2 - INVESTMENT SECURITIES:

Securities are classified as held-to-maturity, available-for-sale or trading. Securities for which the Group has the positive intent and ability to hold to maturity are classified as held-to-maturity and are carried at amortized cost. There were no held-to-maturity securities as of March 31, 2003 and June 30, 2002. The Group’s securities are classified as available-for-sale or trading. Securities that might be sold prior to maturity because of interest rate changes, to meet liquidity needs, or to better match the repricing characteristics of funding sources are classified as available-for-sale.  These securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of tax, in other comprehensive income.  If and when the impairment of a security is deemed to be other-than-temporary, any unrealized holding loss will be reclassified and charged to earnings.

The Group classifies as trading those securities that are acquired and held principally for the purpose of selling them in the near future.  These securities are carried at fair value with realized and unrealized changes in fair value included in earnings in the period in which the changes occur. Interest revenue arising from trading instruments is included in the consolidated statements of income as part of net interest income rather than in the trading profit or loss account. The Group’s investment in the Federal Home Loan Bank (FHLB) of New York has no readily determinable fair value and can only be sold to the FHLB at par value. Therefore, carrying value represents its fair value.

Premiums and discounts are amortized to interest income over the life of the related securities using the interest method.  Net realized gains or losses on sales of investment securities and unrealized loss valuation adjustments considered other than temporary, if any, are reported separately in the consolidated statements of income.  The cost of securities sold is determined using the specific identification method.

Trading Securities

A summary of trading securities owned by the Group at March 31, 2003 and June 30, 2002 is as follows:

At March 31, 2003, the Group’s trading portfolio weighted average yield was 5.73% (June 30, 2002 - 5.94%).

Investment securities available-for-sale

The amortized cost, gross unrealized gains and losses, fair value, and weighted average yield of the investment securities available- for-sale at March 31, 2003 and June 30, 2002, were as follows:

6

The amortized cost and fair value of the Group’s investment securities available-for-sale at March 31, 2003, by contractual maturity, are shown in the next table.  Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

Proceeds from the sale of investment securities available-for-sale during the first nine months of fiscal 2003 totaled $423,074,041 (2002 - $282,860,864). Gross realized gains and losses on those sales during the first nine months of fiscal 2003 were $10,227,062 and$1,818,513, respectively, (2002 - $6,014,029 and $2,723,059, respectively).

7

NOTE 3 - LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES:

Loans Receivable

The Group’s credit activity is mainly with consumers located in Puerto Rico.  Oriental’s loan transactions are encompassed within three main categories: mortgage, commercial, and consumer.  The composition of the Group’s loan portfolio at March 31, 2003 and June 30, 2002 was as follows:

Allowance for Loan Losses

The Group maintains an allowance for loan losses at a level that management considers adequate to provide for probable losses based upon an evaluation of known and inherent risks.  Oriental’s allowance for loan losses policy provides for a detailed quarterly analysis of probable losses.  The analysis includes a review of historical loan loss experience, value of underlying collateral, current economic conditions, financial condition of borrowers and other pertinent factors.

While management uses available information in estimating probable loan losses, future additions to the allowance may be necessary based on factors beyond Oriental’s control, such as factors affecting Puerto Rico economic conditions. Refer to Table 4 of the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for the changes in the allowance for loan losses for the quarter and nine-month periods ended March 31, 2003 and 2002.

The Group evaluates all loans, some individually and other as homogeneous groups, for purposes of determining impairment. At March 31, 2003 and June 30, 2002, the Group determined that no specific impairment allowance was required for those loans evaluated for impairment.

NOTE 4 - PLEDGED ASSETS:

At March 31, 2003, residential mortgage loans and investment securities available-for-sale amounting to $450,998,962 and  $1,685,187,812, respectively, were pledged to secure public fund deposits, investment securities sold under agreements to repurchase, letters of credit, advances and borrowings from the Federal Home Loan Bank of New York, term notes and interest rate swap agreements. As of March 31, 2003, unpledged securities available-for-sale amounted $333,363,051.

8

NOTE 5 - DERIVATIVES AND HEDGING ACTIVITIES

The Group utilizes various derivative instruments for hedging purposes, such as asset/liability management, and other than hedging purposes. These transactions involve both credit and market risk. The notional amounts are amounts on which calculations and payments are based. Notional amounts do not represent direct credit exposures. Direct credit exposure is limited to the net difference between the calculated amounts to be received and paid, if any. The actual risk of loss is the cost of replacing, at market, these contracts in the event of default by the counterparties. The Group controls the credit risk of its derivative financial instrument agreements through credit approvals, limits, monitoring procedures and collateral, when considered necessary.

The Group generally uses interest rate swaps and interest rate options, such as caps and options, in managing its interest rate risk exposure.  The swaps were entered into to convert short-term borrowings into fixed rate liabilities for longer periods and provide protection against increases in short-term interest rates. Under these swaps, the Group pays a fixed monthly or quarterly cost and receives a floating thirty or ninety-day payment based on LIBOR. Floating rate payments received from the swap counterparties correspond to the floating rate payments made on the short-term borrowings thus resulting in a net fixed rate cost to the Group (cash flow hedging instruments used to hedge a forecasted transaction). Under the caps, the Group pays an up front premium or fee for the right to receive cash flow payments in excess of the predetermined cap rate; thus, effectively capping its interest rate cost for the duration of the agreement.

Derivative instruments are recognized as assets and liabilities at fair value. If certain conditions are met, the derivative may qualify for hedge accounting treatment and be designated as one of the following types of hedges: (a) hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment (“fair value hedge”); (b) a hedge of the exposure to variability of cash flows of a recognized asset, liability or forecasted transaction (“cash flow hedge”) or (c) a hedge of foreign currency exposure (“foreign currency hedge”).

In the case of a qualifying fair value hedge, changes in the value of the derivative instruments that have been highly effective are recognized in current period earnings along with the change in value of the designated hedged item. In the case of a qualifying cash flow hedge, changes in the value of the derivative instruments that have been highly effective are recognized in other comprehensive income, until such time as those earnings are affected by the variability of the cash flows of the underlying hedged item. In either a fair value hedge or a cash flow hedge, net earnings may be impacted to the extent the changes in the value of the derivative instruments do not perfectly offset changes in the value of the hedged items. If the derivative is not designated as a hedging instrument, the changes in fair value of the derivative are recorded in earnings.

Certain contracts contain embedded derivatives. When the embedded derivative possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract, it should be bifurcated, carried at fair value, and designated as a trading or non-hedging derivative instrument.

The Group’s swaps, excluding those used to manage exposure to the stock market, and caps outstanding and their terms at March 31, 2003 and June 30, 2002 are set forth in the table below:

The Group offers its customers certificates of deposit with an option tied to the performance of one of the following stock market indexes: Standard & Poor’s 500, Dow Jones Industrial Average and Russell 2000. At the end of five years, the depositor will receive a specified percentage of the average increase of the month-end value of the corresponding stock index.  If such index decreases, the depositor receives the principal without any interest. The Group uses swap and option agreements with major money center banks and major broker dealer companies to manage its exposure to changes in those indexes. Under the terms of the option agreements, the Group will receive the average increase in the month-end value of the corresponding index in exchange for a fixed premium. Under the term of the swap agreements, the Group will receive the average increase in the month-end value of the corresponding index in

9

exchange for a quarterly fixed interest cost. The changes in fair value of the options purchased, the swap agreements and the options embedded in the certificates of deposit are recorded in earnings.

Derivatives instruments are generally negotiated over-the-counter (“OTC”) contracts. Negotiated OTC derivatives are generally entered into between two counterparties that negotiate specific agreement terms, including the underlying instrument, amount, exercise price and maturity.

Information pertaining to the notional amounts of the Group’s derivative financial instruments as of March 31, 2003 and June 30, 2002 is as follows:

At March 31, 2003 and June 30, 2002, the fair value of derivatives was recognized as either assets or liabilities in the Consolidated Statements of Financial Condition as follows: the fair value of the interest rate swaps used to manage the exposure to the stock market on stock indexed deposits represented a liability of $724,000 ($1.8 million, June 2002); the purchased options used to manage the exposure to the stock market on stock indexed deposits represented an other asset of $4.0 million  ($10.3 million, June 2002); and the options sold to customers embedded in the certificates of deposit represented a liability of $4.1 million  ($10.5 million, June 2002) recorded in deposits. The fair value of the interest rate swaps represented a liability of $38.0 million ($22.6 million, June 2002) presented in “Accrued Expenses and Other Liabilities”. The fair value of the Caps represented an other asset of $1.2 thousand ($4.3 million as of June 30, 2002).

NOTE 6 - STOCKHOLDERS’ EQUITY TRANSACTIONS:

Stock Dividend

On January 29, 2002, the Group declared a ten percent (10%) stock dividend on common stock held by shareholders of record as of April 1, 2002. As a result, 1,249,125 shares of common stock were distributed on April 15, 2002. Also, on October 28, 2002, the Group declared a twenty-five percent (25%) stock split effected in the form of a dividend on common stock held by registered shareholders as of December 30, 2002. As a result, 3,864,800 shares of common stock were distributed on January 15, 2003. For purpose of the computation of income per common share, cash dividend and stock price, the stock dividends were retroactively recognized for all periods presented in the accompanying consolidated financial statements.

Treasury Stock

On March 26, 2003, the Group’s Board of Directors announced the authorization of a new program for the repurchase of up to $9.0 million of its outstanding shares of common stock. This program supersedes the ongoing repurchase program established earlier.  The Group will make such repurchases from time to time, depending on market conditions and prices. During the nine-month periods ended March 31, 2003 and 2002, the Group repurchased 67,000 and 136,825 shares of its common stock for $1.4 million and $2.6 million, respectively.

10

Stock Options

The Group has four stock options plans: the 1988, 1996, 1998, and 2000 Incentive Stock Option Plans. These plans offer key officers and employees an opportunity to purchase shares of the Group’s common stock. The Compensation committee of the Board of Directors has sole authority and absolute discretion as to the number of stock options to be granted, their vesting rights, and the options exercise price. The plans provide for a proportionate adjustment in the exercise price and the number of shares that can be purchased in case of a stock split, reclassification of stock, and a merger or reorganization. Stock options vest upon completion of specified years of service.

The Group follows the intrinsic value-based method of accounting for measuring compensation expense, if any. Compensation expense is generally recognized for any excess of the quoted market price of the Group’s stock at measurement date over the amount an employee must pay to acquire the stock. For the outstanding options, the Group established the exercise price based on the fair value of the Group’s stock at the grant date. Therefore, the options had no intrinsic value upon grant, and therefore no expense was recorded. In September 2001, the Group canceled 271,500 of non-vested options granted with a discount in fiscal years 1999 and 2000. At the cancellation, the unrecognized compensation cost was recorded with a charge to income and a credit to additional paid in capital. The stock options compensation recorded in fiscal 2002 amounted to $826,000.

Each quarter, the Group reports the potential dilutive impact of stock options in its diluted earnings per share using treasury-stock method.  Out-of-the-money stock options (i.e., the average stock price during the period is below the strike price of the option) are not included in diluted earnings per share.

Stock options outstanding as of March 31, 2003 and June 30, 2002 amounted to 2,149,842 and 2,665,788, respectively, after given retroactive effect to the 25% stock split effected in the form of a dividend on common stock declared on October 28, 2002.

As required under Statement of Financial Accounting Standards (“SFAS”) No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation,” and SFAS No. 148, “Accounting for Stock-Based Compensation Transition and Disclosure,” the pro forma effects of stock-based compensation on net income and earnings per common share have been estimated at the date of grant using the Black-Scholes option-pricing mode.

The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no restrictions and are fully transferable and negotiable in a free trading market. Black-Scholes does not consider the employment, transfer or vesting restrictions that are inherent in the Group’s employee options. Use of an option valuation model, as required by SFAS 123, includes highly subjective assumptions based on long-term predictions, including the expected stock price volatility and average life of each option grant. Because the Group’s employee options have characteristics significantly different from those of freely traded options, and because changes in the subjective input assumptions can materially affect the Group’s estimate of the fair value of those options, in the Group’s opinion, the existing valuation models, including Black-Scholes, are not reliable single measures and may misstate the fair value of the Group’s employee options.  Options granted for the nine-month periods ended March 31, 2003 and 2002 amounted 46,250 and 132,688 options, respectively, after given retroactive effect to the 25% stock split. As required by SFAS 123, the Black-Scholes weighted average estimated fair values of stock options granted during the quarter periods ended March 31, 2003 and 2002 were $5.23 and $3.88 per option, respectively and for the nine-month periods ended March 31, 2003 and 2002 were $5.61 and $3.82 per option, respectively,  after given retroactive effect to the 25% stock split.

11

For purposes of pro forma disclosures, the estimated fair value of the options is assumed to be amortized to expense over the options’ vesting periods.  The pro forma effects of recognizing compensation expense under the fair value method on net income and earnings per common share were as follows (in thousand, except for earnings per share):

NOTE 7 - SEGMENT REPORTING:

The Group operates three major reportable segments: Financial Services, Retail Banking and Treasury. Management determined the reportable segments based on the internal reporting used to evaluate performance and to assess where to allocate resources. Other factors such as the Group’s organizational chart, nature of products, distribution channels and economic characteristics of the products were also considered in the determination of the reportable segments. The Group measures the performance of these reportable segments, based on pre-established goals of different financial parameters such as net income, net interest income, loan production, and fees generated.

The Group’s two largest business segments are retail banking and treasury. The Bank’s branches, mortgage banking and treasury functions are its main components, with traditional banking products such as deposits and personal, mortgage and commercial loans. The mortgage banking activities are carried out by the bank’s mortgage banking division, which principal activity is to originate and purchase mortgage loans for the Group’s own portfolio. From time to time, if conditions so warrant, it may sell loans to other financial institutions or securitize conforming loans into GNMA, FNMA and FHLMC certificates using another institution as issuer. The other institution services mortgages included in the resulting GNMA, FNMA, and FHLMC pools. The Group also sells the rights to service mortgage loans for others.

The Group’s third largest business segment is financial services. It is comprised of the Bank’s trust division (Oriental Trust), the brokerage subsidiary (Oriental Financial Services Corp.), the insurance subsidiary (Oriental Insurance, Inc.), and the recently acquired pension plan administration subsidiary (Caribbean Pension Consultants, Inc.). The core operations of this segment are financial planning, money management and investment brokerage services, insurance sales activity, corporate and individual trust services, as well as pension plan administration services.

Intersegment sales and transfers, if any, are accounted for as if the sales or transfers were to third parties, that is, at current market prices. The accounting policies of the segments are the same as those described in the “Summary of Significant Accounting Policies” included in the Group’s Annual Report on Form 10-K.

12

Following are the results of operations and the selected financial information by operating segment for each of the quarter periods and nine-month periods ended March 31, 2003 and 2002:

Unaudited - quarter periods ended March 31 (Dollars in thousands)