UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
or
WEBSTER FINANCIAL CORPORATION
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.
[X] Yes [ ] No
Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Indicate the number of shares outstanding for each of the issuer’s classes of common stock, as of the latest practicable date.
Webster Financial Corporation and Subsidiaries
INDEX
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ITEM 1. INTERIM FINANCIAL STATEMENTS
CONSOLIDATED STATEMENTS OF CONDITION (unaudited)
See accompanying Notes to Consolidated Interim Financial Statements.
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CONSOLIDATED STATEMENTS OF INCOME (unaudited)
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CONSOLIDATED STATEMENTS OF INCOME (unaudited), continued
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (unaudited)
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CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (unaudited)
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CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
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CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited), continued
Assets acquired and liabilities assumed were as follows:
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NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS
NOTE 1: Basis of Presentation and Principles of Consolidation
The Consolidated Interim Financial Statements include the accounts of Webster Financial Corporation (“Webster” or the “Company”) and its subsidiaries. The Consolidated Interim Financial Statements and Notes thereto have been prepared in conformity with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. All significant intercompany transactions have been eliminated in consolidation. Amounts in prior period financial statements are reclassified whenever necessary to conform to current period presentations. The results of operations for the three months ended March 31, 2004 are not necessarily indicative of the results which may be expected for the year as a whole.
The preparation of the Consolidated Interim Financial Statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities, as of the date of the Consolidated Interim Financial Statements and the reported amounts of revenues and expenses for the periods presented. The actual results of Webster could differ from those estimates. Material estimates that are susceptible to near-term changes include the determination of the allowance for loan losses, the valuation allowance for the deferred tax asset and the determination of the obligation for pension and other post retirement benefits. These Consolidated Interim Financial Statements should be read in conjunction with the audited Consolidated Financial Statements and Notes thereto included in Webster’s Annual Report on Form 10-K for the year ended December 31, 2003.
NOTE 2: Stock-Based Compensation
At March 31, 2004 and 2003, Webster had a fixed stock-based compensation plan that covered employee and non-employee directors. During 2002, effective January 1, 2002, Webster adopted the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation”, on a prospective basis, for all employee and non-employee stock options granted January 1, 2002 and thereafter. Prior to January 1, 2002, the provisions of APB No. 25 and related interpretations were applied for option grant accounting. Therefore, the cost related to this stock-based compensation included in the determination of net income for 2004 and 2003 is less than that which would have been recognized if the fair value based method had been applied to all option grants since the original effective date of SFAS No. 123. Awards under the plan, in general, vest over periods ranging from 3 to 4 years. Webster also grants restricted stock to senior management and directors.
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The following table illustrates the effect on net income and earnings per share if the fair value based method had been applied to stock option awards in each of the periods presented.
The fair value of each option is determined as of the grant date using the Black-Scholes Option-Pricing Model with the following weighted-average assumptions used for grants issued during the first quarter of 2004: expected option term of 6.8 years, expected dividend yield of 2.00%, expected volatility of 30.59%, expected forfeiture rate of 5.00%, and weighted risk-free interest rate of 3.26%. For the first quarter of 2003, the following weighted-average assumptions were: expected option term of 8.7 years, expected dividend yield of 2.15%, expected volatility of 31.75%, expected forfeiture rate of 4.46% and weighted risk-free interest rate of 3.97%. The Black-Scholes model was developed to estimate the fair value of traded options, which have different characteristics than employee stock options. In addition, changes to the subjective input assumptions can result in materially different fair market value estimates. Therefore, this model may not necessarily provide a reliable single measure of the fair value of employee stock options.
In addition, the cost of restricted stock granted is reflected in compensation and benefits expense and totaled $286,000 and $395,000, net of taxes, for the three months ended March 31, 2004 and 2003.
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NOTE 3: Purchase and Sale Transactions
The following purchase and sale transactions have been completed or are pending during 2004. The results of operations of the acquired companies are included in the Consolidated Statements of Income subsequent to the date of acquisition.
Completed Transactions
Phoenix National Trust CompanyOn December 18, 2003, Webster announced a definitive agreement to acquire Phoenix National Trust Company, (“Phoenix”), a wholly-owned subsidiary of the Phoenix Companies, Inc. The purchase was completed on March 31, 2004. Phoenix was merged into Webster Trust Company, N.A., a subsidiary of Webster Bank. Phoenix offers trust, custody and other financial services.
Duff & Phelps, LLC
Webster sold its majority interest in Duff & Phelps, LLC, the Chicago-based financial advisory services and investment banking firm, to a private partnership group. Webster will maintain a strategic alliance with Duff & Phelps, with preferred customer status. The sale was completed on March 15, 2004.
Pending Transactions
FIRSTFED AMERICA BANCORP, INC.
On October 7, 2003, a definitive agreement to acquire FIRSTFED AMERICA BANCORP, INC. (“FIRSTFED”), headquartered in Swansea, Massachusetts, the holding company of First Federal Savings Bank of America, was announced. The agreement is a combination of cash and stock transaction valued at approximately $465 million, or $24.50 per common share of FIRSTFED stock, payable 60% in Webster common stock and 40% in cash. FIRSTFED is a federally chartered thrift with $2.6 billion in assets as of December 31, 2003 and 26 branches; 19 in Massachusetts and 7 in Rhode Island. The merger is subject to customary closing conditions, including approval by regulatory authorities and is expected to close in the second quarter of 2004. Both the Office of the Comptroller of the Currency and the Federal Reserve Bank of Boston approved the transaction effective April 21, 2004. FIRSTFED shareholders approved the transaction on April 22, 2004. The remaining regulatory approval is that of the Massachusetts Board of Bank Incorporation.
On April 21, 2004, Webster completed the purchase of a banking branch with related deposits and loans from Hudson River Bank & Trust Company. The branch, located in Cohoes, New York, had deposit liabilities of approximately $11 million. The branch will be closed and merged with Webster’s Scarsdale, New York branch.
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NOTE 4: Securities
A summary of available for sale securities follows:
NOTE 5: Loans Held for Sale
Loans held for sale totaled $135.8 million and $89.8 million at March 31, 2004 and December 31, 2003, respectively. These balances consisted entirely of residential loans originated by Webster Bank.
At March 31, 2004 and December 31, 2003, residential mortgage origination commitments totaled $400.5 million and $166.7 million, respectively. Residential commitments outstanding at March 31, 2004 consisted of adjustable rate and fixed rate mortgages of $46.5 million and $354.0 million, respectively, at rates ranging from 3.4% to 7.8%. Residential commitments outstanding at December 31, 2003 consisted of adjustable rate and fixed rate mortgages of $24.0 million and $142.7 million, respectively, at rates ranging from 3.9% to 7.8%. Commitments to originate loans generally expire within 60 days. At March 31, 2004 and December 31, 2003, Webster also had outstanding commitments to sell residential mortgage loans of $325.0 million and $149.6 million, respectively.
At March 31, 2004 and December 31, 2003, Webster serviced, for the benefit of others, residential and commercial loans totaling approximately $699.6 million and $742.8 million, respectively.
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NOTE 6: Loans, Net
A summary of loans, net follows:
At March 31, 2004, loans, net included $11.2 million of net premiums and $29.3 million of net deferred costs. At December 31, 2003, loans, net included $255,000 of net premiums and $29.0 million of net deferred costs. The unadvanced portions of residential and commercial construction loans totaled $314.9 million and $70.7 million at March 31, 2004 and December 31, 2003, respectively.
At March 31, 2004 and December 31, 2003, unused portions of home equity credit lines extended were $1.1 billion and $1.2 billion, respectively. Unused commercial lines of credit, letters of credit, standby letters of credit, equipment financing commitments and outstanding commercial loan commitments totaled $1.9 billion at March 31, 2004 and $1.8 billion at December 31, 2003. Consumer loan commitments totaled $32.4 million and $14.2 million at March 31, 2004 and December 31, 2003, respectively.
Webster is a party to financial instruments with off-balance sheet risk to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and commitments to sell residential first mortgage loans and commercial loans. These instruments involve, to varying degrees, elements of credit and interest-rate risk in excess of the amount recognized in the Consolidated Statements of Condition. See Note 15 for further discussion.
The estimated fair value of commitments to extend credit is considered insignificant at March 31, 2004 and December 31, 2003. Future loan commitments represent residential and commercial mortgage loan commitments, commercial loan and equipment financing commitments, letters of credit and commercial and home equity unused credit lines. The interest rates for these loans are generally established shortly before closing. The interest rates on home equity lines of credit adjust with changes in the prime rate.
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A majority of the outstanding letters of credit are performance standby letters of credit within the scope of FASB Interpretation No. (“FIN”) 45. These are irrevocable undertakings by Webster, as guarantor, to make payments in the event a specified third party fails to perform under a nonfinancial contractual obligation. Most of the performance standby letters of credit arise in connection with lending relationships and have a term of one year or less.
The risk involved in issuing stand-by letters of credit is essentially the same as the credit risk involved in extending loan facilities to customers, and they are subject to the same credit origination, portfolio maintenance and management procedures in effect to monitor other credit and off-balance sheet products. At March 31, 2004, Webster’s standby letters of credit totaled $143.6 million. At March 31, 2004, the fair value of stand-by letters of credit is not material to the unaudited interim financial statements.
NOTE 7: Allowance for Loan Losses
The following table provides a summary of the activity in the allowance for loan losses:
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NOTE 8: Deferred Tax Asset, Net
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at March 31, 2004 and December 31, 2003 are summarized below. Temporary differences result from the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. A 100% valuation allowance has been applied to the State of Connecticut deferred tax assets due to uncertainties of realization.
Management believes that Webster will realize its net deferred tax asset, based upon its recent historical and anticipated future levels of pre-tax income. There can be no absolute assurance, however, that Webster will generate any specific level of future income.
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NOTE 9: Goodwill and Intangible Assets
The following tables set forth the carrying values of goodwill and intangible assets, net of accumulated amortization.
During the first quarter of 2004, Duff & Phelps, LLC was sold. The sale resulted in the reduction of $7.1 million of associated goodwill.
No identified intangible assets were added during the first quarter of 2004.
Changes in the carrying amount of goodwill for the three months ended March 31, 2004 are as follows:
*Includes insurance operations
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Amortization of intangible assets for the three months ended March 31, 2004, totaled $4.1 million. Estimated annual amortization expense of current intangible assets with finite useful lives, absent any impairment or change in estimated useful lives, is summarized below.
NOTE 10: Deposits
The following table summarizes the composition of deposits.
Interest expense on deposits is summarized as follows:
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NOTE 11: Federal Home Loan Bank Advances
Advances payable to the Federal Home Loan Bank (“FHLB”) are summarized as follows:
Webster Bank had additional borrowing capacity of approximately $680.9 million from the FHLB at March 31, 2004 and $140.6 million at December 31, 2003. Advances are secured by a blanket security agreement against certain qualifying assets, principally residential mortgage loans and securities. At March 31, 2004 and December 31, 2003, investment securities were not fully utilized as collateral. If all securities had been used for collateral, borrowing capacity at March 31, 2004 and December 31, 2003 would have been increased by an additional $1.7 billion and $1.8 billion, respectively. At March 31, 2004 the Bank was in compliance with the FHLB collateral requirements.
Total callable FHLB advances at March 31, 2004 were $242.0 million, a decline from $642.0 million at December 31, 2003. During the first quarter of 2004, Webster Bank purchased the call option from the FHLB, restructuring the callable advances into non-callable.
As of March 31, 2004, $1.0 billion of fixed rate advances were converted to floating rate through the use of interest rate swaps. See Note 15 of Notes to Consolidated Interim Financial Statements for further information.
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NOTE 12: Federal Funds Purchased and Securities Sold Under Agreement to Repurchase
The following table summarizes balances for other borrowings:
The following table sets forth certain information concerning short-term borrowings.
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NOTE 13: Shareholders’ Equity
Applicable regulations of the Office of Thrift Supervision (“OTS”) require federal savings banks to satisfy certain minimum capital requirements, including a leverage capital requirement (expressed as a ratio of core or Tier 1 capital to adjusted total assets) and risk-based capital requirements (expressed as a ratio of core or Tier 1 capital and total capital to total risk-weighted assets). OTS regulated institutions are also subject to a minimum tangible capital requirement (expressed as a ratio of tangible capital to adjusted total assets). At March 31, 2004, Webster Bank exceeded all OTS regulatory capital requirements and met the requirements for a “well capitalized” institution.
The following table provides information on the capital ratios.
On April 21, 2004, Webster Bank completed its conversion from a federal savings bank to a national bank charter, regulated by the Office of the Comptroller of the Currency. As part of that conversion Webster Trust Company, N.A. was merged into Webster Bank. Webster is now a bank holding company, regulated by the Board of Governors of the Federal Reserve System. Webster and Webster Bank, respectively, will be subject to capital requirements similar to those applicable to the Bank at March 31, 2004 as a federal savings bank. At March 31, 2004, giving effect to the conversion, Webster Bank and Webster would have capital in excess of applicable requirements and would be considered well capitalized.
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NOTE 14: Business Segments
Webster has three segments for purposes of reporting business line results. These segments include Retail Banking, Commercial Banking and Wealth and Investment Services. The balance of the activity is reflected in Corporate. The methodologies and organizational hierarchies that define the business segments are periodically reviewed and revised. The first quarter 2003 results have been restated, to reflect changes in the methodologies adopted and reflected in the results for the first quarter, 2004. The following table presents the statement of income and total assets for Webster’s reportable segments.
Three months ended March 31, 2004
Three months ended March 31, 2003
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The Retail Banking segment includes insurance services, small business lending, consumer lending and deposit generation and direct banking activities, which include the operation of automated teller machines and telebanking customer support and sales. The Retail Banking segment also includes the residential real estate lending, loan servicing and secondary marketing activities. The growth in net interest income compared to a year ago can be attributed to the increases in consumer loans and lower cost deposits. Increase in deposit services fees from the growth in deposits as a result of the High Performance Checking product has improved the level of noninterest income for 2004.
The Commercial Banking segment includes middle market, specialized, equipment financing, asset-based and commercial real estate lending, deposit and cash management activities and financial advisory services. The results for 2004 reflect the growth in equipment financing, middle market and commercial real estate loans, which was a primary reason for the 23% increase in net interest income from the 2003 period. Noninterest income declined chiefly due to the sale of Duff & Phelps in March 2004.
Wealth and Investment Services includes Webster Financial Advisors, Webster Trust Company, N.A., Webster Investment Services and Fleming, Perry and Cox, which combine to provide comprehensive wealth management services for individuals and institutions. Its primary sources of revenue are fees from trust management activities and investment product sales. Additional fee revenues and expense control improved the results in the 2004 period as compared to the 2003 period.
Corporate includes the Treasury unit, which is responsible for managing the wholesale investment portfolio and funding needs. It also includes expenses not allocated to the business lines, the residual impact of methodology allocations such as the provision for loan losses and funds transfer pricing offsets. The decrease for the current year’s net income was chiefly due to a declining wholesale interest-rate spread. The yield on wholesale assets for the first quarter of 2004 declined 83 basis points from the same quarter a year earlier while wholesale borrowing costs declined only 34 basis points.
Management uses certain methodologies to allocate income and expenses to the business lines. Funds transfer pricing assigns interest income and interest expense to each line of business on a matched maturity funding concept based on each business’s assets and liabilities. The provision for loan losses is allocated to business lines on an “expected loss” basis. Expected loss is an estimate of the average loss rate that individual credits will experience over an economic cycle, based on historical loss experiences and the grading assigned each loan. This economic cycle methodology differs from that used to determine our consolidated provision for loan losses, which is based on an evaluation of the adequacy of the allowance for loan losses considering the risk characteristics in the portfolio at a point in time. The difference between the sum of the provisions for each line of business determined using the expected loss methodology and the consolidated provision is included in Corporate. Indirect expenses are allocated to segments. These expenses include administration, finance, technology and processing operations and other support functions. Taxes are allocated to each segment based on the effective rate for the period shown.
NOTE 15: Derivative Financial Instruments
At March 31, 2004, Webster had outstanding interest rate swaps with a notional amount of $1.3 billion. These swaps are to hedge FHLB advances and subordinated debt and qualify for fair value hedge accounting under SFAS No. 133. The swaps are used to transform FHLB advances, repurchase agreements and subordinated debt from fixed to floating rate. Of the total, $350 million of the interest rate swaps mature in 2004, $100 million in 2005, $50 million in 2006, $500 million in 2007, $103 million in 2008 and $200 million in 2013 and an equivalent amount of the hedged debt matures on these dates.
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Webster has outstanding interest swaps with a notional amount of $72.5 million against the cost of brokered deposits. The swaps transform the fixed rate deposits to floating rate and mature $31.5 million in 2006 and $41.0 million in 2008.
Webster Bank transacts certain derivative products with its customer base. These customer derivatives are offset with matching derivatives with other counterparties in order to minimize the risk. Exposure with respect to these derivatives is largely limited to nonperformance by either of the parties in the transaction – the customer or the other counterparty. The notional amount of customer derivatives and the offsetting counterparty derivatives each totaled $124.1 million at March 31, 2004. The customer derivatives and the offsetting matching derivatives are marked to market and any difference is reflected in noninterest income.
Certain derivative instruments, primarily forward sales of mortgage-backed securities (“MBSs”), are utilized by Webster Bank in its efforts to manage risk of loss associated with its mortgage loan commitments and mortgage loans held for sale. Prior to the closing and funds disbursement on a single-family residential mortgage loan, an interest-rate locked commitment is generally extended to the borrower. During such time, the Bank is subject to risk that market rates of interest may change. If market rates rise, investors generally will pay less to purchase such loans resulting in a reduction in the gain on sale of the loans or, possibly, a loss. In an effort to mitigate such risk, forward delivery sales commitments, which agree to deliver whole mortgage loans to various investors or issue MBSs, are established. At March 31, 2004, outstanding rate locks totaled approximately $276.4 million and the residential mortgage held for sale portfolio totaled $135.8 million. Forward sales, which include mandatory forward commitments of approximately $254.0 million and best efforts forward commitments of approximately $71.0 million at March 31, 2004, establish the price to be received upon the sale of the related mortgage loan, thereby mitigating certain interest rate risk. The Bank will still have certain execution risk, that is, risk related to its ability to close and deliver to its investors the mortgage loans it has committed to sell. The derivative activities associated with loans held for sale qualify as a fair value hedge under SFAS No. 133. A highly effective relationship has been established between loans held for sale and certain forward sales commitments.
The interest rate locked loan commitments are recorded at fair value, with changes in fair value recorded in current period earnings. To the extent that loans held for sale are not allocated to the previously discussed forward sales commitments, the changes in the fair value of the forward sales commitments are also recorded to current period earnings. The value of the interest rate locked commitments and forward sales commitments will be adjusted monthly based upon market interest rates and the level of locked loan commitments and unallocated forward sales commitments. Generally, the value of the locked loan commitment will increase in a falling rate environment and decrease in a rising interest rate environment. The opposite is true for the forward loan sale commitment. The goal is to offset the change in the market value of the locked loan commitments with the change in the market value of the forward loan sales commitments.
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NOTE 16: Pension and Other Benefits
The following table provides information regarding net benefit costs for the periods shown.
Webster plans to contribute at least an amount equal to the greater of the contribution required to meet the minimum funding standards under IRC Section 412 (estimated at $0 for 2004), or the amount necessary to avoid an additional minimum liability as defined in SFAS No. 87 and No. 132. Additional contributions will be made as deemed appropriate by management in conjunction with the plans actuaries. For 2004, the preliminary estimated contribution ranges from $7.0 million to $9.0 million. As of March 31, 2004, no contribution has been made.
NOTE 17: Subsequent Events
On April 21, 2004, Webster Bank completed its conversion from a federal savings bank to a national bank charter, regulated by the Office of the Comptroller of the Currency. As part of that conversion Webster Trust Company, N.A. was merged into Webster Bank. Webster is now a bank holding company, regulated by the Board of Governors of the Federal Reserve System. Webster and Webster Bank, respectively, will be subject to capital requirements similar to those applicable to the Bank at March 31, 2004 as a federal savings bank. At March 31, 2004, giving effect to the conversion, Webster Bank and Webster would have capital in excess of applicable requirements and would be considered well capitalized. As a commercial bank, Webster Bank will be able to grow its commercial lending portfolio beyond the statutory limitations imposed on thrift institutions.
On April 7, 2004, Webster issued $150 million of senior notes. The notes, which are not redeemable prior to April 15, 2014, have a fixed coupon of 5.125% and were priced to yield 5.187% at issuance. The notes have been rated investment grade by Moody’s, Standard & Poor’s and Fitch. The net proceeds will be used to partially fund the cash portion of the purchase price of the pending acquisition of FIRSTFED.
As part of the announcement on October 7, 2003 of the acquisition of FIRSTFED, plans to deleverage the combined institution by $1.5 billion were announced. These original projections included a combination of investment portfolio reductions, loans sales and/or loan securitizations in order to achieve the $1.5 billion reduction. However, present plans call for only a $750 million deleveraging to be achieved through investment portfolio sales. The updated plans continued to accomplish Webster’s goals of improving the company’s funding mix, assisting in the transformation to a commercial bank balance sheet and maintaining an appropriate level of regulatory capital.
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NOTE 18: Recent Accounting Pronouncements
In March 2004, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments (“SAB 105”), which provides guidance about the measurement of loan commitments required to be accounted for as derivative instruments and recognized at fair value under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities. SAB 105 also requires companies to disclose their accounting policy for those loan commitments including methods and assumptions used to estimate fair value and associated hedging strategies. SAB 105 is effective for all loan commitments accounted for as derivatives that are entered into after March 31, 2004. Webster’s current policies are consistent with the guidance issued in SAB 105.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward Looking Statements
This report contains forward-looking statements within the meaning of the Securities and Exchange Act of 1934, as amended. Actual results could differ materially from management expectations, projections and estimates. Factors that could cause future results to vary from current management expectations include, but are not limited to, general economic conditions, legislative and regulatory changes, monetary and fiscal policies of the federal government, changes in tax policies, rates and regulations of federal, state and local tax authorities, changes in interest rates, deposit flows, the cost of funds, demand for loan products, demand for financial services, competition, changes in the quality or composition of Webster’s loan and investment portfolios, changes in accounting principles, policies or guidelines, and other economic, competitive, governmental and technological factors affecting Webster’s operations, markets, products, services and prices. Some of these and other factors are discussed in Webster’s annual and quarterly reports previously filed with the Securities and Exchange Commission. Such developments could have an adverse impact on Webster’s financial position and results of operations.
Summary
Results for the first quarter of 2004 were largely influenced by the path of interest rates during the quarter and their effect on mortgage related activity (securities, lending and mortgage originations).
Overall mortgage related income volatility was exacerbated by the dramatic shifts in interest rates during the quarter. We look at overall mortgage related income volatility as a combination of several items. First is the reduction to net interest income caused by the acceleration in premium amortization on mortgage backed securities due to the higher level of prepayments in this low interest rate environment. The premium exposure in the portfolio is down to $15 million from $40 million a year ago. Second is the impact of SFAS 91 net loan cost reversals due to prepayments on residential mortgages and home equity loans and lines. Third is the mortgage service rights valuation changes, which was a net expense in the current quarter. These three factors are offset by prepayment fees collected on consumer loans and gains on sale of loans and loan servicing in our national wholesale mortgage origination business.
On a combined basis these mortgage related items negatively impacted pretax income by $3.2 million in the quarter, or about five cents per share after tax, which was slightly more negative than in the previous quarter. The goal is that over time our national wholesale business will provide a balanced hedge against mortgage related volatility. To offset the first quarter shortfall, we took gains on sale of mortgage backed securities, which rose in price as rates fell. Based on the recent convincing upward movement in interest rates we expect that the negative collective earnings impact from these mortgage related items should recede in future quarters.
General – Description of Business
Webster Financial Corporation (“Webster” or the “Company”), through its subsidiaries, Webster Bank, Webster Insurance, Inc. (“Webster Insurance”), and Fleming, Perry & Cox (“Fleming”), delivers financial services to individuals, families and businesses primarily in Connecticut and equipment financing, asset-based lending, mortgage origination and financial advisory services to public and private companies throughout the United States. The Bank provides business and consumer banking, mortgage origination and lending, trust and investment services and insurance services through 119 banking and other offices, 233 ATM’s and its Internet website (www.websteronline.com). The Bank was founded in 1935 and converted from a federal mutual to a federal stock institution in 1986. Since October 17, 2002, Webster’s common stock has traded on the New York Stock Exchange under the symbol of “WBS”. Prior to that date, Webster’s common stock traded on the NASDAQ under the symbol of “WBST”. Webster’s financial reports can be accessed through its website within 24 hours of filing with the SEC.
On April 21, 2004, Webster Bank completed its conversion from a federal savings bank to a national bank, regulated by the Office of the Comptroller of the Currency. As part of that conversion, Webster is also a bank holding company,
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regulated by the Board of Governors of the Federal Reserve System. The Bank and Webster, respectively, will be subject to capital requirements similar to those applicable to the Bank at March 31, 2004 as a federal savings bank. At March 31, 2004, giving effect to the conversion, the Bank and Webster would have capital in excess of applicable requirements.
Critical Accounting Policies
Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. Management believes that our most critical accounting policies, which involve the most complex or subjective decisions or assessments, are as follows:
Allowance for Loan Losses
Arriving at an appropriate level of allowance for loan losses involves a high degree of judgment. The allowance for loan losses provides for probable losses based upon evaluations of known and inherent risks in the loan portfolio. To assess the adequacy of the allowance, management uses historical information as well as the prevailing business environment, as it is affected by changing economic conditions and various external factors, which may impact the portfolio in ways currently unforeseen. The allowance is increased by provisions for loan losses and by recoveries of loans previously charged-off and reduced by loans charged-off. For a full discussion of the methodology of assessing the adequacy of the allowance for loan losses, see the “Allowance for Loan Losses” section within Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2003 Annual Report on Form 10-K.
Valuation of Goodwill/Intangible Assets and Analysis for Impairment
Webster, in part, has increased its market share through acquisitions accounted for under the business combinations method of accounting, as well as from the purchase of other financial institution’s branches and selected assets (not entire institution). Acquisitions under the purchase method require that assets acquired and liabilities assumed be recorded at their fair value which is an estimate determined by the use of internal or other valuation techniques. These valuation estimates result in the creation of goodwill and other intangible assets resulting from the excess purchase price paid over the fair value of assets acquired. Goodwill is subject to ongoing periodic impairment tests and is evaluated using various fair value techniques including multiples of price/equity and price/earnings ratios. For a discussion of impairment testing methodology, see Note 9 of Notes to Consolidated Financial Statements included in Webster’s 2003 Annual Report on Form 10-K.
Deferred Income Taxes
Certain aspects of income tax accounting require management judgment, including determining the expected realization of deferred tax assets and liabilities, for inclusion in its Consolidated Statements of Condition. Such judgments are subjective and involve estimates and assumptions about matters that are inherently uncertain. Should actual factors and conditions differ materially from those used by management, the actual realization of the net deferred tax assets or liabilities could differ materially from that recorded in the financial statements. Valuation allowances are established against those deferred tax assets determined not likely to be realized (a full valuation allowance has been established for the Connecticut portion of the net deferred tax assets).
Pension and Other Postretirement Benefits
The determination of the obligation and expense for pension and other postretirement benefits is dependent upon certain assumptions used in calculating such amounts. Key assumptions used in the actuarial valuations include the discount rate, expected long-term rate of return on plan assets and rates of increase in compensation and health care costs. Actual results could differ from the assumptions and market driven rates may fluctuate. Significant differences in actual experience or significant changes in the assumptions may materially affect the future pension and other postretirement obligations and expense. See Note 18 of Notes to Consolidated Financial Statements in Webster’s 2003 Annual Report on Form 10-K for further information.
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Financial Condition
Webster’s total assets grew by $521.6 million or 3.6% during the first quarter period with total assets reaching $15.1 billion. The increase was primarily due to increases in loans of $318.0 million, securities of $132.3 million, loans held sale of $45.9 million and other assets of $48.9 million. These increases were partially offset by a decrease of $20.3 million in short-term investments. The increase in loans was due primarily to growth in residential mortgage loans of $228.1 million, commercial loans of $60.3 million and home equity loans of $24.9 million. Total securities increased $132.3 million with the growth occurring primarily in available for sale securities.
Total liabilities rose $462.5 million, or 3.4%, for the current period. The increase in total liabilities is primarily due to deposit growth of $265.9 million and total borrowings increasing $184.1 million. The growth in total deposits is the result of increases in NOW accounts of 4.4%, regular savings accounts of 1.2% and money market deposit accounts of 12.5% while certificates of deposit remained relatively unchanged. The increase in borrowings reflects a higher level of treasury tax and loan deposits for the current quarter period that were partially offset by lower FHLB advances and repurchase agreements.
The net increase in total equity of $59.1 million is primarily due to net income of $42.3 million and a favorable change in net unrealized gains on available for sale securities of $22.6 million for the current period. These changes were partially offset by $9.3 million in common stock dividend payments.
Lending Activities
Webster originates various types of residential, commercial and consumer loans. At March 31, 2004 and December 31, 2003, total loans were $9.5 billion and $9.2 billion, respectively. The Bank offers commercial and residential permanent and construction mortgage loans, commercial and industrial loans including asset-based loans, equipment financing loans and secured and unsecured loans to middle market, small business and consumer loans including home equity lines of credit and home equity loans. At March 31, 2004 and December 31, 2003, residential loans represented 42% and 41% of Webster’s loan portfolio and commercial loans (including commercial real estate) represented 36% and 37%, respectively. The remaining portion of the loan portfolios consisted of consumer loans. Refer to Webster’s 2003 Annual Report on Form 10-K, pages 4 through 10, for a more complete description of the Webster’s lending activities and credit administration policies and procedures.
Residential Mortgage Loans and Mortgage Banking Activity
Webster is dedicated to providing a full complement of residential mortgage loan products that meet the financial needs of its customers. For the three months ending March 31, 2004 and 2003, originated residential mortgage loans totaled $419.0 million and $975.0 million, respectively. As interest rates rose during the end of 2003, originations volume slowed. During the first quarter of 2004, interest rates fell and application activity increased from the previous quarter, which will impact the second quarter volume. Webster’s channels for the origination of these loans include its network of branches, referrals, loan officers, call center, as well as its National Wholesale Lending Group through third party licensed mortgage brokers in targeted areas of the United States. A majority of all this originated loan volume, including servicing, is sold in the secondary market. Webster sells these residential mortgage loans in a manner consistent with its asset/liability management objectives. At March 31, 2004 and December 31, 2003, there were $135.8 million and $89.8 million, respectively, of residential mortgage loans held for sale. See Notes 5 and 6 of Notes to Consolidated Interim Financial Statements within this report for further information.
The residential mortgage loan portfolio totaled $4.0 billion and $3.7 billion at March 31, 2004 and December 31, 2003, respectively. At March 31, 2004, approximately $1.1 million, or 26%, of the total residential mortgage loan portfolio were adjustable rate loans. Adjustable rate mortgage loans are offered at initial interest rates discounted from the fully-indexed rate. Adjustable rate loans originated during 2004 and 2003, when fully-indexed, will be 2.75% above the constant maturity one-year U.S. Treasury yield index. At March 31, 2004, approximately $2.9 billion, or 74% of the total residential mortgage loan portfolio was fixed rate.
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Commercial Lending
The following is a discussion of commercial loans by each of Webster’s commercial lending divisions.
Middle Market
The Middle Market Division provides a full array of financial services to a diversified group of companies, primarily privately held and located in Connecticut, with annual revenues greater than $10 million. At March 31, 2004 and December 31, 2003, Middle Market loans, including commercial and owner-occupied commercial real estate, totaled $748.6 million and $701.1 million, respectively, an increase of 6.8%. The increase resulted from a combination of increased utilization of lines of credit and newly developed relationships. Originations for the first three months of 2004 and 2003 totaled $47.2 million and $65.1 million, for each period.
Asset-Based Lending
Webster Business Credit Corporation (“WBCC”), the asset-based lending subsidiary, was previously named Whitehall Business Credit Corporation and changed its name effective January 5, 2004. Asset-based loans are generally secured by accounts receivable and inventory of the borrower and, in some cases, also include additional collateral such as property and equipment. At March 31, 2004, total asset-based loans were $539.3 million, an increase of 2.4% over the $526.9 million at December 31, 2003. WBCC directly originates loans for its portfolio and sells participations to other financial institutions. In addition, it participates in loans originated by other banks and financial institutions. In its direct originations, it generally establishes depository relationships with the borrower through cash management accounts. At March 31, 2004 and December 31, 2003, the total of these deposits was $30.5 million and $26.4 million, respectively. During the first quarter of 2004, WBCC funded $37.0 million against new commitments of $121.1 million compared to funding of $41.0 million and new commitments of $91.4 for same period for 2003.
Specialized Lending
Webster participated in the syndicated loan market through a diversified portfolio of loans, which represent transactions with large national borrowers whose businesses command significant market share and help to diversify Webster’s overall portfolio. These loans generally consist of participations in revolving lines of credit and term loans with maturities up to 7 years. Webster entered this market as a means of providing geographic and industry diversification to the commercial loan portfolio.
At March 31, 2004 and December 31, 2003, the Specialized Lending Division administered $158.0 million and $173.3 million of funded loans against commitments of $297.5 million and $323.9 million, respectively. This reduction is in accordance with Webster’s strategic plan. Additionally, the portfolio contained $84.2 million and $84.6 million of funded Collateralized Loan Obligations (“CLOs”) against commitments of $91.7 million at both March 31, 2004 and December 31, 2003. All of these CLOs carry an investment grade rating by at least one of the independent rating agencies.
Small Business Banking
Webster’s Small Business Banking Division (“SBB”) provides a full array of commercial loan and deposit products to small businesses located throughout Connecticut. The target market reaches businesses with annual revenues of up to $10 million – providing commercial loan products with relationship exposures of up to $2 million, and the breadth of Webster’s business deposit products. This market segment represents a significant percentage of commercial businesses located within the boundaries of Connecticut. A dedicated group of business bankers, as well as through the branch network, provide a full range of financial products and services to existing customers as well as potential new customers. SBB also plays a major role in supporting the Community Reinvestment Act goals by providing credit facilities to a wide range of small businesses, including many local not-for-profit organizations. A Fair Isaac-based credit scoring model is utilized in whole or in part, for approvals of up to $250,000 and offers a $100,000 same-day decisioned unsecured line of credit products. A comprehensive set of commercial loan products are offered, including lines of credit, letters of credit, term loans and commercial mortgages loans on owner-occupied and investment real estate. SBB utilizes an automated “early warning” system to aid in the identification of potential portfolio or customer-level credit quality issues. Implemented in the fourth quarter of 2003, a Risk Management tool is utilized in ongoing efforts to monitor and anticipate portfolio performance. Through recent expansion efforts and focused training, SBB serves as a referral source
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for other Bank products including cash management, insurance, international products and investments. Webster also offers Small Business Administration (“SBA”) guaranteed loans under its Preferred Lender Program status. As of March 31, 2004 (the second quarter for the SBA), Webster Bank ranked third in Connecticut among SBA lenders with 41 loans totaling $5.8 million. Webster also ranked second in the state for SBA 504 program with 5 loans totaling $3.0 million. Customers may also take advantage of several loan programs provided through the Connecticut Development Authority.
The portfolio totaled approximately $392.1 million at March 31, 2004, a 2.4% increase from $382.9 million at December 31, 2003. The portfolio balance increased 20.3% from $325.8 million at March 31, 2003. This improving trend continued for the ninth consecutive quarter due principally to improved retention efforts and more focused calling activity. Included in the portfolio at March 31, 2004 is $210.9 million of loans secured by commercial real estate. Originations totaled $54.2 million for the first quarter of 2004, a 39.3% increase compared to the same period 2003 of $38.9 million.
An objective of the strategic plan is to also focus on deposit growth as part of the overall customer relationship. A variety of innovative small business deposit products and marketing programs has been developed to meet depositors’ needs and attract both short-term and long-term deposits. At March 31, 2004, small business deposit balances totaled $960 million, up from $844 million a year earlier, an increase of 14%.
Equipment Financing
Center Capital Corporation (“Center Capital”), a nationwide equipment financing subsidiary, transacts loan business with end-users of equipment, either by soliciting this business on a direct basis or through referrals from various manufacturers, dealers and distributors with whom they have business relationships. The portfolio totaled $527.0 million at March 31, 2004 compared with $506.3 million at December 31, 2003, an increase of 4.1%. Center Capital originated $66.4 million in loans during the first quarter of 2004, compared to $55.8 million during the same period a year ago.
Insurance Premium Financing
On January 24, 2003, Budget Installment Corp. (“BIC”), an insurance premium financing company based in Rockville Centre, New York, which finances commercial property and casualty premiums for businesses that pay their insurance premiums on an installment basis, was acquired. The majority of its borrowers are located in the Long Island, New York City and Northern New Jersey areas. At March 31, 2004, total loans outstanding were $63.5 million compared to $61.4 million at December 31, an increase of 3.4%. Loans originated for the first quarter of 2004, totaled $43.9 million compared to $21.1 million for the same period in 2003.
Commercial Real Estate Lending
Webster provides financing for the purpose of acquiring, developing, constructing, improving or refinancing commercial real estate where the property is the primary collateral securing the loan and the income which is produced from the property and its tenants is the primary repayment source. It also makes acquisition, development and construction loans to residential builders. At March 31, 2004 and December 31, 2003, outstanding commercial real estate loans totaled $1.3 billion for each period. Included in these loans are owner-occupied loans originated by the Middle Market and Small Business Banking Divisions of $411.5 million and $395.6 million at March 31, 2004 and December 31, 2003, respectively.
Cultivating relationships with high quality local, regional and national developers, both directly and through loan participations with selected banks outside its primary market, has been the unit’s goal as it seeks to maintain a core group of borrowers for repeat business, for cross selling opportunities, and to diversify its portfolio by geographic location. During the first quarter of 2004, Webster originated $90.4 million of commercial real estate loans, an increase of $27.4 million, or 43.5%, from the three month period a year earlier.
Consumer Lending
At March 31, 2004 and December 31, 2003, consumer loans totaled $2.2 billion and $2.1 billion, respectively. Consumer loans outstanding increased significantly in 2003 and, at December 31, 2003 represented 23.6% of the total loan portfolio. This growth in balances continued during the first three months of 2004, as loans grew $22.7 million, or 1.1%, to $2.2 billion. The growth occurred in home equity loans and is attributable to the lower interest rate environment and
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the expansion of lending into states contiguous to Connecticut and other targeted states using the National Wholesale Mortgage network of regional offices as a distribution channel. Originations during the first quarter of 2004 totaled $188.8 million compared to $328.9 million for the same period a year earlier.
Investment Activities
Webster maintains an investment portfolio that is primarily structured to provide a source of liquidity for its operating needs, to generate interest income and provide a means to balance interest rate sensitivity. At March 31, 2004 and December 31, 2003, the investment portfolio totaled $4.4 billion and $4.3 billion, respectively. At both March 31, 2004 and December 31, 2003, the portfolio consisted primarily of mortgage-backed securities. See Note 4 of Notes to Consolidated Interim Financial Statements for details on the components of the portfolio.
The portfolio is managed by the Treasury Group in accordance with regulatory guidelines and established corporate investment policies. These guidelines and policies include limitations on aspects such as investment grade and ratings, concentrations and investment type to help manage risk associated with investing in securities.
Deposit Activities
Total deposits increased $265.9 million, or 3.2%, to $8.6 billion at March 31, 2004 from December 31, 2003 and $854.3 million or 11.0% from March 31, 2003. The increases primarily occurred in core deposits, which consist of interest-bearing and noninterest bearing demand deposits, savings accounts and money market deposit accounts. These changes reflect the success of Webster’s strategic plan, which calls for increasing core deposits as a percentage of total deposits. The percentage of core deposits increased to 67.7% at March 31, 2004 up from 66.8% at December 31, 2003 and from 66.4% at March 31 a year ago. The growth in the first three months of 2004 can be attributed to the continued success with High Performance Checking products, (for Consumer and Small Business customers), de novo branch activity and the Bank’s marketing efforts. See Note 10 of Notes to Consolidated Interim Financial Statements for additional information.
Borrowed Funds
Total borrowed funds increased $184.1 million, or 3.7%, to $5.1 billion at March 31, 2004 from December 31, 2003. Wholesale borrowings increased to fund the growth in the loan and investment portfolios. See Notes 11 and 12 of Notes to Consolidated Interim Financial Statements for additional information.
Asset/Liability Management and Market Risk
Interest rate risk is the sensitivity of the market value of interest-sensitive assets and liabilities and the sensitivity of earnings to changes in interest rates over short-term and long-term time horizons. The Asset/Liability Management Committee manages interest rate risk to maximize net income and net market value over time in changing interest rate environments, within limits set by the Board of Directors. Management measures interest rate risk using simulation analyses to measure earnings and equity at risk. Earnings at risk is defined as the change in earnings from a base scenario due to changes in interest rates. Equity at risk is defined as the change in the net economic value of assets and liabilities due to changes in interest rates compared to a base net economic value. Economic value is measured as the net present value of future cash flows. Simulation analysis incorporates assumptions about balance sheet changes such as asset and liability growth, loan and deposit pricing and changes to the mix of assets and liabilities. Key assumptions relate to the behavior of interest rates and spreads, prepayment speeds and the run-off of deposits. From such simulations, interest rate risk is quantified and appropriate strategies are formulated and implemented.
Interest rate risk simulation analyses cannot precisely measure the impact that higher or lower rate environments will have on net interest income or market value. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes, changes in cash flow patterns and market conditions, as well as changes in management’s strategies. Results may also vary based upon actual customer loans and deposit behaviors as compared with those simulated. These simulated estimates assume that management does not take any action to mitigate any
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negative effects from changing interest rates. Management believes that Webster’s interest rate risk position at March 31, 2004 represents a reasonable level of risk.
The following table summarizes the estimated economic value of assets, liabilities and hedges at March 31, 2004 and December 31, 2003 and the projected change to economic values if interest rates instantaneously increase or decrease by 100 basis points.
The book value of assets exceeded the estimated economic value at March 31, 2004 and December 31, 2003 because the equity at risk model assigns no value to goodwill and other intangible assets, which totaled $322.5 million and $330.9 million, respectively.
As noted in the table above, the estimated volatility in economic value of equity has not changed significantly from year end. The yield curve fell 25-50 basis points between December 31, 2003 and March 31, 2004 which shortened the duration of assets by 0.2 years. The decline in liability duration was due mainly to a change in the average life assumptions for core deposits. In 2004, management began to compare changes in estimated economic value with base net economic value instead of Tier 1 Capital when calculating equity at risk. Changing this factor had no impact on the measured change in net economic value but did modestly reduce the net change measurement as a percentage of the now larger denominator. The percentage measurement is now more consistent with industry practice.
The estimated impact on Webster’s net income as of March 31, 2004, for the subsequent twelve month period, if interest rates increase or decrease by 100 basis points gradually was an increase of 0.5% and a decrease of 1.2%, respectively. The estimated impact, as of December 31, 2003, for an instantaneous 100 basis point change was a decrease of 1.5% and a decrease of 0.1%, respectively. Measuring earnings at risk using graduated rate changes instead of rate shocks are more realistic and, therefore, are more useful in measuring and managing risk.
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We expect interest rates to rise throughout 2004 and are positioned to benefit from this expectation while staying prepared to respond to changing conditions.
Liquidity and Capital Resources
Liquidity management allows Webster to meet its cash needs at a reasonable cost under various operating environments. Liquidity is actively managed and reviewed in order to maintain stable, cost-effective funding to support the balance sheet. Liquidity comes from a variety of sources such as the cash flow from operating activities including principal and interest payments on loans and investments, unpledged securities, which can be sold or utilized as collateral to secure funding and by the ability to attract new deposits. Webster’s goal is to maintain a strong increasing base of core deposits to support its growing balance sheet.
Management monitors current and projected cash needs and adjusts liquidity as necessary. Webster has a detailed liquidity contingency plan, which is designed to respond to liquidity concerns in a prompt and comprehensive manner. It is designed to provide early detection of potential problems and details specific actions required to address liquidity risks.
At March 31, 2004 and December 31, 2003, FHLB advances outstanding totaled $2.4 billion and $2.5 billion. Webster Bank is a member of the FHLB system and had additional borrowing capacity from the FHLB of approximately $680.9 million at March 31, 2004. In addition, unpledged securities could have been used to increase borrowing capacity at the FHLB by an additional $1.7 billion or used to collateralize other borrowings such as repurchase agreements.
The main sources of liquidity at the holding company level are dividends from Webster Bank, investment income and net proceeds from capital offerings and borrowings. The main uses of liquidity are the payment of dividends to common stockholders, repurchases of common stock, purchases of investment securities, and the payment of interest on borrowings and capital securities. There are certain regulatory restrictions on the payment of dividends by Webster Bank to Webster. At March 31, 2004, $138.1 million of retained earnings were available for dividend to the holding company. Webster also maintains $75.0 million in available revolving lines of credit with correspondent banks.
On July 23, 2002, Webster announced an additional stock buyback program of 2.4 million shares, or approximately 5 percent of its 48.0 million shares of outstanding common stock as of the announcement date. Through March 31, 2004, Webster has repurchased 1,862,541 shares of its common stock under the buyback program with 537,459 remaining shares to be repurchased. During the first quarter of 2004, 51,671 shares were repurchased at a total cost of $2.4 million, for an average per share cost of $47.19. Of the total shares repurchased for the first quarter period, 7,964 were repurchased specifically under the July 23, 2002 program.
Asset Quality
Loan Portfolio Review and Allowance for Loan Loss Methodology
Webster devotes significant attention to maintaining asset quality through conservative underwriting standards, active servicing of loans and aggressively managing nonperforming assets. The allowance for loan losses is maintained at a level estimated by management to provide adequately for probable losses inherent in the current loan portfolio. Probable losses are estimated based upon a quarterly review of the loan portfolio, loss experience, specific problem loans, economic conditions and other pertinent factors which, in management’s judgment, deserve current recognition in estimating loan losses. In assessing the specific risks inherent in the portfolio, management takes into consideration the risk of loss on nonperforming loans and classified loans, including an analysis of the collateral for these loans.
The adequacy of the allowance is subject to judgment in its determination. Actual loan losses could differ materially from management’s estimate if actual loss factors and conditions differ significantly from the assumptions utilized.
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These factors and conditions include the general economic conditions within Connecticut and nationally, trends within industries where the loan portfolio is concentrated, real estate values, interest rates and the financial condition of individual borrowers. While management believes the allowance for loan losses is adequate at March 31, 2004, actual results in future periods may prove different and these differences could be significant. Management considers the adequacy of the allowance for loan losses to be a critical accounting policy.
Refer to the Allowance for Loan Losses Methodology section within Management’s Discussion and Analysis on pages 34 through 36 of Webster’s 2003 Annual Report on Form 10-K for additional information.
Nonperforming Assets
The amount of nonperforming assets decreased to $41.3 million, or 0.27% of total assets, at March 31, 2004 from $42.9 million, or 0.29% of total assets, at December 31, 2003 and from $61.9 million, or 0.43% of total assets, at March 31, 2003. During 2004, nonperforming assets declined $1.6 million. Commercial nonperforming loans decreased by $3.9 million in the first quarter but this decrease was offset by increases in nonperforming Residential and Commercial Real Estate loans which increased by $4.1 million.
The decline in nonperforming assets at March 31, 2004 from a year earlier occurred primarily in the commercial lending area.
The following table details Webster’s nonperforming assets:
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The allowance for loan losses at March 31, 2004 was $123.6 million and represented 338% of nonperforming loans and 1.30% of total loans. This compares with an allowance of $121.7 million that represented 323% of nonperforming loans and 1.32% of total loans at December 31, 2003. The allowance was $118.6 million or 219% of nonperforming loans and 1.39% of total loans at March 31, 2003. For additional information on the allowance, see Note 7 of Notes to Consolidated Interim Financial Statements elsewhere in this report.
Other Past Due Loans
The following table sets forth information as to loans past due 30–89 days.
The overall increase in loans past due 30-89 days of $6.9 million at March 31, 2004 from December 31, 2003 is primarily due to increases of $4.9 million in commercial real estate loans and commercial loans of $4.1 million, partially offset by reduced residential and consumer loans. The increase in commercial loans was the result of two loans totaling $7.0 million, which became past due during the quarter.
Troubled Debt Restructurings
At March 31, 2004 and December 31, 2003, total accruing troubled debt restructurings were $609,000 and $731,000, respectively. This compares to $1.2 million at March 31, 2003. These restructured loans are performing in accordance with terms of restructuring. A troubled debt restructuring occurs when, for economic or legal reasons related to debtor’s financial difficulties, a financial institution grants a concession to the debtor that it would not otherwise consider. Interest income recognized for total restructured loans for the three months ended March 31, 2004 under the restructured terms totaled $8,607 as compared to $10,778 that would have been booked under their original terms. At March 31, 2004, the $609,000 of debt restructurings were performing in accordance with their restructured terms and are not included in nonperforming loans.
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Classified Loans
Webster employs a dynamic risk rating system, designed to reflect the changes in the credit risk profile of each loan. The credit risk profile assesses the risks associated with both the borrower and the related loan facility. The rating system includes Classified rating categories which correspond directly to the regulatory definitions for Substandard, Doubtful, and Loss rated loans.
The following table summarizes classified loans, including nonperforming loans.
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Webster believes that early identification and management of problem loans serves to minimize future losses, therefore it employs a rigorous portfolio review and management process, which identifies deteriorating credit risk and proactively manages problem loans. At March 31, 2004 and December 31, 2003, classified loans, including nonperforming loans, totaled $123.4 million and $108.8 million, respectively. Total classified loans as a percentage of total loans increased to 1.3% at March 31, 2004 from 1.2% at December 31, 2003, principally due to increased levels of loans classified as accruing substandard in the commercial portfolios. The increase in substandard accruing commercial classified loans for the current period is primarily due to one loan totaling approximately $8.8 million. Classified loans at March 31, 2004 declined from a year earlier by $3.2 million.
The total of nonperforming loans included in classified loans at March 31, 2004 was $36.0 million, down $222,000 from year end and $16.3 million from March 31, 2003. The remaining classified loans of $87.4 million continued to perform in accordance with their contractual terms and accrue interest. Due to their classification as substandard, these currently performing loans are considered by management to be potential problem loans, and may in the future become nonperforming loans.
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RESULTS OF OPERATIONS
A comparison of the three month period ended March 31, 2004 and 2003.
General
Net income for the three months ended March 31, 2004, was $42.3 million, or $.90 per diluted share, compared to $39.9 million, or $.86 per diluted share for the same period a year earlier.
The increase in net income for the current quarter was driven by a growth in total revenues and lower operating expenses. Total revenue, consisting of net interest income and total noninterest income, rose approximately 1.7% for the period as compared to a year ago. Impacting the quarter was the implementation on December 31, 2003 of Financial Accounting Standards Board Interpretation No. 46 (revised) (“FIN 46R”), which required the reclassification of $3.5 million of capital trust securities expense in the first quarter of 2004 from noninterest expense to interest expense. Adjusting the prior period for this effect, total revenues would have grown $5.6 million, or 4%, from a year ago. This growth was primarily the result of an increase in loans funded by growth in retail deposits.
Net Interest Income
Net interest income was $105.8 million in the first quarter compared to $104.7 million in the same quarter a year ago. Excluding the effect of FIN 46R, net interest income would have grown by $4.1 million or 4% from a year ago. This increase was primarily driven by the volume increase in loans, which was partially offset by the lower interest rate environment. Lower rates drove down the yields earned on earning assets as well as the rates paid on deposits and borrowings.
Webster anticipates that the decline in net interest margin has reached its low point and will begin to rise in the latter half of 2004. Cash flows have been redeployed into investments with shorter maturities, at significantly reduced yields, in anticipation of rising interest rates.
Interest Income
Total interest income on a fully tax equivalent basis for the first quarter of 2004 decreased $4.9 million, or 2.9%, from the prior year. The decline is primarily due to a decrease of 57 basis points in the yield on earning assets. Declines occurred in both the loan and loans held for sale portfolios, where yields dropped 47 and 45 basis points, respectively, compared to the first quarter a year ago. The declines were a result of a lower interest rate environment during 2004 as compared to 2003, caused an accelerated level of prepayments on fixed rate loans replaced with loans at significantly lower yields, such as residential mortgages, and floating rate loans were repriced at significantly lower yields. Declines also occurred in both the securities and short-term investments portfolio, where yields decreased 83 and 18 basis points, respectively. The investment portfolio was also impacted by the low interest rate environment as mortgage related securities prepaid, premium amortization was accelerated as existing investment lives were shortened and proceeds were reinvested at significantly lower yields. The impact on interest income of lower yields on interest-earning assets was partially offset by an increase in the volume of average earnings assets of approximately $1.0 billion. Substantially all this volume growth occurred in the loan portfolios.
Interest Expense
Total interest expense for the first quarter of 2004 decreased $6.3 million, or 9.7%, from the first quarter of 2003. The decrease was primarily due to a 35 basis point decline in the overall cost of interest-bearing liabilities. The cost of deposits and borrowings declined 33 and 34 basis points, respectively. The low interest rate environment was the primary factor for this decline as existing and new deposits were repriced at lower yields. Partially offsetting the favorable impact of lower interest rates was the increased expense resulting from growth in volume of deposits and borrowings. Also contributing to the increases was the FIN 46R reclass of capital trust securities in the first quarter of 2004.
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The following table shows the major categories of average assets and average liabilities together with their respective interest income or expense and the rates earned or paid by Webster.
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Net interest income can be understood in terms of the impact of changing rates and changing volumes. The following table describes the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have impacted interest income and interest expense during the periods indicated. Information is provided in each category with respect to changes attributable to changes in volume (changes in volume multiplied by prior rate), changes attributable to changes in rates (changes in rates multiplied by prior volume) and the total net change. The change attributable to the combined impact of volume and rate has been allocated proportionately to the change due to volume and the change due to rate.
Provision for Loan Losses
The provision for loan losses was $5.0 million for the quarter, the same amount as provided in the first quarter a year ago. Management performs a quarterly review of the loan portfolio and based on this review determines the level of provision necessary to maintain an adequate loan loss allowance. Several factors influence the amount of the provision, primarily growth in the loan portfolio, net charge-offs, the risk of loss on nonperforming and classified loans, and the level of economic activity. Net charge-offs in the first quarter of 2004 were $3.1 million, compared to $3.4 million in the same period a year earlier. The annualized net charge-off ratio for the current quarter was 0.13% of total average loans, down from 0.16% a year earlier. At March 31, 2004 and December 31, 2003, the allowance for loan losses totaled $123.6 million and $121.7 million, or 1.30% and 1.32% of total loans, and represented 338% and 323% of nonperforming loans, respectively.
For further information see the “Loan Portfolio Review and Allowance for Loan Loss Methodology” included in the “Financial Condition – Asset Quality” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations on pages 32 through 36 of this report.
Noninterest Income
Noninterest income for the three months ended March 31, 2004 increased $1.6 million from the same period a year earlier. Deposit fees increased as a result of higher level of deposits and increased amounts of insufficient funds and ATM fees. Loan fees increased primarily due to increases in prepayment penalties, line usage fees and lease financing fees, offset by a decrease in loan servicing fees due to a decline in the volume of mortgage loans serviced for others. Writedowns of mortgage servicing rights in the three months ended March 31, 2004 was $367,000 as compared to $731,000 the same quarter a year earlier. The decrease in financial advisory services revenue resulted from the sale of Duff & Phelps during the current period. Gains on sales of loans and loan servicing decreased in 2004 over the same period in 2003. As a result of the reduced volume of mortgage loans originated and sold compared to the same period in the previous year. Gains on sale of securities increased during the first three months of 2004 over the same period a year earlier.
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Noninterest Expenses
Total noninterest expenses for the first quarter of 2004 were $92.1 million, a decrease from $92.8 million in the year ago period. Adjusting for the effect of FIN 46R, expenses grew by $2.3 million or 2.5% from a year ago. All this increase occurred in compensation and benefits and is attributable to the impact of acquisitions, and continued investment in personnel, technology and infrastructure to meet our strategic plan for growth.
Income Taxes
Income tax expense for the three months ended March 31, 2004 is higher than the prior year period primarily due to a higher level of income before taxes, partially offset by a lower effective tax rate. The effective tax rates for the three months ended March 31, 2004 and 2003 were approximately 33.2% and 33.5% respectively.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information regarding quantitative and qualitative disclosures about market risk appears under Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, on pages 31 through 33 under the caption “Asset/Liability Management and Market Risk”.
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ITEM 4. CONTROLS AND PROCEDURES
The Company’s management, including the Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) (the “Exchange Act”) as of the end of the period covered by this report. Based upon that evaluation, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to any material information relating to the Company and its subsidiaries required to be included in the Company’s Exchange Act filings.
There were no changes made in the Company’s internal controls over financial reporting that occurred during the Company’s most recent fiscal quarter that has materially affected or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.
PART II
ITEM 1. LEGAL PROCEEDINGS
There are no material pending legal proceedings, other than ordinary routine litigation incidental to its business, to which Webster or any of its subsidiaries is a party or of which any of their property is the subject.
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES
The following table provides information with respect to any purchase made by or on behalf of Webster or any “affiliated purchaser”, as defined by Section 240.10b-18(a)(3) of the Securities and Exchange Act of 1934, of shares of Webster common stock.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 5. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
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SIGNATURE
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.
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