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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- ----- EXCHANGE ACT OF 1934
For the fiscal year ended: December 31, 1997
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File No.: 0-21137
R&G FINANCIAL CORPORATION
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(Exact name of registrant as specified in its charter)
Puerto Rico 66-0532217
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(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
280 Jesus T. Pinero Avenue
Hato Rey, San Juan, Puerto Rico 00918
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(Address of Principal (Zip Code)
Executive Offices)
Registrant's telephone number, including area code: (787) 758-2424
Securities registered pursuant to Section 12(b) of the Act: Not Applicable
Securities registered pursuant to Section 12(g) of the Act:
Class B Common Stock (par value $.01 per share)
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(Title of Class)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [ X ] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.
As of March 20, 1998, the aggregate value of the 4,777,285 shares of Class B
Common Stock of the Registrant issued and outstanding on such date, which
excludes 147,189 shares held by all directors and officers of the Registrant as
a group, was approximately $149.0 million. This figure is based on the last
known trade price of $31.19 per share of the Registrant's Class B Common Stock
on March 20, 1998.
Number of shares of Class B Common Stock outstanding as of March 20, 1998:
4,924,474
DOCUMENTS INCORPORATED BY REFERENCE
List hereunder the following documents incorporated by reference and the
Part of the Form 10-K into which the document is incorporated:
(1) Portions of the Annual Report to Stockholders for the fiscal year ended
December 31, 1997 are incorporated into Parts II and IV.
(2) Portions of the definitive proxy statement for the Annual Meeting of
Stockholders are incorporated into Part III.
PART I
Item 1. Business
General
R&G Financial Corporation (the "Company" or "R&G Financial") is the
holding company for R&G Mortgage Corp., a Puerto Rico mortgage banking company
("R&G Mortgage") and R-G Premier Bank of Puerto Rico, a Puerto Rico-chartered
commercial bank (the "Bank"). The Company was organized under Puerto Rico law in
March 1996. In July 1996, the Company acquired the 88.1% ownership interest in
the common stock of the Bank and the 100% ownership interest in the common stock
of R&G Mortgage held by the Company's Chairman of the Board and Chief Executive
Officer, Mr. Victor J. Galan, in exchange for shares of Class A common stock of
the Company. In August 1996, the Company conducted an underwritten public
offering of Class B common stock. In December 1996, the Company acquired the
remaining 11.9% ownership interest in the common stock of the Bank. At December
31 1997, the Company had total consolidated assets of $1.5 billion, total
consolidated borrowings of $627.9 million, total consolidated deposits of $722.4
million, and total consolidated stockholders' equity of $138.1 million. After
taking into consideration an 80% stock dividend paid in 1997, as of December 31,
1997, the Company had 9,220,278 Class A shares of common stock outstanding, all
of which were owned by Mr. Galan, and 4,924,474 publicly held Class B shares of
common stock outstanding.
Mr. Victor J. Galan, the Chairman of the Board, Chief Executive Officer
and controlling shareholder of R&G Financial, originally organized R&G Mortgage
in 1972. In February 1990, R&G Mortgage acquired a 74.7% interest in a two
branch federal savings and loan association with total assets of $52.9 million,
which was re-named R&G Federal Savings Bank. Recognizing the complementary
operational aspects and cross selling opportunities that are inherent in
operating both a mortgage bank and banking institution, during 1990 Mr. Galan
successfully integrated both the Bank's and R&G Mortgage's operations, which
structure has since been emulated in Puerto Rico. Embarking on a retail branch
expansion strategy, the Bank in 1993 acquired a two branch savings and loan
association with total assets of $78.6 million and, in June 1995, acquired from
a commercial bank $77.2 million in deposits and, after consolidation, six branch
offices. In November 1994, the Bank converted to a Puerto Rico-chartered
commercial bank and took its present name.
R&G Financial competes for business in Puerto Rico by providing a wide
range of financial services to residents of all of Puerto Rico's major cities
through branch offices and mortgage banking facilities at 18 locations. The
operations of both R&G Mortgage and the Bank have expanded substantially during
the 1990's, due in large part to R&G Mortgage's emergence as the second largest
originator of loans secured by single-family residential properties in Puerto
Rico. During the year ended December 31, 1997, R&G Mortgage originated
approximately 28.4% of all single-family residential loans originated in Puerto
Rico, which has resulted in significant growth in its servicing portfolio as
well as facilitated rapid expansion of the Bank's franchise and operations. R&G
Mortgage's servicing portfolio has increased by 91.3% since December 31, 1991
and, at December 31, 1997, R&G Mortgage serviced approximately 56,400 accounts
with an
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aggregate loan balance of $3.0 billion. The Bank's asset size, which amounted to
$996.3 million at December 31, 1997, has increased by $943.4 million since R&G
Mortgage became affiliated with the Bank in February 1990, while the branch
office network had increased from two to 15 offices.
R&G Financial has generally sought to achieve long-term financial
strength and profitability by increasing the amount and stability of its net
interest income and non-interest income. R&G Financial has sought to implement
this strategy by (i) establishing and emphasizing the growth of its mortgage
banking activities, including growing its loan servicing operation; (ii)
expanding its retail banking franchise in order to achieve increased market
presence and to increase core deposits; (iii) enhancing R&G Financial's net
interest income by increasing R&G Financial's loans held for investment,
particularly single-family residential loans; (iv) developing new business
relationships through an increased emphasis on commercial real estate and
commercial business lending; (v) diversifying R&G Financial's retail products
and services, including an increase in consumer loan originations (such as
credit cards); (vi) meeting the banking needs of its customers through, among
other things, the offering of trust and investment services; and (vii)
controlled growth and the pursuit of a variety of acquisition opportunities when
appropriate.
The Company is subject to regulation and supervision by the Board of
Governors of the Federal Reserve System ("Federal Reserve Board") and is subject
to various reporting and other requirements of the Securities and Exchange
Commission ("SEC").
R&G Mortgage. R&G Mortgage was originally organized in 1972. R&G
Mortgage is engaged primarily in the business of originating first and second
mortgage loans on single family residential properties secured by real estate
which are either insured by the Federal Housing Administration ("FHA") or
guaranteed by the Veterans Administration ("VA"). To a lesser extent, R&G
Mortgage is also engaged in the origination of subprime--credit
quality--residential mortgage loans through a wholly owned subsidiary ("Champion
Mortgage Corporation") which commenced operations in October 1997. Pursuant to
agreements entered into between R&G Mortgage and the Bank, non-conforming
conventional single-family residential loans and consumer loans secured by real
estate are also originated by R&G Mortgage for portfolio retention by the Bank.
The Bank retains the non-conforming conventional single-family residential loans
because these loans generally do not satisfy resale guidelines of purchasers in
the secondary mortgage market, primarily because of size or other underwriting
technicalities at the time of origination. Jumbo loans may be packaged into
collateralized mortgage obligations ("CMOs") and sold while loans with
underwriting technicalities may be cured through payment experience and
subsequently sold. During the years ended December 31, 1997, 1996 and 1995, R&G
Mortgage originated a total of $598.2 million, $448.1 million and $322.7 million
of loans, respectively. These aggregate originations include loans originated by
R&G Mortgage directly for the Bank of $285.8 million, $211.3 million and $156.3
million during such respective periods, or 47.8%, 47.2% and 48.4%, respectively,
of total originations.
2
R&G Mortgage pools FHA/VA loans into mortgage-backed securities which
are guaranteed by the Government National Mortgage Association ("GNMA"), which
securities are sold to securities broker dealers and other investors.
Conventional loans may either be sold directly to agencies such as the Federal
National Mortgage Association ("FNMA") and the Federal Home Loan Mortgage
Corporation ("FHLMC") or to private investors, or which may be pooled into FNMA-
or FHLMC-backed mortgage-backed securities which are generally sold to
investors. During the years ended December 31, 1997, 1996 and 1995, R&G Mortgage
sold $246.1 million, $244.8 million and $195.6 million of loans, respectively,
which includes loans securitized and sold but does not include loans originated
for the Bank. R&G Mortgage generally retains the servicing function with respect
to the loans which have been securitized and sold. R&G Mortgage is subject to
regulation and examination by the FHA, FNMA, FHLMC, GNMA, VA, the Department of
Housing and Urban Development ("HUD") and the Office of the Commissioner of
Financial Institutions ("OCFI") of Puerto Rico.
R-G Premier Bank. The Bank's principal business consists of attracting
deposits from the general public and tax-advantaged funds from eligible Puerto
Rico corporations and using such deposits, together with funds obtained from
other sources, to originate (through R&G Mortgage) and purchase loans secured
primarily by residential real estate in Puerto Rico, and to purchase
mortgage-backed and other securities. To a lesser extent but with increasing
emphasis over the past few years, the Bank also originates consumer loans,
commercial business loans and loans secured by commercial real estate. Such
loans offer higher yields, are generally for shorter terms and facilitate the
Bank's provision of a full range of financial services to its customers. The
Bank also offers trust services through its Trust Department. Total loan
originations by the Bank during the years ended December 31, 1997, 1996 and 1995
amounted to $89.0 million, $122.8 million and $124.6 million, respectively. The
Bank's deposits are insured by the Federal Deposit Insurance Corporation
("FDIC") and it is regulated and examined by the FDIC as its primary federal
regulatory agency as well as by the OCFI.
Affiliated Transactions. As an integral part of R&G Mortgage's
acquisition of a controlling interest in the Bank in February 1990, R&G Mortgage
and the Bank entered into various agreements which address how the parties would
conduct themselves in specifically delineated affiliated transactions (the
"Affiliated Transaction Agreements"). Under federal law and regulations, certain
transactions between a federally insured financial institution and an affiliate,
such as the Bank and R&G Mortgage, are regulated. Generally, these provisions
regulate extensions of credit to directors, officers and principal shareholders
of the Bank, and establish standards for the terms of, limit the amount of, and
establish collateral requirements with respect to, various transactions between
federally insured financial institutions and its affiliates. See generally
"Regulation - R&G Financial - Limitations on Transactions with Affiliates."
The Affiliated Transaction Agreements include a Master Purchase,
Servicing and Collections Agreement (the "Master Purchase Agreement"), a Master
Custodian Agreement, a Master Production Agreement, a Securitization Agreement
and a Data Processing Computer Service Agreement. In accordance with applicable
regulations, the terms of these agreements were negotiated at arm's length on
the basis that they are substantially the same, or at least as
3
favorable to the Bank, as those prevailing for comparable transactions with, or
involving, other nonaffiliated companies.
Pursuant to the Master Production Agreement, the Bank, on a monthly
basis, determines its loan production targets and goals (the "Loan Production
Goals") and R&G Mortgage assists the Bank to reach its Loan Production Goals by,
among other things: (i) advertising, promoting and marketing to the general
public; (ii) interviewing prospective borrowers and initial processing of loan
applications, consistent with the Bank's underwriting guidelines and Loan
Production Goals previously established; and (iii) providing personnel and
facilities with respect to the execution of any loan agreement approved by the
Bank. In exchange for these services, the Bank remits to R&G Mortgage a
percentage of the processing or originating fees charged to the borrowers under
loan agreements, as set forth in the agreements. See "-Lending Activities of the
Bank - Originations, Purchases and Sales of Loans."
The Master Purchase Agreement provides for the sale by the Bank to R&G
Mortgage of the servicing rights to all first and second mortgage loans secured
by residential properties which become part of the Bank's loan portfolio. The
Master Purchase Agreement further provides that R&G Mortgage will service all
other loans held in the Bank's loan portfolio (including single-family
residential loans retained by the Bank and certain commercial real estate
loans), although R&G Mortgage does not actually acquire such servicing rights.
The Master Purchase Agreement further provides that R&G Mortgage exclusively
will service such loans and that the Bank will process payments of such loans,
all according to a fee schedule. See " - Mortgage Banking Activities - Loan
Originations, Purchases and Sales of Loans."
Under the Securitization Agreement, R&G Mortgage renders securitization
services with respect to the pooling of some of the Bank's mortgage loans into
mortgage-backed securities. With respect to securitization services rendered,
the Bank pays a securitization fee of 25 basis points. The Master Custodian
Agreement provides that the Bank shall be the custodial agent for R&G Mortgage
of certain documentation related to the issuance by R&G Mortgage of GNMA, FNMA
or FHLMC mortgage-backed certificates. In consideration of these services, the
Bank receives a fee for each mortgage note included in a mortgage-backed
certificate per year for which it acts as custodian, as set forth in the
agreement. See "- Mortgage Banking Activities Loan Originations, Purchases and
Sales of Loans."
Mortgage Banking Activities
Loan Originations, Purchases and Sales. During the years ended December
31, 1997, 1996 and 1995, R&G Mortgage originated a total of $598.2 million,
$448.1 million and $322.7 million of loans, respectively. These aggregate
originations include loans originated by R&G Mortgage directly for the Bank of
$285.8 million, $211.3 million and $156.3 million during the years ended
December 31, 1997, 1996 and 1995, respectively, or 48%, 47% and 48%,
respectively, of total originations. The loans originated by R&G Mortgage for
the Bank are
4
comprised primarily of conventional residential loans and, to a lesser extent,
consumer loans secured by real estate.
R&G Mortgage is engaged to a significant extent in the origination of
FHA-insured and VA-guaranteed single-family residential loans which are
primarily securitized into GNMA mortgage-backed securities and sold to
institutional and/or private investors in the secondary market. During the years
ended December 31, 1997, 1996 and 1995, R&G Mortgage originated $280.1 million,
$222.0 million and $154.9 million, respectively, of FHA/VA loans, which
represented 46.8%, 49.5% and 48.0%, respectively, of total loans originated
during such respective periods.
R&G Mortgage also originates conventional single-family residential
loans which are either insured by private mortgage insurers or do not exceed 80%
of the appraised value of the mortgaged property. During the years ended
December 31, 1997, 1996 and 1995, R&G Mortgage originated $265.9 million, $204.9
million and $151.9 million, respectively, of conventional single-family
residential mortgage loans. Substantially all conforming conventional
single-family residential loans are securitized and sold in the secondary market
while substantially all non-conforming conventional single-family residential
loans are originated by R&G Mortgage on behalf of the Bank and either held by
the Bank in its portfolio or subsequently securitized by R&G Mortgage and sold
in the secondary market.
Non-conforming loans generally consist of loans which, primarily because
of size or other underwriting technicalities which may be cured through
seasoning, do not satisfy the guidelines for resale of FNMA, FHLMC, GNMA and
other private secondary market investors at the time of origination. Management
believes that these loans are essentially of the same credit quality as
conforming loans. During the years ended December 31, 1997, 1996 and 1995,
non-conforming conventional loans represented approximately 39%, 42% and 43%,
respectively, of R&G Mortgage's total volume of mortgage loans originated,
substantially all of which were originated by R&G Mortgage on behalf of the
Bank. During the years ended December 31, 1997, 1996 and 1995, 77.5%, 88.9% and
81.0% of loans originated by R&G Mortgage on behalf of the Bank consisted of
single-family residential loans during such respective periods. R&G Mortgage
originates single-family residential, construction and commercial real estate
loans on behalf of the Bank pursuant to the terms of a Master Production
Agreement between R&G Mortgage and the Bank. See "- Lending Activities of the
Bank - Origination, Purchase and Sale of Loans."
While R&G Mortgage makes available a wide variety of mortgage products
designed to respond to consumer needs and competitive conditions, it currently
emphasizes 15-year and 30-year conventional first mortgages and 15-year and
30-year FHA loans and VA loans. Substantially all of such loans consist of
fixed-rate mortgages. The average loan size for FHA/VA mortgage loans and
conventional mortgage loans is approximately $68,200 and $73,000, respectively.
5
R&G Mortgage also offers second mortgage loans up to $125,000 with a
maximum term of 15 years. The maximum loan-to-appraised value ratio on second
mortgage loans permitted by R&G Mortgage is 75% (including the amount of any
first mortgage). In addition, R&G Mortgage also offers real estate secured
consumer loans up to $40,000 with a maximum term of 10 years. The maximum
loan-to-appraised value ratio on real estate secured consumer loans permitted by
R&G Mortgage is 80%. R&G Mortgage will secure such loans with either a first or
second mortgage on the property.
R&G Mortgage's loan origination activities are conducted out of its
offices and mortgage banking centers. Residential mortgage loan applications are
attributable to walk-in customers, existing customers and advertising and
promotion, referrals from real estate brokers and builders, loan solicitors and
mortgage brokers. At December 31, 1997, R&G Mortgage employed 66 loan
originators who are compensated in part on a commission basis.
Loan origination activities performed by R&G Mortgage include
soliciting, completing and processing mortgage loan applications and preparing
and organizing the necessary loan documentation. Loan applications are examined
for compliance with underwriting criteria and, if all requirements are met, R&G
Mortgage issues a commitment to the prospective borrower specifying the amount
of the loan and the loan origination fees, points and closing costs to be paid
by the borrower or seller and the date on which the commitment expires.
R&G Mortgage also purchases FHA loans and VA loans from other mortgage
bankers for resale to institutional investors and other investors in the form of
GNMA mortgage-backed securities. R&G Mortgage's strategy is to increase its
servicing portfolio primarily though internal originations through its branch
network and, to a lesser extent, purchases from third parties. Purchases of
loans from other mortgage bankers in the wholesale loan market is generally
limited to FHA loans and VA loans and such purchases provide R&G Mortgage with a
source of low cost production that allows R&G Mortgage to continue to increase
the size of its servicing portfolio. R&G Mortgage purchased $158.5 million,
$45.6 million and $19.5 million of loans from third parties during the years
ended December 31, 1997, 1996 and 1995, respectively.
6
The following table sets forth loan originations, purchases and sales by
R&G Mortgage for the periods indicated.
Year Ended December 31,
------------------------------------
1997 1996 1995
-------- -------- --------
(Dollars in Thousands)
Loans Originated For the Bank:
Conventional loans(1):
Number of loans ..................... 3,390 2,756 2,226
Volume of loans ..................... $233,488 $190,072 $140,363
FHA/VA loans:
Number of loans ..................... -- -- --
Volume of loans ..................... -- $ -- $ --
Consumer loans(2):
Number of loans ..................... 2,318 1,004 974
Volume of loans ..................... $ 52,287 $ 21,208 $ 15,944
Total loans:
Number of loans ..................... 5,708 3,760 3,200
Volume of loans ..................... $285,775 $211,280 $156,307
Percent of total volume ............. 35% 43% 46%
For Third Parties:
Conventional loans(1):
Number of loans ..................... 444 214 151
Volume of loans ..................... $ 32,419 $ 14,835 $ 11,496
FHA/VA loans:
Number of loans ..................... 4,107 3,117 2,313
Volume of loans ..................... $280,053 $221,967 $154,916
Total loans:
Number of loans ..................... 4,551 3,331 2,464
Volume of loans ..................... $312,472 $236,802 $166,412
Percent of total volume ............. 39% 48% 48%
-------- -------- --------
Total loan originations ........... $598,247 $448,082 $322,719
======== ======== ========
Loans Purchased For R&G Mortgage:
Number of loans ....................... 2,052 583 305
Volume of loans (3) ................... $158,456 $ 45,604 $ 19,525
Percent of total volume ............... 20% 9% 6%
GNMA Pools Purchased for R&G Mortgage:
Volume of loans ....................... $ 51,537 -- --
Percent of total volume ............... 6% -- --
-------- -------- --------
Total loan originations and purchases $808,240 $493,686 $342,244
======== ======== ========
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Year Ended December 31,
-----------------------------------------
1997 1996 1995
--------- --------- ---------
(Dollars in Thousands)
Loans Sold To Third Parties(4):
Conventional loans(1):
Number of loans ...................... 429 178 151
Volume of loans ...................... $ 39,495 $ 12,560 $ 11,999
FHA/VA loans:
Number of loans ...................... 2,775 3,564 2,252
Volume of loans(3) ................... $ 206,643 $ 232,254 $ 183,607
Total loans:
Number of loans ...................... 3,204 3,742 2,403
Volume of loans ...................... $ 246,138 $ 244,814 $ 195,606
Percent of total volume .............. 30% 50% 57%
--------- --------- ---------
Adjustments:
Loans originated for the Bank .......... $ 276,327 $(211,280) $(156,307)
Loans amortization ..................... (5,086) (7,224) (1,960)
--------- --------- ---------
Increase (decrease) in loans held for sale $ 271,241 $ 30,368 $ (11,629)
========= ========= =========
Average Initial Loan Origination Balance:
The Bank:
Conventional loans(1) ................ $ 69 $ 69 $ 63
FHA/VA loans ......................... -- -- --
Third Parties:
Conventional loans(1) ................ $ 73 69 76
FHA/VA loans ......................... 68 71 63
Total Average Initial Balance:
Conventional loans(1) ................ 69 69 64
FHA/VA loans ......................... 68 71 63
Refinancings(5):
The Bank ............................... 30% 33% 58%
Third Parties .......................... 31% 24% 26%
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(1) Includes non-conforming loans.
(2) All but $1.5 million and $3.3 million of such loans were secured by real
estate at December 31, 1996 and 1995, respectively.
(3) Excludes $7.9 million and $36.1 million of loans purchased from another
financial institution and securitized and sold to the same financial
institution during 1996 and 1995, respectively.
(4) Includes loans converted into mortgage-backed securities.
(5) As a percent of the total dollar volume of loans originated by R&G
Mortgage for the Bank or third parties, as the case may be. In the case
of the Bank, refinancings do not necessarily represent refinancings of
loans previously held by the Bank.
8
All loan originations, regardless of whether originated through R&G
Mortgage or purchased from third parties, must be underwritten in accordance
with R&G Mortgage's underwriting criteria, including loan-to-appraised value
ratios, borrower income qualifications, debt ratios and credit history, investor
requirements, necessary insurance and property appraisal requirements. R&G
Financial's underwriting standards also comply with the relevant guidelines set
forth by HUD, VA, FNMA, FHLMC, bank regulatory authorities, private mortgage
investment conduits and private mortgage insurers, as applicable. R&G Mortgage's
underwriting personnel, while operating out of its loan offices, make
underwriting decisions independent of R&G Mortgage's mortgage loan origination
personnel.
Typically, when a mortgage loan is originated, the borrower pays an
origination fee. These fees are generally in the range of 0% to 7% of the
principal amount of the mortgage loan, and are payable at the closing of such
loan. R&G Mortgage receives these fees on mortgage loans originated through its
retail branches. R&G Mortgage may charge additional fees depending upon market
conditions and regulatory considerations as well as R&G Mortgage's objectives
concerning mortgage loan origination volume and pricing. R&G Mortgage incurs
certain costs in originating mortgage loans, including overhead, out-of-pocket
costs and, in some cases, where the mortgage loans are subject to a purchase
commitment from private investors, related commitment fees. The volume and type
of mortgage loans and of commitments made by investors vary with competitive and
economic conditions (such as the level of interest rates and the status of the
economy in general), resulting in fluctuations in revenues from mortgage loan
originations. Generally accepted accounting principles ("GAAP") require that
general operating expenses incurred in originating mortgage loans be charged to
current expense. Direct origination costs and origination income must be
deferred and amortized using the interest method, until the repayment or sale of
the related mortgage loans. Historically, the value of servicing rights which
result from R&G Mortgage's origination activities has exceeded the net costs
attributable to such activities.
R&G Mortgage customarily sells most of the loans that it originates,
except for those originated on behalf of the Bank pursuant to the Master
Production Agreement. See "-Lending Activities of the Bank - Origination,
Purchases and Sales of Loans." The loans originated by R&G Mortgage (including
FHA loans, VA loans and conventional loans) are secured by real property located
in Puerto Rico and constitute "eligible investments" which results in favorable
tax treatment under U.S. and Puerto Rico tax laws. See "- Puerto Rico Secondary
Mortgage Market and Favorable Tax Treatment." During the years ended December
31, 1997, 1996 and 1995, R&G Mortgage sold $246.1 million, $244.8 million and
$195.6 million of loans, respectively, which includes loans securitized and sold
but does not include loans originated by R&G Mortgage on behalf of the Bank.
With respect to such loan sales, $206.6 million or 83.9%, $232.3 million or
94.9% and $183.6 million or 93.9% consisted of GNMA-guaranteed mortgage-backed
securities of FHA loans or VA loans packaged into pools of $1 million or more
($2.5 million to $5 million for serial notes as described below). These
securities were sold primarily to securities broker-dealers and other investors
in Puerto Rico.
9
Certain GNMA-guaranteed mortgage-backed securities sold by R&G Mortgage
are in the form of GNMA serial notes which permit the investor to receive
interest monthly and to select among several expected maturity dates of the
notes included in an issue, with each maturity having a specific yield. GNMA
serial notes are sold in pools of $2.5 million to $5 million. GNMA serial notes
are sold to securities broker-dealers in packages consisting of notes of
different yields and maturities, which range from one to 30 years and have an
average maturity of 12 years, taking into account historical experience with
prepayments of the underlying mortgages. The rates on the serial notes or GNMA
pools must be 1/2 of 1% less than the rates on the mortgages comprising the
pool. Upon completion of the necessary processing, the GNMA-guaranteed
mortgage-backed securities are either offered to the public directly through the
Bank's Trust Department or indirectly through securities broker-dealers. During
the years ended December 31, 1997, 1996 and 1995, R&G Mortgage issued GNMA
serial notes totalling approximately $397.2 million, $236.4 million and $184.4
million, respectively.
Conforming conventional loans originated or purchased by R&G Mortgage
are generally sold directly to FNMA, FHLMC or private investors for cash or are
grouped into pools of $1 million or more in aggregate principal balance and
exchanged for FNMA or FHLMC-issued mortgage-backed securities, which R&G
Mortgage sells to securities broker-dealers. In connection with any such
exchanges, R&G Mortgage pays guarantee fees to FNMA and FHLMC. The issuance of
mortgage-backed securities provides R&G with flexibility in selling the
mortgages which it originates or purchases and also provides income by
increasing the value and marketability of the loans.
Mortgage loans that do not conform to GNMA, FNMA or FHLMC requirements
(so-called "non-conforming loans") are generally originated on behalf of the
Bank and either retained in the Bank's portfolio, sold to financial institutions
or other private investors or securitized into "private label" CMOs through
grantor trusts or other mortgage conduits and sold through securities
broker-dealers. Non-conforming loans consist of jumbo loans or loans that do not
satisfy all requirements of FNMA, FHLMC and GNMA at the time of origination of
the loan (such as missing tax returns, slightly higher loan-to-value ratios,
etc.).
Each CMO normally consists of several classes of senior, subordinate and
residual certificates. The residual certificates evidence a right to receive
payments on the mortgage loans after payment of all required amounts on the
senior and subordinate certificates then due. Some form of credit enhancement,
such as an insurance policy, letter of credit or subordination, will generally
be used to increase the credit rating of the senior certificates and thereby
improve their marketability. During the year ended December 31, 1995, R&G
Mortgage and the Bank completed sales of approximately $38.2 million of CMOs in
securitization transactions. There were no sales in 1997 or 1996. In connection
with such transactions, either the Bank or R&G Mortgage generally retains the
residual certificates issued by the respective trusts as well as the subordinate
certificates issued in such transactions. As of December 31, 1997, R&G Mortgage
held CMOs (which were primarily issued by R&G Mortgage) with a fair value of
$15.2 million and residual certificates issued in CMO transactions involving R&G
Mortgage and the Bank with a fair value of $7.9 million. In addition, the Bank
held CMO subordinated certificates and
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residual certificates from one of its issues with a fair value of $8.4 million
at December 31, 1997. See "- Investment Activities." Currently a liquid
secondary market for subordinate or residual certificates does not exist in
Puerto Rico. The value of residual certificates is subject to substantial
fluctuations as a result of changes in prevailing interest rates. However, such
residuals often exhibit elasticity and convexity characteristics which R&G
Financial can utilize to hedge other components of its portfolio. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operation" incorporated by reference in Item 7 hereof.
While R&G Mortgage's exchanges of mortgage loans into agency securities
and sales of mortgage loans are generally made on a non-recourse basis, R&G
Mortgage also engages in the sale or exchange of mortgage loans on a recourse
basis. In the past, recourse sales often involved the sale of non-conforming
loans to FNMA, FHLMC and local financial institutions. R&G Financial estimates
the fair value of the retained recourse obligation at the time mortgage loans
are sold. Normally, the fair value of any retained recourse is immaterial
because R&G Mortgage is able to resell repurchased loans for at least their
carrying costs. Accordingly, as of December 31, 1997, R&G Financial did not deem
it necessary to establish reserves for possible losses related to its recourse
obligations. At December 31, 1997, R&G Mortgage had loans in its servicing
portfolio with provisions for recourse in the principal amount of approximately
$374.4 million, as compared to $290.9 million and $238.2 million as of December
31, 1996 and 1995, respectively. Of the recourse loans existing at December 31,
1997, approximately $340.5 million in principal amount consisted of loans sold
to FNMA and FHLMC and converted into mortgage-backed securities of such
agencies, and approximately $33.9 million in principal amount consisted of
non-conforming loans sold to other private investors.
Pursuant to the terms of the Master Purchase Agreement, R&G Mortgage
renders securitization services with respect to the pooling of some of the
Bank's mortgage loans into mortgage-backed securities. With respect to the
securitization services rendered, the Bank pays a securitization fee of 25 basis
points. In addition, pursuant to the terms of a Master Custodian Agreement
entered into by R&G Mortgage and the Bank, the Bank acts as the custodial agent
for R&G Mortgage of certain documentation related to the issuance by R&G
Mortgage of GNMA or FHLMC mortgage-backed certificates. In consideration of
these services, the Bank receives an annual fee of $5.0 for each mortgage note
included in a mortgage-backed certificate for which it acts as custodian. See
also "- General - Affiliated Transactions" and "Regulation - R&G Financial -
Limitations on Transactions with Affiliates."
Loan Servicing. R&G Mortgage acquires servicing rights through its
mortgage loan originations (including originations on behalf of the Bank) and
purchases from third parties. When R&G Mortgage sells the mortgage loans it has
originated or purchased, it generally retains the rights to service such loans
and receives the related servicing fees. Loan servicing includes collecting
principal and interest and remitting the same to the holders of the mortgage
loans or mortgage-backed securities to which such mortgage loan relates, holding
escrow funds for the payment of real estate taxes and insurance premiums,
contacting delinquent borrowers, supervising foreclosures in the event of
unremedied defaults and generally administering the loans. R&G Mortgage receives
annual loan servicing fees ranging from 0.25% to 0.50% of the
11
declining outstanding principal balance of the loans serviced plus any late
charges. In general, R&G Mortgage's servicing agreements are terminable by the
investor for cause without penalty or after payment of a termination fee ranging
from 0.5% to 1.0% of the outstanding principal balance of the loans being
serviced.
R&G Mortgage's servicing portfolio has grown significantly over the past
several years. At December 31, 1997, R&G Mortgage's servicing portfolio totalled
$3.0 billion and consisted of a total of 56,442 loans. At December 31, 1997, R&G
Mortgage's servicing portfolio included $448.9 million of loans serviced for the
Bank or 15.0% of the total servicing portfolio. Substantially all of the
mortgage loans in R&G Mortgage's servicing portfolio are secured by single
(one-to-four) family residences. All of R&G Mortgage's mortgage servicing
portfolio is comprised of mortgages secured by real estate located in Puerto
Rico.
Pursuant to the terms of a Master Purchase Agreement, the Bank sells to
R&G Mortgage the servicing rights to all first and second mortgage loans secured
by residential properties which become part of the Bank's loan portfolio. The
Master Purchase Agreement further provides that R&G Mortgage will service all
other loans held in the Bank's loan portfolio (including single-family
residential loans retained by the Bank and certain commercial real estate
loans), although R&G Mortgage does not actually acquire such servicing rights.
The Bank pays R&G Mortgage servicing fees with respect to the loans serviced by
R&G Mortgage on behalf of the Bank. In addition, pursuant to the Master Purchase
Agreement, the Bank processes payments of all loans originated by R&G Mortgage
on behalf of the Bank. In connection therewith, R&G Mortgage pays the Bank a fee
equal to between $0.50 and $1.00 per loan. See also "- General - Affiliated
Transactions" and "Regulation - R&G Financial - Limitations on Transactions with
Affiliates."
R&G Mortgage's mortgage loan servicing portfolio is subject to reduction
by reason of normal amortization, prepayments and foreclosure of outstanding
mortgage loans. Additionally, R&G Mortgage may sell mortgage loan servicing
rights from time to time.
12
The following table sets forth certain information regarding the total
loan servicing portfolio of R&G Mortgage for the periods indicated.
Year Ended December 31,
--------------------------------------------------
1997 1996 1995
---------------- ---------------- ----------------
(Dollars in Thousands)
Composition of Servicing Portfolio at End of Period:
Conventional and other mortgage loans(1)................... $1,148,739 $ 971,327 $ 811,269
FHA/VA loans............................................... 1,852,149 1,578,842 1,486,931
---------- ---------- ----------
Total servicing portfolio(2)............................. $3,000,888 $2,550,169 $2,298,200
========== ========== ==========
Activity in the Servicing Portfolio:
Beginning servicing portfolio.............................. $2,550,169 $2,298,200 $2,114,743
Add: Loan originations and purchases....................... 778,126 506,696 325,870
Servicing of portfolio loans acquired............... 5,301 36,478 239,414
Less: Sale of servicing rights............................. -- 42,080 196,895(3)
Run-offs(4)......................................... 332,708 249,125 184,932
---------- ---------- ----------
Ending servicing portfolio................................. $3,000,888 $2,550,169 $2,298,200
========== ========== ==========
Number of loans serviced(5)................................ 56,442 50,979 48,240
Average loan size(5)....................................... $ 53 $ 50 $48
Average servicing fee rate(5).............................. 0.532% 0.532% 0.505%
- --------------
(1) Includes non-conforming loans.
(2) At the dates shown, included $448.9 million, $323.8 million and $290.8
million of loans serviced for the Bank, respectively, which constituted
15.0%, 12.70% and 12.65% of the total servicing portfolio, respectively.
(3) R&G Mortgage sold servicing rights during 1994 and recognized a gain of
$2.9 million. Pursuant to a subservicing agreement with the purchaser of
the servicing rights, R&G Mortgage continued to service the loans
subject to such sale and they remained in R&G Mortgage's servicing
portfolio until 1995.
(4) Run-off refers to regular amortization of loans, prepayments and
foreclosures. Includes one-time transfer in 1997 of $49.0 million of
mortgage loans to a financial institution who acquired a commercial bank
whose loans were being serviced by R&G Mortgage.
(5) At December 31, 1997, R&G Mortgage was servicing 6,507 loans for the
Bank with an average loan size of approximately $69,000 and at an
average servicing rate of 0.284%. Amounts include late and other
miscellaneous charges.
13
The following table sets forth certain information at December 31, 1997
regarding the number of, and aggregate principal balance of, the mortgage loans
serviced by R&G Mortgage for the Bank and for third parties at various mortgage
interest rates.
At December 31, 1997
------------------------------------------------------------------------------
Loans Serviced Loans Serviced
for the Bank for Third Parties
---------------------------------- -----------------------------------
Number of Aggregate Number of Aggregate
Loans Principal Balance Loans Principal Balance
Mortgage Interest Rate ------------- -------------------- -------------- --------------------
(Dollars in Thousands) (Dollars in Thousands)
Less than 7.00%............ 51 $ 2,646 2,734 $ 136,804
7.00% - 7.49%.............. 260 24,693 8,325 520,445
7.50% - 7.99%.............. 562 57,188 15,127 833,118
8.00% - 8.49%.............. 2,732 201,968 7,442 454,494
8.50% - 8.99%.............. 1,818 119,252 7,803 338,867
9.00% - 9.49%.............. 478 24,183 3,102 114,954
9.50% - 9.99%.............. 167 7,380 2,445 68,646
10.00% - 10.49%............ 135 3,964 981 33,224
10.50% - 10.99%............ 154 4,146 596 16,801
11.00% or more............. 150 3,438 1,380 34,677
----- -------- ------ ----------
6,507 $448,858 49,903 $2,552,030
===== ======== ====== ==========
At December 31, 1997
---------------------------------
Total Loans
Serviced
---------------------------------
Number of Aggregate
Loans Principal Balance
Mortgage Interest Rate ------------ --------------------
(Dollars in Thousands)
Less than 7.00%............ 2,785 $139,450
7.00% - 7.49%.............. 8,585 545,138
7.50% - 7.99%.............. 15,689 890,306
8.00% - 8.49%.............. 10,174 656,462
8.50% - 8.99%.............. 9,621 458,119
9.00% - 9.49%.............. 3,580 139,137
9.50% - 9.99%.............. 2,612 76,026
10.00% - 10.49%............ 1,116 37,188
10.50% - 10.99%............ 750 20,947
11.00% or more............. 1,530 38,115
------ ----------
56,442 $3,000,888
====== ==========
The amount of principal prepayments on mortgage loans serviced by R&G
Mortgage was $87.2 million, $72.5 million and $68.2 million for the years ended
December 31, 1997, 1996 and 1995, respectively. This represented approximately
2.9%, 2.8% and 3.0% of the aggregate principal amount of mortgage loans serviced
during such periods. The primary means used by R&G Mortgage to reduce the
sensitivity of its servicing fee income to changes in interest and prepayment
rates is the development of a strong internal origination capability that has
allowed R&G Mortgage to continue to increase the size of its servicing portfolio
even in times of high prepayments.
Servicing agreements relating to the mortgage-backed securities programs
of FNMA, FHLMC and GNMA, and certain other investors, require R&G Mortgage to
advance funds to make scheduled payments of principal, interest, taxes and
insurance, if such payments have not been received from the borrowers. During
the years ended December 31, 1997, 1996 and 1995, the monthly average amount of
funds advanced by R&G Mortgage under such servicing agreements was $1.4 million,
$1.3 million and $4.4 million, respectively. Funds advanced by R&G Mortgage
pursuant to these arrangements are generally recovered by R&G Mortgage within 30
days.
In connection with its loan servicing activities, R&G Mortgage holds
escrow funds for the payment of real estate taxes and insurance premiums with
respect to the mortgage loans it services. At December 31, 1997, R&G Mortgage
held $58.8 million of such escrow funds, $50.2 million of which were deposited
in the Bank and $8.6 million of which were deposited with other financial
institutions. The escrow funds deposited with the Bank lower its overall cost of
funds
14
and is a means of compensating it for processing mortgages checks received by
R&G Mortgage, while the escrow funds deposited with other financial institutions
serve as part of R&G Mortgage's compensating balances which permit R&G Mortgage
to borrow funds from such institutions (pursuant to certain warehouse lines of
credit) at rates that are lower than would otherwise apply. See "- Sources of
Funds - Borrowings."
The degree of risk associated with a mortgage loan servicing portfolio
is largely dependent on the extent to which the servicing portfolio is
non-recourse or recourse. In non-recourse servicing, the principal credit risk
to the servicer is the cost of temporary advances of funds. In recourse
servicing, the servicer agrees to share credit risk with the owner of the
mortgage loans such as FNMA or FHLMC or with an insurer or guarantor. Losses on
recourse servicing occur primarily when foreclosure sale proceeds of the
property underlying a defaulted mortgage are less than the then outstanding
principal balance and accrued interest of such mortgage loan and the cost of
holding and disposing of such underlying property. At December 31, 1997, R&G
Mortgage was servicing mortgage loans with an aggregate principal amount of
$374.4 million on a recourse basis. During the last three years, losses incurred
due to recourse servicing have not been significant.
R&G Mortgage's general strategy is to retain the servicing rights
related to the mortgage loans it originates and purchases. Nevertheless, there
is a market in Puerto Rico for servicing rights, which are generally valued in
relation to the present value of the expected income stream generated by the
servicing rights. Among the factors which influence the value of a servicing
portfolio are servicing fee rates, loan balances, loan types, loan interest
rates, the expected average life of the underlying loans (which may be reduced
through foreclosure or prepayment), the value of escrow balances, delinquency
and foreclosure experience, servicing costs, servicing termination rights of
permanent investors and any recourse provisions. During the year ended December
31, 1995, R&G Mortgage sold servicing rights on $196.9 million of mortgage
loans. Although R&G Mortgage may on occasion consider future sales of a portion
of its servicing portfolio, management does not anticipate sales of servicing
rights to become a significant part of its operations.
The market value of, and earnings from, R&G Mortgage's mortgage loan
servicing portfolio may be adversely affected if mortgage interest rates decline
and mortgage loan prepayments increase. In a period of declining interest rates
and accelerated prepayments, income generated from R&G Mortgage's mortgage loan
servicing portfolio may also decline. Conversely, as mortgage interest rates
increase, the market value of R&G Mortgage's mortgage loan servicing portfolio
may be positively affected. See Note 1 to R&G Financial's Notes to Consolidated
Financial Statements for a discussion of SFAS No. 122 and the treatment of
servicing rights, incorporated by reference into Item 8 hereof.
15
Mortgage Loan Delinquencies and Foreclosures. The following table shows
the delinquency statistics for R&G Mortgage's servicing portfolio at the dates
indicated.
Year Ended December 31,
----------------------------------------------------------------------------------------
1997 1996 1995
-------------------------- -------------------------- --------------------------
Percent of Percent of Percent of
Number of Servicing Number of Servicing Number of Servicing
Loans Portfolio Loans Portfolio Loans Portfolio
------------ ------------ ------------ ------------ ------------ ------------
Loans delinquent for:
30-59 days.......................... 2,531 4.48% 2,775 5.44% 3,366 6.98%
60-89 days.......................... 572 1.01 533 1.05 906 1.88
90 days or more..................... 778 1.38 646 1.27 988 2.05
----- ---- ----- ---- ----- -----
Total delinquencies(1)............ 3,881 6.87% 3,954 7.76% 5,260 10.90%
===== ==== ===== ==== ===== =====
Foreclosures pending(2)............... 681 1.21% 693 1.36% 459 0.95%
===== ==== ===== ==== ===== =====
- -----------------
(1) Includes at December 31, 1997, an aggregate of $26.4 million of
delinquent loans serviced for the Bank, or .88% of the total servicing
portfolio and $2.7 million of delinquent loans held in R&G Mortgage's
own portfolio.
(2) At December 31, 1997, the Bank had foreclosures pending on $12.2 million
of loans being serviced by R&G Mortgage, which constituted 0.41% of the
servicing portfolio. R&G Mortgage had foreclosures pending on $2.1 of
loans it is servicing for its own portfolio at December 31, 1997.
While delinquency rates in Puerto Rico are generally higher than in the
mainland United States, these rates are not necessarily indicative of future
foreclosure rates or losses on foreclosures. Real estate owned as a result of
foreclosures ("REO") related to R&G Mortgage's mortgage banking business arise
primarily through foreclosure on mortgage loans repurchased from investors
either because of breach of representations or warranties or pursuant to
recourse arrangements. As of December 31, 1997, 1996 and 1995, R&G Mortgage held
REO with a book value of approximately $165,000, $0 and $0, respectively. Sales
of REO resulted in gains to R&G Mortgage of $145,000 and $30,000 for the years
ended December 31, 1997 and 1995, respectively, and a net loss to R&G Mortgage
of $57,000 for the year ended December 31, 1996. There is no liquid secondary
market for the sale of R&G Mortgage's REO.
With respect to mortgage loans securitized through GNMA programs, R&G
Mortgage is fully insured as to principal by the FHA and VA against foreclosure
loans. As a result of these programs, foreclosure on these loans had generated
no loss of principal as of December 31, 1997. R&G Mortgage, however, incurs
about $3,000 per loan foreclosed in interest and legal charges during the time
between payment by R&G Mortgage and FHA or VA reimbursement. For the years ended
December 31, 1997, 1996 and 1995, total expenses related to FHA or VA loans
foreclosed amounted to $189,000, $302,000 and $230,000, respectively. Although
FNMA and FHLMC are obligated to reimburse R&G Mortgage for principal and
interest payments advanced
16
by R&G Mortgage as a servicer (except for recourse servicing), the funding of
delinquent payments or the exercise of foreclosure rights involves costs to R&G
Mortgage which may not be recouped. Such nonrecouped expenses have to date been
immaterial.
Any significant adverse economic developments in Puerto Rico could
result in an increase in defaults or delinquencies on mortgage loans that are
serviced by R&G Mortgage or held by R&G Mortgage pending sale in the secondary
mortgage market, thereby reducing the resale value of such mortgage loans.
Puerto Rico Secondary Mortgage Market and Favorable Tax Treatment. In
general, the Puerto Rico market for mortgage-backed securities is an extension
of the United States market with respect to pricing, rating of the investment
instruments, and other matters. However, United States and Puerto Rico tax laws
provide an economic incentive for Puerto Rico residents and Section 936
Corporations (defined below) to invest in certain mortgage loans and
mortgage-backed securities originated in Puerto Rico, including FHA and VA loans
and GNMA certificates, thereby tending to increase the secondary market demand
for, and the resale value of, such mortgage loans and mortgage-backed
securities. These tax advantages also favorably affect R&G Financial's net
interest income by helping create a pool of lower-cost funds that R&G Financial
can access through financial intermediaries such as banks and broker-dealers and
use to fund mortgage loans and mortgage-backed securities pending sale.
Under various Puerto Rico industrial incentives acts (the "Industrial
Incentives Acts"), certain investment income earned by qualified manufacturing
entities or service enterprises that have grants of tax exemption issued
thereunder ("Exempt Companies"), is exempt from Puerto Rico income tax.
Investment income that qualifies for this exemption includes interest on certain
mortgage loans and interest on funds of Exempt Companies ("936 Funds") placed
with eligible institutions in Puerto Rico (primarily savings and loan
associations, commercial banks and registered broker-dealers), provided such
funds are invested in certain "eligible activities" in accordance with
regulations promulgated by the OCFI, including certain mortgage loans and
mortgage-backed securities. The Industrial Incentives Acts also encourage
investment in Puerto Rico by allowing Exempt Companies to reduce the otherwise
applicable 10% tax (the "Tollgate Tax") on distributions to shareholders by
investing their exempt industrial development income ("IDI") in Puerto Rico for
fixed periods of time, generally from five years to ten years.
A new Industrial Incentive Act was approved by the Government of Puerto
Rico effective January 1, 1998: the Tax Incentive Act of 1998 (the "1998 TIA").
Grants issued under the 1998 TIA will provide for a flat rate of tax on the
operating income of Exempt Companies. The same types of investment income that
qualified for exemption under the Industrial Incentive Acts will continue to be
exempt under the 1998 TIA. Because grantees of tax exemption under the 1998 TIA
will not be subject to Tollgate Taxes, they will not have an incentive to invest
their IDI in qualifying investments in Puerto Rico, as grantees under the
Industrial Incentive Acts presently do in order to reduce their Tollgate Taxes.
It should be noted, however, that Exempt Companies currently operating pursuant
to grants issued under the Industrial Incentives Acts generally will not be
affected by the provisions of the 1998 TIA. Although such Exempt Companies may
renegotiate their grants under the 1998 TIA, an amount of IDI equal to the IDI
derived in the taxable year preceding the change to the 1998 TIA (or, if
greater, the average annual IDI by
17
taking the three years, out of the previous five years, where the highest amount
of IDI is derived) will continue to be subject to the tax treatment, including
Tollgate Taxes, provided in the Industrial Incentive Act under which their grant
was originally issued.
Most Exempt Companies are United States corporations which operate in
Puerto Rico under Section 936 of the Code. Corporations that meet certain
requirements and elect the benefits of Section 936 ("Section 936 Corporations")
are entitled to credit against their United States corporate income tax a
portion of such tax attributable to (i) income derived from sources outside the
United States from the active conduct of a trade or business within Puerto Rico
or from the sale or exchange of substantially all assets used in the active
conduct of such trade or business ("Active Business Income") and (ii) qualified
possession source investment income ("QPSII"). QPSII generally includes interest
derived from mortgage loans secured by real property located in Puerto Rico and
mortgage-backed securities consisting of such mortgage loans as well as interest
on deposits with financial institutions in Puerto Rico which in turn use such
funds to finance the origination of mortgage loans and other qualifying assets.
The credit provided for QPSII tends to increase the demand for Puerto Rico
mortgage loans and mortgage-backed securities as well as to reduce funding costs
for mortgage banking institutions.
The Omnibus Budget Reconciliation Act of 1993 (the "OBRA Amendments")
and the Small Business Job Protection Act of 1996 (the "SBJPA") amended various
provisions of Section 936. The OBRA Amendments, which are generally effective
for taxable years beginning after December 31, 1993, permit a taxpayer to
compute the tax credit available under Section 936 (the "936 Credit") as under
prior law but limit the amount of credit allowed with respect to Active Business
Income under one of two alternatives to be selected at the option of the
taxpayer. Under the first alternative, the limit is equal to a fixed percentage
of the amount of tax credit allowable under prior law (the "Fixed Percentage
Method"). This fixed percentage commenced at 60% for taxable years beginning in
1994 and is reduced by 5% per year until 1998. For taxable years beginning in
1998, such percentage would be 40%. Under the second alternative (the "Economic
Activity Method"), which is based on the amount of economic activity conducted
by the taxpayer in Puerto Rico, the credit may not exceed the sum of the
following three components: (i) 60% of the qualified possession wages and the
allocable fringe benefits paid by the taxpayer, (ii) applicable percentages of
certain depreciation deductions claimed for regular tax purposes by the taxpayer
with respect to qualified tangible property and (iii) a portion of the
possession income taxes paid by the taxpayer except where the taxpayer uses the
profit-split method for determining its income. The OBRA Amendments did not
limit the 100% credit available under Section 936 for QPSII, including income
received from investment in certain Puerto Rico mortgage loans and
mortgage-backed securities.
The SBJPA repealed (i) the 936 Credit attributable to QPSII generally
for income received or accrued after June 30, 1996, and (ii) the 936 Credit
attributable to Active Business Income for taxable years beginning after
December 31, 1995. The SBJPA, however, provided grandfather rules under which a
Section 936 Corporation that had elected the benefits of the Section 936 Credit
and which was engaged in active trade or business within Puerto Rico on October
13, 1995 (an "Existing Claimant") would be eligible to claim the 936 Credit
attributable to Active Business Income during a transition period. A corporation
may also qualify as an Existing Claimant if it
18
acquires all the assets of a trade or business of a corporation that meets the
active trade or business requirement and the election requirement is satisfied.
The amount and computation method of the 936 Credit during the
transition period depends upon whether a Section 936 Corporation is using the
Economic Activity Method or the Fixed Percentage Method. A Section 936
Corporation that is an Existing Claimant and uses the Economic Activity Method
may continue to determine its 936 Credit attributable to Active Business Income
as under present law for taxable years beginning after December 31, 1995 and
before January 1, 2002. For taxable years beginning after December 31, 2001 and
before January 1, 2006, a Section 936 Corporation's Active Business Income
eligible for the 936 Credit is subject to a cap, described below. A Section 936
Corporation that is an Existing Claimant and is using the Fixed Percentage
Method may continue to determine its 936 Credit attributable to Active Business
Income under the existing rules for taxable years beginning after December 31,
1995 and before January 1, 1998. For taxable years beginning after December 31,
1997 and before January 1, 2006, the Section 936 Corporation's Active Business
Income that is eligible for the 936 Credit is also subject to a cap. For taxable
years beginning after December 31, 2005, the 936 Credit attributable to Active
Business Income is terminated. Under the cap rules for both the Economic
Activity Method and the Fixed Percentage Method, the income eligible for the 936
Credit is limited to the "adjusted base period income" of the Section 936
Corporation. Computation of the "adjusted base period income" involves three
steps: (i) the Section 936 Corporation base period years are determined (which
are, generally, three of the Section 936 Corporation's five most recent years
ending before October 14, 1995, determined by disregarding the taxable years in
which the Section 936 Corporation's Active Business Income was the highest and
the lowest); (ii) Active Business Income of the Section 936 Corporation in each
of the base period years is adjusted for inflation; and (iii) the income in the
base period years, as adjusted for inflation, is averaged.
In response to certain proposals put forth by the Government of Puerto
Rico (the "Puerto Rico Government Proposals"), the SBJPA added Section 30A to
the Code ("Section 30A"). The Puerto Rico Government Proposals included a
ten-year grandfather period for the existing 936 Credit and the creation of a
new tax credit for qualifying corporations that invest in "economically
developing jurisdictions." Section 30A incorporates in part the Puerto Rico
Government Proposals and provides for an income tax credit to domestic
corporations operating in Puerto Rico. This new credit is determined under
guidelines similar to the Economic Activity Method.
The modification of Section 936 as enacted into law could have an
adverse effect on the general economic condition of Puerto Rico, R&G Financial's
service area, by reducing incentives for investment in Puerto Rico. Any such
adverse effect on the general economy of Puerto Rico could lead to an increase
in mortgage delinquencies and a reduction in the level of residential
construction and demand for mortgage loans. The elimination of the credit for
QPSII could also lead to a decrease in the amount of 936 Funds invested in
Puerto Rico financial assets by 936 Corporations, thereby increasing funding
costs and decreasing liquidity in the Puerto Rico financial market. The
magnitude of the impact of any such changes on R&G Financial's profitability or
financial condition cannot be determined at this time. R&G Financial has taken
steps to attempt to reduce the impact of any such adverse changes by
diversifying its sources of
19
funding and identifying additional investors for its mortgage products. During
recent periods, the disparity between the cost of 936 Funds and other sources of
funding such as the Eurodollar market has decreased, thereby reducing the
adverse effect that the loss of such funding could have on the profitability of
R&G Financial.
In the absence of the 936 Credit and as a means of continuing to defer
U.S. income taxation, subsidiaries of multi-national companies operating under
Section 936 of the Code may transfer their operations to a corporation organized
under Puerto Rico law, or under the laws of foreign countries. Generally, a
non-U.S. corporation is not subject to United States income taxes to the extent
it does not derive U.S. source income and may be entitled to defer U.S. income
taxation until dividends are repatriated to the United States. Under Section 954
of the Code, foreign subsidiaries of multi-national companies whose parent
corporation is incorporated in the U.S. are not subject to federal income tax on
profits on products which they manufacture. Though a Puerto Rico corporation, or
a foreign corporation operating in Puerto Rico, is subject to local Puerto Rico
taxes, the benefits under the Industrial Incentives Acts and the 1998 TIA for
companies that manufacture or provide services in Puerto Rico, would continue to
be available. In addition, under Section 901 and 902 of the Code and subject to
certain limitations and exceptions, U.S. shareholders of a Puerto Rico or other
non-U.S. corporation would be allowed to claim a foreign tax credit with respect
to income tax paid in Puerto Rico. United States shareholders are also not
required to recognize income attributable to manufacturing operations of a
Puerto Rico or other non-U.S. corporation as a general rule under Subpart F of
the Code. However, under Section 367 of the Code, multi-national corporations
may be required to recognize income upon the transfer of operations to a Puerto
Rico or other non-U.S. corporation, depending upon the nature and value of the
property transferred. Several multi-national 936 Corporations have taken such
steps since the legislation with respect to Section 936 was first introduced in
the U.S. Congress.
In July 1997, the Government of Puerto Rico amended the tax law that
provided Puerto Rico income tax exemption on interest income generated by FHA
and VA loans secured by real estate property located in Puerto Rico and
mortgage-backed securities secured by such mortgage loans ("GNMAs"). Under the
amended law, FHA and VA loans closed prior to August 1, 1997 will continue to be
exempt. The interest income on FHA and VA mortgage loans originated on or after
August 1, 1997 for purposes other than to finance the acquisition of new
housing, and GNMAs secured by such loans, are no longer exempt, and are taxable
at a preferential 17% tax rate to individuals and certain taxpayers other than
corporations. FHA and VA loans to finance the purchase of new housing, and GNMAs
secured by such loans, continue to be exempt. Individuals who are bona fide
residents of Puerto Rico are also not subject to United States federal income
tax on income from Puerto Rico sources, including interest income derived from
mortgage loans originated in Puerto Rico whose mortgagors are residents of
Puerto Rico. The exemption for interest earned on qualifying FHA loans, VA loans
and GNMA certificates tends to increase the demand for these products and the
price R&G Financial may obtain upon their sale. There can be no assurance that
the tax exempt treatment of interest on FHA and VA loans will not be further
reviewed or modified in the future.
Any change in Puerto Rico's political status could result in the
elimination or modification of these tax benefits described above.
20
Lending Activities of the Bank
General. At December 31, 1997, R&G Financial's loans receivable, net
totalled $765.1 million, which represented 50.6% of R&G Financial's $1.5 billion
of total assets. At December 31, 1997, $733.1 million or 95.8% of R&G
Financial's loans receivable, net were held by the Bank. The principal category
of loans in R&G Financial's portfolio are conventional loans which are secured
by first liens on single-family residences. Conventional residential real estate
loans are loans which are neither insured by the FHA nor partially guaranteed by
the VA. At December 31, 1997, $475.5 million or 99.7% of R&G Financial's first
mortgage single-family residential loans consisted of conventional loans. The
other principal categories of loans in R&G Financial's loans receivable, net
portfolio are second mortgage residential real estate loans, construction loans,
commercial real estate loans, commercial business loans and consumer loans.
21
Loan Portfolio Composition. The following table sets forth the
composition of R&G Financial's loan portfolio by type of loan at the dates
indicated. Except as noted in the footnotes to the table, all of the loans are
held in the Bank's loan portfolio.
December 31,
------------------------------------------------------------------------------
1997 1996 1995
----------------------- ---------------------- ----------------------
Amount Percent Amount Percent Amount Percent
----------- ---------- ------------ --------- ------------ ---------
(Dollars in Thousands)
Residential real estate - first
mortgage(1)....................................... $476,729 61.25% $370,876 60.75% $282,498 58.23%
Residential real estate - second
mortgage.......................................... 17,831 2.29 15,757 2.58 14,372 2.96
Residential construction............................ 13,367 1.72 5,351 .88 15,046 3.10
Commercial construction and land
acquisition....................................... 5,785 .74 5,700 .93 5,523 1.14
Commercial real estate.............................. 81,722 10.50 69,514 11.39 61,862 12.74
Commercial business................................. 38,069 4.89 31,063 5.09 27,816 5.74
Consumer loans:
Loans secured by deposits......................... 12,472 1.60 9,409 1.54 7,497 1.55
Real estate secured consumer loans................ 81,252 10.44 42,893 7.03 33,381 6.88
Unsecured consumer loans.......................... 51,162 6.57 59,864 9.81 37,180 7.66
------- ------ ------- ------ ------- ------
Total loans receivable.......................... 778,389 100.00% 610,427 100.00% 485,175 100.00%
------- ------ ------- ------ ------- ------
Less:
Allowance for loan losses......................... (6,772) (3,332) (3,510)
Loans in process.................................. (6,218) (2,430) (5,727)
Deferred loan fees................................ 172 41 (266)
Unearned interest................................. (512) (955) (1,831)
------- ------- -------
(13,330) (6,676) (11,334)
------- ------- -------
Loans receivable, net(2).......................... $765,059 $603,751 $473,841
======== ======== ========
December 31,
----------------------------------------------------------
1994 1993
--------------------------- --------------------------
Amount Percent Amount Percent
------------- ------------- -------------- -----------
(Dollars in Thousands)
Residential real estate - first
mortgage(1)....................................... $194,707 62.14% $137,396 60.95%
Residential real estate - second
mortgage.......................................... 13,298 4.24 11,135 4.94
Residential construction............................ 12,039 3.84 3,940 1.75
Commercial construction and land
acquisition....................................... 1,062 0.34 1,084 0.48
Commercial real estate.............................. 43,029 13.72 30,290 13.44
Commercial business................................. 14,102 4.51 15,417 6.84
Consumer loans:
Loans secured by deposits......................... 5,829 1.86 3,815 1.69
Real estate secured consumer loans................ 29,279* 9.34* 22,355* 9.92*
Unsecured consumer loans.......................... * * * *
------- ------ ------- ------
Total loans receivable.......................... 313,345 100.00% 225,432 100.00%
------- ------ ------- ------
Less:
Allowance for loan losses......................... (2,887) (3,029)
Loans in process.................................. (5,945) (1,531)
Deferred loan fees................................ (424) (456)
Unearned interest................................. (2,475) (3,796)
------- -------
(11,731) (8,812)
------- -------
Loans receivable, net(2).......................... $301,614 $216,620
======== ========
(1) Includes $33.9 million, $49.7 million and $55.2 million of residential
real estate - first mortgage loans which are held by R&G Mortgage at
December 31, 1997, 1996 and 1995, respectively.
(2) Does not include mortgage loans held for sale of $46.9 million, $54.5
million, $21.3 million, $22.0 million and $174.2 million at December 31,
1997, 1996, 1995, 1994 and 1993, respectively.
* R&G Financial is unable to distinguish these two sub-categories of
consumer loans during the years ended December 31, 1994 and 1993.
22
Contractual Principal Repayments and Interest Rates. The following
table sets forth certain information at December 31, 1997 regarding the dollar
amount of loans maturing in R&G Financial's total loan portfolio based on the
contractual terms to maturity. Loans having no stated schedule of repayments and
no stated maturity are reported as due in one year or less.
Due 1-5 years Due 5 or more
after years after
Due 1 year December 31, December 31,
or less 1997 1997 Total(1)
----------- ------------- -------------- -----------
(In Thousands)
Residential real estate........................... $ 77 $ 683 $493,724 $494,484
Residential construction.......................... 13,443 -- -- 13,443
Commercial real estate(2)......................... 21,342 25,296 40,869 87,507
Commercial business............................... 6,224 25,305 6,540 38,069
Consumer:
Loans on savings................................ 6,572 5,320 580 12,472
Real estate secured consumer loans.............. 2,342 8,741 70,169 81,252
Unsecured consumer loans........................ 3,677 41,213 6,272 51,162
------- -------- -------- --------
Total(3).......................................... $53,677 $106,558 $618,154 $778,389
======= ======== ======== ========
- ---------------
(1) Amounts have not been reduced for the allowance for loan losses, loans
in process, deferred loan fees or unearned interest.
(2) Includes $5.8 million of commercial construction and land acquisition
loans.
(3) Does not include mortgage loans held for sale.
23
The following table sets forth the dollar amount of total loans due
after one year from December 31, 1997, as shown in the preceding table, which
have fixed interest rates or which have floating or adjustable interest rates.
Floating or
Fixed rate adjustable-rate Total
-------------------- ----------------------- -----------------------
(In Thousands)
Residential real estate..................... $494,407 $ -- $494,407
Residential construction.................... -- -- --
Commercial real estate(1)................... 4,652 61,513 66,165
Commercial business......................... 23,613 8,232 31,845
Consumer:
Loans on savings.......................... 5,900 -- 5,900
Real estate secured consumer loans........ 78,910 -- 78,910
Unsecured consumer loans.................. 47,485 -- 47,485
-------- -------- --------
Total.................................... $654,967 $ 69,745 $724,712
======== ======== ========
- ---------------
(1) Includes $5.8 million of commercial construction and land acquisition
loans.
Scheduled contractual amortization of loans does not reflect the
expected term of R&G Financial's loan portfolio. The average life of loans is
substantially less than their contractual terms because of prepayments and, with
respect to conventional loans originated for the Bank after February 1994,
due-on-sales clauses, which give R&G Financial the right to declare a
conventional loan immediately due and payable in the event, among other things,
that the borrower sells the real property subject to the mortgage and the loan
is not repaid. The average life of mortgage loans tends to increase when current
mortgage loan rates are higher than rates on existing mortgage loans and,
conversely, decrease when rates on existing mortgage loans are lower than
current mortgage loan rates (due to refinancing of adjustable-rate and
fixed-rate loans at lower rates). Under the latter circumstance, the weighted
average yield on loans decreases as higher-yielding loans are repaid or
refinanced at lower rates.
24
Origination, Purchase and Sales of Loans. The following table sets
forth loan originations, purchases and sales by the Bank for the periods
indicated.
Year Ended December 31,
-------------------------------------------------------
1997 1996 1995
------------------ ----------------- ------------------
(Dollars in Thousands)
Loan originations:
Loans originated by R&G Mortgage:
Residential mortgages................................ $221,451 $187,845 $126,599
Commercial mortgages................................. 555 -- --
Construction loans................................... 11,482 2,227 13,764
Consumer loans....................................... 52,287 21,208 15,944
Total loans originated by R&G Mortgage............. 285,775 211,280 156,307
Other loans originated:
Commercial real estate............................... 37,129 36,140 48,497
Commercial business.................................. 15,393 33,318 21,556
Consumer loans:
Loans on deposit..................................... 19,711 13,988 12,546
Real estate secured consumer loans................... -- 80 3,436
Unsecured consumer loans............................. 16,742 39,312 38,589
Total other loans originated....................... 88,975 122,838 124,624
Loans purchased(1)................................... 60,646 8,047 807
Total loans originated and purchased............... 435,396 342,165 281,738
Loans sold(2)........................................ (107,217) (49,726) (75,093)
Loan principal reductions............................ (133,837) (114,792) (78,519)
Net increase before other items, net................. 194,329 177,647 128,126
Loans securitized and transferred to
mortgage-backed securities......................... (11,346) (43,673) (17,631)
Other increases (decreases).......................... -- -- 179
Net increase in loan portfolio....................... $182,996 $133,974 $110,674
- --------------
(1) Comprised of conventional, commercial real estate and secured consumer
loans purchased from other financial institutions aggregating $54.0
million, $4.6 million and $2.0 million, respectively, in the year ended
December 31, 1997, and conventional loans of $8.1 million and $807,000
in the years ended December 31, 1996 and 1995.
(2) Loans sold by the Bank in 1995 include approximately $55.2 million of
loans sold to two commercial banks which have been recognized in R&G
Financial's Consolidated Financial Statements as a transfer of loans
with recourse. Accordingly, the aggregate principal amount of the loans
have been reported as an asset in R&G Financial's Consolidated
Financial Statements. See "Sources of Funds - Borrowings."
R&G Financial, through the Bank, originates for both investment and
sale mortgage loans secured by residential real estate (secured by both first
and second mortgage liens) as well as
25
construction loans (for residential real estate), commercial real estate loans,
commercial business loans and consumer loans.
Pursuant to the Master Production Agreement, R&G Mortgage will assist
the Bank in meeting its loan production targets and goals by, among other
things, (i) advertising, promoting and marketing to the general public; (ii)
interviewing prospective borrowers and conducting the initial processing of the
requisite loan applications, consistent with the Bank's underwriting guidelines;
and (iii) providing personnel and facilities with respect to the execution of
loan agreements approved by the Bank. R&G Mortgage performs the foregoing loan
origination services on behalf of the Bank with respect to residential mortgage
loans, some commercial real estate loans and construction loans. R&G Mortgage
receives from the Bank 75% of the applicable loan origination fee with respect
to loans originated by R&G Mortgage on behalf of the Bank pursuant to the terms
of the Master Production Agreement. During the years ended December 31, 1997,
1996 and 1995, R&G Mortgage received $5.2 million, $4.5 million and $3.6
million, respectively, of loan origination fees with respect to loans originated
by R&G Mortgage on behalf of the Bank pursuant to the terms of the Master
Production Agreement. These fees are eliminated in consolidation in R&G
Financial's Consolidated Financial Statements. See also "- General Affiliated
Transactions" and "Regulation - R&G Financial - Limitations on Transactions with
Affiliates."
The Bank originates commercial real estate, commercial business and
consumer loans. Applications for commercial real estate, commercial business and
unsecured consumer loans are taken at all of the Bank's branch offices and may
be approved by various lending officers of the Bank within designated limits,
which are established and modified from time to time to reflect an individual's
expertise and experience. All loans in excess of an individual's designated
limits are referred to an officer with the requisite authority. In addition, the
Management Credit Committee is authorized to approve all loans not exceeding
$2.5 million, and the Executive Committee of the Board of Directors is
authorized to approve all loans exceeding $2.5 million. All loans originated or
purchased by the Bank must be approved by one of the three committees set forth
above. Management of the Bank believes that its relatively centralized approach
to approving loan applications ensures strict adherence to the Bank's
underwriting guidelines while still allowing the Bank to approve loan
applications on a timely basis.
The Bank also purchases conventional loans secured by first liens on
single-family residential real estate from unrelated financial institutions.
Such loan purchases are underwritten by the Bank pursuant to the same guidelines
as direct loan originations. Loans purchased by the Bank are from time to time
securitized by R&G Mortgage and sold by the Bank. During the years ended
December 31, 1997, 1996 and 1995, the Bank purchased $60.6 million, $8.1 million
and $807,000 of loans, respectively.
During the years ended December 31, 1997, 1996 and 1995, the Bank sold
$107.2 million, $49.7 million and $75.1 million of loans. These loans, which
were primarily nonconforming loans at the time of origination, were generally
sold in packages in privately negotiated transactions with FNMA and FHLMC.
26
Pursuant to the Master Purchase Agreement, the Bank sells to R&G
Mortgage the servicing rights to all first and second mortgage loans secured by
residential properties which are or will become part of the Bank's loan
portfolio once the Bank has a commitment to sell the loans. The Master Purchase
Agreement further provides that R&G Mortgage will service all other loans held
in the Bank's portfolio (including single-family residential loans retained by
the Bank, commercial real estate, commercial business and consumer loans
(although R&G Mortgage does not actually acquire such servicing rights)). In
addition, pursuant to the Master Purchase Agreement, the Bank processes payments
on all loans serviced by R&G Mortgage on behalf of the Bank. Finally, under the
Master Purchase Agreement, R&G Mortgage renders securitization services with
respect to the pooling of some of the Bank's mortgage loans into mortgage-backed
securities. See "- Mortgage Banking Activities."
At December 31, 1997, R&G Financial's five largest loans-to-one
borrower and their related entities amounted to $1.5 million, $1.3 million, $1.2
million, $800,000 and $711,000. The largest loan concentration is a loan to a
developer of a new shopping center in Carolina. The project is in its final
stages of completion. The second largest loan concentration consists of a
commercial loan for the financing of new equipment for a medical laboratory
located in Bayamon. The third largest loan concentration is an interim
construction loan with an aggregate balance of $681,000 to a developer of 55
single family detached residential units located in Humacao with the balance
comprised of other commercial loans. The fourth largest loan concentration
represents a cash collateral personal loan at the Bank's Mayaguez branch. The
fifth largest loan consist of a commercial working capital line of credit
secured by the assignment of lease contracts. All of R&G Financial's five
largest loan concentrations were performing in accordance with their terms as of
December 31, 1997.
Single-Family Residential Real Estate Loans. The Bank has historically
concentrated its lending activities on the origination of loans secured by first
mortgage liens on existing single-family residences. At December 31, 1997,
$476.7 million or 61.3% of R&G Financial's total loans held for investment
consisted of such loans, $475.5 million or 99.7% of which consisted of
conventional loans. The Bank's first mortgage single-family residential loans
consist exclusively of fixed-rate loans with terms of between 15 and 30 years.
As evidenced by this statistic, the Puerto Rico residential mortgage market has
not been receptive to long-term adjustable rate mortgage loans.
The Bank's first mortgage single-family residential loans typically do
not exceed 80% of the appraised value of the security property. Pursuant to
underwriting guidelines adopted by the Board of Directors, the Bank can lend up
to 95% of the appraised value of the property securing a first mortgage
single-family residential loan provided the Bank obtains private mortgage
insurance with respect to the top 25% of the loan.
The Bank also originates loans secured by second mortgages on
single-family residential properties. At December 31, 1997, $17.8 million or
2.3% of R&G Financial's total loans held for investment consisted of second
mortgage loans on single-family residential properties. The Bank offers such
second mortgage loans in amounts up to $125,000 for a term not to exceed 15
27
years. The loan-to-value ratio of second mortgage loans generally is limited to
75% of the property's appraised value (including the first mortgage).
Construction Loans. In recent years, the Bank has been active in
originating loans to construct single-family residences. These construction
lending activities generally are conducted throughout Puerto Rico, although
loans are concentrated in areas contiguous to Bank branches. At December 31,
1997, residential construction loans amounted to $13.4 million or 1.7% of R&G
Financial's total loans held for investment, while commercial construction and
land acquisition loans amounted to $5.8 million or 0.7% of total loans held for
investment.
The Bank primarily offers construction loans to individual borrowers
for the purpose of constructing single-family residences. Substantially all of
the Bank's construction lending to individuals is originated on a
construction/permanent mortgage loan basis. Construction/permanent loans are
made to individuals who hold a contract with a general contractor acceptable to
the Bank to construct their personal residence. The construction phase of the
loan provides for monthly payments on an interest only basis at a designated
fixed rate for the term of the construction period, which generally does not
exceed nine months. Thereafter, the permanent loan is made at then market rates,
provided that such rate shall not be more than 2% greater than the interim
construction rate. R&G Mortgage's construction loan department approves the
proposed contractors and administers the loan during the construction phase. The
Bank's construction/permanent loan program has been successful due to its
ability to offer borrowers a single closing and, consequently, reduced costs. At
December 31, 1997, the Bank's construction loan portfolio included 127
construction/permanent loans with an aggregate principal balance of $12.7
million.
The Bank has also originated construction loans to developers on a very
limited basis to develop single family residential properties. The Bank does not
intend to actively engage in this business and will primarily undertake such
investments to accommodate a valued developer client if the Bank determines that
the project is worthy and the risk is acceptable. At December 31, 1997, the Bank
had one residential construction loan outstanding to develop a single-family
subdivision, consisting of 55 units in Humaco. The loan, which involved a $1.2
million credit facility for the fourth phase of the project, had an outstanding
balance of $681,000 at December 31, 1997. The loan is performing in accordance
with its terms. This loan is referenced in the discussion of the Bank's largest
loan concentrations above.
In addition to the foregoing, at December 31, 1997, the Bank had seven
land acquisition loans with outstanding balances ranging from $186,000 to
$650,000, and an aggregate balance of $2.9 million, which were made in
connection with projects to construct single-family residences. The Bank and the
financial institution which made the interim construction loan have entered into
an agreement pursuant to which the Bank is to be paid a percentage of the
proceeds from each home as it is released upon construction and sale. The Bank
expects to make the permanent construction loan on some of these projects. The
Bank does not expect to be active in this business.
28
The Bank intends to continue to increase its involvement in
single-family residential construction lending. Such loans afford the Bank the
opportunity to increase the interest rate sensitivity of its loan portfolio.
Construction lending is generally considered to involve a higher level of risk
as compared to permanent single-family residential lending, due to the
concentration of principal in a limited number of loans and borrowers and the
effects of general economic conditions on real estate developers and managers.
Moreover, a construction loan can involve additional risks because of the
inherent difficulty in estimating both a property's value at completion of the
project and the estimated costs (including interest) of the project. The nature
of these loans is such that they are generally more difficult to evaluate and
monitor. The Bank has taken steps to minimize the foregoing risks by, among
other things, limiting its construction lending primarily to residential
properties. In addition, the Bank has adopted underwriting guidelines which
impose stringent loan-to-value (80% with respect to single-family residential
real estate), debt service and other requirements for loans which are believed
to involve higher elements of credit risk and by working with builders with whom
it has established relationships or knowledge thereof. At December 31, 1997,
$368,000 of the Bank's construction loans were classified as non-performing.
Commercial Real Estate Loans. The Bank has also originated mortgage
loans secured by commercial real estate. At December 31, 1997, $81.7 million or
10.5% of R&G Financial's total loans held for investment consisted of such
loans. As of such date, the Bank's commercial real estate loan portfolio
consisted of approximately 775 loans with an average principal balance of
$105,000. At December 31, 1997, $6.0 million of R&G Financial's commercial real
estate loans were classified as nonperforming.
Commercial real estate loans originated by the Bank are primarily
secured by office buildings, retail stores, warehouses and general purpose
industrial space. Although terms vary, commercial real estate loans generally
are amortized over a period of 7-15 years and have maturity dates of five to
seven years. The Bank will originate these loans with interest rates which
adjust monthly in accordance with a designated prime rate plus a margin, which
generally is negotiated at the time of origination. Such loans will have a floor
but no ceiling on the amount by which the rate of interest may adjust over the
loan term. Loan-to-value ratios on the Bank's commercial real estate loans are
currently limited to 80% or lower. As part of the criteria for underwriting
commercial real estate loans, the Bank generally requires a debt coverage ratio
(the ratio of net cash from operations before payment of debt service to debt
service) of 1.30 or more. It is also the Bank's general policy to seek
additional protection to mitigate any weaknesses identified in the underwriting
process. Additional coverage may be provided through mortgage insurance,
secondary collateral and/or personal guarantees from the principals of the
borrower.
Commercial real estate lending entails different and significant risks
when compared to single-family residential lending because such loans typically
involve large loan balances to single borrowers and because the payment
experience on such loans is typically dependent on the successful operation of
the project or the borrower's business. These risks can also be significantly
affected by supply and demand conditions in the local market for apartments,
offices, warehouses or other commercial space. The Bank attempts to minimize its
risk exposure by limiting the extent of its commercial lending generally. In
addition, the Bank imposes stringent
29
loan-to-value ratios, requires conservative debt coverage ratios, and
continually monitors the operation and physical condition of the collateral.
Although the Bank has begun to increase its emphasis on commercial real estate
lending, management does not currently anticipate that its portfolio of
commercial real estate loans will grow significantly as a percentage of the
total loan portfolio.
Commercial Business Loans. Beginning in 1991, the Bank began
emphasizing commercial business loans, including working capital lines of
credit, inventory and accounts receivable loans, equipment financing (including
equipment leases), term loans, insurance premiums loans and loans guaranteed by
the Small Business Administration. Depending on the collateral pledged to secure
the extension of credit, maximum loan to value ratios are 75% or less, with
exceptions permitted to a maximum of 80%. Loan terms may vary from one to 15
years. The interest rates on such loans are generally variable and are indexed
to a designated prime rate, plus a margin. The Bank also generally obtains
personal guarantees from the principals of the borrowers. At December 31, 1997,
commercial business loans amounted to $38.1 million or 4.9% of total loans held
for investment. Although the Bank has begun to increase its emphasis on
commercial business lending, management does not currently anticipate that its
portfolio of commercial business loans will grow significantly as a percentage
of the total loan portfolio.
Consumer Loans. The Bank has begun to emphasize the origination of real
estate secured consumer loans in order to provide a full range of financial
services to its customers and because such loans generally have shorter terms
and higher interest rates than other mortgage loans. At December 31, 1997,
$144.9 million or 18.6% of R&G Financial's total loans held for investment
consisted of consumer loans. This amount is comprised mostly of real estate
secured consumer loans (which are originated by R&G Mortgage), but the Bank also
offers loans secured by deposit accounts, credit card loans and other secured
and unsecured consumer loans. Most of the Bank's consumer loans are secured and
have been primarily obtained through newspaper advertising, although loans are
also obtained from existing and walk-in customers. Although the Bank has begun
to increase its emphasis on collateralized consumer lending, management does not
currently anticipate that its portfolio of consumer loans will grow
significantly as a percentage of the total loan portfolio.
The Bank currently offers loans secured by deposit accounts, which
amounted to $12.5 million at December 31, 1997. Such loans are originated
generally for up to 90% of the account balance, with a hold placed on the
account restricting the withdrawal of the account balance. The Bank offers real
estate secured loans in amounts up to 75% of the appraised value of the
property, including the amount of any existing prior liens. Real estate secured
consumer loans have a maximum term of 10 years, which may be extended within the
sole discretion of the Bank, and an interest rate which is set at a fixed rate
based on market conditions. The Bank secures the loan with a first or second
mortgage on the property and will originate the loan even if another institution
holds the first mortgage. At December 31, 1997, real estate secured consumer
loans totalled $81.2 million. In November 1995, the Bank began issuing credit
cards in its own name. At December 31, 1997, credit card receivables totalled
$2.3 million.
30
Consumer loans generally have shorter terms and higher interest rates
than mortgage loans but generally involve more credit risk than mortgage loans
because of the type and nature of the collateral and, in certain cases, the
absence of collateral. In addition, consumer lending collections are dependent
on the borrower's continuing financial stability, and thus are more likely to be
adversely effected by job loss, divorce, illness and personal bankruptcy. In
many cases, any repossessed collateral for a defaulted consumer loan will not
provide an adequate source of repayment of the outstanding loan balance because
of improper repair and maintenance of the underlying security. The remaining
deficiency may not warrant further substantial collection efforts against the
borrower. At December 31, 1997, $4.0 million of consumer loans were classified
as non-performing.
Asset Quality
General. When a borrower fails to make a required payment on a loan,
R&G Financial attempts to cure the deficiency by contacting the borrower and
seeking payment. Contacts are generally made between the 10th and 15th day after
a payment is due. In most cases, deficiencies are cured promptly. If a
delinquency extends beyond 15 days, the loan and payment history is reviewed and
efforts are made to collect the loan. While R&G Financial generally prefers to
work with borrowers to resolve such problems, when the account becomes 90 days
delinquent in the case of mortgage loans, R&G Financial does institute
foreclosure or other proceedings, as necessary, to minimize any potential loss.
In the case of consumer loans, the Bank refers the file for collection action
after 60 days.
Loans secured by real estate are placed on non-accrual status when, in
the judgment of management, the probability of collection of interest is deemed
to be insufficient to warrant further accrual. When such a loan is placed on
non-accrual status, previously accrued but unpaid interest is deducted from
interest income. As a matter of policy, the Bank does not accrue interest on
loans past due 90 days or more which are secured by real estate. The Bank
generally takes the same position in the case of consumer loans.
Real estate acquired by the Bank as a result of foreclosure or by
deed-in-lieu of foreclosure are classified as real estate owned until sold.
Pursuant to a statement of position ("SOP 92-3") issued by the American
Institute of Certified Public Accountants in April 1992, which provides guidance
on determining the balance sheet treatment of foreclosed assets in annual
financial statements for periods ending on or after December 15, 1992, there is
a rebuttable presumption that foreclosed assets are held for sale and such
assets are recommended to be carried at the lower of fair value minus estimated
costs to sell the property, or cost (generally the balance of the loan on the
property at the date of acquisition). After the date of acquisition, all costs
incurred in maintaining the property are expensed and costs incurred for the
improvement or development of such property are capitalized up to the extent of
their net realizable value. The Bank's accounting for its real estate owned
complies with the guidance set forth in SOP 92-3.
31
The following table sets forth the amounts and categories of R&G
Financial's non-performing assets at the dates indicated. R&G Financial did not
have any troubled debt restructurings at any of the periods presented. Except as
otherwise indicated in the footnotes to the table, the non-performing assets are
assets of the Bank.
December 31,
------------------------------------------------------------------------------
1997 1996 1995 1994 1993