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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
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FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OF THE SECURITIES EXCHANGE ACT OF
1934
For the fiscal year ended December 31, 1999
Commission File No.: 0-22193
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LIFE FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 33-0743196
(State or other jurisdiction of (I.R.S. Employer
Incorporation or organization) Identification No.)
10540 Magnolia Avenue, Suite B, Riverside, California 92505
(Address of principal executive offices)
(909) 637-4000
(Registrant's telephone number, including area code)
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Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.01 per share
(Title of class)
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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 the 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. [_]
The aggregate market value of the voting stock held by non-affiliates of
the registrant, i.e., persons other than directors and executive officers of
the registrant is $17,632,484 and is based upon the last sales price as quoted
on The Nasdaq Stock Market for March 26, 2000.
As of March 26, 2000, the Registrant had 6,668,436 shares outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the 2000 Annual Meeting of Stockholders
are incorporated by reference into Part III of this Form 10-K.
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INDEX
Page
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PART I
ITEM 1. BUSINESS...................................................... 3
ITEM 2. PROPERTIES.................................................... 29
ITEM 3. LEGAL PROCEEDINGS............................................. 29
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........... 29
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS...................................................... 30
ITEM 6. SELECTED FINANCIAL DATA....................................... 30
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS.................................... 31
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................... 43
ITEM 9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE......................................... 76
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............ 76
ITEM 11. EXECUTIVE COMPENSATION........................................ 76
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT................................................... 76
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................ 76
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON
FORM 8-K..................................................... 77
SIGNATURES.............................................................. 78
2
ITEM 1. BUSINESS
General
LIFE Financial Corporation
LIFE Financial Corporation ("LIFE Financial" or "Company"), a Delaware
corporation organized in 1997, is a saving and loan holding company that owns
100% of the capital stock of LIFE Bank (the "Bank"), the Company's principal
operating subsidiary. The Bank was incorporated and commenced operations in
1983. The Company's primary businesses includes retail banking, mortgage
banking and loan servicing.
LIFE Bank
LIFE Bank is a federally chartered stock savings bank incorporated and
licensed under the laws of the United States. The Bank is a member of the
Federal Home Loan Bank of San Francisco ("FHLB"), which is a member bank of the
Federal Home Loan Bank System. The Bank's deposit accounts are insured up to
the $100,000 maximum amount currently allowable under federal laws by the
Savings Association Insurance Fund ("SAIF"), which is a separate insurance fund
administered by the Federal Deposit Insurance Corporation ("FDIC"). The Bank is
subject to examination and regulation by the Office of Thrift Supervision
("OTS") and the FDIC. The Bank is further subject to regulations of the Board
of Governors of the Federal Reserve System ("FRB") concerning reserves required
to be maintained against deposits and certain other matters.
The principal business of the Bank is attracting retail deposits from the
general public and investing those deposits, together with funds generated from
operations and borrowings, primarily in one- to four-family residential
mortgage loans. At December 31, 1999, the Bank had five and currently has six
retail bank branches located in Orange, San Bernardino and Riverside Counties,
California. Additionally, the Bank conducts its national mortgage banking and
loan servicing business from its corporate headquarters in Riverside,
California.
The mortgage banking business originates, purchases and sells conforming,
jumbo, non-conforming and other non-prime credit quality mortgage loans through
a network of approved correspondents and independent mortgage brokers. The
Company's originations and purchases are primarily 1st lien conforming, jumbo
and other non-conforming mortgages with approximately 75% of all originations
within the "A", "Alt A" and "A minus" credit categories. Additionally, the Bank
originates residential construction and consumer related loans.
At December 31, 1999, the loan servicing division serviced in excess of $1.8
billion in mortgage and consumer loans. The loan-servicing portfolio is
comprised of loans owned by the Bank of $458.6 million and loans serviced for
others of $1.4 billion.
The Company's principal sources of income are the net spread between
interest earned and the interest costs associated with deposits and other
borrowings used to finance its loan and investment portfolio, gains recognized
on whole loan sales, and servicing fee income.
At December 31, 1999, the Company had consolidated total assets of $547.6
million, total deposits of $468.9 million and total stockholders' equity of
$34.5 million. Additionally, the Bank met and exceeded all three regulatory
capital requirements, with ratios of core capital to total assets of 6.28%,
core capital to risk-weighted assets of 9.54%, and total capital to risk-
weighted assets of 10.34%. Based on the foregoing, the Bank qualified as a
"well capitalized" institution under the prompt corrective action rules of the
OTS.
Background
Prior to 1999, the Company's principal business was wholesale mortgage
banking. The Bank was primarily engaged in the origination of subprime
residential mortage loans and 2nd trust mortgage loans. As a result of the
issuance of Thrift Bulletin 72 in late 1998, the Company eliminated the High
LTV product and
3
focused on 1st trust mortgage loans to borrowers with non-prime credit
histories. The loans were sold directly to the secondary market in whole loan
sales or through securitization whereby the Company would retain the excess
cash flows ("Residual Mortgage-Backed Securities" or "Residuals") from each
securitization transaction. The market value of the Residuals are highly
dependent on certain assumptions related to loan prepayment speeds and the
predictability of credit losses.
In mid-1999, the Board of Directors hired a new President and Chief
Executive Officer, Mr. Robert K. Riley. Mr. Riley has and will continue to
build a full complement of professionals experienced in retail banking,
mortgage banking, loan servicing, financial management, and the core operations
of a financial services company. The Company's new management is undertaking a
comprehensive restructuring of all of the Company's operations including retail
banking, loan servicing, and mortgage banking with specific focus on reducing
the risk profile of the Company's core lending businesses and establishing core
earnings for the Company augmented by non-recurring gain-on-sale income from
its mortgage banking operations.
As part of an overall strategy to reduce the risk profile and earnings
volatility at the Company, the Company completed transactions to eliminate all
of its Residual Mortgage-Backed Securities and extinguish all short term debt
used to finance the Residuals. At December 31, 1998 the Company had five
Residuals valued at $50.3 million and $26.3 million in revolving and other
short-term debt. By completing the desecuritization of the Company's 1996-1 and
1997-1A & 1B transactions and the sale of the Company's 1997-2, 1997-3 and
1998-1A and 1B Residuals the Company was able to retire all of the Company's
short-term debt obligations during 1999.
Recent Developments
During the first quarter of 2000, the Company has consolidated its mortgage-
banking operations into its headquarters located in Riverside, California. The
consolidation included the Company's regional production offices located in
Colorado, Massachusetts and Florida. The Company retained its national team of
account executives and continues to originate mortgage loans nationwide. This
consolidation has resulted in improved service levels, cost reductions and
increased consistency in credit quality. With the centralization of mortgage-
banking operations and the sale of Residuals with related mortgage servicing
rights, the Company was able to reduce costs by lowering its staffing levels at
its Corporate Headquarters located in Riverside, California.
Competition
The Company's operating results and its growth prospects are most directly
and materially influenced by (1) the health and vibrancy of the United States
real estate markets, and the underlying economic forces which affect such
markets, (2) the overall complexion of the interest rate environment, including
the absolute level of market interest rates and the volatility of such rates,
(3) the prominence of competitive forces which provide customers, or potential
customers, of the company with alternative sources of mortgage funds or
investments which compete with the Company's products and services, and (4)
regulations promulgated by the regulatory authorities, including those of the
OTS, the FDIC and the FRB. The Company's success in identifying trends in each
of these factors, and implementing strategies to exploit such trends, strongly
influence the Company's long-term results and growth prospects.
As a purchaser and originator of mortgage loans, the Company faces intense
competition, primarily from mortgage banking companies, commercial banks,
credit unions, thrift institutions, credit card issuers and finance companies.
Many of these competitors in the financial services business are substantially
larger and have more capital and other resources than the Company. Furthermore,
certain large national finance companies and conforming mortgage originators
are adapting their conforming origination programs and allocation of resources
to the origination of alternative and non-conforming mortgage loans. In
addition, certain of these larger mortgage companies and commercial banks have
begun to offer products similar to those offered by the
4
Company targeting customers similar to those of the Company. The entrance of
these competitors into the Company's market could have a material adverse
effect on the Company's results of operations and financial condition.
Competition can take many forms, including convenience in obtaining a loan,
service, marketing and distribution channels and interest rates. Furthermore,
the current level of gains realized by the Company and its competitors on the
sale of the type of loans purchased and originated is attracting additional
competitors, including at least one quasi-governmental agency, into this market
with the effect of lowering the gains that may be realized by the Company on
future loan sales. Competition may be affected by fluctuations in interest
rates and general economic conditions. During periods of rising rates,
competitors which have "locked in" low borrowing costs may have a competitive
advantage. During periods of declining rates, competitors may solicit the
Company's borrowers to refinance their loans. During economic slowdowns or
recessions, the Company's borrowers may have new financial difficulties and may
be receptive to offers by the Company's competitors.
The Company depends largely on third-party originators ("Originators") for
its purchases and originations of new loans. The Company's competitors also
seek to establish relationships with the Company's Originators. The Company's
future results may become more exposed to fluctuations in the volume and cost
of its wholesale loans resulting from competition from other purchasers of such
loans, market conditions and other factors.
In addition, the Company faces increasing competition for deposits and other
financial products from non-bank institutions such as brokerage firms and
insurance companies in such areas as short-term money market funds, corporate
and government securities funds, mutual funds and annuities. In order to
compete with these other institutions with respect to deposits and fee
services, the Company relies principally upon local promotional activities,
personal relationships established by officers, directors and employees of the
Company and specialized services tailored to meet the individual needs of the
Company's customers.
Lending Activities
General. The Company originates, purchases, sells, and services primarily
1st lien conforming, jumbo, non-conforming, and other non-prime mortgages. The
Company purchases and originates mortgage loans and other real estate secured
loans primarily through a network of Mortgage Banking Correspondents and
Mortgage Brokers on a nationwide basis. The Company's primary means of
marketing its products is direct contact between its national team of account
executives and its Correspondents and Mortgage Brokers. Each of the Company's
account executives is responsible for maintaining and expanding existing Bank
relationships within the account executive's assigned territory. Loans
originated or purchased are generally originated for whole loan sale in the
secondary mortgage market.
The underwriting and quality control functions are managed through the
Company's corporate offices in Riverside, California. The Company believes that
its underwriting process begins with its staff of experienced management and
underwriters, clear underwriting policies, loan review procedures and the
monitoring by its independent quality control group. As an integral part of its
lending operation, the Company ensures that its underwriters assess each loan
application and subject property against the Company's underwriting guidelines.
Loan Approval Procedures and Authority. The Board of Directors establishes
the lending policies of the Company and delegates authority and responsibility
for loan approvals to management. Management has adopted policies which vest
approvals with individual underwriters for limited loan size amounts.
Exceptions to Bank policy, larger loan requests and more complex transactions,
are required to be reviewed and approved or declined by senior level
underwriters, supervisors and/or managers.
The Bank will not make loans-to-one borrower that are in excess of
regulatory limits. Pursuant to Office of Thrift Supervision ("OTS")
regulations, loans-to-one borrower cannot exceed 15% of the Bank's unimpaired
capital and surplus. At December 31, 1999, the Bank's loans-to-one borrower
limit equaled $5.3 million. See "--Regulation--Federal Savings Institution
Regulation--Loans-to-One Borrower."
5
One- to Four-Family Mortgage Lending. The Bank offers both fixed-rate and
adjustable-rate mortgage loans secured by one- to four-family residences
located in its primary market area and throughout the United States, with
maturities up to thirty years. At December 31, 1999, the Bank's total (gross)
loans outstanding were $458.6 million, of which $381.9 million or 83.3% were
one- to four-family residential loans. Of the one- to four- family residential
mortgage loans outstanding at that date, 51.9% were fixed rate loans, and 48.1%
were adjustable rate mortgage loans. The Bank's policy is to originate one- to
four-family residential mortgage loans in amounts in excess of 80% of the lower
of the appraised value or the selling price of the property securing the loan
with mortgage insurance.
Multi-family Lending. The Company originates and purchases multi-family real
estate loans in its primary market area. The Company has streamlined and
standardized its processing of multi-family real estate loans with a view to
sale in the secondary market. In reaching a decision on whether to make a
multi-family loan, the Bank considers the qualifications of the borrower as
well as the underlying property. Some of the factors to be considered are: the
net operating income of the mortgaged premises before debt service and
depreciation; the debt service ratio (the ratio of net earnings to debt
service); and the ratio of the loan amount to appraised value.
When evaluating the qualifications of the borrower for a multi-family loan,
the Bank considers the financial resources and income level of the borrower and
the borrower's experience in owning and managing similar property. In making
its assessment of the creditworthiness of the borrower, the Bank generally
reviews the financial statements, employment and credit history of the
borrower, as well as other related documentation.
Construction Lending. The Company originates construction loans for owner
occupied single-family homes, single-family homes on a speculative basis and
single family tract, generally in-fill projects of 10 homes or fewer. Those
projects built on a speculative basis are to merchant builders who have
demonstrated by past performance the ability to construct and effectively
market the completed product within budget and where management is comfortable
with the underlying economic conditions. The Company's loan to value maximum
policy on a speculative residential project or a commercial project is not to
exceed 75% of completed value. All construction loans at the time are priced on
a variable rate, which is adjusted daily with a spread over Wall Street Journal
Prime. The Company generally requires that the Borrower maintain a minimum 10%
cash equity position in the project. Presently, the Company lends construction
funds only in California with a concentration in Southern California.
Construction financing is generally considered to involve a higher degree of
credit risk than financing on improved, owner-occupied real estate. Risk of
loss on a construction loan is dependent largely on the accuracy of the initial
estimate of the property's value at completion of construction or development
compared to the estimated cost (including financing) of construction. If the
estimate of value proves to be inaccurate, the Bank may be confronted with a
project, when completed, having a value which is insufficient to assure full
repayment. The Bank mitigates this risk by performing a thorough analysis of
the cost estimates and actively monitoring the project during each phase of
construction.
Consumer and Other Lending. The Company's consumer and other loans generally
consist of overdraft lines of credit, small commercial business loans and
unsecured personal loans. At December 31, 1999, the Company's consumer and
other loan portfolio was $2.7 million.
Loan Servicing. The Bank also services mortgage loans for other investors.
All of the loans currently being serviced for others are loans that were
originated and sold by the Bank. The Company's loan servicing activities
include (i) the collection and remittance of mortgage loan payments, (ii)
accounting for principal and interest and other collections and expenses, (iii)
holding and disbursing escrow or impounding funds for real estate taxes and
insurance premiums, (iv) inspecting properties when appropriate, (v) contacting
delinquent borrowers, and (vi) acting as fiduciary in foreclosing and disposing
of collateral properties. The Company receives a servicing fee for performing
these services for others. At December 31, 1999, the Bank was servicing $1.4
billion of loans for other investors.
6
Loan Portfolio Composition. At December 31, 1999, the Company's gross loans
outstanding totaled $458.6 million, of which $327.0 million, or 71.3%, were
held for sale and $131.6 million, or 28.7%, were held for investment. The types
of loans that the Company may originate are subject to federal law, state law,
and regulations. Interest rates charged by the Company on loans are affected by
the demand for such loans and the supply of money available for lending
purposes and the rates offered by competitors. These factors are, in turn,
affected by, among other things, economic conditions, monetary policies of the
federal government, including the Federal Reserve Board, and legislative tax
policies.
7
The following table sets forth the composition of the Company's loan
portfolio in dollar amounts and as a percentage of the portfolio at the dates
indicated.
At December 31,
--------------------------------------------------------------------------------------------
1999 1998 1997 1996 1995
------------------ ------------------ ------------------ ----------------- -----------------
Percent Percent Percent Percent Percent
Amount of Total Amount of Total Amount of Total Amount of Total Amount of Total
-------- -------- -------- -------- -------- -------- ------- -------- ------- --------
(Dollars in thousands)
Real estate(1):
Residential:
One-to-four family.... $381,932 83.29% $294,033 87.11% $278,205 89.02% $54,275 78.67% $54,007 84.04%
Multi-family.......... 9,851 2.15 17,380 5.15 10,653 3.41 4,752 6.89 2,412 3.75
Commercial............ 11,860 2.59 14,225 4.21 16,763 5.36 9,659 14.00 7,522 11.71
Construction.......... 52,175 11.38 8,571 2.54 -- 0.00 -- 0.00 -- 0.00
Other loans:
Loans secured by
deposit accounts...... 205 0.04 270 0.08 165 0.05 177 0.25 186 0.29
Unsecured commercial
loans................. 43 0.01 124 0.04 63 0.02 67 0.10 70 0.11
Unsecured consumer
loans................. 2,490 0.54 2,951 0.87 6,675 2.14 65 0.09 63 0.10
-------- ------ -------- ------ -------- ------ ------- ------ ------- ------
Total gross loans... 458,556 100.00% 337,554 100.00% 312,524 100.00% 68,995 100.00% 64,260 100.00%
====== ====== ====== ====== ======
Less (plus):
Undisbursed loan
funds................. 25,885 6,399 -- -- --
Deferred loan
origination (costs)
Fees and (premiums)
and discounts......... (4,406) (5,946) (8,393) (543) (298)
Allowance for
estimated loan
losses................ 2,749 2,777 2,573 1,625 1,177
-------- -------- -------- ------- -------
Loans Receivable,
net................. $434,328 $334,324 $318,344 $67,913 $63,381
======== ======== ======== ======= =======
- ----
(1) Includes second trust deeds.
8
Loan Maturity. The following table shows the contractual maturity of the
Bank's gross loans at December 31, 1999. There were $327.0 million of loans
held for sale, gross, at December 31, 1999. The table does not reflect
prepayment assumptions.
At December 31, 1999
---------------------------------------------------------------
One-to-Four Multi- Other Total Loans
Family Family Commercial Construction Loans Receivable
----------- ------- ---------- ------------ ----- -----------
(Dollars in thousands)
Amounts due:
One year or less....... $ 270 $ 21 $ 836 $51,038 $ 326 $ 52,491
After one year:
More than one year to
three years.......... 280 118 2,867 1,137 2,257 6,659
More than three years
to five years........ 152 1,062 737 -- 84 2,035
More than five years
to 10 years.......... 1,183 27 4,634 -- 45 5,889
More than 10 years to
20 years............. 123,352 5,855 1,849 -- -- 131,056
More than 20 years.... 256,695 2,770 936 -- 25 260,426
-------- ------- ------- ------- ----- --------
Total amount due..... 381,932 9,853 11,859 52,175 2,737 458,556
Less (plus):
Undisbursed loan
funds................. -- -- -- 25,885 -- 25,885
Unamortized discounts
(premiums)............ (5,858) (49) (25) -- 149 (5,783)
Deferred loan
origination fees
(costs)............... (2,477) 30 73 311 (35) (2,098)
Lower of Cost or
Market................ 2,985 63 76 334 17 3,475
Allowance for estimated
loan losses........... 2,300 58 70 306 15 2,749
-------- ------- ------- ------- ----- --------
Total loans, net..... 384,982 9,751 11,665 25,339 2,591 434,328
-------- ------- ------- ------- ----- --------
Loans held for sale,
net................... 316,052 6,126 6,228 -- 2,321 330,727
-------- ------- ------- ------- ----- --------
Loans held for
investment, net....... $ 68,930 $ 3,625 $ 5,437 $25,339 $ 270 $103,601
======== ======= ======= ======= ===== ========
The following table sets forth at December 31, 1999, the dollar amount of
gross loans receivable contractually due after December 31, 2000, and whether
such loans have fixed interest rates or adjustable interest rates. The
Company's adjustable-rate mortgage loans require that any payment adjustment
resulting from a change in the interest rate be made to both the interest and
payment in order to result in full amortization of the loan by the end of the
loan term, and thus, do not permit negative amortization.
Due After December 31, 2000
----------------------------
Fixed Adjustable Total
-------- ---------- --------
(Dollars in thousands)
Real estate loans:
Residential
One-to-four family........................... $198,273 $183,389 $381,662
Multi-family................................. 2,481 7,350 9,831
Commercial.................................... 4,884 6,140 11,024
Construction.................................. -- 1,137 1,137
Other loans................................... 2,388 23 2,411
-------- -------- --------
Total gross loans receivable............... $208,026 $198,039 $406,065
======== ======== ========
9
The following table sets forth the Company's loan originations, purchases,
sales, and principal repayments for the periods indicated:
For the Year Ended
December 31,
------------------------------
1999 1998 1997
---------- ---------- --------
(Dollars in thousands)
Gross loans(1)
Beginning balance............................... $ 337,554 $ 312,524 $ 68,995
Loans originated:
One to four family(2)......................... 387,999 440,685 341,294
Multi-family.................................. 13,591 34,596 18,019
Commercial and land........................... 10,164 22,274 13,631
Construction loans............................ 54,045 8,571 0
Other loans................................... 1,743 309 837
---------- ---------- --------
Total loans originated...................... 467,542 506,435 373,781
Loans purchased................................ 573,626 674,117 399,326
---------- ---------- --------
Sub total--Production.......................... 1,041,168 1,180,552 773,107
---------- ---------- --------
Total....................................... 1,378,722 1,493,076 842,102
Less:
Principal repayments........................... 114,944 79,085 17,289
Sales of loans................................. 799,353 610,468 94,705
Securitization of loans........................ 0 462,067 415,350
Transfer to REO................................ 5,869 3,902 2,234
---------- ---------- --------
Total Gross loans........................... 458,556 337,554 312,524
Ending balance loans held for sale.............. 326,965 238,664 280,859
---------- ---------- --------
Ending balance loans held for investment........ $ 131,591 $ 98,890 $ 31,665
========== ========== ========
- --------
(1) Gross loans includes loans held for investment and loans held for sale.
(2) Includes second trust deeds.
Delinquencies and Classified Assets. Federal regulations and the Bank's
Classification of Assets Policy require that the Bank utilize an internal asset
classification system as a means of reporting problem and potential problem
assets. The Bank has incorporated the OTS internal asset classifications as a
part of its credit monitoring system. The Bank currently classifies problem and
potential problem assets as "Substandard," "Doubtful" or "Loss" assets. An
asset is considered "Substandard" if it is inadequately protected by the
current net worth and paying capacity of the obligor or of the collateral
pledged, if any. "Substandard" assets include those characterized by the
"distinct possibility" that the insured institution will sustain "some loss" if
the deficiencies are not corrected. Assets classified as "Doubtful" have all of
the weaknesses inherent in those classified "Substandard" with the added
characteristic that the weaknesses present make "collection or liquidation in
full," on the basis of currently existing facts, conditions, and values,
"highly questionable and improbable." Assets classified as "Loss" are those
considered "uncollectible" and of such little value that their continuance as
assets without the establishment of a specific loss allowance is not warranted.
Assets which do not currently expose the insured institution to sufficient risk
to warrant classification in one of the aforementioned categories but possess
weaknesses are required to be designated "Special Mention."
When an insured institution classifies one or more assets, or portions
thereof, as Substandard or Doubtful, under current OTS policy the Bank is
required to consider establishing a general valuation allowance in an amount
deemed prudent by management. The general valuation allowance, which is a
regulatory term, represents a loss allowance which has been established to
recognize the inherent credit risk associated with lending and investing
activities, but which, unlike specific allowances, has not been allocated to
particular problem assets. When an insured institution classifies one or more
assets, or portions thereof, as "Loss," it is
10
required either to establish a specific allowance for losses equal to 100% of
the amount of the asset so classified or to charge off such amount.
A savings institution's determination as to the classification of its assets
and the amount of its valuation allowances is subject to review by the OTS
which can order the establishment of additional general or specific loss
allowances. The OTS, in conjunction with the other federal banking agencies,
adopted an interagency policy statement on the allowance for loan and lease
losses. The policy statement provides guidance for financial institutions on
both the responsibilities of management for the assessment and establishment of
adequate allowances and guidance for banking agency examiners to use in
determining the adequacy of general valuation allowances. Generally, the policy
statement recommends that institutions have effective systems and controls to
identify, monitor and address asset quality problems; that management has
analyzed all significant factors that affect the collectibility of the
portfolio in a reasonable manner; and that management has established
acceptable allowance evaluation processes that meet the objectives set forth in
the policy statement. While the Bank believes that it has established an
adequate allowance for estimated loan losses, there can be no assurance that
regulators, in reviewing the Bank's loan portfolio, will not request the Bank
to materially increase at that time its allowance for estimated loan losses,
thereby negatively affecting the Bank's financial condition and earnings at
that time. Although management believes that an adequate allowance for
estimated loan losses has been established, actual losses are dependent upon
future events and, as such, further additions to the level of allowances for
estimated loan losses may become necessary.
The Bank's Internal Asset Review Committee reviews and classifies the Bank's
assets quarterly and reports the results of its review to the Board of
Directors. The Bank classifies assets in accordance with the management
guidelines described above. REO is classified as Substandard. The following
table sets forth information concerning substandard loans, REO and total
classified assets at December 31, 1999.
At December 31, 1999
------------------------------------------------------
Total
Substandard,
Doubtful and
Loans REO Loss Assets
----------------- ------------------ -----------------
Gross Number of Gross Number of Gross Number of
Balance Loans Balance Properties Balance Assets
------- --------- ------- ---------- ------- ---------
(Dollars in thousands)
Residential:
One-to-four family.... $3,793 62 $2,330 29 $6,123 91
Multi-family.......... 198 1 -- -- 198 1
Commercial.............. -- -- -- -- -- --
Other loans............. 27 7 -- -- 27 7
------ --- ------ --- ------ ---
Total loans......... $4,018 70 $2,330 29 $6,348 99
====== === ====== === ====== ===
At December 31, 1999 the Bank had $1.3 million of assets classified as
Special Mention, $6.3 million of assets classified as Substandard, there were
no assets classified as Doubtful or Loss. As of December 31, 1999, assets
classified as Special Mention secured by one- to four-family residential
properties include 59 loans totaling $1.2 million. At December 31, 1999, the
largest loan classified as Special Mention had a loan balance of $139,000 and
is secured by a one- to four-family residential property.
Non-Accrual and Past-Due Loans. The following table sets forth information
regarding non-accrual loans, troubled-debt restructurings and REO in the
Company's loan portfolio. There was one troubled-debt restructured loan within
the meaning of SFAS 15, and 29 REO properties at December 31, 1999. The
Company's current policy is to cease accruing interest on loans 90 days or more
past due. For the years ended December 31, 1999, 1998, 1997, 1996 and 1995,
respectively, the amount of interest income that would have been recognized on
nonaccrual loans if such loans had continued to perform in accordance with
their contractual terms was $384,000, $789,000, $424,000, $179,000, and
$67,000, none of which was recognized. For the same periods, the amount of
interest income recognized on troubled debt restructurings was $0, $0, $0,
$12,000, and $11,000.
11
At December 31,
--------------------------------------
1999 1998 1997 1996 1995
------ ------ ------ ------ ------
(Dollars in thousands)
Non-accrual loans:
One-to-four family................... $2,462 $7,134 $3,245 $2,361 $1,305
Multi-family........................ 198 0 0 45 0
Commercial and land................. 0 131 131 0 82
Other loans......................... 27 279 1,750 10 10
------ ------ ------ ------ ------
Total nonaccrual loans............ 2,687 7,544 5,126 2,416 1,397
Foreclosure in process(3)............ 1,331 0 0 0 0
------ ------ ------ ------ ------
Total nonperforming loans......... 4,018 7,544 5,126 2,416 1,397
REO, net(1).......................... 2,214 1,898 1,440 561 827
------ ------ ------ ------ ------
Total nonperforming assets........ $6,232 $9,442 $6,566 $2,977 $2,224
====== ====== ====== ====== ======
Restructured loans.................... $ 0 $ 131 $ 131 $ 131 $ 131
Allowance for estimated loan losses as
a percent of gross loans
receivable(2)........................ 0.60% 0.82% 0.82% 2.36% 1.83%
Allowance for estimated loan losses as
a percent of total nonperforming
loans(3)............................. 68.43% 36.81% 50.20% 67.26% 84.25%
Nonperforming loans as a percent of
gross loans receivable(2)(3)......... 0.88% 2.23% 1.64% 3.50% 2.17%
Nonperforming assets as a percent of
total assets(3)...................... 1.14% 2.21% 1.65% 2.93% 3.00%
- --------
(1) REO balances are shown net of related loss allowances.
(2) Gross loans includes loans receivable held for investment and loans
receivable held for sale.
(3) Non-performing assets consist of non-performing loans and REO. Prior to
April 1, 1996, non-performing loans consisted of all loans 45 days or more
past due and all other non-accrual loans. Following March 31, 1996, non-
performing loans consisted of all loans 90 days or more past due and all
other non-accrual loans. At December 31, 1999, nonperforming loans
consisted of all loans 90 days or more past due, foreclosures in process
less than 90 days past due, and all other non-accrual loans.
12
The following table sets forth delinquencies in the Company's loan portfolio
as of the dates indicated:
At December 31, 1999 At December 31, 1998
--------------------------------- ---------------------------------
60-89 Days 90 Days or More 60-89 Days 90 Days or More
---------------- ---------------- ---------------- ----------------
Number Principal Number Principal Number Principal Number Principal
of Balance of Balance of Balance of Balance
Loans of Loans Loans of Loans Loans of Loans Loans of Loans
------ --------- ------ --------- ------ --------- ------ ---------
(Dollars in thousands)
One to four family...... 33 $1,179 62 $3,793 6 $326 68 $7,134
Multi-family............ 0 -- 1 198 0 -- 0 --
Commercial.............. 0 -- 0 -- 0 -- 1 131
Other loans............. 26 84 7 27 36 160 61 279
--- ------ --- ------ --- ---- --- ------
Total................... 59 $1,263 70 $4,018 42 $486 130 $7,544
=== ====== === ====== === ==== === ======
Delinquent loans to
total gross loans...... 0.28% 0.88% 0.14% 2.23%
====== ====== ==== ======
At December 31, 1997
---------------------------------
60-89 Days 90 Days or More
---------------- ----------------
Number Principal Number Principal
of Balance of Balance
Loans of Loans Loans of Loans
------ --------- ------ ---------
(Dollars in thousands)
One to four family........................... 27 $2,328 33 $3,245
Multi-family................................. 0 -- 0 --
Commercial................................... 0 -- 1 131
Other loans.................................. 115 583 321 1,750
--- ------ --- ------
Total........................................ 142 $2,911 355 $5,126
=== ====== === ======
Delinquent loans to total gross loans........ 0.93% 1.64%
====== ======
Allowance for Loan Losses. The Company maintains an allowance for loan
losses to absorb losses inherent primarily in the loans held for investment
portfolio. Loans held for sale are carried at the lower of cost or estimated
market value. Net unrealized losses, if any, are recognized in a lower of cost
or market valuation allowance by charges to operations. The allowance is based
on ongoing, quarterly assessments of probable estimated losses inherent in the
loan portfolios. The Company's methodology for assessing the appropriateness of
the allowance consists of several key elements, which include the formula
allowance, specific allowance for identified problem loans and portfolio
segments and the unallocated allowance. In addition, the allowance incorporates
the results of measuring impaired loans as provided in Statement of financial
Accounting Standards ("SFAS") No. 114, "Accounting by Creditors for Impairment
of a Loan" and SFAS No. 118 "Accounting by Creditors for Impairment of Loan-
Income Recognition and Disclosures." These accounting standards prescribe the
measurement methods, income recognition and disclosures related to impaired
loans.
The formula allowance is calculated by applying loss factors to outstanding
loans held for investment. The factors are based upon the composite industry
standards and may be adjusted for significant factors that, in management's
judgment, affect the collectibility of the portfolios as of the evaluation
date.
Specific allowances are established in cases where management has identified
significant conditions or circumstances related to a credit that management
believes indicates the probability that a loss has been incurred in excess of
the amount determined by the application of the formula allowance.
The unallocated allowance is based upon management's evaluation of various
conditions, the effect of which are not directly measured in the determination
of the formula and specific allowance. The evaluation of the inherent loss with
respect to these conditions is subject to a higher degree of uncertainty
because they are not identified with specific problem credits or portfolio
segments. The conditions evaluated in connection with the unallocated allowance
include the following conditions that existed as of the balance sheet date:
13
(1) then-existing general economic and business conditions affecting the key
lending areas of the Company, (2) credit quality trends, (3) loan volumes and
concentrations, (4) recent loss experience in particular segments of the
portfolio, and (5) regulatory examination results.
Executive management reviews the conditions quarterly in discussion with the
Company's senior officers. To the extent that any of these conditions are
evidenced by a specifically identifiable problem credit or portfolio segment as
of the evaluation date, management's estimate of the effect of such condition
may be reflected as a specific allowance applicable to such credit or portfolio
segment. Where any of these conditions is not evidenced by a specifically
identifiable problem credit or portfolio segment as of the evaluation date,
management's evaluation of the probable loss related to such condition is
reflected in the unallocated allowance. By assessing the probable estimated
losses inherent in the loan portfolios on a quarterly basis, the Company is
able to adjust specific and inherent loss estimates based upon more recent
information that has become available.
As of December 31, 1999, the Company's allowance for loan losses was $2.7
million or 0.60% of total gross loans, and 68.43% of non-performing loans
compared to an allowance for loan losses of $2.8 million at December 31, 1998
or 0.82% of gross loans and 36.81% of non-performing loans. The following table
sets forth activity in the Company's allowance for loan losses for the periods
set forth in the table.
At or for the Year
Ended December 31,
----------------------------
In thousands 1999 1998 1997
- ------------ -------- -------- --------
Balance at beginning of period.................... $ 2,777 $ 2,573 $ 1,625
Provision for loan losses......................... 5,382 4,166 1,850
Charge-offs:
Real estate:
One to four family............................ 3,163 1,023 901
Multi-family.................................. -- -- --
Commercial.................................... -- -- --
Other loans..................................... 2,677 3,048 8
-------- -------- --------
Total charge-offs............................... 5,840 4,071 909
Recoveries........................................ 430 109 7
-------- -------- --------
Balance at end of period.......................... $ 2,749 $ 2,777 $ 2,573
======== ======== ========
Average net loans outstanding..................... $411,189 $329,699 $191,140
======== ======== ========
Net charge-offs to average net loans.............. 1.31% 1.20% 0.47%
The following table sets forth the amount of the Company's allowance for
loan losses, the percent of allowance for loan losses to total allowance and
the percent of gross loans to total gross loans in each of the categories
listed at the dates indicated.
1999 1998 1997
----------------------------- ----------------------------- -----------------------------
Percent of Percent of Percent of Percent of Percent of Percent of
Allowance Gross Loans Allowance Gross Loans Allowance Gross Loans
to Total to Total to Total to Total to Total to Total
Amount Allowance Gross Loans Amount Allowance Gross Loans Amount Allowance Gross Loans
------ ---------- ----------- ------ ---------- ----------- ------ ---------- -----------
In thousands
------------ ------
One to four family...... $2,582 93.93% 83.29% $1,984 71.45% 64.54% $1,206 46.87% 89.02%
Multi-family............ 64 2.33 2.15 68 2.46 5.16 66 2.57 3.41
Commercial.............. 6 0.22 2.59 250 9.00 4.22 150 5.83 5.36
Construction............ 26 0.95 11.38 60 2.16 2.54 -- 0.00 0.00
Other................... 71 2.57 0.59 415 14.93 23.44 1,151 44.73 2.21
------ ------ ------ ------ ------ ------ ------ ------ ------
Total allowance........ $2,749 100.00% 100.00% $2,777 100.00% 100.00% $2,573 100.00% 100.00%
====== ====== ====== ====== ====== ====== ====== ====== ======
Real Estate Owned. At December 31, 1999, the Company had $2.2 million of
REO, net of allowances. Real estate properties acquired through or in lieu of
loan foreclosure are initially recorded at the lower of fair value or the
balance of the loan at the date of foreclosure through a charge to the
allowance for estimated loan losses. After
14
foreclosure, valuations are periodically performed by management and an
allowance for REO losses is established by a charge to operations if the
carrying value of a property exceeds its fair value less estimated cost to
sell. It is the policy of the Company to obtain an appraisal and /or a market
evaluation on all REO at the time of possession and every six months
thereafter.
Investment Activities
Federally chartered savings institutions, such as the Bank, have the
authority to invest in various types of liquid assets, including United States
Treasury obligations, securities of various federal agencies, certificates of
deposit of insured banks and savings institutions, bankers' acceptances, and
federal funds. Subject to various restrictions, federally chartered savings
institutions may also invest their assets in commercial paper, investment-grade
corporate debt securities and mutual funds whose assets conform to the
investments that a federally chartered savings institution is otherwise
authorized to make directly. Additionally, the Bank must maintain minimum
levels of investments that qualify as liquid assets under OTS regulations. See
"--Regulation--Federal Savings Institution Regulation--Liquidity."
Historically, the Bank has maintained liquid assets above the minimum OTS
requirements and at a level considered to be adequate to meet its normal daily
activities.
The investment policy of the Company as established by the Board of
Directors attempts to provide and maintain liquidity, generate a favorable
return on investments without incurring undue interest rate and credit risk,
and complement the Company's lending activities. Specifically, the Company's
policies generally limit investments to government and federal agency-backed
securities and non-government guaranteed securities, including corporate debt
obligations, that are investment grade. The Company's policies provide the
authority to invest in marketable securities guaranteed by the U.S. government
and agencies thereof and other financial institutions.
At December 31, 1999 the Company had $5 thousand in its mortgage-backed
securities portfolio, all of which were insured or guaranteed by the FHLMC and
are being held-to-maturity. The Company may increase its investment in
mortgage-backed securities in the future depending on its liquidity needs and
market opportunities. Investments in mortgage-backed securities involve a risk
that actual prepayments will be greater than estimated prepayments over the
life of the security which may require adjustments to the amortization of any
premium or accretion of any discount relating to such instruments thereby
reducing the net yield on such securities. There is also reinvestment risk
associated with the cash flows from such securities. In addition, the market
value of such securities may be adversely affected by changes in interest
rates.
The following table sets forth certain information regarding the carrying
and fair values of the Company's securities at the dates indicated. There were
no securities available-for-sale at the dates indicated.
At December 31
--------------------------------------------------
1999 1998 1997
---------------- ---------------- ----------------
Carrying Fair Carrying Fair Carrying Fair
Value Value Value Value Value Value
-------- ------- -------- ------- -------- -------
(Dollars in thousands)
Securities
Residual mortgage-backed
securities............... $ 0 $ 0 $50,296 $50,296 $45,352 $45,352
Held to maturity:
US Treasury and other
agency securities........ 29,955 29,945 2,000 2,012 5,003 5,021
Mortgage backed
securities............... 5 5 8 8 9 9
Other securities (FHLB
Stock)................... 2,873 2,873 2,463 2,463 1,067 1,067
------- ------- ------- ------- ------- -------
Total mortgage & other
securities............. $32,833 $32,823 $54,767 $54,779 $51,431 $51,449
======= ======= ======= ======= ======= =======
At December 31, 1998, the Company had five residual mortgage-backed
securities valued at $50.3 million. By completing the desecuritization of the
Company's 1996-1 and 1997-1A and 1B transactions and the sale of the Company's
1997-2, 1997-3, and 1998-1A and 1B Residuals, the Company divested its holdings
of residual mortgage-backed securities retained from securitizations during
1999.
15
The Company sold its remaining residual mortgage-backed securities retained
from securitization and related mortgage servicing rights for an amount valued
at $19.3 million in cash and other consideration. The Company received from the
purchaser of the residual mortgage-backed securities, a contractual right to
receive 50% of any cash realized from the residual mortgage-backed securities
(the "Participation Contract"). The right to receive cash flows under the
Participation Contract begins after the purchaser recaptures their initial cash
investment of $8.1 million and a 15% internal rate of return (the "Hurdle
Amount") from the transaction. Additionally, the Company entered into a credit
guaranty related to a $14.6 million pool of sub- performing loans in the 1998-
1A and 1B securitization whereby the Company guaranteed the difference between
the December 1, 1999, unpaid principal balance and the realized value of those
loans at final disposition. At December 31, 1999, the Company estimated the
obligation under the credit guaranty at $4.3 million. Any proceeds paid to the
purchaser under the credit guaranty will be applied to the $8.1 million Hurdle
Amount for cash distributions on the Participation Contract.
The table below sets forth certain information regarding the carrying value,
weighted average yields and contractual maturities of the Company's securities
as of December 31, 1999.
At December 31, 1999
-----------------------------------------------------------------------------------------
More than One More than Five
Year to Five Years to Ten More than
One Year or Less Years Years Ten Years Total
----------------- ----------------- ----------------- ----------------- -----------------
Weighted Weighted Weighted Weighted Weighted
Carrying Average Carrying Average Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield Value Yield Value Yield
-------- -------- -------- -------- -------- -------- -------- -------- -------- --------
(Dollars in thousands)
Held to maturity
investment securities
US Treasury and other
agency securities..... $29,955 5.95% $ -- 0.00% $ -- 0.00% $ -- 0.00% $29,955 5.95%
Mortgage-backed
securities............ -- 0.00 -- 0.00 -- 0.00 5 3.16 5 3.16
Other securities....... 2,723 5.30 -- 0.00 -- 0.00 150 0.00 2,873 5.02
------- ----- ----- ----- -------
Total Investment
Securities............. $32,678 5.90% $ -- 0.00% $ -- 0.00% $ 155 0.11% $32,833 5.87%
======= ===== ===== ===== =======
Sources of Funds
General. Deposits, lines of credit, loan repayments and prepayments,
proceeds from loan sales and cash flows generated from operations and
borrowings are the primary sources of the Company's funds for use in lending,
investing and for other general purposes.
Deposits. The Company offers a variety of deposit accounts with a range of
interest rates and terms. The Company's deposits consist of passbook savings,
checking accounts, money market savings accounts and certificates of deposit.
For the year ended December 31, 1999, certificates of deposit constituted 92.5%
of total average deposits. The term of the fixed-rate certificates of deposit
offered by the Company vary from 30 days to eighteen years. Specific terms of
an individual account vary according to the type of account, the minimum
balance required, the time period funds must remain on deposit and the interest
rate, among other factors. The flow of deposits is influenced significantly by
general economic conditions, changes in money market rates, prevailing interest
rates and competition. At December 31, 1999, the Company had $428.0 million of
certificate accounts maturing in one year or less.
The Company relies primarily on customer service and long-standing
relationships with customers to attract and retain local deposits; however,
market interest rates and rates offered by competing financial institutions
significantly affect the Company's ability to attract and retain deposits. From
time to time the Company utilize brokered deposits. At December 31, 1999, the
Company had no brokered deposits.
Although the Company has a significant portion of its deposits in shorter
term certificates of deposit, management monitors activity on the Company's
certificate of deposit accounts and, based on historical experience, and the
Company's current pricing strategy, believes that it will retain a large
portion of such accounts upon maturity. Further increases in short-term
certificate of deposit accounts, which tend to be more sensitive to movements
in market interest rates than core deposits, may result in the Company's
deposit base being less stable than if it had a large amount of core deposits
which, in turn, may result in further increases in the Company's cost of
deposits. Notwithstanding the foregoing, the Company believes that it will
continue to have access to sufficient amounts of certificates of deposit
accounts which, together with other funding sources, will provide it with the
necessary level of liquidity to continue to implement its business strategies.
16
The following table presents the deposit activity of the Company for the
periods indicated:
For the Year Ended
December 31,
--------------------------
1999 1998 1997
-------- -------- --------
(Dollars in thousands)
Net deposits (withdrawals)....................... $123,302 $ 97,638 $118,078
Interest credited on deposit accounts............ 22,124 14,030 7,976
-------- -------- --------
Total increase in deposit accounts............. $145,426 $111,668 $126,054
======== ======== ========
At December 31, 1999, the Company had $130.1 million in certificate accounts
in amounts of $100,000 or more maturing as follows:
Weighted
Maturity Period Amount Average Rate
--------------- ------ ------------
(Dollars in
thousands)
Three months or less................................... $ 35,962 5.55%
Over three months through 12 months.................... 93,343 6.07
Over 12 months......................................... 808 6.27
--------
Total................................................ $130,113 5.93%
========
The following table sets forth the distribution of the Company's average
deposit accounts for the periods indicated and the weighted average interest
rates on each category of deposits presented.
For the Year For the Year For the Year
Ended December 31, Ended December 31, Ended December 31,
-------------------------- -------------------------- --------------------------
1999 1998 1997
-------------------------- -------------------------- --------------------------
(Dollars in Thousands)
Percent Percent Percent
of Total Weighted of Total Weighted of Total Weighted
Average Average Average Average Average Average Average Average Average
Balance Deposits Rate Balance Deposits Rate Balance Deposits Rate
-------- -------- -------- -------- -------- -------- -------- -------- --------
Passbook accounts....... $ 4,639 1.09% 2.10% $ 4,324 1.69% 2.36% $ 4,003 2.73% 2.10%
Money market accounts... 6,857 1.62 4.28 4,779 1.87 4.79 2,971 2.02 2.96
Checking accounts....... 20,337 4.80 1.51 17,966 7.01 1.72 11,756 8.00 2.37
-------- ------ -------- ------ -------- ------
Sub-total.............. 31,833 7.51 2.30 27,069 10.57 2.36 18,730 12.75 2.41
Certificate accounts:
Three months or less... 8,706 2.05 5.12 9,148 3.57 5.52 15,887 10.81 5.54
Four through 12
months................ 328,635 77.53 5.40 192,871 75.28 5.85 88,129 59.97 6.01
13 through 36 months... 50,786 11.98 5.57 22,105 8.63 5.84 18,467 12.57 5.71
37 months or greater... 3,945 0.93 6.55 4,997 1.95 6.55 5,730 3.90 6.28
-------- ------ -------- ------ -------- ------
Total certificate
accounts.............. 392,072 92.49 5.43 229,121 89.43 5.85 128,213 87.25 5.92
-------- ------ -------- ------ -------- ------
Total average
deposits.............. $423,905 100.00% 5.17% $256,190 100.00% 5.48% $146,943 100.00% 5.47%
======== ====== ======== ====== ======== ======
17
The following table presents, by various rate categories, the amount of
certificate accounts outstanding at the date indicated and the periods to
maturity of the certificate accounts outstanding at December 31, 1999.
Period to Maturity from December 31, 1999 At December 31,
--------------------------------------------------------------- -----------------
Less
than One One to Two to Three to Four to More than
Yr Two Yrs Three Yrs Four Yrs Five Yrs Five Yrs Total 1998 1997
-------- ------- --------- -------- -------- --------- -------- -------- --------
(Dollars in thousands)
Certificate Accounts:
0 to 4.00%............ $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0
4.01 to 5.00%......... 31,223 125 2 64 4 48 31,466 16,436 2,344
5.01 to 6.00%......... 186,383 1,333 263 96 10 400 188,485 266,323 102,920
6.01 to 7.00%......... 209,913 121 17 6 0 115 210,172 12,648 87,009
7.01 to 8.00%......... 435 282 97 36 59 300 1,209 1,568 1,572
8.01 to 9.00%......... -- -- -- -- -- -- -- -- --
Over 9.01%............ -- -- -- -- -- -- -- -- --
-------- ------ ---- ---- --- ---- -------- -------- --------
Total............... $427,954 $1,861 $379 $202 $73 $863 $431,332 $296,975 $193,845
======== ====== ==== ==== === ==== ======== ======== ========
Borrowings. From time to time the Bank has obtained advances from the FHLB
as an alternative to retail deposit funds and internally generated funds and
may do so in the future as part of its operating strategy. FHLB advances may
also be used to acquire certain other assets as may be deemed appropriate for
investment purposes. These advances are collateralized primarily by certain of
the Bank's mortgage loans and mortgage-backed securities and secondarily by the
Bank's investment in capital stock of the FHLB. See "Regulation--Federal Home
Loan Bank System." Such advances are made pursuant to several different credit
programs, each of which has its own interest rate and range of maturities. The
maximum amount that the FHLB will advance to member institutions, including the
Bank, fluctuates from time-to-time in accordance with the policies of the OTS
and the FHLB. At December 31, 1999, the Bank had no outstanding advances from
the FHLB.
Both the Company and the Bank have the ability to enter into lines of credit
to finance mortgages, mortgage-backed securities and for other corporate
purposes. At December 31, 1999, the Bank has a warehouse line of credit in the
amount of $250.0 million, of which zero has been drawn at December 31, 1999.
The line of credit is secured by mortgage loans or mortgage-backed securities
with interest rates from LIBOR plus 50 basis points to LIBOR plus 100 basis
points. In addition, the Company has two lines of credit in the amount of
$40 million and $10 million secured by residual assets created by the Company's
securitizations and stock of the Bank, respectively. $17.9 million was
outstanding under the lines at December 31, 1999 and both lines were fully
repaid at January 31, 2000. The warehouse and residual financing lines of
credit are uncommitted and may be terminated by the lenders at will. The $10
million unsecured revolving line of credit is a committed, 364 day, facility
that matures in November 2000. These lines of credit contain affirmative,
negative and financial covenants. Due to the sale of the Company's residual
mortgage-backed securities, certain covenants related to the $40 million and
$10 million line of credit were violated. The Company was in compliance with
all other lines of credit covenants at December 31, 1999.
On March 14, 1997, the Company issued subordinated debentures (the
"Debentures") in the aggregate principal amount of $10.0 million through the
Debenture Offering. On September 15, 1998, holders of $8.5 million in
Debentures exercised their option to put their Debentures as of December 14,
1998, thereby reducing outstanding Debentures to $1.5 million. See
"Regulation--Federal Savings Institution Regulation-- Capital Requirements."
Additionally, see further detail in "Note 10 Subordinated Debentures--Notes to
Consolidated Financial Statements".
18
The following table sets forth certain information regarding the Company's
borrowed funds at or for the years ended on the dates indicated:
At or For Year Ended December 31,
------------------------------------
1999 1998 1997
----------- ----------- -----------
(Dollars in thousands)
FHLB advances
Average balance outstanding............ $ 15,363 $ 1,154 $ 8,284
Maximum amount outstanding at any
month-end during the year ............ 35,170 17,062 17,800
Balance outstanding at end of year..... -- -- 9,000
Weighted average interest rate during
the year.............................. 5.23% 5.02% 5.82%
Debentures
Average balance outstanding............ $ 1,500 $ 9,526 $ 7,997
Maximum amount outstanding at any
month-end during the year............. 1,500 10,000 10,000
Balance outstanding at end of year..... 1,500 1,500 10,000
Weighted average interest rate during
the year.............................. 14.01% 14.03% 14.09%
Lines of credit
Average balance outstanding............ $ 30,237 $ 112,886 $ 48,765
Maximum amount outstanding at any
month-end during the year............. 45,834 345,848 226,846
Balance outstanding at end of year..... 17,873 39,977 100,170
Weighted average interest rate during
the year.............................. 8.48% 6.62% 6.53%
Total borrowings
Average balance outstanding............ $ 47,100 $ 123,566 $ 65,046
Maximum amount outstanding at any
month-end during the year............. 60,757 372,910 254,646
Balance outstanding at end of year..... 19,373 41,477 119,170
Weighted average interest rate during
the year.............................. 7.59% 7.18% 7.37%
Asset Securitizations
In a securitization, the Company will generally transfer a pool of loans to
a trust with the Company retaining the excess cash flows, known as residuals,
from the securitization which consist of the difference between the interest
rate of the mortgages and the coupon rate of the securities after adjustment
for servicing and other costs such as trustee fees and credit enhancement fees.
The cash generally will be used to repay advances on lines of credit used to
finance the pool of loans that were acquired by the Company. Generally, the
holders of the securities from the asset securitization are entitled to receive
scheduled principal collected on the pool of securitized loans and interest at
the pass-through interest rate on the certificate balance. The residual asset
represents the subordinated right to receive cash flows from the pool of
securitized loans after payment of the required amounts to the holders of the
securities and the costs associated with the securitization. The Company
recognizes gain on sale of the loans in the securitization, which represents
the excess of the estimated fair value of the residuals, net of closing and
underwriting costs, less the allocated cost basis of the loans sold in the
fiscal quarter in which such loans are sold. Management believes that it has
made reasonable estimates of the fair value of the residual interests on its
balance sheets. Concurrent with recognizing such gain on sale, the Company
records the residual interests as assets on its balance sheet. The recorded
value of these residual interests are amortized as cash distributions are
received from the trust holding the respective loan pool and are marked to
market on a quarterly basis. The fair values of such residuals are based in
part on market interest rates and projected loan prepayment and credit loss
rates. See Note 1 to the consolidated financial statements for further
discussion. Increases in interest rates or higher than anticipated rates of
loan prepayments or credit losses of these or similar securities may require
the Company to write down the value of such residuals and result in a material
adverse effect on the Company's results of operations and financial condition.
The Company revalued the residuals and recorded a pre-tax unrealized loss of
$16.6 million for the year ended December 31, 1998, due to a combination of
higher-than-expected prepayment speeds and credit losses. The Company is not
aware of an active market for the residuals.
19
The Company may arrange for credit enhancement for a transaction to achieve
an improved credit rating on the securities issued if this improves the level
of profitability or cash flow generated by such transaction. This credit
enhancement may take the form of an insurance and indemnity policy, insuring
the holders of the securities of timely payment of the scheduled pass-through
of interest and principal. In addition, the pooling and servicing agreements
that govern the distribution of cash flows from the loan pool included in a
transaction typically require over-collateralization as an additional means of
credit enhancement. Over-collateralization may in some cases also require an
initial deposit, the sale of loans at less than par or retention in the trust
of collections from the pool until a specified over-collateralization amount
has been attained. The purpose of the over-collateralization is to provide a
source of payment to investors in the event of certain shortfalls in amounts
due to investors. These amounts are subject to increase up to a reserve level
as specified in the related securitization documents. Cash amounts on deposit
are invested in certain instruments as permitted by the related securitization
documents. To the extent amounts on deposit exceed specified levels,
distributions are made to the holders of the residual interest; and at the
termination of the related trust, any remaining amounts on deposit are
distributed to the holders of the residual interest. Losses resulting from
defaults by borrowers on the payment of principal or interest on the loans in a
securitization will reduce the over-collateralization to the extent that funds
are available and may result in a reduction in the value of the residual
interest. See Note 1 to consolidated financial statements.
Subsidiaries
As of December 31, 1999, the Company had three subsidiaries: the Bank, Life
Investment Holdings, Inc., and Life Financial Investment and Insurance
Services, Inc. Life Financial Investment and Insurance Services, Inc was
incorporated in California in 1999 as a service entity engaged in the sale of
insurance and insurance-related products. Life Investment Holdings, Inc. was
incorporated in Delaware in 1997 as a bankruptcy-remote entity for use in the
Company's asset securitization activities. The Bank had no subsidiaries at
December 31, 1999.
Personnel
As of December 31, 1999, the Company had 334 full-time employees and 18
part-time employees. The employees are not represented by a collective
bargaining unit and the Company considers its relationship with its employees
to be satisfactory.
Year 2000 Compliance
General
As a financial institution operating in multiple states, the Company is
dependent on computer systems and applications to conduct its business. The
Company has prepared its systems and applications for the year 2000 (Y2k). The
Y2k issue is the result of computer programs being written using two digit year
fields instead of four digit year fields. If the computer systems cannot
distinguish between the year 1900 and the year 2000, system failures or
miscalculations could result, disrupting operations and causing, among other
things, a temporary inability to process transactions or engage in normal
business activities for both the Company and its customers.
The Program
The Company has developed, and is actively engaged in, a comprehensive risk-
based Y2k program consisting of a team involving members from various areas in
the organization. The project team has been in place since May of 1998. The
program is designed to make its computer systems and equipment Y2k ready.
"Computer systems and equipment" includes systems generally thought of as
information technology (IT) dependent, such as accounting, data processing, and
telephone equipment, as well as systems not obviously IT dependent, such as
photocopiers, facsimile machines, and security systems. The non-IT dependent
systems may contain embedded technology, and the Company has included these
systems as part of the program. Both the IT dependent and non-IT dependent
portions of the program are complete.
20
The Company defines year 2000 readiness as information technology that
accurately processes date/time data from, into, and between the years 1999 and
2000, as well as leap year calculations, with:
. All mission-critical systems and processes reviewed, renovated or
replaced, as necessary.
. All mission-critical systems and processes tested.
. All key vendors, customers, and business partners identified and
assessed for risk.
. Adequate change control procedures in place for re-testing of new or
upgraded systems.
. Contingency plans in place to support business resumption requirements.
The Y2k program consists of five stages: (i) awareness, (ii) assessment,
(iii) renovation, (iv) validation, and (v) implementation. During the awareness
phase, the Company identified the project team and responsibilities, prepared
and allocated the project budget, defined the project scope, and established
program and management policies. This phase, although complete, continues to be
reviewed. The assessment phase entailed an inventory of IT and non-IT systems,
hardware, vendors, material customers, and facilities. Inventoried systems were
also prioritized to identify critical systems. This phase is also complete, but
is reviewed continually to manage changes to systems and relationships. The
renovation, validation, and implementation phases were complete as of June 30,
1999.
To complete the five program phases, the Company primarily used internal
resources. The service bureau responsible for the Company's mission critical
business financial systems provided assistance with validation of third party
systems that interface with their systems through proxy testing.
The Company's systems use a combination of methodologies for date fields.
Where possible, date fields were expanded to a full eight digits. For date
fields that were retained in a six-digit format, a windowing technique was
used. For the Company's mission critical business financial systems, the
windowing technique is described as follows. If the last two digits of the date
are 00-49, the century is 2000. If the last two digits of the date are 50-99,
the century is 1900.
Contingency Planning
An institution-wide contingency plan is in place, with Y2k issues
incorporated, and testing completed. The contingency plan enables the Company
to continue to operate, to the extent that it can do so safely, including
performing certain processes manually and repairing or obtaining replacement
systems.
Customer Awareness
The Company has devoted significant time and effort in developing customer
awareness as part of the Y2k program. Internal training of all employees was
completed in several sessions over several months during 1999. In addition, the
company provides informational brochures to customers as part of its program
activities, regular program updates to third parties with which the Company has
material relationships, and program status reports as part of its customer and
employee newsletter.
Costs
Through 1999, the amount of approximately $231,378 incurred and expensed for
developing and implementing the Y2k program has not had a material effect on
the Company's operations. There are no additional costs expected as a result of
the Y2k program. None of the Company's other information technology projects
have been delayed or deferred as a result of implementing the Y2k program.
Risks
The Company believes that implementation of completed renovations on its
internal systems and equipment will allow it to be Y2k compliant in a timely
manner. There can be no assurances, however, that the
21
Company's internal systems or equipment, or those of third parties on which the
Company relies, will be Y2k compliant in a timely manner, or that the Company's
or third parties' contingency plans will mitigate the effects of noncompliance.
The Company has initiated communications with its critical external
relationships to determine the extent to which the Company will assess and
attempt to mitigate its risks with respect to the failure of these entities to
be Y2k ready. The effect, if any, on the Company's results of operations from
the failure of such parties to be Y2k ready cannot reasonably be estimated.
The Company is part of a regulated industry which has issued standards for
Y2k readiness and is conducting audits to ensure compliance with those
standards. To date, the Company has satisfied its regulators as to its
compliance with Y2k standards. The Company believes its most likely worst case
scenario is that customers could experience some manual processes or an
inability to access their cash immediately. Although the Company does not
believe that this scenario will occur, it is assessing the effect of such
scenarios by using current financial data. In the event that this scenario does
occur, the Company does not expect that it would have a material adverse effect
on the Company's financial position, liquidity, and results of operations.
Forward-looking Statements
The preceding Y2k issue discussion contains various forward-looking
statements which represent the Company's beliefs or expectations regarding
future events. When used in the Y2k issue discussion, the words "believes,"
"expects," "estimates," and similar expressions are intended to identify
forward-looking statements. Forward-looking statements include, without
limitation, the Company's expectations as to when it will complete the
renovation, validation, and implementation phases of its Y2k program, as well
as its contingency plans; its estimated cost of achieving Y2k readiness; and
the Company's belief that its internal systems and equipment will be Y2k
compliant in a timely manner. All forward-looking statements involve a number
of risks and uncertainties that could cause the actual results to differ
materially from the projected results. Factors that may cause these differences
include, but are not limited to: the availability of qualified personnel and
other information technology resources, the ability to identify and renovate
all data sensitive lines of computer code or to replace embedded computer chips
in affected systems and equipment, and the actions of government agencies and
other third parties with respect to Y2k readiness.
REGULATION
General
The Company, as a savings and loan holding company, is required to file
certain reports with, and otherwise comply with the rules and regulations of
the OTS under the Home Owners' Loan Act, as amended (the "HOLA"). In addition,
the activities of savings institutions, such as the Bank, are governed by the
HOLA and the Federal Deposit Insurance Act ("FDI Act").
The Bank is subject to extensive regulation, examination and supervision by
the OTS, as its primary federal regulator, and the FDIC, as the deposit
insurer. The Bank is a member of the Federal Home Loan Bank ("FHLB") System and
its deposit accounts are insured up to applicable limits by the SAIF managed by
the FDIC. The Bank must file reports with the OTS and the FDIC concerning its
activities and financial condition in addition to obtaining regulatory
approvals prior to entering into certain transactions such as mergers with, or
acquisitions of, other savings institutions. The OTS and/or the FDIC conduct
periodic examinations to test the Bank's safety and soundness and compliance
with various regulatory requirements. This regulation and supervision
establishes a comprehensive framework of activities in which an institution can
engage and is intended primarily for the protection of the insurance fund and
depositors. The regulatory structure also gives the regulatory authorities
extensive discretion in connection with their supervisory and enforcement
activities and examination policies, including policies with respect to the
classification of assets and the establishment of adequate loan loss reserves
for regulatory purposes. Any change in such regulatory requirements and
policies, whether by the OTS, the FDIC or Congress, could have a material
adverse impact on the Company, the Bank
22
and their operations. Certain of the regulatory requirements applicable to the
Bank and to the Company are referred to below or elsewhere herein. The
description of statutory provisions and regulations applicable to savings
institutions and their holding companies set forth in this Form 10-K does not
purport to be a complete description of such statutes and regulations and their
effects on the Bank and the Company.
Holding Company Regulation
The Company is a nondiversified unitary savings and loan holding company
within the meaning of the HOLA. As a unitary savings and loan holding company,
the Company generally is not restricted under existing laws as to the types of
business activities in which it may engage, provided that the Bank continues to
be a qualified thrift lender ("QTL"). See "Federal Savings Institution
Regulation--QTL Test." Upon any non-supervisory acquisition by the Company of
another savings institution or savings bank that meets the QTL test and is
deemed to be a savings institution by the OTS, the Company would become a
multiple savings and loan holding company (if the acquired institution is held
as a separate subsidiary) and would be subject to extensive limitations on the
types of business activities in which it could engage. The HOLA limits the
activities of a multiple savings and loan holding company and its non-insured
institution subsidiaries primarily to activities permissible for bank holding
companies under Section 4-C-(8) of the Bank Holding Company Act ("BHC Act"),
subject to the prior approval of the OTS, and certain activities authorized by
OTS regulation, and no multiple savings and loan holding company may acquire
more than 5% the voting stock of a company engaged in impermissible activities.
The HOLA prohibits a savings and loan holding company, directly or
indirectly, or through one or more subsidiaries, from acquiring more than 5% of
the voting stock of another savings institution or holding company thereof,
without prior written approval of the OTS or acquiring or retaining control of
a depository institution that is not insured by the FDIC. In evaluating
applications by holding companies to acquire savings institutions, the OTS must
consider the financial and managerial resources and future prospects of the
company and institution involved, the effect of the acquisition on the risk to
the insurance funds, the convenience and needs of the community and competitive
factors.
The OTS is prohibited from approving any acquisition that would result in a
multiple savings and loan holding company controlling savings institutions in
more than one state, subject to two exceptions: (i) the approval of interstate
supervisory acquisitions by savings and loan holding companies and (ii) the
acquisition of a savings institution in another state if the laws of the state
of the target savings institution specifically permit such acquisitions. The
states vary in the extent to which they permit interstate savings and loan
holding company acquisitions.
Although savings and loan holding companies are not subject to specific
capital requirements or specific restrictions on the payment of dividends or
other capital distributions, HOLA does prescribe such restrictions on
subsidiary savings institutions as described below. The Bank must notify the
OTS 30 days before declaring any dividend to the Company. In addition, the
financial impact of a holding company on its subsidiary institution is a matter
that is evaluated by the OTS and the agency has authority to order cessation of
activities or divestiture of subsidiaries deemed to pose a threat to the safety
and soundness of the institution.
Federal Savings Institution Regulation
Capital Requirements. The OTS capital regulations require savings
institutions to meet three minimum capital standards: a 1.5% tangible capital
ratio, a 4% leverage (core) capital ratio and an 8% risk-based capital ratio.
Core capital is defined as common stockholders' equity (including retained
earnings), certain noncumulative perpetual preferred stock and related surplus,
and minority interests in equity accounts of consolidated subsidiaries less
intangibles other than certain mortgage servicing rights and credit card
relationships. The OTS regulations require that, in meeting the tangible,
leverage (core) and risk-based capital standards, institutions must generally
deduct investments in and loans to subsidiaries engaged in activities as
principal that are not permissible for a national bank.
23
The risk-based capital standard for savings institutions requires the
maintenance of total capital (which is defined as core capital and
supplementary capital) to risk-weighted assets 8%. In determining the amount of
risk-weighted assets, all assets, including certain off-balance sheet assets,
are multiplied by a risk-weight factor of 0% to 100%, as assigned by the OTS
capital regulation based on the risks OTS believes are inherent in the type of
asset. The components of core capital are equivalent to those discussed earlier
under the 4% leverage standard. The components of supplementary capital
currently include cumulative preferred stock, long-term perpetual preferred
stock, mandatory convertible securities, subordinated debt and intermediate
preferred stock and, within specified limits, the allowance for loan and lease
losses. Overall, the amount of supplementary capital included as part of total
capital cannot exceed 100% of core capital.
The OTS regulatory capital requirements also incorporate an interest rate
risk component. Savings institutions with "above normal" interest rate risk
exposure are subject to a deduction from total capital for purposes of
calculating their risk-based capital requirements. A savings institution's
interest rate risk is measured by the decline in the net portfolio value of its
assets (i.e., the difference between incoming and outgoing discounted cash
flows from assets, liabilities and off-balance sheet contracts) that would
result from a hypothetical 200 basis point increase or decrease in market
interest rates divided by the estimated economic value of the institution's
assets, as calculated in accordance with guidelines set forth by the OTS. A
savings institution whose measured interest rate risk exposure exceeds 2% must
deduct an amount equal to one-half of the difference between the institution's
measured interest rate risk and 2%, multiplied by the estimated economic value
of the institution's assets. The dollar amount is deducted from an
institution's total capital in calculating compliance with its risk-based
capital requirement. Under the rule, there is a two quarter lag between the
reporting date of an institution's financial data and the effective date for
the new capital requirement based on that data. A savings institution with
assets of less than $300 million and risk-based capital ratios in excess of 12%
is not subject to the interest rate risk component, unless the OTS determines
otherwise. The Director of the OTS may waive or defer a savings institution's
interest rate risk component on a case-by-case basis. For the present time, the
OTS has deferred implementation of the interest rate risk component. At
December 31, 1999, the Bank met each of its capital requirements.
The following table presents the Bank's capital position at December 31,
1999.
Capital Ratios
----------------
Actual Required Excess Actual Required
Capital Capital Amount Percent Percent
------- -------- ------- ------- --------
(Dollars in thousands)
Tangible......................... $32,473 $ 7,755 $24,718 6.28% 1.50%
Core (leverage).................. 32,473 20,680 11,793 6.28% 4.00%
Risk-based....................... 35,222 27,245 7,977 10.34% 8.00%
Prompt Corrective Regulatory Action. Under the OTS prompt corrective action
regulations, the OTS is required to take certain supervisory actions against
undercapitalized institutions, the severity of which depends upon the
institution's degree of undercapitalization. Generally, a savings institution
that has a total risk-based capital of less than 8% or a leverage ratio or a
Tier 1 capital ratio that is less than 4% is considered to be
"undercapitalized." A savings institution that has a total risk-based capital
ratio less than 6%, a Tier 1 capital ratio is less than 3% or a leverage ratio
that is less than 3% is considered to be "significantly undercapitalized" and a
savings institution that has a tangible capital to asset ratio equal to or less
than 2% is deemed to be "critically undercapitalized." Compliance with the plan
must be guaranteed by any parent holding company. In addition, numerous
mandatory supervisory actions become immediately applicable to the institution
depending upon its category, including, but not limited to, increased
monitoring by regulators and restrictions on growth, capital distributions and
expansion. The OTS could also take any one of a number of discretionary
supervisory actions, including the issuance of a capital directive and the
replacement of senior executive officers and directors.
Insurance of Deposit Accounts. Deposits of the Bank are presently insured by
the SAIF. The FDIC maintains a risk-based assessment system by which
institutions are assigned to one of three categories based on
24
their capitalization and one of three subcategories based on examination
ratings and other supervisory information. An institution's assessment rate
depends on the categories to which it is assigned. Assessment rates for SAIF
member institutions are determined semiannually by the FDIC and currently range
from zero basis points for the healthiest institutions to 27 basis points for
the riskiest.
In addition to the assessment for deposit insurance, institutions are
required to pay on bonds issued in the late 1980s by the Financing Corporation
("FICO") to recapitalize the predecessor to the SAIF. During 1984, FICO
payments for SAIF members approximated 6.10 basis points, while Bank Insurance
Fund ("BIF"--the deposit insurance fund that covers most commercial bank
deposits) members paid 1.22 basis points. By law, there will be equal sharing
of FICO payments between the members of both insurance funds on the earlier of
January 1, 2000 or the date the two insurance funds merge.
Insurance of deposits may be terminated by the FDIC upon a finding that the
institution has engaged in unsafe or unsound practices, is in an unsafe or
unsound condition to continue operations or has violated any applicable law,
regulation, rule, order or condition imposed by the FDIC or the OTS. The
management of the Bank does not know of any practice, condition or violation
that might lead to termination of deposit insurance.
Thrift Rechartering Legislation. Various proposals to eliminate the federal
thrift charter, create a uniform financial institutions charter and abolish the
OTS have been introduced in Congress. Some bills would require federal savings
institutions to convert to a national bank or some type of state charter by a
specified date under some bills, or they would automatically become national
banks. Under some proposals, converted federal thrifts would generally be
required to conform their activities to those permitted for the charter
selected and divestiture of nonconforming assets would be required over a two
year period, subject to two possible one year extensions. State chartered
thrifts would become subject to the same federal regulation as applies to state
commercial banks. A more recent bill passed by the House Banking Committee
would allow savings institutions to continue to exercise activities being
conducted when they convert to a bank regardless of whether a national bank
could engage in the activity. Holding companies for savings institutions would
become subject to the same regulation as holding companies that control
commercial banks, with some limited grandfathering, including savings and loan
holding company activities. The grandfathering would be lost under certain
circumstances such as a change in control of the Company. The Bank is unable to
predict whether such legislation would be enacted or the extent to which the
legislation would restrict or disrupt its operations.
Loans-to-One Borrower. Under the HOLA, savings institutions are generally
subject to the limits on loans-to-one borrower applicable to national banks.
Generally, savings institutions may not make a loan or extend credit to a
single or related group of borrowers in excess of 15% of its unimpaired capital
and surplus. An additional amount may be lent, equal to 10% of unimpaired
capital and surplus, if such loan is secured by readily-marketable collateral,
which is defined to include certain financial instruments and bullion. At
December 31, 1999, the Bank's limit on loans to one borrower was $5.3 million.
At December 31, 1999, the Bank's largest aggregate outstanding balance of
loans-to-one borrower was $1.3 million.
QTL Test. The HOLA requires savings institutions to meet a QTL test. Under
the QTL test, a savings association is required to maintain at least 65% of its
"portfolio assets" (total assets less: (i) specified liquid assets up to 20% of
total assets; (ii) intangibles, including goodwill; and (iii) the value of
property used to conduct business) in certain "qualified thrift investments"
(primarily residential mortgages and related investments, including certain
mortgage-backed securities) in at least 9 months out of each 12 month period.
A savings association that fails the QTL test must convert to a bank charter
or operate under certain restrictions. As of December 31, 1999, the Bank
maintained 99.99% of its portfolio assets in qualified thrift investments and,
therefore, met the QTL test. Recent legislation has expanded the extent to
which education loans, credit card loans and small business loans may be
considered "qualified thrift investments."
Limitation on Capital Distributions. OTS regulations impose limitations upon
all capital distributions by savings institutions, such as cash dividends,
payments to repurchase or otherwise acquire its shares, payments
25
to shareholders of another institution in a cash-out merger and other
distributions charged against capital. The rule establishes three tiers of
institutions, which are based primarily on an institution's capital level. An
institution that exceeds all fully phased-in capital requirements before and
after a proposed capital distribution ("Tier 1 Bank") and has not been advised
by the OTS that it is in need of more than normal supervision, could, after
prior notice but without obtaining approval of the OTS, make capital
distributions during a calendar year equal to the greater of (i) 100% of its
net earnings to date during the calendar year plus the amount that would reduce
by one-half its "surplus capital ratio" (the excess capital over its fully
phased-in capital requirements) at the beginning of the calendar year or (ii)
75% of its net income for the previous four quarters. Any additional capital
distributions would require prior regulatory approval. In the event the Bank's
capital fell below its regulatory requirements or the OTS notified it that it
was in need of more than normal supervision, the Bank's ability to make capital
distributions could be restricted. In addition, the OTS could prohibit a
proposed capital distribution by any institution, which would otherwise be
permitted by the regulation, if the OTS determines that such distribution would
constitute an unsafe or unsound practice. At December 31, 1999, the Bank was a
Tier 1 Bank.
Liquidity. The Bank is required to maintain an average daily balance of
specified liquid assets equal to a monthly average of not less than a specified
percentage (currently 4%) of its net withdrawable deposit accounts plus short-
term borrowings. Monetary penalties may be imposed for failure to meet these
liquidity requirements. The Bank's average liquidity ratio for the quarter
ended December, 1999 was 5.07%, which exceeded the applicable requirements. The
Bank has never been subject to monetary penalties for failure to meet its
liquidity requirements.
Branching. OTS regulations permit nationwide branching by federally
chartered savings institutions to the extent allowed by federal statute. This
permits federal savings institutions to establish interstate networks and to
geographically diversify their loan portfolios and lines of business. The OTS
authority preempts any state law purporting to regulate branching by federal
savings institutions.
Transactions with Related Parties. The Bank's authority to engage in
transactions with related parties or "affiliates" (e.g., any company that
controls or is under common control with an institution, including the Company
and its non-savings institution subsidiaries) is limited by Sections 23A and
23B of the Federal Reserve Act ("FRA"). Section 23A restricts the aggregate
amount of covered transactions with any individual affiliate to 10% of the
capital and surplus of the savings institution. The aggregate amount of covered
transactions with all affiliates is limited to 20% of the savings institution's
capital and surplus. Certain transactions with affiliates are required to be
secured by collateral in an amount and of a type described in Section 23A and
the purchase of low quality assets from affiliates is generally prohibited.
Section 23B generally provides that certain transactions with affiliates,
including loans and asset purchases, must be on terms and under circumstances,
including credit standards, that are substantially the same or at least as
favorable to the institution as those prevailing at the time for comparable
transactions with non-affiliated companies.
Enforcement. Under the FDI Act, the OTS has primary enforcement
responsibility over savings institutions and has the authority to bring actions
against the institution and all institution-affiliated parties, including
stockholders, and any attorneys, appraisers and accountants who knowingly or
recklessly participate in wrongful action likely to have an adverse effect on
an insured institution. Formal enforcement action may range from the issuance
of a capital directive or cease and desist order to removal of officers and/or
directors to institution of receivership, conservatorship or termination of
deposit insurance. Civil penalties cover a wide range of violations and can
amount to $25,000 per day, or even $1 million per day in especially egregious
cases. Under the FDI Act, the FDIC has the authority to recommend to the
Director of the OTS enforcement action to be taken with respect to a particular
savings institution. If action is not taken by the Director, the FDIC has
authority to take such action under certain circumstances. Federal law also
establishes criminal penalties for certain violations.
Standards for Safety and Soundness. The FDI Act requires each federal
banking agency to prescribe for all insured depository institutions standards
relating to, among other things, internal controls, information
26
systems and audit systems, loan documentation, credit underwriting, interest
rate risk exposure, asset growth, and compensation, fees , benefits and such
other operational and managerial standards as the agency deems appropriate. The
federal banking agencies have adopted final regulations and Interagency
Guidelines Prescribing Standards for Safety and Soundness ("Guidelines") to
implement these safety and soundness standards. The Guidelines set forth the
safety and soundness standards that the federal banking agencies use to
identify and address problems at insured depository institutions before capital
becomes impaired. If the appropriate federal banking agency determines that an
institution fails to meet any standard prescribed by the Guidelines, the agency
may require the institution to submit to the agency an acceptable plan to
achieve compliance with the standard, as required by FDI Act. The final rule
establishes deadlines for the submission and review of such safety and
soundness compliance plans.
Federal Reserve System
The Federal Reserve Board regulations require savings institutions to
maintain non-interest earning reserves against their transaction accounts
(primarily NOW and regular checking accounts). The Federal Reserve Board
regulations generally required for 1999 that reserves be maintained against
aggregate transaction accounts as follows: for accounts aggregating $44.3
million or less (subject to adjustment by the Federal Reserve Board) the
reserve requirement was 3%; and for accounts aggregating greater than $44.3
million, the reserve requirement was $1.33 million plus 10% (subject to
adjustment by the Federal Reserve Board between 8% and 14%) against that
portion of total transaction accounts in excess of $44.3 million. The first
$5.0 million of otherwise reservable balances (subject to adjustments by the
Federal Reserve Board) were exempted from the reserve requirements. The Bank
maintained compliance with the foregoing requirements. The balances maintained
to meet the reserve requirements imposed by the Federal Reserve Board may be
used to satisfy liquidity requirements imposed by the OTS.
FEDERAL AND STATE TAXATION
Federal Taxation
General. The Company and the Bank report their income on a consolidated
basis and the accrual method of accounting, and are subject to federal income
taxation in the same manner as other corporations with some exceptions,
including particularly the Bank's reserve for bad debts discussed below. The
following discussion of tax matters is intended only as a summary and does not
purport to be a comprehensive description of the tax rules applicable to the
Bank or the Company. The Bank has not been audited by the IRS. For its 1999
taxable year, the Bank is subject to a maximum federal income tax rate of
35.0%.
Bad Debt Reserves. For fiscal years beginning prior to December 31, 1996,
thrift institutions which qualified under certain definitional tests and other
conditions of the Internal Revenue Code of 1986 (the "Code") were permitted to
use certain favorable provisions to calculate their deductions from taxable
income for annual additions to their bad debt reserve. A reserve could be
established for bad debts on qualifying real property loans (generally secured
by interests in real property improved or to be improved) under (i) the
Percentage of Taxable Income Method (the "PTI Method") or (ii) the Experience
Method. The reserve for nonqualifying loans was computed using the Experience
Method.
The Small Business Job Protection Act of 1996 (the "1996 Act"), which was
enacted on August 20, 1996, requires savings institutions to recapture (i.e.,
take into income) certain portions of their accumulated bad debt reserves. The
1996 Act repeals the reserve method of accounting for bad debts effective for
tax years beginning after 1995. Thrift institutions that would be treated as
small banks are allowed to utilize the Experience Method applicable to such
institutions, while thrift institutions that are treated as large banks (those
generally exceeding $500 million in assets) are required to use only the
specific charge-off method. Thus, the PTI Method of accounting for bad debts is
no longer available for any financial institution.
27
To the extent the allowable bad debt reserve balance using the thrift's
historical computation method exceeds the allowable bad debt reserve method
under the newly enacted provisions, such excess is required to be recaptured
into income under the provisions of Code Section 481(a). Any Section 481(a)
adjustment required to be taken into income with respect to such change
generally will be taken into income ratably over a six-taxable year period,
beginning with the first taxable year beginning after 1995, subject to the
residential loan requirement.
Under the residential loan requirement provision, the recapture required by
the 1996 Act will be suspended for each of two successive taxable years,
beginning with the Bank's current taxable year, in which the Bank originates a
minimum of certain residential loans based upon the average of the principal
amounts of such loans made by the Bank during its six taxable years preceding
its current taxable year.
Under the 1996 Act, the Bank is permitted to use the Experience Method to
compute its allowable addition to its reserve for bad debts for the current
year. The Bank's bad debt reserve as of December 31, 1995 was computed using
the permitted Experience Method computation and was therefore not subject to
the recapture of any portion of its bad debt reserve as discussed above.
Distributions. Under the 1996 Act, if the Bank makes "non-dividend
distributions" to the Company, such distributions will be considered to have
been made from the Bank's unrecaptured tax bad debt reserves (including the
balance of its reserves as of December 31, 1987) to the extent thereof, and
then from the Bank's supplemental reserve for losses on loans, to the extent
thereof, and an amount based on the amount distributed (but not in excess of
the amount of such reserves) will be included in the Bank's income. Non-
dividend distributions include distributions in excess of the Bank's current
and accumulated earnings and profits, as calculated for federal income tax
purposes, distributions in redemption of stock, and distributions in partial or
complete liquidation. Dividends paid out of the Bank's current or accumulated
earnings and profits will not be so included in the Bank's income.
The amount of additional taxable income triggered by a non-dividend is an
amount that, when reduced by the tax attributable to the income, is equal to
the amount of the distribution. Thus, if the Bank makes a non-dividend
distribution to the Company, approximately one and one-half times the amount of
such distribution (but not in excess of the amo