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Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
þ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the Quarterly Period Ended September 30, 2009
Commission File Number 000-25193
CAPITAL CROSSING PREFERRED CORPORATION
(Exact name of registrant as specified in its charter)
Massachusetts
(State or other jurisdiction of incorporation or organization)
(State or other jurisdiction of incorporation or organization)
04-3439366
(I.R.S. Employer Identification Number)
(I.R.S. Employer Identification Number)
1271 Avenue of the Americas, 46th Floor, New York, New York
(Address of principal executive offices)
(Address of principal executive offices)
10020
(Zip Code)
(Zip Code)
(212) 377-1503
(Registrants telephone number, including area code)
(Registrants telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its
corporate Web site, if any, every Interactive Data File required to be submitted and posted
pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12
months (or for such shorter period that the registrant was required to submit and post such files).
Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a
non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated
filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
(Check one):
Large accelerated filer o | Accelerated filer o | Non-accelerated filer þ (Do not check if a smaller reporting company) |
Smaller reporting company o |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act). Yes o No þ
The number of shares outstanding of the registrants sole class of common stock was 100 shares,
$.01 par value per share, as of November 13, 2009. No common stock was held by non-affiliates of
the issuer.
Capital Crossing Preferred Corporation
Table of Contents
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Ex-31.1 Section 302 Certification of Chief Executive Officer | ||||||||
Ex-31.2 Section 302 Certification of Chief Financial Officer | ||||||||
Ex-32 Section 906 Certification of Chief Executive Officer and Chief Financial Officer |
Table of Contents
PART I
Item 1. Condensed Financial Statements
Capital Crossing Preferred Corporation
Balance Sheets
(unaudited)
Balance Sheets
(unaudited)
September 30, | December 31, | |||||||
2009 | 2008 | |||||||
(in thousands) | ||||||||
ASSETS |
||||||||
Cash account with parent |
$ | 202 | $ | 208 | ||||
Interest-bearing deposits with parent |
50,036 | 43,549 | ||||||
Total cash and cash equivalents |
50,238 | 43,757 | ||||||
Loans held for sale |
30,326 | | ||||||
Loans held for investment, net of discounts and net deferred loan
income |
| 52,998 | ||||||
Less allowance for loan losses |
| (915 | ) | |||||
Loans held for investment, net |
| 52,083 | ||||||
Accrued interest receivable |
149 | 227 | ||||||
Total assets |
$ | 80,713 | $ | 96,067 | ||||
LIABILITIES AND STOCKHOLDERS EQUITY |
||||||||
Accrued expenses and other liabilities |
$ | 253 | $ | 931 | ||||
Total liabilities |
253 | 931 | ||||||
Stockholders equity: |
||||||||
Preferred stock, Series B, 8% cumulative, non-convertible;
$.01 par value; $1,000 liquidation value per share plus
accrued dividends; 1,000 shares authorized, 937 shares
issued and outstanding |
| | ||||||
Preferred stock, Series D, 8.50% non-cumulative, exchangeable;
$.01 par value; $25 liquidation value per share; 1,725,000 shares
authorized, 1,500,000 shares issued and outstanding |
15 | 15 | ||||||
Common stock, $.01 par value, 100 shares authorized,
issued and outstanding |
| | ||||||
Additional paid-in capital |
95,121 | 95,121 | ||||||
Accumulated deficit |
(14,676 | ) | | |||||
Total stockholders equity |
80,460 | 95,136 | ||||||
Total liabilities and stockholders equity |
$ | 80,713 | $ | 96,067 | ||||
See accompanying notes to condensed financial statements.
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Capital Crossing Preferred Corporation
Statements of Income (Loss)
(unaudited)
Statements of Income (Loss)
(unaudited)
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
(in thousands) | ||||||||||||||||
Interest income: |
||||||||||||||||
Interest and fees on loans |
$ | 839 | $ | 1,298 | $ | 2,347 | $ | 3,845 | ||||||||
Interest on interest-bearing deposits |
75 | 269 | 468 | 739 | ||||||||||||
Total interest income |
914 | 1,567 | 2,815 | 4,584 | ||||||||||||
Provision for loan losses loans held for investment |
| 55 | 915 | 210 | ||||||||||||
Valuation allowance on loans held for sale |
(541 | ) | | (16,751 | ) | | ||||||||||
Net revenue |
373 | 1,622 | (13,021 | ) | 4,794 | |||||||||||
Operating expenses: |
||||||||||||||||
Loan servicing and advisory services |
35 | 52 | 123 | 151 | ||||||||||||
Other general and administrative |
146 | 72 | 716 | 173 | ||||||||||||
Total operating expenses |
181 | 124 | 839 | 324 | ||||||||||||
Net income (loss) |
192 | 1,498 | (13,860 | ) | 4,470 | |||||||||||
Preferred stock dividends |
| 816 | 816 | 2,447 | ||||||||||||
Net income (loss) available to common stockholder |
$ | 192 | $ | 682 | $ | (14,676 | ) | $ | 2,023 | |||||||
See accompanying notes to condensed financial statements.
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Capital Crossing Preferred Corporation
Statements of Changes in Stockholders Equity
(unaudited)
Statements of Changes in Stockholders Equity
(unaudited)
Nine Months Ended September 30, 2009 | ||||||||||||||||||||||||||||||||||||
Preferred Stock | Preferred Stock | Additional | Retained | Total | ||||||||||||||||||||||||||||||||
Series B | Series D | Common Stock | Paid-in | Earnings/ | Stockholders | |||||||||||||||||||||||||||||||
Shares | Amount | Shares | Amount | Shares | Amount | Capital | Accumulated Deficit | Equity | ||||||||||||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||||||||||||||
Balance at December 31, 2008 |
1 | $ | | 1,500 | $ | 15 | | $ | | $ | 95,121 | $ | | $ | 95,136 | |||||||||||||||||||||
Net loss |
| | | | | | | (13,860 | ) | (13,860 | ) | |||||||||||||||||||||||||
Cumulative dividends on preferred stock, Series B |
| | | | | | | (19 | ) | (19 | ) | |||||||||||||||||||||||||
Dividends on preferred stock, Series D |
| | | | | | | (797 | ) | (797 | ) | |||||||||||||||||||||||||
Balance at September 30, 2009 |
1 | $ | | 1,500 | $ | 15 | | $ | | $ | 95,121 | $ | (14,676 | ) | $ | 80,460 | ||||||||||||||||||||
Nine Months Ended September 30, 2008 | ||||||||||||||||||||||||||||||||||||
Preferred Stock | Preferred Stock | Additional | Total | |||||||||||||||||||||||||||||||||
Series B | Series D | Common Stock | Paid-in | Retained | Stockholders | |||||||||||||||||||||||||||||||
Shares | Amount | Shares | Amount | Shares | Amount | Capital | Earnings | Equity | ||||||||||||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||||||||||||||
Balance at December 31, 2007 |
1 | $ | | 1,500 | $ | 15 | | $ | | $ | 115,354 | $ | | $ | 115,369 | |||||||||||||||||||||
Net income |
| | | | | | | 4,470 | 4,470 | |||||||||||||||||||||||||||
Cumulative dividends on preferred stock, Series B |
| | | | | | | (56 | ) | (56 | ) | |||||||||||||||||||||||||
Dividends on preferred stock, Series D |
| | | | | | | (2,391 | ) | (2,391 | ) | |||||||||||||||||||||||||
Balance at September 30, 2008 |
1 | $ | | 1,500 | $ | 15 | | $ | | $ | 115,354 | $ | 2,023 | $ | 117,392 | |||||||||||||||||||||
See accompanying notes to condensed financial statements.
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Capital Crossing Preferred Corporation
Statements of Cash Flows
(unaudited)
Statements of Cash Flows
(unaudited)
Nine Months Ended | ||||||||
September 30, | ||||||||
2009 | 2008 | |||||||
(in thousands) | ||||||||
Cash flows provided by operating activities: |
||||||||
Net (loss) income |
$ | (13,860 | ) | $ | 4,470 | |||
Adjustments to reconcile net (loss) income to net cash provided by operating activities: |
||||||||
Valuation allowance on loans held for sale |
16,751 | | ||||||
Provision for loan losses |
(915 | ) | (210 | ) | ||||
Decrease in accrued interest receivable |
80 | 69 | ||||||
Increase (decrease) in accrued expenses and other liabilities |
135 | (25 | ) | |||||
Net cash provided by operating activities |
2,191 | 4,304 | ||||||
Cash flows provided by investing activities: |
||||||||
Loan repayments |
5,921 | 10,862 | ||||||
Cash provided by investing activities |
5,921 | 10,862 | ||||||
Cash flows used in financing activities: |
||||||||
Payment of preferred stock dividends |
(1,631 | ) | (2,447 | ) | ||||
Cash used in financing activities |
(1,631 | ) | (2,447 | ) | ||||
Net change in cash and cash equivalents |
6,481 | 12,719 | ||||||
Cash and cash equivalents at beginning of period |
43,757 | 50,581 | ||||||
Cash and cash equivalents at end of period |
$ | 50,238 | $ | 63,300 | ||||
See accompanying notes to condensed financial statements.
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Capital Crossing Preferred Corporation
Notes to Condensed Financial Statements
Three and Nine Months Ended September 30, 2009 and 2008
Notes to Condensed Financial Statements
Three and Nine Months Ended September 30, 2009 and 2008
Note 1. Basis of Presentation
Capital Crossing Preferred Corporation (the Company) is a Massachusetts corporation
organized on March 20, 1998, to acquire and hold real estate assets. The Companys current
principal business objective is to hold mortgage assets that will generate net income for
distribution to stockholders. The Company may acquire additional mortgage assets in the future.
However, management currently has no intention of acquiring additional assets other than any assets
that may be acquired in a potential alternative transaction to the terminated asset exchange
described below. Effective as of April 27, 2009, Lehman Brothers Bank, FSB, the owner of all of the
Companys common stock, formally changed its name to Aurora Bank FSB (prior to and after the name
change, Aurora Bank). Aurora Bank is a subsidiary of Lehman Brothers Holdings Inc. (LBHI; LBHI
with its subsidiaries, Lehman Brothers). Prior to the merger with Aurora Bank, which is further
discussed below, the Company was a subsidiary of Capital Crossing Bank (Capital Crossing), a
federally insured Massachusetts trust company, and Capital Crossing owned all of the Companys
common stock. The Company operates in a manner intended to allow it to be taxed as a real estate
investment trust, or a REIT, under the Internal Revenue Code of 1986, as amended. As a REIT, the
Company generally will not be required to pay federal income tax if it distributes its earnings to
its stockholders and continues to meet a number of other requirements.
On March 31, 1998, Capital Crossing capitalized the Company by transferring mortgage loans
valued at $140.7 million in exchange for 1,000 shares of the Companys 8% Cumulative
Non-Convertible Preferred Stock, Series B, valued at $1.0 million and 100 shares of the Companys
common stock valued at $139.7 million.
On May 11, 2004, the Company closed its public offering of 1,500,000 shares of its 8.50%
Non-Cumulative Exchangeable Preferred Stock, Series D. The net proceeds to the Company from the
sale of Series D preferred stock was $35.3 million. Effective July 15, 2009, the Series D
preferred stock is redeemable at the option of the Company, with the prior consent of the Office of
Thrift Supervision (the OTS).
On February 14, 2007, Capital Crossing was acquired by Aurora Bank through a two step merger
transaction. An interim thrift subsidiary of Aurora Bank was merged into Capital Crossing.
Immediately following such merger, Capital Crossing was merged into Aurora Bank. Under the terms of
the agreement, Lehman Brothers paid $30.00 per share in cash in exchange for each outstanding share
of Capital Crossing.
All shares of the Companys 9.75% Non-Cumulative Exchangeable Preferred Stock, Series A and
10.25% Non-Cumulative Exchangeable Preferred Stock, Series C were redeemed on March 23, 2007. The
Companys Series B preferred stock and Series D preferred stock remain outstanding and remain
subject to their existing terms and conditions, including the call feature with respect to the
Series D preferred stock.
These
condensed financial statements are unaudited and have been prepared in accordance with the rules and
regulations of the Securities and Exchange Commission (SEC) relating to interim financial
statements and in conformity with accounting principles generally accepted in the United States of
America (GAAP). Certain information and note disclosures normally included in annual financial
statements prepared in accordance with GAAP have been condensed or omitted pursuant to these rules
and regulations, although the Company believes that the disclosures made are adequate to make the
information not misleading. Certain prior period amounts have been reclassified to conform to
current period presentation. It is the opinion of management that the condensed financial
statements reflect all adjustments that are normal and recurring and that are necessary for a fair
presentation of the results for the interim periods presented. These condensed financial statements
included in this Form 10-Q should be read in conjunction with the financial statements and notes
thereto included in the Companys Annual Report on Form 10-K as of, and for the year ended December
31, 2008. Interim results are not necessarily indicative of results to be expected for the entire
year.
On February 5, 2009, as discussed below, the Company agreed to transfer 207 loans secured
primarily by commercial real estate and multifamily residential real estate to Aurora Bank in
exchange for 205 loans secured primarily by residential real estate. As a result, during the first
quarter of 2009 the Company reclassified all of its loan assets as held for sale and recorded a
valuation allowance to reflect these loan assets at the lower of their accreted cost or fair value
in accordance with Statement of Financial Accounting Standards (SFAS) No. 65, Accounting for
Certain Mortgage Banking Activities (codified primarily in ASC 948) (ASC 948).
Notwithstanding the termination of the asset exchange prior to its consummation, as discussed
below, the Company continues to record these loan assets at the lower of their accreted cost or
fair value in accordance with ASC 948 as the Company continues to explore potential alternative
transactions. Prior to February 5, 2009, the Companys loan assets were considered held for
investment and recorded at accreted cost adjusted for the amortization of any purchase discount and
deferred fees less an allowance for loan losses.
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In preparing financial statements in conformity with GAAP, management is required to make
estimates and assumptions that affect the reported amounts of assets and liabilities as of the date
of the balance sheet and reported amounts of revenues and expenses during the reporting period.
Material estimates that are particularly susceptible to significant change in the near term relate
to the determination of the fair value of loans held for sale. The fair value of the loan portfolio
was estimated based upon an internal analysis by
management which considered, among other things, information, to the extent available, about
then current sale prices, bids, credit quality, liquidity and other available information for loans
with similar characteristics as the Companys loan portfolio. For a more detailed discussion of
the basis for the estimates of the fair value of the Companys loan portfolio, please see Note 5
below. Prior to February 5, 2009, material estimates also included the determination of the
allowance for losses on loans, the allocation of purchase discount on loans between accretable and
nonaccretable portions, and the rate at which the discount is accreted into interest income.
Note 2. Recent Developments
Bankruptcy of Lehman Brothers Holdings Inc.
On September 15, 2008, LBHI, the parent company of Aurora Bank, filed a voluntary petition
under Chapter 11 of the U.S. Bankruptcy Code. The bankruptcy filing of LBHI has materially and
adversely affected the capital and liquidity of Aurora Bank, the parent of the Company. This has
led to increased regulatory constraints being placed on Aurora Bank by its bank regulatory
authorities, primarily the OTS. Certain of these constraints apply to Aurora Banks subsidiaries,
including the Company. As more fully discussed below, both the bankruptcy filing of LBHI and the
increased regulatory constraints placed on Aurora Bank have negatively impacted the Companys
ability to conduct its business according to its business objectives.
Terminated Asset Exchange
On February 5, 2009, the Company and Aurora Bank entered into an Asset Exchange Agreement (the
Agreement) pursuant to which the Company agreed to transfer 207 loans secured primarily by
commercial real estate and multifamily residential real estate (together, the Loans) to Aurora
Bank in exchange for 205 loans secured primarily by residential real estate (the Exchange). The
Loans represented substantially all of the Companys assets, excluding cash and interest-bearing
deposits as of December 31, 2008. The Exchange was subject to certain conditions to closing as well
as the receipt of a non-objection letter from the OTS. On July 20, 2009, the Company and Aurora
Bank mutually agreed to terminate the Agreement. The Agreement was terminated following receipt of
a letter from the OTS failing to grant Aurora Banks requests for non-objection with respect to the
Exchange. As a result of the termination of the Agreement, which termination was without liability
to either party, the Exchange was not consummated and the Company continues to own the portfolio of
loans secured by commercial real estate and multifamily real estate that the Company owned prior to
entering into the Agreement. The Company continues to consider potential alternative transactions
involving its loan portfolio and has received preapproval from the OTS for transactions that meet
certain guidelines, however there can be no assurances that any such alternative transaction will
occur. As a result of entering into the Agreement and continuing to consider potential alternative
transactions, the Company reclassified all of its loan assets as held for sale and now records
these loan assets at the lower of their accreted cost or fair value in accordance with ASC 948.
Aurora Bank Regulatory Actions and Capital Levels
On January 26, 2009, the OTS entered a cease and desist order against Aurora Bank (the
Order). The Order, among other things, requires Aurora Bank to file various privileged
prospective operating plans with the OTS to manage the liquidity and operations of Aurora Bank
going forward, including a strategic plan to be activated whenever Aurora Banks capital ratios are
less than specified levels. This strategic plan will remain operative until the OTS confirms that
the Order has been lifted based, among other things, on Aurora Banks capital ratios. The Order
requires Aurora Bank to ensure that each of its subsidiaries, including the Company, complies with
the Order, including the operating restrictions contained in the Order. These operating
restrictions, among other things, restrict transactions with affiliates, contracts outside the
ordinary course of business and changes in senior executive officers, board members or their
employment arrangements without prior written notice to the OTS. More detailed information can be
found in the Order itself, which was entered against Aurora Bank under its former name, Lehman
Brothers Bank, FSB, a copy of which is available on the OTS website. In addition, on February 4,
2009, the OTS issued a prompt corrective action directive to Aurora Bank (the PCA Directive). The
PCA Directive requires Aurora Bank to, among other things, raise its capital ratios such that it
will be deemed to be adequately capitalized and places additional constraints on Aurora Bank and
its subsidiaries, including the Company. More detailed information can be found in the PCA
Directive itself, which was entered against Aurora Bank under its former name, Lehman Brothers
Bank, FSB, a copy of which is available on the OTS website.
On June 26, 2009, the OTS notified Aurora Bank that, as a result of the Order and the PCA
Directive, the prior approval of the OTS is currently required before payment by the Company of
dividends on the Series D and Series B preferred stock is made. As a result of the notice from the
OTS, the Board of Directors of the Company (the Board of Directors) voted not to declare or pay
preferred stock dividends that would have been payable on July 15 and October 15, 2009. Aurora Bank
has made a formal request to the OTS to approve the payment of future dividends on the preferred
stock and responded to requests from the OTS for additional information on the payment of these
dividends; however, the OTS has not yet ruled on this request and there can be no assurance that
such approval will be received from the OTS or when or if such OTS approval requirement will be
removed. Furthermore, even if approval is received from the OTS, any future dividends on the
preferred stock will be payable only when, as and if declared by the Board of Directors. The terms
of the
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Series D preferred stock provide that dividends on the Series D preferred stock are not
cumulative and if no dividend is declared for a quarterly dividend period, the holders of the
Series D preferred stock will have no right to receive a dividend for that period, and the Company
will have no obligation to pay a dividend for that period, whether or not dividends are declared
and paid for any future period. The terms of the Series B preferred stock provide that dividends on
the Series B preferred stock are cumulative and if no dividend is declared for a quarterly dividend
period, the holders of the Series B preferred stock will have a legal right to receive a dividend
payment for each period in which no dividend was declared, prior to the payment of dividends to the
Series D and common stockholders. At September 30, 2009, the Company had $38,000 of dividends in
arrears related to the Companys 8% Series B preferred stock.
In order to continue to qualify as a REIT, the Company generally is required each year to
distribute to its stockholders at least 90% of its net taxable income, excluding net capital gains.
As a REIT, the Company generally is not required to pay federal income tax if it continues to meet
this and a number of other requirements. If the OTS does not grant approval to the Company to pay
dividends to its stockholders in an amount necessary to retain the Companys REIT qualification,
including at least 90% of its net taxable income (if any), the Company will fail to qualify as a
REIT and, as a result, will be subject to federal income tax. These condensed financial statements
do not include any adjustments that might result from this uncertainty.
As of September 30, 2009, Aurora Bank maintained its status as adequately capitalized under
applicable regulatory guidelines according to a recent public filing by Aurora Bank with the OTS
and taking into account the Order and PCA Directive. The classification of Aurora Banks
capitalization level, however, is subject to review and acceptance by the OTS. On August 5, 2009,
the bankruptcy court issued an order permitting LBHI to take certain actions intended to strengthen
the capital position of Aurora Bank, including: (1) the increase of the maximum amount available to
Aurora Bank under its repurchase facility with LBHI from $325 million to $450 million, (2) the
increase of the advance rate available under the repurchase facility from 50% to 75% of the value
of the assets that serve as collateral for the repurchase facility and (3) the approval of a
servicing advancement bridge facility for Aurora Bank from LBHI in the amount of $500 million.
Note 3. Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (codified primarily
in ASC 820-10) (ASC 820-10). This standard defines fair values, establishes a framework for
measuring fair value in conformity with GAAP, and expands disclosures about fair value
measurements. Prior to this standard, there were varying definitions of fair value and limited
guidance for applying those definitions under GAAP. In addition, the guidance was dispersed among
many accounting pronouncements that require fair value measurements. This standard was intended to
increase consistency and comparability in fair value measurements and disclosures about fair value
measurements. The provisions of this standard became effective January 1, 2008. The Company applies
the provisions of ASC 820-10 in the determination of the fair value of the loan assets for purposes
of the determination of the lower of accreted cost or fair value of the loans classified as held
for sale.
In April 2009, the FASB issued Staff Position No. FAS 157-4, Determining Fair Value When the
Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and
Identifying Transactions That Are Not Orderly (codified primarily in ASC 820-10-65) (ASC
820-10-65). ASC 820-10-65 emphasizes that the objective of fair value measurement described in ASC
820-10 remains unchanged and provides additional guidance for determining whether market activity
for a financial asset or liability has significantly decreased and for identifying circumstances
that indicate that transactions are not orderly. ASC 820-10-65 indicates that if a market is
determined to be inactive and the related market price is deemed to be reflective of a distressed
sale price, then management judgment may be required to estimate fair value. Further, ASC
820-10-65 identifies factors to be considered when determining whether or not a market is inactive.
ASC 820-10-65 is effective for interim and annual reporting periods ending after June 15, 2009, and
is applied prospectively. The Company believes its valuation methodologies already considered the
concepts discussed in ASC 820-10-65. Therefore, its application did not have an impact on the
earnings or financial position of the Company.
In April 2009, the FASB issued Staff Position No. FAS 107-1 and APB 28-1, Interim Disclosures
about Fair Value of Financial Instruments (primarily codified in ASC 825-10-65) (ASC 825-10-65).
ASC 825-10-65 requires disclosures about the fair value of financial instruments in interim
financial statements. Upon adoption by the Company on June 30, 2009, the disclosures required by
FSP 107-1 and ASC 825-10-65 are to be provided prospectively. The required disclosures are provided
in Note 5 below.
In May 2009, the FASB issued SFAS No. 165, Subsequent Events (codified primarily in ASC
855-10) (ASC 855-10). This standard establishes general accounting and disclosure with respect
to events that occur after the balance sheet date but before financial statements are issued or
otherwise available. The standard sets forth guidance with respect to (a) the period after the
balance sheet date during which management of a reporting entity should evaluate events or
transactions that may occur for potential recognition or disclosure in its financial statements;
(b) the circumstances under which an entity should recognize events or transactions occurring after
the balance sheet date in its financial statements; and (c) the disclosures that an entity should
provide about events or transactions that occur after the balance sheet date. The Company adopted
ASC 855-10 effective June 30, 2009. Accordingly, the Company evaluated events occurring subsequent
to the date of the balance sheet for potential recognition or disclosure in the financial
statements. Events occurring through November 13, 2009, the date this Form 10-Q was filed with the
SEC, were evaluated.
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In June 2009, the FASB issued SFAS No. 168, The FASB Accounting Standards Codification and the
Hierarchy of Generally Accepted Accounting Principles a replacement of FASB Statement No. 162
(codified primarily in ASC 105-10) (ASC 105-10). ASC 105-10 identifies the sources of accounting
principles and the framework for selecting the principles used in the preparation of financial
statements of nongovernmental entities that are presented in conformity with GAAP. The objective of
ASC 105-10 is to establish the FASB Accounting Standards Codification (the Codification) as the
source of authoritative accounting principles recognized by the FASB. After the effective date of
ASC 105-10, all non-grandfathered, non-SEC accounting literature not included in the Codification
is superseded and deemed non-authoritative. ASC 105-10 revises the framework for selecting the
accounting principles to be used in the preparation of financial statements that are presented in
conformity with GAAP. In doing so, the Codification will require the references within the
Companys financial statement to be modified. Additionally, ASC 105-10 may require the Company to
evaluate whether certain modifications will need to be accounted for as an accounting change or
as a correction of an error in accordance with SFAS
No. 154, Accounting Changes and Error Corrections-a replacement of APB Opinion No. 20 and FASB
Statement No. 3 (codified primarily in ASC 250-10). The Company adopted ASC 105-10 effective
September 30, 2009. The effect of adopting this standard did not materially affect the interim
financial statements, other than the footnote disclosures which were expanded to incorporate the
guidance provided by this new standard.
Note 4. Loans
As a result of entering into the Asset Exchange Agreement and in accordance with ASC 948,
effective February 5, 2009 all of the Companys loan assets were considered held for sale and
recorded at the lower of their accreted cost or fair value. The Companys loan assets continue to
be recorded at the lower of their accreted cost or fair value and the Company continues to explore
potential alternative transactions. As discussed in more detail in Note 5 below, the fair value of
the Companys loan portfolio was estimated based upon an internal analysis by management which
considered, among other factors, information, to the extent available, about then current sale
prices, bids, credit quality, liquidity and other available information for loans with similar
characteristics as the Companys loan portfolio. Management also considers the geographical
location and geographical concentration of the loans in the Companys portfolio in its analysis.
The amount by which the accreted cost of the Companys loan assets exceeded the fair value at
the date the loans were reclassified as held for sale was recognized as a valuation allowance.
Subsequent changes to the valuation allowance will be included in the determination of net income
in the period in which the change occurs. Increases in the fair value of the loan assets will be
recognized only up to the accreted cost of the loans on the date they were classified as held for
sale.
Any remaining discount relating to the purchase of the loans by the Company is not amortized
as interest revenue during the period the loans are classified as held for sale. Deferred revenue
associated with loans held for sale is deferred until the related loan is sold.
Commercial mortgage loans constituted approximately 60.1% of the fair value of the Companys
total loan portfolio at September 30, 2009. Commercial mortgage loans are generally subject to
greater risks than other types of loans. The Companys commercial mortgage loans, like most
commercial mortgage loans, generally lack standardized terms, tend to have shorter maturities than
other mortgage loans and may not be fully amortizing.
A summary of the fair value of the Companys loans, which were considered held for sale as of
September 30, 2009, follows:
September 30, 2009 | ||||
(in thousands) | ||||
Mortgage loans on real estate: |
||||
Commercial real estate |
$ | 18,234 | ||
Multi-family residential |
11,561 | |||
One-to-four family residential |
531 | |||
Loans, net of valuation allowance
of $16,751 |
$ | 30,326 | ||
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A summary of the balances of the Companys loans, which were considered held for investment as
of December 31, 2008, follows:
December 31, 2008 | ||||
(in thousands) | ||||
Mortgage loans on real estate: |
||||
Commercial real estate |
$ | 31,633 | ||
Multi-family residential |
20,384 | |||
One-to-four family residential |
981 | |||
Total loans, net of discounts |
52,998 | |||
Less: |
||||
Allowance for loan losses |
(915 | ) | ||
Loans, net |
$ | 52,083 | ||
During the nine months ended September 30, 2009, the Company reversed a $915,000 allowance for
loan losses and recorded a valuation allowance of $16.8 million because the Companys loan
portfolio is considered held for sale and, therefore, is recorded at the lower of accreted cost or
fair value in accordance with ASC 948. The determination of fair value includes, among other
factors, consideration of the creditworthiness of borrowers, and therefore no allowance for loan
losses existed at September 30, 2009, compared to an allowance for loan losses of approximately
$970,000 at September 30, 2008 and $915,000 at December 31, 2008.
Activity in the allowance for loan losses follows:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
(in thousands) | ||||||||||||||||
Balance at beginning of period |
$ | | $ | 1,025 | $ | 915 | $ | 1,180 | ||||||||
Provision for loan losses |
| (55 | ) | (915 | ) | (210 | ) | |||||||||
Balance at end of period |
$ | | $ | 970 | $ | | $ | 970 | ||||||||
Since the Companys loan portfolio is now classified as held for sale and recorded at the
lower of accreted cost or fair value in accordance with ASC 948, there was no nonaccretable
discount at September 30, 2009. No loans were acquired in 2009 or 2008.
The estimated fair value of non-performing loans totaled $1.7 million as of September
30, 2009. Non-performing loans, net of discount, totaled $682,000 as of September 30, 2008.
The increase in non-performing assets is due to the fact that 12 loans, representing 9
borrowers, were not performing as of September 30, 2009. Loans are considered
non-performing when payment is past due by ninety days or more.
Note 5. Fair Value
Fair Value Measurements
As a result of entering into the Asset Exchange Agreement and in accordance with ASC 948,
effective February 5, 2009 the Companys loans were reclassified as held for sale and the Company
recorded a valuation allowance in the first quarter. Notwithstanding the termination of the
Exchange prior to consummation, the Companys loan assets continue to be recorded at the lower of
accreted cost or fair value in the balance sheet in accordance with ASC 948 as the Company
continues to explore potential alternative transactions. ASC 820-10, defines fair value and
establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to
measure fair value. ASC 820-10 defines fair value as the price at which an asset or liability could
be exchanged in a current transaction between knowledgeable, willing parties. Where available, fair
value is based on observable market prices or inputs or derived from such prices or inputs. Where
observable prices or inputs are not available, other valuation methodologies are applied. At
September 30, 2009, the fair value of the Companys loan portfolio was estimated based upon an
internal analysis by management which considered, among other factors, information, to the extent
available, about then current sale prices, bids, credit quality, liquidity and other available
information for loans with similar characteristics as the Companys loan portfolio. Management also
considers the geographical location and geographical concentration of the loans in the Companys
portfolio in its analysis. The valuation of the loan portfolio involves some level of management
estimation and judgment, the degree of which is dependent on the terms of the loans and the
availability of market prices and inputs.
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ASC 820-10 requires the categorization of financial assets and liabilities based on a
hierarchy of the inputs to the valuation techniques used to measure fair value. The hierarchy gives
the highest priority to quoted prices in active markets for identical assets or liabilities (Level
I) and the lowest priority to valuation methods using unobservable inputs (Level III). The three
levels are described below:
Level I Inputs are unadjusted, quoted prices in active markets for identical assets
or liabilities at the measurement date.
Level II Inputs are either directly or indirectly observable for the asset or
liability through correlation with market data at the measurement date and for the
duration of the instruments anticipated life.
Level III Inputs reflect managements best estimate of what market participants
would use in pricing the asset or liability at the measurement date. Consideration is
given to the risk inherent in the valuation technique and the risk inherent in the
inputs to the model.
The loans categorization within the fair value hierarchy is based on the lowest level of
significant input to its valuation.
The categorization of the level of judgment in the fair value determination of the Companys
loans at September 30, 2009 was:
Level I | Level II | Level III | Total | |||||||||||||
(in thousands) | ||||||||||||||||
Loans Held for Sale: |
||||||||||||||||
Commercial real estate |
| | $ | 18,234 | $ | 18,234 | ||||||||||
Multi-family residential |
| | 11,561 | 11,561 | ||||||||||||
One-to-four family residential |
| | 531 | 531 | ||||||||||||
| | $ | 30,326 | $ | 30,326 | |||||||||||
The table presented below summarizes the change in balance sheet carrying value associated
with Level III loans during the three months ended September 30, 2009. Caution should be utilized
when evaluating reported net revenues for Level III loans. The net loss of $541,000 for the three
months ended September 30, 2009 is included in valuation allowance for loans held for sale on the
Condensed Statements of Income (Loss).
Balance | Balance | |||||||||||||||||||
June 30, | Transfers | Gains / | September 30, | |||||||||||||||||
2009 | Payments | In | (Losses), net (1) | 2009 | ||||||||||||||||
(in thousands) | ||||||||||||||||||||
Loans Held for Sale: |
||||||||||||||||||||
Commercial real estate |
$ | 19,876 | $ | (1,399 | ) | $ | (243 | ) | $ | 18,234 | ||||||||||
Multi-family residential |
12,713 | (873 | ) | (279 | ) | 11,561 | ||||||||||||||
One-to-four family
residential |
575 | (25 | ) | (19 | ) | 531 | ||||||||||||||
Total |
$ | 33,164 | $ | (2,297 | ) | $ | 0 | $ | (541 | ) | $ | 30,326 |
(1) | The current period gains/(losses) from changes in values of Level III loans represent gains/(losses) from changes in values of those loans only for the period(s) in which the loans were classified as Level III. |
The table presented below summarizes the change in balance sheet carrying value
associated with Level III loans during the nine months ended September 30, 2009. Caution should be
utilized when evaluating reported net revenues for Level III loans. The net loss of $16,751,000
for the nine months ended September 30, 2009 is included in valuation allowance for loans held for
sale on the Condensed Statements of Income (Loss).
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Balance | Balance | |||||||||||||||||||
December 31, | Transfers | Gains / | September 30, | |||||||||||||||||
2008 | Payments | In | (Losses), net (1) | 2009 | ||||||||||||||||
(in thousands) | ||||||||||||||||||||
Loans Held for Sale: |
||||||||||||||||||||
Commercial real estate |
$ | 0 | $ | (2,406 | ) | $ | 29,775 | $ | (9,135 | ) | $ | 18,234 | ||||||||
Multi-family residential |
0 | (1,194 | ) | 19,982 | (7,227 | ) | 11,561 | |||||||||||||
One-to-four family
residential |
0 | (50 | ) | 970 | (389 | ) | 531 | |||||||||||||
Total |
$ | 0 | $ | (3,650 | ) | $ | 50,727 | $ | (16,751 | ) | $ | 30,326 |
(1) | The current period gains/(losses) from changes in values of Level III loans represent gains/(losses) from changes in values of those loans only for the period(s) in which the loans were classified as Level III. |
Fair Value of Financial Instruments
ASC 825-10-65 requires disclosure of the estimated fair value of all financial instruments
where it is practicable to estimate such values. In determining the fair value measurements for
financial assets and liabilities, the Company utilizes quoted prices, when available. If quoted
prices are not available, the Company estimates fair value using present value or other valuation
techniques that utilize inputs that are observable for the asset or liability, either directly or
indirectly, when available. When observable inputs are not available, inputs may be used that are
unobservable and, therefore, reflect the Companys own assumptions about the assumptions market
participants would use in pricing the asset or liability based on the best information available in
the circumstances.
ASC 825-10-65 excludes certain financial instruments and all nonfinancial instruments
from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not
represent the underlying value of the Company.
The following methods and assumptions were used by the Company in estimating fair value
disclosures for financial instruments:
Cash and cash equivalents: The carrying amounts of cash and interest-bearing deposits
approximate fair value because of the short-term maturity of these instruments.
Loans: The fair value of the Companys loan portfolio was estimated based upon an internal
analysis by management which considered, among other factors, information, to the extent available,
about then current sale prices, bids, credit quality, liquidity and other available information for
loans with similar characteristics as the Companys loan portfolio. Management also considers the
geographical location and geographical concentration of the loans in the Companys portfolio in its
analysis. The valuation of the loan portfolio involves some level of management estimation and
judgment, the degree of which is dependent on the terms of the loans and the availability of market
prices and inputs.
Accrued interest receivable: The carrying amount of accrued interest receivable
approximates fair value because of the short-term nature of the receivable.
The estimated fair values, and related carrying amounts, of the Companys financial
instruments are as follows:
September 30, 2009 | December 31, 2008 | |||||||||||||||
Carrying Amount |
Fair Value | Carrying Amount |
Fair Value | |||||||||||||
(in thousands) | ||||||||||||||||
Cash and cash equivalents |
$ | 50,238 | $ | 50,238 | $ | 43,757 | $ | 43,757 | ||||||||
Loans held for sale |
30,326 | 30,326 | | | ||||||||||||
Loans held for investment,
net of discounts and net
deferred loan income |
| | 52,083 | 37,046 | ||||||||||||
Accrued interest receivable |
149 | 149 | 227 | 227 |
Note 6. Related Party Transactions
Aurora Bank performs advisory services and services the loans owned by the Company.
Aurora Bank in its role as servicer under the terms of the master service agreement receives an
annual servicing fee equal to 0.20%, payable monthly, on the gross average outstanding principal
balances of loans serviced for the immediately preceding month. Additionally, Aurora Bank is paid
an annual
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advisory fee equal to 0.05%, payable monthly, of the gross average outstanding principal
balances of the Companys loans for the immediately preceding month, plus reimbursement for certain
expenses incurred by Aurora Bank as advisor. Servicing and advisory fees for the quarters ended
September 30, 2009 and 2008 totaled $34,000 and $40,000, respectively, of which $34,000 and $36,000
respectively, are included in accrued expenses and other liabilities on the Condensed Balance
Sheets at September 30, 2009 and 2008, respectively. Certain of the servicing and advisory functions
required to be performed under the master service agreement and the advisory agreement have been
subcontracted by Aurora Bank to an unrelated third party. There is no additional cost to the
Company as a result of such subcontracting.
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
This report contains certain statements that constitute forward-looking statements within
the meaning of the Private Securities Litigation Reform Act of 1995. Words such as expects,
anticipates, believes, estimates and other similar expressions or future or conditional verbs
such as will, should, would, and could are intended to identify such forward-looking
statements. These statements are not historical facts, but instead represent the Companys current
expectations, plans or forecasts of its future results, growth opportunities, business outlook,
loan growth, credit losses, liquidity position and other similar matters, including, but not
limited to, the ability to pay dividends with respect to the Series D preferred stock, the ability
to consummate any alternative transaction to the terminated asset exchange, future bank regulatory
actions that may impact the Company and the effect of the bankruptcy of LBHI on the Company. These
statements are not guarantees of future results or performance and involve certain risks,
uncertainties and assumptions that are difficult to predict and often are beyond the Companys
control. Actual outcomes and results may differ materially from those expressed in, or implied by,
the Companys forward-looking statements. You should not place undue reliance on any
forward-looking statement and should consider all uncertainties and risks, including, among other
things, the risks set forth herein and in our Annual Report on Form 10-K for the year ended
December 31, 2008, as well as those discussed in any of the Companys other subsequent Securities
and Exchange Commission filings. Forward-looking statements speak only as of the date they are
made, and the Company undertakes no obligation to update any forward-looking statement to reflect
the impact of circumstances or events that arise after the date the forward-looking statement was
made.
Possible events or factors could cause results or performance to differ materially from
what is expressed in our forward-looking statements. These possible events or factors include, but
are not limited to, those risk factors discussed under Item 1A Risk Factors in our Annual Report
on Form 10-K for the year ended December 31, 2008 or in Item 1A of this Quarterly Report on Form
10-Q, and the following: limitations by regulatory authorities on the Companys ability to
implement its business plan and restrictions on its ability to pay dividends; further regulatory
limitations on the business of Aurora Bank that are applicable to the Company; negative economic
conditions that adversely affect the general economy, housing prices, the job market, consumer
confidence and spending habits which may affect, among other things, the credit quality of our loan
portfolios (the degree of the impact of which is dependent upon the duration and severity of these
conditions); the level and volatility of interest rates; changes in consumer, investor and
counterparty confidence in, and the related impact on, financial markets and institutions;
legislative and regulatory actions which may adversely affect the Companys business and economic
conditions as a whole; the impact of litigation and regulatory investigations; various monetary and
fiscal policies and regulations; changes in accounting standards, rules and interpretations and the
impact on the Companys financial statements; the ability to
consummate any alternative transaction
to the terminated asset exchange; and changes in the nature and quality of the types of loans held
by the Company.
The following discussion of the Companys financial condition, results of operations, capital
resources and liquidity should be read in conjunction with the condensed financial statements and
related notes included elsewhere in this report and the audited financial statements and related
notes included in the Companys Annual Report on Form 10-K for the year ended December 31, 2008 as
filed with the SEC.
Executive Level Overview
Aurora Bank owns all of the Companys common stock. The Companys Series B preferred stock and
Series D preferred stock remain outstanding and remain subject to their existing terms and
conditions, including the call feature with respect to the Series D preferred stock.
All of the mortgage assets in the Companys loan portfolio at September 30, 2009 were acquired
from Capital Crossing, previously the sole common stockholder, and it is anticipated that
substantially all additional mortgage assets, if any assets are acquired in the future, will be
acquired from Aurora Bank, currently the sole common stockholder. As of September 30, 2009, the
Company held loans acquired from Capital Crossing with an aggregate fair value of approximately
$30.3 million.
Commercial mortgage loans constituted approximately 60.1% of the fair value of the Companys
total loan portfolio at September 30, 2009. Commercial mortgage loans are generally subject to
greater risks than other types of loans. The Companys commercial mortgage loans, like most
commercial mortgage loans, generally lack standardized terms, tend to have shorter maturities than
other mortgage loans and may not be fully amortizing. For these reasons, the Company may experience
higher rates of default on its
12
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mortgage loans than it would if its loan portfolio was more
diversified and included a greater number of owner-occupied residential or other mortgage loans.
Properties underlying the Companys current mortgage assets are also concentrated primarily in
California, New England and Nevada. As of September 30, 2009, approximately 64.5% of the fair value
of the Companys mortgage loans were secured by properties located in California, 6.9% in New
England and 5.6% in Nevada. Beginning in 2007 and continuing through September 2009, the housing
and real estate sectors in California and Nevada were hit particularly hard by the recession
with higher overall foreclosure rates than the national average. If these regions experience
further adverse economic, political or business conditions, or natural hazards, the Company will
likely experience higher rates of loss and delinquency on its mortgage loans than if its loans were
more geographically diverse.
Net income available to the common stockholder decreased $490,000 to $192,000 for the three
months ended September 30, 2009, compared to net income of $682,000 for the same period in 2008.
The decrease in net income available to the common stockholder is primarily the result of a
$653,000 reduction in interest income, a net reduction in the fair value of loans of $541,000
during the quarter, and an increase in general and administrative expenses of $74,000, offset by an
$816,000 reduction in dividends as no dividends were declared in the third quarter of 2009.
Decisions regarding the utilization of the Companys cash are based, in large part, on its
current and future commitments to pay preferred stock dividends and its ability to pay dividends on
its preferred stock and common stock in amounts necessary to continue to preserve its status as a
REIT under the Internal Revenue Code. Future decisions regarding mortgage asset acquisitions and
returns of capital will be based on the levels of the Companys cash and cash equivalents at the
time, the preferred stock dividends at the time and the required income necessary to generate
adequate dividend coverage in the future, the dividends on its preferred stock and common stock
necessary to continue to preserve the Companys status as a REIT and other factors determined to be
relevant at the time. Future decisions will also be subject to the receipt of OTS approval, as
necessary.
Impact of Economic Recession
Dramatic declines in the housing market over the past year, with falling home prices and
increasing foreclosures, unemployment and underemployment, have negatively impacted the credit
performance of mortgage loans and resulted in significant write-downs of asset values by financial
institutions, including government-sponsored entities as well as major commercial and investment
banks. Reflecting concern about the stability of the financial markets generally and the strength
of counterparties, many lenders and institutional investors have reduced or ceased providing
funding to borrowers, including to other financial institutions. This market turmoil and tightening
of credit have led to an increased level of delinquencies, decreased consumer spending, lack of
confidence, increased market volatility and widespread reduction of business activity generally.
The resulting economic pressure on borrowers, and lack of confidence in the financial markets have
negatively impacted, and may further negatively impact, the credit quality of our commercial loan
portfolio and may impact the credit quality of our residential loan portfolio and in turn, the
value the Company could realize upon the sale or exchange of all or a portion of the loans. The
depth and breadth of the downturn as well as the resulting impact on the credit quality of both our
commercial and residential loan portfolios remain unclear. Continued market turbulence and
economic uncertainty may result in further reductions in the fair value of the loans held for sale
in future periods.
Bankruptcy of LBHI
On September 15, 2008, LBHI filed a voluntary petition for relief under Chapter 11 of the
U.S. Bankruptcy Code. Aurora Bank is a subsidiary of LBHI. Aurora Bank has not been placed into
bankruptcy, reorganization, conservatorship or receivership and the Company has not filed for
bankruptcy protection. The bankruptcy of LBHI may limit the ability of LBHI to contribute capital
to Aurora Bank now or in the future. In addition, the timing and amount of any payments received by
Aurora Bank with respect to debts owed to Aurora Bank by LBHI may be limited by the bankruptcy of
LBHI, which could in turn negatively impact the assets, capital levels and regulatory capital
ratios of Aurora Bank. On August 5, 2009, the bankruptcy court issued an order permitting LBHI to
take certain actions intended to strengthen the capital position of Aurora Bank, including: (1) the
increase of the maximum amount available to Aurora Bank under its repurchase facility with LBHI
from $325 million to $450 million, (2) the increase of the advance rate available under the
repurchase facility from 50% to 75% of the value of the assets that serve as collateral for the
repurchase facility and (3) the approval of a servicing advancement bridge facility for Aurora Bank
from LBHI in the amount of $500 million. The Company is dependent in virtually every phase of its
operations on the management of Aurora Bank and, as a subsidiary of Aurora Bank, is subject to
regulation by federal banking authorities. The bankruptcy of LBHI and its potential negative
effects on Aurora Bank has resulted in increased oversight, and we expect will continue to result
in increased oversight of the Company by the OTS and may result in further restrictions on the
Companys ability to conduct its business.
Terminated Asset Exchange
On February 5, 2009, the Company and Aurora Bank entered into an Asset Exchange Agreement
pursuant to which the Company agreed to transfer 207 loans secured primarily by commercial real
estate and multifamily residential real estate to Aurora Bank in
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exchange for 205 loans secured
primarily by residential real estate. The Loans represented substantially all of the Companys
assets, excluding cash and interest-bearing deposits as of December 31, 2008. The Exchange was
subject to certain conditions to closing as well as the receipt of a non-objection letter from the
OTS. On July 20, 2009, the Company and Aurora Bank mutually agreed to terminate the Agreement. The
Agreement was terminated following receipt of a letter from the OTS failing to grant Aurora Banks
requests for non-objection with respect to the Exchange. As a result of the termination of the
Agreement, which termination was without liability to either party, the Exchange was not
consummated and the Company continues to own the portfolio of loans secured by commercial real
estate and multifamily real estate that the Company owned prior to entering into the Agreement. The
Company continues to explore potential alternative transactions involving its loan portfolio and
has received preapproval from the OTS for transactions that meet certain
guidelines; however there can be no assurances that any such alternative transaction will
occur. As a result of entering into the Agreement and continuing to explore potential alternative
transactions, the Company reclassified all of its loan assets as held for sale and now records
these loan assets at the lower of their accreted cost or fair value in accordance with ASC 948.
Regulatory Actions Involving Aurora Bank
On January 26, 2009, the OTS entered a cease and desist order against Aurora Bank. The
Order, among other things, required Aurora Bank to file various privileged prospective operating
plans with the OTS to manage the liquidity and operations of Aurora Bank going forward, including a
strategic plan to be activated whenever Aurora Banks capital ratios are less than specified
levels. This strategic plan will remain operative until the OTS confirms that the Order has been lifted based,
among other things, on Aurora Banks capital ratios. The Order requires Aurora Bank to ensure that
each of its subsidiaries, including the Company, complies with the Order, including the operating
restrictions contained in the Order. These operating restrictions, among other things, restrict
transactions with affiliates, contracts outside the ordinary course of business and changes in
senior executive officers, board members or their employment arrangements without prior written
notice to the OTS. In addition, on February 4, 2009, the OTS issued a prompt corrective action
directive to Aurora Bank. The PCA Directive requires Aurora Bank to, among other things, raise its
capital ratios such that it will be deemed to be adequately capitalized and places additional
constraints on Aurora Bank and its subsidiaries, including the Company. More detailed information
can be found in the Order and the PCA Directive themselves, which were entered against Aurora Bank
under its former name, Lehman Brothers Bank, FSB, copies of which are available on the OTS
website.
On June 26, 2009, the OTS notified Aurora Bank that, as a result of the Order and the PCA
Directive, the prior approval of the OTS is currently required before payment by the Company of
dividends on the Series D and Series B preferred stock is made. As a result of the notice from the
OTS, the Board of Directors voted not to declare or pay preferred stock dividends that would have
been payable on July 15 and October 15, 2009. Aurora Bank has made a formal request to the OTS to
approve the payment of future dividends on the preferred stock and responded to requests from the
OTS for additional information on the payment of these dividends; however, the OTS has not yet
ruled on this request and there can be no assurance that such approval will be received from the
OTS or when or if such OTS approval requirement will be removed. Furthermore, even if approval is
received from the OTS, any future dividends on the preferred stock will be payable only when, as
and if declared by the Board of Directors. The terms of the Series D preferred stock provide that
dividends on the Series D preferred stock are not cumulative and if no dividend is declared for a
quarterly dividend period, the holders of the Series D preferred stock will have no right to
receive a dividend for that period, and the Company will have no obligation to pay a dividend for
that period, whether or not dividends are declared and paid for any future period. The terms of the
Series B preferred stock provide that dividends on the Series B preferred stock are cumulative and
if no dividend is declared for a quarterly dividend period, the holders of the Series B preferred
stock will have a legal right to receive a dividend payment for each period in which no dividend
was declared, prior to the payment of dividends to the Series D and common stockholders. At
September 30, 2009, the Company had $38,000 of dividends in arrears related to the Companys 8%
Series B preferred stock.
As of September 30, 2009, Aurora Bank maintained its status as adequately capitalized under
applicable regulatory guidelines according to a recent public filing by Aurora Bank with the OTS
and taking into account the Order and PCA Directive. The classification of Aurora Banks
capitalization level, however, is subject to review and acceptance by the OTS.
The bankruptcy of LBHI and its potential negative effects on Aurora Bank has resulted in
increased oversight, and we expect will continue to result in increased oversight, of the Company
by the OTS and may result in further restrictions on the Companys ability to conduct its business.
Application of Critical Accounting Policies and Estimates
Our discussion and analysis of financial condition and results of operations are based upon
our condensed financial statements, which have been prepared in accordance with U.S. generally
accepted accounting principles, or GAAP. The preparation of these condensed financial statements in
conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts
of assets and liabilities at the date of the condensed financial statements and the reported amount
of revenues and expenses in the reporting period. Our actual results may differ from these
estimates. We describe below those accounting policies that require material subjective or complex
judgments and that have the most significant impact on our financial condition and results of
operations. Our management evaluates these estimates on an ongoing basis, based upon information
currently available and on various assumptions
14
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management believes are reasonable as of the date on
the front cover of this report. Although a number of our significant accounting policies have
changed since all of the Companys loan assets are now considered held for sale and, as discussed
further below, recorded at the lower of their accreted cost or fair value in accordance with ASC
948, the remainder of the Companys significant accounting policies summarized in Note 1 to our
financial statements included in our Annual Report on Form 10-K for the year ended December 31,
2008 remain in effect.
Loans Held for Sale. On February 5, 2009, the Company agreed to transfer 207 loans secured
primarily by commercial real estate and multifamily residential real estate to Aurora Bank in
exchange for 205 loans secured primarily by residential real estate. As a result, during the first
quarter of 2009 the Company reclassified all of its loan assets as held for sale and recorded a
valuation allowance to reflect these loan assets at the lower of their accreted cost or fair value
in accordance with ASC 948. Despite the termination of the asset exchange prior to its
consummation, the Company continues to account for the loan portfolio as held for sale as it
explores other potential
alternative transactions. Prior to February 5, 2009, the Companys loan assets were recorded
at accreted cost less an allowance for loan losses. The fair value of the Companys loan portfolio
as of September 30, 2009 was estimated based upon an internal analysis by management which
considered, among other things, information, to the extent available, about then current sale
prices, bids, credit quality, liquidity and other available information for loans with similar
characteristics as the Companys loan portfolio. Management also considers the geographical
location and geographical concentration of the loans in the Companys portfolio in its analysis.
The internal analysis involves some level of management estimation and judgment, the degree of
which is dependent on the terms of the loans and the availability of market prices and inputs.
The amount by which the accreted cost of the Companys loan assets exceeded the fair value at
the date the loans were reclassified as held for sale was recognized as a valuation allowance.
Subsequent changes to the valuation allowance will be included in the determination of net income
in the period in which the change occurs. Increases in the fair value of the loan assets will be
recognized only up to the accreted cost of the loans on the date they were classified as held for
sale.
Any remaining discount relating to the purchase of the loans by the Company are not amortized
as interest revenue during the period the loans are classified as held for sale. Deferred revenue
associated with loans held for sale is deferred until the related loan is sold.
Discounts on Acquired Loans. Prior to entering into the Asset Exchange Agreement on February
5, 2009 and reclassifying the loans as held for sale, in accordance with Statement of Position No.
03-3 Accounting for Certain Loans or Debt Securities Acquired in a Transfer (codified primarily in
ASC 310-30) (SOP 03-3), the Company reviewed acquired loans for differences between contractual
cash flows and cash flows expected to be collected from the Companys initial investment in the
acquired loans to determine if those differences were attributable, at least in part, to credit
quality. If those differences were attributable to credit quality, the loans contractually
required payments receivable in excess of the amount of its cash flows expected at acquisition, or
nonaccretable discount, was not accreted into income. Prior to February 5, 2009, SOP 03-3 required
that the Company recognize the excess of all cash flows expected at acquisition over the Companys
initial investment in the loan as interest income using the interest method over the term of the
loan. This excess is referred to as accretable discount.
No loans acquired since the adoption of SOP 03-3 were within the scope of the SOP.
Loans which, at acquisition, do not have evidence of deterioration of credit quality since
origination are outside the scope of SOP No. 03-3. For such loans, the discount, representing the
excess of the amount of reasonably estimable and probable discounted future cash collections over
the purchase price, was accreted into interest income using the interest method over the term of
the loan. Prepayments were not considered in the calculation of accretion income. Additionally,
discounts were not accreted on non-performing loans.
There was judgment involved in estimating the amount of the Companys future cash flows on
acquired loans. The amount and timing of actual cash flows could differ materially from
managements estimates. If cash flows could not be reasonably estimated for any loan, and
collection was not probable, the cost recovery method of accounting was used. Under the cost
recovery method, any amounts received were applied against the recorded amount of the loan.
Nonaccretable discount was generally offset against the related principal balance when the amount
at which a loan was resolved or restructured was determined. There was no effect on the income
statement as a result of these reductions.
Subsequent to acquisition, if cash flow projections improved, and it was determined that the
amount and timing of the cash flows related to the nonaccretable discount were reasonably estimable
and collection was probable, the corresponding decrease in the nonaccretable discount was
transferred to the accretable discount and was accreted into interest income over the remaining
life of the loan on the interest method. If cash flow projections deteriorated subsequent to
acquisition, the decline was accounted for through a provision for loan losses included in
earnings.
Allowance for Loan Losses. Prior to entering into the Asset Exchange Agreement on February 5,
2009 and reclassifying the loans as held for sale, the Company maintained an allowance for probable
loan losses that were inherent in its loan portfolio. Since the
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loan portfolio is now classified as
held for sale and recorded at the lower of its accreted cost or fair value, the Company no longer
maintains an allowance for loan losses. In prior periods, arriving at an appropriate level of
allowance for loan losses required a high degree of judgment. The allowance for loan losses was
increased or decreased through a provision for loan losses.
In determining the adequacy of the allowance for loan losses, management made significant
judgments. Aurora Bank initially reviewed the Companys loan portfolio to identify loans for which
specific allocations were considered prudent. Specific allocations included the results of
measuring impaired loans under SFAS No. 114, Accounting by Creditors for Impairment of a Loan
(codified primarily in ASC 310-10) (ASC 310-10). Next, management considered the level of loan
allowances deemed appropriate for loans determined not to be impaired under ASC 310-10. The
allowance for these loans was determined by a formula whereby the portfolio was stratified by type
and internal risk rating categories. Loss factors were then applied to each strata based on various
considerations including collateral type, loss experience, delinquency trends, current economic
conditions and industry standards. The allowance for loan losses was managements estimate of the
probable loan losses incurred as of the balance sheet date.
The determination of the allowance for loan losses required managements use of significant
estimates and judgments. In making this determination, management considered known information
relative to specific loans, as well as collateral type, loss experience,
delinquency trends, current economic conditions and industry trends, generally. Based on these
factors, management estimated the probable loan losses incurred as of the reporting date and
increased or decreased the allowance through a change in the provision for loan losses. Loan losses
were charged against the allowance when management believed the net investment of the loan, or a
portion thereof, was uncollectible. Subsequent recoveries, if any, were credited to the allowance
when cash payments were received.
Gains and losses on sales of loans are determined using the specific identification method.
The excess (deficiency) of any cash received as compared to the net investment is recorded as gain
(loss) on sales of loans. There were no loans sold during the nine months ended September 30, 2009.
Results of Operations for the Three Months Ended September 30, 2009 and 2008
Interest income
The following table sets forth the yields on the Companys interest-earning assets for the
periods indicated:
Three Months Ended September 30, | ||||||||||||||||||||||||
2009 | 2008 | |||||||||||||||||||||||
Average | Interest | Average | Interest | |||||||||||||||||||||
Balance | Income | Yield | Balance | Income | Yield | |||||||||||||||||||
(dollars in thousands) | ||||||||||||||||||||||||
Loans, net (1) |
$ | 45,376 | $ | 839 | 7.34 | % | $ | 56,466 | $ | 1,298 | 9.14 | % | ||||||||||||
Interest-bearing deposits |
48,482 | 75 | 0.62 | % | 61,181 | 269 | 1.75 | % | ||||||||||||||||
Total interest-earning assets |
$ | 93,858 | $ | 914 | 3.86 | % | $ | 117,647 | $ | 1,567 | 5.30 | % | ||||||||||||
(1) | For purposes of providing a meaningful yield comparison, the forgoing table reflects the average accreted cost of the loans, net of discounts, and not the fair value of the loan portfolio. Non-performing loans are excluded from average balance calculations. |
The decline in interest income for the three months ended September 30, 2009 compared to the
three months ended September 30, 2008 is primarily due to a decrease in the average balance of
loans and yield on loans and interest bearing deposits.
The average accreted cost of the loans, net of discounts, for the three months ended September
30, 2009 totaled $45.3 million compared to $56.5 million for the same period in 2008. This decrease
is primarily attributable to loan payoffs and amortization of loans. No loans have been acquired by
the Company since 2005 and management currently has no intention of acquiring additional loans
other than in connection with a potential alternative transaction to the asset exchange. For the
three months ended September 30, 2009, the yield on the loan portfolio decreased to 7.34% compared
to 9.14% for the same period in 2008. For the three months ended September 30, 2009, interest and
fee income recognized on loan payoffs decreased $77,000, or 28%, to $198,000 from $275,000 for the
three months ended September 30, 2008. The level of interest and fee income recognized on loan
payoffs varies for numerous reasons, as further discussed below. The yield from regularly scheduled
interest and accretion income decreased to 5.60% for the three months ended September 30, 2009 from
7.20% for the same period in 2008 primarily due to a $189,000 reduction in interest income
resulting from the discontinuance of the amortization of purchase discount and fees on loans as a
result of the loans being reclassified to held for sale during the first quarter of 2009, a
reduction in average balances and decreases in market interest rates.
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The average balance of interest-bearing deposits decreased $12.7 million or 20.8% to
$48.5 million for the three months ended September 30, 2009, compared to $61.2 million for the same
period in 2008. The changes in the average balances of interest-bearing deposits are the result of
periodic dividend payments and returns of capital partially offset by cash flows from loan
repayments. In July, 2009 the rate earned on interest-bearing deposits decreased from 1.75% to
0.30%, resulting in a decrease in interest income and yield for the three months ended September
30, 2009.
The table above presents the average accreted cost balance of the Companys loans, net of
discounts, and does not present the loans at their fair value. Therefore, for periods prior to
February 5, 2009, income on loans includes the portion of the purchase discount that is accreted
into income over the remaining lives of the related loans using the interest method. Because the
carrying value of the loan portfolio is net of purchase discount, the related yield on this
portfolio generally is higher than the aggregate contractual rate paid on the loans. The total
yield includes the excess of a loans expected discounted future cash flows over its net
investment, recognized using the interest method. For periods after February 5, 2009, the yields
shown in the above table are representative of actual yields.
Prior to February 5, 2009, when a loan was paid off, the excess of any cash received over the
net investment was recorded as interest income. In addition to the amount of purchase discount that
was recognized at that time, income may also have included interest owed by the borrower prior to
the Companys acquisition of the loan, interest collected if on non-performing status,
prepayment fees and other loan fees (other interest and fee income). For periods after February
5, 2009, when a loan is paid off, the excess of any cash received over the net investment is
considered in the assessment of the valuation allowance. The following table sets forth, for the
periods indicated, the components of interest and fees on loans. There can be no assurance
regarding future interest income, including the yields and related level of such income, or the
relative portion attributable to loan payoffs as compared to other sources.
Three Months Ended September 30, | |||||||||||||||||
2009 | 2008 | ||||||||||||||||
Interest | Interest | ||||||||||||||||
Income | Yield | Income | Yield | ||||||||||||||
(dollars in thousands) | |||||||||||||||||
Regularly scheduled interest and accretion income |
$ | 641 | 5.60 | % | $ | 1,023 | 7.20 | % | |||||||||
Interest and fee income recognized on loan payoffs: |
|||||||||||||||||
Nonaccretable discount |
| | | | |||||||||||||
Accretable discount |
192 | 1.68 | % | 271 | 1.91 | % | |||||||||||
Other interest and fee income |
6 | 0.06 | % | 4 | 0.03 | % | |||||||||||
198 | 1.74 | % | 275 | 1.94 | % | ||||||||||||
$ | 839 | 7.34 | % | $ | 1,298 | 9.14 | % | ||||||||||
The amount of loan payoffs and related discount income is influenced by several factors,
including the interest rate environment, the real estate market in particular areas, the timing of
transactions, and circumstances related to individual borrowers and loans. The amount of individual
loan payoffs is often times a result of negotiations between the Company and the borrower. Based
upon credit risk analysis and other factors, the Company will, in certain instances, accept less
than the full amount contractually due in accordance with the loan terms.
Provision for loan losses
Prior to entering into the Asset Exchange Agreement on February 5, 2009 and reclassifying the
loans as held for sale, the Company maintained an allowance for probable loan losses that were
inherent in its loan portfolio. Since the loan portfolio is now classified as held for sale and
recorded at the lower of its accreted cost or fair value, the Company no longer maintains an
allowance for loan losses as the determination of fair value includes consideration of, among other
factors, the creditworthiness of borrowers. Prior to the reclassification of the loan portfolio on
February 5, 2009, the determination of the allowance for loan losses required managements use of
significant estimates and judgments. In making this determination, management considered known
information relative to specific loans, as well as collateral type, loss experience, delinquency
trends, current economic conditions and industry trends, generally. Based on these factors,
management estimated the probable loan losses incurred as of the reporting date and increased or
decreased the allowance through a change in the provision for loan losses. The Company recorded a
reduction of the allowance for loan losses of $55,000 for the three months ended September 30, 2008
due to the decrease in the balance of loans due to payoffs without a significant change in the
credit profile of the remaining portfolio during the period.
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Operating expenses
Loan servicing and advisory expenses decreased $17,000, or 32.7%, to $35,000 for the three
months ended September 30, 2009 from $52,000 for the three months ended September 30, 2008. The
decrease is primarily the result of a decrease in loan servicing expenses due to the decrease in
the average balance of the loan portfolio.
Other general and administrative expenses increased $74,000 or 102.8%, to $146,000 for the
three months ended September 30, 2009 compared to $72,000 for the three months ended September 30,
2008. This increase is primarily attributable to an increase in legal fees, an increase in external
audit expenses and an increase in printing fees. This increase was partially offset by a decrease
in directors fees.
Preferred stock dividends
Preferred stock dividends decreased $816,000 to $0 for the three months ended September 30,
2009 as compared to $816,000 for the three months ended September 30, 2008. On June 26, 2009, the
OTS notified Aurora Bank that, as a result of the Order and the PCA Directive, the prior approval
of the OTS is currently required before payment by the Company of dividends on the Series D and
Series B preferred stock is made. As a result of the notice from the OTS, the Board of Directors
voted not to declare or pay preferred stock dividends that would have been payable on July 15 and
October 15, 2009. Aurora Bank has made a formal request to the OTS to approve the payment of future
dividends on the Series D preferred stock and responded to requests from the OTS for additional
information on the payment of these dividends; however, the OTS has not yet ruled on this request
and there can be no assurance that such approval will be received from the OTS or when or if such
OTS approval requirement will be removed. Furthermore, even if approval is received from the OTS,
any future dividends on the preferred stock will be payable only when, as and if declared by the
Board of Directors. The terms of the Series D preferred stock provide that dividends on the Series
D preferred stock are not cumulative and if no dividend is declared for a quarterly dividend
period, the holders of the Series D preferred stock will have no right to receive a dividend for
that period, and the Company will have no obligation to pay a dividend for that period, whether or
not dividends are declared and paid for any future period. The terms of the Series B preferred
stock provide that dividends on the Series B preferred stock are cumulative and if no dividend is
declared for a quarterly dividend period, the holders of the Series B preferred stock will have a
legal right to receive a dividend payment for each period in which no dividend was declared, prior
to the payment of dividends to the Series D and common stockholders. At September 30, 2009, the
Company had $38,000 of dividends in arrears related to the Companys 8% Series B preferred stock.
The Company, subject to receipt of approval from the OTS, intends to pay dividends on its preferred
stock and common stock in amounts necessary to continue to preserve its status as a REIT under the
Internal Revenue Code.
Results of Operations for the Nine Months Ended September 30, 2009 and 2008
Interest income
The following table sets forth the yields on the Companys interest-earning assets for the
periods indicated:
Nine Months Ended September 30, | ||||||||||||||||||||||||
2009 | 2008 | |||||||||||||||||||||||
Average | Interest | Average | Interest | |||||||||||||||||||||
Balance | Income | Yield | Balance | Income | Yield | |||||||||||||||||||
(dollars in thousands) | ||||||||||||||||||||||||
Loans, net (1) |
$ | 47,155 | $ | 2,347 | 6.65 | % | $ | 60,766 | $ | 3,845 | 8.45 | % | ||||||||||||
Interest-bearing deposits |
46,349 | 468 | 1.35 | % | 56,431 | 739 | 1.75 | % | ||||||||||||||||
Total interest-earning assets |
$ | 93,504 | $ | 2,815 | 4.03 | % | $ | 117,197 | $ | 4,584 | 5.22 | % | ||||||||||||
(1) | For purposes of providing a meaningful yield comparison, the forgoing table reflects the average accreted cost of the loans, net of discounts, and not the fair value of the loan portfolio. Non-performing loans are excluded from average balance calculations. |
The decline in interest income for the nine months ended September 30, 2009 compared to the
nine months ended September 30, 2008 is primarily due to a decrease in the average balance and
yield on loans and interest-bearing deposits.
The average accreted cost of the loans, net of discounts, for the nine months ended September
30, 2009 totaled $47.2 million compared to $60.8 million for the same period in 2008. This decrease
is primarily attributable to loan payoffs and amortization of loans. No loans have been acquired by
the Company since 2005 and management currently has no intention of acquiring additional loans
other than in connection with a potential alternative transaction to the asset exchange. For the
nine months ended September 30, 2009, the yield
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on the loan portfolio decreased to 6.65% compared to 8.45% for the same period in 2008. For the nine months ended September 30, 2009, interest and
fee income recognized on loan payoffs decreased $217,000, or 42%, to $304,000 from $521,000 for the
nine months ended September 30, 2008. The level of interest and fee income recognized on loan
payoffs varies for numerous reasons, as further discussed
below. The yield from regularly scheduled interest and accretion income decreased to 5.79% for the
nine months ended September 30, 2009 from 7.31% for the same period in 2008 primarily due to a
$551,000 reduction in interest income resulting from the discontinuance of the amortization of
purchase discount and fees on loans as a result of the loans being reclassified to held for sale
during the first quarter of 2009, a reduction in average balances and decreases in market interest
rates.
The average balance of interest-bearing deposits decreased $10.1 million or 17.9% to $46.3
million for the nine months ended September 30, 2009, compared to $56.4 million for the same period
in 2008. The changes in the average balances of interest-bearing deposits are the result of
periodic dividend payments and returns of capital partially offset by cash flows from loan
repayments. In July, 2009 the rate earned on interest-bearing deposits decreased from 1.75% to
0.30%, resulting in a decrease in interest income and yield for the nine months ended September 30,
2009.
The table above presents the average accreted cost balance of the Companys loans, net of
discounts, and does not present the loans at their fair value. Therefore, for periods prior to
February 5, 2009, income on loans includes the portion of the purchase discount that is accreted
into income over the remaining lives of the related loans using the interest method. Because the
carrying value of the loan portfolio is net of purchase discount, the related yield on this
portfolio generally is higher than the aggregate contractual rate paid on the loans. The total
yield includes the excess of a loans expected discounted future cash flows over its net
investment, recognized using the interest method. For periods after February 5, 2009, the yields
shown in the above table are representative of actual yields.
Prior to February 5, 2009, when a loan was paid off, the excess of any cash received over the
net investment was recorded as interest income. In addition to the amount of purchase discount that
was recognized at that time, income may also have included interest owed by the borrower prior to
the Companys acquisition of the loan, interest collected if on non-performing status,
prepayment fees and other loan fees (other interest and fee income). For periods after February
5, 2009, when a loan is paid off, the excess of any cash received over the net investment is
considered in the assessment of the valuation allowance. The following table sets forth, for the
periods indicated, the components of interest and fees on loans. There can be no assurance
regarding future interest income, including the yields and related level of such income, or the
relative portion attributable to loan payoffs as compared to other sources.
Nine Months Ended September 30, | |||||||||||||||||
2009 | 2008 | ||||||||||||||||
Interest | Interest | ||||||||||||||||
Income | Yield | Income | Yield | ||||||||||||||
(dollars in thousands) | |||||||||||||||||
Regularly scheduled interest and accretion income |
$ | 2,043 | 5.79 | % | $ | 3,324 | 7.31 | % | |||||||||
Interest and fee income recognized on loan payoffs: |
|||||||||||||||||
Nonaccretable discount |
| | | | |||||||||||||
Accretable discount |
278 | 0.79 | % | 459 | 1.01 | % | |||||||||||
Other interest and fee income |
26 | 0.07 | % | 62 | 0.13 | % | |||||||||||
304 | 0.86 | % | 521 | 1.14 | % | ||||||||||||
$ | 2,347 | 6.65 | % | $ | 3,845 | 8.45 | % | ||||||||||
The amount of loan payoffs and related discount income is influenced by several factors,
including the interest rate environment, the real estate market in particular areas, the timing of
transactions, and circumstances related to individual borrowers and loans. The amount of individual
loan payoffs is often times a result of negotiations between the Company and the borrower. Based
upon credit risk analysis and other factors, the Company will, in certain instances, accept less
than the full amount contractually due in accordance with the loan terms.
Provision for loan losses
Prior to entering into the Asset Exchange Agreement on February 5, 2009 and reclassifying the
loans as held for sale, the Company maintained an allowance for probable loan losses that were
inherent in its loan portfolio. Since the loan portfolio is now classified as held for sale and
recorded at the lower of its accreted cost or fair value, the Company no longer maintains an
allowance for loan losses as the determination of fair value includes consideration of, among other
factors, the creditworthiness of borrowers. During the nine months ended September 30, 2009, the
Company recorded a $915,000 reversal of the allowance for loan losses and recorded a valuation
allowance of $16,751,000 to reflect the change to record the Companys loan portfolio at fair
value. Prior to the reclassification of the loan portfolio, the determination of the allowance for
loan losses required managements use of significant estimates and judgments. In making this
determination, management considered known information relative to specific loans, as well as
collateral type, loss experience, delinquency trends, current economic conditions and industry
trends, generally. Based on these factors, management
19
Table of Contents
estimated the probable loan losses incurred as of the reporting date and increased or decreased the allowance through a change in the provision
for loan losses. The Company recorded a reduction of the allowance for loan losses of $210,000 for
the nine months ended September 30, 2008 due to the decrease in the balance of loans due to payoffs
without a significant change in the credit profile of the remaining portfolio during the period.
Operating expenses
Loan servicing and advisory expenses decreased $28,000, or 18.5%, to $123,000 for the nine
months ended September 30, 2009 from $151,000 for the nine months ended September 30, 2008. The
decrease is primarily the result of a decrease in loan servicing expenses due to the decrease in
the average balance of the loan portfolio. This decrease was partially offset by a increase in
environmental fees.
Other general and administrative expenses increased $544,000 or 314.5%, to $717,000 for the
nine months ended September 30, 2009 compared to $173,000 for the nine months ended September 30,
2008. This increase is primarily attributable to an increase in legal fees and an increase in
external audit expenses. This increase was partially offset by a decrease in directors fees.
Preferred stock dividends
Preferred stock dividends decreased $1,631,000, or 66.7%, to $816,000, for the nine months
ended September 30, 2009 compared to $2,447,000 for the same period in 2008. As discussed above,
the OTS notified Aurora Bank that, as a result of the Order and the PCA Directive, the prior
approval of the OTS is currently required before payment by the Company of dividends on the Series
D and Series B preferred stock is made and therefore the Board of Directors voted not to declare or
pay the preferred stock dividends that would have been payable on July 15 and October 15, 2009.
Aurora Bank has made a formal request to the OTS to approve the payment of future dividends on the
preferred stock and responded to requests from the OTS for additional information on the payment of
those dividends, however, there can be no assurance that such approval will be received from the
OTS or when or if such OTS approval requirement will be removed. Furthermore, even if approval is
received from the OTS, any future dividends on the preferred stock will be payable only when, as
and if declared by the Board of Directors. The terms of the Series D preferred stock provide that
dividends on the Series D preferred stock are not cumulative and if no dividend is declared for a
quarterly dividend period, the holders of the Series D preferred stock will have no right to
receive a dividend for that period, and the Company will have no obligation to pay a dividend for
that period, whether or not dividends are declared and paid for any future period. The terms of the
Series B preferred stock provide that dividends on the Series B preferred stock are cumulative and
if no dividend is declared for a quarterly dividend period, the holders of the Series B preferred
stock will have a legal right to receive a dividend payment for each period in which no dividend
was declared, prior to the payment of dividends to the Series D and common stockholders. At
September 30, 2009, the Company had $38,000 of dividends in arrears related to the Companys 8%
Series B preferred stock. The Company, subject to receipt of approval from the OTS, intends to pay
dividends on its preferred stock and common stock in amounts necessary to continue to preserve its
status as a REIT under the Internal Revenue Code.
Changes in Financial Condition
Interest-bearing deposits with parent
Interest-bearing deposits with parent consist entirely of money market accounts with Aurora
Bank. The balance of interest-bearing deposits increased $6.5 million to $50.0 million at September
30, 2009 compared to $43.5 million at December 31, 2008. The increase in the balance of
interest-bearing deposits is primarily a result of cash flows from loan repayments.
Loan portfolio
To date, all of the Companys loans have been acquired from Aurora Bank. A summary of the fair
value of the Companys loans, which were considered held for sale as of September 30, 2009,
follows:
20
Table of Contents
September 30, | ||||
2009 | ||||
(in thousands) | ||||
Mortgage loans on real estate: |
||||
Commercial real estate |
$ | 18,234 | ||
Multi-family residential |
11,561 | |||
One-to-four family residential |
531 | |||
Loans, net of valuation
allowance of $16,751 |
$ | 30,326 | ||
A summary of the balances of the Companys loans, which were considered held for investment as
of December 31, 2008, follows:
December 31, | ||||
2008 | ||||
(in thousands) | ||||
Mortgage loans on real estate: |
||||
Commercial real estate |
$ | 31,633 | ||
Multi-family residential |
20,384 | |||
One-to-four family residential |
981 | |||
Total loans, net of discounts |
52,998 | |||
Less: |
||||
Allowance for loan losses |
(915 | ) | ||
Loans, net |
$ | 52,083 | ||
The decrease in the total amount of loans is primarily attributable to the reclassification of
the Companys loans to held for sale in connection with entering into the Asset Exchange Agreement
and the related valuation allowance recorded to reflect the loans at the lower of their accreted
cost or fair value. The Company has historically acquired primarily performing commercial real
estate and multifamily residential mortgage loans. During the nine month periods ended September
30, 2009 and September 30, 2008, the Company did not acquire any loans from Aurora Bank.
The Companys loan portfolio is secured by one-to-four family residential units, multi-family
residential units, and commercial real estate. Commercial real estate is comprised of loans
secured by warehouses, retail stores, apartment complexes, churches, industrial buildings, and
hotels. These properties range across the continental United States with the bulk concentrated in
California, Nevada, and New England, as discussed in Significant Concentration of Credit Risk,
below.
The Company intends that each loan acquired from Aurora Bank in the future, if any are
acquired in the future, will be a whole loan, and will be originated or acquired by Aurora Bank in
the ordinary course of its business. The Company also intends that all loans held by it will be
serviced pursuant to its master service agreement with Aurora Bank.
The estimated fair value of non-performing loans totaled $1.7 million as of September 30,
2009. Non-performing loans, net of discount, totaled $682,000 as of September 30, 2008. The
increase in non-performing assets is due to the fact that 12 loans, representing 9 borrowers, were
not performing as of September 30, 2009. Loans generally are placed on non-performing status and
the accrual of interest is generally discontinued when the collectability of principal and interest
is not probable or estimable. Unpaid interest income previously accrued on such loans is reversed
against current period interest income. A loan is returned to accrual status when it is brought
current in accordance with managements anticipated cash flows at the time of acquisition and
collection of future principal and interest is probable and estimable.
Allowance for Loan Losses
Prior to entering into the Asset Exchange Agreement on February 5, 2009 and reclassifying the
loans as held for sale, the Company maintained an allowance for probable loan losses that were
inherent in its loan portfolio. Since the loan portfolio is now classified as held for sale and
recorded at the lower of its accreted cost or fair value, the Company will no longer maintain an
allowance
21
Table of Contents
for loan losses as the determination of fair value includes consideration of, among other
factors, the creditworthiness of borrowers. During the nine months ended September 30, 2009, the
Company recorded a $915,000 reversal of the allowance for loan losses and recorded a valuation
allowance of $16.8 million to reflect the change to record the Companys loan portfolio at fair
value. Prior to the reclassification of the loan portfolio, the determination of the allowance for loan losses required
managements use of significant estimates and judgments. In making this determination, management
considered known information relative to specific loans, as well as collateral type, loss
experience, delinquency trends, current economic conditions and industry trends, generally. Based
on these factors, management estimated the probable loan losses incurred as of the reporting date
and increased or decreased the allowance through a change in the provision for loan losses.
The following table sets forth certain information relating to the activity in the allowance
for loan losses for the periods indicated:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
(in thousands) | ||||||||||||||||
Balance at beginning of period |
$ | | $ | 1,025 | $ | 915 | $ | 1,180 | ||||||||
Provision for loan losses |
| (55 | ) | (915 | ) | (210 | ) | |||||||||
Balance at end of period |
$ | | $ | 970 | $ | | $ | 970 | ||||||||
Interest Rate Risk
The Companys income consists primarily of interest income. If there is a decline in market
interest rates, the Company may experience a reduction in interest income and a corresponding
decrease in funds available to be distributed to its stockholders. The reduction in interest income
may result from downward adjustments of the indices upon which the interest rates on floating-rate
loans and interest-bearing deposits are based and from prepayments of mortgage loans with fixed
interest rates, resulting in reinvestment of the proceeds in lower yielding assets. The Company
does not intend to use any derivative products to manage its interest rate risk. The majority of
the Companys loan portfolio consists of fixed rate loans with contractual interest rates that are
not affected by changes in market interest rates. Approximately 27% of the accreted cost balance of
the Companys performing loan portfolio, however, is comprised of floating-rate loans with
contractual interest rates that may fluctuate based on changes in market interest rates. In
addition, negative fluctuations in interest rates could reduce the amount of interest paid on
interest-bearing cash deposits of the Company, which could negatively impact the amount of cash
available to pay dividends on the Series D and Series B preferred stock. The Company is not able to
precisely quantify the potential impact on its operating results or funds available for
distribution to stockholders from material changes in interest rates.
Significant Concentration of Credit Risk
Concentration of credit risk generally arises with respect to the Companys loan portfolio
when a number of borrowers engage in similar business activities, or activities in the same
geographical region. Concentration of credit risk indicates the relative sensitivity of Companys
performance to both positive and negative developments affecting a particular industry or
geographic region. The Companys balance sheet exposure to geographic concentrations directly
affects the credit risk of the loans within its loan portfolio.
At September 30, 2009, 64.5%, 6.9% and 5.6% of the fair value of the Companys real estate
loan portfolio consisted of loans in California, New England and Nevada, respectively. At December
31, 2008, 64.5%, 7.4% and 5.1% of the Companys net real estate loan portfolio consisted of loans
located in California, New England and Nevada, respectively. Consequently, the portfolio may
experience a higher default rate in the event of adverse economic, political or business
developments or natural hazards in California, New England or Nevada that may affect the ability of
property owners to make payments of principal and interest on the underlying mortgages. Beginning
in 2007 and continuing through September 2009, the housing and real estate sectors in California
and Nevada were hit particularly hard by the recession with higher overall foreclosure rates than
the national average. If these regions experience further adverse economic, political or business
conditions, or natural hazards, the Company will likely experience higher rates of loss and
delinquency on its mortgage loans than if its loans were more geographically diverse.
Liquidity Risk Management
The objective of liquidity management is to ensure the availability of sufficient cash flows
to meet all of the Companys financial commitments. In managing liquidity risk, the Company takes
into account various legal limitations placed on a REIT. The Companys principal liquidity need is
to pay dividends on its preferred shares and common shares.
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If and to the extent that any additional assets are acquired in the future, such acquisitions
are intended to be funded primarily with available cash balances or through repayment of principal
balances of mortgage assets by individual borrowers. The Company does not have and does not
anticipate having any material capital expenditures. To the extent that the Board of Directors
determines that additional funding is required, the Company may raise such funds through additional
equity offerings, debt financing or retention of cash flow (after consideration of provisions of
the Internal Revenue Code requiring the distribution by a REIT of at least 90% of its REIT taxable
income and taking into account taxes that would be imposed on undistributed income), or a
combination of these methods. The Company does not currently intend to incur any indebtedness. The
organizational documents of the Company limit the amount of indebtedness which it is permitted to
incur without the approval of the Series D preferred stockholders to no more than 100% of the total
stockholders equity of the Company. Any such debt may include intercompany advances made by Aurora
Bank to the Company.
The Company may also issue additional series of preferred stock, subject to OTS approval.
However, the Company may not issue additional shares of preferred stock ranking senior to the
Series D preferred shares without the consent of holders of at least two-thirds of the Series D
preferred shares outstanding at that time. Although the Companys charter does not prohibit or
otherwise restrict Aurora Bank or its affiliates from owning shares of Series D preferred stock and
exercising their right to vote as a holder of Series D preferred stock, to the Companys knowledge
the amount of shares of Series D preferred stock held by Aurora Bank or its affiliates is
insignificant (less than 1%). Additional shares of preferred stock ranking on a parity with the
Series D preferred shares may not be issued without the approval of a majority of the Companys
independent directors.
Impact of Inflation and Changing Prices
The Companys asset and liability structure is substantially different from that of an
industrial company in that virtually all of the Companys assets are monetary in nature. Management
believes the impact of inflation on financial results depends upon the Companys ability to react
to changes in interest rates and by such reaction, reduce the inflationary impact on performance.
Interest rates do not necessarily move in the same direction, or at the same magnitude, as the
prices of other goods and services.
Various information disclosed elsewhere in this quarterly report will assist the reader in
understanding how the Company is positioned to react to changing interest rates and inflationary
trends. In particular, the discussion of market risk and other maturity and repricing information
of the Companys assets is contained in Item 3. Quantitative and Qualitative Disclosures About
Market Risk below.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market risk is the risk of loss from adverse changes in market prices and interest rates.
Currently, approximately 27% of the accreted cost balance of the Companys performing loan
portfolio is comprised of floating-rate loans with contractual interest rates that may fluctuate
based on changes in market interest rates. In addition, negative fluctuations in interest rates
could reduce the amount of interest paid on interest-bearing cash deposits of the Company. The
Companys market risk arises primarily from interest rate risk inherent in holding loans. To that
end, Aurora Bank actively monitors the interest rate risk exposure of the Company pursuant to an
advisory agreement.
Aurora Bank reviews, among other things, the sensitivity of the Companys assets to interest
rate changes, the book and market values of assets, purchase and sale activity, and anticipated
loan payoffs. Aurora Banks senior management also approves and establishes pricing and funding
decisions with respect to the Companys overall asset and liability composition.
The Companys methods for evaluating interest rate risk include an analysis of its
interest-earning assets maturing or repricing within a given time period. Since the Company has no
interest-bearing liabilities, a period of rising interest rates would tend to result in an increase
in net interest income. A period of falling interest rates would tend to adversely affect net
interest income.
The following table sets forth the Companys interest-rate-sensitive assets categorized by
repricing dates and weighted average yields at September 30, 2009. For fixed rate instruments, the
repricing date is the maturity date. For adjustable-rate instruments, the repricing date is deemed
to be the earliest possible interest rate adjustment date. Assets that are subject to immediate
repricing are placed in the overnight column.
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Within | Over One | Over Two | Over Three | Over Four | Over | |||||||||||||||||||||||||||||||
One | to Two | to Three | to Four | to Five | Five | Fair | ||||||||||||||||||||||||||||||
Overnight | Year | Years | Years | Years | Years | Years | Total | Value | ||||||||||||||||||||||||||||
(dollars in thousands) | ||||||||||||||||||||||||||||||||||||
Interest-bearing deposits |
$ | 50,036 | $ | | $ | | $ | | $ | | $ | | $ | | $ | 50,036 | $ | 50,036 | ||||||||||||||||||
.30 | % | |||||||||||||||||||||||||||||||||||
Fixed-rate loans (1) |
252 | 1,778 | 5,699 | 1,404 | 2,347 | 1,141 | 22,023 | 32,644 | 21,830 | |||||||||||||||||||||||||||
14.50 | % | 5.13 | % | 6.95 | % | 4.73 | % | 6.01 | % | 4.68 | % | 4.34 | % | |||||||||||||||||||||||
Adjustable-rate loans (1) |
2,884 | 8,811 | 30 | 98 | 185 | 47 | | 12,055 | 6,846 | |||||||||||||||||||||||||||
6.20 | % | 4.77 | % | 7.15 | % | 7.74 | % | 6.52 | % | 7.53 | % | |||||||||||||||||||||||||
Total rate-sensitive assets |
$ | 53,172 | $ | 10,589 | $ | 5,729 | $ | 1,502 | $ | 2,532 | $ | 1,188 | $ | 22,023 | $ | 94,735 | $ | 78,712 | ||||||||||||||||||
(1) | Loans are presented at the average accreted costs of the loans, net of discount, and exclude non-performing loans. |
Based on the Companys experience, management applies the assumption that, on average,
approximately 5% of the outstanding fixed and adjustable-rate loans will prepay annually.
The Companys loan portfolio is subject to general market risk, including, without limitation,
negative economic conditions that adversely affect the general economy, housing prices, the job
market, consumer confidence and spending habits which may affect, among other things, the credit
quality of our loan portfolios (the degree of the impact of which is dependent upon the duration
and severity of these conditions); the level and volatility of interest rates; changes in consumer,
investor and counterparty confidence in, and the related impact on, financial markets and
institutions; and various monetary and fiscal policies and regulations. The fair value of the
Companys loan portfolio and the amount of the Companys loans that are non-performing may be
negatively affected by these factors.
Item 4T. Controls and Procedures
The Companys management, with the participation of its President and Chief Financial Officer,
evaluated the effectiveness of the Companys disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange
Act), as of September 30, 2009. Based on this evaluation, the Companys President and Chief
Financial Officer concluded that, as of September 30, 2009, the Companys disclosure controls and
procedures were (1) designed to ensure that material information relating to the Company is made
known to the President and Chief Financial Officer by others within the entity, particularly during
the period in which this report was being prepared, and (2) effective, in that they provide
reasonable assurance that information required to be disclosed by the Company in the reports that
it files or submits under the Exchange Act is recorded, processed, summarized, and reported within
the time periods specified in the SECs rules and forms.
No change to our internal control over financial reporting (as defined in Rules 13a-15(f) and
15d-15(f) under the Exchange Act) occurred during the quarter ended September 30, 2009 that has
materially affected, or is reasonably likely to materially affect, our internal control over
financial reporting.
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PART II
Item 1. Legal Proceedings
From time to time, the Company may be involved in routine litigation incidental to its
business, including a variety of legal proceedings with borrowers, which would contribute to the
Companys expenses, including the costs of carrying non-performing assets. The Company is
currently not a party to any material proceedings.
Item 1A. Risk Factors
A number of risk factors, including, without limitation, the risk factor set forth below and
the risk factors found in Item 1A of the Companys Annual Report on Form 10-K for the annual period
ended December 31, 2008, may cause the Companys actual results to differ materially from
anticipated future results, performance or achievements expressed or implied in any forward-looking
statements contained in this Quarterly Report on Form 10-Q or any other report filed by the Company
with the SEC. All of these factors should be carefully reviewed, and the reader of this Quarterly
Report on Form 10-Q should be aware that there may be other factors that could cause difference in
future results, performance or achievements.
If the OTS does not approve Aurora Banks request to permit the payment of future dividends, the
Company will be prohibited from paying dividends in the future and therefore may fail to qualify as
a REIT
On June 26, 2009, the OTS notified Aurora Bank that the prior approval of the OTS is currently
required before payment by the Company of dividends on the Series D preferred stock as a result of
the Order and the PCA Directive. As a result of the notice from the OTS, the Board of Directors
voted not to declare or pay the Series D preferred stock dividends that would have been payable on
July 15 and October 15, 2009. Aurora Bank has made a formal request to the OTS to approve the
payment of future dividends on the Series D preferred stock and responded to requests from the OTS
for additional information on the payment of these dividends; however, the OTS has not yet ruled on
this request and there can be no assurance that such approval will be received from the OTS or when
or if such OTS approval requirement will be removed. If the OTS does not approve this request, the
Company will be prohibited from paying future dividends, which could result in the Company failing
to qualify as a REIT. In order to qualify as a REIT, the Company generally is required each year to
distribute to its stockholders at least 90% of its net taxable income, excluding net capital gains.
The Company may retain the remainder of REIT taxable income or all or part of its net capital gain,
but will be subject to tax at regular corporate rates on such income. In addition, the Company is
subject to a 4% nondeductible excise tax on the amount, if any, by which certain distributions
considered as paid by the Company with respect to any calendar year are less than the sum of (1)
85% of its ordinary income for the calendar year, (2) 95% of its capital gains net income for the
calendar year and (3) 100% of any undistributed income from prior periods.
Item 4. Submission of Matters to a Vote of Security Holders
During the three months ended September 30, 2009, no matters were submitted for approval to
Aurora Bank, the sole common stockholder of the Company. No matters were submitted to a vote of the
holders of the Series D preferred stock during this period.
Item 5. Other Information
None
Item 6. Exhibits
31.1
|
Certification pursuant to Exchange Act Rules 13a-15(e) and 15d-15(e) of the President. | |
31.2
|
Certification pursuant to Exchange Act Rules 13a-15(e) and 15d-15(e) of the Chief Financial Officer. | |
32
|
Certification pursuant to 18 U.S.C. Section 1350 of the President and Chief Financial Officer. |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, Capital Crossing
Preferred Corporation has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
CAPITAL CROSSING PREFERRED CORPORATION
Date: November 13, 2009 | By: | /s/ Lana Franks | ||
Lana Franks | ||||
President (Principal Executive Officer) | ||||
Date: November 13, 2009 | By: | /s/ Thomas OSullivan | ||
Thomas OSullivan | ||||
Chief Financial Officer (Principal Financial Officer) |
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EXHIBIT INDEX
Exhibit | Item | Page Number | ||||
31.1
|
Certification pursuant to Exchange Act Rules 13a-15(e) and 15d-15(e) of the President. | 28 | ||||
31.2
|
Certification pursuant to Exchange Act Rules 13a-15(e) and 15d-15(e) of the Chief Financial Officer. | 29 | ||||
32
|
Certification pursuant to 18 U.S.C. Section 1350 of the President and Chief Financial Officer. | 30 |
27