UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C., 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OF THE SECURITIES
EXCHANGE ACT OF 1934
For Fiscal Year ended December 31, 2006
Commission File: 001-15849
SANTANDER BANCORP
(Exact name of Corporation as specified in its charter)
Incorporated in the Commonwealth of Puerto Rico
I.R.S. Employer Identification No. 66-0573723
207 Ponce de León Avenue
Hato Rey, Puerto Rico 00917
Telephone Number: (787) 777-4100
Securities registered pursuant to Section 12(b) of the Securities Exchange Act of 1934:
| | | |
| | | Name of each exchange on |
| Title of each class | | which registered |
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| Common Stock, $2.50 par value | | New York Stock Exchange |
Securities registered pursuant to Section 12(g) of the Securities Exchange Act of 1934:
NONE
Indicate by check mark if the registrant is a well-known seasoned issuer (as defined in Rule 405 of the Securities Act). Yes þ No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act). Yes o No þ.
Indicate by check mark whether the Corporation (1) has filed all reports required to be filed by Section 13 of the Securities Exchange Act of 1934 during the preceding 12 months (for such shorter period that the Corporation was required to file such reports) and has been subject to such filing requirement for the past 90 days. Yes þ No o
Indicate by check mark if disclosure of delinquent files pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definite proxy or information statement incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. þ
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or non-accelerated filer (as defined in Rule 12b-2 of the Act).
Large accelerated filer o Accelerated filer þ Non-accelerated filer o
Indicate by check mark whether the registrant is shell company (as defined in Rule 12b-2 of the Act). Yes o No þ.
As of June 30, 2006 the Corporation had 46,639,104 shares of common stock outstanding. The aggregate market value of the common stock held by non-affiliates of the Corporation was $108,000,209 based upon the reported closing price of $24.62 on the New York Stock Exchange on that date.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Corporation’s Proxy Statement relating to the 2007 Annual Meeting of Stockholders of the Corporation to be held on or about May 24, 2007, are incorporated herein by reference to Item 10 through 14 of Part III.
SANTANDER BANCORP
CONTENTS
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Santander BanCorp
PART I
ITEM 1. BUSINESS
General
Santander BanCorp (the “Corporation”) is a publicly owned financial holding company, registered under the Bank Holding Company Act of 1956, (“BHC Act”) as amended and, accordingly, subject to the supervision and regulation by the Federal Reserve Board. The Corporation was incorporated under the laws of the Commonwealth of Puerto Rico (“Puerto Rico” or the “Island”) to serve as the financial holding company for Banco Santander Puerto Rico (“Banco Santander” or the “Bank”).
Banco Santander Central Hispano, S.A. (“Santander Spain”) currently owns 90.6% of the Corporation’s outstanding stock, directly and through its subsidiaries. Santander Spain (SAN.MC, STD.N) is the main financial group (“Santander Group” or “Group”) in Spain and Latin America, and the largest in the Euro Zone by market capitalization. It is the first Financial Group in Spain and Latin America and maintains an important business activity in Europe, where it reached a prominent presence in the United Kingdom through the acquisition of Abbey National. The Santander Group also owns the third largest banking group in Portugal and Santander Consumer Finance, a leading consumer finance franchise with presence in Germany, Italy and seven other European countries.
In Latin America, the Santander Group is the leading banking franchise. In this region, the Group maintains a leading position where it manages over $250 billion in business volumes (loans, deposits and off-balance sheet items under management) has 4,370 offices in nine countries. In 2006, Santander reported US$1,409 million in net attributable income in Latin America, 29% higher than the prior year.
The Corporation offers a full range of financial services through its subsidiaries Banco Santander Puerto Rico, Santander Securities Corporation, Santander Insurance Agency, Inc., Santander Mortgage Corporation, Santander International Bank of Puerto Rico, Inc., Santander Asset Management Corporation, Santander Financial Services, Island Insurance Corporation and Santander PR Capital Trust I. As of December 31, 2006, the Corporation had, on a consolidated basis, total assets of $9.2 billion, total net loans of $6.8 billion, total deposits of $5.3 billion and stockholder’s equity of $579.2 million. The Corporation also had $14.2 billion of customer financial assets under management.
Banco Santander Puerto Rico
The Corporation’s main subsidiary, Banco Santander Puerto Rico, is one of the Island’s largest financial institutions (based on number of branches and customer deposits as reported with the SEC and the Office of the Commissioner of Financial Institutions of Puerto Rico) with a network of 61 branches and 144 ATMs, representing one of the largest branch franchises in Puerto Rico. As of December 31, 2006, the Bank had total assets of approximately $8.2 billion, total deposits of $5.4 billion and stockholders’ equity of $592.5 million.
The Bank is a Puerto Rico chartered commercial bank subject to examination by the Federal Deposit Insurance Corporation (“FDIC”) and the Commissioner of Financial Institutions of Puerto Rico (“Commissioner”). It provides a wide range of financial products and services to a diverse customer base that includes small and medium-size businesses, large corporations and individuals. In addition, the Bank provides mortgage banking services through its wholly-owned subsidiary, Santander Mortgage Corporation (“Santander Mortgage”), which has 38 offices in Puerto Rico. The Bank also provides specialized products and services to foreign customers through its wholly owned subsidiary, Santander International Bank of Puerto Rico, Inc. (“Santander International Bank”), an international banking entity organized under the International Banking Center Regulatory Act of Puerto Rico (“IBC Act”).
Santander Mortgage
Since 1992, the Corporation has engaged in mortgage banking through Santander Mortgage. Santander Mortgage’s business principally consists in the origination and acquisition of loans secured by residential mortgages. Santander Mortgage is engaged in the origination of FHA-insured and VA-guaranteed single-family residential loans, which are primarily securitized into GNMA mortgage-backed securities and sold to institutional or private investors in the secondary market. Conventional loans that conform to the mortgage securitization programs of FNMA and FHLMC are generally pooled into FNMA and FHLMC mortgage-backed securities and sold to investors in the secondary market. Conventional loans that do not
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conform to the requirements of FNMA or FHLMC, so called non-conforming loans are generally sold to the Bank. Santander Mortgage complements its internal loan originations by purchasing FHA loans and VA loans from other mortgage bankers for resale to institutional investors and other investors in the form of GNMA mortgage-backed securities. Purchases of loans from other mortgage bankers in the wholesale loan market provide Santander Mortgage with a source of low cost production.
Santander International Bank
Santander International Bank is a wholly owned subsidiary of Banco Santander Puerto Rico, organized during 2001 to operate as an international banking entity under the International Banking Center Regulatory Act of Puerto Rico (the “IBC Act”). Santander International Bank was created for the purpose of providing specialized products and services to foreign customers.
Santander Securities
Santander Securities is the second largest securities broker-dealer (based on broker-dealer customer assets and mutual funds managed as reported with the SEC and the Office of the Commissioner of Financial Institutions of Puerto Rico) in Puerto Rico with approximately $9.0 billion in assets under management, composed of over $5.6 billion in customer assets at the retail broker-dealer and $3.4 billion in managed gross assets and institutional accounts at its wholly owned subsidiary, Santander Asset Management. Santander Securities has three offices islandwide and an office in Miami, Fl.
Santander Asset Management Corporation
Santander Asset Management is a wholly owned subsidiary of Santander Securities created for the purpose of managing assets for Puerto Rico investment companies (mutual funds) and institutional accounts. The funds managed by Santander Asset Management invest primarily in fixed-income securities, including Puerto Rico and U.S. Government securities, mortgage- and asset-backed securities and municipal obligations. Santander Asset Management also services its institutional accounts, which consist primarily of university endowments, insurance companies, governmental agencies, pension funds and individual investors.
Santander Insurance Agency
The Corporation’s subsidiary, Santander Insurance Agency (“Santander Insurance”) was established in October 2000 as the first financial holding company insurance operation to receive approval from the Commissioner of Insurance of Puerto Rico (“Insurance Commissioner”). This was a result of the Gramm-Leach-Bliley Act of 1999 (“Gramm-Leach-Bliley Act”) that authorized financial holding companies to enter into the insurance business. Santander Insurance Agency offers a growing base of products, including life, disability, unemployment and title insurance as a corporate agent, and also operates as a general agent offering bid, payment and performance bonds, and insurance to cover equipment and auto leases.
Santander Financial Services
During the first quarter of 2006, the Corporation closed the acquisition of Island Finance, the second largest consumer finance company in Puerto Rico (as reported with the Office of the Commissioner of Financial Institutions). This acquisition further diversifies Santander in Puerto Rico and bolsters net interest margin. Island Finance is a well established consumer finance business in Puerto Rico. The company has operated in Puerto Rico over 40 years, it is one of the most recognized brand names in consumer finance and commands a 34% market share as of September 30, 2006 (as reported with the Office of the Commissioner of Financial Institutions). This acquisition boosted Santander’s business footprint by adding 70 retail branches and close to 200,000 clients. Santander Financial Services, Inc. through, Island Finance, provides consumer loans and real estate-secured loans to customers, as well as sales finance contracts through retail merchants.
Island Insurance Corporation
In July 2006, the Corporation acquired at book value Island Insurance Corporation from Wells Fargo for $5.7 million. Island Insurance Corporation is a Puerto Rico life insurance company, duly licensed by the Puerto Rico Commissioner of Insurance. This corporation is currently inactive.
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Santander PR Capital Trust I
A statutory trust organized under the Statutory Trust Act of the state of Delaware. It was formed for the purpose of issuing trust redeemable preferred securities issued pursuant to the acquisition of Island Finance in 2006.
Operations
The Corporation operates a client-oriented, full-service bank, offering products and services in the areas of commercial, mortgage and consumer banking. Insurance, securities and asset management services are also offered through the Corporation’s various subsidiaries. The Corporation organizes its operations in five reportable segments: Commercial Banking, Mortgage Banking, Consumer Finance, Treasury and Investments and Wealth Management.
While the Bank offers a wide variety of financial services to its customers, its primary products and services are grouped into the following categories:
Commercial Banking. The Corporation’s integrated business model is built upon the strength of its commercial banking franchise and its distribution capabilities. This segment’s goal is to be an agile client-service organization with the primary focus on satisfying the total financial needs of its customers through specialized retail and wholesale banking services. These two units of the commercial banking segment are closely interrelated and are differentiated mostly by the composition of their respective client-bases.
Retail Banking. The Retail Banking unit serves individual clients and small-and medium-sized businesses providing them with a full range of financial products and services through branches across Puerto Rico. Each branch represents an important vehicle for distributing the retail banking solutions. Branch personnel promote cross selling of financial products and coordinate service delivery.
Wholesale Banking. The Wholesale Banking unit serves major corporate and institutional clients including the public sector, not-for-profit organizations and specialized industries such as universities, healthcare and financial institutions. This unit also houses certain specialized services such as construction lending, international commerce and cash management. Wholesale banking also calls into play the substantial resources of our worldwide operations, when such involvement is deemed appropriate or necessary to achieve the client’s financial objectives. Wholesale banking clients are offered a full array of commercial banking products and services, including cash management, bank card products, letters of credit and a variety of other foreign trade-related services. This unit works closely with retail banking branch personnel when its specialized services are required.
Mortgage Banking. Santander Mortgage, the third largest mortgage loan originator (based on information on mortgage production obtained from the Office of the Commissioner of Financial Institutions of Puerto Rico) and servicer in Puerto Rico originates, sells, and services a variety of residential mortgage loans. Santander Mortgage sells mortgages to the Bank for its mortgage portfolio and to various other financial institutions through securitizations of conforming loans. Total mortgage loan originations amounted to $911.6 million in 2006, and the mortgage loan portfolio grew by 23.6%, reaching $2.7 billion by year-end.
Consumer Finance.The Island Finance operation provides consumer loans and real estate-secured loans in Puerto Rico through its 70 stores in Puerto Rico, as well as sales finance contracts through retail merchants. Island Finance provides mostly sub-prime lending thus entering a market segment not previously covered by the Corporation.
Treasury and Investments. The Corporation’s Treasury Department handles its investment portfolio and liquidity position. It also focuses on offering another level of financial service to our clients in the form of derivative instruments that can protect the owner of small- and medium-sized business from the impact of interest rate fluctuations.
Wealth Management. The Corporation’s Wealth Mangement segment includes the operations of its subsidiary Santander Securities. Santander Securities offers a complete range of products and services as part of an overall wealth management program that includes asset management and other trust services. The combination of Santander Asset Management products and Santander Securities’ distribution capabilities has allowed the Group to provide a diverse range of high quality investment alternatives in the Puerto Rico market.
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The principal offices of the Corporation are located at 207 Ponce de León Avenue, San Juan, Puerto Rico, and the main telephone number is (787) 777-4100. The Corporation’s Internet web site is http://www.santandernet.com.
Forward Looking Statements
When used in this Form 10-K or future filings by Santander BanCorp with the Securities and Exchange Commission, in the Corporation’s press releases or other public or shareholder communications, or in oral statements made with the approval of an authorized executive officer, the word of phrases “would be”, “will allow”, “intends to”, “will likely result”, “are expected to”, “is anticipated”, “estimate”, “project”, “believe” , or similar expressions are intended to identify “forward looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.
The future results of the Corporation could be affected by subsequent events and could differ materially from those expressed in forward-looking statements. If future events and actual performance differ from the Corporation’s assumptions, the actual results could vary significantly from the performance projected in the forward-looking statements.
The Corporation wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made, and to advise readers that various factors, including regional and national conditions, substantial changes in levels of market interest rates, credit and other risks of lending and investment activities, competitive and regulatory factors and legislative changes, could affect the Corporation’s financial performance and could cause the Corporation’s actual results for future periods to differ materially from those anticipated or projected. The Corporation does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.
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REGULATION AND SUPERVISION
Holding Company Operations — Federal Regulation
General
Bank Holding Company Activities and Other Limitations.The Corporation is subject to ongoing regulation, supervision, and examination by the Board of Governors of the Federal Reserve System (the “Federal Reserve”), under the BHC Act, as amended by the Gramm-Leach-Bliley. As a bank holding company, the Corporation is required to file with the Federal Reserve periodic and annual reports and other information concerning its own business operations and those of its subsidiaries. In addition, under the provisions of the BHC Act, a bank holding company must obtain Federal Reserve Board approval before it acquires directly or indirectly ownership or control of more than 5% of the voting shares of a second bank. Furthermore, Federal Reserve Board approval must also be obtained before such a company acquires all or substantially all of the assets of a second bank or merges or consolidates with another bank holding company. The Federal Reserve Board also has authority to issue cease and desist orders against holding companies and their non-bank subsidiaries.
A bank holding company is prohibited under the BHC Act, with limited exceptions, from engaging, directly or indirectly, in any business unrelated to the business of banking, or of managing or controlling banks. One of the exceptions to these prohibitions permits ownership by a bank holding company of the shares of any company if the Federal Reserve, after due notice and opportunity for hearing, by regulation or order has determined that the activities of the company in question are so closely related to the business of banking or of managing or controlling banks as to be a proper incident thereto.
Under the Federal Reserve policy, a bank holding company such as the Corporation is expected to act as a source of financial strength to its main banking subsidiaries and to also commit support to them. This support may be required at times when, absent such policy, the bank holding company might not otherwise provide such support. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to the federal bank regulatory agency to maintain capital of a subsidiary bank will be assumed by the bankruptcy trustee and be entitled to a priority of payment. In addition, any capital loans by a bank holding company to any of its subsidiary banks must be subordinated in right of payment to deposits and to certain other indebtedness of such subsidiary bank. The Bank is currently the only depository institution subsidiary of the Corporation.
The Gramm-Leach-Bliley Act and the regulation enacted and promulgated under the Act have revised and expanded the existing provisions of the BHC Act by permitting a bank holding company to elect to become a financial holding company to engage in a full range of financial activities. The qualification requirements provide that in order for a bank holding company to elect to be treated as a financial holding company (and to maintain such treatment) all the subsidiary banks controlled by the bank holding company at the time of election to become a financial holding company must be and remain at all times well capitalized and well managed. On May 15, 2000, the Corporation elected to become a financial holding company under the provisions of the Gramm-Leach Bliley Act.
Financial holding companies may engage, directly or indirectly, in any activity that is determined to be (i) financial in nature, (ii) incidental to such financial activity, or (iii) complementary to a financial activity and does not pose a substantial risk to the safety and soundness of depository institutions or to the financial system generally. The Gramm-Leach-Bliley Act, specifically provides that the following activities have been determined to be “financial in nature”: (a) Lending, trust and other banking activities; (b) Insurance activities; (c) Financial or economic advice or services; (d) Pooled investments; (e) Securities underwriting and dealing; (f) Existing bank holding company domestic activities; (g) Existing bank holding company foreign activities; and (h) Merchant banking activities. Santander Insurance Agency, which is a wholly-owned subsidiary of the Corporation, offers insurance agency services. Santander Securities, which is also a wholly-owned subsidiary of the Corporation, offers securities brokerage, dealing and underwriting services.
In addition, the Gramm-Leach-Bliley Act specifically gives the Federal Reserve the authority, by regulation or order, to expand the list of “financial” or “incidental” activities, but requires consultation with the U.S. Treasury, and gives the Federal Reserve authority to allow a financial holding company to engage in any activity that is “complementary” to a financial activity and does not “pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.”
Under the Gramm-Leach-Bliley Act, if the Corporation fails to meet any of the requirements for being a financial holding company and is unable to cure such deficiencies within certain prescribed periods of time, the Federal Reserve Board could
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require the Corporation to divest control of its depository institution subsidiaries or alternatively cease conducting financial activities that are not permissible for bank holding companies that are not financial holding companies.
USA Patriot Act of 2001
Under Title III of the USA Patriot Act of 2001 (the “USA Patriot Act”), also known as the International Money Laundering Abatement and Anti-Terrorism Financing Act of 2001, all financial institutions, including the Corporation and the Bank, are required in general to identify their customers, adopt formal and comprehensive anti-money laundering programs, scrutinize or prohibit altogether certain transactions of special concern, and be prepared to respond to inquiries from U.S. law enforcement agencies concerning their customers and their transactions. Additional information-sharing among financial institutions, regulators, and law enforcement authorities is encouraged by the presence of an exemption from the privacy provisions of the Gramm-Leach-Bliley Act for financial institutions that comply with this provision and the authorization of the Secretary of the Treasury to adopt rules to further encourage cooperation and information-sharing.
The U.S. Treasury Department (“Treasury”) has issued a number of regulations implementing the USA Patriot Act that apply certain of its requirements to financial institutions. The regulations impose new obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing. Treasury is expected to issue a number of additional regulations that will further clarify the USA Patriot Act’s requirements.
Failure of a financial institution to comply with the USA Patriot Act’s requirements could have serious legal and reputational consequences for the institutions. The Corporation and the Bank have adopted appropriate policies, procedures and controls to address compliance with the USA Patriot Act under existing regulations, and will continue to revise and update their policies, procedures and controls to reflect changes required by the USA Patriot Act and Treasury’s regulations. The Corporation believes that the cost of compliance with Title III of the USA Patriot Act is not likely to be material to the Corporation.
Privacy Policies
Under the Gramm-Leach-Bliley Act, all financial institutions are required to adopt privacy policies, restrict the sharing of nonpublic customer data with nonaffiliated parties at the customer’s request and establish policies and procedures to protect customer data from unauthorized access. The Corporation and its subsidiaries have adopted policies and procedures in order to comply with the privacy provisions of the Gramm-Leach-Bliley Act and the regulations issued thereunder.
Dividend Restrictions
The Corporation is subject to certain restrictions generally imposed on Puerto Rico corporations (i.e., that dividends may be paid out only from the Corporation’s net assets in excess of capital or in the absence of such excess, from the Corporation’s net earnings for such fiscal year and/or the preceding fiscal year). The Federal Reserve Board has also issued a policy statement that provides that bank holding companies should generally pay dividends only out of current operating earnings.
At present, the principal source of funds for the Corporation is dividends declared and paid by the Bank. The ability of the Bank to declare and pay dividends on its common stock is restricted by the Puerto Rico Banking Law (the “Banking Law”), the Federal Deposit Insurance Act and FDIC regulations. In general terms, the Banking Law provides that when the expenditures of a bank are greater than receipts, the excess of expenditures over receipts shall be charged against undistributed profits of the bank and the balance, if any, shall be charged against the required reserve fund of the bank. If there is an insufficient reserve fund to cover such balance in whole or in part, the outstanding amount shall be charged against the bank’s capital account. The Banking Law provides that until said capital has been restored to its original amount and the reserve fund to 20% of the original capital, the bank may not declare any dividends.
In general terms, the Federal Deposit Insurance Act and the FDIC regulations restrict the payment of dividends when a bank is undercapitalized, when a bank has failed to pay insurance assessments, or when there are safety and soundness concerns regarding such bank.
Federal Home Loan Bank System
Banco Santander is a member of the Federal Home Loan Bank (FHLB) system. The FHLB system consists of twelve regional Federal Home Loan Banks governed and regulated by the Federal Housing Finance Board (FHFB). The Federal Home Loan Banks serve as reserve or credit facilities for member institutions within their assigned regions. They are funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB system, and they make loans (advances) to
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members in accordance with policies and procedures established by the FHLB system and the boards of directors of each regional FHLB.
The Bank is a member of the FHLB of New York and as such is required to acquire and hold shares of capital stock in that FHLB in an amount equal to the greater of 1.0% of the aggregate principal amount of its unpaid residential mortgage loans, home purchase contracts and similar obligations at the beginning of each year, 5.0% of its FHLB advances outstanding or 1.0% of 30.0% of total assets. The Bank is in compliance with the stock ownership rules described above with respect to such advances, commitments and letters of credit and home mortgage loans and similar obligations. All loans, advances and other extensions of credit made by the FHLB-NY to the Bank are secured by a portion of the Bank’s mortgage loan portfolio, certain other investments and the capital stock of the FHLB-NY held by the Bank. As of December 31, 2006 the Bank had $50.7 million in FHLB’s capital stock.
Limitations on Transactions with Affiliates
Transactions between financial institutions such as the Bank and any affiliate are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a financial institution is any company or entity, which controls, is controlled by or is under common control with the financial institution. In a holding company context, the parent bank holding company and any companies which are controlled by such parent holding company (or by the ultimate parent company of such bank holding company) are affiliates of the financial institution. Generally, Sections 23A and 23B of the Federal Reserve Act (i) limit the extent to which the financial institution or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such institution’s capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such institution’s capital stock and surplus and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the institution or subsidiary as those provided to a non-affiliate. The term “covered transaction” includes the making of loans, purchase of assets, issuance of a guarantee and other similar transactions. In addition, loans or other extensions of credit by the financial institution to the affiliate are required to be collateralized in accordance with the requirements set forth in Section 23A of the Federal Reserve Act.
The Gramm-Leach-Bliley Act amended several provisions of section 23A and 23B of the Federal Reserve Act. The amendments provide that financial subsidiaries of banks are treated as affiliates for purposes of sections 23A and 23B of the Federal Reserve Act, but the amendment provides that (i) the 10% capital limit on transactions between the bank and such financial subsidiary as an affiliate is not applicable, and (ii) the investment by the bank in the financial subsidiary does not include retained earnings in the financial subsidiary. Certain anti-evasion provisions have been included that relate to the relationship between any financial subsidiary of a bank and sister companies of the bank: (1) any purchase of, or investment in, the securities of a financial subsidiary by any affiliate of the parent bank is considered a purchase or investment by the bank; or (2) if the Federal Reserve determines that such treatment is necessary, any loan made by an affiliate of the parent bank to the financial subsidiary is to be considered a loan made by the parent bank.
The Federal Reserve adopted Regulation W, effective April 1, 2003, that deals with the provisions of Sections 23A and 23B. The regulation unifies and updates staff interpretations issued over the years, incorporates several new interpretations and provisions (such as to clarify when transactions with an unrelated third party will be attributed to an affiliate), and addresses new issues arising as a result of the expanded scope of nonbanking activities engaged in by banks and bank holding companies in recent years and authorized for financial holding companies under the Gramm-Leach-Bliley Act.
In addition, Sections 22(h) and (g) of the Federal Reserve Act place restrictions on loans to executive officers, directors and principal stockholders. Under Section 22(h) of the Federal Reserve Act loans to a director, an executive officer and to a greater than 10% stockholder of a financial institution, and certain affiliated interests of these, may not exceed, together with all other outstanding loans to such person and affiliated interests, the financial institution’s loans to one borrower limit, generally equal to 15% of the institution’s unimpaired capital and surplus. Section 22(h) of the Federal Reserve Act also requires that loans to directors, executive officers and principal stockholders be made on terms substantially the same as offered in comparable transactions to other persons and also requires prior board approval for certain loans. In addition, the aggregate amount of extensions of credit by a financial institution to insiders cannot exceed the institution’s unimpaired capital and surplus. Furthermore, Section 22(g) of the Federal Reserve Act places additional restrictions on loans to executive officers.
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Capital Requirements
The Federal Reserve has adopted capital adequacy guidelines pursuant to which it assesses the adequacy of capital in examining and supervising a bank holding company and in analyzing applications to it under the BHC Act. The Federal Reserve capital adequacy guidelines generally require bank holding companies to maintain total capital equal to 8% of total risk-adjusted assets, with at least one-half of that amount consisting of Tier I or core capital and up to one-half of that amount consisting of Tier II or supplementary capital. Tier I capital for bank holding companies generally consists of the sum of common stockholders’ equity and perpetual preferred stock, subject in the case of the latter to limitations on the kind and amount of such perpetual preferred stock which may be included as Tier I capital, less goodwill and, with certain exceptions, intangibles. Tier II capital generally consists of hybrid capital instruments, perpetual preferred stock which is not eligible to be included as Tier I capital; term subordinated debt and intermediate-term preferred stock; and, subject to limitations, generally allowances for loan losses. Assets are adjusted under the risk-based guidelines to take into account different risk characteristics, with the categories ranging from 0% (requiring no additional capital) for assets such as cash to 100% for the bulk of assets which are typically held by a bank holding company, including multi-family residential and commercial real estate loans, commercial business loans and commercial loans. Off-balance sheet items also are adjusted to take into account certain risk characteristics.
In addition to the risk-based capital requirements, the Federal Reserve requires bank holding companies to maintain a minimum leverage capital ratio of Tier I capital to total assets of 3.0%. Total assets for purposes of this calculation do not include goodwill and any other intangible assets and investments that the Federal Reserve determines should be deducted from Tier I capital. The Federal Reserve has announced that the 3.0% Tier I leverage capital ratio requirement is the minimum for the top-rated bank holding companies without supervisory, financial or operational weaknesses or deficiencies or those which are not experiencing or anticipating significant growth. Other bank holding companies will be expected to maintain Tier I leverage capital ratios of at least 4.0% or more, depending on their overall condition. As of December 31, 2006, the Corporation exceeded each of its capital requirements and was a well-capitalized institution as defined in the Federal Reserve regulations.
Sarbanes-Oxley
The Sarbanes-Oxley Act of 2002 (“SOA”) was enacted to address corporate and accounting fraud. SOA contains reforms of various business practices and numerous aspects of corporate governance. Management understands that substantially all of these requirements have been implemented pursuant to regulations issued by the Securities and Exchange Commission (the “SEC”). The following is a summary of certain key provisions of SOA.
SOA provides for the establishment of the Public Company Accounting Oversight Board (PCAOB) that enforces auditing, quality control and independence standards and is funded by fees from all publicly traded companies. SOA imposed higher standards for auditor independence and restricts provision of consulting services by auditing firms to companies they audit. Any non-audit services being provided to a public company audit client require pre-approval by the company’s audit committee. In addition, SOA makes certain changes to the requirements for partner rotation after a period of time. SOA requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with the SEC, subject to civil and criminal penalties if they knowingly or willingly violate this certification requirement. In addition, counsel is required to report evidence of a material violation of the securities laws or a breach of fiduciary duties to its chief executive officer or its chief legal officer, and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the board of directors or the board itself.
Under this law, longer prison terms apply to corporate executives who violate federal securities laws; the period during which certain types of suits can be brought against a company or its officers is extended and bonuses issued to top executives prior to restatement of a company’s financial statements are now subject to disgorgement if such restatement was due to corporate misconduct. Executives are also prohibited from insider trading during retirement plan “blackout” periods, and loans to company executives (other than loans by financial institutions permitted by federal rules or regulations) are restricted. In addition, the legislation accelerated the time frame for disclosures by public companies, as they must immediately disclose any material changes in their financial condition or operations. Directors and executive officers required to report changes in ownership in a company’s securities must now report within two business days of the change.
SOA also increased responsibilities and codified certain requirements relating to audit committees of public companies and how they interact with the company’s registered public accounting firm. Audit committee members must be independent and are barred from accepting consulting, advisory or other compensatory fees from the issuer. In addition, companies are required to disclose whether at least one member of the committee is a “financial expert” (as such term will be defined by the SEC) and
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if not, why not. Audit committees of publicly traded companies have authority to retain their own counsel and other advisors funded by the company. Audit committees must establish procedures for receipt, retention and treatment of complaints regarding accounting and auditing matters and procedures for confidential, anonymous submission of employee concerns regarding questionable accounting or auditing matters. It is the responsibility of the audit committee to hire, oversee and work on disagreements with Company’s independent auditor.
A company’s registered public accounting firm is prohibited from performing statutorily mandated audit services for a company if the company’s chief executive officer, chief financial officer, controller, chief accounting officer or any person serving in equivalent positions had been employed by such firm and participated in the audit of such company during the one-year period preceding the audit initiation date. SOA also prohibits any officer or director of a company or any other person acting under their direction from taking any action to fraudulently influence, coerce, manipulate or mislead any independent public or certified accountant engaged in the audit of the company’s financial statements for the purpose of rendering the financial statements materially misleading. SOA also has provisions related to inclusion of internal control report and assessment by management in the annual report to stockholders. The law also requires the company’s registered public accounting firm that issues the audit report to attest to and report on management’s assessment of the company’s internal controls. In addition, SOA requires that each financial report required to be prepared in accordance with (or reconciled to) generally accepted accounting principles and filed with the SEC reflect all material correcting adjustments that are identified by a registered public accounting firm in accordance with generally accepted accounting principles and rules and regulations of the SEC.
Banking Operations
General
Banks are extensively regulated under federal and state law. References under this heading to applicable statutes or regulations are brief summaries of portions thereof which do not purport to be complete and which are qualified in their entirety by reference to those statutes and regulations. Any change in applicable laws or regulations may have a material adverse effect on the business of commercial banks and bank holding companies, including the Corporation, the Bank or Santander Central Spain. However, management is not aware of any current recommendations by any federal or state regulatory authority that, if implemented, would have or would be reasonably likely to have a material effect on the liquidity, capital resources or operations of the Bank or the Corporation.
The Bank is incorporated under the Banking Law of Puerto Rico, a “state bank” and an “insured depository institution” under the Federal Deposit Insurance Act (“FDIA”), and a “foreign bank” within the meaning of the International Banking Act of 1978 (“IBA”). The Bank is subject to extensive regulation and examination by the Commissioner, the FDIC, and certain requirements established by the Federal Reserve. The federal and Puerto Rico laws and regulations that apply to banks regulate, among other things, the scope of their business, their investments, their reserves against deposits, the timing of the availability of deposited funds and the nature and amount of and collateral for certain loans. In addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve as it attempts to control the money supply and credit availability in order to influence the economy.
As a creditor and financial institution, the Bank is subject to certain regulations promulgated by the Federal Reserve, including, without limitation, Regulation B (Equal Credit Opportunity Act), Regulation DD (Truth in Savings Act), Regulation E (Electronic Funds Transfer Act), Regulation F (Limits on Exposure to Other Banks), Regulation Z (Truth in Lending Act), Regulation CC (Expedited Funds Availability Act), Regulation X (Real Estate Settlement Procedures Act), Regulation BB (Community Reinvestment Act) and Regulation C (Home Mortgage Disclosure Act).
There are periodic examinations by the Commissioner and the FDIC to test the Bank’s compliance with various statutory and regulatory requirements. This regulation and supervision establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions against banking organizations and institution-affiliated parties, as defined. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. In addition, certain actions are required by statute and implementing regulations. Other actions or inaction may provide the basis for enforcement action, including misleading or untimely reports filed with regulatory authorities.
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Any change in statutory and regulatory requirements whether by the Commissioner, the FDIC or the U.S. Congress or Puerto Rico legislature could have a material adverse impact on the Corporation, the Bank and their operations. The Corporation cannot determine the ultimate effect of such potential legislation, if enacted, or implementing regulations, would have upon the Corporation’s final condition or results of operations.
Ownership and Control
Because of the Bank’s status as a bank, owners of the common stock are subject to certain restrictions and disclosure obligations under various federal laws, including the BHC Act and the Change in Bank Control Act (the “CBCA”). Regulations pursuant to the BHC Act generally require prior Federal Reserve approval for an acquisition of control of an insured institution (as defined) or holding company thereof by any person (or persons acting in concert). Control is deemed to exist if, among other things, a person (or persons acting in concert) acquires more than 25% of any class of voting stock of an insured institution or holding company thereof. Control is presumed to exist subject to rebuttal, if a person (or persons acting in concert) acquires more than 10% of any class of voting stock and either (i) the company has registered securities under Section 12 of the Securities Exchange Act of 1934, or (ii) no person will own, control or hold the power to vote a greater percentage of that class of voting securities immediately after the transaction. The concept of acting in concert is very broad and also is subject to certain rebuttable presumptions, including among others, that relatives, business partners, management officials, affiliates and others are presumed to be acting in concert with each other and their businesses. The FDIC’s regulations implementing the CBC Act are generally similar to those described above.
The Banking Law requires the approval of the Commissioner for changes in control of a Puerto Rico bank. See “Banking Operations-Puerto Rico Regulation.”
FDIC Capital Requirements
Under authority granted in the FDIA, the FDIC has promulgated regulations and adopted a statement of policy regarding the capital adequacy of state-chartered banks that are not members of the Federal Reserve System. For purposes of the FDIA, Puerto Rico is treated as a state and the Bank as such is a state-chartered non-member bank.
The FDIC’s capital regulations establish a minimum leverage capital requirement for state-chartered non-member banks. For the most highly-rated banks the requirement is 4% Tier I capital, with an additional cushion of at least 100 to 200 basis points for all other state-chartered, nonmember banks, which effectively increases the minimum Tier I leverage ratio for such other bank from 4% to 5% or more. Under the FDIC’s regulations, the highest-rated banks are those that the FDIC determines are not anticipating or experiencing significant growth and have well diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity, good earnings and, in general, which are considered a strong banking organization and are rated composite 1 under the Uniform Financial Institutions Rating System. Tier I leverage or core capital is defined as the sum of common stockholders’ equity (including retained earnings), noncumulative perpetual preferred stock and related surplus, and minority interests in consolidated subsidiaries, minus all intangible assets other than certain qualifying supervisory goodwill and certain purchased mortgage servicing rights.
The FDIC also requires that state-chartered nonmember banks meet a risk-based capital standard. The risk-based capital standard requires the maintenance of total capital (which is defined as Tier I capital plus supplementary (Tier II) capital) to risk weighted assets of 8%. Under the standards the FDIC applies, the Bank’s assets are assigned weights of 0% to 100% based upon credit and certain other risks it believes are inherent in the type of asset or item. The components of Tier I capital are equivalent to those discussed above under the 4% leverage capital standard. The components of supplementary capital include certain perpetual preferred stock, certain mandatory convertible securities, certain subordinated debt and intermediate preferred stock and general allowances for loan losses. Allowance for loan losses included in supplementary capital is limited to a maximum of 1.25% of risk-weighted assets. Overall, the amount of capital counted toward supplementary capital cannot exceed 100% of core capital. As of December 31, 2006, the Bank exceeded each of its core capital requirements and was a well-capitalized institution as defined in the FDIC regulations.
In August 1995, the FDIC and other federal banking agencies published a final rule modifying their existing risk-based capital standards to provide for consideration of interest rate risk when assessing the capital adequacy of a bank. Under the final rule, the FDIC must explicitly include a bank’s exposure to declines in the economic value of its capital due to changes in interest rates as a factor in evaluating a bank’s capital adequacy. In June 1996, the FDIC and other federal banking agencies adopted a joint policy statement on interest rate risk policy. Because market conditions, bank structure, and bank activities vary, the agencies concluded that each bank needs to develop its own interest rate risk management program tailored to its needs and
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circumstances. The policy statement describes prudent principles and practices that are fundamental to sound interest rate risk management, including appropriate board and senior management oversight and comprehensive risk management process that effectively identifies, measures, monitors and controls such interest rate risk.
Failure to meet capital guidelines could subject an insured bank like the Bank to a variety of prompt corrective actions and enforcement remedies under the FDIA (as amended by FDICIA), including, with respect to an insured bank, the termination of deposit insurance by the FDIC, and to certain restrictions on its business. In general terms, undercapitalized depository institutions are prohibited from making any capital distributions (including dividends), are subject to restrictions on borrowing from the Federal Reserve System, and are subject to growth limitations and are required to submit capital restoration plans.
At December 31, 2006, the Bank was well capitalized. Like any other institution, the Bank’s capital category, as determined by applying the prompt corrective action provisions of law, may not constitute an accurate representation of the overall financial condition or prospects of the Bank, and should be considered in conjunction with other available information regarding the Bank’s financial condition and results of operations.
Cross-Guarantees
Under the FDIA, a depository institution (which term includes both banks and savings associations), the deposits of which are insured by the FDIC, can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to any commonly controlled FDIC-insured depository institution “in danger of default.” “Default” is defined generally as the appointment of a conservator or a receiver and “in danger of default” is defined generally as the existence of certain conditions indicating that a default is likely to occur in the absence of regulatory assistance. In some circumstances (depending upon the amount of the loss or anticipated loss suffered by the FDIC), cross-guarantee liability may result in the ultimate failure or insolvency of one or more insured depository institution to its parent company is subordinated to the subsidiary bank’s cross-guarantee liability with respect to commonly controlled insured depository institutions. The Bank is currently the only FDIC insured depository institution controlled by Santander Central Spain.
FDIC Deposit Insurance Assessments
Banco Santander Puerto Rico is subject to FDIC deposit insurance assessments. On February 8, 2006, the Federal Deposit Insurance Reform Act of 2005 (the “Reform Act”) was signed by the President. The Reform Act provides for the merger of the Bank Insurance Fund (“BIF”) and Savings Association Insurance Fund (“SAIF”) into a single Deposit Insurance Fund, (“DIF”), increases the maximum amount of the insurance coverage for certain retirement accounts, and possible “inflation adjustments” in the maximum amount of coverage available with respect to other insured accounts. In addition, it granted a one-time initial assessment credit to recognize institutions’ past contributions to the fund.
The deposits of Banco Santander Puerto Rico are insured up to the applicable limits by the DIF of the FDIC and are subject to the deposit insurance assessments to maintain the DIF. For 2006 the FDIC utilized a risk based assessment system that imposed insurance premiums based upon a matrix that took into account a bank’s capital level and supervisory rating. Premiums under that assessment system ranged from 0 cents for each $100 of domestic deposits for well-capitalized and well managed banks to 27 cents for each $100 of domestic deposits for the weakest institution. Banco Santander Puerto Rico was not required to pay insurance premium to the FDIC during 2006.
Under the Reform Act, the FDIC made significant changes to its risk-based assessment system so that effective January 1, 2007, the FDIC imposes insurance premium based upon a matrix that is designed to more closely tie what banks pay for deposit insurance to the risk they pose. The new FDIC risk-based assessment system imposes premium based upon factors that vary depending upon the size of the bank. These factors are: for banks with less than $10 billion in assets- capital level, supervisory rating, and certain financial ratios; for banks with $10 billion up to $30 billion in assets- capital level, supervisory rating, certain financial ratios and (if at least one is available) debt issuer ratings, and additional risk information; and for banks with over $30 billion in assets- capital level, supervisory rating, debt issuer ratings (unless none are available in which case certain financial ratios are used), and additional risk information. The FDIC has adopted a new base schedule of rates that the FDIC can adjust up or down, depending on the revenue needs of the DIF, and has set initial premiums for 2007 that range from 5 cents per $100 of domestic deposits for the banks in the lowest risk category to 43 cent per $100 of domestic deposits for banks in the highest risk category. The new assessment system is expected to result in increased annual assessments on the deposits of our bank subsidiaries of 5 to 7 basis points per $100 of deposit. Our bank subsidiary has available FDIC credits to offset future assessments. Significant increases in the insurance assessments of Banco Santander Puerto Rico will increase our costs once the credits are fully utilized.
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On December 28, 2006, Banco Santander Puerto Rico reached an agreement to transfer two million dollars ($2,000,000.00) in FDIC Assessment Credits to an unrelated financial institution for the purchase price of one million eight hundred fifty five thousand dollars ($1,855,000.00). Banco Santander Puerto Rico complied with Final Rule of the Reform Act and submitted the executed Transfer Form to the FDIC’s Division of Finance. As of December 31, 2006, Banco Santander Puerto Rico still has available $5.2 million in FDIC credits to offset future assessments. Significant increases in the insurance assessments of Banco Santander Puerto Rico will increase our costs once the credit is fully utilized.
Banco Santander Puerto Rico is also subject to separate assessments to repay bonds (“FICO bonds”). The assessment for the payment on the FICO bonds for the quarter beginning on January 1, 2007 is 1.22 cents per $100 of DIF- assessable deposits.
The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance. Management is aware of no existing circumstances which would result in termination of the Bank’s insurance.
Standards for Safety and Soundness
The FDIA, as amended by FDICIA and the Riegle Community Development and Regulatory Improvement Act of 1994, requires the FDIC and the other federal bank regulatory agencies to prescribe standards of safety and soundness, by regulations or guidelines, relating generally to operations and management, asset growth, asset quality, earnings, stock valuation, and compensation. The FDIC and the other federal bank regulatory agencies adopted, effective August 9, 1995, a set of guidelines prescribing safety and soundness standards pursuant to FDICIA, as amended. The guidelines establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal shareholder.
Community Reinvestment
Under the Community Reinvestment Act (“CRA”), each insured depository institution has a continuing and affirmative obligation, consistent with the safe and sound operation of such institution, to help meet the credit needs of its entire community, including low-and moderate-income neighborhoods. The CRA does not establish specific lending requirements or programs for such institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires each federal banking agency, in connection with its examination of an insured depository institution, to assess and assign one of four ratings to the institution’s record of meeting the credit needs of its community and to take such records into account in its evaluation of certain applications by the institution, including application for charters, branches and other deposit facilities, relocations, mergers, consolidations, acquisitions of assets or assumptions of liabilities and savings and loan holding company acquisitions. The CRA also requires that all institutions make public disclosure of their CRA ratings. The Bank received a rating of “outstanding” as of the most recent CRA report issued by the FDIC.
Brokered Deposits
FDIC regulations adopted under the FDIA govern the receipt of brokered deposits by banks. Well capitalized institutions are not subject to limitations on brokered deposits, while adequately capitalized institutions are able to accept, renew or rollover brokered deposits only with a waiver from the FDIC and subject to certain restrictions on the yield paid on such deposits. Undercapitalized institutions are not permitted to accept brokered deposits. The Bank does not believe the brokered deposits regulation has had or will have a material effect on the funding or liquidity of the Bank, which is currently a well-capitalized institution.
Federal Limitations on Activities and Investments
The equity investments and activities as a principal of FDIC-insured state-chartered banks such as the Bank are generally limited to those that are permissible for national banks. Under regulations dealing with equity investments, an insured state bank generally may not directly or indirectly acquire or retain any equity investment of a type, or in an amount, that is not
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permissible for a national bank. However, an insured state bank is not prohibited from, among other things, (i) acquiring or retaining a majority interest in a subsidiary, (ii) investing as a limited partner in a partnership the sole purpose of which is direct or indirect investment in the acquisition, rehabilitation or new construction of a qualified housing project, provided that such limited partnership investments may not exceed 2% of the bank’s total assets, (iii) acquiring up to 10% of the voting stock of a company that solely provides or reinsures director’, trustees’ and officers’ liability insurance coverage or bankers’ blanket bond group insurance coverage for insured depository institutions, and (iv) acquiring or retaining the voting shares of a depository institution if certain requirements are met. In addition, an insured state-chartered bank may not, directly or indirectly through a subsidiary, engage as principal in any activity that is not permissible for a national bank unless the FDIC has determined that such activities would pose no risk to the insurance fund of which it is a member and the bank is in compliance with applicable regulatory capital requirements. Any insured state-chartered bank that is directly or indirectly engaged in any activity that is not permitted for a national bank must cease such impermissible activity.
Interstate Branching
Effective June 1, 1997, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Riegle-Neal Act”) amended the FDIA and certain other statutes to permit state and national banks with different home states to merge across state lines, with approval of the appropriate federal banking agency, unless the home state of a participating bank had passed legislation prior to May 31, 1997 expressly prohibiting interstate mergers. Under the Riegle-Neal Act amendments, once a state or national bank has established branches in a state, that bank may establish and acquire additional branches at any location in the state of which any bank involved in the interstate merger transaction could have established or acquired branches under applicable federal or state law. If a state opts out of interstate branching within the specified time period, no bank in any other state may establish a branch in the state which has opted out, whether through an acquisition orde novo.
For purposes of the Riegle-Neal Act’s amendments to the FDIA, the Bank is treated as a state bank and is subject to the same restriction on interstate branching as other state banks. However, for purposes of the IBA, the Bank is considered to be a foreign bank and may branch interstate by merger orde novoto the same extent as a domestic bank in the Bank’s home state. It is not yet possible to determine how these statutes will be harmonized, with respect either to which federal agency will approve interstate transactions or to which “home state” determination rules will apply.
Banking Operations-Puerto Rico Regulation
General
As a commercial bank organized under the laws of Puerto Rico the Bank is subject to the supervision, examination and regulation of the Commissioner, pursuant to the Puerto Rico Banking Law of 1933 (the “Banking Law”). The Banking Law contains provisions governing the incorporation and organization, rights and responsibilities of directors, officers and stockholders as well as the corporate powers, lending limitations, capital requirements, investment requirements and other aspects of the Bank and its affairs. In addition, the Commissioner is given extensive rule making power and administrative discretion under the Banking Law.
Section 12 of the Banking Law requires the prior approval of the Commissioner with respect to a transfer of capital stock of a bank that results in a change of control of the bank. Under Section 12, a change of control is presumed to occur if a person or a group of persons acting in concert, directly or indirectly, acquire more than 5% of the outstanding voting capital stock of the bank. The Commissioner has interpreted the restrictions of Section 12 as applying to acquisitions of voting securities of entities controlling a bank, such as a bank holding company. Under the Banking Law, the determination of the Commissioner whether to approve a change of control filing is final and non-appealable.
Section 16 of the Banking Law requires every bank to maintain a legal reserve which shall not be less than 20% of its demand liabilities, except government deposits (federal state and municipal) which are secured by actual collateral. The reserve is required to be composed of any of the following securities or combination thereof: (1) legal tender of the United States; (2) checks on banks or trust companies located in any part of Puerto Rico, to be presented for collection during the day following that on which they are received; (3) money deposited in other banks or depository institutions, subject to immediate collection; (4) federal funds sold to any Federal Reserve Bank and securities purchased under agreement to resell executed by the bank with such funds that are subject to be repaid to the bank on or before the close of the next business day; and (5) any other asset that the Commissioner determines from time to time.
Section 17 of the Banking Law permits Puerto Rico commercial banks to make loans to any one person, firm, partnership or corporation, up to an aggregate amount of 15% the sum of: (i) paid-in capital; (ii) reserve fund of the commercial bank; and
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(iii) any other components that the Commissioner may determine from time to time. As of December 31, 2006, the legal lending limit for the Bank under this provision was approximately $54.9 million. If such loans are secured by collateral worth at least 25% more than the amount of the loan, the aggregate maximum amount may reach one third of the sum of the Bank’s paid-in capital, reserve fund, retained earnings and any other components that the Commissioner may determine from time to time. There are no restrictions under Section 17 of the Banking Law on the amount of loans which are wholly secured by bonds, securities and other evidences of indebtedness of the Government of the United States, of the Commonwealth of Puerto Rico, or by bonds, not in default, of authorities, instrumentalities or dependencies of the Commonwealth of Puerto Rico or its municipalities.
Section 17 of the Banking Law also prohibits Puerto Rico commercial banks from making loans secured by their own stock, and from purchasing their own stock in connection therewith, unless such purchase is necessary to prevent losses because of a debt previously contracted in good faith. The stock so purchased by the Puerto Rico commercial bank must be sold by the bank in a public or private sale within one year from the date of purchase.
The Banking Law provides that no officers, directors, agents or employees of a Puerto Rico commercial bank may serve or discharge a position of officer, director, agent or employee of another Puerto Rico commercial bank, financial company, savings and loan association, trust company, company engaged in granting mortgage loans or any other institution engaged in the money lending business in Puerto Rico. This prohibition is not applicable to the affiliates of a Puerto Rico commercial bank.
Section 27 of the Banking Law also requires that at least 10% of the yearly net income of a Puerto Rico commercial bank be credited to a reserve fund until the amount deposited to the credit of the reserve fund is equal to 100% of total paid-in capital (common and preferred) of the commercial bank. As of December 31, 2006, the Bank had an adequate reserve fund established.
Section 27 of the Banking Law also provides that when the expenditures of a Puerto Rico commercial bank are greater than receipts, the excess of the expenditures over receipts shall be charged against the undistributed profits of the bank, and the balance, if any, shall be charged against the reserve fund, as a reduction thereof. If there is no reserve fund sufficient to cover such balance in whole or in part, the outstanding amount shall be charged against the capital account and no dividends shall be declared until said capital has been restored to its original amount and the reserve fund to 20% of the original capital of the bank.
Section 14 of the Banking Law authorizes the Bank to conduct certain financial and related activities directly or through subsidiaries, including lease financing of personal property, operating small loans companies and mortgage loans activities. The Bank currently has two subsidiaries, Santander Mortgage, a mortgage company, and Santander International Bank, an international banking entity.
The Finance Board, which is composed of the Commissioner, the Secretary of the Treasury, the Secretary of Commerce, the Secretary of Consumer Affairs, the President of the Economic Development Bank, the President of the Government Development Bank, and the President of the Planning Board, has the authority to regulate the maximum interest rates and finance charges that may be charged on loans to individuals and unincorporated businesses in Puerto Rico. The current regulations of the Finance Board provide that the applicable interest rate on loans to individuals and unincorporated businesses, including real estate development loans but excluding certain other personal and commercial loans secured by mortgages on real estate properties, is to be determined by free competition. Regulations adopted by the Finance Board deregulated the maximum finance charges on retail installment sales contracts, and for credit card purchases. These regulations do not set a maximum rate for charges on retail installment sales contracts and for credit card purchases and set aside previous regulations which regulated these maximum finance charges. Furthermore, there is no maximum rate set for installment sales contracts involving motor vehicles, commercial, agricultural and industrial equipment, commercial electric appliances and insurance premiums.
IBC Act
Santander International Bank, an international banking entity, is subject to supervision and regulation by the Commissioner of Financial Institutions under the International Banking Center Regulatory Act (the “IBC Act”). Under the IBC Act, no sale, encumbrance, assignment, merger, exchange or transfer of shares, interest or participation in the capital of an IBE may be initiated without the prior approval of the Commissioner, if by such transaction a person would acquire, directly or indirectly, control of 10% or more of any class of stock, interest or participation in the capital of the IBE. The IBC Act and the regulations issued thereunder by the Commissioner (the IBC Regulations) limit the business activities that may be carried out
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by an IBE. Such activities are limited in part to persons and assets located outside of Puerto Rico. The IBC Act further provides that every IBE must have not less than $300,000 of unencumbered assets or acceptable financial securities in Puerto Rico.
Under the IBC Act, without the prior approval of the Office of the Commissioner, Santander International Bank may not amend its articles of incorporation or issue additional shares of capital stock or other securities convertible into additional shares of capital stock unless such shares are issued directly to the shareholders of Santander International Bank previously identified in the application to organize the international banking entity, in which case notification to the Commissioner must be given within ten (10) business days following the date of the issue.
Pursuant to the IBC Act, Santander International Bank must maintain its original accounting books and records in its principal place of business in Puerto Rico. Santander International Bank is also required to submit to the Commissioner quarterly and annual reports of its financial condition and results of operations, including annual audited financial statements.
The IBC Act empowers the Commissioner to revoke or suspend, after notice and hearing, a license issued thereunder if, among other things, the IBE fails to comply with the IBC Act, the IBC Regulations, or the terms of its license, or if the Commissioner finds that the business of the IBE is conducted in a manner not consistent with the public interest.
Mortgage Banking Operations
Santander Mortgage is subject to the rules and regulations of FHA, VA, FNMA, FHLMC, HUD and GNMA with respect to originating, processing, selling and servicing mortgage loans and the issuance and sale of mortgage-backed securities. Those rules and regulations, among other things, prohibit discrimination and establish underwriting guidelines which include provisions for inspections, appraisals and required credit reports on prospective borrowers and fix maximum loan amounts, and with respect to VA loans, fix maximum interest rates. Moreover, lenders such as Santander Mortgage are required annually to submit to FHA, VA, FNMA, FHLMC, GNMA and HUD, audited financial statements, and each regulatory entity has its own financial requirements. Santander Mortgage’s affairs are also subject to supervision and examination by FHA, VA, FNMA, FHLMC, GNMA and HUD at all times to assure compliance with the applicable regulations, policies and procedures. Mortgage origination activities are subject to, among others, the Equal Credit Opportunity Act, Federal Truth-in-Lending Act, the Real Estate Settlement Procedures Act and the regulations promulgated thereunder which, among other things, prohibit discrimination and require the disclosure of certain basic information to mortgagors concerning credit terms and settlement costs. Santander Mortgage is licensed by the Commissioner under the Puerto Rico Mortgage Banking Law (the “Mortgage Banking Law”), and as such is subject to regulation by the Commissioner, with respect to, among other things, licensing requirements and establishment of maximum origination fees on certain types of mortgage loans products. Although Santander Mortgage believes that it is in compliance in all material respects with applicable Federal and Puerto Rico laws, rules and regulations, there can be no assurance that more restrictive laws or rules will not be adopted in the future, which could make compliance more difficult or expensive, restricting Santander Mortgage’s ability to originate or sell mortgage loans or sell mortgage-backed securities, further limit or restrict the amount of interest and other fees earned from the origination of loans, or otherwise adversely affect the business or prospects of Santander Mortgage.
Section 5 of the Mortgage Banking Law requires the prior approval of the Commissioner for the acquisition of control of any mortgage banking institution licensed under such law. For purposes of the Mortgage Banking Law, the term “control” means the power to direct or influence decisively, directly or indirectly, the management or policies of a mortgage banking institution. The Mortgage Banking Law provides that a transaction that results in the holding of less than 10% of the outstanding voting securities of a mortgage banking institution shall not be considered a change in control.
Broker Dealer Operations
Santander Securities is registered as a broker-dealer with the SEC and the Commissioner, and is also a member of the National Association of Securities Dealers, Inc. (the “NASD”). As a registered broker-dealer, it is subject to regulation and supervision by the SEC, the Commissioner and the NASD in matters relating to the conduct of its securities business, including record keeping and reporting requirements, supervision and licensing of employees and obligations to customers. In particular, Santander Securities is subject to the SEC’s net capital rules, which specify minimum net capital requirements for registered broker-dealers and are designed to ensure that broker-dealers maintain regulatory capital in relation to their liabilities and the size of their customer business.
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Insurance Operations
Santander Insurance Agency is registered as a corporate agent and general agency with the office of the Commissioner of Insurance of Puerto Rico (the “Insurance Commissioner”). Santander Insurance Agency is subject to regulation and supervision by the Commissioner relating to, among other things, licensing of employees, sales practices, charging of commissions and obligations to customers.
Island Insurance Corporation is registered as an insurance company with the office of the Commissioner of Insurance of Puerto Rico (the “Insurance Commissioner”). Island Insurance Corporation is subject to regulation and supervision by the Insurance Commissioner. As of December 31, 2006, this corporation is inactive .
Availability at our website
We make available free of charge, through our investor relations section at our internet website, www.santandernet.com, our Form 10-K, Form 10-Q and Form 8-K reports and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC.
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ITEM 1A. RISK FACTORS
The Corporation is subject to risk in several areas. Discussed below, and elsewhere in this report, are the various risk factors that could cause the Corporation’s financial condition and results of operations to vary significantly from period to period. Please refer to the “Regulation and Supervision” section of this report for more information about legislative and regulatory risks. Also refer to the MD&A section, Quantitative and Qualitative Disclosures about Market Risk, and the Financial Statements and Supplementary Data sections in this report for additional information about credit, interest rate and market risks. Any factor described below or elsewhere in this report or in our 2006 Annual Report to Stockholders could, by itself or together with one or more other factors, have a material adverse effect on the Corporation’s financial condition and results of operations.
General business, economic and political conditions.The Corporation’s businesses and earnings are affected by general economic and political conditions in Puerto Rico and the United States of America. General business and economic conditions that could affect the Corporation include short-term and long-term interest rates, inflation, monetary supply, fluctuations in both debt and equity capital markets, and the strength of the United States and Puerto Rico economies. A period of reduced economic growth or a recession has historically resulted in a reduction in lending activity and an increase in the rate of defaults on loans. A recession may have an adverse impact on net interest income and fee income. The Corporation may also experience significant losses on the loan portfolio due to defaults as customers become unable to meet their obligations, which would result in an adverse effect on earnings as higher reserves for loan losses would be required. Geopolitical conditions can also affect the Corporation’s earnings. Acts or threats of terrorism, actions taken by the United States or other governments in response to acts or threats of terrorism and/or military conflicts, could affect the general business and economic conditions in Puerto Rico, United States and abroad.
The Corporation’s financial activities and credit exposure are concentrated in Puerto Rico. As a result, the Corporation’s financial condition and results of operations are highly dependent on economic conditions in Puerto Rico. An extended economic slowdown, adverse political or economic developments or natural disasters such as hurricanes, affecting Puerto Rico could result in a reduction in lending activities and an increase in the level of nonperforming assets and charge offs, all of which would adversely affect the Corporation’s profitability.
Competition.The Corporation operates in a highly competitive environment in Puerto Rico from other United States, Puerto Rico and foreign banks as well as mortgage banking companies, insurance companies and brokers-dealers. Increased competition could require that the Corporation lower rates charged on loans or increase rates offered on deposits, which could adversely affect profitability.
The Corporation’s business model is based on a diversified mix of businesses that provide a broad range of financial products and services, delivered through multiple distribution channels. The Corporation’s success depends, in part, on its ability to adapt its products and services to evolving industry standards. There is increasing pressure to provide products and services at lower prices. This can reduce the Corporation’s net interest margin and income from fee-based products and services. In addition, the widespread adoption of new technologies, including internet services, could require the Corporation to incur in substantial expenditures to modify or adapt its existing products and services in order to remain competitive. The Corporation is at risk of not being successful or timely in introducing new products and services, responding or adapting to changes in consumer spending and saving habits, achieving market acceptance of its products and services, or developing and maintaining loyal customers.
Interest rate risk.Net interest income is the interest earned on loans, securities and other assets minus the interest paid on deposits, long-term and short-term debt and other liabilities. Net interest income is the difference between the yield on assets and the rate paid on deposits and other sources of funding. These rates are highly sensitive to many factors beyond the Corporation’s control, including general economic conditions and the policies of various governmental and regulatory agencies. Changes in monetary policy, including changes in interest rates, will influence the origination of loans, the prepayment speed of loans, the purchase of investments, the generation of deposits and the rates received on loans and investment securities and paid on deposits or other sources of funding. The impact of these changes may be magnified if the Corporation does not effectively manage the relative sensitivity of its assets and liabilities to changes in market interest rates.
Changes in interest rates could adversely affect net interest margin. Although the yield earned on assets and funding costs tend to move in the same direction in response to changes in interest rates, one can rise or fall faster than the other, causing the Corporation’s net interest margin to expand or contract. The Corporation’s liabilities tend to be shorter in duration than its assets, so they may adjust faster in response to changes in interest rates.
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Changes in the slope of the “yield curve” — or the spread between short-term and long-term interest rates — could also reduce the Corporation’s net interest margin. Normally, the yield curve is upward sloping, meaning short-term rates are lower than long-term rates. However, since the Corporation’s liabilities tend to be shorter in duration than its assets, they may adjust faster in response to changes in interest rates. As a result, when interest rates rise, the Corporation’s funding costs may rise faster than the yield earned on its assets causing net interest margin to contract until the yield catches up.
The Corporation assesses its interest rate risk by estimating the effect on earnings under various scenarios that differ based on assumptions about the direction, magnitude and speed of interest rate changes and the slope of the yield curve. Some interest rate risk is hedged with derivatives. However, not all interest rate risk is hedged. There is always the risk that changes in interest rates could reduce net interest income and earnings in material amounts, especially if actual conditions turn out to be materially different than what the Corporation expected. For example, if interest rates rise or fall faster than the Corporation assumed, or the slope of the yield curve changes, the Corporation may incur significant losses on debt securities held as investments. To reduce interest rate risk, the Corporation may rebalance its investment and loan portfolios, refinance its debt and take other strategic actions. Certain losses or expenses may be incurred when such strategic actions are taken. Refer to the “Risk Management — Asset Liability Management” section of the MD&A.
Credit Risk.When the Corporation lends money or commits to lend money or enters into a contract with a counterparty, it incurs credit risk, or the risk of losses if borrowers do not repay their loans or counterparties fail to perform according to the term of their contract. The Corporation allows for and reserves against credit risks based on its assessment of credit losses inherent in its loan portfolio (including unfunded credit commitments). The process for determining the amount of the allowance for loan losses is critical to the Corporation’s financial condition and results of operations. It requires difficult, subjective and complex judgments, including forecasts of economic conditions and how these economic predictions might impair the ability of borrowers to repay their loans. As is the case with any such assessments, there is always the chance that the Corporation will fail to identify the proper factors or that it will fail to accurately estimate the impacts of factors that are identified.
For further discussion of credit risk and the Corporation’s credit risk management policies and procedures, refer to “Credit Risk Management and Loan Quality” in the MD&A.
Changes in market prices of managed assets.The Corporation earns fee income from managing assets for others and providing brokerage services. Since investment management fees are often based on the value of assets under management, a fall in the market prices of those assets could reduce the Corporation’s fee income. Changes in stock market prices could affect the trading activity of investors, reducing commissions and other fees earned from the brokerage business.
Changes in accounting standards.The Corporation’s accounting policies are fundamental to understanding its financial condition and results of operations. Some of these policies require the use of estimates and assumptions that may affect the value of assets or liabilities and financial results. Several of our accounting policies are critical because they require management to make difficult, subjective and complex judgments about matters that are inherently uncertain and because it is likely that materially different amounts would be reported under different conditions or using different assumptions. For a description of the Corporation’s critical accounting policies, refer to “Critical Accounting Policies” in the MD&A.
From time to time the Financial Accounting Standards Board (FASB), the SEC and other regulatory bodies, change the financial accounting and reporting standards that govern the preparation of external financial statements. These changes are beyond the Corporation’s control, can be difficult to predict and could materially impact how it reports financial condition and results of operations. In some cases, the Corporation could be required to apply a new or revised standard retroactively, resulting in the restatement of prior period financial statements.
Federal and state regulations.The Corporation, the banks and non banking subsidiaries are subject to extensive state and federal regulation, supervision and legislation that govern almost all aspects of its operations. These regulations protect depositors, federal deposit insurance funds, consumers and the banking system as a whole, not stockholders. The Corporation and its non banking subsidiaries are also heavily regulated by securities regulators. This regulation is designed to protect investors in securities we sell or underwrite. Congress and state legislatures and foreign, federal and state regulatory agencies continually review laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including interpretation or implementation of statutes, regulations or policies, could affect the Corporation in substantial and unpredictable ways including limiting the types of financial services and products it may offer and increasing the ability of non banks to offer competing financial services and products. Implementation of regulatory changes could also be costly to the Corporation.
20
Governmental fiscal and monetary policy.The Corporation’s earnings are affected by domestic and international monetary policy. For example, the Board of Governors of the Federal Reserve System regulates the supply of money and credit in the United States. These policies, to a large extent, determine the Corporation’s cost of funds for lending and investing and the returns earned on those loans and investments, both of which affect net interest margin. These policies can also affect the value of financial instruments, such as debt securities and mortgage servicing rights as well as affecting borrowers by potentially increasing the risk that they may fail to repay their loans.
The Corporations earnings are also affected by the fiscal policies that are adopted by various governmental authorities of Puerto Rico and the United States. Changes in tax laws can have a potentially adverse impact on the Corporation’s earnings.
Changes in domestic and international monetary and fiscal policies are beyond the Corporation’s control and are difficult to predict.
Liquidity risk.Liquidity is essential to business and could be impaired by an inability to access the capital markets or unforeseen outflows of cash. This situation may arise due to circumstances that the Corporation may be unable to control, such as a general market disruption. The Corporation’s credit ratings are important to its liquidity. A reduction in credit ratings could adversely affect its liquidity and competitive position, increase borrowing costs, limit access to the capital markets. For a further discussion of the Corporation’s liquidity, refer to “Liquidity Risk” in the MD&A.
Operational risk.The Corporation is exposed to operational risk. In its daily operations, the Corporation relies on the continued efficacy of its technical and telecommunication systems, operational infrastructure, relationships with third parties and the vast array of associates and key executives in its day to day and ongoing operations. Failure by any or all of these resources subjects the Corporation to risks that may vary in size, scale and scope. This includes but is not limited to operational or technical failures, ineffectiveness or exposure due to interruption in third party support as expected, the risk of fraud or theft by employees or outsiders, unauthorized transactions by employees or operational errors (including clerical or recordkeeping errors), as well as, the loss of key individuals or failure on the part of the key individuals to perform properly.
Reputational risk.The Corporation is subject to reputational risk, or the risk to earnings and capital from negative public opinion. The Corporation’s ability to attract and retain customers and employees could be adversely affected to the extent its reputation is damaged. The Corporation’s failure to address, or to appear to fail to address various issues that could give rise to reputational risk could cause harm to the Corporation and its business prospects and could lead to litigation and regulatory action. These issues include, but are not limited to, appropriately addressing potential conflicts of interest; legal and regulatory requirements; ethical issues; money laundering ; privacy; properly maintaining customer and associated personal information; record keeping; sales and trading practices; and the proper identification of the legal, reputational, credit, liquidity, and market risks inherent in its products.
Merger risk.There are significant risks associated with mergers. Future business acquisitions could be material to the Corporation and could require the issuance of additional capital or incurring of debt. In that event, the Corporation could become more susceptible to economic downturns and competitive pressures. Merger risk includes the possibility that projected growth opportunities and cost savings fail to be realized, and that the integration process results in the loss of key employees, or that the disruption of ongoing business from the merger could adversely affect the Corporation’s ability to maintain relationships with customers.
Litigation risk.The volume of claims and the amount of damages and penalties claimed in litigation and regulatory proceedings against financial institutions remains high. Substantial legal liability or significant regulatory action against the Corporation could have material adverse financial effects or cause significant reputational harm to the Corporation, which could result in serious financial consequences.
The SEC and other government agencies are currently conducting investigations of mortgage loan transfers and related transactions among several Puerto Rico banking institutions. The Corporation is unable to predict whether or to what extent such investigations will have adverse effects on the Corporation.
Fiscal Reform and the Current Economic Condition of the Commonwealth of Puerto Rico.A budgetary crisis during 2006 resulting in a temporary shutdown of certain government agencies, significant tax and fiscal reform have been key factors in the current economic condition in Puerto Rico.
The current economic uncertainty that exists in Puerto Rico, tax and fiscal reform, coupled with increases in the price of petroleum and other consumer goods are aggravating the concerns over the economic situation of the Island. The partial
21
shutdown of the government, the increase in petroleum prices, along with rising interest rates and uncertainties relating to tax reform may adversely impact employment and economic growth in Puerto Rico. These factors may also have an adverse effect on the credit quality of the Corporation’s loan portfolios, as delinquency rates are expected to increase in the short-term, until the economy stabilizes.
The Puerto Rico economy slowed down significantly and entered into a moderate recession in 2006. Economic data available for 2006 reveals negative performance in a series of key indicators such as: the Coincident Index of Economic Activity, non-farm employment, construction investment, retail sales and new auto sales. The most recent data for the Coincident Index of Economic Activity, an overall indicator of current economic activity that is highly correlated with real gross product, shows negative performance for eight consecutive months as of November 2006. The quarterly trend of the Coincident Index shows that the local economy began to show signs of moderation in 2005 but took turn for the negative in 2Q06. The moderate recession, as showed by the Coincident Index, appears to be caused by the cumulative effect of a series of factors and was accelerated by the government temporary shutdown last May 2006. In late 2005 and early 2006, the Coincident Index reflected a slowdown as the mounting effect of high oil prices, increasing interest rates and raises in prices of several public services began restraining consumer spending. However, the Coincident Index turned negative in 2Q06 as a result of the temporary government shutdown in May 2006. The Executive and Legislative branches experienced a political impasse over the implementation of a fiscal and tax reform that led to a temporary government shutdown in May 2006. The shutdown drove the unemployment rate to 19.8% in the month of May 2006 and seriously weakened consumer and investor confidence (credit downgrades also affected investor confidence; see next section Downgrades of Commonwealth of Puerto Rico Debt Obligations).
It is apparent that economic weakness has persisted to the end of 2006, given that the resolution of the political impasse brought about the implementation of a tax reform that introduced a consumption-based tax in Puerto Rico and restrictions in government expenditures and investments. These two additional factors reinforced economic weakness. A series of key economic indicators such as non-farm employment, construction investment, government tax receipts and new auto sales registered declines in 4Q06.
The Corporation is subject to the general effects of the local recession through a series of factors: 1) weaker than expected banking activity due to a slowdown and declines in loan and deposit growth and 2) potential deterioration in credit quality as the recessionary conditions affect consumers and business and limit their capacity to meet obligations. The actual economic scenario can also impact areas of non-interest income of the Corporation.
Downgrades of Commonwealth of Puerto Rico debt obligations.The debt of the Commonwealth of Puerto Rico and of certain of its agencies and instrumentalities was downgraded by the major rating agencies in 2006.
On May 8, 2006, Moody’s Investors Service downgraded the Government’s general obligation bond rating to Baa3 from Baa2, and kept the rating on “watch list”. In addition to the Commonwealth’s general obligation bonds, the downgrade affected several Commonwealth-guaranteed bonds, Commonwealth appropriation bonds, and government bond programs directly or indirectly linked to the general creditworthiness of the Commonwealth. All have been downgraded by one notch. The Commonwealth’s appropriation bonds, and some of the subordinated revenue bonds of the Highway and Transportation Authority, are now rated just below investment grade at Ba1. Standard and Poors’ Rating Services (S&P) maintained its rating of BBB on the Government’s general obligations that were also placed under the credit watch list. In addition, the Moody’s and S&P lowered the ratings of the Government Development Bank (GDB), Puerto Rico’s fiscal arm, due to its deteriorated liquidity position.
According to Moody’s, the downgrade reflected the Government’s strained financial condition, the ongoing political conflict and lack of agreement regarding the measures necessary to end the government’s multi-year trend of financial deterioration. More specifically, the downgrade was the direct result of excessive spending from the Central Government such that it had outpaced revenues and had created major unfunded public programs and public works. In addition, the Government receipts were based on a broken tax system that promoted evasion. The government deficits that emerged from the situation were met through borrowing from the Government Development Bank. Thus, the Executive and Legislative branches needed to agree on measures to control expenses, implement a tax reform and take steps to restore the liquidity of the GDB.
In July 2006, Moody’s and S&P removed the Commonwealth’s general obligations from their respective watch lists. This action came about after the Puerto Rico Executive and Legislative branches managed to approve a balanced budget for fiscal year 2007 (which runs from July 1 to June 30) and moved forward to implement a tax reform. These actions allowed bringing the GDB back to its liquidity position. Since the approval of the tax reform that introduced a consumption-based tax in Puerto
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Rico, the Central Government has issued nearly $2.0 billion in bonds and has supported the issuance of bonds in several public corporations and other entities including the Puerto Rico Aqueduct and Sewer Authority and the University of Puerto Rico.
As of December 31, 2006, the Corporation’s credit exposure to the Commonwealth of Puerto Rico and its political subdivisions and municipalities was $391.2 million composed of $335.8 million in credit facilities and $55.9 million in outstanding bonds and other obligations. The Corporation believes that the credit exposure to the Commonwealth of Puerto Rico and its political subdivisions and municipalities is manageable. The Commonwealth of Puerto Rico has a long-standing record of supporting all of its debt obligations. It has never defaulted in the payment of principal or interest on any public debt. The Corporation’s level of exposure is manageable given the fact that its outstanding loans and investment securities have either one or more of the following characteristics: (i) investment grade rated counterparties, (ii) identifiable source of repayment, (iii) high ranking in repayment priority or (iv) tangible collateral. Collateral for the Corporation’s credit exposure to the Commonwealth of Puerto Rico consists of $60.0 million in marketable securities and $19.1 million in real estate. In addition, $88.0 million are loans or obligations to various Municipalities for which payments are secured by the full faith, credit and unlimited taxing power of the Municipalities. In the investment securities portfolio there are $23.0 million which are rated AAA and $32.9 million in bonds that were subject of a rating downgrade during the year 2006. The Corporation anticipates recovery of the amortized cost of these securities at maturity. Since the Corporation has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, and the contractual term of these investments do not permit the issuer to settle the securities at a price less than the amortized cost, the Corporation does not consider these investments to be other-than-temporarily impaired at December 31, 2006.
Despite its limited exposure, the Corporation continues to closely monitor the financial condition and developments of the Government of Puerto Rico given that fiscal crises, such as the one experienced in 2006, can curtail consumer and investor confidence and produce adverse economic conditions that in turn can have a negative impact on the Corporation’s financial and operating results.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None
ITEM 2. PROPERTIES
As of December 31, 2006, the Corporation owned twenty-one facilities, which consisted of two office buildings, eleven branches and eight parking lots. The Corporation occupies one hundred twenty-one leased branch premises, while warehouse space is rented in one location. In addition, office space is rented at the Torre Santander building, in Hato Rey Puerto Rico, at the Santander Tower in Galeria San Patricio building, in Guaynabo, Puerto Rico and at Professional Office Park IV building, in Río Piedras, Puerto Rico. The Corporation’s management believes that each of its facilities is well maintained and suitable for its purpose. The principal properties owned by Santander BanCorp for banking operations and other services are described below:
Banco Santander Main Building,a seven story corporate headquarters building located at 207 Ponce de León Avenue, Hato Rey, Puerto Rico. Banco Santander is the sole occupant.
Santander Operations Facility,a three story office building located at No. 3 Arterial Hostos Avenue, New San Juan Center, Hato Rey, Puerto Rico. The main activities conducted in this building are operations, management information systems, accounting, human resources and consumer banking. Evertec personnel occupies office space in this building for the proof and transit functions.
ITEM 3. LEGAL PROCEEDINGS
The Corporation is involved as plaintiff or defendant in a variety of routine litigation incidental to the normal course of business. Management believes, based on the opinion of legal counsel, that it has adequate defense with respect to such litigation and that any losses therefrom would not have a material adverse effect on the consolidated results of operations or consolidated financial condition of the Corporation.
On December 8, 2005, the Corporation received a subpoena from the SEC for the production of documents concerning its mortgage loan transactions with an unrelated local financial institution. The Corporation has provided information and has cooperated fully with the SEC in connection with these inquiries.
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Other than this matter, there are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Corporation or its subsidiary is a party or of which any of their property is subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDERS MATTERS
Santander BanCorp’s Common Stock, $2.50 par value (the “Common Stock”), is traded on the New York Stock Exchange (the “NYSE”) under the symbol “SBP”, and on the Madrid Stock Exchange (LATIBEX) under the symbol “XSBP”, respectively. The table below sets forth, for the calendar quarters indicated, the high and low sales prices on the NYSE during such periods.
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | Cash | | Book |
| | | | | | | | | | | Dividends | | Value |
| Period | | High | | Low | | per Share | | per Share |
| | | | | | | | | | | | | | | | | |
2006 | | | | | | | | | | | | | | | | |
| 1st Quarter | | $ | 25.98 | | | $ | 20.10 | | | $ | 0.16 | | | $ | 12.06 | |
| 2nd Quarter | | | 25.23 | | | | 22.47 | | | | 0.16 | | | | 11.93 | |
| 3rd Quarter | | | 24.45 | | | | 18.89 | | | | 0.16 | | | | 12.35 | |
| 4th Quarter | | | 19.80 | | | | 17.46 | | | | 0.16 | | | | 12.42 | |
| | | | | | | | | | | | | | | | | |
2005 | | | | | | | | | | | | | | | | |
| 1st Quarter | | $ | 33.93 | | | $ | 26.33 | | | $ | 0.16 | | | $ | 11.68 | |
| 2nd Quarter | | | 27.93 | | | | 20.88 | | | | 0.16 | | | | 12.25 | |
| 3rd Quarter | | | 29.75 | | | | 23.97 | | | | 0.16 | | | | 12.16 | |
| 4th Quarter | | | 29.47 | | | | 24.00 | | | | 0.16 | | | | 12.22 | |
As of December 31, 2006 the approximate number of record holders of the Corporation’s Common Stock was 145, which does not include beneficial owners whose shares are held in record names of brokers and nominees. The last sales price for the Common Stock as quoted on the NYSE on such date was $17.85 per share representing a market capitalization of $0.8 billion as of December 31, 2006.
Dividend Policy and Dividends Paid
The payment of dividends by the Corporation will depend on the earnings, cash position and capital needs of the Bank, its subsidiaries, general business conditions and other factors deemed relevant by the Corporation’s Board of Directors. The ability of the Corporation to pay dividends may be restricted also by various regulatory requirements and policies of regulatory agencies having jurisdiction over the Corporation and the Bank.
Dividends on the Corporation’s common stock are payable when, as and if declared by the Board of Directors of the Corporation, out of funds legally available therefor. The Corporation currently pays regular quarterly cash dividends. During 2004 the Corporation declared and paid cash dividends of $0.49 per common share for a total dividend payment to common shareholders of $21.9 million. During 2005 and 2006, the Corporation declared and paid cash dividends of $0.64 per common share, for a total dividend payment to common shareholders of $29.9 million. The annualized dividend yield for the year ended December 31, 2006 was 3.59%.
On July 9, 2004, the Board of Directors declared a 10% stock dividend to all shareholders of record as of July 20, 2004, payable on August 3, 2004 amounting to approximately 4.2 million shares. Cash was paid in lieu of fractional shares. The earnings per share computations for all periods presented in the accompanying financial information have been adjusted to reflect this stock dividend.
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Stock Performance Graph
The graph below shows the cumulative stockholder return of the Common Stock of the Corporation during the measurement period. The graph compares the return of the Common Stock of the Corporation (identified by its official symbol as “SBP”) to the cumulative return of the Puerto Rico Stock Index (PRSI) and the S&P Small Cap Commercial Bank Index (S6CBNK). The performance of the Common Stock and the mentioned indexes are valued using a base value of 100. The Common Stock value as of December 29, 2006 was $17.85. The Board of Directors of the Corporation acknowledges that the market price of the Common Stock is influenced by many factors. The stock price shown in the graph is not necessarily indicative of future performance.
This stock performance graph will not be deemed to be soliciting material under the proxy rules or incorporated by reference into any filing under the Securities Act or the Exchange Act, unless the Corporation specifically states otherwise.
ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected consolidated and other financial and operating information for the Corporation and subsidiaries and certain statistical information as of the dates and for the periods indicated. This information should be read in conjunction with the Corporation’s consolidated financial statements and the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Selected Statistical Information” appearing elsewhere in this Annual Report. The selected Balance Sheet and Statement of Income data as of and for the year ended December 31, 2006 and 2005 have been derived from the Corporation’s consolidated audited financial statements.
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Santander BanCorp and Subsidiaries
Selected Financial Data
| | | | | | | | | | | | | | | | | | | | | |
| | | Year ended December 31, | |
| | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | | | 2003 | | | 2002 | |
| | | (Dollars in thousands, except per data share) | |
| CONDENSED INCOME STATEMENTS | | | | | | | | | | | | | | | | | | | | |
| Interest income | | $ | 618,320 | | | $ | 439,605 | | | $ | 363,822 | | | $ | 335,784 | | | $ | 387,249 | |
| Interest expense | | | 327,714 | | | | 212,583 | | | | 140,762 | | | | 132,612 | | | | 179,748 | |
| | | | | | | | | | | | | | | | |
| Net interest income | | | 290,606 | | | | 227,022 | | | | 223,060 | | | | 203,172 | | | | 207,501 | |
| Security gains | | | — | | | | 17,842 | | | | 11,475 | | | | 10,790 | | | | 12,236 | |
| (Loss) gain on extinguishment of debt | | | — | | | | (5,959 | ) | | | — | | | | 13,638 | | | | — | |
| Broker-dealer, asset management and insurance fees | | | 56,973 | | | | 53,016 | | | | 51,113 | | | | 49,526 | | | | 35,277 | |
| Other income | | | 61,496 | | | | 60,459 | | | | 54,651 | | | | 36,207 | | | | 52,545 | |
| Operating expenses | | | 277,783 | | | | 221,386 | | | | 217,377 | | | | 223,815 | | | | 210,739 | |
| Provision for loan losses | | | 65,583 | | | | 20,400 | | | | 26,270 | | | | 49,745 | | | | 63,630 | |
| Income tax provision (benefit) | | | 22,540 | | | | 30,788 | | | | 9,724 | | | | (46 | ) | | | 4,907 | |
| | | | | | | | | | | | | | | | |
| Net income | | $ | 43,169 | | | $ | 79,806 | | | $ | 86,928 | | | $ | 39,819 | | | $ | 28,283 | |
| | | | | | | | | | | | | | | | |
| PER PREFERRED SHARE DATA | | | | | | | | | | | | | | | | | | | | |
| Outstanding shares: | | | | | | | | | | | | | | | | | | | | |
| Average | | | — | | | | — | | | | — | | | | 2,610,008 | | | | 2,610,008 | |
| End of period | | | — | | | | — | | | | — | | | | — | | | | 2,610,008 | |
| Cash Dividend per Share | | $ | — | | | $ | — | | | $ | — | | | $ | 2.73 | | | $ | 1.75 | |
| PER COMMON SHARE DATA* | | | | | | | | | | | | | | | | | | | | |
| Net income | | $ | 0.93 | | | $ | 1.71 | | | $ | 1.86 | | | $ | 0.70 | | | $ | 0.50 | |
| Book value | | $ | 12.42 | | | $ | 12.19 | | | $ | 11.86 | | | $ | 10.20 | | | $ | 12.79 | |
| Outstanding shares: | | | | | | | | | | | | | | | | | | | | |
| Average | | | 46,639,104 | | | | 46,639,104 | | | | 46,639,104 | | | | 46,661,248 | | | | 47,310,217 | |
| End of period | | | 46,639,104 | | | | 46,639,104 | | | | 46,639,104 | | | | 46,639,104 | | | | 46,806,604 | |
| Cash Dividend per Share | | $ | 0.64 | | | $ | 0.64 | | | $ | 0.49 | | | $ | 0.44 | | | $ | 0.44 | |
| AVERAGE BALANCES | | | | | | | | | | | | | | | | | | | | |
| Loans held for sale and loans, net of allowance for loan losses | | $ | 6,439,205 | | | $ | 5,871,433 | | | $ | 4,723,538 | | | $ | 4,009,801 | | | $ | 4,385,433 | |
| Allowance for loan losses (1) | | | 87,465 | | | | 67,956 | | | | 73,518 | | | | 64,909 | | | | 57,633 | |
| Earning assets | | | 8,262,748 | | | | 7,882,180 | | | | 7,300,735 | | | | 6,453,419 | | | | 6,629,265 | |
| Total assets | | | 8,820,630 | | | | 8,285,992 | | | | 7,634,471 | | | | 6,797,701 | | | | 7,013,135 | |
| Deposits | | | 5,054,687 | | | | 5,082,520 | | | | 4,153,245 | | | | 3,749,684 | | | | 4,096,818 | |
| Borrowings | | | 2,876,720 | | | | 2,415,172 | | | | 2,811,152 | | | | 2,322,957 | | | | 2,167,700 | |
| Preferred equity | | | — | | | | — | | | | — | | | | 64,175 | | | | 65,250 | |
| Common equity | | | 563,593 | | | | 576,226 | | | | 495,963 | | | | 526,660 | | | | 552,803 | |
| PERIOD END BALANCES | | | | | | | | | | | | | | | | | | | | |
| Loans held for sale and loans, net of allowance for loans losses | | $ | 6,836,693 | | | $ | 5,954,890 | | | $ | 5,490,120 | | | $ | 4,136,670 | | | $ | 4,044,425 | |
| Allowance for loan losses (1) | | | 106,863 | | | | 66,842 | | | | 69,177 | | | | 69,693 | | | | 56,906 | |
| Earning assets | | | 8,598,703 | | | | 7,933,139 | | | | 8,069,346 | | | | 7,079,888 | | | | 7,073,541 | |
| Total assets | | | 9,188,168 | | | | 8,271,948 | | | | 8,323,647 | | | | 7,366,656 | | | | 7,375,771 | |
| Deposits | | | 5,313,974 | | | | 5,224,650 | | | | 4,748,139 | | | | 4,142,228 | | | | 4,499,431 | |
| Borrowings | | | 2,954,515 | | | | 2,212,245 | | | | 2,863,367 | | | | 2,595,033 | | | | 2,130,593 | |
| Preferred equity | | | — | | | | — | | | | — | | | | — | | | | 65,250 | |
| Common equity | | | 579,220 | | | | 568,527 | | | | 553,346 | | | | 475,706 | | | | 533,205 | |
Continued on the following page
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Continued from the previous page
| | | | | | | | | | | | | | | | | | | | | |
| | | Year ended December 31, | |
| | | 2006 | | | 2005 | | | 2004 | | | 2003 | | | 2002 | |
| | | (Dollars in thousands) | |
SELECTED RATIOS | | | | | | | | | | | | | | | | | | | | |
Performance: | | | | | | | | | | | | | | | | | | | | |
| Net interest margin (2) | | | 3.63 | % | | | 3.02 | % | | | 3.33 | % | | | 3.42 | % | | | 3.33 | % |
| Efficiency ratio (3) | | | 66.82 | % | | | 62.97 | % | | | 62.78 | % | | | 67.06 | % | | | 68.31 | % |
| Return on average total assets | | | 0.49 | % | | | 0.96 | % | | | 1.14 | % | | | 0.59 | % | | | 0.40 | % |
| Return on average common equity | | | 7.66 | % | | | 13.85 | % | | | 17.53 | % | | | 5.54 | % | | | 3.84 | % |
| Dividend payout | | | 68.82 | % | | | 37.43 | % | | | 26.34 | % | | | 62.86 | % | | | 88.00 | % |
| Average net loans/average total deposits | | | 127.39 | % | | | 115.52 | % | | | 113.73 | % | | | 106.94 | % | | | 107.04 | % |
| Average earning assets/average total assets | | | 93.68 | % | | | 95.13 | % | | | 95.63 | % | | | 94.94 | % | | | 94.53 | % |
| Average stockholders’ equity/average assets | | | 6.39 | % | | | 6.95 | % | | | 6.50 | % | | | 8.69 | % | | | 8.81 | % |
| Fee income to average assets | | | 1.20 | % | | | 1.15 | % | | | 1.18 | % | | | 1.30 | % | | | 1.08 | % |
Capital: | | | | | | | | | | | | | | | | | | | | |
| Tier I capital to risk-adjusted assets | | | 7.87 | % | | | 9.09 | % | | | 8.63 | % | | | 8.47 | % | | | 11.51 | % |
| Total capital to risk-adjusted assets | | | 10.93 | % | | | 12.30 | % | | | 11.05 | % | | | 10.03 | % | | | 12.71 | % |
| Leverage Ratio | | | 5.81 | % | | | 6.50 | % | | | 6.43 | % | | | 5.89 | % | | | 8.37 | % |
Asset quality: | | | | | | | | | | | | | | | | | | | | |
| Non-performing loans to total loans | | | 1.54 | % | | | 1.22 | % | | | 1.57 | % | | | 2.34 | % | | | 3.01 | % |
| Annualized net charge-offs to average loans | | | 0.93 | % | | | 0.38 | % | | | 0.56 | % | | | 0.91 | % | | | 1.32 | % |
| Allowance for loan losses to period-end loans | | | 1.54 | % | | | 1.11 | % | | | 1.24 | % | | | 1.66 | % | | | 1.39 | % |
| Allowance for loan losses to non-performing loans | | | 100.01 | % | | | 90.72 | % | | | 79.05 | % | | | 70.85 | % | | | 46.10 | % |
| Allowance for loan losses to non-performing loans plus accruing loans past-due 90 days or more | | | 83.62 | % | | | 87.17 | % | | | 76.11 | % | | | 69.16 | % | | | 44.68 | % |
| Non-performing assets to total assets | | | 1.23 | % | | | 0.92 | % | | | 1.10 | % | | | 1.40 | % | | | 1.91 | % |
| Recoveries to charge-offs | | | 9.30 | % | | | 18.28 | % | | | 32.83 | % | | | 22.12 | % | | | 15.77 | % |
EARNINGS TO FIXED CHARGES: | | | | | | | | | | | | | | | | | | | | |
| Excluding interest on deposits | | | 1.42 | x | | | 2.19 | x | | | 2.17 | x | | | 1.51 | x | | | 1.34 | x |
| Including interest on deposits | | | 1.20 | x | | | 1.51 | x | | | 1.68 | x | | | 1.30 | x | | | 1.18 | x |
EARNINGS TO FIXED CHARGES AND PREFERRED STOCK DIVIDENDS: | | | | | | | | | | | | | | | | | | | | |
| Excluding interest on deposits | | | 1.42 | x | | | 2.19 | x | | | 2.17 | x | | | 1.38 | x | | | 1.27 | x |
| Including interest on deposits | | | 1.20 | x | | | 1.51 | x | | | 1.68 | x | | | 1.23 | x | | | 1.15 | x |
OTHER DATA AT END OF PERIOD | | | | | | | | | | | | | | | | | | | | |
| Customer financial assets under management | | $ | 14,154,000 | | | $ | 12,960,000 | | | $ | 12,827,700 | | | $ | 10,669,700 | | | $ | 9,242,600 | |
| | | | | | | | | | | | | | | | | | | | | |
| Full services branches | | | 61 | | | | 64 | | | | 65 | | | | 66 | | | | 66 | |
| Consumer Financial branches | | | 70 | | | | — | | | | — | | | | — | | | | — | |
| | | | | | | | | | | | | | | | |
| Total branches | | | 131 | | | | 64 | | | | 65 | | | | 66 | | | | 66 | |
| ATMs | | | 144 | | | | 149 | | | | 150 | | | | 141 | | | | 139 | |
| | |
| * | | Share and per share data is based on the average number of shares outstanding during the periods, after giving retroactive effect in 2003 and 2002, to the 10% stock dividends declared on July 9, 2004. Basic and diluted earning per share are the same. |
| |
| (1) | | After retroactive reclassification adjustment of allowance for losses on off balance sheet items for the years ended December 31, 2003 and 2002. |
| |
| (2) | | On a tax equivalent basis. |
| |
| (3) | | Operating expenses divided by net interest income on a tax equivalent basis, plus other income excluding securities gains and losses, gain on sale of FDIC assessement credits and gain on tax credits purchased in 2006, (loss) gain on extinguisment of debt in 2003 and 2005 and gain on sale of building in 2004. |
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Description of the Business
Santander BanCorp and subsidiaries (the “Corporation”) is a diversified financial holding company headquartered in San Juan, Puerto Rico, offering a full range of financial products and services to consumers and commercial customers through its subsidiaries. The Corporation’s subsidiaries are engaged in the following businesses:
| • | | Commercial Banking — Banco Santander Puerto Rico |
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| • | | Mortgage Banking — Santander Mortgage Corporation |
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| • | | Securities Brokerage and Investment Banking — Santander Securities Corporation |
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| • | | Asset Management — Santander Asset Management Corporation |
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| • | | Consumer Finance — Santander Financial Services, Inc. |
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| • | | Insurance — Santander Insurance Agency, Inc. and Island Insurance Corporation |
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| • | | International Banking — Santander International Bank of Puerto Rico, Inc. |
Basis of Presentation
The Corporation’s financial statements are prepared in conformity with accounting principles generally accepted in the United States of America and with general practices within the financial services industry, which are described in the notes to the consolidated financial statements. In preparing the consolidated financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Accounting policies that are critical to the overall financial statements are fully described in the “Critical Accounting Policies” section below.
On July 9, 2004, the Corporation declared a 10% stock dividend to all common shareholders of record as of July 20, 2004. All share and per share computations for 2003 and 2002 were restated to reflect the stock dividend.
Forward-Looking Statements
This discussion of financial results contains forward-looking statements about the Corporation. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words or phrases like “would be”, “will allow”, “intends to”, “will likely result”, “are expected to”, “will continue”, “is anticipated”, “estimate”, “project”, “believe”, or similar expressions and are intended to identify “forward looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.
The future results of the Corporation could be affected by subsequent events and could differ materially from those expressed in forward-looking statements. If future events and actual performance differ from the Corporation’s assumptions, the actual results could vary significantly from the performance projected in the forward-looking statements. The Corporation wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made, and to advise readers that various factors, including regional and national conditions, substantial changes in levels of market interest rates, credit and other risks of lending and investment activities, competitive and regulatory factors and legislative changes, could affect the Corporation’s financial performance and could cause the Corporation’s actual results for future periods to differ materially from those anticipated or projected. The Corporation does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.
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Overview of Management’s Discussion and Analysis of Financial Condition and Results of Operations
This overview of management’s discussion and analysis highlights selected information in this document and may not contain all of the information that is important to the reader. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting estimates, you should carefully read this entire document. All accompanying tables, financial statements and notes included elsewhere in this report should be considered an integral part of this analysis.
The Corporation reported net income of $43.2 million for the year ended December 31, 2006, or $0.93 per common share decreasing $36.6 million or 45.9% from $79.8 million for the year ended December 31, 2005. This decrease in net income was principally due to: (i) a decrease of $11.8 million in gain on sale of securities (net of loss on extinguishment of debt); (ii) an increase in operating expenses of $56.4 million comprised of $44.5 million pertaining to the Island Finance operation, and $10.4 million related to a personnel reduction program implemented during the third quarter of 2006; (iii) a $5.9 million decrease in gain on sale of loans; and partially offset by an increase of $19.6 in net interest income after provision for loan losses and a decrease in income tax expense of $8.2 million. The increase in net interest income, provision for loan losses and operating expenses during the period is primarily associated with the Island Finance operation.
Earnings per common share for the year ended December 31, 2006 were $0.93 decreasing by $0.78 from $1.71 for the year ended December 31, 2005. Return on average common equity (ROE) and return on average assets (ROA) were 7.66% and 0.49%, respectively, for the year ended December 31, 2006, reflecting a decrease of 619 basis points in ROE and 47 basis points in ROA when compared to ROE and ROA of 13.85% and 0.96%, respectively, for the year ended December 31, 2005. The efficiency ratio (on a tax-equivalent basis) for the year ended December 31, 2006, was 66.82%, a decline of 385 basis point compared 62.97% for the same period in 2005.
Income before provision for income tax reflected a decrease of $44.9 million or 40.6% to $65.7 million for the year ended December 31, 2006, compared with $110.6 million for the same period in 2005. This change was principally attributed to a decrease in other income of $6.9 million or 5.5% and an increase in operating expenses of $56.4 million or 25.5% for the year ended in December 31, 2006 compared with the year ended December 31, 2005. This increase was offset by an improvement in net interest income before provision for loan losses of $63.6 million or 28.0% for the same period.
The Corporation’s principal source of revenues is net interest income, which is the difference between the interest earned on loans and investments and the interest paid on customer deposits and other interest-bearing liabilities. Net interest income represents approximately 39.4% of the Corporation’s total revenues (defined as interest income plus other income) for 2006. Net interest income is affected by the relative amounts of interest-earning assets and interest-bearing liabilities, and the interest rates earned or paid on these balances.
Lending activities are one of the most important aspects of the Corporation’s operations. As a result of management’s focus on regaining market share and the acquisition of Island Finance operations, the net loan portfolio continued to increase during 2006. The net loan portfolio, including loans held for sale, increased $0.9 billion, or 14.8% reaching $6.8 billion at December 31, 2006, compared to $6.0 billion at December 31, 2005. As of December 31, 2006, the allowance for loan losses reached $106.9 million, reflecting an increase of $40.0 million or 59.9%, which includes $41.3 million related to Island Finance portfolio. Excluding Island Finance figures, the allowance for loan losses decreased 1.9% or $1.3 million compared to $66.8 million at December 31, 2005, as result of the continued effort to improve the credit quality and the collection process. The ratio of allowance for loan losses to total loans increased to 1.54% at December 31, 2006 from 1.11% at December 31, 2005.
Although the Corporation has diversified its sources of revenues, interest income from the loan portfolio continues to account for the majority of total revenues, representing 72.7% of total gross revenues for 2006. As a result, the primary influence on the Corporation’s operating results is the demand for loans in Puerto Rico, which is significantly affected by economic conditions, competition, the demand and supply of housing, the fiscal policies of the federal and Puerto Rico governments and interest rate levels. Changes in interest rates, the Corporation’s principal market risk, can significantly impact its results of operations by affecting net interest income and the gains or losses realized on the sale of loans and securities. As described under “Risk Management”, the Corporation uses derivative instruments to hedge, to a limited extent, its interest rate risk in order to protect its net interest income under different interest rate scenarios.
Broker-dealer, asset management and insurance fees accounted for 48.1% of the Corporation’s other income and 13.9% of its total revenues for 2006. The Corporation also earns revenues from other sources that are not as dependent on interest levels, such as bank service fees on deposit accounts and credit card fees. Other income, including broker-dealer, asset management and insurance fees, accounted for 16.1% of total revenues for 2006.
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Operating expenses increased $56.4 million or 25.5% from $221.4 million for the year ended December 31, 2005 to $277.8 million for the same period in 2006. This increase was due in part to the operating expenses of Island Finance of $44.5 million and a personnel reduction program of $10.4 million in 2006. For the year ended December 31, 2006 there were increases in salaries and employee benefits of $26.7 million together with an increase in other operating expenses of $29.7million. Excluding the Island Finance operation and expenses related to the personnel reduction program, operating expenses increased by 8.1% and 0.7%, respectively, for the quarter and the year ended December 31, 2006.
Deposits at December 31, 2006 were $5.3 billion, reflecting an increase of $89.3 million or 1.7% compared to deposits of $5.2 billion as of December 31, 2005.
Total borrowings at December 31, 2006 (comprised of federal funds purchased and other borrowings, securities sold under agreements to repurchase, commercial paper issued, term and capital notes) reflected an increase of $742.3 million or 33.6% to $3.0 billion at December 31, 2006 compared with $2.2 billion at December 31, 2005. This increase was due principally to the debt incurred pursuant to the acquisition of Island Finance.
As of December 31, 2006, the Company had $14.2 billion in customer financial assets under management, reflecting an increase of 9.1% compared with prior year. This is a significant part of the financial assets of Puerto Rico households and reflects the Corporation’s strong positioning in its primary market. Customer financial assets under management include bank deposits (excluding brokered deposits), broker-dealer customer accounts, mutual fund assets managed, and trust, institutional and private accounts under management. The growth in customer financial assets and the stability of customer deposits is a strong indication of the Corporation’s successful efforts to regain market share and reposition as a leading provider of financial services. Included in the $14.2 billion referred to above, approximately $1.2 billion from the trust business recently sold would be transferred either to the acquiring financial institution or any other institution that the trust client elects during the first semester of 2007.
SBP common stock price per share was $17.85 as of December 31, 2006 resulting in a market capitalization of $0.8 billion (including affiliated holdings).
During the fourth quarter of 2006, Santander BanCorp declared and paid a cash dividend of 16 cents per common share to its shareholders of record, resulting in a current annual dividend yield of 3.6%.
During 2006 the Corporation dedicated significant effort and resources to the acquisition of Island Finance. On February 28, 2006 the Corporation acquired substantially all the assets and business operations in Puerto Rico of Island Finance for $742 million. The Island Finance operation was acquired by Santander Financial Services, Inc. (“Santander Financial”) a 100% owned subsidiary of the Corporation. In connection with this transaction the Corporation entered into a $725 million loan agreement with Santusa Holding, S.L., a subsidiary of its parent company. The Corporation also completed the private placement of $125 million Trust Preferred Securities (“Preferred Securities”) and issued Junior Subordinated Debentures in the aggregate principal amount of $129 million in connection with the issuance of the Preferred Securities. The Preferred Securities are classified as subordinated notes and the dividends as interest expense in the accompanying condensed consolidated financial statements. As a result of this acquisition the Corporation increased its presence throughout Puerto Rico to 131 branches due to Island Finance’s extensive branch network, and also diversified and increased its loan portfolio, consumer client base and improved its net interest margin.
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The table below presents condensed results of operations and selected financial information of Island Finance for the ten months (since acquisition) ended December 31, 2006.
| | | | | |
| | | Ten months | |
| | | Ended | |
| Santander Financial Services | | December 31, 2006 | |
| | | ($ in thousands) | |
Condensed Statement of Income | | | | |
| Interest income | | $ | 118,154 | |
| Interest expense | | | (34,738 | ) |
| | | | |
| Net interest income | | | 83,416 | |
| Provision for loan losses | | | (43,208 | ) |
| | | | |
| Net interest income after provision for loan losses | | | 40,208 | |
| Other income | | | 3,006 | |
| Operating expenses | | | (44,501 | ) |
| | | | |
| Loss before tax | | | (1,287 | ) |
| Income tax benefit | | | (486 | ) |
| | | | |
Net loss of Santander Financial | | $ | (801 | ) |
| | | | |
| | | | | |
Other Selected Information | | | | |
| Total assets | | $ | 805,173 | |
| Net loans | | | 583,986 | |
| Allowance for loan losses | | | 41,281 | |
| Non performing loans | | | 24,731 | |
| Net interest margin | | | 16.59 | % |
| | | | | |
Other indirect enterprise information: | | | | |
| Credit insurance commissions, net of income tax | | $ | 2,894 | |
| Interest expense mark-up (to Santander BanCorp), net of income tax | | $ | 2,505 | |
Critical Accounting Policies
The consolidated financial statements of Santander BanCorp are prepared in accordance with accounting principles generally accepted in the United States of America and with general practices within the financial services industry. In preparing the consolidated financial statements, management is required to make judgments, involving significant estimates and assumptions, in the application of its accounting policies about matters that are inherently uncertain. Management arrives at these estimates and assumptions, which may materially affect the reported amounts of certain assets, liabilities, revenues and expenses, considering the facts and circumstances at a specific point in time. Changes in those facts and circumstances could produce actual results that differ from those estimates. Detailed below is a discussion of the Corporation’s critical accounting policies. These policies are critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates. For a complete discussion of the Corporation’s significant and critical accounting policies refer to the notes to the consolidated financial statements and the discussion throughout this document which should be read in conjunction with this section.
Allowance for Loan Losses. The Corporation assesses the overall risks in its loan portfolio and establishes and maintains a reserve for probable losses thereon. The allowance for loan losses is maintained at a level sufficient to provide for estimated loan losses based on the evaluation of known and inherent risks in the Corporation’s loan portfolio. The Corporation’s management evaluates the adequacy of the allowance for loan losses on a monthly basis.
The determination of the allowance for loan losses is one of the most complex and critical accounting estimates the Corporation’s management makes. The allowance for loan losses is composed of three different components. An asset-specific reserve based on the provisions of Statements of Financial Accounting Standards (“SFAS”) No. 114 “Accounting by Creditors for Impairment of a Loan” (as amended), an expected loss estimate based on the provisions of SFAS No. 5 “Accounting for Contingencies”, and an unallocated reserve based on the effect of probable economic deterioration above and beyond what is reflected in the asset-specific component of the allowance.
Commercial and construction loans exceeding a predetermined monetary threshold are identified for evaluation of impairment on an individual basis pursuant to SFAS No. 114. The Corporation considers a loan impaired when interest and/or principal is past due 90 days or more, or, when based on current information and events it is probable that the Corporation will be unable to
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collect all amounts due according to the contractual terms of the loan agreement. The asset-specific reserve on each individual loan identified as impaired is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except as a practical expedient, the Corporation may measure impairment based on the loan’s observable market price, or the fair value of the collateral, net of estimated disposal costs, if the loan is collateral dependent. Most of the asset-specific reserves of the Corporation’s impaired loans are measured on the basis of the fair value of the collateral.
A reserve for expected losses is determined under the provisions of SFAS No. 5 for all loans not evaluated individually for impairment, based on historical loss experience by loan type, management judgment of the quantitative factors (historical net charge-offs, statistical loss estimates, etc.), as well as qualitative factors (current economic conditions, portfolio composition, delinquency trends, industry concentrations, etc.). The Corporation groups small homogeneous loans by type of loan (consumer, credit card, mortgage, auto, etc.) and applies a loss factor, which is determined using an average history of actual net losses over the previous 2 to 3 years and other statistical loss estimates. Historical loss rates are reviewed at least quarterly and adjusted based on changing borrower and/or collateral conditions and actual collections and charge-off experience. Historical loss rates for the different portfolios may be adjusted for significant factors that in management’s judgment reflect the impact of any current conditions on loss recognition. Factors that management considers in the analysis include the effect of the trends in the nature and volume of loans (delinquency, charge-offs, non accrual), changes in the mix or type of collateral, asset quality trends, changes in the internal lending policies and credit standards, collection practices and examination results from internal and external agencies.
An additional or unallocated reserve is maintained to cover the effect of probable economic deterioration above and beyond what is reflected in the asset-specific component of the allowance. This component represents management’s view that given the complexities of the lending portfolio and the assessment process, including the inherent imprecision in the financial models used in the loss forecasting process, there are estimable losses that have been incurred but not yet specifically identified, and as a result not fully provided for in the asset-specific component of the allowance. The level of the unallocated reserve may change periodically after evaluating factors impacting assumptions used in the calculation of the asset specific component of the reserve.
The underlying assumptions, estimates and assessments used by management to determine the components of the allowance for loan losses are periodically evaluated and updated to reflect management’s current view of overall economic conditions and other relevant factors impacting credit quality and inherent losses. Changes in such estimates could significantly impact the allowance and provision for loan losses. The Corporation could experience loan losses that are different from the current estimates made by management. Based on current and expected economic conditions, the expected level of net loan losses and the methodology established to evaluate the adequacy of the allowance for loan losses, management considers that the Corporation has established an adequate position in its allowance for loan losses. Refer to the allowance for loan losses section for further information.
Valuation of Certain Financial Instruments. Certain financial instruments including derivatives, hedged items, trading and investment securities available for sale, are recorded at fair value and unrealized gains and losses are recorded in other comprehensive income or other gains and losses, as appropriate. Fair values for most of the Corporation’s trading and investment securities are based on listed market prices, if available. If listed market prices are not available, fair value is determined based on other relevant factors including price quotations for similar instruments. For securities where listed market prices are not readily available, the determination of the fair value requires management judgment as to the benchmark to be used. Significant changes in factors such as interest rates and accelerated prepayment rates could affect the value of the trading and investment securities. Management assesses the fair value of its portfolio at least monthly. Any impairment that is considered other than temporary is recorded in the consolidated statement of income.
Fair values for certain derivative contracts are derived from pricing models that consider current market and contractual prices for the underlying financial instruments, counterparty credit risk, as well as time value and yield curve or volatility factors underlying the positions. Management applies judgment in determining the models used and required adjustment to such models, if any, in the valuation process. The primary risk of material changes to the value of the derivative instruments is the fluctuation in interest rates. However, the Corporation uses derivative instruments principally as part of a designated hedging program so that a change in the value of a derivative is generally offset by a corresponding change in the value of the hedged item. Changes in these estimates may have a significant impact on the carrying amount and the related valuation gains and losses on these financial instruments.
Management believes that its estimates of fair value are reasonable given the process of obtaining external prices, periodic reviews of internal models by affiliated and unaffiliated experts, and the consistent application of methodologies.
Transfers of Financial Assets. The Corporation occasionally engages in transfers of financial assets and accounts for them in accordance with the provisions of SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities — a replacement of FASB Statement No. 125” (SFAS No. 140). Paragraph 9 of SFAS No. 140 provides that a transfer of financial assets in which the transferor surrenders control over those financial assets shall be
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accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. A transferor has surrendered control if all of the following conditions are met: (a) the transferred assets have been isolated from the transferor—put presumptively beyond the reach of creditors, even in bankruptcy; (b) each transferee has the right to pledge or exchange the assets it received and no condition constrains the transferee from taking advantage of its right to pledge or exchange; and (c) the transferor does not maintain effective control over the transferred assets through either (i) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (ii) the ability to unilaterally cause the holder to return specified assets, other than through a cleanup call. In accordance with SFAS No. 140, a gain or loss on the sale is recognized based on the carrying amount of the financial assets involved in the transfer, allocated between the assets transferred and the retained interests based on their relative fair value at the date of transfer. When the Corporation transfers financial assets and the transfer fails any one of the SFAS No. 140 sales criteria, the Corporation is not permitted to derecognize the transferred financial assets and the transaction is accounted for as a secured borrowing.
Income taxes. In preparing the consolidated financial statements, the Corporation is required to estimate income taxes. This involves an estimation of current income tax expense together with an assessment of temporary differences resulting from differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The determination of current income tax expense involves estimates and assumptions that require the Corporation to assume certain positions based on its interpretation of current tax regulations. Changes in assumptions affecting estimates may be required in the future and estimated tax liabilities may need to be increased or decreased accordingly. The accrual for tax contingencies is adjusted in light of changing facts and circumstances, such as the progress of tax audits, case law and emerging legislation. The Corporation’s effective tax rate includes the impact of tax contingency accruals and changes to such accruals, including related interest and penalties, as considered appropriate by management. When particular matters arise, a number of years may elapse before such matters are audited by the taxing authorities and finally resolved. Favorable resolution of such matters or the expiration of the statute of limitations may result in the release of tax contingencies, which are recognized as a reduction to the Corporation’s effective rate in the year of resolution. Unfavorable settlement of any particular issue could increase the effective rate and may require the use of cash in the year of resolution.
The determination of deferred tax expense or benefit is based on changes in the carrying amounts of assets and liabilities that generate temporary differences. The carrying value of the Corporation’s net deferred tax assets assumes that the Corporation will be able to generate sufficient future taxable income based on estimates and assumptions. If these estimates and related assumptions change, the Corporation may be required to record valuation allowances against its deferred tax assets resulting in additional income tax expense in the consolidated statements of income. Management evaluates its deferred tax assets on a quarterly basis and assesses the need for a valuation allowance. A valuation allowance is established when management believes that it is more likely than not that some portion of its deferred tax assets will not be realized. Changes in valuation allowance from period to period are included in the Corporation’s tax provision in the period of change. During the year ended December 31, 2006, the Corporation had no recorded valuation allowances related to its net deferred tax assets (see Note 15 to the consolidated financial statements).
Goodwill and other intangible assets. The Corporation accounts for goodwill in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” The reporting units are tested annually as of the end of the third quarter of each year to determine whether their carrying value exceeds their fair market value. Should this be the case, the value of goodwill or indefinite-lived intangibles may be impaired and written down. Goodwill and other indefinite lived intangible assets are also tested for impairment on an interim basis if an event occurs or circumstances change between annual tests that would more likely than not reduce the fair value of the reporting unit below its carrying amount. If there is a determination that the fair value of the goodwill or other identifiable intangible asset is less than the carrying value, an impairment loss is recognized in an amount equal to the difference. Impairment losses, if any, are reflected in operating income in the consolidated statement of income.
The Corporation uses judgment in assessing goodwill and intangible assets for impairment. Estimates of fair value are based on projections of revenues, operating costs and cash flows of each reporting unit considering historical and anticipated future results, general economic and market conditions as well as the impact of planned business or operational strategies. The valuations employ a combination of present value techniques to measure fair value and consider market factors. Generally, the Corporation engages third party specialists to assist with its valuations. Additionally, judgment is used in determining the useful lives of finite-lived intangible assets. Changes in judgments and projections could result in a significantly different estimate of the fair value of the reporting units and could result in an impairment of goodwill.
As a result of the purchase price allocations from prior acquisitions and the Corporation’s decentralized structure, goodwill is included in multiple reporting units. Due to certain factors such as the highly competitive environment, cyclical nature of the business in some of the reporting units, general economic and market conditions as well as planned business or operational strategies, among others, the profitability of the Corporation’s individual reporting units may periodically suffer from downturns in these factors. These factors may have a relatively more pronounced impact on the individual reporting units as compared to the Corporation as a whole and might adversely affect the fair value of the reporting units. If material adverse
33
conditions occur that impact the Corporation’s reporting units, the Corporation’s reporting units, and the related goodwill would need to be written down to an amount considered recoverable.
The Corporation’s goodwill, resulted from business acquisitions, and consists of $10.5 million that resulted from the acquisition by the Bank of Banco Central Hispano P.R., $24.3 million that resulted from the acquisition by Santander Securities of the acquisition of Merryll Lynch’s retail brokerage business in Puerto Rico and $113.5 million that resulted from the acquisition of Island Finance. The value of the goodwill is inherent primarily in the commercial banking segment, the wealth management segment and consumer finance segment, respectively.
The sustained value of the goodwill is supported ultimately by revenue from the commercial banking segment, the wealth management segment and the consumer finance segment. A decline in earnings as a result of a lack of growth, or our inability to deliver cost effective services over sustained periods, could lead to a perceived impairment of goodwill, which would be evaluated and, if necessary be recorded as a write-down in the consolidated statement of income.
On an annual basis, or more frequently if circumstances dictate, management reviews goodwill and evaluates events or other developments that may indicate impairment in the carrying amount. The evaluation for potential impairment is inherently complex, and involves significant judgment in the use of estimates and assumptions.
To determine the fair value of the reporting units being evaluated for goodwill impairment, the Corporation used an independent consultant. The determination of the fair value of the reporting units involves the use of estimates and assumptions including expected results of operations, an assumed discount rate and an assumed growth rate for the reporting units. Specifically, the independent consultant prepared analyses regarding the fair value of equity of the Corporation’s reporting units, Commercial Banking, Wealth Management and Consumer Finance. The consultant used three separate valuation approaches:
Market Multiple Approach: provides indications of value based upon comparisons of the Reporting Unit to market values and pricing evidence of public companies in the same or similar lines of businesses. Market ratios (pricing multiples) and performance fundamentals relating the public companies’ stock prices (equity) or enterprise values to certain underlying fundamental data are applied to the Reporting Unit to determine indications of its fair value.
Comparable Transaction Approach: includes an examination of recent transactions in which companies involved in the same or similar lines of business to the Reporting Unit were acquired. Acquisition values and pricing evidence are used in much the same manner as the Market Multiple Approach for indication of the Reporting Unit’s fair value.
Discounted Cash Flow Approach: calculates the present value of the projected future cash flows to be generated by the Reporting Unit using appropriate discount rates. The discount rates are intended to reflect all associated risks of realizing the projected future cash flows. Terminal values are computed as of the end of the last period for which cash flows are projected to determine an estimate of the values of the Reporting Unit as of that future point in time. Discounting the terminal values back to the present and adding the present values of the future cash flows yields indications of the Reporting Unit’s fair value.
Events that may indicate goodwill impairment include significant or adverse changes in the business, economic or political climate; unanticipated competition; adverse action or assessment by a regulator; plans for disposition of a segment; among others.
Due to the adverse economic conditions in Puerto Rico during 2006, the Corporation used an independent consultant to perform an interim goodwill impairment test for Island Finance as of September 30, 2006, even though only seven months had passed since its acquisition. As a result of the interim impairment test performed on this reporting unit, management determined that the Consumer Finance goodwill was not impaired. The Corporation will continue to closely monitor this reporting unit in order to anticipate any possible deterioration in the value of its goodwill.
In assessing the recoverability of goodwill and other intangibles, the Corporation must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, the Corporation may be required to record impairment charges for these assets not previously recorded. Based on management’s assessment of the value of the Corporation’s goodwill which includes an independent valuation, among others, management determined that the Corporation’s goodwill was not impaired. The key assumptions used by management to determine the fair value of the reporting units include company specific risk elements that are consistent
34
with the risks inherent in its current business models for each reporting unit. Changes in judgment and estimates could result in a significantly different estimate of the fair value of the reporting units and could result in an impairment of goodwill.
Intangible assets, with an indefinite life, are not amortized and are tested for impairment at least annually comparing the fair value with the carrying amount of those assets. In determining the indefinite life for those assets, the Corporation considers the expected cash flows and several factors such as legal, regulatory, economic, contractual, competition and others, which could limit the useful life.
Tangible and intangible assets with finite useful lives are amortized over their estimated useful lives. Useful lives are based on management’s estimates of the period that the assets will generate revenue. If circumstances and conditions indicate deterioration in the value of tangible assets and intangible assets with finite useful lives, the book value would be adjusted and a loss would be recognized in current operations. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the Corporation reviews finite-lived intangible assets for impairment whenever an event occurs or circumstances change which indicates that the carrying amount of such assets may not be fully recoverable. Measurement of an impairment loss is based on the fair value of the asset compared to its carrying value. If the fair value of the asset is determined to be less than the carrying value, an impairment loss is incurred in an amount equal to the difference. Impairment losses, if any, are reflected in operating income in the consolidated statement of income. The Corporation concluded that there was no impairment for the year ended 2006.
Pension and Other Postemployment Benefits. The determination of the Corporation’s obligation and expense for pension and other postretirement benefits is dependent on the selection of certain assumptions used by actuaries in calculating such amounts. Those assumptions are described in Note 17 to the consolidated financial statements and include, among others, the discount rate, expected long-term rate of return on plan assets and rates of increase in compensation and healthcare costs. Management participates in the determination of these factors, which normally undergo evaluation against industry assumptions, among other factors. In accordance with accounting principles generally accepted in the United States of America, actual results that differ from the Corporation’s assumptions are accumulated and amortized over future periods and therefore, generally affect recognized expense and recorded obligation in such future periods. The Corporation uses an independent actuarial firm for the determination of the pension and post-retirement benefit costs and obligations.
In September 2006, the FASB issued SFAS No. 158 which requires recognition of a plan’s over-funded or under-funded status as an asset or liability with an offsetting adjustment to accumulated other comprehensive income (AOCI). Actuarial gains or losses, prior service costs and transition assets or obligations will be subsequently recognized as components of net periodic benefit costs. Additional minimum pension liabilities (AMPL) and related intangible assets are derecognized upon adoption of the standard.
In developing the expected return on plan assets, the Corporation considers the asset allocation, historical returns on the types of assets held in the pension trust, the current economic environment, as well as input from the actuaries, financial analysts and the Corporation’s long-term inflation assumptions and interest rate scenarios. The expected rate of return for plan assets was set at 8.5% for the years ended December 31, 2006, 2005 and 2004. In selecting a discount rate, the Corporation considers the Moody’s long-term AA Corporate Bond yield as a guide. At December 31, 2006, the Corporation’s discount rate was 5.75%.
Management believes that the assumptions made are appropriate; however, significant differences in actual experience or significant changes in assumptions may materially affect pension obligations and future expense.
Results of Operations
The following financial discussion is based upon and should be read in conjunction with the Corporation’s consolidated financial statements for the years ended December 31, 2006, 2005, and 2004.
The following table sets forth the principal components of the Corporation’s net income for the years ended December 31, 2006, 2005 and 2004.
35
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars in thousands) | |
Components of net income: | | | | | | | | | | | | |
| Net interest income | | $ | 290,606 | | | $ | 227,022 | | | $ | 223,060 | |
| Provision for loan losses | | | 65,583 | | | | 20,400 | | | | 26,270 | |
| Other income | | | 118,469 | | | | 125,358 | | | | 117,239 | |
| Other operating expenses | | | 277,783 | | | | 221,386 | | | | 217,377 | |
| Provision for income tax | | | 22,540 | | | | 30,788 | | | | 9,724 | |
| | | | | | | | | | |
| Net income | | $ | 43,169 | | | $ | 79,806 | | | $ | 86,928 | |
| | | | | | | | | | |
2006 compared to 2005.The Corporation’s net income decreased $36.6 million or 45.9% for the year ended December 31, 2006 compared to figures reported in 2005. This decrease was principally due to an increase of $56.4 million or 25.5% in other operating expenses and $45.2 million or 221.5% in provision for loan losses and decreases of $6.9 million or 5.5% in other income. The increase in operating expenses was mainly due to Island Finance operations and expenses related to the personnel reduction program. These changes were partially offset by an increase in net interest income of $63.6 million and decrease in provision for income tax of $8.2 million.
2005 compared to 2004. The Corporation’s net income decreased $7.1 million, or 8.2%, for the year ended December 31, 2005 compared to the same period in 2004. This effect was principally due to an increase of $21.1 million and $4.0 million in provision for income tax and in other operating expenses, respectively. These changes were partially offset by an increase in net interest income and other income of $9.8 million and $8.1 million, respectively, and a decrease in the provision for loan losses of $5.9 million.
Net Interest Income
The Corporation reported net interest income of $290.6 million, $227.0 million and $223.1 million for the years ended December 31, 2006, 2005, and 2004, respectively.
To facilitate the comparison of assets with different tax attributes, the interest income on tax-exempt assets under this heading and under the heading “Change in Interest Income and Interest Expense—Volume and Rate Analysis,” has been adjusted by an amount equal to the income taxes which would have been paid had the interest income been fully taxable. This tax equivalent adjustment is derived using the applicable statutory tax rate and resulted in an adjustment of $9.0 million in 2006, $11.1 million in 2005 and $20.2 million in 2004.
The following table sets forth the principal components of the Corporation’s net interest income for the years ended December 31, 2006, 2005 and 2004.
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars in thousands) | |
| | | | | | | | | | | | | |
| Interest income — tax equivalent basis | | $ | 627,306 | | | $ | 450,664 | | | $ | 383,984 | |
| Interest expense | | | (327,714 | ) | | | (212,583 | ) | | | (140,762 | ) |
| | | | | | | | | | |
| Net interest income — tax equivalent basis | | $ | 299,592 | | | $ | 238,081 | | | $ | 243,222 | |
| | | | | | | | | | |
| Net interest margin — tax equivalent basis (1) | | | 3.63 | % | | | 3.02 | % | | | 3.33 | % |
| | |
| (1) | | Net interest margin for any period equals tax-equivalent net interest income divided by average interest-earning assets for such period. |
2006 compared to 2005.For the year ended December 31, 2006, net interest margin, on a tax equivalent basis, was 3.63% compared with 3.02% for the same period in 2005. This increase of 61 basis points in net interest margin was mainly due to an increase of 187 basis points in the yield on average interest earning assets primarily as a result of the acquisition of the assets of Island Finance. Excluding the Island Finance operation, net interest margin, on a tax equivalent basis, for the year ended December 31, 2006 is 2.80%, a decrease of 22 basis points compared to December 31, 2005. Interest income, on a tax equivalent basis increased $176.6 million or 39.2% during the year ended December 31, 2006 compared to the same period in
36
2005, while interest expense increased $115.1 million or 54.2% over the same period. The increase in interest income, on a tax equivalent basis, was mainly due to an increase in interest income on average net loans of $176.9 million from $361.7 million in 2005 to $538.7 million in 2006.
Average interest-earning assets increased $380.6 million or 4.8% to $8.3 billion at December 31, 2006 compared with December 31, 2005. The increment in average interest-earning assets compared to the year ended December 31, 2005 was driven by an increase in average net loans of $567.8 million, which was partially offset by decreases in average investment securities and average interest-bearing deposits of $103.6 million and $83.6 million, respectively. The increase in average net loans was due to an increase of $538.2 million or 28.5% in average mortgage loans as a result of the Corporation’s continued emphasis of growing this portfolio by strengthening its residential mortgage production capabilities. There was also an increase of $590.2 million or 115.5% in the average consumer loan portfolio as a result of the acquisition of Island Finance. The increase in the average consumer loan portfolio was comprised of an increase of $523.6 in consumer finance portfolio as a result of the acquisition of Island Finance, $41.5 million in personal loans and $25.1 in credit card loans. The increase in the consumer loan portfolio was partially offset by a decrease in the commercial loan portfolio of $541.1 million or 15.3% due to the settlement with Doral of $608.2 million of commercial loans secured by mortgages during the second quarter of 2006 and the settlement with R&G of $301.3 million of commercial loans secured by mortgages during the fourth quarter of 2005. Excluding the settlement of the loans with Doral and R&G, the average commercial loan portfolio grew $426.3 million or 16.6%.
There was an increase of 133 basis points in the average cost of interest bearing liabilities. The Corporation’s interest expense on average interest-bearing liabilities reflected an increase of 54.2% to $327.7 million for year ended December 31, 2006 from $212.6 million for the same period in 2005. This growth was due to increases in interest expense on total average interest-bearing deposits of $51.2 million or 41.9% and average borrowings (including average term notes and average subordinated notes) of $64.0 million or 70.8% for the year ended December 31, 2006 compared to December 31, 2005. Interest expense on average time deposits increased 48.8% or $40.6 million in 2006 compared to the same period in 2005, while interest expense on savings and NOW accounts increased $10.5 million or 27.0% over the same periods.
Average interest-bearing liabilities reached $7.4 billion as of December 31, 2006, reflecting an increment of $549.2 million or 8.0% when compared to figures reported in 2005. The increase of $461.5 million or 19.1% in average borrowings (including term and subordinated notes) to $2.9 billion in 2006 was due to several financing transactions incurred related the Island Finance acquisition during the first quarter of 2006. Average time deposits (including brokered deposits) were $2.6 billion as of December 31, 2006, an increase of $171.6 million or 6.9% (including an increase in brokered deposits of $286.0 million or 28.7%) from $2.5 billion in 2005. The growth in average borrowings (including term and subordinated notes) and average other time deposits were partially offset by a decrease in average savings and NOW account of $83.9 million to $1.9 billion as of December 31, 2006.
2005 compared to 2004. The higher short-term interest rate scenario has impacted the Corporation’s net interest margin during 2005. The increase in short term in interest rates was mainly due to the increase in the discount rate by the Federal Reserve. The increase in short-term rates with only a minor repricing of long term rates has resulted in a flattening of the yield curve. The Corporation’s tax equivalent net interest income for the year ended December 31, 2005 was $238.1 million, decreasing $5.1 million or 2.1% from $243.2 million for the year ended December 31, 2004. This decrease was primarily due to an increase in cost of funds of 88 basis points from 2.23% in 2004 to 3.11% in 2005, together with an increase in average interest-bearing liabilities of $525.8 million. This was partially offset by an increase in average interest-earning assets of $581.4 million and an increase in the yield of such assets of 46 basis points from 5.26% on 2004 to 5.72% in 2005.
Interest expense on average interest-bearing liabilities increased $71.8 million or 51.0% compared with the same period in 2004. Interest expense on other time deposits (including brokered deposits) reflected an increase of $48.4 million or 138.9% to $83.3 million for the year ended December 31, 2005 from $34.9 million for the same period in 2004. Total cost of funds increased 88 basis points in 2005 compared to 2004, due to an increase in rates paid on deposits as a result of the higher interest rate scenario. This increase contributed to the decrease in net interest margin of 31 basis points to 3.02% and of an increase in cost of funding earning assets of 77 basis points to 2.70% for the year ended December 31, 2005.
The increase in average interest-bearing liabilities of $525.8 million or 8.3% to $6.8 billion for the year ended December 31, 2005 compared with $6.3 billion for the same period in 2004 was due to an increase in average interest-bearing deposits of $921.8 million. The increase in average interest-bearing deposits was due to an increase in average other time deposits of $893.0 million or 56.5% (including an increase in brokered deposits of $609.1 million or 157.1%). This increment was partially offset by a decrease in borrowings (comprised of federal funds purchased and other borrowings, securities sold under agreements of repurchase and commercial paper issued) of $352.9 million or 13.3% compared with the same period in 2004. Average securities sold under agreements to repurchase decreased by 35.3%, in part due to the extinguishment of certain
37
repurchase agreements during the first quarter and management’s emphasis in using lower cost borrowings. Average federal funds purchased and other borrowings increased by $250.0 million or 43.8% for the year ended December 31, 2005. Average subordinated notes also increased by $52.7 million or 179.7% due to a new note issuance of $50 million in the last quarter of 2005.
The Corporation’s interest income on a tax equivalent basis reflected an increase of $66.7 million or 17.4% compared with the same period in 2004. This change was due to an increase of $97.7 million or 37.0% in interest earned on the average loan portfolio partially offset by a decrease of $35.1 million or 30.3% in average investment portfolio.
Average interest-earning assets increased $581.4 million in 2005 compared to 2004. This increase was due to an increase in average net loans of $1.2 billion or 24.3% to $5.9 billion for the year ended December 31, 2005 compared with $4.7 billion for the same period in 2004. This improvement was partially offset by a decrease in average investment securities of 24.2% or $554.7 million. Pursuant to management’s objective of increasing its mortgage loan lending activity during 2005, the average mortgage loan portfolio reached $1.9 billion, reflecting an increase of 35.8% or 497.9 million compared with $1.4 billion for the year ended December 31, 2004. Total mortgage loan originations and gross purchases from third parties in 2005 were $748.1 million and $289.9 million, respectively. Total sales to third parties were $233.3 million for the year ended December 31, 2005.
The average consumer loan portfolio grew 21.7% or $91.1 million reaching $511.1 million for the year ended December 31, 2005. This increase was a result of an improvement of average credit card and average personal loans of 34.5% and 21.2%, to $149.1 million and $359.1 million, respectively. There was an increase in the average commercial loan portfolio and lease finance portfolio of 20.6% and 6.5%, to $3.2 billion and $118.2 million, respectively, for the year ended December 31, 2005.
The increase in the average net loan portfolio was offset by a decrease in average investment securities of $554.7 million or 24.2%. The decrease in average investment securities was mainly attributed to the sale of $785 million of securities during the first quarter of 2005, which also resulted in a reduction in the yield on investment securities of 40 basis points from 5.04% for the year ended December 31, 2004 to 4.64 % for the year ended December 31, 2005. The above mentioned sale generated a gain of $16.9 million that was partially offset by a loss of $6 million on the extinguishment of certain term repo transactions that were financing part of the securities sold.
The following table shows average balances and, where applicable, interest amounts earned on a tax-equivalent basis and average rates for the Corporation’s assets and liabilities and stockholders’ equity for the years ended December 31, 2006, 2005 and 2004.
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| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Year ended December 31, | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | Average | | | | | | | Average | | | Average | | | | | | | Average | | | Average | | | | | | | Average | |
| | | Balance | | | Interest | | | Rate | | | Balance | | | Interest | | | Rate | | | Balance | | | Interest | | | Rate | |
| | | | | | | | | | | | | | | (Dollars in thousands) | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Assets | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-earning assets: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest bearing deposits | | $ | 94,890 | | | $ | 4,439 | | | | 4.68 | % | | $ | 133,622 | | | $ | 4,065 | | | | 3.04 | % | | $ | 71,547 | | | $ | 1,054 | | | | 1.47 | % |
| Federal funds sold and securities purchased under agreements to resell | | | 91,049 | | | | 4,531 | | | | 4.98 | % | | | 135,928 | | | | 4,187 | | | | 3.08 | % | | | 209,719 | | | | 3,123 | | | | 1.49 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total interest-bearing deposits | | | 185,939 | | | | 8,970 | | | | 4.82 | % | | | 269,550 | | | | 8,252 | | | | 3.06 | % | | | 281,266 | | | | 4,177 | | | | 1.49 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| U.S. Treasury securities | | | 58,137 | | | | 2,759 | | | | 4.75 | % | | | 8,353 | | | | 262 | | | | 3.14 | % | | | 5,650 | | | | 75 | | | | 1.33 | % |
| Obligations of other U.S. government agencies and corporations | | | 744,923 | | | | 36,417 | | | | 4.89 | % | | | 857,421 | | | | 42,275 | | | | 4.93 | % | | | 1,174,965 | | | | 66,536 | | | | 5.66 | % |
| Obligations of government of Puerto Rico and political subdivisions | | | 90,478 | | | | 4,982 | | | | 5.51 | % | | | 80,529 | | | | 4,323 | | | | 5.37 | % | | | 43,962 | | | | 3,512 | | | | 7.99 | % |
| Collateralized mortgage obligations and mortgage backed securities | | | 692,986 | | | | 32,965 | | | | 4.76 | % | | | 747,944 | | | | 32,200 | | | | 4.31 | % | | | 1,030,725 | | | | 43,055 | | | | 4.18 | % |
| Other | | | 51,080 | | | | 2,595 | | | | 5.08 | % | | | 46,950 | | | | 1,672 | | | | 3.56 | % | | | 40,629 | | | | 2,650 | | | | 6.52 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total investment securities | | | 1,637,604 | | | | 79,718 | | | | 4.87 | % | | | 1,741,197 | | | | 80,732 | | | | 4.64 | % | | | 2,295,931 | | | | 115,828 | | | | 5.04 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Loans : | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Commercial | | | 2,562,821 | | | | 175,214 | | | | 6.84 | % | | | 3,220,447 | | | | 178,994 | | | | 5.56 | % | | | 2,670,644 | | | | 127,809 | | | | 4.79 | % |
| Construction | | | 302,370 | | | | 26,242 | | | | 8.68 | % | | | 202,226 | | | | 15,418 | | | | 7.62 | % | | | 205,861 | | | | 10,848 | | | | 5.27 | % |
| Consumer | | | 577,652 | | | | 63,542 | | | | 11.00 | % | | | 511,094 | | | | 48,631 | | | | 9.52 | % | | | 420,002 | | | | 45,800 | | | | 10.90 | % |
| Consumer Finance | | | 523,610 | | | | 118,077 | | | | 22.55 | % | | | | | | | | | | | | | | | | | | | | | | | | |
| Mortgage | | | 2,425,611 | | | | 146,558 | | | | 6.04 | % | | | 1,887,420 | | | | 110,994 | | | | 5.88 | % | | | 1,389,517 | | | | 71,610 | | | | 5.15 | % |
| Lease financing | | | 134,606 | | | | 8,985 | | | | 6.68 | % | | | 118,202 | | | | 7,643 | | | | 6.47 | % | | | 111,032 | | | | 7,912 | | | | 7.13 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Gross loans | | | 6,526,670 | | | | 538,618 | | | | 8.25 | % | | | 5,939,389 | | | | 361,680 | | | | 6.09 | % | | | 4,797,056 | | | | 263,979 | | | | 5.50 | % |
| Allowance for loan losses | | | (87,465 | ) | | | | | | | | | | | (67,956 | ) | | | | | | | | | | | (73,518 | ) | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Loans, net | | | 6,439,205 | | | | 538,618 | | | | 8.36 | % | | | 5,871,433 | | | | 361,680 | | | | 6.16 | % | | | 4,723,538 | | | | 263,979 | | | | 5.59 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total interest-earning assets/ interest income (tax-equivalent basis) | | | 8,262,748 | | | | 627,306 | | | | 7.59 | % | | | 7,882,180 | | | | 450,664 | | | | 5.72 | % | | | 7,300,735 | | | | 383,984 | | | | 5.26 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total non-interest-earning assets | | | 557,882 | | | | | | | | | | | | 403,812 | | | | | | | | | | | | 333,736 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Total assets | | $ | 8,820,630 | | | | | | | | | | | $ | 8,285,992 | | | | | | | | | | | $ | 7,634,471 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Liabilities and stockholders’ equity | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Savings and NOW accounts | | $ | 1,861,167 | | | $ | 49,470 | | | | 2.66 | % | | $ | 1,945,095 | | | $ | 38,939 | | | | 2.00 | % | | $ | 1,916,270 | | | $ | 25,416 | | | | 1.33 | % |
| Other time deposits | | | 1,362,653 | | | | 57,648 | | | | 4.23 | % | | | 1,476,996 | | | | 46,488 | | | | 3.15 | % | | | 1,193,078 | | | | 23,932 | | | | 2.01 | % |
| Brokered deposits | | | 1,282,704 | | | | 66,262 | | | | 5.17 | % | | | 996,741 | | | | 36,785 | | | | 3.69 | % | | | 387,682 | | | | 10,931 | | | | 2.82 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Interest-bearing deposits | | | 4,506,524 | | | | 173,380 | | | | 3.85 | % | | | 4,418,832 | | | | 122,212 | | | | 2.77 | % | | | 3,497,030 | | | | 60,279 | | | | 1.72 | % |
| Borrowings | | | 2,611,231 | | | | 138,500 | | | | 5.30 | % | | | 2,295,932 | | | | 85,740 | | | | 3.73 | % | | | 2,648,854 | | | | 74,261 | | | | 2.80 | % |
| Term Notes | | | 40,883 | | | | 1,460 | | | | 3.57 | % | | | 37,158 | | | | 1,229 | | | | 3.31 | % | | | 132,947 | | | | 5,640 | | | | 4.24 | % |
| Subordinated Notes | | | 224,606 | | | | 14,374 | | | | 6.40 | % | | | 82,082 | | | | 3,402 | | | | 4.14 | % | | | 29,351 | | | | 582 | | | | 1.98 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total interest-bearing liabilities interest expense | | | 7,383,244 | | | | 327,714 | | | | 4.44 | % | | | 6,834,004 | | | | 212,583 | | | | 3.11 | % | | | 6,308,182 | | | | 140,762 | | | | 2.23 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total non interest-bearing liabilities | | | 873,793 | | | | | | | | | | | | 875,762 | | | | | | | | | | | | 830,326 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total liabilities | | | 8,257,037 | | | | | | | | | | | | 7,709,766 | | | | | | | | | | | | 7,138,508 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Stockholders’ Equity | | | 563,593 | | | | | | | | | | | | 576,226 | | | | | | | | | | | | 495,963 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Total liabilities and stockholders’ equity | | $ | 8,820,630 | | | | | | | | | | | $ | 8,285,992 | | | | | | | | | | | $ | 7,634,471 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Net interest income | | | | | | $ | 299,592 | | | | | | | | | | | $ | 238,081 | | | | | | | | | | | $ | 243,222 | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Net interest spread | | | | | | | | | | | 3.15 | % | | | | | | | | | | | 2.61 | % | | | | | | | | | | | 3.03 | % |
| Cost of funding earning assets | | | | | | | | | | | 3.97 | % | | | | | | | | | | | 2.70 | % | | | | | | | | | | | 1.93 | % |
| Net interest margin (tax equivalent basis) | | | | | | | | | | | 3.63 | % | | | | | | | | | | | 3.02 | % | | | | | | | | | | | 3.33 | % |
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Changes in Interest Income and Interest Expense-Volume and Rate Analysis
The following table allocates changes in the Corporation’s tax equivalent interest income and interest expense between changes in the average volume of interest-earning assets and interest-bearing liabilities and changes in their respective interest rates for the years 2006 compared to 2005 and 2005 compared to 2004. Volume and rate variances have been calculated based on activities in average balances over the period and changes in interest rates on average interest-earning assets and average interest-bearing liabilities.
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | 2006 vs. 2005 | | | 2005 vs. 2004 | |
| | | Increase (decrease) due to change in: | | | Increase (decrease) due to change in: | |
| | | Volume | | | Rate | | | Total | | | Volume | | | Rate | | | Total | |
| | | | | | | | | | | (Dollars in thousands) | | | | | | | | | |
Interest Income — tax equivalent basis: | | | | | | | | | | | | | | | | | | | | | | | | |
| Federal funds purchased and securities purchased under agreements to resell | | $ | (1,679 | ) | | $ | 2,023 | | | $ | 344 | | | $ | (1,390 | ) | | $ | 2,454 | | | $ | 1,064 | |
| Time deposits with other banks | | | (1,400 | ) | | | 1,774 | | | | 374 | | | | 1,352 | | | | 1,659 | | | | 3,011 | |
| Investment securities | | | (4,934 | ) | | | 3,920 | | | | (1,014 | ) | | | (26,289 | ) | | | (8,807 | ) | | | (35,096 | ) |
| Loans, net | | | 37,637 | | | | 139,301 | | | | 176,938 | | | | 68,768 | | | | 28,933 | | | | 97,701 | |
| | | | | | | | | | | | | | | | | | | |
| Total interest income | | | 29,624 | | | | 147,018 | | | | 176,642 | | | | 42,441 | | | | 24,239 | | | | 66,680 | |
| | | | | | | | | | | | | | | | | | | |
Interest Expense: | | | | | | | | | | | | | | | | | | | | | | | | |
| Savings and NOW accounts | | | (1,744 | ) | | | 12,275 | | | | 10,531 | | | | 388 | | | | 13,135 | | | | 13,523 | |
| Other time deposits | | | 6,118 | | | | 34,519 | | | | 40,637 | | | | 25,060 | | | | 23,350 | | | | 48,410 | |
| Borrowings | | | 12,993 | | | | 39,767 | | | | 52,760 | | | | (10,835 | ) | | | 22,314 | | | | 11,479 | |
| Long-term borrowings | | | 7,798 | | | | 3,405 | | | | 11,203 | | | | (1,671 | ) | | | 80 | | | | (1,591 | ) |
| | | | | | | | | | | | | | | | | | | |
| Total interest expense | | | 25,165 | | | | 89,966 | | | | 115,131 | | | | 12,942 | | | | 58,879 | | | | 71,821 | |
| | | | | | | | | | | | | | | | | | | |
| Net interest income (expense) — tax equivalent basis | | $ | 4,459 | | | $ | 57,052 | | | $ | 61,511 | | | $ | 29,499 | | | $ | (34,640 | ) | | $ | (5,141 | ) |
| | | | | | | | | | | | | | | | | | | |
During 2006, the increase in net interest income on a tax equivalent basis was driven primarily by increases in volume and yield earned on interest earning-assets of 187 basis points which is higher than the increase in volume and interest rates paid on interest-bearing liabilities of 133 basis points. The increase attributed to rate on loans is a direct result of Island Finance loans which had an average yield of 22.6% for the ten month period ended December 31, 2006. In addition the increase in the prime rate during the year is reflected in the increase in rates for 2006.
During 2005, the decrease in net interest income on a tax equivalent basis was driven primarily by an increase in interest rates paid on interest-bearing liabilities of 88 basis points, which is higher than the increase in yield earned on interest earning-assets of 46 basis points. Although the increase in the volume of interest bearing-liabilities is lower than the increase in the volume of interest earning-assets, the increase in rates of interest bearing-liabilities impacted net interest income more than the increase in volume of interest earning-assets.
Provision for Loan Losses
2006 compared to 2005.The provision for loan losses increased $45.2 million or 221.5% from $20.4 million for the year ended December 31, 2005 to $65.6 million for the year ended December 31, 2006. The increase in the provision for loan losses was due primarily to the Island Finance operation, which registered a provision for loan losses of $43.2 million for the ten months (from acquisition) ended December 31, 2006.
2005 compared to 2004.The provision for loan losses decreased $5.9 million or 22.3% to $20.4 million for the year ended December 31, 2005 compared with $26.3 million in the same period in 2004. The continuing effort to reinforce lending and collection procedures and the increasing production in the lower risk mortgage portfolio supported a decrease in the allowance for loans losses. The Corporation presented lower net charge-offs through the last years. During the year 2005, charge-offs reflected a decrease of 30.2% compared with the same period in 2004.
40
Refer to the discussions under “Allowance for Loan Losses” and “Risk Management” for further analysis of the allowance for loan losses, the allocation of the allowance by loan category and non-performing assets and related ratios.
Other Income
Other income consists of service charges on deposit accounts, other service fees, including mortgage servicing fees and fees on credit cards, broker-dealer, asset management and insurance fees, gains and losses on sales of securities, gain on sale of mortgage servicing rights, certain other gains and losses and certain other income.
The following table sets forth the components of our other income for the years ended December 31, 2006, 2005 and 2004:
| | | | | | | | | | | | | |
| | | Year ended December 31, | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars In thousands) | |
| | | | | | | | | | | | | |
| Bank service fees on deposit accounts | | $ | 13,432 | | | $ | 12,883 | | | $ | 12,776 | |
| Other service fees: | | | | | | | | | | | | |
| Credit card fees | | | 17,870 | | | | 15,242 | | | | 12,841 | |
| Mortgage-servicing fees | | | 2,554 | | | | 2,283 | | | | 1,828 | |
| Trust fees | | | 3,004 | | | | 2,912 | | | | 2,951 | |
| Other fees | | | 12,218 | | | | 8,952 | | | | 8,581 | |
| Broker-dealer, asset management and insurance fees | | | 56,973 | | | | 53,016 | | | | 51,113 | |
| Gain on sale of securities, net | | | — | | | | 17,842 | | | | 11,475 | |
| Loss on extinguishment of debt | | | — | | | | (5,959 | ) | | | — | |
| Gain on sale of loans | | | 1,994 | | | | 7,876 | | | | 431 | |
| Trading gains | | | 1,243 | | | | 277 | | | | 124 | |
| (Loss) gain on derivatives | | | (478 | ) | | | 1,963 | | | | 3,459 | |
| Other gains, net | | | 4,428 | | | | 4,774 | | | | 8,139 | |
| Other | | | 5,231 | | | | 3,297 | | | | 3,521 | |
| | | | | | | | | | |
| | | $ | 118,469 | | | $ | 125,358 | | | $ | 117,239 | |
| | | | | | | | | | |
The table below details the breakdown of commissions from broker-dealer, asset management and insurance operations:
| | | | | | | | | | | | | |
| | | Year ended December 31, | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars in thousands) | |
| | | | | | | | | | | | | |
| Broker-dealer | | $ | 25,269 | | | $ | 25,542 | | | $ | 30,180 | |
| Asset management | | | 19,969 | | | | 20,119 | | | | 15,901 | |
| | | | | | | | | | |
| Total Santander Securities and subsidiary | | | 45,238 | | | | 45,661 | | | | 46,081 | |
| Insurance | | | 11,735 | | | | 7,355 | | | | 5,032 | |
| | | | | | | | | | |
| Total | | $ | 56,973 | | | $ | 53,016 | | | $ | 51,113 | |
| | | | | | | | | | |
2006 compared to 2005.For the year ended December 31, 2006, other income decreased $6.9 million or 5.5% compared to the same period in 2005. This decrease was due to lower gains on sale of securities (net of the loss on extinguishment of debt) of $11.9 million and lower gain on sale of loans of $5.9 million. There was a loss on derivatives in 2006 of $0.5 million compared to a gain in 2005 of $2.0 million. This variance was due primarily to a loss on valuation of mortgage loans available for sale of $1.2 million in 2006. Insurance fees reflected an increase of $4.4 million due primarily to the effect of the Island Finance operation on the insurance operations for the period. The Corporation recognized a gain on sale of an FDIC assessment credit of $1.9 million during the fourth quarter of 2006.
Bank service charges, fees and other increased $6.8 million, or 16.1% for the year ended December 31, 2006. These improvements were mainly due to increases in credit cards fees, account analysis fees, mortgage services fees and other fees of $2.7 million and $0.5 million, $0.3 million and $3.3 million, respectively.
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Insurance fees reflected an increase of $4.4 million to $11.7 million in 2006 (which includes $4.7 million derived from Island Finance loans), from $7.4 million reported in the same period in 2005. For the year ended December 31, 2006, broker-dealer and asset management reflected a decrease of $0.4 million compared to the same period in 2005. The broker-dealer asset management and insurance operations contributed 48.1% of commissions to the Corporation’s other income for the year ended December 31, 2006.
2005 compared to 2004.For the year ended December 31, 2005, other income increased $8.1 million or 6.9% to $125.4 million from $117.2 million in 2004. This increase was the result of higher gain on sale of securities of $6.4 million. During March 2005, the Company sold $785 million of investment securities and realized a gain of $16.9 million. This gain was partially offset by a loss of $6.7 million on the extinguishment of certain repo transactions that were funding part of the securities sold. During the year ended December 31, 2005, there was a higher gain on sale of loans of $7.4 million as a result of sales of mortgage loans and the sale of certain previously charged-off consumer loans to an unrelated third party.
Bank services fees on deposit accounts such as services fees, overdraft fees and others, reflected an increase of $0.1 million to $12.9 million for the year ended in December 31, 2005 compared with prior year figures. There was also an increase of $2.4 million and $0.5 million in credit card fees and mortgage servicing fees, respectively. The improvement in service fees and other fees was supported by the higher level of loan portfolio.
Broker-dealer, asset management and insurance fees increased by $1.9 million to $53.0 million in 2005 due to an improvement of $2.3 million or 46.2% in insurance commissions earned by Santander Insurance. Santander Securities’ business includes securities underwriting and distribution, sales, trading, financial planning, investment advisory services and securities brokerage services. In addition, Santander Securities provides portfolio management services through its wholly owned subsidiary, Santander Asset Management. The broker-dealer asset management and insurance operation contributed 42.3% of commissions to the Corporation’s other income for the year ended December 31, 2005.
For the year ended December 31, 2005, the decrease in broker-dealer commissions was due to the decrease in underwriting and fixed income activity during the year compared to the year ended December 31, 2004. The increase in assets management commissions for the year ended December 31, 2005 compared to the same period in 2004 was due to the growth in assets under management resulting from the issuance of closed-end mutual funds.
During the first quarter of 2005, the Corporation entered into an arrangement with another unrelated financial institution (the “Counterparty”) where, in substance, the parties agreed to purchase and sell similar mortgage loan portfolios. Pursuant to this arrangement, during March of 2005, the Corporation sold mortgage loans with an unpaid principal balance of $87.2 million for $88.9 million and realized a gain on sale of $1.7 million. Since the Corporation retained the servicing on the mortgage loans, it also recognized a servicing asset of $1.1 million. During April and May of 2005, the Corporation purchased from the Counterparty mortgage loans with unpaid principal balances of $59.9 million and $29.7 million for $61.1 million and $30.2 million, respectively, resulting in premiums to the Counterparty of $1.2 million and $0.5 million, respectively. The Counterparty retained the servicing on the mortgage loans sold to the Corporation. Adjustments were made to the prices paid by the Corporation in the April and May transactions to put the parties in roughly the same economic positions they would have been in had the transactions occurred simultaneously. The Corporation undertook a review and analysis of these transactions in consultation with its legal counsel. After such review and analysis of these transactions and the arrangements entered into with the Counterparty, the Corporation determined that it had properly recognized gain from the transactions under GAAP.
The decrease in other gains of $3.4 million consisted principally of a non recurring gain on sale of building of $2.8 million during 2004 and gain on sale of servicing rights of $0.4 million in 2004.
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Operating Expenses
The following table sets forth information as to the Corporation’s other operating expenses for the years ended December 31, 2006, 2005 and 2004:
| | | | | | | | | | | | | |
| | | Year ended December 31, | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars in thousands) | |
| | | | | | | | | | | | | |
| Salaries | | $ | 78,945 | | | $ | 58,547 | | | $ | 57,376 | |
| Pension and other benefits | | | 55,428 | | | | 48,775 | �� | | | 49,458 | |
| Expenses deferred as loan origination costs | | | (12,662 | ) | | | (12,320 | ) | | | (15,252 | ) |
| | | | | | | | | | |
| Total personnel costs | | | 121,711 | | | | 95,002 | | | | 91,582 | |
| | | | | | | | | | |
| Occupancy costs | | | 22,476 | | | | 16,811 | | | | 13,959 | |
| | | | | | | | | | |
| Equipment expenses | | | 4,797 | | | | 3,802 | | | | 3,775 | |
| | | | | | | | | | |
| EDP servicing expense, amortization and technical services | | | 40,084 | | | | 31,589 | | | | 34,462 | |
| | | | | | | | | | |
| Communications | | | 11,358 | | | | 8,232 | | | | 8,976 | |
| | | | | | | | | | |
| Business promotion | | | 11,613 | | | | 11,065 | | | | 10,435 | |
| | | | | | | | | | |
| Other taxes | | | 11,514 | | | | 8,443 | | | | 8,584 | |
| | | | | | | | | | |
| Other operating expenses: | | | | | | | | | | | | |
| Professional fees | | | 12,589 | | | | 9,844 | | | | 12,235 | |
| Amortization of intangibles | | | 4,081 | | | | 1,697 | | | | 1,170 | |
| Printing and supplies | | | 1,939 | | | | 1,775 | | | | 1,725 | |
| Credit card expenses | | | 10,741 | | | | 8,844 | | | | 7,561 | |
| Insurance | | | 2,810 | | | | 2,461 | | | | 2,113 | |
| Examinations & FDIC assessment | | | 1,914 | | | | 1,809 | | | | 1,108 | |
| Transportation and travel | | | 2,802 | | | | 2,242 | | | | 2,044 | |
| Repossessed assets provision and expenses | | | 1,879 | | | | 1,871 | | | | 2,758 | |
| Collections and related legal costs | | | 1,542 | | | | 1,461 | | | | 2,464 | |
| All other | | | 13,933 | | | | 14,438 | | | | 12,426 | |
| | | | | | | | | | |
| Other operating expenses | | | 54,230 | | | | 46,442 | | | | 45,604 | |
| | | | | | | | | | |
| Non personnel expenses | | | 156,072 | | | | 126,384 | | | | 125,795 | |
| | | | | | | | | | |
| Total Operating Expenses | | $ | 277,783 | | | $ | 221,386 | | | $ | 217,377 | |
| | | | | | | | | | |
| | | | | | | | | | | | | |
| Efficiency ratio-on a tax equivalent basis | | | 66.82 | % | | | 62.97 | % | | | 62.78 | % |
| Personnel cost to average assets | | | 1.38 | % | | | 1.15 | % | | | 1.20 | % |
| Other operating expenses to average assets | | | 1.77 | % | | | 1.53 | % | | | 1.65 | % |
| Assets per employee | | $ | 3,929 | | | $ | 5,199 | | | $ | 4,797 | |
2006 compared to 2005.For the year ended December 31, 2006, the Efficiency Ratio, on a tax equivalent basis, was 66.82% reflecting an increase of 385 basis points compared to 62.97% for the year ended December 31, 2005. This increase was mainly the result of higher operating expenses during the year ended December 31, 2006 resulting in part from expenses related to a personnel reduction program. Payments pursuant to the personnel reduction program reached $10.4 million for the year ended December 31, 2006. Excluding these personnel reduction expenses, the Efficiency Ratio was 64.31%, a 134 basis point increase for the year ended December 31, 2006 compared to the same period in 2005. In addition, during the fourth quarter of 2006, operating expenses were impacted by a pension plan curtailment pursuant to the Corporation’s decision to freeze its defined benefit pension plan, resulting in the recognition of an additional expense of $0.9 million. The Corporation also recognized $0.8 million pursuant to a Long Term Incentive Plan to certain employees. The Corporation’s parent company, BSCH, sponsors a Long Term Incentive Plan (the “Plan”) for certain of its employees and those of its subsidiaries, including the Corporation. The Plan contains service, performance and market conditions. In December 2006, the Corporation’s Board of Directors approved the Plan, which provides for settlement in cash to the participating employees. The Corporation will accrue the liability and recognize monthly compensation expense over the fourteen month period from December 2006 to January 2008, when the plan becomes exercisable. The cost of the plan will be reimbursed to the Corporation by BSCH, at which time it would be recognized as a capital contribution. As of December 31, 2006 the performance and market conditions of the plan were met and the Corporation therefore recognized a compensation expense of $810,000 related to the Plan.
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For the year ended December 31, 2006, operating expenses increased $56.4 million or 25.5% from $221.4 million for the year ended December 31, 2005 to $277.8 million for the same period in 2006. This increase was due to operating expenses of Island Finance of $44.5 million and expenses related to a personnel reduction program of $10.4 million in 2006. For the year ended December 31, 2006 there were increases in salaries and employee benefits of $26.7 million together with an increase in other operating expenses of $29.7million. Island Finance salaries and employee benefits were $21.1 million for the ten months (since acquisition) ended December 31, 2006 and other operating expenses were $23.4 million. Increases in salaries and employee benefits due to the Island Finance operation of $21.1 million, payments pursuant to the personnel reduction program of $10.4 million, the pension plan curtailment of $0.9 million and long-term incentive plan of $0.8 million, were partially offset by decreases in accruals for performance compensation of $4.4 million and $1.5 million in temporary personnel.
The increase of $29.7 million in other operating expenses (which includes Island Finances operating expenses of $23.4 million) comprised, principally, increases of $8.5 million in EDP servicing, amortization and technical services, $5.7 million in occupancy costs, $3.1 million in communications, $3.1 million in other taxes, $2.7 million in professional fees, $2.4 million in amortization of intangibles and $1.9 million in credit card expenses. EDP servicing amortization and technical services included EDP servicing fees of $2.3 million paid by Island Finance to Wells Fargo pursuant to a servicing agreement where the latter will continue to provide EDP servicing on the loan portfolio for a period of eighteen months from the acquisition date.
Excluding Island Finance expenses and expenses related to personnel reductions, operating expenses reflected an increase of $1.5 million or 0.7% for the year ended December 31, 2006 compared to December 31, 2005. There were increases in EDP servicing, amortization and technical services of $4.1 million, credit card expenses of $1.5 million and other taxes of $1.0 million, which were partially offset by a decrease of $4.8 million in salaries and other employee benefits.
2005 compared to 2004. For the year ended December 31, 2005 the efficiency ratio increased 19 basis points to 62.97% from 62.78% for the same period in 2004 due to an increase in other income adjusted by gain on sale of securities, loss on extinguishment of liabilities in 2005 and gain on sale of building in 2004. The increase in average assets, with stable operating expenses, promotes a well defined operating structure and efficient use of resources and procedures.
Total other operating expenses amounted to $221.3 million for the year ended December 31, 2005, an increase of $4.0 million or 1.8% compared with $217.4 million for the same period in 2004. There was an increase in personnel costs of $3.4 million driven principally by a decrease in expenses deferred as loan origination cost, as a result of lower standard cost of originating consumer loans, of $2.9 million. There was an increase in salaries of $1.2 million offset by a decrease in pension and other benefits of $1.7 million.
Other non personnel expenses reflected an increase of $0.6 million due to an increase of $2.9 million in occupancy cost, $1.3 million in credit card expenses, $0.7 million in examinations and FDIC assessment, and $2.0 million in other operating costs. These increases was offset by a decrease in EDP servicing expenses, amortization and technical services of $2.9 million, professional services of $2.4 million and collection an related legal cost of $1.0 million.
Due its strict cost control measures, management was successful in maintaining non personnel cost at essentially the same level as in 2004.
The Corporation focused on controlling expenses, resulting in a decrease in personnel costs as a percentage of average assets, from 1.20% in 2004 to 1.15% in 2005, and in other operating expenses as a percentage of average assets, from 1.65% in 2004 to 1.53% in 2005. Full-time equivalent employees were 1,591 at December 31, 2005, compared to 1,735 at December 31, 2004.
Income Taxes
In Puerto Rico, the maximum statutory corporate income tax rate applicable to the Corporation is 39%. However, there is an alternative minimum tax of 22% on the Corporation’s alternative minimum taxable income which, in general, applies if the Corporation’s regular income tax liability is less than the Corporation’s alternative minimum tax liability. Additionally, during 2005, a temporary two-year surtax of 2.5% applicable to corporations was enacted. This surtax is applicable to taxable years beginning after December, 31, 2004. An additional 2% surtax was imposed on the Corporation for a period of one year commencing on January 1, 2006 as a result of the Puerto Rico Government deficit. These surtaxes increased the maximum marginal corporate income tax rate to 43.5% for the year ended December 31, 2006. The Corporation is also subject to municipal license tax at various rates that do not exceed 1.5% on the Corporation’s taxable gross income. Under the Puerto Rico Internal Revenue Code, as amended (“the PR Code”), the Corporation and each of its subsidiaries are treated as separate
44
taxable entities and are not entitled to file consolidated tax returns. The PR Code provides a dividend received deduction of 100% on dividends received from controlled subsidiaries subject to taxation in Puerto Rico.
The Corporation is subject to United States federal income tax on its taxable income that is effectively connected with the Corporation’s trade or business in the mainland United States. The Corporation is also subject to United States federal income tax on certain income that is not effectively connected with the Corporation’s trade or business in the mainland United States, such as interest (excluding portfolio interest) and certain dividends earned on United States securities and loans. Interest derived by the Corporation on obligations of the United States represents portfolio interest and is not subject to federal income taxes. Subject to certain limitations, any federal income tax is creditable against Puerto Rico income taxes.
The difference between the statutory marginal tax rate and the effective tax rate is primarily due to the interest income earned on certain investments and loans which is exempt from income tax (net of the disallowance of expenses attributable to the exempt income) and to the disallowance of certain expenses and other items.
Puerto Rico international banking entities, or IBE’s, are currently exempt from taxation under Puerto Rico law. During 2004, the Legislature of Puerto Rico and the Governor of Puerto Rico approved a law amending the IBE Act. This law imposes income taxes at normal statutory rates on each IBE that operates as a unit of a bank, if the IBE’s net income generated after December 31, 2003 exceeds 40% of the bank’s net income in the taxable year commenced on July 1, 2003, 30% of the bank’s net income in the taxable year commencing on July 1, 2004, and 20% of the bank’s net income in the taxable year commencing on July 1, 2005, and thereafter. It does not impose income taxation on an IBE that operates as a subsidiary of a bank as in the case of our subsidiary, Santander International Bank.
2006 compared to 2005.The provision for income tax was $22.5 million (or 34.3% pretax earnings), a decrease of $8.2 million or 26.8% for the year ended December 31, 2006 compared to $30.8 million (or 27.8% of pretax earnings) for the same period in 2005. The decrease in the provision for income tax during 2006 was due in primarily to lower taxable income in 2006 compared to 2005 and was partially offset by the increase in tax rates due to special surtaxe imposed on the Corporation, refer to Note 15 of the consolidated financial statements for additional information.
2005 compared to 2004.The provision for income tax was $30.8 million, an increase of $21.1 million or 216.6% for the year ended December 31, 2005 compared to $9.7 million (or 10.1% of pretax earnings) for the same period in 2004. The increase in provision for income tax during 2005 was due to in part to higher taxable income in 2005 than in 2004 due to a change in the composition of the Corporation’s taxable and tax-exempt assets over those periods. Also, the incremental effect of the additional surtax of 2.5%, corresponding to the year ended December 31, 2005 was $1.9 million.
Financial Condition
Assets
The Corporation’s total assets were $9.2 billion and $8.3 billion as of December 31, 2006 and 2005, respectively; an increase of $916.2 million or 11.1% over 2005. As of December 31, 2006, there was an increase of $881.8 million in net loans, including loans held for sale compared to December 31, 2005 balances. The investment securities portfolio decreased $141.0 million, from $1.6 billion as of December 31, 2005 to $1.5 billion as of December 31, 2006.
The net loan portfolio, including loans held for sale, reflected an increase of 14.8% or $881.8 million, reaching $6.8 billion at December 31, 2006, compared to the figures reported as of December 31, 2005. The mortgage loan portfolio at December 31, 2006 grew $507.0 million or 23.6% compared to December 31, 2005. Mortgage loans originated during the fourth quarter of 2006 reached $244.5 million or 27.9% more than the same quarter last year. Mortgage loans originated during the year ended December 31, 2006 reached $911.6 million or 21.9% more than the same period last year. Construction loans increased $221.5 million or 103.6% as of December 31, 2006 compared to December 31, 2005. The consumer loan portfolio also reflected growth of $664.3 million or 117.1%, as of December 31, 2006, compared to December 31, 2005 due primarily to the acquisition of Island Finance. The commercial loan portfolio decreased $249.5 million or 7.5% compared to December 31, 2005, as a result of the settlement of commercial loans secured by mortgages with Doral during the second quarter of 2006.
There was an increase in other assets of $75.1 million, which consisted, mainly, of $44.2 million in accounts receivable, $11.8 in derivative assets and $9.0 million in prepaid assets. These increases were partially offset by decreases in cash and cash equivalents of $38.8 million and interest bearing deposits of $49.6 million
45
Short Term Investments and Interest-bearing Deposits in Other Financial Institutions
The Corporation sells federal funds, purchases securities under agreements to resell and deposits funds in interest-bearing accounts in other financial institutions to help meet liquidity requirements and provide temporary holdings until the funds can be otherwise invested or utilized. As of December 31, 2006, 2005 and 2004, the Corporation had interest-bearing deposits, federal funds sold and securities purchased under agreements to resell as detailed below:
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars in thousands) | |
| Interest-bearing deposits | | $ | 52,235 | | | $ | 109,867 | | | $ | 92,612 | |
| Federal funds sold | | | 35,412 | | | | 15,000 | | | | 231,500 | |
| Securities purchased under agreements to resell | | | 37,995 | | | | 77,429 | | | | 95,150 | |
| | | | | | | | | | |
| | | $ | 125,642 | | | $ | 202,296 | | | $ | 419,262 | |
| | | | | | | | | | |
Investment Portfolio
The following tables set forth the Corporation’s investments in government securities and certain other financial investments at December 31, 2006 and 2005, by contractual maturity, giving comparative carrying and fair values and average yield for each of the categories. The Corporation has evaluated the conditions under which it might sell its investment securities. As a result, most of its investment securities have been classified as available for sale. The Corporation may decide to sell some of the securities classified as available for sale either as part of its efforts to manage its interest rate risk, or in response to changes in interest rates, prepayment risk or similar economic factors. Investment securities available for sale are carried at fair value and unrealized gains and losses net of taxes on these investments are included in accumulated other comprehensive income or loss, which is a separate component of stockholders’ equity.
Gains or losses on sales of investment securities available for sale are recognized when realized and are computed on the basis of specific identification. At December 31, 2006, 2005 and 2004, investment securities available for sale were $1.4 billion, $1.6 billion and $2.0 billion, respectively.
Investment securities held to maturity are carried at cost, adjusted for premium amortization and discount accretion. The Corporation classifies as investment securities held to maturity those investments for which the Corporation has the intent and ability to hold until maturity. There were no investment securities held to maturity as of December 31, 2006, 2005 and 2004.
During December 2004, BSCH communicated to the Corporation that, upon the formal adoption of International Financial Reporting Standards (“IFRS”) by the Bank of Spain, it expected to adopt IFRS effective January 1, 2005, and that, with regards to the consolidated held-to-maturity investment portfolio, it was seriously considering taking advantage of a one-time transition guidance to reclassify such investment portfolio as available for sale, as permitted by IFRS. BSCH encouraged the Corporation to conform the classification of such investment portfolio in the Corporation’s US GAAP financial statements to the classification pursuant to the one-time transition guidance under IFRS, effective January 1, 2005. After thorough consideration, in February of 2005, management of the Corporation determined that it would, subject to its Board approval, reclassify its held-to-maturity investment portfolio to the available-for-sale category under US GAAP. Management of the Corporation believes that because the deliberation process leading to the February 2005 decision was initiated during December of 2004, at December 31, 2004, the Corporation could not demonstrate that it had the positive intent to hold the aforesaid investment portfolio to maturity ; the “positive intent” is required by Statement of Financial Accounting Standards No. 115 (“SFAS 115”),Accounting for Certain Investments in Debt and Equity Securities, in order for securities scoped under SFAS 115 to be classified as held to maturity. Further, because such transfer does not qualify under the exemption provisions for the sale or transfer of held-to-maturity securities under SFAS 115, the reclassification decision by the Corporation is deemed to have “tainted” the held-to-maturity category and it will not be permitted to classify prospectively investment securities scoped under SFAS 115 as held-to-maturity for a period of two years. At December 31, 2004, the securities reclassified from held to maturity to available for sale had a fair value of $840.0 million and an amortized cost of $813.8 million, which resulted in a credit to Other Comprehensive Income of $16.0 million, net of income taxes, related to the unrealized holding gain.
Other investment securities include debt, equity or other securities that do not have readily determinable fair values and are stated at amortized cost. The Corporation includes in this category stock owned to comply with regulatory requirements, such as Federal Home Loan Bank (FHLB) stock.
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The Corporation acquires certain securities for trading purposes and carries its trading account at fair value. Financial instruments including, to a limited extent, derivatives, such as option contracts, are used in dealing and other trading activities and are carried at fair value. The Corporation classifies as trading those securities that are acquired and held principally for the purpose of selling them in the near term. Realized and unrealized changes in fair value are recorded separately in the trading profit or loss account as part of the results of operations in the period in which the changes occur. At December 31, 2006, 2005 and 2004, the Corporation had $50.8 million, $37.7 million and $34.2 million of securities held for trading, respectively.
The following table presents the carrying value and fair value of the Corporation’s investment portfolio by major category as of the December 31, 2006, 2005 and 2004:
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | Carrying | | | Fair | | | Carrying | | | Fair | | | Carrying | | | Fair | |
| Available for Sale | | Value | | | Value | | | Value | | | Value | | | Value | | | Value | |
| | | (Dollars in thousands) | |
| U.S. Treasury | | $ | 63,995 | | | $ | 63,995 | | | $ | 24,576 | | | $ | 24,576 | | | $ | 7,578 | | | $ | 7,578 | |
| U.S. Agency Notes | | | 658,340 | | | | 658,340 | | | | 727,199 | | | | 727,199 | | | | 1,427,931 | | | | 1,427,931 | |
| P.R. Government Obligations | | | 55,942 | | | | 55,942 | | | | 53,600 | | | | 53,600 | | | | 52,688 | | | | 52,688 | |
| Mortgage-backed Securities | | | 631,437 | | | | 631,437 | | | | 754,231 | | | | 754,231 | | | | 489,785 | | | | 489,785 | |
| Foreign Securities | | | 75 | | | | 75 | | | | 75 | | | | 75 | | | | 150 | | | | 150 | |
| | | | | | | | | | | | | | | | | | | |
| | | $ | 1,409,789 | | | $ | 1,409,789 | | | $ | 1,559,681 | | | $ | 1,559,681 | | | $ | 1,978,132 | | | $ | 1,978,132 | |
| | | | | | | | | | | | | | | | | | | |
The tables below summarize the contractual maturity of the Corporation’s available for sale, held to maturity investment securities and other investment securities at December 31, 2006, 2005 and 2004:
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| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | December 31, 2006 | |
| | | | | | | | | | | After One | | | After Five Years | | | | | | | | | | | | | |
| | | Within | | | Year to | | | to | | | | | | | | | | | | | |
| | | One Year | | | Five Years | | | Ten Years | | | Over Ten Years | | | Total | | | | | | | |
| | | Carrying | | | Avg | | | Carrying | | | Avg | | | Carrying | | | Avg | | | Carrying | | | Avg | | | Carrying | | | Fair | | | Avg | |
| | | Value | | | Yield | | | Value | | | Yield | | | Value | | | Yield | | | Value | | | Yield | | | Value | | | Value | | | Yield | |
| | | (Dollars in thousands) |
| U.S. Treasury | | $ | 63,995 | | | | 5.14 | % | | $ | — | | | | — | | | $ | — | | | | — | | | $ | — | | | | — | | | $ | 63,995 | | | $ | 63,995 | | | | 5.14 | % |
| U.S. Agency Notes | | | 188,503 | | | | 4.82 | % | | | 469,837 | | | | 3.89 | % | | | — | | | | — | | | | — | | | | — | | | | 658,340 | | | | 658,340 | | | | 4.15 | % |
| P.R. Government Obligations | | | 948 | | | | 3.85 | % | | | 15,482 | | | | 4.26 | % | | | 24,565 | | | | 5.28 | % | | | 14,947 | | | | 5.79 | % | | | 55,942 | | | | 55,942 | | | | 5.10 | % |
| Mortgage-backed Securities | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 631,437 | | | | 4.99 | % | | | 631,437 | | | | 631,437 | | | | 4.99 | % |
| Foreign Securities | | | 25 | | | | 750 | % | | | 50 | | | | 4.65 | % | | | — | | | | — | | | | — | | | | — | | | | 75 | | | | 75 | | | | 5.60 | % |
| Other Securities | | | 50,710 | | | | 5.50 | % | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 50,710 | | | | 50,710 | | | | 5.50 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Securities | | $ | 304,181 | | | | 5.00 | % | | $ | 485,369 | | | | 3.90 | % | | $ | 24,565 | | | | 5.28 | % | | $ | 646,384 | | | | 5.01 | % | | $ | 1,460,499 | | | $ | 1,460,499 | | | | 4.64 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | December 31, 2005 | |
| | | | | | | | | | | After One | | | After Five Years | | | | | | | | | | | | | |
| | | Within | | | Year to | | | to | | | | | | | | | | | | | |
| | | One Year | | | Five Years | | | Ten Years | | | Over Ten Years | | | Total | | | | | | | |
| | | Carrying | | | Avg | | | Carrying | | | Avg | | | Carrying | | | Avg | | | Carrying | | | Avg | | | Carrying | | | Fair | | | Avg | |
| | | Value | | | Yield | | | Value | | | Yield | | | Value | | | Yield | | | Value | | | Yield | | | Value | | | Value | | | Yield | |
| | | (Dollars in thousands) |
| U.S. Treasury | | $ | 24,576 | | | | 3.85 | % | | $ | — | | | | — | | | $ | — | | | | — | | | $ | — | | | | — | | | $ | 24,576 | | | $ | 24,576 | | | | 3.85 | % |
| U.S. Agency Notes | | | 254,610 | | | | 2.96 | % | | | 259,152 | | | | 3.68 | % | | | 213,437 | | | | 4.15 | % | | | — | | | | — | | | | 727,199 | | | | 727,199 | | | | 3.57 | % |
| P.R. Government Obligations | | | 12,790 | | | | 4.93 | % | | | 9,877 | | | | 4.07 | % | | | 27,215 | | | | 4.83 | % | | | 3,718 | | | | 6.35 | % | | | 53,600 | | | | 53,600 | | | | 4.82 | % |
| Mortgage-backed Securities | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 754,231 | | | | 5.00 | % | | | 754,231 | | | | 754,231 | | | | 5.00 | % |
| Foreign Securities | | | — | | | | — | | | | 75 | | | | 5.60 | % | | | — | | | | — | | | | — | | | | — | | | | 75 | | | | 75 | | | | 5.60 | % |
| Other Securities | | | 41,862 | | | | 5.00 | % | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 41,862 | | | | 41,862 | | | | 5.00 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Securities | | $ | 333,838 | | | | 3.36 | % | | $ | 269,104 | | | | 3.70 | % | | $ | 240,652 | | | | 4.22 | % | | $ | 757,949 | | | | 5.01 | % | | $ | 1,601,543 | | | $ | 1,601,543 | | | | 4.33 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | December 31, 2004 | |
| | | | | | | | | | | After One | | | After Five Years | | | | | | | | | | | | | |
| | | Within | | | Year to | | | to | | | | | | | | | | | | | |
| | | One Year | | | Five Years | | | Ten Years | | | Over Ten Years | | | Total | | | | | | | |
| | | Carrying | | | Avg | | | Carrying | | | Avg | | | Carrying | | | Avg | | | Carrying | | | Avg | | | Carrying | | | Fair | | | Avg | |
| | | Value | | | Yield | | | Value | | | Yield | | | Value | | | Yield | | | Value | | | Yield | | | Value | | | Value | | | Yield | |
| | | (Dollars in thousands) |
| U.S. Treasury | | $ | 7,578 | | | | 2.16 | % | | $ | — | | | | — | | | $ | — | | | | — | | | $ | — | | | | — | | | $ | 7,578 | | | $ | 7,578 | | | | 2.16 | % |
| U.S. Agency Notes | | | 3,057 | | | | 2.24 | % | | | 1,062,627 | | | | 4.56 | % | | | 362,247 | | | | 4.13 | % | | | — | | | | — | | | | 1,427,931 | | | | 1,427,931 | | | | 4.45 | % |
| P.R. Government Obligations | | | 8,470 | | | | 4.42 | % | | | 22,189 | | | | 4.51 | % | | | 13,800 | | | | 4.24 | % | | | 8,229 | | | | 6.42 | % | | | 52,688 | | | | 52,688 | | | | 4.73 | % |
| Mortgage-backed Securities | | | — | | | | — | | | | 890 | | | | 8.36 | % | | | 75 | | | | 9.50 | % | | | 488,820 | | | | 4.30 | % | | | 489,785 | | | | 489,785 | | | | 4.31 | % |
| Foreign Securities | | | 75 | | | | 6.98 | % | | | 75 | | | | 5.60 | % | | | — | | | | — | | | | — | | | | — | | | | 150 | | | | 150 | | | | 6.29 | % |
| Other Securities | | | — | | | | — | | | | 37,500 | | | | 1.72 | % | | | — | | | | — | | | | — | | | | — | | | | 37,500 | | | | 37,500 | | | | 1.72 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Securities | | $ | 19,180 | | | | 4.94 | % | | $ | 1,123,281 | | | | 4.29 | % | | $ | 376,122 | | | | 4.13 | % | | $ | 497,049 | | | | 4.33 | % | | $ | 2,015,632 | | | $ | 2,015,632 | | | | 4.41 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
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Loan Portfolio
The following table analyzes the Corporation’s loans by type of loan, including loans held for sale, as of December 31, 2006, 2005, 2004, 2003 and 2002.
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Year ended December 31, | |
| | | 2006 | | | 2005 | | | 2004 | | | 2003 | | | 2002 | |
| | | | | | | % of | | | | | | | % of | | | | | | | % of | | | | | | | % of | | | | | | | % of | |
| | | | | | | Total | | | | | | | Total | | | | | | | Total | | | | | | | Total | | | | | | | Total | |
| | | Amount | | | Loans | | | Amount | | | Loans | | | Amount | | | Loans | | | Amount | | | Loans | | | Amount | | | Loans | |
| | | (Dollars in thousands) | |
| Commercial, industrial and agricultural | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Retail commercial banking | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Middle-market | | $ | 1,662,566 | | | | 23.9 | % | | $ | 1,574,459 | | | | 26.1 | % | | $ | 1,439,609 | | | | 25.9 | % | | $ | 1,354,879 | | | | 32.2 | % | | $ | 1,220,996 | | | | 29.8 | % |
| Agricultural | | | 59,315 | | | | 0.9 | % | | | 61,531 | | | | 1.0 | % | | | 62,198 | | | | 1.1 | % | | | 62,925 | | | | 1.5 | % | | | 67,768 | | | | 1.7 | % |
| SBA | | | 66,734 | | | | 1.0 | % | | | 69,763 | | | | 1.2 | % | | | 72,963 | | | | 1.3 | % | | | 72,060 | | | | 1.7 | % | | | 74,160 | | | | 1.8 | % |
| Factor liens | | | 20,553 | | | | 0.3 | % | | | 16,696 | | | | 0.3 | % | | | 16,818 | | | | 0.3 | % | | | 18,291 | | | | 0.4 | % | | | 14,026 | | | | 0.3 | % |
| Other | | | 6,965 | | | | 0.1 | % | | | 40,072 | | | | 0.7 | % | | | 11,978 | | | | 0.2 | % | | | 2,754 | | | | 0.1 | % | | | 4,699 | | | | 0.1 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Retail commercial banking | | | 1,816,133 | | | | 26.2 | % | | | 1,762,521 | | | | 29.3 | % | | | 1,603,566 | | | | 28.8 | % | | | 1,510,909 | | | | 35.9 | % | | | 1,381,649 | | | | 33.7 | % |
| Corporate banking | | | 673,566 | | | | 9.7 | % | | | 1,205,664 | | | | 20.0 | % | | | 1,598,443 | | | | 28.8 | % | | | 753,839 | | | | 17.9 | % | | | 585,946 | | | | 14.3 | % |
| Construction | | | 435,182 | | | | 6.3 | % | | | 213,705 | | | | 3.5 | % | | | 199,799 | | | | 3.6 | % | | | 209,655 | | | | 5.0 | % | | | 309,505 | | | | 7.5 | % |
| Lease Financing | | | 132,655 | | | | 1.9 | % | | | 125,168 | | | | 2.1 | % | | | 112,152 | | | | 2.0 | % | | | 105,849 | | | | 2.5 | % | | | 92,993 | | | | 2.3 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Commercial | | | 3,057,536 | | | | 44.1 | % | | | 3,307,058 | | | | 54.9 | % | | | 3,513,960 | | | | 63.2 | % | | | 2,580,252 | | | | 61.3 | % | | | 2,370,093 | | | | 57.8 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Consumer | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Personal (installment and other loans) | | | 412,952 | | | | 5.9 | % | | | 397,169 | | | | 6.6 | % | | | 319,204 | | | | 5.7 | % | | | 287,590 | | | | 6.8 | % | | | 379,678 | | | | 9.3 | % |
| Automobile | | | 2 | | | | 0.0 | % | | | 610 | | | | 0.0 | % | | | 6,434 | | | | 0.1 | % | | | 21,232 | | | | 0.5 | % | | | 48,384 | | | | 1.2 | % |
| Credit Cards | | | 193,260 | | | | 2.8 | % | | | 169,416 | | | | 2.8 | % | | | 128,622 | | | | 2.3 | % | | | 95,362 | | | | 2.3 | % | | | 102,463 | | | | 2.5 | % |
| Consumer Finance | | | 625,266 | | | | 9.0 | % | | | — | | | | 0.0 | % | | | — | | | | 0.0 | % | | | — | | | | 0.0 | % | | | — | | | | 0.0 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Consumer | | | 1,231,480 | | | | 17.7 | % | | | 567,195 | | | | 9.4 | % | | | 454,260 | | | | 8.2 | % | | | 404,184 | | | | 9.6 | % | | | 530,525 | | | | 12.9 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Mortgage | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Residential | | | 2,649,128 | | | | 38.1 | % | | | 2,141,358 | | | | 35.6 | % | | | 1,583,418 | | | | 28.5 | % | | | 1,219,091 | | | | 29.0 | % | | | 1,196,231 | | | | 29.2 | % |
| Commercial | | | 5,412 | | | | 0.1 | % | | | 6,121 | | | | 0.1 | % | | | 7,659 | | | | 0.1 | % | | | 2,836 | | | | 0.1 | % | | | 4,482 | | | | 0.1 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Mortgage | | | 2,654,540 | | | | 38.2 | % | | | 2,147,479 | | | | 35.7 | % | | | 1,591,077 | | | | 28.6 | % | | | 1,221,927 | | | | 29.1 | % | | | 1,200,713 | | | | 29.3 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Loans, net of unearned interest and deferred fees | | $ | 6,943,556 | | | | 100.0 | % | | $ | 6,021,732 | | | | 100.0 | % | | $ | 5,559,297 | | | | 100.0 | % | | $ | 4,206,363 | | | | 100.0 | % | | $ | 4,101,331 | | | | 100.0 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
The loan portfolio, including loans held for sale, reflected an increase of 15.3% or $921.8 million, reaching $6.9 billion at December 31, 2006, compared to the figures reported as of December 31, 2005. The mortgage loan portfolio at December 31, 2006 grew $507.0 million or 23.6% compared to December 31, 2005. Mortgage loans originated during the year ended December 31, 2006 reached $911.6 million or 21.9% more than the same period last year. The consumer loan portfolio also reflected growth of $664.3 million or 117.1%, as of December��31, 2006, compared to December 31, 2005 due primarily to the acquisition of Island Finance. The commercial loan portfolio (including construction and lease financing) decreased $249.5 million or 7.5% compared to December 31, 2005, as a result of the settlement of commercial loans secured by mortgages with Doral during the second quarter of 2006.
Allowance for Loan Losses
The Corporation systematically assesses the overall risks in its loan portfolio and establishes and maintains an allowance for probable losses thereon. The allowance for loan losses is maintained at a level sufficient to provide for estimated loan losses based on the evaluation of known and inherent risks in its loan portfolio. Management evaluates the adequacy of the allowance for loan losses on a monthly basis. This evaluation involves the exercise of judgment and the use of assumptions and estimates that are subject to revision, as more information becomes available. In determining the allowance, management considers the portfolio risk characteristics, prior loss experience, prevailing and projected economic conditions, loan impairment measurements and the results of its internal and regulatory agencies’ loan reviews. Based on current and expected economic
49
conditions, the expected level of net loan losses and the methodology established to evaluate the adequacy of the allowance for loan losses, management considers that the allowance for loan losses is adequate to absorb probable losses in the Corporation’s loan portfolio.
Commercial and construction loans over a predetermined amount are individually evaluated on a quarterly basis for impairment following the provisions of SFAS No. 114, “Accounting by Creditors of a Loan.” A loan is impaired when based on current information and events; it is probable that the Corporation will be unable to collect all amounts due according to the contractual terms of the loan agreement. The impairment loss, if any, on each individual loan identified as impaired is measured based on the present value of expected cash flows discounted at the loan’s effective interest rate, except as a practical expedient, impairment may be measured based on the loan’s observable market price, or the fair value of the collateral, if the loan is collateral dependent. Substantially all of the Corporation’s impaired loans are measured on the basis of the fair value of the collateral, net of estimated disposition costs. The Corporation maintains a detailed analysis of all loans identified as impaired with their corresponding allowances and the specific component of the allowance is computed on a quarterly basis. Additions, deletions or adjustments to the analysis are tracked and formal justification is documented detailing the rationale for such adjustments.
For small, homogeneous type of loans, a general allowance is computed based on average historical loss experience or ratios for each corresponding type of loans (consumer, credit cards, residential mortgages, auto, etc.). The methodology of accounting for all probable losses is made in accordance with the guidance provided by Statement of Accounting Standards (SFAS) No. 5, “Accounting for Contingencies.” In determining the general allowance, the Corporation applies a loss factor for each type of loan based on the average historical net charge off for the previous two or three years for each portfolio adjusted for other statistical loss estimates, as deemed appropriate. Historical loss rates are reviewed at least quarterly and adjusted based on changes in actual collections and charge off experience as well as significant factors that in management’s judgment reflect the impact of any current conditions on loss recognition. Factors that management considers in the analysis of the general reserve include the effect of the trends in the nature and volume of loans (delinquency, charge-offs and non-accrual loans), changes in the mix or type of collateral, asset quality trends, changes in the internal lending policies and credit standards, collection practices and examination results from bank regulatory agencies.
The determination of the allowance for loan losses under SFAS No. 5 is based on historical loss experience by loan type, management judgment of the quantitative factors (historical net charge-offs, statistical loss estimates, etc.), as well as qualitative factors (current economic conditions, portfolio composition, delinquency trends, industry concentrations, etc.), which result in the final determination of the provision for loan losses to maintain a level of allowance for loan losses deemed to be adequate.
The Corporation’s methodology for allocating the allowance among the different parts of the portfolio or different elements of the allowance is based on the historical loss percentages for each type or pool of loan (consumer, commercial, construction, mortgage and other), after assigning the specific allowances for impaired loans on an individual review process. The sum of specific allowances for impaired loans plus the general allowances for each type of loan not specifically examined constitutes the total allowance for loan losses at the end of any reporting period.
An additional or unallocated reserve is maintained to cover the effect of probable economic deterioration above and beyond what is reflected in the asset-specific component of the allowance. This component represents management’s view that given the complexities of the lending portfolio and the assessment process, including the inherent imprecision in the financial models used in the loss forecasting process, there are estimable losses that have been incurred but not yet specifically identified, and as a result not fully provided for in the asset-specific component of the allowance. The level of the unallocated reserve may change periodically after evaluating factors impacting assumptions used in the calculation of the asset specific component of the reserve.
On a quarterly basis, management reviews its determination of the allowance for loan losses which includes the specific allowance computed according to the provisions of SFAS No. 114 and the general allowance for small, homogenous type of loans, which is based on historical loss percentages for each type or pool of loan. This analysis also considers loans classified by the internal loan review department, the internal auditors, the in-house Watch System Unit, and banking regulators.
The Corporation has not changed any aspects of its overall approach in the determination of the allowance for loan losses, and there have been no material changes in assumptions or estimation techniques, as compared to prior periods. The methodology for determining the allowance for loan losses for the recently acquired Island Finance portfolio is the same as the methodology used in determining the allowance for the rest of the Corporation’s portfolios.
50
| | | | | | | | | | | | | | | | | | | | | |
| | | Year ended December 31, | |
| | | 2006 | | | 2005 | | | 2004 | | | 2003 | | | 2002 | |
| | | (Dollars in thousands) | |
| | | | | | | | | | | | | | | | | | | | | |
| Balance at beginning of year | | $ | 66,842 | | | $ | 69,177 | | | $ | 69,693 | | | $ | 56,906 | | | $ | 51,738 | |
| Allowance acquired (Island Finance) | | | 35,104 | | | | — | | | | — | | | | — | | | | — | |
| Provision for loan losses | | | 65,583 | | | | 20,400 | | | | 26,270 | | | | 49,916 | | | | 63,699 | |
| | | | | | | | | | | | | | | | |
| | | | 167,529 | | | | 89,577 | | | | 95,963 | | | | 106,822 | | | | 115,437 | |
| | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
| Losses charged to the allowance: | | | | | | | | | | | | | | | | | | | | |
| Commercial and industrial | | | 9,792 | | | | 8,044 | | | | 19,250 | | | | 9,198 | | | | 19,158 | |
| Construction | | | — | | | | 1,438 | | | | — | | | | 499 | | | | 1,528 | |
| Consumer | | | 16,679 | | | | 17,351 | | | | 18,969 | | | | 36,544 | | | | 45,676 | |
| Consumer Finance | | | 38,345 | | | | — | | | | — | | | | — | | | | — | |
| Leasing | | | 2,071 | | | | 986 | | | | 1,658 | | | | 1,434 | | | | 3,125 | |
| | | | | | | | | | | | | | | | |
| | | | 66,887 | | | | 27,819 | | | | 39,877 | | | | 47,675 | | | | 69,487 | |
| | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
| Recoveries: | | | | | | | | | | | | | | | | | | | | |
| Commercial and industrial | | | 2,463 | | | | 1,686 | | | | 5,271 | | | | 4,478 | | | | 3,443 | |
| Construction | | | — | | | | — | | | | — | | | | 433 | | | | 18 | |
| Mortgage | | | — | | | | — | | | | — | | | | 7 | | | | 1 | |
| Consumer | | | 1,677 | | | | 2,646 | | | | 7,341 | | | | 5,127 | | | | 7,044 | |
| Consumer Finance | | | 1,314 | | | | — | | | | — | | | | — | | | | — | |
| Leasing | | | 767 | | | | 752 | | | | 479 | | | | 501 | | | | 450 | |
| | | | | | | | | | | | | | | | |
| | | | 6,221 | | | | 5,084 | | | | 13,091 | | | | 10,546 | | | | 10,956 | |
| | | | | | | | | | | | | | | | |
| Net loans charged-off | | | 60,666 | | | | 22,735 | | | | 26,786 | | | | 37,129 | | | | 58,531 | |
| | | | | | | | | | | | | | | | |
| Balance at end of year | | $ | 106,863 | | | $ | 66,842 | | | $ | 69,177 | | | $ | 69,693 | | | $ | 56,906 | |
| | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
Ratios: | | | | | | | | | | | | | | | | | | | | |
| Allowance for loan losses to year-end loans | | | 1.54 | % | | | 1.11 | % | | | 1.24 | % | | | 1.66 | % | | | 1.39 | % |
| Recoveries to charge-offs | | | 9.30 | % | | | 18.28 | % | | | 32.83 | % | | | 22.12 | % | | | 15.77 | % |
| Net charge-offs to average loans | | | 0.93 | % | | | 0.38 | % | | | 0.56 | % | | | 0.91 | % | | | 1.32 | % |
| Allowance for loan losses to net charge-offs | | | 176.15 | % | | | 294.00 | % | | | 258.26 | % | | | 187.71 | % | | | 97.22 | % |
| Allowance for loan losses to non-performing loans | | | 100.01 | % | | | 90.72 | % | | | 79.05 | % | | | 70.85 | % | | | 46.10 | % |
| |
Provision for loan losses to: | | | | | | | | | | | | | | | | | | | | |
| Net charge-offs | | | 108.11 | % | | | 89.73 | % | | | 98.07 | % | | | 134.44 | % | | | 108.83 | % |
| Average loans | | | 1.00 | % | | | 0.34 | % | | | 0.55 | % | | | 1.23 | % | | | 1.43 | % |
During the third quarter of 2004, the Corporation reclassified its reserves related to unfunded lending commitments and standby letters of credit from the allowance for loan losses to other liabilities. Prior period amounts have been reclassified to conform to the current presentation. Changes in the reserve for unfunded commitments and standby letters of credit were as follows:
| | | | | | | | | | | | | | | | | | | | | |
| | | Year ended December 31, | |
| | | 2006 | | | 2005 | | | 2004 | | | 2003 | | | 2002 | |
| | | | | | | (Dollars in thousands) | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
| Balance at beginning of year | | $ | 1,666 | | | $ | 1,269 | | | $ | 879 | | | $ | 1,050 | | | $ | 1,119 | |
| Provision for credit losses | | | 198 | | | | 397 | | | | 390 | | | | (171 | ) | | | (69 | ) |
| | | | | | | | | | | | | | | | |
| Balance at end of year | | $ | 1,864 | | | $ | 1,666 | | | $ | 1,269 | | | $ | 879 | | | $ | 1,050 | |
| | | | | | | | | | | | | | | | |
2006 compared to 2005. The allowance for loan losses increased $40.0 million to $106.9 million from $66.8 million as of December 31, 2005. The most significant change in the allowance for loan losses was due to the acquisition of Island Finance which had and allowance for loan losses of $41.3 million as of December 31, 2006.
51
The Corporation’s allowance for loan losses was $106.7 million or 1.54% of period-end loans at December 31, 2006, a 43 basis points increase over 1.11% reported as of December 31, 2005. The increase in this ratio was partially due to an increment in non-performing loans during the period. Non-performing loans increased $33.2 million or 45.0% to $106.9 million as of December 31, 2006 from $73.7 million as of December 31, 2005. The non-performing loans of Island Finance portfolio reached $24.7 million at December 31, 2006.
Island Finance loans acquired pursuant to the Asset Purchase Agreement on February 28, 2006 are subject to a guarantee by Wells Fargo of up to $21.0 million (maximum reimbursement amount) for net losses in excess of $34.0 million, occurring on or prior to the 15th month anniversary of the acquisition. The Corporation is provided with an additional guarantee of up to $7.0 million for net losses incurred in the acquired loan portfolio in excess of $34.0 million during months 16 to 18 of the anniversary, subject to the maximum aggregate reimbursement amount of $21.0 million. Through December 31, 2006, the Corporation had claimed $11.2 million from Wells Fargo under this guarantee.
The ratio of allowance for loan losses to non-performing loans reflected an increase of 929 basis points to 100.01% during the year ended 2006 when compared to 90.72% for the same period in 2005. This increase was a result of an increase in the provision for loans losses related to Island Finance portfolio. Excluding non-performing mortgage loans, this ratio is 235.8% and 235.5% as of December 31, 2006 and 2005, respectively.
The annualized ratio of net charge-off to average loans for the year ended December 31, 2006 was 0.93%, increasing 55 basis points from 0.38% for the year ended December 31, 2005. This change was due to an increment in average gross loans of $0.6 billion or 10.0% when compared with figures reported in 2005, related to the Island Finance loan portfolio acquired. Losses charged to the allowance amounted to $66.9 million in 2006, an increase of $39.1 million when compared $27.8 million of losses charged to the allowance in 2005. This increase was due to Island Finance charge-offs of $38.3 million in 2006.
2005 compared to 2004. During 2005, the Corporation’s asset quality improved resulting in a decrease in the allowance for loan losses of 3.4% from $69.2 million at December 31, 2004 to $66.8 million at December 31, 2005.
There was a significant reduction in loans charged to the allowance of 30.2% to $27.8 million at December 31, 2005 from $39.9 million compared to the same period in 2004. In addition, the ratio of allowance for loan losses to net charge-offs reflected an improving trend from 258.26% at December 31, 2004 to 294.00% at December 31, 2005. This increase was as a result of a decrease in commercial and industrial portfolio charge-offs of 58.2% reaching $8.0 million in 2005 from $19.3 million in 2004. The ratio of recoveries to charged-off was 18.28% for the year ended December 31, 2005, decreasing 1,455 basis points from December 31, 2004. The reduction in recoveries was due to the reduction in charge-offs and to the sale of certain previously charged-off consumer loans to an unrelated third party during the second quarter 2005. This resulted in an improvement of 18 basis points in the annualized ratio of net charged-off to average loans from 0.56% at December 31, 2004 to 0.38% at December 31, 2005.
The allowance for loan losses to non-performing loans improved from 79.05% in 2004 to 90.72% in 2005 mainly due to a significant reduction in total non-performing loans of 15.8% from $87.5 million at year ended December 31, 2004 to $73.7 million at year ended December 31, 2005. The most significant change in non-performing portfolio composition was a reduction in commercial loan portfolio (without real estate collateral) of 48.8% to $14.3 million in 2005 compared with prior year figures of $28.0 million. Construction and consumer loans also reflected decreases of 69.5% or $7.8 million and 30.3% or $2.1 million, respectively. Non-performing mortgage loans showed an increase of 24.9% at December 31, 2005. Historically, this portfolio experienced the lowest rates of losses. Excluding non-performing mortgage loans this ratio is 235.5% compared to 135.0% as of December 31, 2005 and 2004.
Net charge-offs of $22.7 million were partially offset by a provision of $20.4 million for the year ended 2005. Lower net charge-offs in 2005 together with the lower non-performing loans resulted in a lower provision for loan losses while still maintaining an allowance for loan losses to year-end loans of 1.11%.
As of December 31, 2005, impaired loans (loans evaluated individually for impairment) also presented an important reduction of 39.1% to $48.8 million from $80.1 million as of December 31, 2004, reflecting a decrease in the allowance for impaired loan of 54.4%
Broken down by major loan categories, the allowance for loan losses for each of the five years in the period ended December 31, 2006 was as follows:
52
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Year ended December 31, | |
| | | 2006 | | | 2005 | | | 2004 | | | 2003 | | | 2002 | |
| | | | | | | % of loans | | | | | | | % of loans | | | | | | | % of loans | | | | | | | % of loans | | | | | | | % of loans | |
| | | | | | | in each | | | | | | | in each | | | | | | | in each | | | | | | | in each | | | | | | | in each | |
| | | | | | | category to | | | | | | | category to | | | | | | | category to | | | | | | | category to | | | | | | | category to | |
| | | Amount | | | Total Loans | | | Amount | | | Total Loans | | | Amount | | | Total Loans | | | Amount | | | Total Loans | | | Amount | | | Total Loans | |
| | | (Dollars in thousands) | |
| Commercial | | $ | 29,846 | | | | 35.9 | % | | $ | 27,765 | | | | 49.3 | % | | $ | 29,469 | | | | 57.6 | % | | $ | 26,219 | | | | 53.8 | % | | $ | 21,415 | | | | 48.0 | % |
| Construction | | | 3,128 | | | | 6.3 | % | | | 1,456 | | | | 3.5 | % | | | 1,208 | | | | 3.6 | % | | | 1,194 | | | | 5.0 | % | | | 4,149 | | | | 7.5 | % |
| Consumer | | | 20,099 | | | | 8.7 | % | | | 30,664 | | | | 9.4 | % | | | 30,832 | | | | 8.2 | % | | | 33,751 | | | | 9.6 | % | | | 29,711 | | | | 12.9 | % |
| Consumer Finance | | | 41,281 | | | | 9.0 | % | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | |
| Mortgage | | | 9,249 | | | | 38.2 | % | | | 2,415 | | | | 35.7 | % | | | 4,250 | | | | 28.6 | % | | | 3,318 | | | | 29.1 | % | | | 124 | | | | 29.3 | % |
| Lease financing | | | 555 | | | | 1.9 | % | | | 2,128 | | | | 2.1 | % | | | 2,068 | | | | 2.0 | % | | | 2,922 | | | | 2.5 | % | | | 1,833 | | | | 2.3 | % |
| Unallocated | | | 2,705 | | | | — | | | | 2,414 | | | | — | | | | 1,350 | | | | — | | | | 2,289 | | | | — | | | | (326 | ) | | | — | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | $ | 106,863 | | | | 100.0 | % | | $ | 66,842 | | | | 100.0 | % | | $ | 69,177 | | | | 100.0 | % | | $ | 69,693 | | | | 100.0 | % | | $ | 56,906 | | | | 100.0 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Under the caption “Unallocated” the Corporation maintains an unallocated reserve for loan losses of $2.7 million as of December 31, 2006. The unallocated reserve is maintained to cover the effect of probable economic deterioration above and beyond what is reflected in the asset-specific component of the allowance. This component represents management’s view that given the complexities of the lending portfolio and the assessment process, including the inherent imprecision in the financial models used in the loss forecasting process, there are estimable losses that have been incurred but not yet specifically identified, and as a result not fully provided for in the asset-specific component of the allowance. The level of the unallocated reserve may change periodically after evaluating factors impacting assumptions used in the calculation of the asset specific component of the reserve.
Any loan considered to be impaired is measured by the Corporation at the present value of expected future cash flows using the loan’s effective interest rate, or as a practical expedient, at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. A loan is impaired when, based on current information and events, it is probable that the Corporation will be unable to collect all amounts due according to the contractual terms of the agreement. At December 31, 2006, 2005 and 2004, the portion of the allowance for loan losses related to impaired loans was $4.4 million, $2.2 million and $4.9 million, respectively. Please refer to Notes 1 and 5 to the consolidated financial statements for further information.
Liabilities
The principal sources of funding for the Corporation are its equity capital, core deposits from retail and commercial clients, and wholesale deposits and borrowings raised in the interbank and commercial markets.
As of December 31, 2006, total liabilities amounted $8.6 billion, reflecting an increase of 11.8% or $0.9 billion compared to $7.7 billion as of December 31, 2005. This increase in total liabilities was mainly due to increases in federal funds sold and other borrowings of $859.6 million or 111.8% and term and subordinated capital notes of $124.7 million or 77.3%. These increases were partially offset by decreases in commercial paper issued of $124.8 million or 37.3% and securities sold under agreements to repurchase of $117.2 million or 12.4%. The increase in borrowings was due to debt of $725 million incurred pursuant to the acquisition of Island Finance, the refinancing of other existing debt of the Corporation and the private placement of $125 million Trust Preferred Securities classified as borrowings in the consolidated financial statements. In December 2006, the Corporation and Santander Financial Services, entered into a Bridge Facility Agreement (the “Agreement”) with National Australia Bank Limited (the “Lender”). The proceeds of the Agreement were used to refinance the outstanding indebtedness incurred in connection with the previously announced amended and restated loan agreement with Lloyds TBS Bank PLC and for general corporate purposes. Under the Agreement, the Corporation and Santander Financial had available $275 million and $525 million, respectively, all of which was drawn. The amounts drawn under the Agreement (the “Loan”) bear interest at an annual rate equal to the 3 month LIBOR rate plus 0.10% per annum. Pursuant to the Agreement, the Company and Santander Financial will pay the Lender a facility fee (the “Facility Fee”) of 0.02% of the principal amount of the Loan within three days of the execution of the Agreement. The entire principal balance of the Loan is due and payable on September 21, 2007. The Loan is guaranteed by Santander Spain, the parent of the Corporation. The Corporation pays Santander Spain a guarantee fee equal to 10 basis points (0.1%) of the principal amount of the Loan.
53
During the last quarter of 2005, the Corporation issued a Conservation Trust of Puerto Rico Notes of $50 million to obtain long term financing at a reasonable interest rate. Proceeds from the offering were used to finance the loan portfolio.
The following table sets forth the Corporation’s average daily balance of liabilities for the years ended December 31, 2006, 2005 and 2004 by source, together with the average interest rates paid thereon.
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Year ended December 31, | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | | | | | % of | | | | | | | | | | | % of | | | | | | | | | | | % of | | | | |
| | | Average | | | Total | | | Average | | | Average | | | Total | | | Average | | | Average | | | Total | | | Average | |
| | | Balance | | | Liabilities | | | Cost | | | Balance | | | Liabilities | | | Cost | | | Balance | | | Liabilities | | | Cost | |
| | | (Dollars in thousands) | |
| Savings deposits | | $ | 1,861,167 | | | | 22.5 | % | | | 2.66 | % | | $ | 1,945,095 | | | | 25.2 | % | | | 2.00 | % | | $ | 1,916,270 | | | | 26.8 | % | | | 1.33 | % |
| Time deposits | | | 2,645,357 | | | | 32.0 | % | | | 4.68 | % | | | 2,473,737 | | | | 32.1 | % | | | 3.37 | % | | | 1,580,760 | | | | 22.1 | % | | | 2.21 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing deposits | | | 4,506,524 | | | | 54.6 | % | | | 3.85 | % | | | 4,418,832 | | | | 57.3 | % | | | 2.77 | % | | | 3,497,030 | | | | 48.9 | % | | | 1.73 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Federal funds, repos, and commercial paper and other borrowings | | | 2,611,231 | | | | 31.6 | % | | | 5.30 | % | | | 2,295,932 | | | | 29.8 | % | | | 3.73 | % | | | 2,648,854 | | | | 37.1 | % | | | 2.80 | % |
| Term and subordinated notes | | | 265,489 | | | | 3.2 | % | | | 5.96 | % | | | 119,240 | | | | 1.5 | % | | | 3.74 | % | | | 162,298 | | | | 2.3 | % | | | 3.83 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total borrowings | | | 2,876,720 | | | | 34.8 | % | | | 5.36 | % | | | 2,415,172 | | | | 31.3 | % | | | 3.73 | % | | | 2,811,152 | | | | 39.4 | % | | | 2.86 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total interest-bearing liabilities | | | 7,383,244 | | | | 89.4 | % | | | 4.44 | % | | | 6,834,004 | | | | 88.6 | % | | | 3.11 | % | | | 6,308,182 | | | | 88.3 | % | | | 2.23 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Non-interest-bearing deposits | | | 548,163 | | | | 6.6 | % | | | 0.00 | % | | | 663,688 | | | | 8.6 | % | | | 0.00 | % | | | 656,215 | | | | 9.3 | % | | | 0.00 | % |
| Other liabilities | | | 325,620 | | | | 3.9 | % | | | 0.00 | % | | | 212,074 | | | | 2.8 | % | | | 0.00 | % | | | 174,111 | | | | 2.4 | % | | | 0.00 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total non-interest-bearing liabilities | | | 873,783 | | | | 10.6 | % | | | 0.00 | % | | | 875,762 | | | | 11.4 | % | | | 0.00 | % | | | 830,326 | | | | 11.7 | % | | | 0.00 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Liabilities | | $ | 8,257,027 | | | | 100.0 | % | | | 3.97 | % | | $ | 7,709,766 | | | | 100.0 | % | | | 2.76 | % | | $ | 7,138,508 | | | | 100.0 | % | | | 1.97 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
As of December 31, 2006, total deposits were $5.3 billion, reflecting an increase of $0.1 million, or 1.7%, over deposits of $5.2 billion as of December 31, 2005.
The following tables set forth additional details on the Corporation’s average deposit base for the years ended December 31, 2006, 2005 and 2004.
| | | | | | | | | | | | | |
| | | Year ended December 31, | |
| Average Total Deposits | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars in thousands) | |
| | | | | | | | | | | | | |
| Private Demand | | $ | 547,416 | | | $ | 626,829 | | | $ | 595,012 | |
| Public Demand | | | 747 | | | | 36,859 | | | | 61,203 | |
| | | | | | | | | | |
| Non-interest bearing | | | 548,163 | | | | 663,688 | | | | 656,215 | |
| | | | | | | | | | |
| | | | | | | | | | | | | |
| Savings Accounts | | | 792,791 | | | | 859,623 | | | | 786,006 | |
| NOW and Super NOW accounts | | | 412,696 | | | | 470,595 | | | | 527,954 | |
| Government NOW accounts | | | 655,680 | | | | 614,877 | | | | 602,310 | |
| | | | | | | | | | |
| Total Savings Accounts | | | 1,861,167 | | | | 1,945,095 | | | | 1,916,270 | |
| | | | | | | | | | |
| | | | | | | | | | | | | |
| Time deposits: | | | | | | | | | | | | |
| Under $100,000 | | | 259,255 | | | | 231,916 | | | | 215,446 | |
| $100,000 and over | | | 2,386,102 | | | | 2,241,821 | | | | 1,365,304 | |
| | | | | | | | | | |
| Total Time Deposits | | | 2,645,357 | | | | 2,473,737 | | | | 1,580,750 | |
| | | | | | | | | | |
| Total Interest Bearing Deposits | | | 4,506,524 | | | | 4,418,832 | | | | 3,497,020 | |
| | | | | | | | | | |
| Total Deposits | | $ | 5,054,687 | | | $ | 5,082,520 | | | $ | 4,153,235 | |
| | | | | | | | | | |
54
The Corporation’s most important source of funding is its costumer deposits. Total average deposits reached $5.1 billion for the year ended December 31, 2006, a slight decrease of 0.6% compared with figures reported in 2005. The decrease in average deposits was comprised primarily of decreases in average savings accounts of $83.9 million or 4.3% and in average non-interest bearing accounts of $115.5 million or 17.4%. These decreases were partially offset by an increase of $171.2 million or 6.9% in time deposits which included an increase of $0.3 billion in average brokered deposits. Average non-interest bearing deposits are the least expensive sources of funding used by Corporation and represent 6.6%, 8.6% and 9.2% of the Corporation average total liabilities for the years ended December 31, 2006, 2005 and 2004. Total average deposits represented 61.2%, 65.9% and 58.2% of the total average liabilities of the Corporation as of December 31, 2006, 2005 and 2004, respectively.
The following table sets forth the maturities of time deposits of $100,000 or more as of December 31, 2006 and 2005.
| | | | | | | | | |
| | | 2006 | | | 2005 | |
| | | (Dollars in thousands) | |
| Three months or less | | $ | 896,638 | | | $ | 842,274 | |
| Over three months through six months | | | 302,716 | | | | 288,137 | |
| Over six months through twelve months | | | 377,998 | | | | 381,474 | |
| Over twelve months | | | 963,659 | | | | 850,115 | |
| | | | | | | |
| Total | | $ | 2,541,011 | | | $ | 2,362,000 | |
| | | | | | | |
For the year ended December 31, 2006, the Corporation’s customer deposits (average balance) consisted of $548.2 million in non interest-bearing-checking accounts and $4.5 billion of interest-bearing deposits. The increase in average interest-bearing deposits was primarily in time deposits greater than $100,000, which reflected an increment of 6.4% or $144.3 million.
The average balance of the Corporation’s total borrowings increased 19.1% or $461.0 million from $2.4 billion for the year ended December 31, 2005 to $2.9 billion for the year ended December 31, 2006. This increase was due to additional borrowings incurred related to the acquisition of the Island Finance business.
The Corporation’s current funding strategy is to continue to use various alternative funding sources taking into account their relative cost, their availability and the general asset and liability management strategy of the Corporation, placing a stronger emphasis on obtaining client deposits and reducing reliance on borrowings maintaining adequate levels of liquidity and to meet funding requirements.
For further information regarding the Corporation’s borrowings, see Notes 11 and 12 to the consolidated financial statements.
Capital and Dividends
The Corporation does not expect favorable or unfavorable trends that would materially affect our capital resources.
As an investment-grade rated entity by several nationally recognized rating agencies, the Corporation has access to a variety of capital issuance alternatives in the United States and Puerto Rico capital markets. The Corporation continuously monitors its capital raising alternatives. The Corporation may issue additional capital in the future, as needed, to maintain its “well-capitalized” status.
Stockholders’ equity was $579.2 million or 6.3% of total assets at December 31, 2006, compared to $568.5 million or 6.9% of total assets at December 31, 2005. The $10.7 million change in stockholders’ equity was composed by net income of $43.2 million for the period. This improvement in stockholders’ equity was partially offset by dividends declared $29.8 million and an increase in accumulated other comprehensive loss of $2.6 million.
On July 9, 2004, the Board of Directors declared a 10% stock dividend to all shareholders of record as of July 20, 2004, payable on August 3, 2004. Cash was paid in lieu of fractional shares. The earnings per share computations for 2003 and 2002 were adjusted to reflect this stock dividend.
During 2006 and 2005 the Corporation declared and paid annual cash dividends of $0.64 per common share to common shareholders, respectively. The Corporation’s current annualized dividend yield is 3.6% at December 31, 2006.
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The Corporation adopted and implemented various Stock Repurchase Programs in May 2000, December 2000 and June 2002. Under these programs the Corporation acquired 3% of the then outstanding common shares. During November 2002, the Corporation started a fourth Stock Repurchase program under which it may acquire 3% of its outstanding common shares. In November 2002, the Board of Directors authorized the Corporation to repurchase up to 928,204 shares, or approximately 3%, of its shares of outstanding common stock. The Board felt that the Corporation’s shares of common stock represented an attractive investment at prevailing market prices at the time of the adoption of the common stock repurchase program and that, given the relatively small amount of the program, the stock repurchases would not have a significant impact on liquidity and capital positions. The program has no time limitation and management is authorized to effect repurchases at its discretion. The authorization permits the Corporation to repurchase shares from time to time in the open market or in privately negotiated transactions. The timing and amount of any repurchases will depend on many factors, including the Corporation’s capital structure, the market price of the common stock and overall market conditions. All of the repurchased shares will be held by the Corporation as treasury stock and reserved for future issuance for general corporate purposes.
During the years ended December 31, 2006 and 2005, the Corporation did not repurchase any shares of common stock. As of December 31, 2006, the Corporation had repurchased 4,011,260 shares of its common stock under these programs at a cost of $67.6 million. Management believes that the repurchase program has not had a significant effect on the Corporation’s liquidity and capital positions.
The Corporation has a Dividend Reinvestment Plan and a Cash Purchase Plan wherein holders of common stock have the opportunity to automatically invest cash dividends to purchase more shares of the Corporation’s common stock. Shareholders may also make, as frequently as once a month, optional cash payments for investment in additional shares of the Corporation’s common stock.
At December 31, 2006, the Corporation’s common stock price per share was $17.85 representing an aggregate shareholder value of $832.5 million (including affiliated holdings).
The Corporation is subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Corporation’s consolidated financial statements. The regulations require the Corporation to meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Corporation’s capital classification is also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
The Corporation’s common stock is listed on the New York Stock Exchange (“NYSE”) and on the Madrid Stock Exchange (LATIBEX). The symbol on the NYSE and on the LATIBEX for the common stock is “SBP” and “XSBP,” respectively. There were approximately 145 holders of record of the Corporation’s common stock as of December 31, 2006, not including beneficial owners whose shares are held in names of brokers or other nominees.
As of December 31, 2006, the Corporation was classified as a “well capitalized” institution under the regulatory framework for prompt corrective action. At December 31, 2006, the Corporation continued to exceed the regulatory risk-based capital requirements for well-capitalized institutions. Tier I capital to risk-adjusted assets and total capital ratios at December 31, 2006 were 7.87% and 10.93%, respectively, and the leverage ratio was 5.81%. Refer to notes 1 and 24 in the consolidated financial statements for additional information.
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Capital Adequacy Data
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | To be Well Capitalized |
| | | | | | | | | | | For Minimum Capital | | Under Prompt Corrective |
| | | Actual | | Adequacy | | Action Provision |
| | | | | | | | | | | Amount | | Ratio | | Amount | | Ratio |
| | | Amount | | Ratio | | Must be | | Must be | | Must be | | Must be |
| | | | | | | | | | | (Dollars in thousands) | | | | | | | | |
December 31, 2006: | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Capital (to Risk Weighted Assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| Santander BanCorp | | $ | 723,269 | | | | 10.93 | % | | | ³$529,191 | | | | ³8.00 | % | | | N/A | | | | | |
| Banco Santander | | | 651,350 | | | | 11.10 | % | | | ³ 469,346 | | | | ³8.00 | % | | | ³586,683 | | | | ³10.00 | % |
| Tier I (to Risk Weighted Assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| Santander BanCorp | | | 520,794 | | | | 7.87 | % | | | ³ 264,596 | | | | ³4.00 | % | | | N/A | | | | | |
| Banco Santander | | | 583,941 | | | | 9.95 | % | | | ³ 234,673 | | | | ³4.00 | % | | | ³352,010 | | | | ³6.00 | % |
| Leverage (to average assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| Santander BanCorp | | | 520,794 | | | | 5.81 | % | | | ³ 269,000 | | | | ³3.00 | % | | | N/A | | | | | |
| Banco Santander | | | 583,941 | | | | 7.15 | % | | | ³ 244,857 | | | | ³3.00 | % | | | ³408,095 | | | | >5.00 | % |
December 31, 2005: | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Capital (to Risk Weighted Assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| Santander BanCorp | | $ | 726,939 | | | | 12.30 | % | | | ³$472,889 | | | | ³8.00 | % | | | N/A | | | | | |
| Banco Santander | | | 638,181 | | | | 11.05 | % | | | ³ 462,187 | | | | ³8.00 | % | | | ³577,734 | | | | ³10.00 | % |
| Tier I (to Risk Weighted Assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| Santander BanCorp | | | 537,319 | | | | 9.09 | % | | | ³ 236,445 | | | | ³4.00 | % | | | N/A | | | | | |
| Banco Santander | | | 570,056 | | | | 9.87 | % | | | ³ 231,093 | | | | ³4.00 | % | | | ³346,640 | | | | ³6.00 | % |
| Leverage (to average assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| Santander BanCorp | | | 537,319 | | | | 6.51 | % | | | ³ 247,593 | | | | ³3.00 | % | | | N/A | | | | | |
| Banco Santander | | | 570,056 | | | | 6.98 | % | | | ³ 245,222 | | | | ³3.00 | % | | | ³408,703 | | | | >5.00 | % |
December 31, 2004: | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Capital (to Risk Weighted Assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| Santander BanCorp | | $ | 647,799 | | | | 11.05 | % | | | ³$468,849 | | | | ³8.00 | % | | | N/A | | | | | |
| Banco Santander | | | 604,003 | | | | 9.78 | % | | | ³ 494,003 | | | | ³8.00 | % | | | ³617,504 | | | | ³ 10.00 | % |
| Tier I (to Risk Weighted Assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| Santander BanCorp | | | 505,650 | | | | 8.63 | % | | | ³ 234,424 | | | | ³4.00 | % | | | N/A | | | | | |
| Banco Santander | | | 537,161 | | | | 8.70 | % | | | ³ 247,002 | | | | ³4.00 | % | | | ³370,503 | | | | ³6.00 | % |
| Leverage (to average assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| Santander BanCorp | | | 505,650 | | | | 6.43 | % | | | ³ 235,607 | | | | ³3.00 | % | | | N/A | | | | | |
| Banco Santander | | | 537,161 | | | | 6.90 | % | | | ³ 233,389 | | | | ³3.00 | % | | | ³388,982 | | | | >5.00 | % |
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Goodwill and Intangible Assets
Goodwill and intangible assets were $148.3 million and $47.4 million at December 31, 2006, compared with $34.8 million and $10.1 million at December 31, 2005. The increase in Goodwill and intangible assets was related to the Consumer Finance segment with the acquisition of the Island Finance operations. Other intangible assets that reflected increases were mortgage servicing rights arising from the sale of mortgages of $0.5 million and advisory servicing rights of $0.5 million. There was no goodwill impairment recognized during 2006, 2005 or 2004. Refer to Notes 1 and 8 of the consolidated financial statements for additional information. Total goodwill and intangibles at December 31, 2006, 2005 and 2004 consisted of:
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars in millions) | |
| Mortgage Servicing Rights | | $ | 8.4 | | | $ | 8.0 | | | $ | 6.5 | |
| Advisory Servicing Rights | | | 1.8 | | | | 1.3 | | | | 1.5 | |
| Intangible Pension Asset | | | — | | | | 0.8 | | | | — | |
| Trade Name | | | 23.7 | | | | — | | | | — | |
| Customer Relationships | | | 9.7 | | | | — | | | | — | |
| Non-compete Agreement | | | 3.8 | | | | — | | | | — | |
| Goodwill | | | 148.3 | | | | 34.8 | | | | 34.8 | |
| | | | | | | | | | |
| | | $ | 195.7 | | | $ | 44.9 | | | $ | 42.8 | |
| | | | | | | | | | |
Contractual Obligations and Commercial Commitments
As disclosed in the notes to the consolidated financial statements, the Corporation has certain obligations and commitments to make future payments under contracts. At December 31, 2006, the aggregate contractual obligations and commercial commitments were:
| | | | | | | | | | | | | | | | | | | | | |
| | | | | | | Payments due by Period | | | | |
| | | | | | | as of December 31, 2006 | | | | |
| | | | | | | | | | | | | | | | | | | More | |
| | | | | | | Less than | | | | | | | | | | | than | |
| | | Total | | | 1 year | | | 1-3 years | | | 3-5 years | | | 5 years | |
| | | | | | | (Dollars in thousands) | | | | | | | | | |
Contractual Obligations: | | | | | | | | | | | | | | | | | | | | |
| Federal funds purchased and other borrowings | | $ | 1,628,400 | | | $ | 1,153,400 | | | $ | 475,000 | | | $ | — | | | $ | — | |
| Securities sold under agreements to repurchase | | | 830,569 | | | | 480,563 | | | | 150,006 | | | | — | | | | 200,000 | |
| Commercial paper | | | 209,549 | | | | 209,549 | | | | — | | | | — | | | | — | |
| Subordinated notes | | | 244,468 | | | | — | | | | — | | | | — | | | | 244,468 | |
| Term notes | | | 41,529 | | | | — | | | | — | | | | 41,529 | | | | — | |
| Operating lease obligations | | | 57,534 | | | | 18,703 | | | | 14,694 | | | | 9,401 | | | | 14,736 | |
| Pension plan contribution | | | 7,690 | | | | 7,690 | | | | — | | | | — | | | | — | |
| | | | | | | | | | | | | | | | |
| Total | | $ | 3,019,739 | | | $ | 1,869,905 | | | $ | 639,700 | | | $ | 50,930 | | | $ | 459,204 | |
| | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
Other Commercial Commitments: | | | | | | | | | | | | | | | | | | | | |
| Lines of credit and financial guarantees written | | | 184,959 | | | | 87,995 | | | | 31,359 | | | | 64,562 | | | | 1,043 | |
| Commitments to extend credit | | | 1,666,490 | | | | 1,666,490 | | | | — | | | | — | | | | — | |
| | | | | | | | | | | | | | | | |
| Total | | $ | 1,851,449 | | | $ | 1,754,485 | | | $ | 31,359 | | | $ | 64,562 | | | $ | 1,043 | |
| | | | | | | | | | | | | | | | |
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Recent Accounting Pronouncements
Refer to Note 1 to the consolidated financial statements for a description of each of the pronouncements and management’s assessment as to the impact of the adoptions.
ITEM 7A. QUANTITIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Risk Management
The Corporation has specific policies and procedures which structure and delineate the management of risks, particularly those related to credit, interest rate exposure and liquidity risk. Risks are identified, measured and monitored through various committees including the Asset and Liability Committee, Credit and Investment Committees, among others.
Credit Risk Management and Loan Quality
The lending activity of the Corporation represents its core function, and as such, the quality and effectiveness of the loan origination and credit risk areas are imperative to management for the growth and success of the Corporation. The importance of the Corporation’s lending activity has been considered when establishing functional responsibilities, organizational reporting, lending policies and procedures, and various monitoring processes and controls.
Critical risk management responsibilities include establishing sound lending standards, monitoring the quality of the loan portfolio, establishing loan rating systems, assessing reserves and loan concentrations, supervising document control and accounting, providing necessary training and resources to credit officers, implementing lending policies and loan documentation procedures, identifying problem loans as early as possible, and instituting procedures to ensure appropriate actions to comply with laws and regulations.
In addition, the Corporation has an independent Loan Review Department and an independent Internal Audit Division, each of which conducts monitoring and evaluation of loan portfolio quality, loan administration, and other related activities, carried on as part of the Corporation’s lending activity. Both departments provide periodic reports to the Board of Directors, continuously assess the validity of information reported to the Board of Directors and maintain compliance with established lending policies.
The Corporation has also established an internal risk rating system and internal classifications which serve as timely identification of the loan quality issues affecting the loan portfolio.
Credit extensions for commercial loans are approved by credit committees including the Small Loan Credit Committee, the Regional Credit Committee, the Credit Administration Committee, the Management Credit Committee, and the Board of Directors Credit Committee. A centralized department of the Consumer Lending Division approves all consumer loans.
The Corporation’s collateral requirements for loans depend on the financial strength and liquidity of the prospective borrower and the principal amount and term of the proposed financing. Acceptable collateral includes cash, marketable securities, mortgages on real and personal property, accounts receivable, and inventory.
The Corporation’s gross loan portfolio as of December 31, 2006, 2005 and 2004 amounted to $6.9 billion, $6.0 billion and $5.6 billion, respectively, which represented 80.7%, 75.9% and 68.9%, respectively, of the Corporation’s total earning assets. The loan portfolio is distributed among various types of credit, including commercial business loans, commercial real estate loans, construction loans, small business loans, consumer lending and residential mortgage loans. The credit risk exposure provides for diversification among specific industries, specific types of business, and related individuals. As of December 31, 2006, there was no obligor group that represented more than 2.5% of the Corporation’s total loan portfolio. Obligor’s resident or having a principal place of business in Puerto Rico comprised approximately 99% of the Corporation’s loan portfolio.
As of December 31, 2006, the Corporation had over 298,000 consumer loan customers and over 7,900 commercial loan customers. As of such date, the Corporation had 34 clients with commercial loans outstanding over $10.0 million. Although the Corporation has generally avoided cross-border loans, the Corporation had approximately $15.6 million in cross-border loans as of December 31, 2006, which are collateralized with real estate in the United States of America, cash and marketable securities.
The Corporation makes a substantial number of loans to sub-prime borrowers mainly through Island Finance. At December 31, 2006, approximately 63% of Island Finance’s loan portfolio was sub-prime (borrowers with credit scores of 660 or below).
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The actual rates of delinquencies, foreclosures and losses on these loans could be higher during economic slowdowns. Management believes that it has adequate reserves for loan losses as of December 31, 2006 to cover possible losses on this portfolio. The following risk concentration categories existed at year-end. The following risk concentration categories existed at year-end.
Industry Risk
Commercial loans, including commercial real estate and construction loans, amounted to $2.9 billion as of December 31, 2006. The Corporation accepts various types of collateral to guarantee specific loan obligations. As of December 31, 2006, the use of real estate as loan collateral has resulted in a portfolio of approximately $1.5 billion, or 52.5% of the commercial loan portfolio. In addition, as of such date, loans secured by cash collateral and marketable securities amounted to $319.5 million, or 10.9% of the commercial loan portfolio. Commercial loans guaranteed by federal or local government amounted to $33.9 million as of December 31, 2006, which represents 1.2% of the commercial loan portfolio. The remaining commercial loan portfolio had $360.6 million partially secured by other types of collateral including, among others, equipment, accounts receivable, and inventory. As of December 31, 2006, unsecured commercial loans represented $723 million or 24.7% of commercial loans receivable; however, the majority of these loans were backed by personal guarantees.
In addition to the commercial loan portfolio indicated above, as of December 31, 2006, the Corporation had $1.7 billion in unused commitments under commercial lines of credit. These credit facilities are typically structured to mature within one year. As of December 31, 2006, stand-by letters of credit amounted to $185.0 million.
The commercial loan portfolio is distributed among the different economic sectors and there are no concentrations of credit consisting of direct, indirect, or contingent obligations in any specific borrower, an affiliated group of borrowers, or borrowers engaged in or dependent on one industry. The Corporation provides for periodic reviews of industry trends and the credits’ susceptibility to external factors.
Government Risk
As of December 31, 2006, $722.3 million of the Corporation’s investment securities represented exposure to the U.S. government in the form of U.S. Treasury securities and federal agency obligations. In addition, as of such date, $30.1 million of residential mortgages and $80.4 million in commercial loans were insured or guaranteed by the U.S. Government or its agencies through the Small Business Administration (SBA) and Rural Development Programs. The Corporation is one of the largest SBA lenders in Puerto Rico. Furthermore, as of December 31, 2006, there were $55.9 million of investment securities representing obligations of the Commonwealth of Puerto Rico, its agencies, instrumentalities and political subdivisions, $50.0 million of money market deposits with Puerto Rico government banks, as well as $9.1 million of mortgage loans and $326.7 million in commercial loans issued to or guaranteed by Puerto Rico government agencies, instrumentalities, political subdivisions and municipalities. As of December 31, 2006, the Corporation’s credit exposure to the Commonwealth of Puerto Rico and its political subdivisions and municipalities was $391.2 million composed of $335.8 million in credit facilities and $55.9 million in outstanding bonds and other obligations. The Corporation believes that the credit exposure to the Commonwealth of Puerto Rico and its political subdivisions and municipalities is manageable. The Commonwealth of Puerto Rico has a long-standing record of supporting all of its debt obligations. It has never defaulted in the payment of principal or interest on any public debt. The Corporation’s level of exposure is manageable given the fact that its outstanding loans and investment securities have either one or more of the following characteristics: (i) investment grade rated counterparties, (ii) identifiable source of repayment, (iii) high ranking in repayment priority or (iv) tangible collateral. Collateral for the Corporation’s credit exposure to the Commonwealth of Puerto Rico consists of $60.0 million in marketable securities and $19.1 million in real estate. In addition, $88.0 million are loans or obligations to various Municipalities for which payments are secured by the full faith, credit and unlimited taxing power of the Municipalities. In the investment securities portfolio there are $23.0 million which are rated AAA and $32.9 million in bonds that were subject of a rating downgrade during the year 2006. The Corporation anticipates recovery of the amortized cost of these securities at maturity. Since the Corporation has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, and the contractual term of these investments do not permit the issuer to settle the securities at a price less than the amortized cost, the Corporation does not consider these investments to be other-than-temporarily impaired at December 31, 2006.
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Non-performing Assets and Past Due Loans
The following table sets forth non-performing assets as of December 31, 2006, 2005, 2004, 2003 and 2002.
| | | | | | | | | | | | | | | | | | | | | |
| | | Year ended December 31, | |
| | | 2006 | | | 2005 | | | 2004 | | | 2003 | | | 2002 | |
| | | (Dollars in thousands) | |
| Commercial, Industrial and Agricultural | | $ | 15,549 | | | $ | 14,326 | | | $ | 27,975 | | | $ | 30,884 | | | $ | 35,369 | |
| Construction | | | 3,966 | | | | 3,414 | | | | 11,200 | | | | 10,085 | | | | 31,248 | |
| Mortgage | | | 51,341 | | | | 45,292 | | | | 36,252 | | | | 42,107 | | | | 36,071 | |
| Consumer | | | 7,590 | | | | 4,747 | | | | 6,808 | | | | 9,312 | | | | 15,930 | |
| Consumer Finance | | | 24,731 | | | | — | | | | — | | | | — | | | | — | |
| Lease Financing | | | 2,783 | | | | 3,340 | | | | 2,715 | | | | 4,027 | | | | 3,735 | |
| Restructured Loans | | | 892 | | | | 2,560 | | | | 2,560 | | | | 1,953 | | | | 1,085 | |
| | | | | | | | | | | | | | | | |
| Total non-performing loans | | | 106,852 | | | | 73,679 | | | | 87,510 | | | | 98,368 | | | | 123,438 | |
| Total repossessed assets | | | 6,173 | | | | 2,706 | | | | 3,937 | | | | 4,989 | | | | 17,563 | |
| | | | | | | | | | | | | | | | |
| Non-performing assets | | $ | 113,025 | | | $ | 76,385 | | | $ | 91,447 | | | $ | 103,357 | | | $ | 141,001 | |
| | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
| Accruing loans past-due 90 days or more | | $ | 20,938 | | | $ | 2,999 | | | $ | 3,377 | | | $ | 2,404 | | | $ | 3,928 | |
| | | | | | | | | | | | | | | | | | | | | |
| Non-performing loans to total loans | | | 1.54 | % | | | 1.22 | % | | | 1.57 | % | | | 2.34 | % | | | 3.01 | % |
| Non-performing loans plus accruing loans past due 90 days or more to total loans | | | 1.84 | % | | | 1.27 | % | | | 1.63 | % | | | 2.40 | % | | | 3.11 | % |
| Non-performing assets to total assets | | | 1.23 | % | | | 0.92 | % | | | 1.10 | % | | | 1.40 | % | | | 1.91 | % |
| Interest lost | | $ | 3,112 | | | $ | 2,111 | | | $ | 2,351 | | | $ | 3,127 | | | $ | 2,338 | |
Non-performing assets consist of past-due commercial loans, construction loans, lease financing and closed-end consumer loans with principal or interest payments over 90 days on which no interest income is being accrued, and mortgage loans with principal or interest payments over 120 days past due on which no interest income is being accrued, renegotiated loans and other real estate owned.
Once a loan is placed on non-accrual status, interest is recorded as income only to the extent of the Corporation’s management expectations regarding the full collectibility of principal and interest on such loans. The interest income that would have been realized had these loans been performing in accordance with their original terms amounted to $3.1 million, $2.1 million and $2.4 million in 2006, 2005 and 2004, respectively.
Non-performing loans to total loans as of December 31, 2006 were 1.54%, a 32 basis point increase compared to the 1.22% reported as of December 31, 2005. Non-performing loans at December 31, 2006 amounted to $106.9 million comprised of Island Finance non-performing loans of $24.7 million and $82.2 million of non-performing loans of the Bank. The Corporation’s non-performing loans (excluding Island Finance non-performing loans) reflected an increase of $8.4 million or 11.5% compared to non-performing loans as of December 31, 2005. The increase of non-performing loans (excluding Island Finance non-performing loans) is principally due to residential mortgages which increased $6.0 million, when compared to December 31, 2005. Historically, this portfolio experienced the lowest rates of losses. The commercial and consumer loan portfolios also reflected increases during the year ended December 31, 2006 of 8.5% or $1.2 million and 59.9% or $2.8 million, respectively.
Island Finance loans acquired pursuant to the Asset Purchase Agreement on February 28, 2006 are subject to a guarantee by Wells Fargo of up to $21.0 million (maximum reimbursement amount) for net losses in excess of $34.0 million, occurring on or prior to the 15th month anniversary of the acquisition. The Corporation is provided with an additional guarantee of up to $7.0 million for net losses incurred in the acquired loan portfolio in excess of $34.0 million during months 16 to 18 of the anniversary, subject to the maximum aggregate reimbursement amount of $21.0 million.
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Repossessed assets increased $3.5 million or 128.1% to $6.1 million at December 31, 2006, from $2.7 million at December 31, 2005.
As of December 31, 2005, the coverage ratio (allowance for loan losses to total non-performing loans) improved to 100.01% in 2006 from 90.72% in 2005. Excluding non performing mortgage loans (for which the Corporation has historically had a minimal loss experience) this ratio is 192.5% at December 31, 2006 compared to 235.5% as of December 31, 2005.
The accrual of interest on commercial loans, construction loans, lease financing and closed-end consumer loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due, but in no event is it recognized after 90 days in arrears on payments of principal or interest. Interest on mortgage loans is not recognized after four months in arrears on payments of principal or interest. Income is generally recognized on open-end (revolving credit) consumer loans until the loans are charged off. When interest accrual is discontinued, unpaid interest is reversed on all closed-end portfolios. Interest income is subsequently recognized only to the extent that it is received. The non accrual status is discontinued when loans are made current by the borrower.
Potential Problem Loans
As a general rule, the Corporation closely monitors certain loans not disclosed under “Non-performing Assets and Past Due Loans” but that represent a greater than normal credit risk. These loans are not included under the non-performing category, but management provides close supervision of their performance. The identification process is implemented through various risk management procedures, such as periodic review of customer relationships, a risk grading system, an internal watch system and a loan review process. This classification system enables management to respond to changing circumstances and to address the risk that may arise from changing business conditions or any other factors that bear significantly on the overall condition of these loans. The principal amounts of loans under this category as of December 31, 2006 and 2005 were approximately $55.9 million and $69.4 million, respectively.
Asset and Liability Management
The Corporation’s policy with respect to asset and liability management is to maximize its net interest income, return on assets and return on equity while remaining within the established parameters of interest rate and liquidity risks provided by the Board of Directors and the relevant regulatory authorities. Subject to these constraints, the Corporation takes mismatched interest rate positions. The Corporation’s asset and liability management policies are developed and implemented by its Asset and Liability Committee (“ALCO”), which is composed of senior members of the Corporation including the President, Chief Operating Officer, Chief Accounting Officer, Treasurer and other executive officers of the Corporation. The ALCO reports on a monthly basis to the Board of Directors.
Market Risk and Interest Rate Sensitivity
A key component of the Corporation’s asset and liability policy is the management of interest rate sensitivity. Interest rate sensitivity is the relationship between market interest rates and net interest income due to the maturity or repricing characteristics of interest-earning assets and interest-bearing liabilities. For any given period, the pricing structure is matched when an equal amount of such assets and liabilities mature or reprice in that period. Any mismatch of interest-earning assets and interest-bearing liabilities is known as a gap position. A positive gap denotes asset sensitivity, which means that an increase in interest rates would have a positive effect on net interest income, while a decrease in interest rates would have a negative effect on net interest income. The Corporation is experiencing a negative gap at December 31, 2006 with a one-year cumulative gap of $2.6 billion. This denotes liability sensitivity, which means that an increase in interest rates would have a negative effect on net interest income while a decrease in interest rates would have a positive effect on net interest income.
The Corporation’s interest rate sensitivity strategy takes into account not only rates of return and the underlying degree of risk, but also liquidity requirements, capital costs and additional demand for funds. The Corporation’s maturity mismatches and positions are monitored by the ALCO and are managed within limits established by the Board of Directors. The following table sets forth the repricing of the Corporation’s interest earning assets and interest-bearing liabilities at December 31, 2006 and may not be representative of interest rate gap positions at other times. In addition, variations in interest rate sensitivity may exist within the repricing periods presented due to the differing repricing dates within the period. In preparing the interest rate gap report, several assumptions were considered. All assets and liabilities are reported according to their repricing characteristics. For example, a commercial loan maturing in five years with monthly variable interest rate payments is stated in the column of “up to 90 days”. The investment portfolio is reported considering the effective duration of the securities. Expected prepayments and remaining terms are considered for the residential mortgage portfolio. Core deposits are reported in accordance with their effective duration. Effective duration of core deposits is based on price and volume elasticity to market rates. The Corporation reviews on a monthly basis the effective duration of core deposits. Assets and liabilities with embedded options are stated based on full valuation of the asset/liability and the option to ascertain their effective duration.
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| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Interest Rate Sensitivity | |
| | | As of December 31, 2006 | |
| | | 0 to 3 | | | 3 months | | | 1 to 3 | | | 3 to 5 | | | 5 to 10 | | | More than | | | No Interest | | | | |
| | | Months | | | to a Year | | | Years | | | Years | | | Years | | | 10 Years | | | Rate Risk | | | Total | |
| | | (Dollars in thousands) | |
ASSETS: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Investment Portfolio | | $ | 249,837 | | | $ | 5,958 | | | $ | 320,188 | | | $ | 733,037 | | | $ | 89,525 | | | $ | — | | | $ | 112,746 | | | $ | 1,511,291 | |
| Deposits with Other Banks | | | 146,323 | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 104,396 | | | | 250,719 | |
Loan Portfolio: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Commercial | | | 1,326,426 | | | | 287,435 | | | | 337,930 | | | | 315,527 | | | | 232,311 | | | | 60,821 | | | | 61,904 | | | | 2,622,354 | |
| Construction | | | 415,938 | | | | 871 | | | | 4,207 | | | | 11,775 | | | | — | | | | — | | | | 2,429 | | | | 435,220 | |
| Consumer | | | 303,159 | | | | 256,245 | | | | 491,118 | | | | 153,945 | | | | 30,141 | | | | — | | | | (3,128 | ) | | | 1,231,480 | |
| Mortgage | | | 79,753 | | | | 261,164 | | | | 662,583 | | | | 566,504 | | | | 927,507 | | | | 152,467 | | | | 4,524 | | | | 2,654,502 | |
| Fixed and Other Assets | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 482,602 | | | | 482,602 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Assets | | | 2,521,436 | | | | 811,673 | | | | 1,816,026 | | | | 1,780,788 | | | | 1,279,484 | | | | 213,288 | | | | 765,473 | | | | 9,188,168 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
LIABILITIES AND STOCKHOLDERS’ EQUITY: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
External Funds Purchased: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Commercial Paper | | | 209,549 | | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 209,549 | |
| Repurchase Agreements | | | 480,563 | | | | 150,006 | | | | — | | | | 200,000 | | | | — | | | | — | | | | — | | | | 830,569 | |
| Federal Funds and other borrowings | | | 1,350,000 | | | | 278,400 | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 1,628,400 | |
Deposits: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Certificates of Deposit | | | 952,811 | | | | 855,646 | | | | 698,608 | | | | 280,069 | | | | 41,465 | | | | 113 | | | | (22,134 | ) | | | 2,806,578 | |
| Demand Deposits and Savings Accounts | | | 123,429 | | | | 74,359 | | | | 24,479 | | | | 547,618 | | | | — | | | | — | | | | (23,796 | ) | | | 746,089 | |
| Transactional Accounts | | | 431,253 | | | | 224,240 | | | | 533,777 | | | | 572,036 | | | | — | | | | — | | | | — | | | | 1,761,306 | |
| Senior and Subordinated Debt | | | — | | | | — | | | | — | | | | 31,640 | | | | 254,358 | | | | — | | | | — | | | | 285,998 | |
| Other Liabilities and Capital | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 919,679 | | | | 919,679 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Liabilities and Capital | | | 3,547,605 | | | | 1,582,651 | | | | 1,256,864 | | | | 1,631,363 | | | | 295,823 | | | | 113 | | | | 873,749 | | | | 9,188,168 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
Off-Balance Sheet Financial Information | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest Rate Swaps (Assets) | | | 3,005,786 | | | | 755,448 | | | | 1,384,779 | | | | 280,856 | | | | 215,980 | | | | — | | | | — | | | | 5,642,849 | |
| Interest Rate Swaps (Liabilities) | | | (3,338,295 | ) | | | (1,197,653 | ) | | | (1,029,427 | ) | | | (13,906 | ) | | | (63,568 | ) | | | — | | | | — | | | | (5,642,849 | ) |
| Caps | | | 38,704 | | | | 22,907 | | | | 7,510 | | | | 832 | | | | 1,031 | | | | — | | | | — | | | | 70,984 | |
| Caps Final Maturity | | | (38,704 | ) | | | (22,907 | ) | | | (7,510 | ) | | | (832 | ) | | | (1,031 | ) | | | — | | | | — | | | | (70,984 | ) |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| GAP | | | (1,358,678 | ) | | | (1,213,183 | ) | | | 914,514 | | | | 416,375 | | | | 1,136,073 | | | | 213,175 | | | | (108,276 | ) | | | — | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Cumulative GAP | | $ | (1,358,678 | ) | | $ | (2,571,861 | ) | | $ | (1,657,347 | ) | | $ | (1,240,972 | ) | | $ | (104,899 | ) | | $ | 108,276 | | | $ | — | | | $ | — | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Cumulative GAP to earning assets | | | -15.61 | % | | | -29.54 | % | | | -19.04 | % | | | -14.25 | % | | | -1.20 | % | | | 1.24 | % | | | | | | | | |
Interest rate risk is the primary market risk to which the Corporation is exposed. Nearly all of the Corporation’s interest rate risk arises from instruments, positions and transactions entered into for purposes other than trading. They include loans, investment securities, deposits, short-term borrowings, senior and subordinated debt and derivative financial instruments used for asset and liability management.
As part of its interest rate risk management process, the Corporation analyzes on an ongoing basis the profitability of the balance sheet structure, and how this structure will react under different market scenarios. In order to carry out this task, management prepares three standardized reports with detailed information on the sources of interest income and expense: the “Financial Profitability Report”, the “Net Interest Income Shock Report”, and the “Market Value Shock Report.” The first report deals with historical data while the latter two deal with expected future earnings.
The Financial Profitability Report identifies individual components of the Corporation’s non-trading portfolio independently with their corresponding interest income or expense. It uses the historical information at the end of each month to track the yield of such components and to calculate net interest income for such time period.
The Net Interest Income Shock Report uses a simulation analysis to measure the amount of net interest income the Corporation would have from its operations throughout the next twelve months and the sensitivity of these earnings to assumed shifts in
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market interest rates throughout the same period. The most important assumptions of this analysis are: (i) rate shifts are parallel and immediate throughout the yield curve; (ii) rate changes affect all assets and liabilities equally; (iii) interest-bearing demand accounts and savings passbooks will run off in a period of one year; and (iv) demand deposit accounts will run off in a period of one to three years. Cash flows from assets and liabilities are assumed to be reinvested at market rates in similar instruments. The objective is to simulate a dynamic gap analysis enabling a more accurate interest rate risk assessment.
The ALCO has decided to maintain its negative interest rate gap in the current flat yield curve environment. However it is not yet prepared to increase the duration of its investment portfolio with new acquisitions of securities until some steepening in the yield curve is observed. Any increase in the duration of its equity will only be achieved by an increase in the commercial activity of the Bank.
NIM sensitivity analysis captures the maximum acceptable net interest margin loss for a one percent parallel change of all interest rates across the curve. Duration of market value equity analysis entails a valuation of all interest bearing assets and liabilities under parallel movements in interest rates. The ALCO has established limits of $30 million of maximum NIM loss for a 1% parallel shock and $135 million maximum MVE loss for a 1% parallel shock. These limits are established annually at the beginning of year and are changed as warranted by market conditions and the Corporation’s tolerance for possible losses. The limits established for 2005 were $25 million maximum NIM loss for a 1% parallel shock and $125 million maximum MVE loss for a 1% parallel shock. As of December 31, 2006, it was determined for purposes of the Net Interest Income Shock Report that the Corporation had a potential loss in net interest income of approximately $20.5 million if market rates were to increase 100 basis points immediately and parallel across the yield curve, less than the $30 million limit. For purposes of the Market Value Shock Report it was determined that the Corporation had a potential loss of approximately $92.5 million if market rates were to increase 100 basis points immediately parallel across the yield curve, less than the $135 million limit.
As of December 31, 2006 the Corporation had a liability sensitive profile as explained by the negative gap, the NIM shock report and the MVE shock report. Management feels comfortable with the current level of market risk on the balance sheet, and it will change the market risk profile of the Corporation as market conditions vary. Any decision to reposition the balance sheet is taken by the ALCO committee, and is subject to compliance with the established risk limits. Some factors that could lead to shifts in policy could be, but are not limited to, changes in views on interest rate markets, monetary policy, macroeconomic factors as well as legal, fiscal and other factors which could lead to shifts in the asset liability mix.
Derivatives
The Corporation uses derivative financial instruments mostly as hedges of interest rate risk, changes in fair value of assets and liabilities and to secure future cash flows. Refer to Notes 1 and 20 to the consolidated financial statements for details of the Corporation’s derivative transactions as of December 31, 2006 and 2005.
In the normal course of business, the Corporation utilizes derivative instruments to manage exposure to fluctuations in interest rates, currencies and other markets, to meet the needs of customers and for proprietary trading activities. The Corporation uses the same credit risk management procedures to assess and approve potential credit exposures when entering into derivative transactions as those used for traditional lending.
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Hedging Activities:
The following table summarizes the derivative contracts designated as hedges as of December 31, 2006, 2005 and 2004, respectively:
| | | | | | | | | | | | | | | | | |
| | | December 31, 2006 | |
| | | | | | | | | | | | | | | Other | |
| | | | | | | | | | | | | | | Comprehensive | |
| | | Notional | | | | | | | Gain | | | Income | |
| (Dollars in thousands) | | Amounts * | | | Fair Value | | | (Loss) | | | (Loss)** | |
| | | | | | | | | | | | | |
Cash Flow Hedges | | | | | | | | | | | | | | | | |
| Foreign Currency | | $ | — | | | $ | — | | | $ | — | | | $ | 36 | |
| Interest Rate Swaps | | | 825,000 | | | | (351 | ) | | | — | | | | (214 | ) |
Fair Value Hedges | | | | | | | | | | | | | | | | |
| Interest Rate Swaps | | | 1,189,740 | | | | (22,065 | ) | | | 64 | | | | — | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | |
Totals | | $ | 2,014,740 | | | $ | (22,416 | ) | | $ | 64 | | | $ | (178 | ) |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | December 31, 2005 | |
| | | | | | | | | | | | | | | Other | |
| | | | | | | | | | | | | | | Comprehensive | |
| | | Notional | | | | | | | Gain | | | Income | |
| (Dollars in thousands) | | Amounts * | | | Fair Value | | | (Loss) | | | (Loss)** | |
Cash Flow Hedges | | | | | | | | | | | | | | | | |
| Foreign Currency | | $ | 117,725 | | | $ | 2,182 | | | $ | — | | | $ | (36 | ) |
| Interest Rate Swaps | | | — | | | | — | | | | — | | | | 1,369 | |
Fair Value Hedges | | | | | | | | | | | | | | | | |
| Interest Rate Swaps | | | 1,408,772 | | | | (26,880 | ) | | | 28 | | | | — | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | |
Totals | | $ | 1,526,497 | | | $ | (24,698 | ) | | $ | 28 | | | $ | 1,333 | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | December 31, 2004 | |
| | | | | | | | | | | | | | | Other | |
| | | | | | | | | | | | | | | Comprehensive | |
| | | Notional | | | | | | | Gain | | | Income | |
| (Dollars in thousands) | | Amounts * | | | Fair Value | | | (Loss) | | | (Loss)** | |
Cash Flow Hedges | | | | | | | | | | | | | | | | |
| Interest Rate Swaps | | $ | 100,000 | | | $ | (2,242 | ) | | $ | — | | | $ | 3,463 | |
Fair Value Hedges | | | | | | | | | | | | | | | | |
| Interest Rate Swaps | | | 618,648 | | | | (9,764 | ) | | | 579 | | | | — | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | |
Totals | | $ | 718,648 | | | $ | (12,006 | ) | | $ | 579 | | | $ | 3,463 | |
| | | | | | | | | | | | | |
| | |
| * | | The notional amount represents the gross sum of long and short |
| |
| ** | | Net of tax |
Cash Flow Hedges:
The Corporation designates hedges as Cash Flow Hedges when its main purpose is to reduce the exposure associated with the variability of future cash flows related to fluctuations in short term financing rates (such as LIBOR). At the inception of each hedge, management documents the hedging relationship, including its objective and probable effectiveness. To assess ongoing effectiveness of the hedges, the Corporation compares the hedged item’s periodic variable rate with the hedging item’s
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benchmark rate (LIBOR) at every reporting period to determine the effectiveness of the hedge. Any hedge ineffectiveness is recorded currently as a derivative gain or loss in the income statement.
As of December 31, 2006, the total amount, net of tax, included in accumulated other comprehensive income pertaining to the cash flow hedges was an unrealized loss of $214,000. As of December 31, 2005, the total amount, net of tax, included in accumulated other comprehensive income pertaining to the cash flow hedges was an unrealized gain of $1.3 million. As of December 31, 2004, the total amount, net of tax, included in accumulated other comprehensive income pertaining to the cash flow hedges was an unrealized gain of $3.5 million.
Fair Value Hedges:
The Corporation designates hedges as Fair Value Hedges when its main purpose is to hedge the changes in market value of an associated asset or liability. The Corporation only designates these types of hedges if at inception it is believed that the relationship of the changes in the market value of the hedged item and the hedging item will offset each other in a highly effective manner. At the inception of each hedge, management documents the hedging relationship, including its objective and probable effectiveness. To assess ongoing effectiveness of the hedges, the Corporation marks to market both the hedging item and the hedged item at every reporting period to determine the effectiveness of the hedge. Any hedge ineffectiveness is recorded currently as a derivative gain or loss in the income statement.
The fair value hedges have maturities through the year 2032 as of December 31, 2006 and December 31, 2005. The weighted-average rate paid and received on these contracts as of December 31, 2006 is 5.37% and 4.34%, respectively, and 4.84% and 4.33%, as of December 31, 2005, respectively.
The $1.2 billion and $1.4 billion fair value hedges are associated to the swapping of fixed rate debt as of December 31, 2006 and 2005, respectively. The Corporation regularly issues term fixed rate debt, which it in turn swaps to floating rate debt via interest rate swaps. In these cases the Corporation matches all of the relevant economic variables (notional, coupon, payments dates and conventions etc.) of the fixed rate debt it issues to the fixed rate leg of the interest rate swap ( which it receives from the counterparty) and pays the floating rate leg of the interest rate swap. The effectiveness of these transactions is very high since all of the relevant economic variables are matched.
Derivative instruments not designated as hedging instruments:
Any derivative not associated to hedging activity is booked as a freestanding derivative. In the normal course of business the Corporation may enter into derivative contracts as either a market maker or proprietary position taker. The Corporation’s mission as a market maker is to meet the clients’ needs by providing them with a wide array of financial products, which include derivative contracts. The Corporation’s major role in this aspect is to serve as a derivative counterparty to these clients. Positions taken with these clients are hedged (although not designated as hedges) in the OTC market with interbank participants or in the organized futures markets. To a lesser extent, the Corporation enters into freestanding derivative contracts as a proprietary position taker, based on market expectations or to benefit from price differentials between financial instruments and markets. These derivatives are not linked to specific assets and liabilities on the balance sheet or to forecasted transactions in an accounting hedge relationship and, therefore, do not qualify for hedge accounting. These derivatives are carried at fair value and changes in fair value are recorded in earnings. The market and credit risk associated with these activities is measured, monitored and controlled by the Corporation’s Market Risk Group, an independent division from the treasury department. Among other things, this group is responsible for: policy, analysis, methodology and reporting of anything related to market risk and credit risk. The following table summarizes the aggregate notional amounts and the reported derivative assets or liabilities (i.e. the fair value of the derivative contracts) as of December 31, 2006 and 2005 and 2004, respectively:
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| | | | | | | | | | | | | |
| | | December 31, 2006 | |
| | | Notional | | | | | | | Gain | |
| (Dollars in thousands) | | Amounts * | | | Fair Value | | | (Loss) | |
Interest Rate Contracts | | | | | | | | | | | | |
| Interest Rate Swaps | | $ | 3,628,108 | | | $ | (421 | ) | | $ | (592 | ) |
| Interest Rate Caps | | | 70,984 | | | | 3 | | | | 2 | |
| Other | | | 1,988 | | | | 9 | | | | 49 | |
Equity Derivatives | | | 307,056 | | | | — | | | | — | |
| | | | | | | | | | |
Totals | | $ | 4,008,136 | | | $ | (409 | ) | | $ | (541 | ) |
| | | | | | | | | | |
| | | | | | | | | | | | | |
| | | December 31, 2005 | |
| | | Notional | | | | | | | Gain | |
| (Dollars in thousands) | | Amounts * | | | Fair Value | | | (Loss) | |
Interest Rate Contracts | | | | | | | | | | | | |
| Interest Rate Swaps | | $ | 2,176,521 | | | $ | 171 | | | $ | (344 | ) |
| Interest Rate Caps | | | 73,422 | | | | 2 | | | | 13 | |
| Other | | | 7,270 | | | | (40 | ) | | | (43 | ) |
Equity Derivatives | | | 269,917 | | | | — | | | | 2,310 | |
| | | | | | | | | | |
Totals | | $ | 2,527,130 | | | $ | 133 | | | $ | 1,936 | |
| | | | | | | | | | |
| | | | | | | | | | | | | |
| | | December 31, 2004 | |
| | | Notional | | | | | | | Gain | |
| (Dollars in thousands) | | Amounts * | | | Fair Value | | | (Loss) | |
Interest Rate Contracts | | | | | | | | | | | | |
| Interest Rate Swaps | | $ | 335,426 | | | $ | 568 | | | $ | (69 | ) |
| Interest Rate Caps | | | 67,971 | | | | (16 | ) | | | 22 | |
| Other | | | 2,415 | | | | 3 | | | | 3 | |
Equity Derivatives | | | 138,895 | | | | — | | | | 2,924 | |
| | | | | | | | | | |
Totals | | $ | 544,707 | | | $ | 555 | | | $ | 2,880 | |
| | | | | | | | | | |
| | |
| * | | The notional amount represents the gross sum of long and short |
The increase in interest swaps as of December 31, 2006 compared to December 31, 2005 is due to an increase in derivatives sold to clients and affiliates.
Liquidity Risk
Liquidity risk is the risk that not enough cash will be generated from either assets or liabilities to meet deposit withdrawals or contractual loan funding. The Corporation’s general policy is to maintain liquidity adequate to ensure our ability to honor withdrawals of deposits, make repayments at maturity of other liabilities, extend loans and meet working capital needs. The Corporation’s principal sources of liquidity are capital, core deposits from retail and commercial clients, and wholesale deposits raised in the inter-bank and commercial markets. The Corporation manages liquidity risk by maintaining diversified short-term and long-term sources through the Federal funds market, commercial paper program, repurchase agreements and retail certificate of deposit programs. As of December 31, 2006 the Corporation had $3.0 billion in unsecured lines of credit ($2.8 billion available) and $7.2 billion in collateralized lines of credit with banks and financial entities ($5.5 billion available). All securities in portfolio are highly rated and very liquid, enabling us to treat them as a secondary source of liquidity.
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The Corporation does not have significant usage or limitations on its ability to upstream or downstream funds as a method of liquidity. However, there are certain tax constraints when borrowing funds (excluding the placement of deposits) from BSCH or affiliates because Puerto Rico’s tax code requires local corporations to withhold 29% of the interest income paid to non-resident affiliates. The Corporation does not face significant limitations to its ability to downstream funds to its affiliates. The current intra-group credit line for the Corporation is $1.9 billion. This credit line increased during 2006 as a result of the acquisition of Island Finance when credit was initially provided by Santander Spain.
Liquidity is derived from capital, reserves and the securities portfolio. The Corporation has established lines of credit with foreign and domestic banks, has access to U.S. markets through its commercial paper program and also has broadened its relations in the federal funds and repurchase agreement markets to increase the availability of other sources of funds and to augment liquidity as necessary.
During 2006 the Corporation undertook a financing transaction to fund its operations, including cash flow requirements and future growth. During the first quarter of 2006 the Corporation engaged in several financing transactions in order to fund the acquisition of Island Finance. In connection with this transaction, on February 28, 2006, the Corporation entered into a $725 million loan agreement with Santusa Holding, S.L., a subsidiary of its parent company, to be used in connection with the acquisition of substantially all the assets of Island Finance in Puerto Rico from Wells Fargo. The loan bears interest at an annual rate of 4.965%, payable semiannually. The Corporation did not pay any commitment fee or commission in connection with the loan. On June 19, 2006, Santander Bancorp entered into a novation agreement and an amended and restated loan agreement with Lloyds TBS Bank to refinance the terms of the $725 million loan agreement with Santusa Holdings S.L. The loan under the Amended Loan agreement bears interest at an annual rate equal to aggregate of (i) 0.10% per annum, (ii) the 3 month LIBOR rate, and (iii) a percentage rate per annum calculated by Lloyds TBS Bank. The interest under the loan is payable in interest periods of one, three or six months, or such, or other period as requested by the Company at the time of drawing.
In December 2006, the Corporation and Santander Financial Services, entered into a Bridge Facility Agreement (the “Agreement”) with National Australia Bank Limited (the “Lender”). The proceeds of the Agreement were used to refinance the outstanding indebtedness incurred in connection with the previously announced amended and restated loan agreement with Lloyds TBS Bank PLC and for general corporate purposes. Under the Agreement, the Corporation and Santander Financial had available $275 million and $525 million, respectively, all of which was drawn. The amounts drawn under the Agreement (the “Loan”) bear interest at an annual rate equal to the applicable LIBOR rate plus 0.10% per annum. Pursuant to the Agreement, the Company and Santander Financial will pay the Lender a facility fee (the “Facility Fee”) of 0.02% of the principal amount of the Loan within three days of the execution of the Agreement. The entire principal balance of the Loan is due and payable on September 21, 2007.
The Corporation also completed the private placement of $125 million Trust Preferred Securities (“Preferred Securities”) and issued Junior Subordinated Debentures in the aggregate principal amount of $129 million in connection with the issuance of the Preferred Securities. The Preferred Securities are fully and unconditionally guaranteed (to the extent described in the guarantee agreement between the Corporation and the guarantee trustee, for the benefit of the holders from time to time of the Preferred Securities) by the Corporation. The Trust Preferred Securities were acquired by an affiliate of the Corporation. In connection with the issuance of the Preferred Securities, the Corporation issued an aggregate principal amount of $129,000,000 of its 7.00% Junior Subordinated Debentures, Series A, due July 1, 2037 to the Trust.
The Corporation has a high credit rating, which permits the Corporation to utilize various alternative funding sources. The Corporation’s current ratings are as follows:
| | | | | |
| | | Standard | | Fitch |
| | | & Poor’s | | IBCA |
| Short-term funding | | A-1 | | F1+ |
| Long-term funding | | A | | AA- |
Management monitors liquidity levels each month. The focus is on the liquidity ratio, which compares net liquid assets (all liquid assets not subject to collateral or repurchase agreements) against total liabilities plus contingent liabilities. As of
68
December 31, 2006, the Corporation had a liquidity ratio of 11.48%. At December 31, 2006, the Corporation had total available liquid assets of $1.3 billion. The Corporation believes that it has sufficient liquidity to meet current obligations.
The Corporation does not contemplate material uncertainties in the rolling over of deposits, both retail and wholesale, and is not engaged in capital expenditures that would materially affect the capital and liquidity positions. Should any deficiency arise for seasonal or more critical reasons, the Bank would make recourse to alternative sources of funding such as the commercial paper program, its lines of credit with domestic and national banks, unused collateralized lines with Federal Home Loan Banks and others.
Maturity and Interest Rate Sensitivity of Interest-Earning Assets as of December 31, 2006
The following table sets forth an analysis by type and time remaining to maturity of the Corporation’s loans and securities portfolio as of December 31, 2006. Loans are stated before deduction of the allowance for loan losses and include loans held for sale.
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | As of December 31, 2006 | |
| | | Maturities and/or Next Repricing Date | |
| | | | | | | After One Year | | | | | | | |
| | | | | | | Through Five Years | | | After Five Years | | | | |
| | | One Year | | | Fixed | | | Variable | | | Fixed | | | Variable | | | | |
| | | or Less | | | Interest Rates | | | Interest Rates | | | Interest Rates | | | Interest Rates | | | Total | |
| | | | | | | | | | | (Dollars in thousands) | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Cash and Cash Equivalents and other Interest-bearing deposits | | $ | 250,719 | | | $ | — | | | $ | — | | | $ | — | | | $ | — | | | $ | 250,719 | |
| Investment Portfolio | | | 255,796 | | | | 1,053,225 | | | | — | | | | 202,270 | | | | — | | | | 1,511,291 | |
| Loans: | | | | | | | | | | | | | | | | | | | | | | | | |
| Commercial | | | 1,034,660 | | | | 588,253 | | | | 321,983 | | | | 351,744 | | | | 193,059 | | | | 2,489,699 | |
| Construction | | | 181,309 | | | | 15,982 | | | | 229,866 | | | | — | | | | 8,063 | | | | 435,220 | |
| Consumer | | | 319,369 | | | | 258,308 | | | | — | | | | 28,537 | | | | — | | | | 606,214 | |
| Consumer Finance | | | 240,042 | | | | 346,964 | | | | 31,759 | | | | 1,645 | | | | 4,856 | | | | 625,266 | |
| Mortgage | | | 340,919 | | | | 1,229,087 | | | | — | | | | 1,084,496 | | | | — | | | | 2,654,502 | |
| Leasing | | | 56,626 | | | | 65,204 | | | | 7,493 | | | | 3,291 | | | | 41 | | | | 132,655 | |
| | | | | | | | | | | | | | | | | | | |
| Total | | $ | 2,679,440 | | | $ | 3,557,023 | | | $ | 591,101 | | | $ | 1,671,983 | | | $ | 206,019 | | | $ | 8,705,566 | |
| | | | | | | | | | | | | | | | | | | |
Capital Expenditures
The following table reflects capital expenditures for the years ended December 31, 2006, 2005 and 2004.
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars in thousands) | |
| | | | | | | | | | | | | |
| Headquarters/branches | | $ | 1,217 | | | $ | 4,194 | | | $ | 2,478 | |
| Data processing equipment | | | 2,907 | | | | 2,583 | | | | 2,071 | |
| Software | | | 5,818 | | | | 6,111 | | | | 5,096 | |
| Office furniture and equipment | | | 2,161 | | | | 3,138 | | | | 1,947 | |
| | | | | | | | | | |
| Total | | $ | 12,103 | | | $ | 16,026 | | | $ | 11,592 | |
| | | | | | | | | | |
During 2005, the Corporation’s capital expenditures reflected an increase in office furniture and headquarters/branches. The Corporation invested in new facilities to relocate Santander Securities, as well as, in new branches of Banco Santander and remodeling of several existing branches. The increase in data processing equipment and software were pursuant to standard maintenance and improvement procedures.
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Environmental Matters
Under various environmental laws and regulations, a lender may be liable as an “owner” or “operator” for the costs of investigation or remediation of hazardous substances at any mortgaged property or other property of a borrower or at its owned or leased property regardless of whether the lender knew of, or was responsible for, the hazardous substances. In addition, certain cities in which some of the Corporation’s assets are located impose a statutory lien, which may be prior to the lien of the mortgage, for costs incurred in connection with a cleanup of hazardous substances.
Some of the Corporation’s mortgaged properties and owned and leased properties may contain hazardous substances or are located in the vicinity of properties that are contaminated. As a result, the value of such properties may decrease, the borrower’s ability to repay the loan may be affected, the Corporation’s ability to foreclose on certain properties may be affected or the Corporation may be exposed to potential environmental liabilities. The Corporation, however, is not aware of any such environmental costs or liabilities that would have a material adverse effect on the Corporation’s results of operations or financial condition.
Puerto Rico Income Taxes
The Corporation is subject to Puerto Rico income tax. The maximum statutory regular corporate tax rate that the Corporation is subject to under the P.R. Code is 39%. In computing its net income subject to the regular income tax, the Corporation is entitled to exclude from its gross income, interest derived on obligations of the Commonwealth of Puerto Rico and its agencies, instrumentalities and political subdivisions, obligations of the United States Government and its agencies and instrumentalities, certain FHA and VA loans and certain GNMA securities. In computing its net income subject to the regular income tax the Corporation is entitled to claim a deduction for ordinary and necessary expenses, worthless debts, interest and depreciation, among others. The Corporation’s deduction for interest is reduced in the same proportion that the average adjusted basis of its exempt obligations bears to the average adjusted basis of its total assets.
The Corporation is also subject to an alternative minimum tax of 22% imposed on its alternative minimum tax net income. In general, the Corporation’s alternative minimum net income is an amount equal to its net income determined for regular income tax purposes, as adjusted for certain items of tax preference. To the extent that the Corporation’s alternative minimum tax for a taxable year exceeds its regular tax, such excess is required to be paid by the Corporation as an alternative minimum tax. An alternative minimum tax paid by the Corporation in any taxable year may be claimed by the Corporation as a credit in future taxable years against the excess of its regular tax over the alternative minimum tax in such years, and such credits do not expire.
Under the P.R. Code, corporations are not permitted to file consolidated tax returns with their subsidiaries and affiliates. However, the Corporation is entitled to a 100% dividend received deduction with respect to dividends received from Banco Santander Puerto Rico, Santander Securities Corporation, Santander Insurance Agency, or any other Puerto Rico corporation subject to tax under the P.R. Code and in which the Corporation owns at least 80% of the value of its stock or voting power.
Interest paid by the Corporation to non-resident foreign corporations is not subject to Puerto Rico income tax, provided such foreign corporation is not related to the Corporation. Dividends paid by the Corporation to non-resident foreign corporations and individuals (whether resident or not) are subject to a Puerto Rico income tax of 10%.
Puerto Rico international banking entities, or IBE’s, are currently exempt from taxation under Puerto Rico law. During 2004, the Legislature of Puerto Rico and the Governor of Puerto Rico approved a law amending the IBE Act. This law imposes income taxes at normal statutory rates on each IBE that operates as a unit of a bank, if the IBE’s net income generated after December 31, 2003 exceeds 40 percent of the bank’s net income in the taxable year commenced on July 1, 2003, 30 percent of the bank’s net income in the taxable year commencing on July 1, 2004, and 20 percent of the bank’s net income in the taxable year commencing on July 1, 2005, and thereafter. It does not impose income taxation on an IBE that operates as a subsidiary of a bank.
On August 1, 2005 a temporary, two-year surtax of 2.5% applicable to corporations was enacted. This surtax is applicable to taxable years beginning after December 31, 2004 and increased the maximum marginal corporate income tax rate from 39% to 41.5%. An additional 2% surtax was imposed on the Corporation for a period of one year commencing on January 1, 2006 as a result of the Puerto Rico Government’s budget deficit. These surtaxes increased the maximum marginal corporate income tax rate from 39% to 43.5% for the year ended December 31, 2006. The incremental effect of these surtaxes corresponding to the year ended December 31, 2006 was $2.3 million.
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United States Income Taxes
The Corporation, the Bank, Santander Securities and Santander Insurance Agency are corporations organized under the laws of Puerto Rico. Accordingly, the Corporation, the Bank, Santander Securities and Santander Insurance Agency are subject to United States income tax under the Internal Revenue Code of 1986, as amended to the date hereof (the “Code”) only on certain income from sources within the United States or effectively connected with a United States trade or business.
71
CERTIFICATION PURSUANT TO SECTION 303A.12(a) OF THE
NEW YORK STOCK EXCHANGE LISTED COMPANY MANUAL
Santander BanCorp’s Chief Executive Officer, Chief Operating Officer and Chief Accounting Officer have filed with the Securities and Exchange Commission the certifications required by Section 302 of the Sarbanes-Oxley Act of 2002 as Exhibits 31.1, 31.2 and 31.3 to Santander BanCorp’s 2006 Form 10-K. In addition, on June 23, 2006, Santander BanCorp’s CEO certified to the New York Stock Exchange that he was not aware of any violation by the Corporation of the NYSE corporate governance listing standards. The foregoing certification was unqualified.
| | | | | |
| | | |
| | By: | /s/ José Ramón González | |
| | | President and Chief Executive Officer | |
| | | | |
| |
| | | |
| | By: | /s/ Carlos M. García | |
| | | Senior Executive Vice President and | |
| | | Chief Operating Officer | |
| |
| | | |
| | By: | /s/ María Calero | |
| | | Executive Vice President and | |
| | | Chief Accounting Officer | |
| |
72
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Deloitte & Touche LLP
Torre Chardón
350 Chardón Ave. Suite 700
San Juan, PR 00918-2140
USA
Tel: +I 787 759 7171
Fax: +I 787 756 6340
www.deloitte.com
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Santander Bancorp
San Juan, Puerto Rico
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Santander Bancorp and subsidiaries (the “Corporation”, a Puerto Rico corporation and a subsidiary of Santander Central Hispano, S.A.) maintained effective internal control over financial reporting as of December 3 1, 2006, based on criteria established inInternal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission. The Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Corporation’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
| | | |
| | | Member of
Deloitte Touche Tohmatsu |
73
As described in Management’s Report on Internal Control over Financial Reporting, management has excluded Santander Financial Services, Inc. from their assessment of internal control over financial reporting as of December 31, 2006 because this entity was acquired by the Corporation in a purchase business combination during 2006. Santander Financial Services, Inc. represents approximately 9% of the Corporation’s consolidated total assets as of December 31, 2006 and approximately -2% (as a result of a pretax loss of approximately $1.3 million) of the Corporation’s consolidated net income for the year ended December 31, 2006.
In our opinion, management’s assessment that the Corporation maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the criteria established inInternal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of the Corporation as of and for the year ended December 31, 2006 and our report dated March 28, 2007 expressed an unqualified opinion on those financial statements.
March 28, 2007
Stamp No. 2219801
affixed to original.
74
Deloitte & Touche LLP
Torre Chardón
350 Chardón Ave. Suite 700
San Juan, PR 00918-2140
USA
Tel: +I 787 759 7171
Fax: +I 787 756 6340
www.deloitte.com
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Santander Bancorp
San Juan, Puerto Rico
We have audited the accompanying consolidated balance sheets of Santander Bancorp and subsidiaries (the “Corporation”, a Puerto Rico corporation and a subsidiary of Santander Central Hispano, S.A.) as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in stockholders’ equity, comprehensive income, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Santander Bancorp and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2006, based on the criteria established inInternal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 28, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of the Corporation’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Corporation’s internal control over financial reporting.
March 28, 2007
Stamp No. 2219802
affixed to original.
74.01
Santander BanCorp and Subsidiaries
Consolidated Balance Sheets-December 31, 2006 and 2005
(Dollars in thousands, except share data)
| | | | | | | | | |
| | | 2006 | | | 2005 | |
ASSETS | | | | | | | | |
Cash and Cash Equivalents: | | | | | | | | |
| Cash and due from banks | | $ | 125,077 | | | $ | 136,731 | |
| Interest-bearing deposits | | | 780 | | | | 8,833 | |
| Federal funds sold and securities purchased under agreements to resell | | | 73,407 | | | | 92,429 | |
| | | | | | | |
| Total cash and cash equivalents | | | 199,264 | | | | 237,993 | |
| | | | | | | |
Interest-Bearing Deposits | | | 51,455 | | | | 101,034 | |
Trading Securities, at fair value | | | 50,792 | | | | 37,679 | |
Investment Securities Available for Sale,at fair value: | | | | | | | | |
| Securities pledged that can be repledged | | | 867,944 | | | | 995,032 | |
| Other investment securities available for sale | | | 541,845 | | | | 564,649 | |
| | | | | | | |
| Total investment securities available for sale | | | 1,409,789 | | | | 1,559,681 | |
| | | | | | | |
Other Investment Securities,at amortized cost | | | 50,710 | | | | 41,862 | |
Loans Held for Sale,net | | | 196,277 | | | | 213,102 | |
Loans,net | | | 6,640,416 | | | | 5,741,788 | |
Accrued Interest Receivable | | | 102,244 | | | | 77,962 | |
Premises and Equipment,net | | | 56,299 | | | | 55,867 | |
Goodwill | | | 148,300 | | | | 34,791 | |
Intangible Assets | | | 47,427 | | | | 10,092 | |
Other Assets | | | 235,195 | | | | 160,097 | |
| | | | | | | |
| | | $ | 9,188,168 | | | $ | 8,271,948 | |
| | | | | | | |
LIABILITIES AND STOCKHOLDERS’ EQUITY | | | | | | | | |
Deposits: | | | | | | | | |
| Non interest-bearing | | $ | 746,089 | | | $ | 672,225 | |
| Interest-bearing | | | 4,567,885 | | | | 4,552,425 | |
| | | | | | | |
| Total deposits | | | 5,313,974 | | | | 5,224,650 | |
| | | | | | | |
Federal Funds Purchased and Other Borrowings | | | 1,628,400 | | | | 768,846 | |
Securities Sold Under Agreements to Repurchase | | | 830,569 | | | | 947,767 | |
Commercial Paper Issued | | | 209,549 | | | | 334,319 | |
Term Notes | | | 41,529 | | | | 40,215 | |
Subordinated Capital Notes | | | 244,468 | | | | 121,098 | |
Accrued Interest Payable | | | 91,245 | | | | 65,160 | |
Other Liabilities | | | 249,214 | | | | 201,366 | |
| | | | | | | |
| Total liabilities | | | 8,608,948 | | | | 7,703,421 | |
| | | | | | | |
Contingencies and Commitments (Notes 4, 11, 12, 14, 15, 16 and 17) | | | | | | | | |
STOCKHOLDERS’ EQUITY: | | | | | | | | |
| Series A Preferred stock, $25 par value; 10,000,000 shares authorized, none issued and outstanding | | | — | | | | — | |
| Common stock, $2.50 par value; 200,000,000 shares authorized, 50,650,364 shares issued; 46,639,104 shares outstanding in December 2006 and 2005 | | | 126,626 | | | | 126,626 | |
| Capital paid in excess of par value | | | 304,171 | | | | 304,171 | |
| Treasury stock at cost, 4,011,260 shares in December 2006 and 2005 | | | (67,552 | ) | | | (67,552 | ) |
| Accumulated other comprehensive loss, net of taxes | | | (44,213 | ) | | | (41,591 | ) |
| Retained earnings: | | | | | | | | |
| Reserve fund | | | 137,511 | | | | 133,759 | |
| Undivided profits | | | 122,677 | | | | 113,114 | |
| | | | | | | |
| Total stockholders’ equity | | | 579,220 | | | | 568,527 | |
| | | | | | | |
| | | $ | 9,188,168 | | | $ | 8,271,948 | |
| | | | | | | |
The accompanying notes are an integral part of these financial statements.
75
Santander BanCorp and Subsidiaries
Consolidated Statements of Income
Years Ended December 31, 2006, 2005 and 2004
(Dollars in thousands, except per share data)
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
Interest Income: | | | | | | | | | | | | |
| Loans | | $ | 535,327 | | | $ | 359,415 | | | $ | 261,744 | |
| Investment securities | | | 74,023 | | | | 71,938 | | | | 97,901 | |
| Interest-bearing deposits | | | 4,439 | | | | 4,065 | | | | 1,054 | |
| Federal funds sold and securities purchased under agreements to resell | | | 4,531 | | | | 4,187 | | | | 3,123 | |
| | | | | | | | | | |
| Total interest income | | | 618,320 | | | | 439,605 | | | | 363,822 | |
| | | | | | | | | | |
Interest Expense: | | | | | | | | | | | | |
| Deposits | | | 173,380 | | | | 122,212 | | | | 60,279 | |
| Securities sold under agreements to repurchase and other borrowings | | | 139,960 | | | | 86,969 | | | | 79,901 | |
| Subordinated capital notes | | | 14,374 | | | | 3,402 | | | | 582 | |
| | | | | | | | | | |
| Total interest expense | | | 327,714 | | | | 212,583 | | | | 140,762 | |
| | | | | | | | | | |
| Net interest income | | | 290,606 | | | | 227,022 | | | | 223,060 | |
Provision for Loan Losses | | | 65,583 | | | | 20,400 | | | | 26,270 | |
| | | | | | | | | | |
| Net interest income after provision for loan losses | | | 225,023 | | | | 206,622 | | | | 196,790 | |
| | | | | | | | | | |
Other Income: | | | | | | | | | | | | |
| Bank service charges, fees and other | | | 49,078 | | | | 42,272 | | | | 38,977 | |
| Broker-dealer, asset management and insurance fees | | | 56,973 | | | | 53,016 | | | | 51,113 | |
| Gain on sale of securities | | | — | | | | 17,842 | | | | 11,475 | |
| Loss on extinguishment of debt | | | — | | | | (5,959 | ) | | | — | |
| Gain on sale of loans | | | 1,994 | | | | 7,876 | | | | 431 | |
| Gain on sale of building | | | — | | | | — | | | | 2,754 | |
| Other income | | | 10,424 | | | | 10,311 | | | | 12,489 | |
| | | | | | | | | | |
| Total other income | | | 118,469 | | | | 125,358 | | | | 117,239 | |
| | | | | | | | | | |
Other Operating Expenses: | | | | | | | | | | | | |
| Salaries and employee benefits | | | 121,711 | | | | 95,002 | | | | 91,582 | |
| Occupancy costs | | | 22,476 | | | | 16,811 | | | | 13,959 | |
| Equipment expenses | | | 4,797 | | | | 3,802 | | | | 3,775 | |
| EDP servicing, amortization and technical assistance | | | 40,084 | | | | 31,589 | | | | 34,462 | |
| Communication expenses | | | 11,358 | | | | 8,232 | | | | 8,976 | |
| Business promotion | | | 11,613 | | | | 11,065 | | | | 10,435 | |
| Other taxes | | | 11,514 | | | | 8,443 | | | | 8,584 | |
| Other operating expenses | | | 54,230 | | | | 46,442 | | | | 45,604 | |
| | | | | | | | | | |
| Total other operating expenses | | | 277,783 | | | | 221,386 | | | | 217,377 | |
| | | | | | | | | | |
| Income before provision for income tax | | | 65,709 | | | | 110,594 | | | | 96,652 | |
Provision for Income Tax | | | 22,540 | | | | 30,788 | | | | 9,724 | |
| | | | | | | | | | |
Net Income Available to Common Shareholders | | $ | 43,169 | | | $ | 79,806 | | | $ | 86,928 | |
| | | | | | | | | | |
Basic and Diluted Earnings per Common Share | | $ | 0.93 | | | $ | 1.71 | | | $ | 1.86 | |
| | | | | | | | | | |
The accompanying notes are an integral part of these financial statements.
76
Santander BanCorp and Subsidiaries
Consolidated Statements of Changes in Stockholders’ Equity
Years Ended December 31, 2006, 2005 and 2004
(Dollars in thousands)
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
Common Stock: | | | | | | | | | | | | |
| Balance at beginning of year | | | 126,626 | | | | 126,626 | | | | 116,026 | |
| Stock dividend distributed | | | — | | | | — | | | | 10,600 | |
| | | | | | | | | | |
| Balance at end of year | | | 126,626 | | | | 126,626 | | | | 126,626 | |
| | | | | | | | | | |
Capital Paid in Excess of Par Value: | | | | | | | | | | | | |
| Balance at beginning of year | | | 304,171 | | | | 304,171 | | | | 211,742 | |
| Stock dividend distributed | | | — | | | | — | | | | 92,429 | |
| | | | | | | | | | |
| Balance at end of year | | | 304,171 | | | | 304,171 | | | | 304,171 | |
| | | | | | | | | | |
Treasury Stock at cost: | | | | | | | | | | | | |
| Balance at beginning of year | | | (67,552 | ) | | | (67,552 | ) | | | (67,552 | ) |
| | | | | | | | | | |
| Balance at end of year | | | (67,552 | ) | | | (67,552 | ) | | | (67,552 | ) |
| | | | | | | | | | |
Accumulated Other Comprehensive Loss, net of taxes: | | | | | | | | | | | | |
| Balance at beginning of year | | | (41,591 | ) | | | (6,818 | ) | | | (19,465 | ) |
| Unrealized net (loss) gain on investment securities available for sale, net of tax | | | (587 | ) | | | (34,031 | ) | | | 9,094 | |
| Unrealized net (loss) gain on cash flow hedges, net of tax | | | (178 | ) | | | 1,333 | | | | 3,463 | |
| Minimum pension (liability) benefit, net of tax | | | (1,750 | ) | | | (2,075 | ) | | | 90 | |
| Initial adoption of SFAS No. 158, net of tax | | | (107 | ) | | | — | | | | — | |
| | | | | | | | | | |
| Balance at end of year | | | (44,213 | ) | | | (41,591 | ) | | | (6,818 | ) |
| | | | | | | | | | |
Reserve Fund: | | | | | | | | | | | | |
| Balance at beginning of year | | | 133,759 | | | | 126,820 | | | | 118,919 | |
| Transfer from undivided profits | | | 3,752 | | | | 6,939 | | | | 7,901 | |
| | | | | | | | | | |
| Balance at end of year | | | 137,511 | | | | 133,759 | | | | 126,820 | |
| | | | | | | | | | |
Undivided Profits: | | | | | | | | | | | | |
| Balance at beginning of year | | | 113,114 | | | | 70,099 | | | | 116,036 | |
| Net income | | | 43,169 | | | | 79,806 | | | | 86,928 | |
| Transfer to reseve fund | | | (3,752 | ) | | | (6,939 | ) | | | (7,901 | ) |
| Deferred tax benefit amortization | | | (5 | ) | | | (3 | ) | | | (13 | ) |
| Common stock cash dividends | | | (29,849 | ) | | | (29,849 | ) | | | (21,922 | ) |
| Stock dividend distributed | | | — | | | | — | | | | (103,029 | ) |
| | | | | | | | | | |
| Balance at end of year | | | 122,677 | | | | 113,114 | | | | 70,099 | |
| | | | | | | | | | |
| Total stockholders’ equity | | $ | 579,220 | | | $ | 568,527 | | | $ | 553,346 | |
| | | | | | | | | | |
The accompanying notes are an integral part of these financial statements.
77
Santander BanCorp and Subsidiaries
Consolidated Statements of Comprehensive Income
Years Ended December 31, 2006, 2005 and 2004
(Dollars in thousands)
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
Comprehensive income | | | | | | | | | | | | |
| Net income | | $ | 43,169 | | | $ | 79,806 | | | $ | 86,928 | |
| | | | | | | | | | |
| Other comprehensive (loss) income, net of tax: | | | | | | | | | | | | |
| Unrealized (losses) gains on investment securities available for sale, net of tax | | | (926 | ) | | | (18,298 | ) | | | 18,526 | |
| Reclassification adjustment for losses (gains) included in net income, net of tax | | | 339 | | | | (15,733 | ) | | | (9,403 | ) |
| Unrealized losses on investment securities transferred to the held-to- maturity category, net of amortization | | | — | | | | — | | | | (29 | ) |
| | | | | | | | | | |
| Unrealized (losses) gains on investment securities available for sale, net of tax | | | (587 | ) | | | (34,031 | ) | | | 9,094 | |
| | | | | | | | | | |
| Unrealized (losses) gains on derivative used for cash flow hedges, net of tax | | | (178 | ) | | | 1,333 | | | | 3,463 | |
| Minimum pension (liability) benefit, net of tax | | | (1,750 | ) | | | (2,075 | ) | | | 90 | |
| | | | | | | | | | |
| Total other comprehensive (loss) income, net of tax | | | (2,515 | ) | | | (34,773 | ) | | | 12,647 | |
| | | | | | | | | | |
| Comprehensive income | | $ | 40,654 | | | $ | 45,033 | | | $ | 99,575 | |
| | | | | | | | | | |
The accompanying notes are an integral part of these financial statements.
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Santander BanCorp and Subsidiaries
Consolidated Statements of Cash Flows
Years Ended December 31, 2006, 2005 and 2004
(Dollars in thousands)
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
CASH FLOWS FROM OPERATING ACTIVITIES: | | | | | | | | | | | | |
| Net income | | $ | 43,169 | | | $ | 79,806 | | | $ | 86,928 | |
| | | | | | | | | | |
| Adjustments to reconcile net income to net cash used in operating activities: | | | | | | | | | | | | |
| Depreciation and amortization | | | 17,595 | | | | 13,184 | | | | 13,238 | |
| Deferred tax (benefit) provision | | | (2,123 | ) | | | 2,854 | | | | 3,715 | |
| Provision for loan losses | | | 65,583 | | | | 20,400 | | | | 26,270 | |
| Gain on sale of building | | | — | | | | — | | | | (2,754 | ) |
| Gain on sale of securities | | | — | | | | (17,842 | ) | | | (11,475 | ) |
| Gain on sale of loans | | | (1,994 | ) | | | (7,876 | ) | | | (431 | ) |
| Gain on sale of mortgage-servicing rights | | | (170 | ) | | | (83 | ) | | | (400 | ) |
| Losses (gains) on derivatives | | | 477 | | | | (1,964 | ) | | | (3,459 | ) |
| Trading gains | | | (1,243 | ) | | | (805 | ) | | | (1,193 | ) |
| Net (discount) premium amortization (accretion) on securities | | | (3,421 | ) | | | 3,586 | | | | 3,983 | |
| Net (discount) premium amortization (accretion) on loans | | | (3,994 | ) | | | 1,155 | | | | 873 | |
| Purchases and originations of loans held for sale | | | (908,272 | ) | | | (748,086 | ) | | | (733,022 | ) |
| Proceeds from sales of loans | | | 180,463 | | | | 253,902 | | | | 195,465 | |
| Repayments of loans held for sale | | | 6,579 | | | | 12,196 | | | | 35,233 | |
| Proceeds from sales of trading securities | | | 9,750,934 | | | | 1,610,299 | | | | 2,207,495 | |
| Purchases of trading securities | | | (9,755,086 | ) | | | (1,612,989 | ) | | | (2,197,939 | ) |
| Net change in: | | | | | | | | | | | | |
| Increase in accrued interest receivable | | | (24,280 | ) | | | (33,280 | ) | | | (8,284 | ) |
| (Increase) decrease in other assets | | | (70,230 | ) | | | (10,303 | ) | | | 10,402 | |
| Increase in accrued interest payable | | | 26,085 | | | | 42,494 | | | | 3,938 | |
| Increase (decrease) in other liabilities | | | 24,436 | | | | 12,245 | | | | (5,530 | ) |
| | | | | | | | | | |
| Total adjustments | | | (698,661 | ) | | | (460,913 | ) | | | (463,875 | ) |
| | | | | | | | | | |
| Net cash used in operating activities | | | (655,492 | ) | | | (381,107 | ) | | | (376,947 | ) |
| | | | | | | | | | |
| | | | | | | | | | | | | |
CASH FLOWS FROM INVESTING ACTIVITIES: | | | | | | | | | | | | |
| Decrease (increase) in interest-bearing deposits | | | 49,578 | | | | (51,034 | ) | | | (40,000 | ) |
| Proceeds from sales of investment securities available for sale | | | — | | | | 906,150 | | | | 1,450,058 | |
| Proceeds from maturities of investment securities available for sale | | | 29,621,084 | | | | 23,250,923 | | | | 1,595,155 | |
| Purchases of investment securities available for sale | | | (29,591,661 | ) | | | (23,949,534 | ) | | | (2,701,767 | ) |
| Proceeds from maturities of investment securities held to maturity | | | — | | | | — | | | | 47,994 | |
| Purchases of investment securities held to maturity and other investments | | | (8,848 | ) | | | (4,362 | ) | | | (69,739 | ) |
| Repayment of securities and securities called | | | 125,448 | | | | 173,462 | | | | 186,792 | |
| (Payments on) proceeds from derivative transactions | | | (392 | ) | | | 2,303 | | | | 2,943 | |
| Purchases of mortgage loans | | | — | | | | (289,881 | ) | | | (40,625 | ) |
| Net decrease (increase) in loans | | | 359,889 | | | | 292,987 | | | | (836,288 | ) |
| Proceeds from sales of mortgage-servicing rights | | | 170 | | | | 83 | | | | 400 | |
| Proceeds from sale of building | | | — | | | | — | | | | 14,000 | |
| Payment for the acquisition of net assets of consumer finance company, net of cash and cash equivalents acquired | | | (740,761 | ) | | | — | | | | — | |
| Payment for the acquisition of net assets of insurance company, net of cash and cash equivalents acquired | | | (2,074 | ) | | | — | | | | — | |
| Purchases of premises and equipment | | | (5,611 | ) | | | (9,076 | ) | | | (6,258 | ) |
| | | | | | | | | | |
| Net cash (used in) provided by investing activities | | | (193,178 | ) | | | 322,021 | | | | (397,335 | ) |
| | | | | | | | | | |
(Continued)
The accompanying notes are an integral part of these financial statements.
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Santander BanCorp and Subsidiaries
Consolidated Statements of Cash Flows
Years Ended December 31, 2006, 2005 and 2004
(Dollars in thousands)
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
| CASH FLOWS FROM FINANCING ACTIVITIES: | | | | | | | | | | | | |
| Net increase in deposits | | | 89,349 | | | | 489,835 | | | | 611,945 | |
| Net increase (decrease) in federal funds purchased and other borrowings | | | 859,554 | | | | (11,488 | ) | | | 430,334 | |
| Net decrease in securities sold under agreements to repurchase | | | (117,198 | ) | | | (401,677 | ) | | | (458,794 | ) |
| Net (decrease) increase in commercial paper issued | | | (124,770 | ) | | | (295,225 | ) | | | 374,640 | |
| Net increase (decrease) in term notes | | | 1,314 | | | | 8,758 | | | | (134,509 | ) |
| Issuance of subordinated capital notes | | | 124,078 | | | | 49,852 | | | | 58,765 | |
| Dividends paid | | | (22,386 | ) | | | (22,386 | ) | | | (21,922 | ) |
| | | | | | | | | | |
| Net cash provided by (used in) financing activities | | | 809,941 | | | | (182,331 | ) | | | 860,459 | |
| | | | | | | | | | |
| | | | | | | | | | | | | |
NET CHANGE IN CASH AND CASH EQUIVALENTS | | | (38,729 | ) | | | (241,417 | ) | | | 86,177 | |
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR | | | 237,993 | | | | 479,410 | | | | 393,233 | |
| | | | | | | | | | |
CASH AND CASH EQUIVALENTS, END OF YEAR | | $ | 199,264 | | | $ | 237,993 | | | $ | 479,410 | |
| | | | | | | | | | |
(Concluded)
The accompanying notes are an integral part of these financial statements.
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Santander BanCorp and Subsidiaries
Notes to Consolidated Financial Statements
Years Ended December 31, 2006, 2005 and 2004
1. Summary of Significant Accounting Policies and Other Matters:
The accounting and reporting policies of Santander BanCorp (the “Corporation”), 91% owned subsidiary of Banco Santander Central Hispano, S.A. (BSCH), conform with accounting principles generally accepted in the United States of America (hereinafter referred to as “generally accepted accounting principles” or “GAAP”) and with general practices within the financial services industry.
Following is a summary of the Corporation’s most significant accounting policies:
Nature of Operations and Use of Estimates
Santander BanCorp is a financial holding company offering a full range of financial services through its wholly owned banking subsidiary Banco Santander Puerto Rico and Subsidiaries (the “Bank”). The Corporation also engages in broker-dealer, asset management, mortgage banking, consumer finance, international banking, insurance agency services and insurance products through its subsidiaries, Santander Securities Corporation, Santander Asset Management, Santander Mortgage Corporation, Santander Financial Services, Inc., Santander International Bank and Santander Insurance Agency and Island Insurance Corporation, respectively.
Santander BanCorp is subject to the Federal Bank Holding Company Act and to the regulations, supervision, and examination of the Federal Reserve Board.
In preparing the consolidated financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Acquisition
On February 28, 2006 the Corporation acquired substantially all the assets and business operations in Puerto Rico of Island Finance for $742 million. The Island Finance operation was acquired by Santander Financial Services, Inc. (“Santander Financial”) a 100% owned subsidiary of the Corporation. In connection with this transaction the Corporation entered into a $725 million loan agreement with Santusa Holding, S.L., a subsidiary of its parent company. The Corporation also completed the private placement of $125 million Trust Preferred Securities (“Preferred Securities”) and issued Junior Subordinated Debentures in the aggregate principal amount of $129 million in connection with the issuance of the Preferred Securities. The Preferred Securities are classified as subordinated notes and the dividends as interest expense in accompanying condensed consolidated financial statements.
The Corporation recorded the acquisition of Island Finance under the purchase method of accounting in accordance with SFAS No. 141, “Business Combinations.” The purchase price was allocated to the assets acquired and the liabilities assumed based on their fair values at the acquisition date as summarized below.
| | | | | | | | | |
| | | February 28, 2006 | |
| | | (In thousands) | |
| Purchase price | | | | | | $ | 742,000 | |
| | | | | | | | | |
| Loans | | $ | 582,225 | | | | | |
| Other Assets | | | 9,640 | | | | | |
| | | | | | | | |
| Total Assets | | | 591,865 | | | | | |
| Other Liabilities | | | (2,974 | ) | | | | |
| | | | | | | | |
| Net Assets Acquired | | | | | | | 588,891 | |
| Identified Intangibles | | | | | | | 39,600 | |
| | | | | | | | |
| Goodwill | | | | | | $ | 113,509 | |
| | | | | | | | |
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In July 2006, the Corporation acquired at book value Island Insurance Corporation from Wells Fargo for $5.7 million. Island Insurance Corporation is a Puerto Rico life insurance company, duly licensed by the Puerto Rico Commissioner of Insurance. This corporation is currently inactive.
Principles of Consolidation
The consolidated financial statements include the accounts of the Corporation, the Bank and the Bank’s wholly owned subsidiaries, Santander Mortgage Corporation and Santander International Bank; Santander Securities Corporation and its wholly owned subsidiary, Santander Asset Management Corporation; Santander Financial Services, Inc., Santander Insurance Agency and Island Insurance Corporation. All significant intercompany balances and transactions have been eliminated in consolidation.
Cash and Cash equivalents
All highly liquid instruments with a maturity of three months or less, when acquired or generated, are considered cash equivalents.
Securities Purchased/Sold under Agreements to Resell/Repurchase
Repurchase and resell agreements are treated as collateralized financing transactions and are carried at the amounts at which the assets will be subsequently reacquired or resold.
The counterparties to securities purchased under resell agreements maintain effective control over such securities and accordingly those are not reflected in the Corporation’s consolidated balance sheets. The Corporation monitors the market value of the underlying securities as compared to the related receivable, including accrued interest, and requests additional collateral where deemed appropriate.
The Corporation maintains effective control over assets sold under agreements to repurchase; accordingly, such securities continue to be carried on the consolidated balance sheets.
Investment Securities
Investment securities are classified in four categories and accounted for as follows:
| | • | | Debt securities that the Corporation has the intent and ability to hold to maturity are classified as securities held to maturity and reported at cost adjusted for premium amortization and discount accretion. The Corporation may not sell or transfer held-to-maturity securities without calling into question its intent to hold other securities to maturity, unless a nonrecurring or unusual event that could not have been reasonably anticipated has occurred. |
| |
| | • | | Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. Financial instruments including, to a limited extent, derivatives, such as option contracts, are used by the Corporation in dealing and other trading activities and are carried at fair value. Interest revenue and expense arising from trading instruments are included in the consolidated statement of income as part of net interest income. |
| |
| | • | | Debt and equity securities not classified as either securities held to maturity or trading securities, and which have a readily available fair value, are classified as securities available for sale and reported at fair value, with unrealized gains and losses reported, net of taxes, in accumulated other comprehensive income (loss). The specific identification method is used to determine realized gains and losses on securities available for sale, which are included in gain (loss) on sale of investment securities in the consolidated statements of income. |
| |
| | • | | Investments in debt, equity or other securities that do not have readily determinable fair values, are classified as other investment securities in the consolidated balance sheets. These securities are stated at cost. Stock that is owned by the Corporation to comply with regulatory requirements, such as Federal Home Loan Bank (FHLB) stock, is included in this category. |
The amortization of premiums is deducted and the accretion of discounts is added to net interest income based on a method which approximates the interest method over the outstanding period of the related securities. The cost of securities sold is determined by specific identification. For securities available for sale, held to maturity and other investment securities, the
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Corporation reports separately in the consolidated statements of income, net realized gains or losses on sales of investment securities and unrealized loss valuation adjustments considered other than temporary, if any.
Derivative Financial Instruments
The Corporation uses derivative financial instruments mostly as hedges of interest rate risk, changes in fair value of assets and liabilities and to secure future cash flows.
All of the Corporation’s derivative instruments are recognized as assets and liabilities at fair value. If certain conditions are met, the derivative may qualify for hedge accounting treatment and be designated as one of the following types of hedges: (a) hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment (“fair value hedge”); (b) a hedge of the exposure to variability of cash flows of a recognized asset, liability or forecasted transaction (“cash flow hedge”) or (c) a hedge of foreign currency exposure (“foreign currency hedge”).
In the case of a qualifying fair value hedge, changes in the value of the derivative instruments that have been highly effective are recognized in current period earnings along with the change in value of the designated hedged item. If the hedge relationship is terminated, hedge accounting is discontinued and any balance related to the derivative is recognized in current operations, and the fair value adjustment to the hedged item continues to be reported as part of the basis of the item and is amortized to earnings as a yield adjustment. In the case of a qualifying cash flow hedge, changes in the value of the derivative instruments that have been highly effective are recognized in other comprehensive income, until such time as those earnings are affected by the variability of the cash flows of the underlying hedged item. If the hedge relationship is terminated, the net derivative gain or loss related to the discontinued cash flow hedge should continue to be reported in accumulated other comprehensive income (loss) and will be reclassified into earnings when the cash flows that were hedged occur, or when the forecasted transaction affects earnings or is no longer expected to occur. In either a fair value hedge or a cash flow hedge, net earnings may be impacted to the extent the changes in the value of the derivative instruments do not perfectly offset changes in the value of the hedged items. If the derivative is not designated as a hedging instrument, the changes in fair value of the derivative are recorded in earnings.
Certain contracts contain embedded derivatives. When the embedded derivative possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract, it is bifurcated, carried at fair value, and designated as a trading or non-hedging derivative instrument.
Loans Held for Sale
Loans held for sale are recorded at the lower of cost or market computed on the aggregate portfolio basis. The amount by which cost exceeds market value, if any, is accounted for as a valuation allowance with changes included in the determination of net income for the period in which the change occurs.
Loans
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding unpaid principal balances adjusted for the allowance for loan losses, unearned finance charges and any deferred fees or costs on originated loans.
Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and amortized using methods that approximate the interest method over the term of the loans as an adjustment to interest yield. Discounts and premiums on purchased loans are amortized to income over the expected lives of the loans using methods that approximate the interest method.
The accrual of interest on commercial loans, construction loans, lease financing and closed-end consumer loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due, but in no event is it recognized after 90 days in arrears on payments of principal or interest. Interest on mortgage loans is not recognized after four months in arrears on payments of principal or interest. Income is generally recognized on open-end (revolving credit) consumer loans until the loans are charged off. When interest accrual is discontinued, unpaid interest is reversed on all closed-end portfolios. Interest income is subsequently recognized only to the extent that it is received. The non accrual status is discontinued when loans are made current by the borrower.
The Corporation leases vehicles and equipment to individual and corporate customers. The finance method of accounting is used to recognize revenue on lease contracts that meet the criteria specified in Statement of Financial Accounting Standards (“SFAS”) No. 13, “Accounting for Leases,” as amended. Aggregate rentals due over the term of the leases less unearned
83
income are included in lease receivable, which is part of “Loans, net” in the consolidated balance sheets. Unearned income is amortized to income over the lease term so as to yield a constant rate of return on the principal amounts outstanding. Lease origination fees and costs are deferred and amortized over the average life of the portfolio as an adjustment to yield.
Acquired Loans
AICPA Statement of Position 03-3, “Accounting for Certain loans or Debt Securities Acquired in a Transfer” (“SOP 03-3”) which became effective for loans acquired in fiscal years subsequent to December 31, 2004, requires that purchased impaired loans be recorded at fair value and prohibits the carryover of an allowance for loan losses on certain loans acquired in a business combination accounted for as a purchase. Pursuant to SOP 03-3, for certain acquired loans that have experienced deterioration of credit quality between origination and the Corporation’s acquisition of the loans, the amount paid for the loans reflects the Corporation’s determination that it is probable that the Corporation will be unable to collect all amounts due according to the loan’s contractual terms. Certain of the loans acquired in connection with the acquisition of Island Finance had experienced credit deterioration since the date of origination to the date of acquisition and were accounted for under SOP 03-3. At acquisition, the Corporation reviewed each loan to determine whether there was evidence of deterioration of credit quality since origination and if it was probable that the Corporation would be unable to collect all amounts due according to the loans’ contractual terms. For these loans, the excess of undiscounted contractual cash flows over the undiscounted cash flows estimated at the time of acquisition is not accreted into income (nonaccretable difference). The amount representing the excess of cash flows estimated at acquisition over the purchase price is accreted into purchase discount earned over the life of the loan (accretable yield).
The nonaccretable difference is not accreted into income. If cash flows cannot be reasonably estimated for any loan, and collection is not probable, the cost recovery method of accounting may be used. Under the cost recovery method, any amounts received are applied against the recorded amount of the loan.
Subsequent to acquisition, if cash flow projections improve, and it is determined that the amount and timing of the cash flows related to the nonaccretable difference are reasonably estimable and collection is probable, the corresponding decrease in the nonaccretable difference is transferred to the accretable discount and is accreted into interest income over the remaining life of the loans. If cash flow projections deteriorate subsequent to acquisition, the decline is accounted for through the allowance for loan losses.
There is judgment involved in estimating the amount of the loans’ future cash flows. The amount and timing of actual cash flows could differ materially from management’s estimates, which could materially affect the Corporation’s financial condition and results of operations.
The following table summarizes the outstanding loan balances, cash flows expected to be collected and the fair value of the loans acquired in the Island Finance acquisition as of February 28, 2006, to which SOP 03-3 has been applied.
| | | | | |
| (In thousands) | | | | |
| Outstanding contractual receivable balance at acquisition | | $ | 23,149 | |
| | | | |
| Cash flows expected to be collected at acquisition | | $ | 14,129 | |
| | | | |
| Basis in acquired receivable at acquisition | | $ | 13,995 | |
| | | | |
| Carrying amount of acquired receivables at December 31, 2006 | | $ | 8,248 | |
| | | | |
The accretable yield of $134,000 as of February 28, 2006 had been substantially amortized as of December 31, 2006.
Off-Balance Sheet Instruments
In the ordinary course of business, the Corporation enters into off-balance sheet instruments consisting of commitments to extend credit, stand by letters of credit and financial guarantees. Such financial instruments are recorded in the consolidated financial statements when they are funded or when related fees are incurred or received. The Corporation periodically evaluates the credit risks inherent in these commitments, and establishes loss allowances for such risks if and when these are deemed necessary.
84
Fees received for providing loan commitments and letters of credit that result in loans are typically deferred and amortized to interest income over the life of the related loan, beginning with the initial borrowing. Fees on commitments and letters of credit are amortized to other income as banking fees and commissions over the commitment period when funding is not expected.
Allowance for Loan Losses
The allowance for loan losses is a current estimate of the losses inherent in the present portfolio based on management’s ongoing quarterly evaluations of the loan portfolio. Estimates of losses inherent in the loan portfolio involve the exercise of judgment and the use of assumptions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. The allowance is increased by a provision for loan losses, which is charged to expense and reduced by charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses. Because of uncertainties inherent in the estimation process, management’s estimate of credit losses in the loan portfolio and the related allowance may change in the near term.
The Corporation follows a systematic methodology to establish and evaluate the adequacy of the allowance for loan losses. This methodology consists of several key elements.
Larger commercial and construction loans that exhibit potential or observed credit weaknesses are subject to individual review. Where appropriate, allowances are allocated to individual loans based on management’s estimate of the borrower’s ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to the Corporation.
Included in the review of individual loans are those that are impaired as defined by GAAP. Any allowances for loans deemed impaired are measured based on the present value of expected future cash flows discounted at the loans’ effective interest rate or on the fair value of the underlying collateral if the loan is collateral dependent. Commercial business, commercial real estate and construction loans exceeding a predetermined monetary threshold are individually evaluated for impairment. Other loans are evaluated in homogeneous groups and collectively evaluated for impairment. Loans that are recorded at fair value or at the lower of cost or fair value are not evaluated for impairment. Impaired loans for which the discounted cash flows, collateral value or market price exceeds its carrying value do not require an allowance. The Corporation evaluates the collectibility of both principal and interest when assessing the need for loss accrual.
Historical loss rates are applied to other commercial loans not subject to individual review. The loss rates are derived from historical loss trends.
Homogeneous loans, such as consumer installments, credit cards, residential mortgage loans and consumer finance are not individually risk graded. Allowances are established for each pool of loans based on the expected net charge-offs for one year. Loss rates are based on the average net charge-off history by loan category, market loss trends and other relevant economic factors.
An unallocated allowance is maintained to recognize the imprecision in estimating and measuring loss when evaluating allowances for individual loans or pools of loans.
Historical loss rates for commercial and consumer loans may also be adjusted for significant factors that, in management’s judgment, reflect the impact of any current condition on loss recognition. Factors which management considers in the analysis include the effect of the national and local economies, trends in the nature and volume of loans (delinquencies, charge-offs, non-accrual and problem loans), changes in the internal lending policies and credit standards, collection practices, and examination results from bank regulatory agencies and the Corporation’s internal credit examiners.
Allowances on individual loans and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience.
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities
Transfers of financial assets are accounted for as sales, when control over the transferred assets is deemed to be surrendered: (1) the assets have been isolated from the Corporation, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Corporation does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. The Corporation recognizes the financial assets and servicing assets it controls and the liabilities it has incurred. At the same time, it ceases to recognize financial assets when control has been surrendered and liabilities when they are extinguished.
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Premises and Equipment
Premises and equipment are stated at cost, less accumulated depreciation and amortization which is computed utilizing the straight-line method over the estimated useful lives of the assets that range between three and fifty years. Leasehold improvements are stated at cost and are amortized using the straight-line method over the estimated useful lives of the assets or the term of the lease, whichever is lower. Gains or losses on dispositions are reflected in current operations. Costs of maintenance and repairs that do not improve or extend the lives of the respective assets are charged to expense as incurred. Costs of renewals and improvements are capitalized. When assets are sold or disposed of, their cost and related accumulated depreciation are removed from the accounts and any gain or loss is reflected in earnings when realized.
The Corporation evaluates for impairment its long-lived assets, including certain identifiable intangibles and long-lived assets to be disposed of, whenever events and circumstances indicate that the carrying amount of an asset may not be recoverable. No indications of impairment are evident as a result of such review during 2006, 2005 and 2004.
Other Real Estate
Other real estate, normally obtained through foreclosure or other workout situations, is included in other assets and stated at the lower of fair value or carrying value minus estimated costs to sell. Upon foreclosure, the recorded amount of the loan is written-down, if applicable, to the fair value less estimated costs of disposal of the real estate acquired, by charging the allowance for loan losses. Subsequent to foreclosure, any losses in the carrying value of the asset resulting from periodic valuations of the properties are charged to expense in the period incurred. Gains or losses on disposition of other real estate and related operating income and maintenance expenses are included in current operations.
Goodwill and Intangible Assets
The Corporation accounts for goodwill in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” The reporting units are tested annually as of the end of the third quarter of each year to determine whether their carrying value exceeds their fair market value. Should this be the case, the value of goodwill or indefinite-lived intangibles may be impaired and written down. Goodwill and other indefinite lived intangible assets are also tested for impairment on an interim basis if an event occurs or circumstances change between annual tests that would more likely than not reduce the fair value of the reporting unit below its carrying amount. If there is a determination that the fair value of the goodwill or other identifiable intangible asset is less than the carrying value, an impairment loss is recognized in an amount equal to the difference. Impairment losses, if any, are reflected in operating income in the consolidated statement of income.
In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the Corporation reviews finite-lived intangible assets for impairment whenever an event occurs or circumstances change which indicates that the carrying amount of such assets may not be fully recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. Measurement of an impairment loss is based on the fair value of the asset compared to its carrying value. If the fair value of the asset is determined to be less than the carrying value, an impairment loss is incurred in an amount equal to the difference. Impairment losses, if any, are reflected in operating income in the consolidated statement of income.
The Corporation uses judgment in assessing goodwill and intangible assets for impairment. Estimates of fair value are based on projections of revenues, operating costs and cash flows of each reporting unit considering historical and anticipated future results, general economic and market conditions as well as the impact of planned business or operational strategies. The valuations employ a combination of present value techniques to measure fair value and consider market factors. Generally, the Corporation engages third party specialists to assist with its valuations. Additionally, judgment is used in determining the useful lives of finite-lived intangible assets. Changes in judgments and projections could result in a significantly different estimate of the fair value of the reporting units and could result in an impairment of goodwill.
As a result of the purchase price allocations from prior acquisitions and the Corporation’s decentralized structure, goodwill is included in multiple reporting units. Due to certain factors such as the highly competitive environment, cyclical nature of the business in some of the reporting units, general economic and market conditions as well as planned business or operational strategies, among others, the profitability of the Corporation’s individual reporting units may periodically suffer from downturns in these factors. These factors may have a relatively more pronounced impact on the individual reporting units as compared to the Corporation as a whole and might adversely affect the fair value of the reporting units. If material adverse conditions occur that impact the Corporation’s reporting units, the Corporation’s reporting units, and the related goodwill would need to be written down to an amount considered recoverable.
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Based on management’s assessment of the value of the Corporation’s goodwill which includes an independent valuation, among others, management determined that the Corporation’s goodwill was not impaired.
Mortgage-servicing Rights
The Corporation’s mortgage-servicing rights (“MSRs”) are stated at the lower of carrying value or market at each balance sheet date. On a quarterly basis the Corporation evaluates its MSRs for impairment and charges any such impairment to current period earnings. In order to evaluate its MSRs the Corporation stratifies the related mortgage loans on the basis of their risk characteristics which have been determined to be: type of loan (government-guaranteed, conventional, conforming and non-conforming), interest rates and maturities. Impairment of MSRs is determined by estimating the fair value of each stratum and comparing it to its carrying value. An impairment loss amounting to $51,000 and $214,000 was recognized for the years ended December 31, 2006 and 2005, respectively. No impairment was recognized for the year ended December 31, 2004.
MSRs are also subject to periodic amortization. The amortization of MSRs is based on the amount and timing of estimated cash flows to be recovered with respect to the MSRs over their expected lives. Amortization may be accelerated or decelerated to the extent that changes in interest rates or prepayment rates warrant.
Mortgage Banking
Mortgage loan servicing includes collecting monthly mortgagor payments, forwarding payments and related accounting reports to investors, collecting escrow deposits for the payment of mortgagor property taxes and insurance, and paying taxes and insurance from escrow funds when due. No asset or liability is recorded by the Corporation for mortgages serviced, except for mortgage-servicing rights arising from the sale of mortgages, advances to investors and escrow balances.
The Corporation recognizes as a separate asset the right to service mortgage loans for others whenever those servicing rights are acquired. The Corporation acquires MSRs by purchasing or originating loans and selling or securitizing those loans (with the servicing rights retained) and allocates the total cost of the mortgage loans sold to the MSRs (included in intangible assets in the accompanying consolidated balance sheets) and the loans based on their relative fair values. Further, mortgage-servicing rights are assessed for impairment based on the fair value of those rights. MSRs are amortized over the estimated life of the related servicing income. Mortgage loan-servicing fees, which are based on a percentage of the principal balances of the mortgages serviced, are credited to income as mortgage payments are collected.
Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. At December 31, 2006 and 2005, the unpaid principal balances of mortgage loans serviced for others amounted to approximately $818,364,000 and $675,852,000, respectively. In connection with these mortgage-servicing activities, the Corporation administered escrow and other custodial funds which amounted to approximately $2,598,000 and $2,057,000 at December 31, 2006 and 2005, respectively.
Trust Services
In connection with its trust activities, the Corporation administers and is custodian of assets amounting to approximately $3,718,000,000 and $6,838,000,000 at December 31, 2006 and 2005, respectively. Due to the nature of trust activities, these assets are not included in the Corporation’s consolidated balance sheets. In December 2006, the Corporation sold to an unaffiliated third party the servicing rights with respect to the following trust pension accounts: personal trust, customer employee benefit plans, guardianship accounts, insurance trust, escrow accounts and securities custody accounts. No gain or loss was recognized on this transaction. For a period not to exceed ten months after the closing date of the sale, the Corporation will transfer to the purchaser the trust accounts (of approximately $1.2 billion) and related servicing in a timely and orderly manner. Fees collected during the transfer period shall be allocated between both entities on a pro rata basis. The Bank’s Trust Division will focus its effort on the transfer and paying agent and IRA account services.
While the assets and operations of the Trust Division of the Corporation meet the definition of “discontinued operations,” as defined in SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Corporation has not segregated the Division’s assets and results of operation, as the amounts are immaterial. Results of operations (net of taxes) were approximately $908,000, $645,000 and $634,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
Broker-dealer and Asset Management Commissions
Commissions of the Corporation’s broker-dealer operations are composed of brokerage commission income and expenses recorded on a trade date basis and proprietary securities transactions recorded on a trade date basis. Investment banking
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revenues include gains, losses and fees net of syndicate expenses, arising from securities offerings in which the Corporation acts as an underwriter or agent. Investment banking management fees are recorded on offering date, sales concessions on trade date, and underwriting fees at the time the underwriting is completed and the income is reasonably determinable. Revenues from portfolio and other management and advisory fees include fees and advisory charges resulting from the asset management of certain funds and are recognized over the period when services are rendered.
Insurance Commissions
The Corporation’s insurance agency operation earns commissions on the sale of insurance policies issued by unaffiliated insurance companies. Commission revenue is reported net of the provision for commission returns on insurance policy cancellations, which is based on management’s estimate of future insurance policy cancellations as a result of historical turnover rates by types of credit facilities subject to insurance.
Treasury Stock
Treasury stock is recorded at cost and is carried as a reduction of stockholders’ equity in the consolidated balance sheets. As of December 31, 2006 treasury stock has not been retired or reissued.
Income Taxes
The Corporation uses the asset and liability balance sheet method for the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Corporation’s financial statements or tax returns. Deferred income tax assets and liabilities are determined for differences between financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future. The computation is based on enacted tax laws and rates applicable to periods in which the temporary differences are expected to be recovered or settled. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount that is more likely than not to be realized. The Corporation also accounts for any income tax contingencies, if any.
Earnings Per Common Share
Basic and diluted earnings per common share are computed by dividing net income available to common stockholders, by the weighted average number of common shares outstanding during the period. The Corporation’s average number of common shares outstanding, used in the computation of earnings per common share were 46,639,104 for the years ended December 31, 2006, 2005 and 2004. Basic and diluted earnings per common share are the same since no stock options or other potentially dilutive common shares were outstanding during the years ended December 31, 2006, 2005 and 2004.
Statements of Cash Flows
Supplemental Disclosures of Cash Flow Information:
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars in thousands) | |
| Cash paid during the year for: | | | | | | | | | | | | |
| Interest | | $ | 301,619 | | | $ | 195,157 | | | $ | 136,824 | |
| | | | | | | | | | |
| Income taxes | | $ | 34,937 | | | $ | 6,713 | | | $ | 11,322 | |
| | | | | | | | | | |
| Noncash transactions: | | | | | | | | | | | | |
| Stock dividend (See Note 14) | | $ | — | | | $ | — | | | $ | 103,029 | |
| | | | | | | | | | |
| Minimum pension (liability) benefit (See Note 17) | | $ | 1,750 | | | $ | 2,075 | | | $ | (90 | ) |
| | | | | | | | | | |
| Initial adoption of SFAS No. 158 (See Note 17) | | $ | 107 | | | $ | — | | | $ | — | |
| | | | | | | | | | |
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Recent Accounting Pronouncements that Affect the Corporation
The adoption of the following accounting pronouncements did not have a material impact on the Corporation’s results of operations and financial condition:
| | • | | SFAS No. 154, “Accounting Changes and Error Corrections”.In May 2005, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 154, “Accounting Changes and Error Corrections”, a replacement of APB Opinion No. 20 and FASB Statement No. 3. The statement applies to all voluntary changes in accounting principle, and changes the requirements for accounting and reporting of a change in accounting principle. SFAS No. 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle unless it is impracticable. SFAS No. 154 is the result of a broader effort by the FASB to improve the comparability of cross-border financial reporting by working with the International Accounting Standards Board toward development of a single set of high-quality accounting standards. SFAS No. 154 requires that a change in method of depreciation, amortization, or depletion for long-lived, non-financial assets be accounted for as a change in accounting estimate that is effected by a change in accounting principle. APB Opinion No. 20 previously required that such a change be reported as a change in accounting principle. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Statement does not change the transition provisions of any existing accounting pronouncements, including those that are in a transition phase as of the effective date of this statement. The adoption of this statement did not have a material impact on the Corporation’s financial condition, results of operations or cash flows. |
| |
| | • | | SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106, and 132R.” In September 2006, FASB issued SFAS No. 158, which requires recognition of a net liability or asset to report the funded status of defined benefit pension and other postretirement plans on the balance sheet and recognition (as a component of other comprehensive income) of changes in the funded status in the year in which the changes occur. Additionally, SFAS No. 158 requires measurement of a plan’s assets and obligations as of the balance sheet date and additional disclosures in the notes to the financial statements. The recognition and disclosure provisions of SFAS No. 158 are effective for fiscal years ending after December 15, 2006, while the requirement to measure a plan’s assets and obligations as of the balance sheet date is effective for fiscal years ending after December 15, 2008. The standard was effective as of December 31, 2006 for the recognition of our plans’ funded status. Upon adoption of the standard, to recognize the amounts currently recorded in the consolidated statement of condition, the Corporation recorded an after-tax reduction of accumulated other comprehensive income of $107,000. Additional disclosures required by the new standard are included in Note 17. |
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| | • | | Staff Accounting Bulletin No. 108 (“SAB 108”), Financial Statements – Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.In September 2006, the SEC issued SAB 108, which provides guidance on the consideration of prior year misstatements in determining whether the current year’s financial statements are materially misstated. In providing this guidance, the SEC staff references both the “iron curtain” and “rollover” approaches to quantifying a current year misstatement for purposes of determining materiality. The iron curtain approach focuses on how the current year’s statement of financial condition would be affected in correcting misstatements without considering the year in which the misstatement originated. The rollover approach focuses on the amount of the misstatements that originated in the current year’s income statement. The SEC staff indicates that registrants should quantify the impact of correcting all misstatements, including both the carryover and reversing effects of prior year misstatements, on the current year financial statements. This SAB was effective for fiscal years ending after November 15, 2006. Registrants may either restate their financials for any material misstatements arising from the application of this SAB or recognize a cumulative effect of applying SAB 108 within the current year opening balance in retained earnings. The adoption of this statement did not have a material impact on the Corporation’s financial condition, results of operations or cash flows. |
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| | | | The Corporation is evaluating the impact that the following recently issued accounting pronouncements may have on its financial condition and results of operations. |
| | • | | SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments, an amendment of SFAS No. 140 and SFAS No. 133(“SFAS 155”). In February 2006, the FASB issued SFAS No. 155, which permits the Corporation to elect to measure any hybrid financial instrument at fair value (with changes in fair value recognized in earnings) if the hybrid instrument contains an embedded derivative that would otherwise be required to be bifurcated and accounted for separately under SFAS No. 133. The election to measure the hybrid instrument at fair value is made on an instrument-by-instrument basis and is irreversible. The Statement is effective for all instruments acquired, issued, or subject to a remeasurement event occurring after the beginning of the Corporation’s fiscal year that begins after September 15, |
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| | | | 2006. The Corporation is currently evaluating the effects of the adoption of SFAS 155 on its consolidated financial position and results of operations. |
| | • | | SFAS No. 156, “Accounting for Servicing of Financial Assets, an amendment to SFAS No. 140.”In March 2006, the FASB issued SFAS No. 156, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities to (1) require the recognition of a servicing asset or servicing liability under specified circumstances, (2) require that, if practicable, all separately recognized servicing assets and liabilities be initially measured at fair value, (3) create a choice for subsequent measurement of each class of servicing assets or liabilities by applying either the amortization method or the fair value method, and (4) permit the one-time reclassification of securities identified as offsetting exposure to changes in fair value of servicing assets or liabilities from available-for-sale securities to trading securities under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. In addition, SFAS No. 156 amends SFAS No. 140 to require significantly greater disclosure concerning recognized servicing assets and liabilities. SFAS No. 156 is effective for all separately recognized servicing assets and liabilities acquired or issued after the beginning of an entity’s fiscal year that begins after September 15, 2006, with early adoption permitted. The Corporation is currently evaluating the effects of the adoption of SFAS 156 on its consolidated financial position or results of operations. |
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| | • | | SFAS No. 157, “Fair Value Measurements.”In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which provides enhanced guidance for using fair value to measure assets and liabilities. SFAS No. 157 establishes a common definition of fair value, provides a framework for measuring fair value under U.S. GAAP and expands disclosure requirements about fair value measurements. SFAS No. 157 is effective for financial statements issued in fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Corporation is currently evaluating the impact, if any, the adoption of SFAS No. 157 will have on the Company’s financial reporting and disclosures. |
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| | • | | FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). In July 2006, the FASB issued FIN 48,“Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109”, which clarifies the accounting for uncertainty in tax positions. This Interpretation requires that the Corporation recognize in the financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. In evaluating the more-likely-than-not recognition threshold, a company should presume the tax position will be subject to examination by a taxing authority with full knowledge of all relevant information. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. The Corporation does not expect the adoption of this statement to have a material impact on its consolidated financial statements. |
2. Trading Securities:
Proceeds from sales of trading securities during 2006, 2005 and 2004 were approximately $9,750,934,000 $1,610,299,000 and $2,207,495,000 respectively. Net gains of approximately $1,117,000, $1,099,000 and $1,166,000 were realized during 2006, 2005 and 2004, respectively. During 2006, 2005 and 2004, an unrealized holding gain of $96,000, a loss of $294,000 and a gain of $27,000 was recognized, respectively. Trading gain on futures transactions of $30,000 was realized in 2006 and trading losses on futures transactions of $528,000 and $1,069,000 were realized in 2005 and 2004, respectively.
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3. Investment Securities Available for Sale:
The amortized cost, gross unrealized gains and losses, fair value and weighted average yield of investment securities available for sale by contractual maturity are as follows:
| | | | | | | | | | | | | | | | | | | | | |
| | | December 31, 2006 | |
| | | | | | | Gross | | | Gross | | | | | | | Weighted | |
| | | Amortized | | | Unrealized | | | Unrealized | | | Fair | | | Average | |
| | | Cost | | | Gains | | | Losses | | | Value | | | Yield | |
| | | (Dollars in thousands) | |
| Treasury and agencies of the United States Government: | | | | | | | | | | | | | | | | | | | | |
| Within one year | | $ | 252,497 | | | $ | 29 | | | $ | 28 | | | $ | 252,498 | | | | 4.90 | % |
| After one year to five years | | | 485,258 | | | | — | | | | 15,421 | | | | 469,837 | | | | 3.89 | % |
| | | | | | | | | | | | | | | | | |
| | | | 737,755 | | | | 29 | | | | 15,449 | | | | 722,335 | | | | 4.24 | % |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
| Commonwealth of Puerto Rico and its subdivisions: | | | | | | | | | | | | | | | | | | | | |
| Within one year | | | 950 | | | | — | | | | 2 | | | | 948 | | | | 3.85 | % |
| After one year to five years | | | 16,005 | | | | — | | | | 523 | | | | 15,482 | | | | 4.26 | % |
| After five years to ten years | | | 24,966 | | | | 6 | | | | 407 | | | | 24,565 | | | | 5.28 | % |
| Over ten years | | | 14,781 | | | | 166 | | | | — | | | | 14,947 | | | | 5.79 | % |
| | | | | | | | | | | | | | | | | |
| | | | 56,702 | | | | 172 | | | | 932 | | | | 55,942 | | | | 5.10 | % |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
| Mortgage-backed securities: | | | | | | | | | | | | | | | | | | | | |
| Over ten years | | | 653,521 | | | | — | | | | 22,084 | | | | 631,437 | | | | 4.99 | % |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
| Foreign securities | | | | | | | | | | | | | | | | | | | | |
| Within one year | | | 25 | | | | — | | | | — | | | | 25 | | | | 7.50 | % |
| After one year to five years | | | 50 | | | | — | | | | — | | | | 50 | | | | 4.65 | % |
| | | | | | | | | | | | | | | | | |
| | | | 75 | | | | — | | | | — | | | | 75 | | | | 5.60 | % |
| | | | | | | | | | | | | | | | | |
| | | $ | 1,448,053 | | | $ | 201 | | | $ | 38,465 | | | $ | 1,409,789 | | | | 4.57 | % |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
| | | December 31, 2005 | |
| | | | | | | Gross | | | Gross | | | | | | | Weighted | |
| | | Amortized | | | Unrealized | | | Unrealized | | | Fair | | | Average | |
| | | Cost | | | Gains | | | Losses | | | Value | | | Yield | |
| | | (Dollars in thousands) | |
| Treasury and agencies of the United States Government: | | | | | | | | | | | | | | | | | | | | |
| Within one year | | $ | 279,780 | | | $ | 4 | | | $ | 598 | | | $ | 279,186 | | | | 3.40 | % |
| After one year to five years | | | 268,511 | | | | — | | | | 9,359 | | | | 259,152 | | | | 3.68 | % |
| After five years to ten years | | | 219,920 | | | | — | | | | 6,483 | | | | 213,437 | | | | 4.15 | % |
| | | | | | | | | | | | | | | | | |
| | | | 768,211 | | | | 4 | | | | 16,440 | | | | 751,775 | | | | 3.58 | % |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
| Commonwealth of Puerto Rico and its subdivisions: | | | | | | | | | | | | | | | | | | | | |
| Within one year | | | 12,750 | | | | 43 | | | | 3 | | | | 12,790 | | | | 4.93 | % |
| After one year to five years | | | 9,920 | | | | 11 | | | | 54 | | | | 9,877 | | | | 4.07 | % |
| After five years to ten years | | | 27,604 | | | | 34 | | | | 423 | | | | 27,215 | | | | 4.83 | % |
| Over ten years | | | 3,786 | | | | 10 | | | | 78 | | | | 3,718 | | | | 6.35 | % |
| | | | | | | | | | | | | | | | | |
| | | | 54,060 | | | | 98 | | | | 558 | | | | 53,600 | | | | 4.82 | % |
| | | | | | | | | | | | | | | | | |
| Mortgage-backed securities: | | | | | | | | | | | | | | | | | | | | |
| Over ten years | | | 775,073 | | | | — | | | | 20,842 | | | | 754,231 | | | | 5.00 | % |
| | | | | | | | | | | | | | | | | |
| Foreign securities | | | | | | | | | | | | | | | | | | | | |
| After one year to five years | | | 75 | | | | — | | | | — | | | | 75 | | | | 5.60 | % |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
| | | $ | 1,597,419 | | | $ | 102 | | | $ | 37,840 | | | $ | 1,559,681 | | | | 4.42 | % |
| | | | | | | | | | | | | | | | | |
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The number of positions, fair value and unrealized losses at December 31, 2006, of investment securities available for sale that have been in a continuous unrealized loss position for less than twelve months and for twelve months or more, are as follows:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Less than 12 months | | | 12 months or more | | | Total | |
| | | Number | | | | | | | | | | | Number | | | | | | | | | | | Number | | | | | | | |
| | | of | | | Fair | | | Unrealized | | | of | | | Fair | | | Unrealized | | | of | | | Fair | | | Unrealized | |
| | | Positions | | | Value | | | Losses | | | Positions | | | Value | | | Losses | | | Positions | | | Value | | | Losses | |
| | | (Dollars in thousands) | |
| Treasury and agencies of the United States Government | | | 11 | | | $ | 649,737 | | | $ | 15,449 | | | | — | | | $ | — | | | $ | — | | | | 11 | | | $ | 649,737 | | | $ | 15,449 | |
| Commonwealth of Puerto Rico and its subdivisions | | | 6 | | | | 13,673 | | | | 223 | | | | 14 | | | | 21,508 | | | | 709 | | | | 20 | | | | 35,181 | | | | 932 | |
| Mortgage-backed securities | | | 1 | | | | 5,799 | | | | 139 | | | | 30 | | | | 625,638 | | | | 21,945 | | | | 31 | | | | 631,437 | | | | 22,084 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | 18 | | | $ | 669,209 | | | $ | 15,811 | | | | 44 | | | $ | 647,146 | | | $ | 22,654 | | | | 62 | | | $ | 1,316,355 | | | $ | 38,465 | |
| | | | | | | | | | | | | | | | | | | �� | | | | | | | | | |
The Corporation evaluates its investment securities for other-than-temporary impairment on a quarterly basis or earlier if other factors indicative of potential impairment exist. An impairment charge in the consolidated statements of income is recognized when the decline in the fair value of the securities below their cost basis is judged to be other-than-temporary. The Corporation considers various factors in determining whether it should recognize an impairment charge, including, but not limited to the length of time and extent to which the fair value has been less than its cost basis, expectation of recoverability of its original investment in the securities and the Corporation’s intent and ability to hold the securities for a period of time sufficient to allow for any forecasted recovery of fair value up to (or beyond) the cost of the investment.
As of December 31, 2006, management concluded that there was no other-than-temporary impairment in its investment securities portfolio. The unrealized losses in the Corporation’s investments in U.S. and P.R. Government agencies and subdivisions were caused by interest rate increases. Substantially all of these securities are rated the equivalent of AAA by major rating agencies. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Since the Corporation has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, the Corporation does not consider these investments to be other-than-temporarily impaired at December 31, 2006. The unrealized losses in the Corporation’s investment in mortgage-backed securities were also caused by interest rate increases. The Corporation purchased these investments at a discount relative to their face amount, and the contractual cash flows of these investments are guaranteed by an agency of the U.S. government or by other government-sponsored corporations. Accordingly, it is expected that the securities will not be settled at a price less than the amortized cost of the Corporation’s investment. The decline in market value is attributable to changes in interest rates and not credit quality and since the Corporation has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, the Corporation does not consider these investments to be other-than-temporarily impaired at December 31, 2006.
Contractual maturities on certain securities, including mortgage-backed securities, could differ from actual maturities since certain issuers have the right to call or prepay these securities.
The weighted average yield on investment securities available for sale is based on amortized cost, therefore it does not give effect to changes in fair value.
There were no sales of investment securities available for sale during 2006. Proceeds from sales of investment securities available for sale were approximately $906,150,000 and $1,450,058,000, in 2005 and 2004, respectively. Gross gains of approximately $17,849,000 and $12,789,000 were realized in 2005 and 2004, respectively. Gross losses of approximately $7,800 and $1,314,000 were realized in 2005 and 2004, respectively.
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4. Assets Pledged:
At December 31, 2006 and 2005, investment securities and loans were pledged to secure deposits of public funds. The classification and carrying amount of pledged assets, which the secured parties are not permitted to sell or repledge the collateral as of December 31, were as follows:
| | | | | | | | | |
| | | 2006 | | | 2005 | |
| | | (Dollars in thousands) | |
| Investment securities available for sale | | $ | 356,728 | | | $ | 321,789 | |
| Loans | | | 313,582 | | | | 294,433 | |
| Other | | | 22,004 | | | | 18,830 | |
| | | | | | | |
| | | $ | 692,314 | | | $ | 635,052 | |
| | | | | | | |
At December 31, 2006 and 2005, investment securities with a carrying value of approximately $867,944,000 and $995,032,000, respectively, were pledged to securities sold under agreements to repurchase.
5. Loans:
The Corporation’s loan portfolio at December 31 consists of the following:
| | | | | | | | | |
| | | 2006 | | | 2005 | |
| | | (Dollars in thousands) | |
| Commercial and industrial | | $ | 2,489,959 | | | $ | 2,968,178 | |
| Consumer | | | 604,619 | | | | 564,198 | |
| Consumer Finance | | | 849,036 | | | | — | |
| Leasing | | | 143,836 | | | | 137,855 | |
| Construction | | | 438,573 | | | | 217,304 | |
| Mortgage | | | 2,453,429 | | | | 1,929,203 | |
| | | | | | | |
| | | | 6,979,452 | | | | 5,816,738 | |
| Unearned income and deferred fees/costs | | | (232,173 | ) | | | (8,108 | ) |
| Allowance for loan losses | | | (106,863 | ) | | | (66,842 | ) |
| | | | | | | |
| Loans, net | | $ | 6,640,416 | | | $ | 5,741,788 | |
| | | | | | | |
93
At December 31, the recorded investment in loans that were considered impaired is as follows:
| | | | | | | | | |
| | | 2006 | | | 2005 | |
| | | (Dollars in thousands) | |
| Impaired loans with related allowance | | $ | 19,069 | | | $ | 6,800 | |
| Impaired loans that did not require allowance | | | 38,170 | | | | 41,976 | |
| | | | | | | |
| Total impaired loans | | $ | 57,239 | | | $ | 48,776 | |
| | | | | | | |
| | | | | | | | | |
| Allowance for impaired loans | | $ | 4,360 | | | $ | 2,227 | |
| | | | | | | |
| | | | | | | | | |
| Impaired loans measured based on fair value of collateral | | $ | 57,239 | | | $ | 48,776 | |
| | | | | | | |
| Impaired loans measured based on discounted cash flows | | $ | — | | | $ | — | |
| | | | | | | |
| | | | | | | | | |
| Interest income recognized on impaired loans | | $ | 419 | | | $ | 24 | |
| | | | | | | |
The average balance of impaired loans for the years ended December 31, 2006 and 2005 was approximately $53 million and $65 million, respectively.
The following schedule reflects the approximate outstanding principal amount and the effect on earnings of non-accruing loans.
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars in thousands) | |
| Principal balance as of December 31 | | $ | 106,852 | | | $ | 73,679 | | | $ | 87,510 | |
| | | | | | | | | | |
| Interest income which would have been recorded had the loans not been classified as non-accruing | | $ | 3,112 | | | $ | 2,111 | | | $ | 2,351 | |
| | | | | | | | | | |
| | | | | | | | | | | | | |
| Loans past due ninety days or more and still accruing interest | | $ | 20,938 | | | $ | 2,999 | | | $ | 3,377 | |
| | | | | | | | | | |
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6. Allowance for Loan Losses:
Changes in the allowance for loan losses are summarized as follows:
| | | | | | | | | | | | | |
| | | Year ended December 31, | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars in thousands) | |
| Balance at beginning of year | | $ | 66,842 | | | $ | 69,177 | | | $ | 69,693 | |
| Allowance acquired (Island Finance) | | | 35,104 | | | | — | | | | — | |
| Provision for loan losses | | | 65,583 | | | | 20,400 | | | | 26,270 | |
| | | | | | | | | | |
| | | | 167,529 | | | | 89,577 | | | | 95,963 | |
| | | | | | | | | | |
| Losses charged to the allowance: | | | | | | | | | | | | |
| Commercial and industrial | | | 9,792 | | | | 8,044 | | | | 19,250 | |
| Construction | | | — | | | | 1,438 | | | | — | |
| Consumer | | | 16,679 | | | | 17,351 | | | | 18,969 | |
| Consumer Finance | | | 38,345 | | | | — | | | | — | |
| Leasing | | | 2,071 | | | | 986 | | | | 1,658 | |
| | | | | | | | | | |
| | | | 66,887 | | | | 27,819 | | | | 39,877 | |
| | | | | | | | | | |
| Recoveries: | | | | | | | | | | | | |
| Commercial and industrial | | | 2,463 | | | | 1,686 | | | | 5,271 | |
| Consumer | | | 1,677 | | | | 2,646 | | | | 7,341 | |
| Consumer Finance | | | 1,314 | | | | — | | | | — | |
| Leasing | | | 767 | | | | 752 | | | | 479 | |
| | | | | | | | | | |
| | | | 6,221 | | | | 5,084 | | | | 13,091 | |
| | | | | | | | | | |
| Net loans charged-off | | | 60,666 | | | | 22,735 | | | | 26,786 | |
| | | | | | | | | | |
| Balance at end of year | | $ | 106,863 | | | $ | 66,842 | | | $ | 69,177 | |
| | | | | | | | | | |
Island Finance loans acquired pursuant to the Asset Purchase Agreement on February 28, 2006 are subject to a guarantee by Wells Fargo of up to $21.0 million (maximum reimbursement amount) for net losses in excess of $34.0 million, occurring on or prior to the 15th month anniversary of the acquisition. The Corporation is provided with an additional guarantee of up to $7.0 million for net losses incurred in the acquired loan portfolio in excess of $34.0 million during months 16 to 18 of the anniversary, subject to the maximum aggregate reimbursement amount of $21.0 million. Through December 31, 2006, the Corporation had claimed $8.2 million from Wells Fargo under the guarantee.
7. Premises and Equipment:
The Corporation’s premises and equipment at December 31 are as follows:
| | | | | | | | | | | |
| | | Useful life | | | | | | |
| | | in years | | 2006 | | | 2005 | |
| | | | | (Dollars in thousands) | |
| Land | | | | $ | 6,926 | | | $ | 6,926 | |
| Buildings | | 50 | | | 39,875 | | | | 39,278 | |
| Equipment | | 3-10 | | | 52,399 | | | | 48,140 | |
| Leasehold improvements | | Various | | | 29,713 | | | | 24,886 | |
| | | | | | | | | |
| | | | | | 128,913 | | | | 119,230 | |
| Accumulated depreciation and amortization | | | | | (72,614 | ) | | | (63,363 | ) |
| | | | | | | | | |
| | | | | $ | 56,299 | | | $ | 55,867 | |
| | | | | | | | | |
Depreciation and amortization of premises and equipment for the years ended December 31, 2006, 2005 and 2004 were approximately $17.6 million, $13.2 million and $13.2 million, respectively.
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8. Goodwill and Other Intangible Assets:
Goodwill
Goodwill and intangible assets with an indefinite life are tested for impairment at least annually using a two step process at each reporting unit.
The first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, the goodwill of the reporting unit is not considered impaired and the second step of the impairment test is not performed. If the carrying value of the reporting unit exceeds its fair value, the second step in the impairment test consists of comparing the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. The Corporation uses the market multiple, the discounted cash flows and comparable transaction approaches to determine the fair value of each reporting unit.
The Corporation has assigned goodwill to reporting units at the time of acquisition. Goodwill is allocated to the Commercial Banking segment, the Broker-dealer segment and the Consumer Finance segment as follows:
| | | | | | | | | |
| | | 2006 | | | 2005 | |
| | | (Dollars in thousands) | |
| Commercial Banking | | $ | 10,537 | | | $ | 10,537 | |
| Wealth Management | | | 24,254 | | | | 24,254 | |
| Consumer Finance | | | 113,509 | | | | — | |
| | | | | | | |
| | | $ | 148,300 | | | $ | 34,791 | |
| | | | | | | |
Goodwill assigned to the Commercial Banking segment is related to the acquisition of Banco Central Hispano Puerto Rico in 1996, the goodwill assigned to the Broker-dealer segment is related to the acquisition of Merrill Lynch’s retail brokerage business in Puerto Rico by Santander Securities Corporation in 2000 and goodwill assigned to the Consumer Finance segment is related to the acquisition of Island Finance in 2006. There has been no impairment in goodwill for each of the three years in the period ended December 31, 2006.
Other Intangible Assets
Other intangible assets at December 31, were as follows:
| | | | | | | | | |
| | | 2006 | | | 2005 | |
| | | (Dollars in thousands) | |
| Mortgage-servicing rights | | $ | 8,433 | | | $ | 7,974 | |
| Advisory-servicing rights | | | 1,750 | | | | 1,300 | |
| Intangible pension asset | | | — | | | | 818 | |
| Trade name | | | 23,700 | | | | — | |
| Customer relationships | | | 9,717 | | | | — | |
| Non-compete agreements | | | 3,827 | | | | — | |
| | | | | | | |
| | | $ | 47,427 | | | $ | 10,092 | |
| | | | | | | |
Mortgage-servicing rights arise from the right to serve mortgages sold and have an estimated useful life of eight years. The advisory-servicing rights are related to the Corporation’s subsidiary acquisition of the right to serve as the investment advisor for the First Puerto Rico Tax-Exempt Fund, Inc. acquired in 2002 and for First Puerto Rico Growth and Income Fund Inc. and First Puerto Rico Equity Opportunities Fund Inc. acquired in December 2006. This intangible asset is being amortized over a 10-year estimated useful life. The intangible pension asset represents the plan’s unrecognized prior service cost. This asset is revised annually based on the actuarial valuations. Trade name is related to the acquisition of Island Finance and has an indefinite useful life and is therefore not being amortized but is tested for impairment annually. Customer relationships and non-compete agreements are intangible assets related to the acquisition of Island Finance and are being amortized over their estimated useful lives of 10 years and 3 years, respectively.
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The estimated amortization expense for each of the next five years and thereafter of these intangible assets is the following:
| | | | | |
| Year | | Amortization | |
| | | (in thousands) | |
| 2007 | | $ | 4,730 | |
| 2008 | | | 4,730 | |
| 2009 | | | 3,167 | |
| 2010 | | | 2,559 | |
| 2011 | | | 2,411 | |
| Thereafter | | | 6,130 | |
| | | | |
| | | $ | 23,727 | |
| | | | |
9. Other Assets:
Other assets at December 31 consist of the following:
| | | | | | | | | |
| | | 2006 | | | 2005 | |
| | | (Dollars in thousands) | |
| Deferred tax assets, net | | $ | 23,796 | | | $ | 19,635 | |
| Accounts receivable | | | 109,877 | | | | 65,728 | |
| Securities sold not delivered, net | | | 2,945 | | | | 72 | |
| Other real estate | | | 6,173 | | | | 2,249 | |
| Software, net | | | 9,214 | | | | 11,095 | |
| Prepaid expenses | | | 17,437 | | | | 8,468 | |
| Customers’ liabilities on acceptances | | | 3,938 | | | | 3,669 | |
| Derivative assets | | | 59,260 | | | | 47,436 | |
| Other | | | 2,555 | | | | 1,745 | |
| | | | | | | |
| | | $ | 235,195 | | | $ | 160,097 | |
| | | | | | | |
10. Deposits:
At December 31, 2006 and 2005, interest-bearing deposits, including time deposits, amounted to $4,568 million and $4,552 million, respectively. At December 31, 2006 and 2005, time deposits amounted to approximately $2,807 million and $2,606 million, respectively, of which approximately $1,019 million in each year mature after one year.
Maturities of time deposits for the next five years and thereafter follow:
| | | | | |
| Year | | Amount | |
| | | (In thousands) | |
| 2007 | | $ | 1,788,204 | |
| 2008 | | | 154,627 | |
| 2009 | | | 115,343 | |
| 2010 | | | 165,953 | |
| 2011 | | | 121,287 | |
| Thereafter | | | 461,164 | |
| | | | |
| | | $ | 2,806,578 | |
| | | | |
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The detail of deposits and interest expense are as follows:
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | Carrying | | | Interest | | | Carrying | | | Interest | | | Carrying | | | Interest | |
| | | Amount | | | Expense | | | Amount | | | Expense | | | Amount | | | Expense | |
| | | (Dollars in thousands) | |
Non interest bearing | | | | | | | | | | | | | | | | | | | | | | | | |
| Private demand | | $ | 745,685 | | | $ | — | | | $ | 644,794 | | | $ | — | | | $ | 697,722 | | | $ | — | |
| Public demand | | | 404 | | | | — | | | | 27,431 | | | | — | | | | 46,297 | | | | — | |
| | | | | | | | | | | | | | | | | | | |
| | | | 746,089 | | | | — | | | | 672,225 | | | | — | | | | 744,019 | | | | — | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
Savings deposits | | | | | | | | | | | | | | | | | | | | | | | | |
| Savings | | | 707,695 | | | | 21,668 | | | | 855,579 | | | | 18,072 | | | | 812,213 | | | | 15,123 | |
| NOW and other transactions | | | 1,053,612 | | | | 27,802 | | | | 1,090,342 | | | | 19,563 | | | | 1,172,918 | | | | 9,722 | |
| | | | | | | | | | | | | | | | | | | |
| | | | 1,761,307 | | | | 49,470 | | | | 1,945,921 | | | | 37,635 | | | | 1,985,131 | | | | 24,845 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
Certificates of deposits | | | | | | | | | | | | | | | | | | | | | | | | |
| Under $100,000 | | | 265,567 | | | | 12,833 | | | | 244,504 | | | | 8,592 | | | | 225,849 | | | | 4,691 | |
| $100,000 and over | | | 2,541,011 | | | | 111,077 | | | | 2,362,000 | | | | 75,985 | | | | 1,793,140 | | | | 30,743 | |
| | | | | | | | | | | | | | | | | | | |
| | | | 2,806,578 | | | | 123,910 | | | | 2,606,504 | | | | 84,577 | | | | 2,018,989 | | | | 35,434 | |
| | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | $ | 5,313,974 | | | $ | 173,380 | | | $ | 5,224,650 | | | $ | 122,212 | | | $ | 4,748,139 | | | $ | 60,279 | |
| | | | | | | | | | | | | | | | | | | |
11. Other Borrowings:
Following are summaries of borrowings as of and for the periods indicated:
| | | | | | | | | | | | | |
| | | December 31, 2006 | |
| | | Federal Funds | | | Securities Sold | | | Commercial | |
| | | Purchased and | | | Under Agreements | | | Paper | |
| | | Other Borrowings | | | to Repurchase | | | Issued | |
| | | (Dollars in thousands) | |
| Amount outstanding at year-end | | $ | 1,628,400 | | | $ | 830,569 | | | $ | 209,549 | |
| | | | | | | | | | |
| Average indebtedness outstanding during the year | | $ | 1,317,477 | | | $ | 919,899 | | | $ | 373,855 | |
| | | | | | | | | | |
| Maximum amount outstanding during the year | | $ | 1,828,400 | | | $ | 986,759 | | | $ | 750,000 | |
| | | | | | | | | | |
| Average interest rate for the year | | | 5.36 | % | | | 5.31 | % | | | 5.09 | % |
| | | | | | | | | | |
| Average interest rate at year-end | | | 5.41 | % | | | 5.45 | % | | | 5.33 | % |
| | | | | | | | | | |
| | | | | | | | | | | | | |
| | | December 31, 2005 | |
| | | Federal Funds | | | Securities Sold | | | Commercial | |
| | | Purchased and | | | Under Agreements | | | Paper | |
| | | Other Borrowings | | | to Repurchase | | | Issued | |
| | | (Dollars in thousands) | |
| Amount outstanding at year-end | | $ | 768,846 | | | $ | 947,767 | | | $ | 334,319 | |
| | | | | | | | | | |
| Average indebtedness outstanding during the year | | $ | 821,251 | | | $ | 1,051,350 | | | $ | 423,331 | |
| | | | | | | | | | |
| Maximum amount outstanding during the year | | $ | 975,155 | | | $ | 1,565,269 | | | $ | 830,000 | |
| | | | | | | | | | |
| Average interest rate for the year | | | 3.37 | % | | | 4.24 | % | | | 3.20 | % |
| | | | | | | | | | |
| Average interest rate at year-end | | | 4.26 | % | | | 4.71 | % | | | 4.35 | % |
| | | | | | | | | | |
98
Federal funds purchased and other borrowings, securities sold under agreements to repurchase and commercial paper issued mature as follows:
| | | | | | | | | |
| | | December 31, 2006 | | | December 31, 2005 | |
| | | (In thousands) | |
Federal funds purchased and other borrowings: | | | | | | | | |
| Thirty to ninety days | | $ | — | | | $ | 118,846 | |
| Over ninety days | | | 1,628,400 | | | | 650,000 | |
| | | | | | | |
| Total | | $ | 1,628,400 | | | $ | 768,846 | |
| | | | | | | |
Securities sold under agreements to repurchase: | | | | | | | | |
| Within thirty days | | $ | 480,563 | | | $ | 597,761 | |
| Over ninety days | | | 350,006 | | | | 350,006 | |
| | | | | | | |
| Total | | $ | 830,569 | | | $ | 947,767 | |
| | | | | | | |
Commercial paper issued: | | | | | | | | |
| Within thirty days | | $ | 209,549 | | | $ | 334,319 | |
| | | | | | | |
As of December 31, 2006 and 2005 the weighted average maturity of Federal funds purchased and other borrowings over ninety days was 10.63 months and 18.92 months, respectively.
As of December 31, 2006, securities sold under agreements to repurchase (classified by counterparty) were as follows:
| | | | | | | | | | | | | |
| | | | | | | | | | | Weighted- | |
| | | | | | | Fair Value of | | | Average | |
| | | Balance of | | | Underlying | | | Maturity | |
| | | Borrowings | | | Securities | | | in Months | |
| | | (Dollars in thousands) | |
| Barclays Bank PLC | | $ | 229,056 | | | $ | 235,246 | | | | 0.26 | |
| Credit Suisse First Boston LLC | | | 98,841 | | | | 101,603 | | | | 0.33 | |
| Federal Home Loan Bank New York | | | 100,000 | | | | 102,348 | | | | 15.52 | |
| Lehman Brothers RS | | | 250,006 | | | | 271,894 | | | | 62.19 | |
| UBS Financial Services Inc. | | | 152,666 | | | | 156,853 | | | | 0.30 | |
| | | | | | | | | | |
| | | $ | 830,569 | | | $ | 867,944 | | | | 20.75 | |
| | | | | | | | | | |
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The following investment securities were sold under agreements to repurchase:
| | | | | | | | | | | | | | | | | |
| | | December 31, 2006 | |
| | | Carrying | | | | | | | Fair | | | Weighted- | |
| | | Value of | | | | | | | Value of | | | Average | |
| | | Underlying | | | Balance of | | | Underlying | | | Interest | |
| Underlying Securities | | Securities | | | Borrowings | | | Securities | | | Rate | |
| | | (Dollars in thousands) | |
| Obligations of U.S. Government agencies and corporations | | $ | 309,367 | | | $ | 287,569 | | | $ | 309,367 | | | | 5.66 | % |
| Mortgage-backed securities | | | 558,577 | | | | 543,000 | | | | 558,577 | | | | 5.31 | % |
| | | | | | | | | | | | | | |
| Total | | $ | 867,944 | | | $ | 830,569 | | | $ | 867,944 | | | | 5.44 | % |
| | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | December 31, 2005 | |
| | | Carrying | | | | | | | Fair | | | Weighted- | |
| | | Value of | | | | | | | Value of | | | Average | |
| | | Underlying | | | Balance of | | | Underlying | | | Interest | |
| Underlying Securities | | Securities | | | Borrowings | | | Securities | | | Rate | |
| | | (Dollars in thousands) | |
| Obligations of U.S. Government agencies and corporations | | $ | 296,848 | | | $ | 268,285 | | | $ | 296,848 | | | | 5.43 | % |
| Mortgage-backed securities | | | 698,184 | | | | 679,482 | | | | 698,184 | | | | 4.41 | % |
| | | | | | | | | | | | | | |
| Total | | $ | 995,032 | | | $ | 947,767 | | | $ | 995,032 | | | | 4.72 | % |
| | | | | | | | | | | | | | |
12. Subordinated Capital Notes, Term Notes and Trust Preferred Securities:
Subordinated Capital Notes
Subordinated capital notes at December 31 consisted of the following:
| | | | | | | | | |
| | | 2006 | | | 2005 | |
| | | (Dollars in thousands) | |
| Subordinated notes with fixed interest of 6.30% maturing June 1, 2032 | | $ | 71,749 | | | $ | 72,034 | |
| Subordinated notes with fixed interest of 6.10% maturing June 1, 2032 | | | 49,099 | | | | 49,522 | |
| Subordinated notes with fixed interest of 7.00% maturing June 1, 2036 | | | 125,000 | | | | — | |
| | | | | | | |
| | | | 245,848 | | | | 121,556 | |
| Unamortized discount | | | (1,380 | ) | | | (458 | ) |
| | | | | | | |
| | | $ | 244,468 | | | $ | 121,098 | |
| | | | | | | |
100
Term Notes
Term notes payable outstanding at December 31 consisted of the following:
| | | | | | | | | |
| | | 2006 | | | 2005 | |
| | | (Dollars in thousands) | |
| Term notes maturing January 29, 2010 linked to the S&P 500 index | | $ | 30,000 | | | $ | 30,000 | |
| Term notes maturing May 31, 2011 with fixed interest of 0.25%: | | | | | | | | |
| Linked to the S&P 500 | | | 4,000 | | | | 4,000 | |
| Linked to the Dow Jones Euro STOXX 50 | | | 3,000 | | | | 3,000 | |
| Term notes maturing May 25, 2012 linked to the Euro STOXX 50 | | | 5,000 | | | | 5,000 | |
| Term notes maturing May 25, 2012 linked to the NIKKEI | | | 5,000 | | | | 5,000 | |
| | | | | | | |
| | | | 47,000 | | | | 47,000 | |
| Unamortized discount | | | (5,471 | ) | | | (6,785 | ) |
| | | | | | | |
| | | $ | 41,529 | | | $ | 40,215 | |
| | | | | | | |
The term notes issued contain certain general covenants related to financial ratios, among others. The Corporation was in compliance with such covenants at December 31, 2006.
Trust Preferred Securities
At December 31, 2006, the Corporation had a established a trust for the purpose of issuing trust preferred securities to the public in connection with the acquisition of Island Finance. The trust is a 100% owned subsidiary of the Corporation and is consolidated pursuant to the provisions of FIN 46R, “Consolidation of Variable Interest Entities”. In connection with this financing arrangement, the Corporation completed the private placement of $125 million Preferred Securities and issued Junior Subordinated Debentures in the aggregate principal amount of $129 million in connection with the issuance of the Preferred Securities. The Preferred Securities are classified as subordinated notes (included on the table for subordinated capital notes above) and the dividends are classified as interest expense in the accompanying condensed consolidated financial statements.
13. Reserve Fund:
The Banking Law of Puerto Rico requires that a reserve fund be created and that annual transfers of at least 10% of the Bank’s annual net income be made, until such fund equals 100% of total paid-in capital, on common and preferred stock. Such transfers restrict the retained earnings, which would otherwise be available for dividends. At December 31, 2006 and 2005, the reserve fund amounted to approximately $137.5 million and $133.8 million, respectively.
14. Common Stock Transactions:
During 2006 and 2005, the Corporation declared and paid quarterly cash dividends of $0.16 per common share. During 2004, the Corporation declared and paid quarterly cash dividends of $0.11 per common share except for the fourth quarter of 2004 when the Corporation declared a dividend of $0.16 per common share.
The Corporation adopted and implemented Stock Repurchase Programs in May 2000, December 2000 and June 2001. Under these programs, the Corporation acquired 3% of its then outstanding common shares. During November 2002, the Corporation started a fourth Stock Repurchase Program under which it may acquire 3% of its outstanding common shares. As of December 31, 2006 and 2005, a total of 4,011,260 common shares with a cost of approximately $67,552,000 had been repurchased under these programs and are recorded as treasury stock in the accompanying consolidated balance sheets.
The Corporation started a Dividend Reinvestment and Cash Purchase Plan in May 2000 under which holders of common stock have the opportunity to automatically invest cash dividends to purchase more shares of the Corporation. Stockholders may also make, as frequently as once a month, optional cash payments for investment in additional shares of common stock.
On July 9, 2004, the Board of Directors of the Corporation authorized a 10% stock dividend on common stock to stockholders of record as of July 20, 2004 amounting to approximately 4.2 million common shares. The common stock dividend was distributed on August 3, 2004. Cash was paid in lieu of fractional shares.
101
15. Income Tax:
The Corporation is subject to regular or the alternative minimum tax, whichever is higher. The effective tax rate is lower than the statutory rate primarily because interest income on certain United States and Puerto Rico debt securities is exempt from Puerto Rico income taxes.
The Corporation is also subject to federal income tax on its United States (U.S.) source income. However, the Corporation had no taxable U.S. income for each of the three years in the period ended December 31, 2006. The Corporation is not subject to federal income tax on U.S. Treasury securities that qualify as portfolio interest.
On August 1, 2005, a temporary two-year surtax of 2.5% applicable to corporations was enacted. This surtax is applicable to taxable years beginning after December 31, 2004 and increases the maximum marginal corporate income tax rate from 39% to 41.5% for the years ended December 31, 2005 and 2006. An additional 2% surtax was imposed on the Corporation for a period of one year commencing on January 1, 2006 as a result of the Puerto Rico Government’s budget deficit. This surtax increases the maximum marginal corporate income tax rate to 43.5% for the year ended December 31, 2006.
Puerto Rico international banking entities, or IBE’s, are currently exempt from taxation under Puerto Rico law. During 2004, the Legislature of Puerto Rico and the Governor of Puerto Rico approved a law amending the IBE Act. This law imposes income taxes at normal statutory rates on each IBE that operates as a unit of a bank, if the IBE’s net income generated after December 31, 2003 exceeds 40 percent of the bank’s net income in the taxable year commenced on July 1, 2003, 30 percent of the bank’s net income in the taxable year commencing on July 1, 2004, and 20 percent of the bank’s net income in the taxable year commencing on July 1, 2005, and thereafter. It does not impose income taxation on an IBE that operates as a subsidiary of a bank as in the case or our subsidiary, Santander International Bank. However, there cannot be any assurance that the IBE Act will not be modified in the future in a manner to reduce the tax benefits available to an IBE that operates as a subsidiary of a bank.
The components of the provision (benefit) for income tax for the years ended December 31 are as follows:
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars in thousands) | |
| Current tax provision | | $ | 24,663 | | | $ | 27,934 | | | $ | 6,009 | |
| Deferred tax (benefit) provision | | | (2,123 | ) | | | 2,854 | | | | 3,715 | |
| | | | | | | | | | |
| Provision for income tax | | $ | 22,540 | | | $ | 30,788 | | | $ | 9,724 | |
| | | | | | | | | | |
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The difference between the income tax provision and the amount computed using the statutory rate is due to the following:
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | Amount | | | Rate | | | Amount | | | Rate | | | Amount | | | Rate | |
| | | (Dollars in thousands) | |
| Income tax at statutory rate | | $ | 25,626 | | | | 39 | % | | $ | 43,131 | | | | 39 | % | | $ | 37,694 | | | | 39 | % |
| Benefits of net tax-exempt income | | | (5,684 | ) | | | -9 | % | | | (10,250 | ) | | | -9 | % | | | (23,296 | ) | | | -24 | % |
| Release of income tax contingencies | | | (2,000 | ) | | | -3 | % | | | (3,700 | ) | | | -3 | % | | | (5,410 | ) | | | -6 | % |
| Effect of surtaxes | | | 2,269 | | | | 3 | % | | | 1,867 | | | | 1 | % | | | — | | | | 0 | % |
| Other | | | 2,329 | | | | 4 | % | | | (260 | ) | | | 0 | % | | | 736 | | | | 1 | % |
| | | | | | | | | | | | | | | | | | | | | | |
| Provision (benefit) for income tax | | $ | 22,540 | | | | 34 | % | | $ | 30,788 | | | | 28 | % | | $ | 9,724 | | | | 10 | % |
| | | | | | | | | | | | | | | | | | | | | | |
The release of income tax contingencies is due to the expiration of certain tax positions and in 2004 reflects the settlement of examinations by the taxing authorities and the expiration of the statute of limitations for certain tax years.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Corporation’s deferred tax assets and liabilities at December 31, were as follows:
| | | | | | | | | |
| | | 2006 | | | 2005 | |
| | | (Dollars in thousands) | |
| Deferred Tax Assets- | | | | | | | | |
| Unrealized loss on securities available for sale | | $ | 12,375 | | | $ | 12,438 | |
| Allowance for loan losses | | | 5,188 | | | | 4,352 | |
| Postretirement and pension benefits | | | 11,579 | | | | 10,392 | |
| Other | | | 6,295 | | | | 2,985 | |
| | | | | | | |
| | | | 35,437 | | | | 30,167 | |
| | | | | | | |
| Deferred Tax Liabilities- | | | | | | | | |
| Unrealized gain on derivatives | | | 337 | | | | 487 | |
| Amortization of intangibles | | | 8,718 | | | | 4,604 | |
| Difference in accounting treatment of certain loan origination activities, mortgage-servicing rights and other | | | 2,586 | | | | 5,441 | |
| | | | | | | |
| | | | 11,641 | | | | 10,532 | |
| | | | | | | |
| Net deferred tax asset | | $ | 23,796 | | | $ | 19,635 | |
| | | | | | | |
Under the Puerto Rico Income Tax Law, the Corporation and its subsidiaries are treated as separate taxable entities and are not entitled to file consolidated tax returns.
16. Contingencies and Commitments:
The Corporation is involved as plaintiff or defendant in a variety of routine litigation incidental to the normal course of business. Management believes, based on the opinion of legal counsel, that it has adequate defense with respect to such litigation and that any losses there from would not have a material adverse effect on the consolidated results of operations or consolidated financial position of the Corporation.
On December 8, 2005 the Corporation received a subpoena from the Securities and Exchange Commission for the production of documents concerning its mortgage loan transactions with an unrelated local financial institution. The Corporation submitted documents and information to the SEC in response to the subpoena concerning the transactions. The Corporation has cooperated fully with the SEC in connection with these inquiries. The Corporation is unable to predict what adverse consequences, or other effects this investigation might have on its financial condition or results of operations.
The Corporation leases certain operating facilities under non-cancelable operating leases, including leases with related parties, and has other agreements expiring at various dates through 2025. Rent expense charged to operations related to these leases
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was approximately $10,269,000, $6,927,000 and $5,868,000 for 2006, 2005 and 2004, respectively. At December 31, 2006, the minimum unexpired commitments for leases and other commitments are as follows:
| | | | | |
| Year | | Amount | |
| | | (In thousands) | |
| 2007 | | $ | 18,703 | |
| 2008 | | | 8,415 | |
| 2009 | | | 6,279 | |
| 2010 | | | 5,433 | |
| 2011 | | | 3,968 | |
| Thereafter | | | 14,736 | |
| | | | |
| | | $ | 57,534 | |
| | | | |
17. Pension Plans:
The Corporation maintains a qualified noncontributory defined benefit pension plan (the “Corporation’s Plan”), which covers substantially all eligible employees of the Corporation and its subsidiaries. The plan was organized in 1978 under the laws of the Commonwealth of Puerto Rico and is subject to the provisions of the Employee Retirement Income Security Act of 1974 (“ERISA”).
The Corporation’s policy is to contribute to the plan normal costs that are charged to operations. However, in no event may contributions exceed the maximum or minimum limits prescribed by ERISA and the Puerto Rico Income Tax Act.
In 2006, the Corporation elected to freeze its defined benefit pension plan effective December 31, 2006. The plan will not be settled at this time, but no new employees will participate in the Corporation’s Plan. The Corporation recorded a $754,000 loss on curtailment of its defined benefit pension plan through current operations.
In connection with the acquisition of Banco Santander Central Hispano Puerto Rico (“BCHPR”) in 1996, the Bank became the administrator of the acquired financial institution’s noncontributory defined benefit pension plan (the “BCH Plan”). It is management’s intention to keep this pension plan in a frozen status. Active participants of BCHPR’s pension plan who became employees of the Bank were included in the Bank’s pension plan effective January 1, 1997. Beneficiaries of BCHPR’s plan are receiving benefits from this plan. This plan is also subject to the provisions of ERISA.
The Corporation’s Plan uses a December 31 measurement date while the BCH Plan uses a November 30 measurement date.
In September 2006, the FASB issued SFAS No. 158 which requires recognition of a plan’s over-funded or under-funded status as an asset or liability with an offsetting adjustment to accumulated other comprehensive income (AOCI). Actuarial gains or losses, prior service costs and transition assets or obligations will be subsequently recognized as components of net periodic benefit costs. Additional minimum pension liabilities (AMPL) and related intangible assets are derecognized upon adoption of the standard. Changes in the Corporation’s pension assets and liabilities before and after the AMPL and SFAS No. 158 adjustments are detailed below:
| | | | | | | | | | | | | | | | | |
| | | Balance | | | | | | | | |
| | | before AMPL & | | | | | | SFAS | | Adjusted |
| | | SFAS NO. 158 | | AMPL | | No. 158 | | Balance |
| | | Adjustment | | Adjustment | | Adjustment | | Dec. 31, 2006 |
| | | (Dollars in thousands) | | | | |
| Net prepaid pension Cost | | $ | 12,833 | | | $ | — | | | $ | (12,833 | ) | | $ | — | |
| Pension Benefit Liabilities | | | (27,465 | ) | | | (2,050 | ) | | | 12,833 | | | | (16,682 | ) |
| Postretirement Benefit Liability | | | (945 | ) | | | — | | | | (175 | ) | | | (1,120 | ) |
| Accumulated other comprehensive loss* | | | 16,754 | | | | 1,250 | | | | 107 | | | | 18,111 | |
104
Amounts included in AOCI (pre-tax) as of December 31, 2006 were as follows:
| | | | | | | | | | | | | |
| | | Pension | | | Post retirement | | | | |
| | | Plans | | | Benefit Plans | | | Total | |
| | | (Dollars in thousands) | |
| Net transition asset | | $ | (18 | ) | | $ | — | | | $ | (18 | ) |
| Net actuarial loss | | | 29,533 | | | | 175 | | | | 29,708 | |
| | | | | | | | | | |
| | | $ | 29,515 | | | $ | 175 | | | $ | 29,690 | |
| | | | | | | | | | |
The amounts in AOCI that are expected to be recognized as components of net periodic benefit cost during 2007 are as follows:
| | | | | | | | | | | | | |
| | | Pension | | | Post retirement | | | | |
| | | Plans | | | Benefit Plans | | | Total | |
| | | (Dollars in thousands) | |
| Net transition asset | | $ | (2 | ) | | $ | — | | | $ | (2 | ) |
| Net actuarial loss | | | 907 | | | | 5 | | | | 912 | |
| | | | | | | | | | |
| | | $ | 905 | | | $ | 5 | | | $ | 910 | |
| | | | | | | | | | |
105
The following presents the funded status of the Corporation’s Plan at December 31, 2006 and 2005, based on the actuarial assumptions described below.
| | | | | | | | | |
| | | 2006 | | | 2005 | |
| | | (Dollars in thousands) | |
| Change in projected benefit obligation: | | | | | | | | |
| Projected benefit obligation at beginning of year | | $ | 38,287 | | | $ | 34,294 | |
| Service cost-benefits earned during the year | | | 1,762 | | | | 1,670 | |
| Interest cost on projected benefit obligation | | | 2,369 | | | | 2,106 | |
| Plan change | �� | | — | | | | 2,095 | |
| Actuarial (gain) loss | | | 3,558 | | | | (778 | ) |
| Benefit distributions | | | (1,333 | ) | | | (1,100 | ) |
| Effect of plan curtailment | | | (5,199 | ) | | | — | |
| | | | | | | |
| Projected benefit obligation at end of year | | | 39,444 | | | | 38,287 | |
| | | | | | | |
| | | | | | | | | |
| Change in plan assets: | | | | | | | | |
| Fair value of plan assets at beginning of year | | | 25,833 | | | | 25,253 | |
| Actual return on plan assets | | | 3,090 | | | | 570 | |
| Employer contributions | | | 2,676 | | | | 1,110 | |
| Benefit distributions | | | (1,333 | ) | | | (1,100 | ) |
| | | | | | | |
| Fair value of plan assets at end of year | | | 30,266 | | | | 25,833 | |
| | | | | | | |
| | | | | | | | | |
| Funded status | | | (9,178 | ) | | | (12,454 | ) |
| Unrecognized net actuarial gain | | | 8,984 | | | | 12,198 | |
| Unrecognized prior service cost | | | — | | | | 818 | |
| Unrecognized transition amount | | | (18 | ) | | | (20 | ) |
| | | | | | | |
| (Accrued)/prepaid pension benefit | | $ | (212 | ) | | $ | 542 | |
| | | | | | | |
| | | | | | | | | |
| Amounts recognized on the consolidated balance sheets consist of: | | | | | | | | |
| Accrued benefit liability, net of prepaid benefit cost | | $ | (8,966 | ) | | $ | (8,013 | ) |
| Accumulated other comprehensive income | | | 8,966 | | | | 7,737 | |
| Intangible pension assets | | | — | | | | 818 | |
| | | | | | | |
| Net amount recognized | | $ | — | | | $ | 542 | |
| | | | | | | |
| | | | | | | | | |
| Increase in minimum liability included in other comprehensive income | | $ | 1,228 | | | $ | 1,612 | |
| | | | | | | | | |
| Projected benefit obligation | | | 39,444 | | | | 38,287 | |
| Accumulated benefit obligation | | | 39,444 | | | | 33,847 | |
| Fair value of plan assets | | | 30,266 | | | | 25,833 | |
For each of the three years in the period ended December 31, 2006, the pension costs for the Corporation’s Plan included the following components:
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars in thousands) | |
| Service cost during the year | | $ | 1,762 | | | $ | 1,670 | | | $ | 1,259 | |
| Interest cost on projected benefit obligation | | | 2,369 | | | | 2,106 | | | | 1,892 | |
| Expected return on assets | | | (2,228 | ) | | | (2,210 | ) | | | (2,080 | ) |
| Net amortization | | | 773 | | | | 525 | | | | 372 | |
| Curtailment loss | | | 754 | | | | — | | | | — | |
| | | | | | | | | | |
| Net periodic pension cost | | $ | 3,430 | | | $ | 2,091 | | | $ | 1,443 | |
| | | | | | | | | | |
106
Assumptions used to determine benefit obligation for the Corporation’s Plan as of December 31, included:
| | | | | | | | | | | | | |
| | | 2006 | | 2005 | | 2004 |
| Discount rate | | | 5.75 | % | | | 6.00 | % | | | 6.00 | % |
| | | | | | | | | | | | | |
| Rate of compensation increase | | | 3.00 | % | | | 3.00 | % | | | 3.00 | % |
| | | | | | | | | | | | | |
Assumptions used to determine net periodic pension cost for the Corporation’s Plan as of December 31 included:
| | | | | | | | | | | | | |
| | | 2006 | | 2005 | | 2004 |
| Discount rate | | | 6.00 | % | | | 6.00 | % | | | 6.25 | % |
| | | | | | | | | | | | | |
| Rate of compensation increase | | | 3.00 | % | | | 3.00 | % | | | 3.00 | % |
| | | | | | | | | | | | | |
| Expected return on plan assets | | | 8.50 | % | | | 8.50 | % | | | 8.50 | % |
| | | | | | | | | | | | | |
In developing the expected long-term rate of return assumption, the Corporation evaluated input from the Corporation’s Plan actuaries, financial analysts and the Corporation’s long-term inflation assumptions and interest rate scenarios. Projected returns by such consultants are based on broad equity and bond indices. The Corporation also considered historical returns on its plan assets. Based on this analysis the Corporation anticipates that the Plan’s investment managers will continue to generate long-term returns of at least 8.50%.
The Corporation’s Plan asset allocations at December 31, by asset category are as follows:
| | | | | | | | | |
| | | 2006 | | 2005 |
Asset Category: | | | | | | | | |
| Equity securities | | | 62 | % | | | 62 | % |
| Debt securities | | | 36 | % | | | 37 | % |
| Other | | | 2 | % | | | 1 | % |
| | | | | | | | | |
| Total | | | 100 | % | | | 100 | % |
| | | | | | | | | |
Expected contribution to the Corporation’s Plan for 2007 is $5,742,680.
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The following presents the funded status of the BCH Plan at November 30, 2006 and 2005, based on the actuarial assumptions described below:
| | | | | | | | | |
| | | 2006 | | | 2005 | |
| | | (Dollars in thousands) | |
| Change in projected benefit obligation | | | | | | | | |
| Projected benefit obligation at beginning of year | | $ | 32,967 | | | $ | 32,898 | |
| Interest cost on projected benefit obligation | | | 1,998 | | | | 1,936 | |
| Actuarial loss | | | 1,751 | | | | 547 | |
| Benefit distributions | | | (3,827 | ) | | | (2,414 | ) |
| | | | | | | |
| Projected benefit obligation at end of year | | | 32,889 | | | | 32,967 | |
| | | | | | | |
| | | | | | | | | |
| Change in plan assets: | | | | | | | | |
| Fair value of plan assets at beginning of year | | | 24,725 | | | | 24,684 | |
| Actual return on plan assets | | | 1,797 | | | | 409 | |
| Employer contributions | | | 2,690 | | | | 2,046 | |
| Benefit distributions | | | (3,827 | ) | | | (2,414 | ) |
| | | | | | | |
| Fair value of plan assets at end of year | | | 25,385 | | | | 24,725 | |
| | | | | | | |
| | | | | | | | | |
| Funded status | | | (7,504 | ) | | | (8,242 | ) |
| Unrecognized actuarial gain | | | 20,549 | | | | 18,909 | |
| | | | | | | |
| Prepaid pension benefit | | $ | 13,045 | | | $ | 10,667 | |
| | | | | | | |
| | | | | | | | | |
| Amounts recognized on the consolidated balance sheets consist of: | | | | | | | | |
| Accrued benefit liability, net of prepaid benefit cost | | $ | (7,504 | ) | | $ | (8,242 | ) |
| Accumulated other comprehensive income | | | 20,549 | | | | 18,909 | |
| | | | | | | |
| Net amount recognized | | $ | 13,045 | | | $ | 10,667 | |
| | | | | | | |
| | | | | | | | | |
| Increase in minimum liability included in other comprehensive income | | $ | 1,640 | | | $ | 1,790 | |
| | | | | | | | | |
| Projected benefit obligation | | | 32,889 | | | | 32,967 | |
| Accumulated benefit obligation | | | 32,889 | | | | 32,967 | |
| Fair value of plan assets | | | 25,385 | | | | 24,725 | |
For each of the three years in the period ended November 30, 2006, the pension costs for the BCH Plan included the following components. Effective November 30, 1996, the benefits in this plan were frozen.
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars in thousands) | |
| Interest cost on projected benefit obligation | | $ | 1,998 | | | $ | 1,936 | | | $ | 1,990 | |
| Expected return on assets | | | (2,199 | ) | | | (2,092 | ) | | | (2,034 | ) |
| Net amortization | | | 513 | | | | 440 | | | | 391 | |
| | | | | | | | | | |
| Net periodic pension cost | | $ | 312 | | | $ | 284 | | | $ | 347 | |
| | | | | | | | | | |
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Assumptions used to determine benefit obligation for the BCH Plan as of November 30, included:
| | | | | | | | | | | | | |
| | | 2006 | | 2005 | | 2004 |
| Discount rate | | | 5.75 | % | | | 6.00 | % | | | 6.00 | % |
| | | | | | | | | | | | | |
| Rate of compensation increase | | | 0.00 | % | | | 0.00 | % | | | 0.00 | % |
| | | | | | | | | | | | | |
Assumptions used to determine benefit obligations and net periodic pension cost for the BCH Plan as of November 30 included:
| | | | | | | | | | | | | |
| | | 2006 | | 2005 | | 2004 |
| Discount rate | | | 6.00 | % | | | 6.00 | % | | | 6.00 | % |
| | | | | | | | | | | | | |
| Rate of compensation increase | | | 0.00 | % | | | 0.00 | % | | | 0.00 | % |
| | | | | | | | | | | | | |
| Expected return on plan assets | | | 8.50 | % | | | 8.50 | % | | | 8.50 | % |
| | | | | | | | | | | | | |
In developing the expected long-term rate of return assumption, the Corporation evaluated input from the BCH Plan’s actuaries, financial analysts and the Corporation’s long-term inflation assumptions and interest rate scenarios. Projected returns by such consultants are based on broad equity and bond indices. The Corporation also considered historical returns on its plan assets. Based on this analysis the Corporation anticipates that the BCH Plan’s investment managers will continue to generate long-term returns of at least 8.50%.
The Corporation’s asset allocations for the BCH Plan at November 30 by asset category are as follows:
| | | | | | | | | |
| | | 2006 | | 2005 |
Asset Category: | | | | | | | | |
| Equity securities | | | 56 | % | | | 66 | % |
| Debt securities | | | 37 | % | | | 13 | % |
| Other | | | 7 | % | | | 21 | % |
| | | | | | | | | |
| Total | | | 100 | % | | | 100 | % |
| | | | | | | | | |
The Corporation’s expected contribution to the BCH Plan for 2006 is $1,947,605.
The Corporation’s investment policy with respect to the Corporation’s Plan and the BCH Plan is to optimize, without undue risk, the total return on investment of the Plan assets after inflation, within a framework of prudent and reasonable portfolio risk. The investment portfolio is diversified in multiple asset classes to reduce portfolio risk, and assets may be shifted between asset classes to reduce volatility when warranted by projections of the economic and/or financial market environment, consistent with ERISA diversification principles. The Corporation’s target asset allocations for both plans are 60% equity and 40% fixed/variable income. As circumstances and market conditions change, these allocations may be amended to reflect the most appropriate distribution given the new environment consistent with the investment objectives.
Equity securities include common stock of the Corporation as a percentage of the carrying value of the respective plan assets, as detailed below. There were no equity securities of the Corporation in plan assets as of December 31, 2006.
| | | | | |
| | | 2005 |
| Banco Santander Puerto Rico Employees’ Retirement Plan | | | 6 | % |
| Banco Central Hispano Puerto Rico Employees’ Pension Plan | | | 10 | % |
109
Expected future benefit payments for the plans at the end of their respective fiscal years are as follows:
| | | | | | | | | |
| | | Corporation's | | BCH |
| | | Plan | | Plan |
| | | (Dollars in thousands) |
| 2007 | | $ | 1,222 | | | $ | 2,217 | |
| 2008 | | | 1,319 | | | | 1,885 | |
| 2009 | | | 1,394 | | | | 1,944 | |
| 2010 | | | 1,553 | | | | 2,033 | |
| 2011 | | | 1,703 | | | | 2,917 | |
| 2012 through 2016 | | | 11,641 | | | | 16,229 | |
18. Long Term Incentive Plan:
The Corporation’s parent company, BSCH, sponsors a Long Term Incentive Plan (the “Plan”) for certain of its employees and those of its subsidiaries, including the Corporation. The Plan contains service, performance and market conditions. In December 2006, the Corporation’s Board of Directors approved the Plan, which provides for settlement in cash to the participating employees. The Corporation will accrue the liability and recognize monthly compensation expense over the fourteen month period from December 2006 to January 2008, when the plan becomes exercisable. The cost of the plan will be reimbursed to the Corporation by BSCH, at which time it would be recognized as a capital contribution.
As of December 31, 2006 the performance and market conditions of the plan were met and the Corporation therefore recognized a compensation expense of $810,000 related to the Plan.
19. Related Party Transactions:
The Corporation engages in transactions with affiliated companies in the ordinary course of its business. At December 31, 2006, 2005 and 2004 and for the year ended, the Corporation had the following transactions with related parties:
| | | | | | | | | | | | | |
| | | 2006 | | 2005 | | 2004 |
| | | (Dollars in thousands) |
| Deposits from related parties | | $ | 60,062 | | | $ | 40,905 | | | $ | 170,170 | |
| Interest-bearing deposits with affiliates | | | 555 | | | | 389 | | | | 471 | |
| Other borrowings with an affiliate | | | — | | | | 118,846 | | | | — | |
| Loans to directors, officers, and related parties (on substantially the same terms and credit risks as loans to third parties) | | | 4,388 | | | | 5,929 | | | | 8,886 | |
| Technical assistance income for services rendered | | | 2,893 | | | | 2,214 | | | | 2,400 | |
| EDP services received | | | 14,527 | | | | 11,841 | | | | 10,224 | |
| Technical assistance expense for software development | | | 595 | | | | 384 | | | | 700 | |
| Rental income | | | 319 | | | | — | | | | — | |
| Notional value of derivative financial instruments purchased from affiliates | | | 1,705,623 | | | | 972,183 | | | | 116,432 | |
| Notional value of derivative financial instruments sold to affiliates | | | 330,000 | | | | 732,052 | | | | 52,350 | |
An affiliate charged the Corporation approximately $3,076,000 for the use of proprietary computer software in 2006, 2005 and 2004, which amounts are included above under the caption of technical assistance expense for services received.
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20. Derivative Financial Instruments:
As of December 31, 2006, the Corporation had the following derivative financial instruments outstanding:
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | Other | |
| | | | | | | | | | | Gain (Loss) for | | | Comprehensive | |
| | | | | | | | | | | the year | | | Income* for the | |
| | | Notional | | | | | | | ended | | | year ended | |
| | | Value | | | Fair Value | | | Dec. 31, 2006 | | | Dec. 31, 2006 | |
| | | (Dollars in thousands) | |
CASH FLOW HEDGES | | | | | | | | | | | | | | | | |
| Interest rate swaps | | $ | 825,000 | | | $ | (351 | ) | | $ | — | | | $ | (214 | ) |
| Foreign currency swaps | | | — | | | | — | | | | — | | | | 36 | |
FAIR VALUE HEDGES | | | | | | | | | | | | | | | | |
| Interest rate swaps | | | 1,189,740 | | | | (22,065 | ) | | | 64 | | | | — | |
OTHER DERIVATIVES | | | | | | | | | | | | | | | | |
| Options | | | 153,528 | | | | 33,512 | | | | 7,057 | | | | — | |
| Embedded options on stock-indexed deposits | | | (153,528 | ) | | | (33,512 | ) | | | (7,057 | ) | | | — | |
| Interest rate caps | | | 36,889 | | | | 68 | | | | 12 | | | | — | |
| Customer interest rate caps | | | (34,095 | ) | | | (65 | ) | | | (10 | ) | | | — | |
| Customer interest rate swaps | | | (1,619,554 | ) | | | (52 | ) | | | 3,021 | | | | — | |
| Interest rate swaps | | | 1,621,555 | | | | 479 | | | | (3,216 | ) | | | — | |
| Interest rate swaps | | | 387,000 | | | | (849 | ) | | | (397 | ) | | | — | |
| Loan commitments | | | 1,988 | | | | 9 | | | | 49 | | | | — | |
| | | | | | | | | | | | | | | |
| | | | | | | | | | | $ | (477 | ) | | $ | (178 | ) |
| | | | | | | | | | | | | | | |
As of December 31, 2005, the Corporation had the following derivative financial instruments outstanding:
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | Other | |
| | | | | | | | | | | Gain (Loss) for | | | Comprehensive | |
| | | | | | | | | | | the year | | | Income* for the | |
| | | Notional | | | | | | | ended | | | year ended | |
| | | Value | | | Fair Value | | | Dec. 31, 2005 | | | Dec. 31, 2005 | |
| | | (Dollars in thousands) | |
CASH FLOW HEDGES | | | | | | | | | | | | | | | | |
| Interest rate swaps | | $ | — | | | $ | — | | | $ | — | | | $ | 1,369 | |
| Foreign currency swaps | | | 117,725 | | | | 2,182 | | | | | | | | (36 | ) |
FAIR VALUE HEDGES | | | | | | | | | | | | | | | | |
| Interest rate swaps | | | 1,408,772 | | | | (26,880 | ) | | | 28 | | | | — | |
OTHER DERIVATIVES | | | | | | | | | | | | | | | | |
| Options | | | 135,150 | | | | 23,833 | | | | 11,711 | | | | — | |
| Embedded options on stock-indexed deposits | | | (134,767 | ) | | | (23,833 | ) | | | (9,401 | ) | | | — | |
| Interest rate caps | | | 37,571 | | | | 77 | | | | 131 | | | | — | |
| Customer interest rate caps | | | (35,851 | ) | | | (75 | ) | | | (118 | ) | | | — | |
| Customer interest rate swaps | | | (901,760 | ) | | | (3,073 | ) | | | (2,136 | ) | | | — | |
| Interest rate swaps | | | 920,761 | | | | 3,695 | | | | 2,243 | | | | — | |
| Interest rate swaps | | | 354,000 | | | | (451 | ) | | | (451 | ) | | | | |
| Loan commitments | | | 7,270 | | | | (40 | ) | | | (43 | ) | | | — | |
| | | | | | | | | | | | | | | |
| | | | | | | | | | | $ | 1,964 | | | $ | 1,333 | |
| | | | | | | | | | | | | | | |
The Corporation’s principal objective in holding interest rate swap agreements is the management of interest rate risk and changes in the fair value of assets and liabilities. The Corporation’s policy is that each swap contract be specifically tied to
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assets or liabilities with the objective of transforming the interest rate characteristic of the hedged instrument. During 2006, the Corporation swapped $825 million of FHLB Adjustable Rate Credit Advances with maturities between July 2007 and November 2008. The purpose of this swap is to fix the interest paid on the underlying borrowings. These swaps were designated as cash flow hedges. As of December 31, 2006 the total amount, net of tax, included in accumulated other comprehensive income was an unrealized loss of $0.2 million, of which the Corporation expects to reclassify approximately $518,000 into earnings during the next quarter.
As of December 31, 2006, the Corporation also had outstanding interest rate swap agreements, with a notional amount of approximately $1.2 billion, maturing through the year 2032. The weighted average rate paid and received on these contracts is 5.37% and 4.84%, respectively. As of December 31, 2006, the Corporation had retail fixed rate certificates of deposit amounting to approximately $1.0 billion and a subordinated note amounting to approximately $125 million swapped to create a floating rate source of funds. For the year ended December 31, 2006, the Corporation recognized a gain of approximately $64,000 on fair value hedges due to hedge ineffectiveness, which is included in other income in the consolidated statements of income.
As of December 31, 2005, the Corporation also had outstanding interest rate swap agreements, with a notional amount of approximately $1.4 billion, maturing through the year 2032. The weighted average rate paid and received on these contracts is 4.34% and 4.33%, respectively. As of December 31, 2005, the Corporation had retail fixed rate certificates of deposit amounting to approximately $1.3 billion and a subordinated note amounting to approximately $125 million swapped to create a floating rate source of funds. For the year ended December 31, 2005, the Corporation recognized a gain of approximately $28,000 on fair value hedges due to hedge ineffectiveness, which is included in other income in the consolidated statements of income.
The Corporation’s principal objective in entering into foreign currency derivative agreements is for the management of currency risk and changes in the fair value of assets and liabilities arising from fluctuations in foreign currencies. The Corporation’s policy is that each foreign currency contract be specifically tied to assets or liabilities with the objective of transforming the currency exposure of the hedged instrument to U.S. Dollars (“USD”). On December 15, 2005, the Corporation entered into a loan agreement with Banco Santander Central Hispano in which the Corporation borrowed 14,000,000,000 Japanese Yen (“JPY”) for a three month term at a per annum rate of 0.1629%. The purpose of this loan was to fund activity at the holding company level. Given that the Corporation’s business activity is primarily in USD, management decided to hedge the foreign currency exposure arising from this transaction. The Corporation entered into a foreign currency swap (“FX Swap”), of approximately $117.7 million, with an unrelated third party in which the Corporation sold JPY spot to buy USD, and bought JPY forward and sold USD, thus eliminating exposure to changes in USD/JPY exchange rates. The implicit economic cost of this transaction was 4.64%. This rate is equivalent to the three-month LIBOR (as of the date of the transaction) plus 15 basis points. Management classified this transaction as a foreign currency cash flow hedge because the FX swap is hedging the principal and interest to be paid at the maturity of the loan contract. The notional value of the FX swap was $117.7 million and it matured on March 15, 2006.
The Corporation issues certificates of deposit, individual retirement accounts and notes with returns linked to the different indexes, which constitute embedded derivative instruments that are bifurcated from the host deposit and recognized on the consolidated balance sheets. The Corporation enters into option agreements in order to manage the interest rate risk on these deposits and notes; however, these options have not been designated for hedge accounting, therefore gains and losses on the market value of both the embedded derivative instruments and the option contracts are marked to market through earnings and recorded in other gains and losses in the consolidated statements of income. For the year ended December 31, 2006, a loss of approximately $7.1 million was recorded on embedded options on stock-indexed deposits and notes and a gain of approximately $7.1 million was recorded on the option contracts. For the year ended December 31, 2005, a loss of approximately $9.4 million was recorded on embedded options on stock-indexed deposits and notes and a gain of approximately $11.7 million was recorded on the option contracts. Included in the option gain is the maturity of $1.0 billion in swaptions that resulted in a gain of approximately $2.3 million.
The Corporation enters into certain derivative transactions to provide derivative products to customers, which includes interest rate cap, collars and swaps, and simultaneously covers the Corporation’s position with related and unrelated third parties under substantially the same terms and conditions. These derivatives are not linked to specific assets and liabilities on the consolidated balance sheets or the forecasted transaction in an accounting hedge relationship and, therefore, do not qualify for hedge accounting. These derivatives are carried at fair value with changes in fair value recorded as part of other income. The Corporation recognized a loss on these transactions of $193,000 for the year ended December 31, 2006 and a gain of $120,000 for the year ended December 31, 2005.
To a lesser extent, the Corporation enters into freestanding derivative contracts as a proprietary position taker, based on market expectations or on benefits from price differentials between financial instruments and markets. These derivatives are not linked to specific assets and liabilities on the consolidated balance sheets or to the forecasted transaction in an accounting hedge
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relationship and, therefore, do not qualify for hedge accounting. These derivatives are carried at fair value and changes in fair value are recorded in earnings. For the years ended December 31, 2006 and 2005, the Corporation recognized a loss of $397,000 and $451,000, respectively, on these transactions.
The Corporation enters into loan commitments with customers to extend mortgage loans at a specified rate. These loan commitments are written options and are measured at fair value pursuant to SFAS 133. As of December 31, 2006 the Corporation had loan commitments outstanding for approximately $2.0 million and recognized a gain of $49,000 on these commitments. At December 31, 2005, the Corporation had loan commitments outstanding for approximately $7.3 million and recognized a loss of $43,000 on these commitments.
21. Financial Instruments with Off-Balance Sheet Risk:
In the normal course of business, the Corporation is a party to transactions of financial instruments with off-balance sheet risk to meet the financing needs of its customers. These financial instruments may include commitments to extend credit, standby letters of credit, financial guarantees and interest rate caps, swaps and floors written. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized on the consolidated balance sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Corporation has in the different classes of financial instruments.
The Corporation’s exposure to credit loss, in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written, is represented by the contractual notional amount of those instruments.
The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The contract amount of financial instruments, whose amounts represent credit risk as of December 31, 2006 and 2005, was as follows:
| | | | | | | | | |
| | | 2006 | | | 2005 | |
| | | (Dollars in thousands) | |
| Standby letters of credit and financial guarantees written | | $ | 184,959 | | | $ | 211,657 | |
| | | | | | | |
| | | | | | | | | |
| Commitments to extend credit, approved loans not yet disbursed and unused lines of credit | | $ | 1,666,490 | | | $ | 1,461,258 | |
| | | | | | | |
The Corporation issues financial standby letters of credit to guarantee the performance of its customers to third parties. If the customer fails to meet its financial performance obligation to the third party, then the Corporation would be obligated to make the payment to the guaranteed party. At December 31, 2006, the Corporation’s liabilities include $2,241,000 which represents the fair value of the obligations undertaken in issuing the guarantees under the standby letters of credit issued or modified after December 31, 2002, net of the related amortization at inception. The fair value approximates the unamortized fees received from the customers for issuing the standby letters of credit. The fees are deferred and recognized on a straight-line basis over the commitment period. Standby letters of credit outstanding at December 31, 2006 had terms ranging from one month to seven years. The contract amounts of the standby letters of credit of approximately $184,959,000 at December 31, 2006, represent the maximum potential amount of future payments the Corporation could be required to make under the guarantees in the event of non-performance by its customers. These standby letters of credit typically expire without being drawn upon. Management does not anticipate any material losses related to these guarantees.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, income-producing commercial properties and real estate. The Corporation holds collateral as guarantee for most of these financial instruments.
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22. Fair Value of Financial Instruments:
The following methods and assumptions were used to estimate the fair value of each class of financial instrument. The fair value estimates are made at a discrete point in time based on relevant market information and information about the financial instrument. Because no market exists for a significant portion of the Corporation’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
In addition, the fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. In the case of investments and mortgage-backed securities, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in many of the estimates.
Cash and Cash Equivalents and Interest-bearing Deposits
The carrying amount of cash and cash equivalents and interest-bearing accounts is a reasonable estimate of fair value.
Trading Securities, Investment Securities Available for Sale and Other Investments
The fair value of securities is estimated based on bid prices published in financial newspapers or bid quotations received from securities dealers. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.
Loans
Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, consumer, mortgage, construction and other loans. Each loan category is further segmented into fixed and adjustable interest rate terms and by performing and non-performing.
The fair value of performing loans, except residential mortgages, is calculated by discounting scheduled cash flows at market discount rates that reflect the credit and interest rate risk inherent in the loan. For performing residential mortgage loans, fair value is computed by discounting contractual cash flows adjusted for prepayment estimates using a discount rate based on secondary market sources adjusted to reflect differences in servicing costs.
Mortgage loans available for sale are carried at the lower of cost or market and therefore approximate fair value.
Fair value for significant non-performing loans, and loans with payments in arrears, is based on recent internal or external appraisals. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risks, cash flows, and discount rates are judgmentally determined using available market information and specific borrower information.
Accrued Interest Receivable
The carrying amount of accrued interest receivable is a reasonable estimate of its fair value.
Deposits
The fair value of deposits with no stated maturity, such as demand deposits, savings and NOW accounts, money market and checking accounts is equal to the amount payable on demand as of December 31, 2006 and 2005, respectively. The fair value of fixed maturity certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.
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Federal Funds Purchased and Other Borrowings
The carrying amount of federal funds purchased and other borrowings is a reasonable estimate of fair value.
Securities Sold under Agreement to Repurchase
The carrying amount of securities sold under agreement to repurchase is a reasonable estimate of fair value.
Commercial Paper Issued
The fair value of commercial paper issued is based on discounted cash flows using an estimated discount rate based on the Corporation’s incremental borrowing rates currently offered for similar debt instruments.
Subordinated Capital Notes and Term Notes
The fair value of variable rate subordinated capital notes and fluctuating annual rate term notes is equal to the balance as of December 31, 2006 and 2005, since such notes are tied to floating rates. The fair value of the fixed annual rate term notes is based on discounted cash flows, which consider an estimated discount rate currently offered for certain borrowings.
Accrued Interest Payable
The carrying amount of accrued interest payable is a reasonable estimate of fair value.
Standby Letters of Credit and Commitments to Extend Credit
The fair value of commitments to extend credit, financial guarantees and letters of credit is based on judgment regarding future expected loss experience, current economic conditions and the counterparties’ credit standings.
Interest Rate Swap Agreements and Caps
The fair value of interest rate swaps and caps is estimated using the prices currently charged to enter into similar agreements, taking into consideration the remaining terms of the agreements.
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Following are the cost and fair value of financial instruments as of December 31:
| | | | | | | | | | | | | | | | | |
| | | 2006 | | | 2005 | |
| | | Carrying | | | | | | | Carrying | | | | |
| | | Amount | | | Fair Value | | | Amount | | | Fair Value | |
| | | (Dollars in thousands) | |
| Consolidated balance sheets financial instruments: | | | | | | | | | | | | | | | | |
| Cash, cash equivalents and all interest- bearing deposits | | $ | 250,719 | | | $ | 250,719 | | | $ | 339,027 | | | $ | 339,027 | |
| | | | | | | | | | | | | |
| Trading securities | | $ | 50,792 | | | $ | 50,792 | | | $ | 37,679 | | | $ | 37,679 | |
| | | | | | | | | | | | | |
| Investment securities available for sale | | $ | 1,409,789 | | | $ | 1,409,789 | | | $ | 1,559,681 | | | $ | 1,559,681 | |
| | | | | | | | | | | | | |
| Other investment securities | | $ | 50,710 | | | $ | 50,710 | | | $ | 41,862 | | | $ | 41,862 | |
| | | | | | | | | | | | | |
| Loans held for sale | | $ | 196,277 | | | $ | 196,277 | | | $ | 213,102 | | | $ | 213,102 | |
| | | | | | | | | | | | | |
| Loans | | $ | 6,640,416 | | | $ | 6,829,732 | | | $ | 5,741,788 | | | $ | 5,834,452 | |
| | | | | | | | | | | | | |
| Accrued interest receivable | | $ | 102,244 | | | $ | 102,244 | | | $ | 77,962 | | | $ | 77,962 | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Deposits: | | | | | | | | | | | | | | | | |
| Non interest-bearing | | $ | 746,089 | | | $ | 746,089 | | | $ | 672,225 | | | $ | 672,225 | |
| Interest-bearing | | | 4,567,885 | | | | 4,582,696 | | | | 4,552,425 | | | | 4,576,746 | |
| | | | | | | | | | | | | |
| Total | | $ | 5,313,974 | | | $ | 5,328,785 | | | $ | 5,224,650 | | | $ | 5,248,971 | |
| | | | | | | | | | | | | |
| Federal funds purchased and other borrowings | | $ | 1,628,400 | | | $ | 1,628,400 | | | $ | 768,846 | | | $ | 768,846 | |
| | | | | | | | | | | | | |
| Securities sold under agreements to repurchase | | $ | 830,569 | | | $ | 830,569 | | | $ | 947,767 | | | $ | 947,767 | |
| | | | | | | | | | | | | |
| Commercial paper issued | | $ | 209,549 | | | $ | 210,935 | | | $ | 334,319 | | | $ | 334,282 | |
| | | | | | | | | | | | | |
| Subordinated capital and term notes | | $ | 285,997 | | | $ | 303,843 | | | $ | 161,313 | | | $ | 161,921 | |
| | | | | | | | | | | | | |
| Accrued interest payable | | $ | 91,245 | | | $ | 91,245 | | | $ | 65,160 | | | $ | 65,160 | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | 2006 | | | 2005 | |
| | | Contract or | | | | | | | Contract or | | | | |
| | | Notional | | | | | | | Notional | | | | |
| | | Amount | | | Fair Value | | | Amount | | | Fair Value | |
| | | (Dollars in thousands) | |
| Off balance sheet financial instruments: | | | | | | | | | | | | | | | | |
| Standby letters of credit and financial guarantees written | | $ | 184,959 | | | $ | (2,241 | ) | | $ | 211,657 | | | $ | (1,424 | ) |
| | | | | | | | | | | | | |
| Commitments to extend credit, approved loans not yet disbursed and unused lines of credit | | $ | 1,666,490 | | | $ | (1,667 | ) | | $ | 1,461,258 | | | $ | (1,461 | ) |
| | | | | | | | | | | | | |
23. Significant Group Concentrations of Credit Risk:
Most of the Corporation’s business activities are with customers located within Puerto Rico. The Corporation has a diversified loan portfolio with no significant concentration in any economic sector.
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24. Regulatory Matters:
The Corporation and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Corporation’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation and the Bank must meet specific capital guidelines that involve quantitative measures of the assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Corporation’s and the Bank’s capital classification is also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios, as indicated below, of Total and Tier I capital (as defined) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). In management’s opinion, the Corporation and the Bank met all capital adequacy requirements to which they were subject as of December 31, 2006 and 2005.
At December 31, 2006 and 2005, the Corporation’s required and actual regulatory capital amounts and ratios follow:
| | | | | | | | | | | | | | | | | |
| | | December 31, 2006 |
| | | Required | | Actual |
| | | Amount | | Ratio | | Amount | | Ratio |
| | | (Dollars in thousands) |
| Total Capital (to Risk Weighted Assets) | | $ | 529,191 | | | | 8 | % | | $ | 723,269 | | | | 10.93 | % |
| Tier I Capital (to Risk Weighted Assets) | | $ | 264,596 | | | | 4 | % | | $ | 520,794 | | | | 7.87 | % |
| Leverage Ratio | | $ | 269,000 | | | | 3 | % | | $ | 520,794 | | | | 5.81 | % |
| | | | | | | | | | | | | | | | | |
| | | December 31, 2005 |
| | | Required | | Actual |
| | | Amount | | Ratio | | Amount | | Ratio |
| | | (Dollars in thousands) |
| Total Capital (to Risk Weighted Assets) | | $ | 472,889 | | | | 8 | % | | $ | 726,939 | | | | 12.30 | % |
| Tier I Capital (to Risk Weighted Assets) | | $ | 236,445 | | | | 4 | % | | $ | 537,319 | | | | 9.09 | % |
| Leverage Ratio | | $ | 247,593 | | | | 3 | % | | $ | 537,319 | | | | 6.51 | % |
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As of December 31, 2006, the Bank qualified as a well-capitalized institution under the regulatory framework. To be categorized as well capitalized, the institution must maintain minimum total risk-based, Tier I risk based and Tier I leverage ratios as set forth in the table below. At December 31, 2006, there are no conditions or events that management believes to have changed the Bank’s category since the regulator’s last notification.
At December 31, 2006 and 2005, the Bank’s required and actual regulatory capital amounts and ratios follow:
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | December 31, 2006 |
| | | Required | | Actual | | Well-Capitalized |
| | | Amount | | Ratio | | Amount | | Ratio | | Ratio |
| | | (Dollars in thousands) |
| Total Capital (to Risk Weighted Assets) | | $ | 469,346 | | | | 8 | % | | $ | 651,350 | | | | 11.10 | % | | | | | | ≥ | 10 | % |
| Tier I Capital (to Risk Weighted Assets) | | $ | 234,673 | | | | 4 | % | | $ | 583,941 | | | | 9.95 | % | | | | | | ≥ | 6 | % |
| Leverage Ratio | | $ | 244,857 | | | | 3 | % | | $ | 583,941 | | | | 7.15 | % | | | | | | ≥ | 5 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | December 31, 2005 |
| | | Required | | Actual | | Well-Capitalized |
| | | Amount | | Ratio | | Amount | | Ratio | | Ratio |
| | | (Dollars in thousands) | |
| Total Capital (to Risk Weighted Assets) | | $ | 462,187 | | | | 8 | % | | $ | 638,181 | | | | 11.05 | % | | | | | | ≥ | 10 | % |
| Tier I Capital (to Risk Weighted Assets) | | $ | 231,093 | | | | 4 | % | | $ | 570,056 | | | | 9.87 | % | | | | | | ≥ | 6 | % |
| Leverage Ratio | | $ | 245,222 | | | | 3 | % | | $ | 570,056 | | | | 6.98 | % | | | | | | ≥ | 5 | % |
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25. Segment Information:
Types of Products and Services
The Corporation has five (four in 2005) reportable segments: Commercial Banking, Mortgage Banking, Consumer Finance, Treasury and Investments and Wealth Management. Insurance operations and International Banking are other lines of business in which the Corporation commenced its involvement during 2000 and 2001, respectively. However, no separate disclosures are being provided for these operations, since they did not meet the quantitative thresholds for disclosure of segment information. Insurance commissions derived from the Commercial Banking and Consumer Finance segments are reported as part of the Insurance operations included in the “Other” column below.
Measurement of Segment Profit or Loss and Segment Assets
The Corporation’s reportable business segments are strategic business units that offer distinctive products and services that are marketed through different channels. These are managed separately because of their unique technology, marketing and distribution requirements.
The following present financial information of reportable segments as of and for the years ended December 31, 2006, 2005 and 2004. General corporate expenses and income taxes have not been added or deducted in the determination of operating segment profits. The “Other” column includes the items necessary to reconcile the identified segments to the reported consolidated amounts. Included in the “Other” column are expenses of the internal audit, investors’ relations, strategic planning, administrative services, mail, marketing, public relations, electronic data processing departments and comptroller’s departments. The “Eliminations” column includes all intercompany eliminations for consolidation purposes.
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | December 31, 2006 |
| | | Commercial | | Mortgage | | Consumer | | Treasury and | | Wealth | | | | | | | | | | Consolidated |
| | | Banking | | Banking | | Finance | | Investments | | Management | | Other | | Eliminations | | Total |
| | | (Dollars in thousands) |
| Total external revenue | | $ | 311,451 | | | $ | 175,877 | | | $ | 121,159 | | | $ | 80,630 | | | $ | 49,865 | | | $ | 64,956 | | | $ | (67,149 | ) | | $ | 736,789 | |
| Intersegment revenue | | | 8,546 | | | | — | | | | — | | | | — | | | | — | | | | 58,603 | | | | (67,149 | ) | | | — | |
| Interest income | | | 268,806 | | | | 162,572 | | | | 118,154 | | | | 80,275 | | | | 2,283 | | | | 41,359 | | | | (55,129 | ) | | | 618,320 | |
| Interest expense | | | 87,654 | | | | 90,423 | | | | 34,738 | | | | 113,878 | | | | 3,183 | | | | 46,096 | | | | (48,258 | ) | | | 327,714 | |
| Depreciation and amortization | | | 5,567 | | | | 1,852 | | | | 3,633 | | | | 776 | | | | 1,030 | | | | 4,737 | | | | — | | | | 17,595 | |
| Segment income (loss) before income tax | | | 95,180 | | | | 60,595 | | | | (1,287 | ) | | | (38,101 | ) | | | 13,185 | | | | (56,442 | ) | | | (7,421 | ) | | | 65,709 | |
| Segment assets | | | 3,929,196 | | | | 2,715,577 | | | | 805,173 | | | | 1,684,649 | | | | 100,585 | | | | 506,587 | | | | (553,599 | ) | | | 9,188,168 | |
119
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | December 31, 2005 |
| | | Commercial | | Mortgage | | Treasury and | | Wealth | | | | | | | | | | Consolidated |
| | | Banking | | Banking | | Investments | | Management | | Other | | Eliminations | | Total |
| | | (Dollars in thousands) |
| Total external revenue | | $ | 246,704 | | | $ | 173,477 | | | $ | 90,838 | | | $ | 49,714 | | | $ | 21,270 | | | $ | (17,040 | ) | | $ | 564,963 | |
| Intersegment revenue | | | 10,496 | | | | — | | | | — | | | | — | | | | 6,544 | | | | (17,040 | ) | | | — | |
| Interest income | | | 208,098 | | | | 164,261 | | | | 77,447 | | | | 1,697 | | | | (638 | ) | | | (11,260 | ) | | | 439,605 | |
| Interest expense | | | 59,348 | | | | 60,998 | | | | 96,100 | | | | 2,003 | | | | 5,629 | | | | (11,495 | ) | | | 212,583 | |
| Depreciation and amortization | | | 5,774 | | | | 1,808 | | | | 642 | | | | 731 | | | | 4,229 | | | | — | | | | 13,184 | |
| Segment income (loss) before income tax | | | 67,257 | | | | 98,249 | | | | (9,956 | ) | | | 13,835 | | | | (57,861 | ) | | | (930 | ) | | | 110,594 | |
| Segment assets | | | 3,536,945 | | | | 2,837,931 | | | | 1,887,680 | | | | 90,109 | | | | 210,134 | | | | (290,851 | ) | | | 8,271,948 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | December 31, 2004 |
| | | Commercial | | Mortgage | | Treasury and | | Wealth | | | | | | | | | | Consolidated |
| | | Banking | | Banking | | Investments | | Management | | Other | | Eliminations | | Total |
| | | (Dollars in thousands) |
| Total external revenue | | $ | 194,097 | | | $ | 114,719 | | | $ | 113,253 | | | $ | 49,553 | | | $ | 19,238 | | | $ | (9,799 | ) | | $ | 481,061 | |
| Intersegment revenue | | | 5,440 | | | | — | | | | 22 | | | | 6 | | | | 4,331 | | | | (9,799 | ) | | | — | |
| Interest income | | | 158,748 | | | | 108,333 | | | | 99,830 | | | | 1,313 | | | | 1,164 | | | | (5,566 | ) | | | 363,822 | |
| Interest expense | | | 34,499 | | | | 23,141 | | | | 85,802 | | | | 1,107 | | | | 1,884 | | | | (5,671 | ) | | | 140,762 | |
| Depreciation and amortization | | | 6,139 | | | | 1,211 | | | | 237 | | | | 511 | | | | 5,140 | | | | — | | | | 13,238 | |
| Segment income (loss) before income tax | | | 32,324 | | | | 80,311 | | | | 22,351 | | | | 15,041 | | | | (52,755 | ) | | | (620 | ) | | | 96,652 | |
| Segment assets | | | 3,320,311 | | | | 2,585,765 | | | | 2,417,746 | | | | 89,233 | | | | 218,247 | | | | (307,655 | ) | | | 8,323,647 | |
Reconciliation of Segment Information to Consolidated Amounts
Information for the Corporation’s reportable segments in relation to the consolidated totals at December 31, follows:
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
| | | (Dollars in thousands) | |
| Revenues: | | | | | | | | | | | | |
| Total revenues for reportable segments | | $ | 733,421 | | | $ | 557,040 | | | $ | 471,622 | |
| Other revenues | | | 70,517 | | | | 24,963 | | | | 19,238 | |
| Elimination of intersegment revenues | | | (67,149 | ) | | | (17,040 | ) | | | (9,799 | ) |
| | | | | | | | | | |
| Total consolidated revenues | | $ | 736,789 | | | $ | 564,963 | | | $ | 481,061 | |
| | | | | | | | | | |
| | | | | | | | | | | | | |
| Total income before tax of reportable segments | | $ | 127,299 | | | $ | 167,609 | | | $ | 150,027 | |
| Income (loss) before tax of other segments | | | (54,169 | ) | | | (56,085 | ) | | | (52,755 | ) |
| Elimination of intersegment profits | | | (7,421 | ) | | | (930 | ) | | | (620 | ) |
| | | | | | | | | | |
| Consolidated income before tax | | $ | 65,709 | | | $ | 110,594 | | | $ | 96,652 | |
| | | | | | | | | | |
| | | | | | | | | | | | | |
| Assets: | | | | | | | | | | | | |
| Total assets for reportable segments | | $ | 9,146,499 | | | $ | 8,257,552 | | | $ | 8,413,055 | |
| Assets not attributed to segments | | | 595,268 | | | | 305,247 | | | | 218,247 | |
| Elimination of intersegment assets | | | (553,599 | ) | | | (290,851 | ) | | | (307,655 | ) |
| | | | | | | | | | |
| Total consolidated assets | | $ | 9,188,168 | | | $ | 8,271,948 | | | $ | 8,323,647 | |
| | | | | | | | | | |
120
26. Quarterly Results (Unaudited):
The following table reflects the unaudited quarterly results of the Corporation during the years ended December 31, 2006, 2005 and 2004.
| | | | | | | | | | | | | | | | | |
| | | Quarters Ended 2006 |
| | | March 31 | | June 30 | | September 30 | | December 31 |
| | | (Dollars in thousands, except per share data) |
| Interest Income | | $ | 132,084 | | | $ | 158,534 | | | $ | 162,086 | | | $ | 165,616 | |
| Net Interest Income | | | 62,786 | | | | 77,856 | | | | 74,708 | | | | 75,256 | |
| Net Interest Income after Provision for Loan Losses | | | 55,248 | | | | 61,881 | | | | 54,308 | | | | 53,586 | |
| Income before Provision for Income Tax | | | 21,951 | | | | 18,383 | | | | 9,692 | | | | 15,683 | |
| Net income | | | 13,356 | | | | 11,028 | | | | 8,726 | | | | 10,059 | |
| | | | | | | | | | | | | | | | | |
| Earnings per Common Share | | | 0.29 | | | | 0.23 | | | | 0.19 | | | | 0.22 | |
| | | | | | | | | | | | | | | | | |
| | | Quarters Ended 2005 |
| | | March 31 | | June 30 | | September 30 | | December 31 |
| | | (Dollars in thousands, except per share data) |
| Interest Income | | $ | 101,388 | | | $ | 104,050 | | | $ | 112,470 | | | $ | 121,697 | |
| Net Interest Income | | | 56,108 | | | | 54,262 | | | | 55,577 | | | | 61,075 | |
| Net Interest Income after Provision for Loan Losses | | | 49,408 | | | | 50,212 | | | | 50,927 | | | | 56,075 | |
| Income before Provision for Income Tax | | | 33,130 | | | | 28,016 | | | | 23,693 | | | | 25,755 | |
| Net income | | | 25,914 | | | | 19,633 | | | | 17,395 | | | | 16,864 | |
| | | | | | | | | | | | | | | | | |
| Earnings per Common Share | | | 0.56 | | | | 0.42 | | | | 0.37 | | | | 0.36 | |
| | | | | | | | | | | | | | | | | |
| | | Quarters Ended 2004 |
| | | March 31 | | June 30 | | September 30 | | December 31 |
| | | (Dollars in thousands, except per share data) |
| Interest Income | | $ | 87,033 | | | $ | 87,249 | | | $ | 93,319 | | | $ | 96,221 | |
| Net Interest Income | | | 55,182 | | | | 54,753 | | | | 56,809 | | | | 56,316 | |
| Net Interest Income after Provision for Loan Losses | | | 46,432 | | | | 48,753 | | | | 49,789 | | | | 51,816 | |
| Income before Provision for Income Tax | | | 28,937 | | | | 17,217 | | | | 24,372 | | | | 26,126 | |
| Net income | | | 25,978 | | | | 16,755 | | | | 22,422 | | | | 21,773 | |
| | | | | | | | | | | | | | | | | |
| Earnings per Common Share | | | 0.55 | | | | 0.36 | | | | 0.48 | | | | 0.47 | |
121
27. Santander BanCorp (Parent Company Only) Financial Information:
The following condensed financial information presents the financial position of the Parent Company only, as of December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the years in the three year period ended December 31, 2006.
The net income of Santander Bancorp (parent company only) is nominally greater than the consolidated net income of Santander BanCorp and subsidiaries, because it includes a transaction between Santander BanCorp’s wholly owned subsidiaries, Banco Santander and Santander Securities, which has a different accounting treatment in the stand-alone financial statements of each of these entities. Such transaction is eliminated in consolidation.
SANTANDER BANCORP
Balance Sheet Information- December 31, 2006 and 2005
(Dollars in thousands)
| | | | | | | | | |
| | | 2006 | | | 2005 | |
ASSETS | | | | | | | | |
| Cash and due from banks | | $ | 15,890 | | | $ | 9,326 | |
| Interest-bearing deposits | | | 51,000 | | | | 45,000 | |
| | | | | | | |
| Total cash and cash equivalents | | | 66,890 | | | | 54,326 | |
Loans,net | | | 262,824 | | | | 139,435 | |
Investment in Subsidiaries | | | 786,731 | | | | 627,005 | |
Accrued Interest Receivable | | | 10,414 | | | | 1,705 | |
Other Assets | | | 787 | | | | 2,585 | |
| | | | | | | |
| | | $ | 1,127,646 | | | $ | 825,056 | |
| | | | | | | |
LIABILITIES AND STOCKHOLDERS’ EQUITY | | | | | | | | |
Borrowings | | $ | 275,000 | | | $ | 118,846 | |
Subordinated Capital Notes | | | 248,343 | | | | 120,973 | |
Accrued Interest Payable | | | 9,290 | | | | 1,178 | |
Other Liabilities | | | 14,202 | | | | 13,984 | |
| | | | | | | |
| Total liabilities | | | 546,835 | | | | 254,981 | |
| | | | | | | |
STOCKHOLDERS’ EQUITY: | | | | | | | | |
| Common stock, $2.50 par value; 200,000,000 shares authorized, 50,650,364 shares issued; 46,639,104 shares outstanding at December 31, 2006 and 2005 | | | 126,626 | | | | 126,626 | |
| Capital paid in excess of par value | | | 552,195 | | | | 552,195 | |
| Treasury stock at cost, 4,011,260 shares at December 31, 2006 and 2005 | | | (67,552 | ) | | | (67,552 | ) |
| Accumulated other comprehensive loss, net of tax | | | — | | | | (36 | ) |
| Retained earnings- | | | | | | | | |
| Undivided loss | | | (30,458 | ) | | | (41,158 | ) |
| | | | | | | |
| Total stockholders’ equity | | | 580,811 | | | | 570,075 | |
| | | | | | | |
| | | $ | 1,127,646 | | | $ | 825,056 | |
| | | | | | | |
122
Santander BanCorp
Statements of Income Information
Years Ended December 31, 2006, 2005 and 2004
(Dollars in thousands)
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
Interest Income: | | | | | | | | | | | | |
| Loans | | $ | 42,472 | | | $ | 5,629 | | | $ | 1,000 | |
| Interest-bearing deposits | | | 1,952 | | | | 848 | | | | 59 | |
| | | | | | | | | | |
| Total interest income | | | 44,424 | | | | 6,477 | | | | 1,059 | |
| | | | | | | | | | |
Interest Expense: | | | | | | | | | | | | |
| Borrowings | | | 34,661 | | | | 4,253 | | | | 1,378 | |
| Term and subordinated capital notes | | | 14,619 | | | | 3,402 | | | | 502 | |
| | | | | | | | | | |
| Total interest expense | | | 49,280 | | | | 7,655 | | | | 1,880 | |
| | | | | | | | | | |
| Net interest loss | | | (4,856 | ) | | | (1,178 | ) | | | (821 | ) |
Other Income: | | | | | | | | | | | | |
| Derivative gains (losses) | | | 40 | | | | (122 | ) | | | 325 | |
| Equity in earnings of subsidiaries | | | 50,327 | | | | 83,617 | | | | 90,021 | |
| | | | | | | | | | |
| Total other income | | | 50,367 | | | | 83,495 | | | | 90,346 | |
| | | | | | | | | | |
Other Operating Expenses: | | | | | | | | | | | | |
| Professional fees | | | 1,419 | | | | 1,149 | | | | 1,394 | |
| Other taxes | | | 475 | | | | 285 | | | | 180 | |
| Other operating expenses | | | 376 | | | | 202 | | | | 275 | |
| | | | | | | | | | |
| Total other operating expenses | | | 2,270 | | | | 1,636 | | | | 1,849 | |
| | | | | | | | | | |
| Income before provision (benefit) for income tax | | | 43,241 | | | | 80,681 | | | | 87,676 | |
Provision (benefit) for Income Tax | | | 16 | | | | (55 | ) | | | 127 | |
| | | | | | | | | | |
Net Income | | $ | 43,225 | | | $ | 80,736 | | | $ | 87,549 | |
| | | | | | | | | | |
123
Santander BanCorp
Statements of Cash Flows Information
Years Ended December 31, 2006, 2005 and 2004
(Dollars in thousands)
| | | | | | | | | | | | | |
| | | 2006 | | | 2005 | | | 2004 | |
CASH FLOWS FROM OPERATING ACTIVITIES: | | | | | | | | | | | | |
| Net income | | $ | 43,225 | | | $ | 80,736 | | | $ | 87,549 | |
| | | | | | | | | | |
| Adjustments to reconcile net income to net cash provided by (used in) operating activities: | | | | | | | | | | | | |
| Equity in earnings of subsidiaries, net of dividends received | | | (15,684 | ) | | | (51,225 | ) | | | (67,076 | ) |
| Deferred tax provision (benefit) | | | 16 | | | | (55 | ) | | | 127 | |
| Increase in other assets and accrued interest receivable | | | (6,564 | ) | | | (3,759 | ) | | | (522 | ) |
| Decrease (increase) other liabilities and accrued interest payable | | | 851 | | | | 2,097 | | | | (166 | ) |
| | | | | | | | | | |
| Total adjustments | | | (21,381 | ) | | | (52,942 | ) | | | (67,637 | ) |
| | | | | | | | | | |
| Net cash provided by (used in) operating activities | | | 21,844 | | | | 27,794 | | | | 19,912 | |
| | | | | | | | | | |
| | | | | | | | | | | | | |
CASH FLOWS FROM INVESTING ACTIVITIES: | | | | | | | | | | | | |
| Net increase in loans | | | (123,389 | ) | | | (96,435 | ) | | | (6,000 | ) |
| Investment in subsidiary | | | (147,029 | ) | | | — | | �� | | — | |
| | | | | | | | | | |
| Net cash used in investing activities | | | (270,418 | ) | | | (96,435 | ) | | | (6,000 | ) |
| | | | | | | | | | |
| | | | | | | | | | | | | |
CASH FLOWS FROM FINANCING ACTIVITIES: | | | | | | | | | | | | |
| Issuance of borrowings | | | 1,000,000 | | | | 118,846 | | | | 5,000 | |
| Repayment of borrowings | | | (843,846 | ) | | | (30,000 | ) | | | — | |
| Issuance of term and subordinated capital notes | | | 127,370 | | | | 48,385 | | | | 72,588 | |
| Repayment of subordinated notes | | | — | | | | — | | | | (74,000 | ) |
| Dividends paid | | | (22,386 | ) | | | (22,386 | ) | | | (21,922 | ) |
| | | | | | | | | | |
| Net cash provided by (used in) financing activities | | | 261,138 | | | | 114,845 | | | | (18,334 | ) |
| | | | | | | | | | |
NET CHANGE IN CASH AND CASH EQUIVALENTS | | | 12,564 | | | | 46,204 | | | | (4,422 | ) |
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR | | | 54,326 | | | | 8,122 | | | | 12,544 | |
| | | | | | | | | | |
CASH AND CASH EQUIVALENTS, END OF YEAR | | $ | 66,890 | | | $ | 54,326 | | | $ | 8,122 | |
| | | | | | | | | | |
124
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
The Corporation maintains a system of disclosure controls and procedures that are designed to provide reasonable assurance that material information, which is required to be timely disclosed, is accumulated and communicated to management in a timely manner. An evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”)) was performed as of the end of the period covered by this report. This evaluation was performed under the supervision and with the participation of the Corporation’s Chief Executive Officer and Chief Accounting Officer. Based upon that evaluation, the Chief Executive Officer and Chief Accounting Officer concluded that the Corporation’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by the Corporation in the Corporation’s reports that it files or submits under the Exchange Act is accumulated and communicated to management, including its Chief Executive Officer and Chief Accounting Officer, as appropriate, to allow timely decisions regarding required disclosure and are effective to provide reasonable assurance that such information is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms.
Management’s Report on Internal Control over Financial Reporting
Management of the Corporation is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. The Corporation’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America (“GAAP”).
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.
Management has assessed the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2006, based on the criteria set forth by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission in their Internal Control — Integrated Framework. In making its assessment of internal control over financial reporting, management has concluded that the Corporation’s internal control over financial reporting was effective as of December 31, 2006.
The scope of management’s assessment as of December 31, 2006 did not include an assessment of the internal control over financial reporting of Santander Financial Services, Inc, a wholly owned subsidiary of the Corporation, which acquired substantially all the assets and business operations in Puerto Rico of Island Finance on February 28, 2006. The acquisition of Island Finance is material to the Corporation’s consolidated financial statements, and as such represents a material change in internal control over financial reporting. Santander Financial Services, Inc. represents 8.76% of the Corporation’s consolidated total assets as of December 31, 2006 and -1.96% (as a result of a pretax loss of approximately $1.3 million) of the Corporation’s pre-tax income for the year ended December 31, 2006. Changes to certain processes, information technology systems and other components of internal control over financial reporting (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities and Exchange Act of 1934) resulting from the acquisition of Island Finance may occur and are in the process of being evaluated by management as integration activities are implemented. Management intends to complete its assessment of the effectiveness of internal controls over financial reporting for the acquired business within one year of the date of acquisition. Thus, the scope of management’s assessment on internal control over financial reporting for fiscal year 2007 will include Santander Financial Services and the acquired business of Island Finance.
The Corporation’s independent registered public accounting firm, Deloitte & Touche LLP, has audited management’s assessment of the Corporation’s internal control over financial reporting. Their report appears herein.
125
Change in Internal Control Over Financial Reporting
With the exception of the Island Finance acquisition as noted above, there have been no changes in the Corporation’s internal controls over financial reporting during the fiscal year covered by this Annual Report on Form 10-K that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal controls over financial reporting.
ITEM 9B. OTHER INFORMATION
None
PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information contained under the captions “Principal Holders of Capital Stock”, “Section 16(a) Beneficial Ownership Reporting Compliance”, “Board of Directors”, “Nominees for Election”, “Meetings of the Board of Directors and Committees” and “Executive Officers” of the Corporation’s definitive Proxy Statement to be filed with the SEC on or about April 20, 2007, is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information under the caption “Compensation of Executive Officers” of the definitive Proxy Statement to be filed with the SEC on or about April 20, 2007, is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information under the caption “Principal Holders of Capital Stock” of the definitive Proxy Statement to be filed with the SEC on or about April 20,2007, is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information under the caption “Transactions with Related Parties” of the definitive Proxy Statement to be filed with the SEC on or about April 20, 2007, is incorporated herein by reference.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information under the caption “Disclosure of Audit Fees” of the definitive Proxy Statement to be filed with the SEC on or about April 20, 2007, is incorporated herein by reference.
126
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENTS SCHEDULES
A. The following documents are incorporated by reference from Item 8 hereof:
| | (1) | | Consolidated Financial Statements: |
Reports of Independent Registered Public Accounting Firm
Consolidated Balance Sheets at December 31, 2006 and 2005
Consolidated Statements of Income for the Years Ended December 31, 2006, 2005, and 2004
Consolidated Statements of Changes in Stockholders’ Equity for the Years Ended December 31, 2006, 2005 and 2004
Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2006, 2005 and 2004
Consolidated Statements of Cash Flows for the Years Ended December 31, 2006, 2005 and 2004
Notes to Consolidated Financial Statements December 31, 2006, 2005 and, 2004
| | (2) | | Financial Statement Schedules are not presented because the information is not applicable or is included in the Consolidated Financial Statements described in A (1) above or in the notes thereto. |
| |
| | (3) | | The exhibits listed on the Exhibit Index on page 129 of this report are filed herewith or are incorporated herein by reference. |
127
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, there unto duly authorized
| | | | | |
| | | SANTANDER BANCORP
(REGISTRANT) |
| | | | | |
| Dated: 03/28/2007 | | By: | | S/JOSE RAMON GONZALEZ |
| | | | | Director and Vice Chairman |
| | | | | President and Chief Executive Officer |
| | | | | |
| Dated: 03/28/2007 | | By: | | S/CARLOS M. GARCIA |
| | | | | Director |
| | | | | Senior Executive Vice President and
Chief Operating Officer |
| | | | | |
| Dated: 03/28/2007 | | By: | | S/ MARIA CALERO |
| | | | | Director |
| | | | | Executive Vice President and
Chief Accounting Officer |
Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of this Registrant and in the capacities and on the dates indicated.
| | | | | |
| S:\GONZALO DE LAS HERAS | | Chairman | | 03/28/2007 |
| | | | | |
| S:\ JESUS M. ZABALZA | | Director | | 03/28/2007 |
| | | | | |
| S:\ VICTOR ARBULU | | Director | | 03/28/2007 |
| | | | | |
| S:\ ROBERTO VALENTIN | | Director | | 03/28/2007 |
| | | | | |
| S:\ STEPHEN FERRISS | | Director | | 03/28/2007 |
128
EXHIBIT INDEX
| | | | | |
| Exhibit No. | | Description | | Reference |
| (2.0) | | Agreement and Plan of Merger-Banco Santander Puerto Rico and Santander BanCorp | | Exhibit 3.3 8-A12B |
| | | | | |
| (2.1) | | Stock Purchase Agreement Santander BanCorp and Banco Santander Central Hispano, S.A. | | Exhibit 2.1 10K-12/31/00 |
| | | | | |
| (2.2) | | Stock Purchase Agreement dated as of November 28, 2003 by and among Santander BanCorp, Administración de Bancos Latinoamericanos Santander, S.L. and Santander Securities Corporation | | Exhibit 2.2 10Q-06/30/04 |
| | | | | |
| (2.3) | | Settlement Agreement between Santander BanCorp and Administración de Bancos Latinoamericanos Santander, S.L. | | Exhibit 2.3 10Q-06/30/04 |
| | | | | |
| (3.1) | | Articles of Incorporation | | Exhibit 3.1 8-A12B |
| | | | | |
| (3.2) | | Bylaws | | Exhibit 3.1 8-A12B |
| | | | | |
| (4.1) | | Authoring and Enabling Resolutions 7% Noncumulative Perpetual Monthly Income Preferred Stock, Series A | | Exhibit 4.1 10Q-06/30/04 |
| | | | | |
| (4.2) | | Offering Circular for $30,000,000 Banco Santander PR Stock Market Growth Notes Linked to the S&P 500 Index | | Exhibit 4.6 10Q-03/31/04 |
| | | | | |
| (4.3) | | Private Placement Memorandum Santander BanCorp $75,000,000 6.30% Subordinated Notes | | Exhibit 4.3 10KA-12/31/04 |
| | | | | |
| (4.4) | | Private Placement Memorandum Santander BanCorp $50,000,000 6.10% Subordinated Notes | | Exhibit 4.4 10K-12/31/05 |
| | | | | |
| (4.5) | | Indenture dated as of February 28, 2006, between the Santander BanCorp and Banco Popular de Puerto Rico | | Exhibit 4.6 10Q-03/31/06 |
| | | | | |
| (4.6) | | First Supplemental Indenture, dated as of February 28, 2006, between Santander Bancorp and Banco Popular de Puerto Rico | | Exhibit 4.7 10Q-03/31/06 |
| | | | | |
| (4.7) | | Amended and Restated Declaration of Trust and Trust Agreement, dated as of February 28, 2006, among Santander BanCorp, Banco Popular de Puerto Rico Wilmintong Trust Company, the Administrative Trustees named therein and the holders from time to time, of the undivided beneficial ownership interest in The Assets of the Trust. | | Exhibit 4.8 10-Q-03/31/06 |
| | | | | |
| (4.8) | | Guarantee Agreement, dated as of February 28, 2006 between Santander BanCorp and Banco Popular de Puerto Rico | | Exhibit 4.9 10-Q-03/31/06 |
| | | | | |
| (4.9) | | Global Capital Securities Certificate | | Exhibit 4.10 10Q-03/31/06 |
| | | | | |
| (4.10) | | Certificate of Junior Subordinated Debenture | | Exhibit 4.11 10Q-03/31/06 |
| | | | | |
| (10.1) | | Contract for Systems Maintenance between ALTEC & Banco Santander Puerto Rico | | Exhibit 10A 10K-12/31/02 |
| | | | | |
| (10.2) | | Employment Contract-José Ramón González | | Exhibit 10.1 8K-01/04/07 |
| | | | | |
| (10.3) | | Employment Contract-Carlos M. García | | Exhibit 10.2 8K-01/04/07 |
| | | | | |
| (10.4) | | Deferred Compensation Contract-María Calero | | Exhibit 10C 10K-12/31/02 |
| | | | | |
| (10.5) | | Information Processing Services Agreement between America Latina Tecnología de Mexico, SA and Banco Santander Puerto Rico, Santander International Bank of Puerto Rico and Santander Investment International Bank, Inc. | | Exhibit 10A 10Q-06/30/03 |
| | | | | |
| (10.6) | | Employment Contract-Roberto Córdova | | Exhibit 10.3 10Q-03/31/05 |
| | | | | |
| (10.7) | | Employment Contract-Bartolomé Vélez | | Exhibit 10.7 |
| | | | | |
| (10.8) | | Employment Contract-Lillian Díaz | | Exhibit 10.5 10Q-03/31/05 |
| | | | | |
| (10.9) | | Technology Assignment Agreement between CREFISA, Inc. and Banco Santander Puerto Rico | | Exhibit 10.12 10KA-12/31/04 |
| | | | | |
| (10.10) | | Altair System License Agreement between CREFISA, Inc. and Banco Santander Puerto Rico | | Exhibit 10.13 10KA-12/31/04 |
| | | | | |
| (10.11) | | 2005 Employee Stock Option Plan | | Exhibit B Def14-03/26/05 |
| | | | | |
| (10.12) | | Asset Purchase Agreement by and among Wells Fargo & Company, Island Finance Puerto Rico, Inc., Island Finance Sales Finance Corporation and Santander BanCorp and Santander Financial Services, Inc. for the purpose and sale of certain assets of Island Finance Puerto Rico, Inc. and Island Finance Sales Corporation dated as of January 22, 2006. | | Exhibit 10.1 8K-01/25/06 |
| | | | | |
| (10.13) | | Novation Agreement among Santander BancCorp, Santusa Holdings S.L. And Lloyds TBS Bank PLC | | Exhibit 10.1 8K-06/19/06 |
129
EXHIBIT INDEX — Con’t
| | | | | |
| Exhibit No. | | Description | | Reference |
| (10.14) | | Amended and Restated USD 725,000,000 Loan Facility between Santander BanCorp and Lloyds TBS Bank PLC | | Exhibit 10.1 8K-06/19/06 |
| | | | | |
| (10.15) | | Employment Contract-Tomás Torres | | Exhibit 10.16 10Q-09/30/06 |
| | | | | |
| (10.16) | | Employment Contract-Eric Delgado | | Exhibit 10.17 10Q-09/30/06 |
| | | | | |
| (10.17) | | $800 million Bridge Facility Agreement Santander BanCorp, Santander Financial Services and National Australia Bank Limited | | Exhibit 10.1 8K-12/27/06 |
| | | | | |
| (10.18) | | Agreement of Benefits Coverage Agreed with Officers of Grupo Santander | | Exhibit 10.18 |
| | | | | |
| (12) | | Computation of Ratio of Earnings to Fixed Charges | | Exhibit 12 |
| | | | | |
| (14) | | Code of Ethics | | Exhibit 14 10-KA-12/31/04 |
| | | | | |
| (21) | | Subsidiaries of the Registrant | | Exhibit 21 |
| | | | | |
| (22) | | Registrant’s Proxy Statement for the April 30, 2007 Annual Meeting of Stockholders | | Def14A-04/20/07 |
| | | | | |
| (31.1) | | Certification from the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | | Exhibit 31.1 |
| | | | | |
| (31.2) | | Certification from the Chief Operating Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | | Exhibit 31.2 |
| | | | | |
| (31.3) | | Certification from the Chief Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | | Exhibit 31.3 |
| | | | | |
| (32.1) | | Certification from the Chief Executive Officer, Chief Operating Officer and Chief Accounting Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | | Exhibit 32.1 |
130
