10. SHORT-TERM BORROWINGS AND LONG-TERM DEBT
At June 30, 2011, our bank maintained a $30.9 million line of credit with the Federal Reserve discount window, of which there were no advances outstanding. As of June 30, 2011, certain commercial real estate loans totaling $123.8 million have been pledged as collateral on our line of credit with the Federal Reserve discount window. The Federal Reserve does not have the right to sell or repledge these loans. Future advances under this arrangement are subject to approval of the Federal Reserve. Furthermore, all terms and maturities of advances under this arrangement are at the discretion of the Federal Reserve and are generally limited to overnight borrowings. Since September 2009, our bank was no longer eligible to access the Federal Reserve’s primary credit facility but maintained access to its secondary facility. There was no change in the level of credit available to the bank; however, future advances will have higher borrowing costs under the secondary facility.
The bank is a member of and maintained a $646.7 million line of credit with the FHLB as of June 30, 2011. Long-term borrowings under this arrangement totaled $300.8 million at June 30, 2011, compared to $200.0 million and $351.3 million of short-term and long-term borrowings, respectively, at December 31, 2010. There were no short-term borrowings under this arrangement at June 30, 2011. FHLB advances outstanding at June 30, 2011 were secured by investment securities with a fair value of $320.6 million and certain real estate loans totaling $576.3 million in accordance with the collateral provisions of the Advances, Security and Deposit Agreement with the FHLB. Approximately $345.9 million was undrawn under this arrangement at June 30, 2011. The FHLB has no obligation to make future advances to the bank.
On August 20, 2009, we began deferring regularly scheduled interest payments on our outstanding junior subordinated debentures relating to our trust preferred securities. The terms of the junior subordinated debentures and the trust documents allow us to defer payments of interest for up to 20 consecutive quarterly periods without default or penalty. During the deferral period, which currently stands at eight consecutive quarters, the respective trusts have suspended the declaration and payment of dividends on the trust preferred securities. Also during the deferral period, we may not, among other things and with limited exceptions, pay cash dividends on or repurchase our common stock or make any payment on outstanding debt obligations that rank equally with or junior to the junior subordinated debentures. During the deferral period, we will continue to accrue, and reflect in our consolidated financial statements, the deferred interest payments on our junior subordinated debentures. Accrued interest on our outstanding junior subordinated debentures relating to our trust preferred securities was $6.7 million and $5.1 million at June 30, 2011 and December 31, 2010, respectively. With the recent completion of our recapitalization, we may seek regulatory approval to pay all deferred payments under our trust preferred securities.
11. EQUITY
As previously announced, we completed a number of significant transactions as part of our recapitalization during the first half of 2011, including:
| · | on February 2, 2011, we effected a one-for-twenty reverse stock split of our common stock (the “Reverse Stock Split”). Except as otherwise specified, the share and per share amounts for historical periods have been restated to give the effect to the Reverse Stock Split; |
| · | on February 18, 2011, we completed the Private Placement with investments from (1) affiliates of each of The Carlyle Group (“Carlyle”) and Anchorage Capital Group, L.L.C. (together with Carlyle, the “Lead Investors”) pursuant to investment agreements with each of the Lead Investors and (2) various other investors, including certain of our directors and officers, pursuant to subscription agreements with each of such investors; |
| · | concurrently with the closing of the Private Placement, we completed the TARP Exchange of 135,000 shares of our Fixed Rate Cumulative Perpetual Preferred Stock, no par value per share and liquidation preference $1,000 per share, held by the United States Department of the Treasury (the “Treasury”), and accrued and unpaid dividends thereon for 5,620,117 common shares. We also amended the warrant held by the Treasury (the “Amended TARP Warrant”) to, among other things, reduce the exercise price from $255.40 per share to $10 per share. The warrant grants the Treasury the right to purchase 79,288 common shares, subject to adjustment; and |
| · | on May 6, 2011, we completed a $20 million common stock rights offering which allowed shareholders of record as of the close of business on February 17, 2011 or their transferees to purchase newly issued common shares at $10.00 per share. |
The TARP Exchange resulted in a non-cash increase in net income available to common shareholders of $85.1 million as the book value of the preferred stock plus accrued and unpaid dividends was greater than the estimated fair value of the common stock issued to the Treasury of $56.2 million and the fair value of the Amended TARP Warrant at the time of the TARP Exchange. This accounting treatment had no effect on our total shareholders’ equity or our regulatory capital position.
In addition to adjusting the exercise price of the Amended TARP Warrant, its terms were revised to include a “down-round” provision allowing for the future adjustment to the exercise price for any subsequent issuances of common stock by the Company. Subject to certain exceptions, if the Company subsequently issues common stock, or rights or shares convertible into common stock, at a per share price lower than the $10 exercise price of the warrant, the exercise price of the warrant will be reduced to the per share common stock amount received in connection with the issuance and the number of shares of common stock subject to the warrant will be increased. This provision resulted in the warrant being carried as a derivative liability as compared to a common stock equivalent for balance sheet purposes as it possesses the characteristics of a freestanding derivative financial instrument as defined by Accounting Standards Codification (“ASC”) 815-10-15-83, Accounting for Derivatives and Hedging, and similar to the example illustrated in ASC 815-40-55-33 and -34. As a derivative liability, the warrant is carried at fair value, with subsequent remeasurements recorded through the current period's earnings. The initial value attributed to the warrant was $1.7 million, with the fair value estimated using the Black-Scholes options pricing model, with the following assumptions: 67% volatility, a risk-free rate of 3.59%, a yield of 1.45% and an estimated life of 10 years. From February 18, 2011 through March 31, 2011, this instrument’s estimated fair value decreased, which resulted in the recognition of $0.5 million recorded in other noninterest income during the first quarter of 2011. From March 31, 2011 through June 30, 2011, this instrument’s estimated fair value decreased further, which resulted in the recognition of an additional $0.5 million recorded in other noninterest income during the second quarter of 2011.
On June 22, 2011, the Treasury completed a public underwritten offering of 2,850,000 shares of our common stock it received in the TARP Exchange. The Company did not receive any proceeds from this offering. The Treasury continues to hold 2,770,117 shares of our common stock and a warrant to purchase 79,288 shares of our common stock.
In 2009, our Board of Directors suspended the payment of all cash dividends on our common stock. Our ability to pay dividends with respect to common stock is subject to obtaining approval from the FRBSF, DFI and Treasury, and is restricted until our obligations under our trust preferred securities are brought current. Additionally, our ability to pay dividends depends on our ability to obtain dividends from our bank. In addition to obtaining approval from the FDIC and DFI, Hawaii law only permits Central Pacific Bank to pay dividends out of retained earnings. Given that the bank had an accumulated deficit of $468.0 million at June 30, 2011, the bank is prohibited from paying any dividends until this deficit is eliminated. Accordingly, we do not anticipate that the bank will be permitted to pay dividends for the foreseeable future.
12. SHARE-BASED COMPENSATION
Stock Option Activity
The following is a summary of stock option activity for the Company’s stock option plans for the six months ended June 30, 2011:
Components of comprehensive income (loss), net of taxes, for the periods indicated were as follows:
| | Three Months Ended | | | Six Months Ended | |
| | June 30, | | | June 30, | |
| | 2011 | | | 2010 | | | 2011 | | | 2010 | |
| | (Dollars in thousands) | |
| | | | | | | | | | | | |
| Net income (loss) | $ | 8,211 | | | $ | (16,105 | ) | | $ | 12,850 | | | $ | (176,324 | ) |
| Unrealized gain on investment securities | | 10,177 | | | | 3,975 | | | | 11,168 | | | | 1,978 | |
| Unrealized loss on derivatives | | (802 | ) | | | (1,721 | ) | | | (1,918 | ) | | | (3,611 | ) |
| Pension adjustments | | 554 | | | | 516 | | | | 1,109 | | | | 960 | |
| Comprehensive income (loss) | $ | 18,140 | | | $ | (13,335 | ) | | $ | 23,209 | | | $ | (176,997 | ) |
14. PENSION PLANS
Central Pacific Bank has a defined benefit retirement plan (the “Pension Plan”) which covers certain eligible employees. The plan was curtailed effective December 31, 2002, and accordingly, plan benefits were fixed as of that date. The following table sets forth the components of net periodic benefit cost for the Pension Plan:
| | Three Months Ended | | | Six Months Ended | |
| | June 30, | | | June 30, | |
| | 2011 | | | 2010 | | | 2011 | | | 2010 | |
| | (Dollars in thousands) | |
| | | | | | | | | | | | |
| Interest cost | $ | 417 | | | $ | 437 | | | $ | 834 | | | $ | 874 | |
| Expected return on assets | | (457 | ) | | | (428 | ) | | | (914 | ) | | | (856 | ) |
| Amortization of unrecognized loss | | 550 | | | | 514 | | | | 1,100 | | | | 1,028 | |
| Net periodic cost | $ | 510 | | | $ | 523 | | | $ | 1,020 | | | $ | 1,046 | |
The fair values of the defined benefit retirement plan as of June 30, 2011 and December 31, 2010 by asset category were as follows:
| | Level 1 | | | Level 2 | | | Level 3 | | | Total |
| | (Dollars in thousands) |
| June 30, 2011 | | | | | | | | | | |
| Money market accounts | $ | 627 | | | $ | - | | | $ | - | | | $ | 627 |
| Mutual funds | | 7,493 | | | | - | | | | - | | | | 7,493 |
| Government obligations | | - | | | | 4,211 | | | | - | | | | 4,211 |
| Common stocks | | 5,724 | | | | - | | | | - | | | | 5,724 |
| Preferred stocks | | 589 | | | | - | | | | - | | | | 589 |
| Corporate bonds and debentures | | - | | | | 4,154 | | | | - | | | | 4,154 |
| Limited partnerships | | - | | | | 1,170 | | | | - | | | | 1,170 |
| | $ | 14,433 | | | $ | 9,535 | | | $ | - | | | $ | 23,968 |
| | | | | | | | | | | | | | | |
| December 31, 2010 | | | | | | | | | | | | | | |
| Money market accounts | $ | 724 | | | $ | - | | | $ | - | | | $ | 724 |
| Mutual funds | | 7,425 | | | | - | | | | - | | | | 7,425 |
| Government obligations | | - | | | | 3,535 | | | | - | | | | 3,535 |
| Common stocks | | 5,317 | | | | - | | | | - | | | | 5,317 |
| Preferred stocks | | 554 | | | | - | | | | - | | | | 554 |
| Corporate bonds and debentures | | - | | | | 3,482 | | | | - | | | | 3,482 |
| Limited partnerships | | - | | | | 2,183 | | | | - | | | | 2,183 |
| | $ | 14,020 | | | $ | 9,200 | | | $ | - | | | $ | 23,220 |
Our bank also established Supplemental Executive Retirement Plans (“SERPs”), which provide certain officers of our bank with supplemental retirement benefits. The following table sets forth the components of net periodic benefit cost for the SERPs:
| | Three Months Ended | | | Six Months Ended | |
| | June 30, | | | June 30, | |
| | 2011 | | | 2010 | | | 2011 | | | 2010 | |
| | (Dollars in thousands) | |
| | | | | | | | | | | | |
| Service cost | $ | - | | | $ | 7 | | | $ | - | | | $ | 18 | |
| Interest cost | | 103 | | | | 108 | | | | 206 | | | | 216 | |
| Amortization of unrecognized transition obligation | | 4 | | | | 4 | | | | 8 | | | | 8 | |
| Amortization of prior service cost | | 5 | | | | (7 | ) | | | 10 | | | | (14 | ) |
| Amortization of unrecognized (gain) loss | | (4 | ) | | | 5 | | | | (8 | ) | | | 10 | |
| Net periodic cost | $ | 108 | | | $ | 117 | | | $ | 216 | | | $ | 238 | |
15. INCOME TAXES
The valuation allowance for net deferred tax assets at June 30, 2011 and December 31, 2010 was $172.4 million and $178.8 million, respectively. The $6.4 million decrease in our valuation allowance during the first half of 2011 was attributable to a decrease in our net deferred tax assets resulting from the net operating income recognized in the first half of 2011. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the reversal of deferred tax liabilities (including the impact of available carryback and carryforward periods), projected future taxable income and tax-planning strategies in making this assessment. Based upon the Company’s cumulative three year loss position and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Company will be unable to realize the benefits of these deductible differences. The amount of the net deferred tax asset considered realizable, however, could change if estimates of future taxable income during the carryforward period change.
16. EARNINGS (LOSS) PER SHARE
The following table presents the information used to compute basic and diluted earnings (loss) per common share for the periods indicated:
| | Three Months Ended | | | Six Months Ended | |
| | June 30, | | | June 30, | |
| | 2011 | | | 2010 | | | 2011 | | | 2010 | |
| | (In thousands, except per share data) | |
| | | | | | | | | | | | |
| Net income (loss) | $ | 8,211 | | | $ | (16,105 | ) | | $ | 12,850 | | | $ | (176,324 | ) |
| Preferred stock dividends, accretion of discount and | | | | | | | | | | | | | | | |
| conversion of preferred stock to common stock | | - | | | | 2,096 | | | | (83,897 | ) | | | 4,170 | |
| Net income (loss) available to common shareholders | $ | 8,211 | | | $ | (18,201 | ) | | $ | 96,747 | | | $ | (180,494 | ) |
| | | | | | | | | | | | | | | | |
| Weighted average shares outstanding - basic | | 40,700 | | | | 1,515 | | | | 30,059 | | | | 1,514 | |
| Dilutive effect of employee stock options and awards | | 349 | | | | - | | | | 648 | | | | - | |
| Dilutive effect of deferred salary restricted stock units | | 3 | | | | - | | | | 2 | | | | - | |
| Dilutive effect of Treasury warrants | | 26 | | | | - | | | | 24 | | | | - | |
| Weighted average shares outstanding - diluted | | 41,078 | | | | 1,515 | | | | 30,733 | | | | 1,514 | |
| | | | | | | | | | | | | | | | |
| Basic earnings (loss) per share | $ | 0.20 | | | $ | (12.01 | ) | | $ | 3.22 | | | $ | (119.18 | ) |
| Diluted earnings (loss) per share | $ | 0.20 | | | $ | (12.01 | ) | | $ | 3.15 | | | $ | (119.18 | ) |
A total of 41,821 potentially dilutive securities have been excluded from the dilutive share calculation for the three and six months ended June 30, 2011, as their effect was antidilutive, compared to 142,382 for the three and six months ended June 30, 2010.
17. FAIR VALUE OF FINANCIAL ASSETS AND LIABILITIES
Disclosures about Fair Value of Financial Instruments
Fair value estimates, methods and assumptions are set forth below for our financial instruments.
Short-Term Financial Instruments
The carrying values of short-term financial instruments are deemed to approximate fair values. Such instruments are considered readily convertible to cash and include cash and due from banks, interest-bearing deposits in other banks, accrued interest receivable, the majority of short-term borrowings and accrued interest payable.
Investment Securities
The fair value of investment securities is based on market price quotations received from securities dealers. Where quoted market prices are not available, fair values are based on quoted market prices of comparable securities.
Loans
Fair values of loans are estimated based on discounted cash flows of portfolios of loans with similar financial characteristics including the type of loan, interest terms and repayment history. Fair values are calculated by discounting scheduled cash flows through estimated maturities using estimated market discount rates. Estimated market discount rates are reflective of credit and interest rate risks inherent in the Company’s various loan types and are derived from available market information, as well as specific borrower information. The fair value of loans are not based on the notion of exit price.
Other Interest Earning Assets
The equity investment in common stock of the FHLB, which is redeemable for cash at par value, is reported at its par value.
Deposit Liabilities
The fair values of deposits with no stated maturity, such as noninterest-bearing demand deposits and interest-bearing demand and savings accounts, are equal to the amount payable on demand. The fair value of time deposits is based on the higher of the discounted value of contractual cash flows or its carrying value. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.
Short-Term Borrowings and Long-Term Debt
The fair value for a portion of our short-term borrowings is estimated by discounting scheduled cash flows using rates currently offered for securities of similar remaining maturities. The fair value of our long-term debt, primarily FHLB advances, is estimated by discounting scheduled cash flows over the contractual borrowing period at the estimated market rate for similar borrowing arrangements.
Off-Balance Sheet Financial Instruments
The fair values of off-balance sheet financial instruments are estimated based on the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties, current settlement values or quoted market prices of comparable instruments.
For derivative financial instruments, the fair values are based upon current settlement values, if available. If there are no relevant comparables, fair values are based on pricing models using current assumptions for interest rate swaps and options.
Limitations
Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time our entire holdings of a particular financial instrument. Because no market exists for a significant portion of our 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.
Fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of future business and the value of assets and liabilities that are not considered financial instruments. For example, significant assets and liabilities that are not considered financial assets or liabilities include deferred tax assets, premises and equipment and intangible assets. In addition, 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.
| | June 30, 2011 | | | December 31, 2010 | |
| | Carrying/ | | | | | | Carrying/ | | | | |
| | notional | | | Estimated | | | notional | | | Estimated | |
| | amount | | | fair value | | | amount | | | fair value | |
| | (Dollars in thousands) | |
| Financial assets | | | | | | | | | | | |
| Cash and due from banks | $ | 68,986 | | | $ | 68,986 | | | $ | 61,725 | | | $ | 61,725 | |
| Interest-bearing deposits in other banks | | 384,477 | | | | 384,477 | | | | 729,014 | | | | 729,014 | |
| Investment securities | | 1,401,958 | | | | 1,402,011 | | | | 705,345 | | | | 705,430 | |
| Net loans and leases, including loans held for sale | | 1,902,103 | | | | 1,825,194 | | | | 2,046,338 | | | | 1,985,261 | |
| Accrued interest receivable | | 11,711 | | | | 11,711 | | | | 11,279 | | | | 11,279 | |
| | | | | | | | | | | | | | | | |
| Financial liabilities | | | | | | | | | | | | | | | |
| Deposits: | | | | | | | | | | | | | | | |
| Noninterest-bearing deposits | | 687,468 | | | | 687,468 | | | | 611,744 | | | | 611,744 | |
| Interest-bearing demand and savings deposits | | 1,636,386 | | | | 1,636,386 | | | | 1,729,361 | | | | 1,729,361 | |
| Time deposits | | 906,466 | | | | 906,708 | | | | 791,842 | | | | 793,333 | |
Total deposits | | 3,230,320 | | | | 3,230,562 | | | | 3,132,947 | | | | 3,134,438 | |
| Short-term borrowings | | 1,385 | | | | 1,385 | | | | 202,480 | | | | 202,351 | |
| Long-term debt | | 409,076 | | | | 332,619 | | | | 459,803 | | | | 407,175 | |
| Accrued interest payable (included in other liabilities) | | 9,352 | | | | 9,352 | | | | 9,528 | | | | 9,528 | |
| | | | | | | | | | | | | | | | |
| Off-balance sheet financial instruments | | | | | | | | | | | | | | | |
| Commitments to extend credit | | 441,800 | | | | 2,209 | | | | 415,005 | | | | 2,075 | |
| Standby letters of credit and financial guarantees written | | 12,863 | | | | 96 | | | | 11,056 | | | | 83 | |
| Interest rate options | | 33,428 | | | | (114 | ) | | | 63,994 | | | | (170 | ) |
| Forward interest rate contracts | | 17,820 | | | | (12 | ) | | | 40,658 | | | | 682 | |
| Forward foreign exchange contracts | | - | | | | - | | | | 1,889 | | | | 1,891 | |
Fair Value Measurements
We group our financial assets and liabilities at fair value into three levels based on the markets in which the financial assets and liabilities are traded and the reliability of the assumptions used to determine fair value as follows:
| · | Level 1 – Valuation is based upon quoted prices (unadjusted) for identical assets or liabilities traded in active markets. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available. |
| · | Level 2 – Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. |
| · | Level 3 – Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect our own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of discounted cash flow models and similar techniques that requires the use of significant judgment or estimation. |
We base our fair values on the price that we would expect to receive if an asset were sold or pay to transfer a liability in an orderly transaction between market participants at the measurement date. We also maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements.
We use fair value measurements to record adjustments to certain financial assets and liabilities and to determine fair value disclosures. Available for sale securities and derivatives are recorded at fair value on a recurring basis. From time to time, we may be required to record other financial assets at fair value on a nonrecurring basis such as loans held for sale, impaired loans and mortgage servicing rights. These nonrecurring fair value adjustments typically involve application of the lower of cost or fair value accounting or write-downs of individual assets.
The following table presents the balances of assets and liabilities measured at fair value on a recurring basis as of June 30, 2011 and December 31, 2010:
| | | | | Fair Value at Reporting Date Using |
| | | | | Quoted Prices in Active Markets for Identical Assets | | | Significant Other Observable Inputs | | | Significant Unobservable Inputs |
| | Fair Value | | | (Level 1) | | | (Level 2) | | | (Level 3) |
| | (Dollars in thousands) |
| June 30, 2011 | | | | | | | | | | |
| Available for sale securities: | | | | | | | | | | |
| U.S. Government sponsored entities debt securities | $ | 384,780 | | | $ | - | | | $ | 384,780 | | | $ | - |
| States and political subdivisions | | 12,443 | | | | - | | | | - | | | | 12,443 |
| U.S. Government sponsored entities mortgage-backed securities | | 1,002,146 | | | | - | | | | 1,002,146 | | | | - |
| Non-agency collateralized mortgage obligations | | 17 | | | | - | | | | - | | | | 17 |
| Other | | 994 | | | | 994 | | | | - | | | | - |
| Derivatives: | | | | | | | | | | | | | | |
| Interest rate contracts | | (126 | ) | | | - | | | | (126 | ) | | | - |
| Amended TARP Warrant | | (753 | ) | | | - | | | | (753 | ) | | | - |
| Total | $ | 1,399,501 | | | $ | 994 | | | $ | 1,386,047 | | | $ | 12,460 |
| | | | | | | | | | | | | | | |
| December 31, 2010 | | | | | | | | | | | | | | |
| Available for sale securities: | | | | | | | | | | | | | | |
| U.S. Government sponsored entities debt securities | $ | 201,855 | | | $ | - | | | $ | 201,855 | | | $ | - |
| States and political subdivisions | | 12,619 | | | | - | | | | - | | | | 12,619 |
| U.S. Government sponsored entities mortgage-backed securities | | 486,964 | | | | - | | | | 486,964 | | | | - |
| Non-agency collateralized mortgage obligations | | 17 | | | | - | | | | - | | | | 17 |
| Other | | 1,062 | | | | 1,062 | | | | - | | | | - |
| Derivatives: | | | | | | | | | | | | | | |
| Interest rate contracts | | 512 | | | | - | | | | 512 | | | | - |
| Total | $ | 703,029 | | | $ | 1,062 | | | $ | 689,331 | | | $ | 12,636 |
For the six months ended June 30, 2011 and 2010, the changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:
| | Available for sale securities | | | Available for sale non- agency collateralized mortgage obligations (1) | |
| | (Dollars in thousands) | |
| | | | | | |
| Balance at December 31, 2010 | $ | 12,619 | | | $ | 17 | |
| Principal payments received | | (176 | ) | | | - | |
| Balance at June 30, 2011 | $ | 12,443 | | | $ | 17 | |
| | | | | | | | |
| Balance at December 31, 2009 | $ | 13,778 | | | $ | 46,469 | |
| Principal payments received | | (195 | ) | | | (1,052 | ) |
| Realized net losses included in net loss | | - | | | | (7,275 | ) |
| Unrealized net gains included in other comprehensive loss | | - | | | | 6,222 | |
| Sales | | - | | | | (44,347 | ) |
| Balance at June 30, 2010 | $ | 13,583 | | | $ | 17 | |
| | | | | | | | |
| (1) Represents available for sale non-agency collateralized mortgage obligations previously classified as | |
| Level 2 for which the market became inactive during 2008; therefore the fair value measurement was | |
| derived from discounted cash flow models using unobservable inputs and assumptions. | |
For assets measured at fair value on a nonrecurring basis that were recorded at fair value on our balance sheet at June 30, 2011 and December 31, 2010, the following table provides the level of valuation assumptions used to determine the respective fair values:
| | | | | Fair Value Measurements Using |
| | | | | Quoted Prices in Active Markets for Identical Assets | | | Significant Other Observable Inputs | | | Significant Unobservable Inputs |
| | Fair Value | | | (Level 1) | | | (Level 2) | | | (Level 3) |
| | (Dollars in thousands) |
| June 30, 2011 | | | | | | | | | | |
| Impaired loans (1) | $ | 200,419 | | | $ | - | | | $ | 200,419 | | | $ | - |
| Other real estate (2) | | 42,863 | | | | - | | | | 42,863 | | | | - |
| | | | | | | | | | | | | | | |
| December 31, 2010 | | | | | | | | | | | | | | |
| Loans held for sale (1) | $ | 35,300 | | | $ | - | | | $ | 35,300 | | | $ | - |
| Impaired loans (1) | | 205,509 | | | | - | | | | 205,509 | | | | - |
| Other real estate (2) | | 57,507 | | | | - | | | | 57,507 | | | | - |
| | | | | | | | | | | | | | | |
| (1) Represents carrying value and related write-downs of loans for which adjustments are based on agreed |
| upon purchase prices for the loans or the appraised value of the collateral. |
| | | | | | | | | | | | | | | |
| (2) Represents other real estate that is carried at the lower of carrying value or fair value less costs to sell. |
| Fair value is generally based upon independent market prices or appraised values of the collateral. |
18. SEGMENT INFORMATION
We have three reportable segments: Commercial Real Estate, Hawaii Market and Treasury. The segments reported are consistent with internal functional reporting lines. They are managed separately because each unit has different target markets, technological requirements, marketing strategies and specialized skills.
The Commercial Real Estate segment includes construction and real estate development lending in Hawaii, California and Washington. The Hawaii Market segment includes retail branch offices, commercial lending, residential mortgage lending and servicing, indirect auto lending, trust services and retail brokerage services. A full range of deposit and loan products and various other banking services are offered. The Treasury segment is responsible for managing the Company's investment securities portfolio and wholesale funding activities. The All Others category includes activities such as electronic banking, data processing and management of bank owned properties.
The accounting policies of the segments are consistent with the Company's accounting policies that are described in Note 1 to the consolidated financial statements in the Annual Report on Form 10-K for the year ended December 31, 2010 filed with the SEC. The majority of the Company’s net income is derived from net interest income. Accordingly, management focuses primarily on net interest income, rather than gross interest income and expense amounts, in evaluating segment profitability.
Intersegment net interest income (expense) was allocated to each segment based upon a funds transfer pricing process that assigns costs of funds to assets and earnings credits to liabilities based on market interest rates that reflect interest rate sensitivity and maturity characteristics. All administrative and overhead expenses are allocated to the segments at cost. Cash, investment securities, loans and leases and their related balances are allocated to the segment responsible for acquisition and maintenance of those assets. Segment assets also include all premises and equipment used directly in segment operations.
Segment profits (losses) and assets are provided in the following table for the periods indicated.
| | Commercial | | | Hawaii | | | | | | | | | | |
| | Real Estate | | | Market | | | Treasury | | | All Others | | | Total | |
| | (Dollars in thousands) | |
| Three months ended June 30, 2011: | | | | | | | | | | | | | | |
| Net interest income | $ | 6,578 | | | $ | 16,727 | | | $ | 5,674 | | | $ | - | | | $ | 28,979 | |
| Intersegment net interest income (expense) | | (4,339 | ) | | | 15,423 | | | | (5,074 | ) | | | (6,010 | ) | | | - | |
| Credit (provision) for loan and lease losses | | 20,411 | | | | (11,627 | ) | | | - | | | | - | | | | 8,784 | |
| Other operating income | | 224 | | | | 8,668 | | | | 1,704 | | | | 341 | | | | 10,937 | |
| Other operating expense | | (4,073 | ) | | | (22,387 | ) | | | (138 | ) | | | (13,891 | ) | | | (40,489 | ) |
| Administrative and overhead expense allocation | | (984 | ) | | | (12,066 | ) | | | (127 | ) | | | 13,177 | | | | - | |
| Net income (loss) | $ | 17,817 | | | $ | (5,262 | ) | | $ | 2,039 | | | $ | (6,383 | ) | | $ | 8,211 | |
| | | | | | | | | | | | | | | | | | | | |
| Three months ended June 30, 2010: | | | | | | | | | | | | | | | | | | | |
| Net interest income | $ | 12,279 | | | $ | 16,491 | | | $ | 426 | | | $ | - | | | $ | 29,196 | |
| Intersegment net interest income (expense) | | (8,271 | ) | | | 8,158 | | | | 1,276 | | | | (1,163 | ) | | | - | |
| Provision for loan and lease losses | | (1,800 | ) | | | (18,612 | ) | | | - | | | | - | | | | (20,412 | ) |
| Other operating income | | 254 | | | | 9,838 | | | | 2,662 | | | | (17 | ) | | | 12,737 | |
| Other operating expense | | (4,371 | ) | | | (20,565 | ) | | | (352 | ) | | | (12,338 | ) | | | (37,626 | ) |
| Administrative and overhead expense allocation | | (1,195 | ) | | | (10,178 | ) | | | (114 | ) | | | 11,487 | | | | - | |
| Net income (loss) | $ | (3,104 | ) | | $ | (14,868 | ) | | $ | 3,898 | | | $ | (2,031 | ) | | $ | (16,105 | ) |
| | | | | | | | | | | | | | | | | | | | |
| Six months ended June 30, 2011: | | | | | | | | | | | | | | | | | | | |
| Net interest income | $ | 14,319 | | | $ | 33,410 | | | $ | 9,451 | | | $ | - | | | $ | 57,180 | |
| Intersegment net interest income (expense) | | (9,140 | ) | | | 30,650 | | | | (6,297 | ) | | | (15,213 | ) | | | - | |
| Credit (provision) for loan and lease losses | | 21,611 | | | | (11,252 | ) | | | - | | | | - | | | | 10,359 | |
| Other operating income | | 492 | | | | 18,775 | | | | 3,343 | | | | 827 | | | | 23,437 | |
| Other operating expense | | (8,501 | ) | | | (43,405 | ) | | | (227 | ) | | | (25,993 | ) | | | (78,126 | ) |
| Administrative and overhead expense allocation | | (1,923 | ) | | | (22,829 | ) | | | (252 | ) | | | 25,004 | | | | - | |
| Net income (loss) | $ | 16,858 | | | $ | 5,349 | | | $ | 6,018 | | | $ | (15,375 | ) | | $ | 12,850 | |
| | | | | | | | | | | | | | | | | | | | |
| Six months ended June 30, 2010: | | | | | | | | | | | | | | | | | | | |
| Net interest income | $ | 25,611 | | | $ | 33,060 | | | $ | 5,594 | | | $ | - | | | $ | 64,265 | |
| Intersegment net interest income (expense) | | (18,212 | ) | | | 17,828 | | | | (440 | ) | | | 824 | | | | - | |
| Provision for loan and lease losses | | (42,100 | ) | | | (37,149 | ) | | | - | | | | - | | | | (79,249 | ) |
| Other operating income | | 469 | | | | 19,650 | | | | 5,520 | | | | (138 | ) | | | 25,501 | |
| Goodwill impairment | | - | | | | (102,689 | ) | | | - | | | | - | | | | (102,689 | ) |
| Other operating expense (excluding goodwill impairment) | | (14,984 | ) | | | (42,475 | ) | | | (1,017 | ) | | | (25,676 | ) | | | (84,152 | ) |
| Administrative and overhead expense allocation | | (2,410 | ) | | | (20,257 | ) | | | (216 | ) | | | 22,883 | | | | - | |
| Net income (loss) | $ | (51,626 | ) | | $ | (132,032 | ) | | $ | 9,441 | | | $ | (2,107 | ) | | $ | (176,324 | ) |
| | | | | | | | | | | | | | | | | | | | |
| At June 30, 2011: | | | | | | | | | | | | | | | | | | | |
| Investment securities | $ | - | | | $ | - | | | $ | 1,401,958 | | | $ | - | | | $ | 1,401,958 | |
| Loans and leases (including loans held for sale) | | 565,875 | | | | 1,503,162 | | | | - | | | | - | | | | 2,069,037 | |
| Other | | (69,796 | ) | | | 32,833 | | | | 624,934 | | | | 72,767 | | | | 660,738 | |
| Total assets | $ | 496,079 | | | $ | 1,535,995 | | | $ | 2,026,892 | | | $ | 72,767 | | | $ | 4,131,733 | |
| | | | | | | | | | | | | | | | | | | | |
| At December 31, 2010: | | | | | | | | | | | | | | | | | | | |
| Investment securities | $ | - | | | $ | - | | | $ | 705,345 | | | $ | - | | | $ | 705,345 | |
| Loans and leases (including loans held for sale) | | 699,344 | | | | 1,539,848 | | | | - | | | | - | | | | 2,239,192 | |
| Other | | (49,396 | ) | | | 6,228 | | | | 958,665 | | | | 78,017 | | | | 993,514 | |
| Total assets | $ | 649,948 | | | $ | 1,546,076 | | | $ | 1,664,010 | | | $ | 78,017 | | | $ | 3,938,051 | |
19. LEGAL PROCEEDINGS
Overdraft Litigation
In March 2011, the Company and the bank were named as defendants in a putative class action captioned as Gregory and Camila Peterson, individually and on behalf of all others similarly situated, Plaintiffs, v. Central Pacific Bank, Central Pacific Financial Corp. and Doe Defendants 1-50, Defendants, Case No. 11-1-0457-03 VLC, in the First Circuit Court of Hawaii in Honolulu. The complaint asserts claims for unconscionability, conversion, unjust enrichment, and violations of Hawaii’s Uniform Deceptive Trade Practice Act, relating to the bank’s overdraft practices and fees. Plaintiffs seek declaratory relief, restitution, disgorgement, damages, interest, costs and attorneys’ fees. As of the date of this filing, we are in discussions with the plaintiffs to resolve the matter and the parties have agreed to perform additional diligence in an attempt to reach an acceptable outcome. Because this diligence is ongoing, at this time, we are not able to estimate the amount of costs or a reasonable range of potential costs that the Company may need to incur to resolve this matter.
Other Litigation
We are involved in other legal actions arising in the ordinary course of business. Management, after consultation with our legal counsel, believes the ultimate disposition of those matters will not have a material adverse effect on our consolidated financial statements.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
Central Pacific Financial Corp. (“CPF”) is a Hawaii corporation and a bank holding company. Our principal business is to serve as a holding company for our bank subsidiary, Central Pacific Bank. We refer to Central Pacific Bank herein as “our bank” or “the bank,” and when we say “the Company,” “we,” “us” or “our,” we mean the holding company on a consolidated basis with the bank and our other consolidated subsidiaries.
Central Pacific Bank is a full-service community bank with 34 branches and 120 ATMs located throughout the state of Hawaii. The bank offers a broad range of products and services including accepting time and demand deposits and originating loans, including commercial loans, construction loans, commercial and residential mortgage loans, and consumer loans. The bank also has a loan production office in California. As part of our recovery plan, which is described more fully under “—Capital Resources” below, we plan to continue to reduce our exposure to the Mainland.
Recent Events
On April 12, 2011, we announced that the registration statement registering the common shares issued to certain investors in our $325 million capital raise completed in February 2011 (the “Private Placement”) was declared effective by the U.S. Securities and Exchange Commission (“SEC”). The registration statement covers the offer and sale by certain selling shareholders of up to 18,487,715 shares of common stock, no par value per share, which includes 79,288 shares underlying a warrant issued to the United States Department of the Treasury (the “Treasury”). The Company will not receive any proceeds from the sale of common shares by any selling shareholder.
On April 20, 2011, following regulatory approval, we announced the appointments of Crystal K. Rose as Chair of the Board of Directors of CPF and Central Pacific Bank (“CPB”) and John C. Dean, former Executive Chairman of CPF and CPB, as President and Chief Executive Officer (“CEO”) of CPF and CPB. Mr. Dean continues to serve as a director of both the CPF and CPB boards.
In May 2011, we completed our previously announced rights offering (the “Rights Offering”) totaling approximately $20 million whereby shareholders of record as of close of business on February 17, 2011, and their transferees purchased approximately 2,000,000 newly-issued common shares following the expiration of the offering on May 6, 2011 at the same price per share paid by the investors in the Private Placement. The Rights Offering was part of our recapitalization plan.
On June 22, 2011, the Treasury completed a public underwritten offering of 2,850,000 shares of our common stock it received in the TARP Exchange. The Company did not receive any proceeds from this offering. The Treasury continues to hold 2,770,117 shares of our common stock and a warrant to purchase 79,288 shares of our common stock.
Regulatory Matters
In May 2011, the regulatory Consent Order (the “Consent Order”) that the bank entered into with the Federal Deposit Insurance Corporation (the “FDIC”) and the Hawaii Division of Financial Institutions (the “DFI”) on December 9, 2009 was lifted. In place of the Consent Order, the Board of Directors of the bank entered into a Memorandum of Understanding (the “Bank MOU”) with the FDIC and DFI effective May 5, 2011. The Bank MOU continues a number of the same requirements previously required by the Consent Order, including the maintenance of an adequate allowance for loan and lease losses, improvement of our asset quality, limitations on credit extensions, maintenance of qualified management and the prohibition on cash dividends to CPF, among other matters. In addition, the Bank MOU requires the bank to further reduce classified assets below the level previously required by the Consent Order. The Bank MOU lowers the minimum leverage capital ratio that the bank is required to maintain from 10% in the Consent Order to 8% and does not mandate a minimum total risk-based capital ratio.
In addition to the Bank MOU, the Company continues to be subject to a Written Agreement (the “Agreement”) with the Federal Reserve Bank of San Francisco (the “FRBSF”) and DFI dated July 2, 2010, which superseded in its entirety the Memorandum of Understanding that the Company entered into on April 1, 2009 with the FRBSF and DFI. Among other matters, the Agreement provides that unless we receive the consent of the FRBSF and DFI, we cannot: (i) pay dividends; (ii) receive dividends or payments representing a reduction in capital from the bank; (iii) directly or through our non-bank subsidiaries make any payments on subordinated debentures or trust preferred securities; (iv) directly or through any non-bank subsidiaries incur, increase or guarantee any debt; or (v) purchase or redeem any shares of our stock. The Agreement requires that our Board of Directors fully utilize the Company's financial and managerial resources to ensure that the bank complies with the Bank MOU and any other supervisory action taken by the bank’s regulators. We were also required to submit to the FRBSF an acceptable capital plan and cash flow projection.
On February 9, 2011, the bank entered into a separate Memorandum of Understanding (the “BSA MOU”) with the FDIC and DFI relating to compliance with the Bank Secrecy Act (the “BSA”). Under the BSA MOU, the bank is required to (i) fully comply with the BSA and anti-money laundering requirements, (ii) implement a plan to ensure such compliance, including improving and maintaining an adequate system of internal controls, bolstering policies on customer due diligence, providing for comprehensive independent testing to validate compliance, and maintaining an adequate compliance staff, (iii) correct all deficiencies identified by our regulators and (iv) provide them with progress reports.
Even though the Consent Order has been replaced by the Bank MOU, the bank remains subject to a number of requirements as described above. We cannot assure you whether or when the Company and the bank will be in full compliance with the agreements with the regulators or whether or when the Bank MOU, the Agreement and the BSA MOU will be terminated. Even if terminated, we may still be subject to other agreements with regulators that restrict our activities and may also continue to impose capital ratios requirements. The requirements and restrictions of the Bank MOU, the Agreement and the BSA MOU are judicially enforceable and the Company or the bank's failure to comply with such requirements and restrictions may subject the Company and the bank to additional regulatory restrictions including: the imposition of a new consent order; the imposition of civil monetary penalties; the termination of insurance of deposits; the issuance of removal and prohibition orders against institution-affiliated parties; the appointment of a conservator or receiver for the bank; the issuance of directives to increase capital or enter into a strategic transaction, whether by merger or otherwise, with a third party, if we again fall below the capital ratio requirements; and the enforcement of such actions through injunctions or restraining orders.
Legislative Matters
On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The Dodd-Frank Act resulted in sweeping changes in the regulation of financial institutions aimed at strengthening the sound operation of the financial services sector. The Dodd-Frank Act includes the following provisions that, among other things:
| | • | Centralize responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau, responsible for implementing, examining and, for large financial institutions, enforcing compliance with federal consumer financial laws. At the federal level, the FDIC will continue to examine us for compliance with such laws. |
| | • | Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminate the ceiling on the size of the Deposit Insurance Fund (the “DIF”) and increase the floor of the size of the DIF. |
| | • | Apply the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies. |
| | • | Require the FDIC and Federal Reserve System (“FRB”) to seek to make their respective capital requirements for state nonmember banks and bank holding companies countercyclical so that capital requirements increase in times of economic expansion and decrease in times of economic contraction. |
| | • | Implement corporate governance revisions, including with regard to executive compensation and proxy access by shareholders, that apply to all public companies, not just financial institutions. |
| | • | Make permanent the $250,000 limit for federal deposit insurance and increase the cash limit of Securities Investor Protection Corporation protection from $100,000 to $250,000 and provide unlimited federal deposit insurance until December 31, 2012 for non-interest bearing demand transaction accounts at all insured depository institutions. |
| | • | Repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts. |
| | • | Increase the authority of the Federal Reserve to examine us and any of our non-bank subsidiaries. |
| | • | Authorize the FDIC to assess the cost of examinations (the FDIC does not currently assess fees for examining Central Pacific Bank). |
Some of these provisions may have the consequence of increasing our expenses, decreasing our revenues, and changing the activities in which we choose to engage. The environment in which banking organizations will now operate, including legislative and regulatory changes affecting capital, liquidity, supervision, permissible activities, corporate governance and compensation, changes in fiscal policy and steps to eliminate government support for banking organizations, may have long-term effects on the business model and profitability of banking organizations that cannot now be foreseen. Provisions in the legislation that revoke the Tier 1 capital treatment of trust preferred securities do not apply to our debt and equity instruments issued before May 19, 2010, as we are grandfathered under an exception for depositary institution holding companies with total consolidated assets of less than $15 billion as of December 31, 2009. The specific impact of the Dodd-Frank Act on our current activities or new financial activities we may consider in the future, our financial performance and the markets in which we operate will depend on the manner in which the relevant agencies develop and implement the required rules and the reaction of market participants to these regulatory developments. Although some rules under the Dodd-Frank Act have become effective, many aspects of the Dodd-Frank Act are still subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on us, our customers or the financial industry more generally.
Recovery Plan Progress
As previously disclosed, we adopted and implemented a recovery plan in March 2010 to improve our financial health by completing a significant recapitalization, reducing our credit risk exposure and returning to profitability by focusing on our core businesses and traditional markets in Hawaii.
As of June 30, 2011, we have accomplished a number of key milestones in our recovery plan, including:
| · | On February 18, 2011, we successfully completed the $325 million Private Placement. Concurrently with the completion of the Private Placement, we exchanged our TARP preferred stock and accrued and unpaid dividends thereon for common stock (the “TARP Exchange”). |
| · | On May 6, 2011, we sucessfully completed the $20 million Rights Offering. |
| · | The Consent Order was lifted and replaced with the Bank MOU. |
| · | We significantly improved our tier 1 risk-based capital, total risk-based capital, and leverage capital ratios as of June 30, 2011 to 22.48%, 23.80%, and 13.13%, respectively, from 7.64%, 8.98%, and 4.42%, respectively, as of December 31, 2010. Our capital ratios currently exceed the minimum level required by the Bank MOU and are above the levels required for a “well-capitalized” regulatory designation. |
| · | We reported two consecutive profitable quarters with net income of $8.2 million and $4.6 million in the second and first quarters of 2011, respectively. |
| · | We reduced our nonperforming assets by $53.5 million to $249.3 million at June 30, 2011 from $302.8 million at December 31, 2010. |
| · | We reduced our construction and development loan portfolio (excluding owner-occupied loans) as of June 30, 2011 to $226.5 million, or 11.1% of our total loan portfolio. At December 31, 2010, this portfolio totaled $299.9 million, or 13.8% of our total loan portfolio. |
| · | We maintained an allowance for loan and lease losses as a percentage of total loans and leases of 8.16% at June 30, 2011, compared to 8.89% at December 31, 2010. In addition, we maintained an allowance for loan and lease losses as a percentage of nonperforming assets of 66.95% at June 30, 2011, compared to 63.69% at December 31, 2010. |
| · | We reduced total outstanding borrowings with the Federal Home Loan Bank of Seattle (the “FHLB”) to $301.0 million at June 30, 2011 from $551.3 million at December 31, 2010. |
Basis of Presentation
Management’s discussion and analysis of financial condition and results of operations should be read in conjunction with the accompanying consolidated financial statements under “Part I, Item 1. Financial Statements (Unaudited).”
Critical Accounting Policies
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”) requires that management make certain judgments and use certain estimates and assumptions that affect amounts reported and disclosures made. Accounting estimates are deemed critical when a different estimate could have reasonably been used or where changes in the estimate are reasonably likely to occur from period to period and would materially impact our consolidated financial statements as of or for the periods presented. Management has discussed the development and selection of the critical accounting estimates noted below with the audit committee of the board of directors, and the audit committee has reviewed the accompanying disclosures.
Allowance for Loan and Lease Losses
The allowance for loan and lease losses (the “Allowance”) is management’s estimate of credit losses inherent in our loan and lease portfolio at the balance sheet date. We maintain our Allowance at an amount we expect to be sufficient to absorb probable losses inherent in our loan and lease portfolio based on a projection of probable net loan charge-offs.
For loans classified as impaired, an estimated impairment loss is calculated. To estimate loan charge-offs on other loans, we evaluate the level and trend of nonperforming and potential problem loans and historical loss experience. We also consider other relevant economic conditions and borrower-specific risk characteristics, including current repayment patterns of our borrowers, the fair value of collateral securing specific loans, changes in our lending and underwriting standards and general economic factors, nationally and in the markets we serve, including the real estate market generally and the residential and commercial construction markets in particular. Estimated loss rates are determined by loan category and risk profile, and an overall required Allowance is calculated, which includes amounts for imprecision and uncertainty. Based on our estimate of the level of Allowance required, a provision for loan and lease losses (the “Provision”) is recorded to maintain the Allowance at an appropriate level.
Our policy is to charge a loan off in the period in which the loan is deemed to be uncollectible. We consider a loan to be uncollectible when it is probable that a loss has been incurred and the Company can make a reasonable estimate of the loss. In these instances, the likelihood of and/or timeframe for recovery of the amount due is uncertain, weak, or protracted.
Our process for determining the reserve for unfunded commitments is consistent with our process for determining the Allowance and is adjusted for estimated loan funding probabilities. Reserves for unfunded commitments are recorded separately through a valuation allowance included in other liabilities. Credit losses for off-balance sheet credit exposures are deducted from the allowance for credit losses on off-balance sheet credit exposures in the period in which the liability is settled. The allowance for credit losses on off-balance sheet credit losses is established by a charge to other operating expense.
In the second quarter of 2011, we recorded a credit to the Provision of $8.8 million. We had an Allowance, as a percentage of total loans and leases, of 8.16% at June 30, 2011, compared to 8.89% at December 31, 2010. Although our credit risk profile has improved in recent quarters and general economic trends and market conditions have shown signs of stabilization to some degree, as further described in the “Material Trends” section below, concerns over the global and U.S. economies still remain. Accordingly, it is possible that the Hawaii or California real estate markets could begin to deteriorate further. If this occurs, it would result in an increase in loan delinquencies, an increase in loan charge-offs or a need for additional increases in our Allowance; any of which would require an increase in our Provision. Even if economic conditions improve or stay the same, it is possible that we may experience material credit losses and in turn, increases to our Allowance and Provision, due to the elevated risk still inherent in our existing loan portfolio resulting from our high concentration of commercial real estate and construction loans.
Additionally, when establishing our Allowance, we made certain assumptions and judgments with respect to the quality of our loan portfolio. As the economy began to deteriorate in the second half of 2007 and real estate values declined, we found that many of the assumptions and judgments that we made at the time needed to be materially changed in subsequent periods, which resulted in rapid negative credit migration and substantial losses in fiscal 2008, 2009, and 2010. Because of the potential volatility that still exists in the marketplace, we are not able to predict the potential increases that we may need to incur in our Allowance if real estate values do not improve or continue to decline in the markets that we serve, or if the financial condition of our borrowers declines or fails as a result of their continued exposure to the real estate markets and other financial stresses.
Since we cannot predict with certainty the amount of loan and lease charge-offs that will be incurred and because the eventual level of loan and lease charge-offs are impacted by numerous conditions beyond our control, we use our historical loss experience adjusted for current conditions to determine the Allowance and Provision. In addition, various regulatory agencies, as an integral part of their examination processes, periodically review our Allowance. Such agencies may require that we recognize additions to the Allowance based on their judgments about information available to them at the time of their examination. Accordingly, actual results could differ from those estimates. Changes in the estimate of the Allowance and related Provision could materially affect our operating results. The determination of the Allowance requires us to make estimates of losses that are highly uncertain and involves a high degree of judgment.
Loans Held for Sale
Loans held for sale consists of Hawaii residential mortgage loans, as well as Hawaii and Mainland construction and commercial real estate loans. Hawaii residential mortgage loans classified as held for sale are carried at the lower of cost or fair value on an aggregate basis while the Hawaii and Mainland construction and commercial real estate loans are recorded at the lower of cost or fair value on an individual basis.
Loans originated with the intent to be held in our portfolio are subsequently transferred to held for sale when a decision is made to sell these loans. At the time of a loan’s transfer to the held for sale account, the loan is recorded at the lower of cost or fair value. Any reduction in the loan’s value is reflected as a write-down of the recorded investment resulting in a new cost basis, with a corresponding reduction in the Allowance.
In subsequent periods, if the fair value of a loan classified as held for sale is less than its cost basis, a valuation adjustment is recognized in our consolidated statement of operations in other operating expense and the carrying value of the loan is adjusted accordingly. The valuation adjustment may be recovered in the event that the fair value increases, which is also recognized in our consolidated statement of operations in other operating expense.
The fair value of loans classified as held for sale are generally based upon quoted prices for similar assets in active markets, acceptance of firm offer letters with agreed upon purchase prices, discounted cash flow models that take into account market observable assumptions, or independent appraisals of the underlying collateral securing the loans. We report the fair values of Hawaii and mainland construction and commercial real estate loans net of applicable selling costs on our consolidated balance sheets.
Reserve for Residential Mortgage Loan Repurchase Losses
We sell residential mortgage loans on a “whole-loan” basis to government-sponsored entities (“GSEs” or “Agencies”) Fannie Mae and Freddie Mac and also to non-agency investors. These loan sales occur under industry standard contractual provisions that include various representations and warranties, which typically cover ownership of the loan, compliance with loan criteria set forth in the applicable agreement, validity of the lien securing the loan, and other similar matters. We may be required to repurchase certain loans sold with identified defects, indemnify the investor, or reimburse the investor for any credit losses incurred. We establish mortgage repurchase reserves related to various representations and warranties that reflect management’s estimate of losses for loans for which we could have repurchase obligation. The reserves are established by a charge to other operating expense in our consolidated statements of operation. At June 30, 2011 and December 31, 2010, this reserve totaled $6.7 million and $5.0 million, respectively, and is included in other liabilities on our consolidated balance sheets.
The repurchase reserve is applicable to loans we originated and sold with representations and warranties, which is representative of the entire sold portfolio. Originations for agency and non-agency for vintages 2005 through June 30, 2011 were approximately $3.1 billion and $2.8 billion, respectively. Outstanding balances for agency and non-agency (estimated) for vintages 2005 through 2011 as of June 30, 2011 were $2.3 billion and $1.7 billion, respectively. Representations and warranties relating to borrower fraud generally are enforceable for the life of the loan, whereas early payment default clauses generally expire after 90 days, depending on the sales contract. We estimate that outstanding loans sold that have early payment default clauses as of June 30, 2011 total approximately $95.5 million.
The repurchase loss liability is estimated by origination year to capture certain characteristics of each vintage, e.g., economic and housing market conditions, mortgage loan defaults, underwriting standards, etc. Expected repurchases by vintage are based on estimates of current and future investor demand, which are further derived from economic factors, investor demand strategies and other external conditions. To the extent that repurchase demands are made by investors, we may be able to appeal such repurchase demands. However, our appeals success may be affected by the reasons for repurchase demands, the quality of the demands, and our appeals strategies. Loss rate estimates include assumptions about the quality of the sold portfolio, as well as economic and other external factors.
Currently, repurchase demands relate primarily to 2007 and 2008 vintages, during which, debt-to-income ratios and loan-to-values tended to be higher, as the GSEs relaxed enforcement of underwriting standards for conforming loans. During 2010, we experienced an increase in repurchase activity for these older vintage loans, as measured by the number of investor file requests, repurchase demands, and actual repurchases. We believe the increase in repurchase activity relates to continued weak economic conditions as investors continued to experience elevated levels of defaulted loans.
Loans repurchased during the three and six months ended June 30, 2011 totaled approximately $4.2 million and $4.8 million, respectively.
The reasons for repurchases have varied, from misrepresentation to income and documentation errors. Due to the limited amount of historical repurchase activity, we continue to analyze repurchase data for emerging material trends. The number of repurchase requests by vintage and investor type, as well as appeals and repurchases are depicted in table below.
| Repurchase Demands, Appeals, Repurchases [1] | | | | | | | | | | | | | | | |
| Six months ended June 30, 2011 | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | |
| | | Government Sponsored Entities | | | Non-GSE Investors |
| Vintage | | Repurchase Demands | | | Appealed | | | Repurchased | | | Pending Resolution | | | Repurchase Demands | | | Appealed | | | Repurchased | | | Pending Resolution |
| | | | | | | | | | | | | | | | | | | | | | | | |
| 2005 and prior | | 3 | | | - | | | 1 | | | 2 | | | - | | | - | | | - | | | - |
| 2006 | | 2 | | | - | | | - | | | 2 | | | - | | | - | | | - | | | - |
| 2007 | | - | | | - | | | - | | | - | | | 4 | | | - | | | 2 | | | 2 |
| 2008 | | 6 | | | 1 | | | - | | | 5 | | | 7 | | | - | | | 2 | | | 5 |
| 2009 | | 5 | | | - | | | 1 | | | 4 | | | - | | | - | | | - | | | - |
| 2010 | | 9 | | | 3 | | | 1 | | | 5 | | | - | | | - | | | - | | | - |
| 2011 | | 3 | | | 2 | | | - | | | 1 | | | - | | | - | | | - | | | - |
| Total | | 28 | | | 6 | | | 3 | | | 19 | | | 11 | | | - | | | 4 | | | 7 |
| | | | | | | | | | | | | | | | | | | | | | | | |
| [1] Based on repurchase requests received between January 1, 2011 and June 30, 2011. |
The reserve for residential mortgage loan repurchase losses of $6.7 million at June 30, 2011, represents our best estimate of the probable loss that we may incur for various representations and warranties in our loan sales contracts with investors. This represents an increase of $1.7 million from December 31, 2010, which was necessary in our estimation, due to the increase in repurchase activity, and uncertainty and risk around future activity and losses. The table below shows changes in the repurchase losses liability since initial establishment.
| | Six Months Ended June 30, | | | Year Ended December 31, |
| | 2011 | | | 2010 | | | 2010 | | | 2009 | | | 2008 |
| | (Dollars in thousands) |
| | | | | | | | | | | | | | |
| Balance, beginning of period | $ | 5,014 | | | $ | 183 | | | $ | 183 | | | $ | 22 | | | $ | - |
| Change in estimate | | 2,840 | | | | 150 | | | | 6,071 | | | | 161 | | | | 22 |
| Utilizations | | (1,198 | ) | | | - | | | | (1,240 | ) | | | - | | | | - |
| Balance, end of period | $ | 6,656 | | | $ | 333 | | | $ | 5,014 | | | $ | 183 | | | $ | 22 |
Our ability to predict repurchase losses is adversely impacted by the lack of significant historical precedent, as well as the lack of access to the servicing records of loans sold to non-agencies. Additionally, repurchase losses depend upon economic factors and other external conditions that may change over the life of the underlying loans, adding difficulty to the estimation process and requiring considerable management judgment. To the extent that future investor repurchase demand and appeals success differ from past experience, we could have increased demands and increased loss severities on repurchases, causing future additions to the repurchase reserve.
Goodwill and Other Intangible Assets
During the first quarter of 2010, we determined that an impairment test on our remaining goodwill was required because of the uncertainty regarding our ability to continue as a going concern at that time combined with the fact that our market capitalization remained depressed. As a result of that impairment test, we determined that the remaining goodwill associated with our Hawaii Market reporting unit was impaired and we recorded a non-cash impairment charge of $102.7 million. Since that time, we had no goodwill remaining on our consolidated balance sheet.
Prior to the first quarter of 2010, we reviewed the carrying amount of goodwill for impairment on an annual basis and performed additional assessments on a quarterly basis whenever indicators of impairment were evident. Goodwill attributable to each of our reporting units was tested for impairment by comparing their respective fair values to their carrying values. When determining fair value, we utilized a discounted cash flow methodology for our Commercial Real Estate reporting unit and versions of the guideline company, guideline transaction and discounted cash flow methodologies for our Hawaii Market reporting unit. Absent any impairment indicators, we performed our annual goodwill impairment tests during the fourth quarter of each fiscal year.
Similar to our process for evaluating our goodwill for impairment, we also perform an impairment assessment of our other intangible assets whenever events or changes in circumstance indicate that the carrying value of those assets may not be recoverable.
Our impairment assessment of goodwill and other intangible assets involve, among other valuation methods, the estimation of future cash flows and other methods of determining fair value. Estimating future cash flows and determining fair values is subject to judgments and often involves the use of significant estimates and assumptions, including assumptions about the future growth and potential volatility in revenues and costs, capital expenditures, industry economic factors and future business strategy. The variability of the factors we use to perform the goodwill impairment test depends on a number of conditions, including uncertainty about future events and cash flows. All such factors are interdependent and, therefore, do not change in isolation. Accordingly, our accounting estimates may materially change from period to period due to changing market factors. If we had used other assumptions and estimates or if different conditions occur in future periods, including, but not limited to, changes in other reporting units or operating segments, future operating results could be materially impacted.
Deferred Tax Assets and Tax Contingencies
Deferred tax assets (“DTAs”) and liabilities are recognized for the estimated future tax effects attributable to temporary differences and carryforwards. A valuation allowance may be required if, based on the weight of available evidence, it is more likely than not that some portion or all of the DTAs will not be realized. In determining whether a valuation allowance is necessary, we consider the level of taxable income in prior years, to the extent that carrybacks are permitted under current tax laws, as well as estimates of future taxable income and tax planning strategies that could be implemented to accelerate taxable income, if necessary. If our estimates of future taxable income were materially overstated or if our assumptions regarding the tax consequences of tax planning strategies were inaccurate, some or all of our DTAs may not be realized, which would result in a charge to earnings. In 2009, we established a valuation allowance against our net DTAs. See “— Results of Operations — Income Taxes” below.
We have established income tax contingency reserves for potential tax liabilities related to uncertain tax positions. Tax benefits are recognized when we determine that it is more likely than not that such benefits will be realized. Where uncertainty exists due to the complexity of income tax statutes and where the potential tax amounts are significant, we generally seek independent tax opinions to support our positions. If our evaluation of the likelihood of the realization of benefits is inaccurate, we could incur additional income tax and interest expense that would adversely impact earnings, or we could receive tax benefits greater than anticipated which would positively impact earnings.
Defined Benefit Retirement Plan
Defined benefit plan obligations and related assets of our defined benefit retirement plan are presented in Note 14 to the consolidated financial statements. In 2002, the defined benefit retirement plan was curtailed and all plan benefits were fixed as of that date. Plan assets, which consist primarily of marketable equity and debt securities, are typically valued using market quotations. Plan obligations and the annual pension expense are determined by independent actuaries through the use of a number of assumptions. Key assumptions in measuring the plan obligations include the discount rate and the expected long-term rate of return on plan assets. In determining the discount rate, we utilize a yield that reflects the top 50% of the universe of bonds, ranked in the order of the highest yield. Asset returns are based upon the anticipated average rate of earnings expected on the invested funds of the plans.
At December 31, 2010, we used a weighted-average discount rate of 5.1% and an expected long-term rate of return on plan assets of 8.0%, which affected the amount of pension liability recorded as of year-end 2010 and the amount of pension expense to be recorded in 2011. For both the discount rate and the asset return rate, a range of estimates could reasonably have been used which would affect the amount of pension expense and pension liability recorded.
An increase in the discount rate or asset return rate would reduce pension expense in 2011, while a decrease in the discount rate or asset return rate would have the opposite effect. A 0.25% change in the discount rate assumption would impact 2011 pension expense by less than $0.1 million and year-end 2010 pension liability by $0.9 million, while a 0.25% change in the asset return rate would impact 2011 pension expense by less than $0.1 million.
Impact of Recently Issued Accounting Pronouncements on Future Filings
In January 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-01, Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20, which temporarily delays the effective date for public entities of the disclosures about troubled debt restructurings (“TDRs”) in ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. The deferral will allow the FASB to complete its deliberations on what constitutes a TDR, and to coordinate the effective dates of the new disclosures about TDRs for public entities in ASU 2010-20 and the guidance for determining what constitutes a TDR. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.
In April 2011, the FASB issued ASU 2011-02, A Creditor's Determination of Whether a Restructuring is a Troubled Debt Restructuring. This ASU provides additional guidance related to determining whether a creditor has granted a concession, includes factors and examples for creditors to consider in evaluating whether a restructuring results in a delay in payment that is insignificant, prohibits creditors from using the borrower's effective rate test to evaluate whether a concession has been granted to the borrower, and adds factors for creditors to use in determining whether a borrower is experiencing financial difficulties. A provision in ASU 2011-02 also ends the FASB’s deferral of the additional disclosures about TDRs as required by ASU 2010-20. This ASU is effective for the Company's reporting period ending September 30, 2011. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.
In April 2011, the FASB issued ASU 2011-03, “Reconsideration of Effective Control for Repurchase Agreements.” The amendments in this ASU remove from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee. The amendments in this ASU also eliminate the requirement to demonstrate that the transferor possesses adequate collateral to fund substantially all the cost of purchasing replacement financial assets. This ASU is effective prospectively for transactions, or modifications of existing transactions, that occur on or after January 1, 2012. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.
In May 2011, the FASB issued ASU 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” The amendments in this ASU generally represent clarifications of Topic 820, but also include some instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This ASU results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and International Financial Reporting Standards (“IFRS”). This ASU is effective for the Company’s reporting period beginning on January 1, 2012. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.
In June 2011, the FASB issued ASU 2011-05, “Amendments to Topic 220, Comprehensive Income.” Under the amendments in this ASU, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. This ASU eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amendments in this ASU do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. This ASU is effective for the Company’s reporting period beginning on January 1, 2012, with retrospective application required. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.
Financial Summary
During the second quarter of 2011, we reported net income of $8.2 million, or $0.20 per diluted share, compared to a net loss of $16.1 million, or $12.01 per diluted share, reported in the second quarter of 2010. Net income for the first half of 2011 was $12.9 million, or $3.15 per diluted share, compared to a net loss of $176.3 million, or $119.18 per diluted share for the first half of 2010. Our net income per diluted share for the first half of 2011 of $3.15 includes the impact of a one-time accounting adjustment totaling $85.1 million related to the previously mentioned TARP Exchange. Excluding this one-time adjustment, which did not impact our reported net income of $12.9 million, our net income per diluted share for the first half of 2011 was $0.38. See Note 11 to the consolidated financial statements for more information. The net loss in the first half of 2010 included a non-cash goodwill impairment charge of $102.7 million.
Our net income in the first and second quarters of 2011 was driven by continued improvement in our asset quality, which resulted in a significant reduction in our total credit costs. Total credit costs, which includes the Provision, write-downs of loans classified as held for sale, write-downs of foreclosed property and the change in the reserve for unfunded commitments, were reduced from a charge of $21.8 million and $88.3 million in the three and six months ended June 30, 2010, respectively, to credits of $6.4 million and $4.5 million in the three and six months ended June 30, 2011, respectively.
The following table presents annualized returns on average assets, average shareholders’ equity, average tangible equity and basic and diluted earnings per share for the periods indicated. Average tangible equity is calculated as average shareholders’ equity less average intangible assets, which includes goodwill, core deposit premium, customer relationships and non-compete agreements. Average intangible assets were $20.9 million and $21.3 million for the three and six months ended June 30, 2011, respectively, and $23.8 million and $74.6 million for the comparable prior year periods.
| | Three Months Ended | | | Six Months Ended |
| | June 30, | | | June 30, |
| | 2011 | | | 2010 | | | 2011 | | | 2010 |
| | | | | | | | | | | | | | | |
| Return (loss) on average assets | | 0.81 | % | | | | (1.50 | ) % | | | | 0.64 | % | | | | (7.73 | ) % |
| Return (loss) on average shareholders' equity | | 8.08 | | | | | (41.67 | ) | | | | 8.48 | | | | | (146.95 | ) |
| Return (loss) on average tangible equity | | 8.52 | | | | | (49.25 | ) | | | | 9.12 | | | | | (213.29 | ) |
| Basic earnings (loss) per common share | $ | 0.20 | | | | $ | (12.01 | ) | | | $ | 3.22 | * | | | $ | (119.18 | ) |
| Diluted earnings (loss) per common share | | 0.20 | | | | | (12.01 | ) | | | | 3.15 | * | | | | (119.18 | ) |
| | | | | | | | | | | | | | | | | | | |
* Includes the impact of a one-time accounting adjustment totaling $85.1 million related to the TARP Exchange. Excluding this one-time adjustment, our basic and diluted earnings per share was $0.39 and $0.38 for the six months ended June 30, 2011, respectively. |
Material Trends
The global and U.S. economies continue to stabilize following the economic downturn caused by disruptions in the financial system in 2008. Signs of stabilization of the financial markets and growth in the U.S. economy were partly attributable to various initiatives of the U.S. government. Initiatives such as the Emergency Economic Stabilization Act (“EESA”) and the American Recovery and Reinvestment Act (“ARRA”) have thus far helped the financial markets and U.S. economy. Additionally, the Federal Reserve System (“FRB”) implemented a number of initiatives to provide stability and additional liquidity to the financial markets in 2008. These initiatives included providing additional liquidity to the asset-backed commercial paper and money markets and planned purchases of short-term debt obligations issued by Fannie Mae, Freddie Mac and the Federal Home Loan Banks. The FRB lowered the federal funds benchmark rate to a range of zero to 0.25% and the discount rate to 0.50% in December 2008 and kept these rates at those levels until increasing the discount rate to 0.75% in February 2010. In November 2010, the FRB announced an initiative, known as QE2, to purchase an additional $600 billion in assets.
Despite recent signs of stabilization, concerns about the global and U.S. economies still remain, including weak consumer confidence and increased volatility in both energy prices and the capital markets. In addition, growing government indebtedness, a large budget deficit, and recent concerns over the federal debt ceiling have exacerbated the uncertainty surrounding a sustained economic recovery. On August 2, 2011, legislation was enacted to increase the federal debt ceiling and to reduce future spending levels by as much as $2.4 trillion over the next 10 years. Notwithstanding the passage of this legislation, a risk remains that major rating agencies could reduce the ratings of U.S. Treasury securities if the legislation is not deemed sufficient to address the country’s growing debt burden. While the potential effects of a U.S. downgrade are not yet well understood, it could raise borrowing costs and adversely impact the mortgage and housing markets.
The majority of our operations are concentrated in the state of Hawaii, and to a lesser extent, in California and a few western states. Our business performance is significantly influenced by conditions in the banking industry, macro economic conditions and the real estate markets in Hawaii and California. A favorable business environment is generally characterized by expanding gross state product, low unemployment and rising personal income; while an unfavorable business environment is characterized by declining gross state product, high unemployment and declining personal income.
Hawaii’s economy continues to show signs of recovery and is expected to see modest improvement during the remainder of 2011 and stronger growth in 2012, according to the Hawaii State Department of Business, Economic Development & Tourism (“DBEDT”). Tourism remains Hawaii’s most significant economic driver and according to the Hawaii Tourism Authority (“HTA”), total visitor arrivals and visitor expenditures increased by 4.7% and 18.4%, respectively, for the first half of 2011 compared to the same period in 2010. The Department of Labor and Industrial Relations reported that Hawaii’s seasonally adjusted unemployment rate declined from 6.3% in December 2010 to 6.0% in June 2011 and Hawaii’s unemployment rate remained below the national seasonally adjusted unemployment rate of 9.2%. DBEDT projects real personal income and real gross state product to grow by a modest 1.0% and 1.6%, respectively, in 2011.
On March 11, 2011, a massive earthquake triggered a giant tsunami that devastated northeastern Japan. According to the HTA, visitor arrivals and expenditures from Japan accounted for approximately 17.4% and 16.9%, respectively of the total visitor arrivals and expenditures in 2010. Japanese visitor arrivals and expenditures in the second quarter of 2011 were down 20.1% and 5.3%, respectively, compared to the same period in 2010, due to flight suspensions and trip cancellations following the earthquake and tsunami. Despite the negative impact of the earthquake and tsunami on Japanese travel to Hawaii, DBEDT projects that overall visitor arrivals will increase by 3.8% for 2011, a rate similar to its previous forecast conducted before the Japan earthquake. This forecast reflects the decline of Japanese arrivals, tempered by an increase in arrivals from the U.S. mainland and other international markets, especially visitors from Canada.
Historically, real estate lending has been a primary focus for us, including construction, residential mortgage and commercial mortgage loans. As a result, we are dependent on the strength of Hawaii’s real estate market. According to the Honolulu Board of Realtors, Oahu unit sales volume decreased 7.0% for single-family homes and 2.6% for condominiums for the six months ended June 2011 compared to the six months ended June 2010. The median sales price for single-family homes on Oahu for the six months ended June 2011 was $570,000, representing a decrease of 2.6% from the prior year. The median sales price for condominiums on Oahu for the six months ended June 2011 was $304,500, representing a decrease of 0.2% from the prior year. Expectations from local real estate experts and economists are for the Hawaii real estate market to show improvement in the second half of 2011, however, there is no assurance that this will occur. As part of our plans to reduce our credit risk exposure, we have taken and will continue to take, steps to reduce certain aspects of our commercial real estate and construction loan portfolios.
Potential impediments to recovery in the Hawaii economy include projected budget shortfalls for the Hawaii state government in 2011. To address these shortfalls, the Hawaii state government may initiate additional layoffs, furloughs and program cuts, as they have in the past.
California, along with the rest of the nation, appears to be in the midst of a modest, drawn-out recovery. After ending 2010 with some momentum, positive economic signs continued during the early months of 2011. However, during the second quarter of 2011, weak real estate market conditions, depressed construction activity, and public sector fiscal problems continued to dampen economic growth. In addition, unrest in oil producing nations and the earthquake and tsunami that struck Japan resulted in more uncertainty for California’s outlook. The California Association of Realtors (“CAR”) reported that June 2011 unit home sales were down 3.6% from the same period a year ago, while the median sales price decreased by 5.9% from year ago levels to $295,300. CAR anticipates 2011 to be a transition year, moving further toward stabilization, and forecasts California’s annual sales and median sales price to increase 2% to 502,000 units and $312,500, respectively. Labor markets within the state remained weak through the first half of 2011 as California’s seasonally adjusted unemployment rate increased to 11.8% at June 2011 and continues to be well above the national unemployment rate of 9.2%. California state government’s budget crisis is more severe than Hawaii’s. Having already issued IOUs once before to preserve cash, California’s government faces a $25.4 billion shortfall and is looking at further cuts in wages, furloughs and government programs. Although we are not making new loans in California, our existing loan portfolio continues to have significant exposure to its markets.
As we have seen over the past few years, our operating results are significantly impacted by the economy in Hawaii and California and the higher risk nature of our loan portfolio. Loan demand, deposit growth, provision for loan and lease losses, asset quality, noninterest income and noninterest expense are all affected by changes in economic conditions. If the residential and commercial real estate markets we have exposure to do not improve or continue to deteriorate, our results of operations would be negatively impacted.
Results of Operations
Net Interest Income
Net interest income, when expressed as a percentage of average interest earning assets, is referred to as “net interest margin.” Interest income, which includes loan fees and resultant yield information, is expressed on a taxable equivalent basis using an assumed income tax rate of 35%. A comparison of net interest income on a taxable equivalent basis (“net interest income”) for the three and six months ended June 30, 2011 and 2010 is set forth below.
| | Three Months Ended | | | Three Months Ended |
| | June 30, 2011 | | | June 30, 2010 |
| | Average | | | | | | Amount | | | Average | | | | | | Amount |
| | Balance | | | Yield/Rate | | | of Interest | | | Balance | | | Yield/Rate | | | of Interest |
| | (Dollars in thousands) |
| Assets | | | | | | | | | | | | | | | | | | |
| Interest earning assets: | | | | | | | | | | | | | | | | | | |
| Interest-bearing deposits in other banks | $ | 471,173 | | | 0.26 | % | | | $ | 300 | | | $ | 738,766 | | | 0.25 | % | | | $ | 467 |
| Taxable investment securities (1) | | 1,205,762 | | | 2.40 | | | | | 7,241 | | | | 419,827 | | | 3.48 | | | | | 3,655 |
| Tax-exempt investment securities (1) | | 12,480 | | | 8.92 | | | | | 276 | | | | 14,459 | | | 8.05 | | | | | 292 |
| Loans and leases, net of unearned income (2) | | 2,094,555 | | | 5.06 | | | | | 26,464 | | | | 2,822,967 | | | 5.08 | | | | | 35,788 |
| Federal Home Loan Bank stock | | 48,797 | | | - | | | | | - | | | | 48,797 | | | - | | | | | - |
| Total interest earning assets | | 3,832,767 | | | 3.58 | | | | | 34,281 | | | | 4,044,816 | | | 3.98 | | | | | 40,202 |
| Nonearning assets | | 214,354 | | | | | | | | | | | | 247,518 | | | | | | | | |
| Total assets | $ | 4,047,121 | | | | | | | | | | | $ | 4,292,334 | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | |
| Liabilities and Equity | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing demand deposits | $ | 535,057 | | | 0.12 | % | | | $ | 161 | | | $ | 604,983 | | | 0.17 | % | | | $ | 250 |
| Savings and money market deposits | | 1,113,800 | | | 0.18 | | | | | 500 | | | | 1,075,028 | | | 0.55 | | | | | 1,487 |
| Time deposits under $100,000 | | 402,721 | | | 1.03 | | | | | 1,037 | | | | 535,227 | | | 1.61 | | | | | 2,149 |
| Time deposits $100,000 and over | | 438,971 | | | 0.79 | | | | | 865 | | | | 425,938 | | | 1.56 | | | | | 1,659 |
| Short-term borrowings | | 1,730 | | | - | | | | | - | | | | 202,191 | | | 0.61 | | | | | 306 |
| Long-term debt | | 409,152 | | | 2.59 | | | | | 2,642 | | | | 649,910 | | | 3.12 | | | | | 5,053 |
| Total interest-bearing liabilities | | 2,901,431 | | | 0.72 | | | | | 5,205 | | | | 3,493,277 | | | 1.25 | | | | | 10,904 |
| Noninterest-bearing deposits | | 663,119 | | | | | | | | | | | | 568,140 | | | | | | | | |
| Other liabilities | | 66,195 | | | | | | | | | | | | 66,308 | | | | | | | | |
| Total liabilities | | 3,630,745 | | | | | | | | | | | | 4,127,725 | | | | | | | | |
| Shareholders' equity | | 406,381 | | | | | | | | | | | | 154,592 | | | | | | | | |
| Non-controlling interests | | 9,995 | | | | | | | | | | | | 10,017 | | | | | | | | |
| Total equity | | 416,376 | | | | | | | | | | | | 164,609 | | | | | | | | |
| Total liabilities and equity | $ | 4,047,121 | | | | | | | | | | | $ | 4,292,334 | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | |
| Net interest income | | | | | | | | | $ | 29,076 | | | | | | | | | | | $ | 29,298 |
| | | | | | | | | | | | | | | | | | | | | | | |
| Net interest margin | | | | | 3.04 | % | | | | | | | | | | | 2.90 | % | | | | |
| | Six Months Ended | | | Six Months Ended |
| | June 30, 2011 | | | June 30, 2010 |
| | Average | | | | | | Amount | | | Average | | | | | | Amount |
| | Balance | | | Yield/Rate | | | of Interest | | | Balance | | | Yield/Rate | | | of Interest |
| | (Dollars in thousands) |
| Assets | | | | | | | | | | | | | | | | | | |
| Interest earning assets: | | | | | | | | | | | | | | | | | | |
| Interest-bearing deposits in other banks | $ | 544,153 | | | 0.26 | % | | | $ | 689 | | | $ | 621,935 | | | 0.26 | % | | | $ | 797 |
| Taxable investment securities (1) | | 1,049,131 | | | 2.38 | | | | | 12,465 | | | | 612,880 | | | 3.84 | | | | | 11,759 |
| Tax-exempt investment securities (1) | | 12,728 | | | 8.79 | | | | | 559 | | | | 30,255 | | | 7.17 | | | | | 1,085 |
| Loans and leases, net of unearned income (2) | | 2,141,816 | | | 5.17 | | | | | 55,030 | | | | 2,934,483 | | | 5.01 | | | | | 73,100 |
| Federal Home Loan Bank stock | | 48,797 | | | - | | | | | - | | | | 48,797 | | | - | | | | | - |
| Total interest earning assets | | 3,796,625 | | | 3.64 | | | | | 68,743 | | | | 4,248,350 | | | 4.11 | | | | | 86,741 |
| Nonearning assets | | 212,298 | | | | | | | | | | | | 315,313 | | | | | | | | |
| Total assets | $ | 4,008,923 | | | | | | | | | | | $ | 4,563,663 | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | |
| Liabilities and Equity | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing demand deposits | $ | 532,246 | | | 0.11 | % | | | $ | 293 | | | $ | 608,072 | | | 0.17 | % | | | $ | 508 |
| Savings and money market deposits | | 1,110,691 | | | 0.22 | | | | | 1,232 | | | | 1,110,717 | | | 0.57 | | | | | 3,136 |
| Time deposits under $100,000 | | 421,984 | | | 1.15 | | | | | 2,403 | | | | 533,425 | | | 1.64 | | | | | 4,334 |
| Time deposits $100,000 and over | | 386,860 | | | 0.98 | | | | | 1,876 | | | | 525,676 | | | 1.33 | | | | | 3,455 |
| Short-term borrowings | | 70,338 | | | 0.59 | | | | | 204 | | | | 237,974 | | | 0.42 | | | | | 495 |
| Long-term debt | | 424,537 | | | 2.55 | | | | | 5,359 | | | | 653,767 | | | 3.14 | | | | | 10,168 |
| Total interest-bearing liabilities | | 2,946,656 | | | 0.78 | | | | | 11,367 | | | | 3,669,631 | | | 1.21 | | | | | 22,096 |
| Noninterest-bearing deposits | | 670,949 | | | | | | | | | | | | 580,062 | | | | | | | | |
| Other liabilities | | 78,242 | | | | | | | | | | | | 63,976 | | | | | | | | |
| Total liabilities | | 3,695,847 | | | | | | | | | | | | 4,313,669 | | | | | | | | |
| Shareholders' equity | | 303,078 | | | | | | | | | | | | 239,973 | | | | | | | | |
| Non-controlling interests | | 9,998 | | | | | | | | | | | | 10,021 | | | | | | | | |
| Total equity | | 313,076 | | | | | | | | | | | | 249,994 | | | | | | | | |
| Total liabilities and equity | $ | 4,008,923 | | | | | | | | | | | $ | 4,563,663 | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | |
| Net interest income | | | | | | | | | $ | 57,376 | | | | | | | | | | | $ | 64,645 |
| | | | | | | | | | | | | | | | | | | | | | | |
| Net interest margin | | | | | 3.04 | % | | | | | | | | | | | 3.06 | % | | | | |
| | | | | | | | | | | | | | | | | | | | | | | |
| (1) At amortized cost. | | | | | | | | | | | | | | | | | | | | | | |
| (2) Includes nonaccrual loans. | | | | | | | | | | | | | | | | | | | | | | |
Net interest income expressed on a taxable-equivalent basis of $29.1 million for the second quarter of 2011, decreased by $0.2 million, or 0.8%, from the second quarter of 2010, while taxable-equivalent net interest income for the first half of 2011 decreased by $7.3 million, or 11.2%, to $57.4 million from the comparable prior year period. The decrease in net interest income for the current quarter and first half of 2011 was primarily attributable to a significant reduction in average loans and leases as we continued our efforts to improve our credit risk profile by reducing our exposure to certain sectors of the construction and commercial real estate sectors. Partially offsetting this reduction was an increase in average taxable investment securities and a decrease in average interest-bearing liabilities as we continue to redeploy a portion of our excess liquidity into higher yielding investment securities and reduce our overall funding costs. The decrease in net interest income for the current quarter also reflects a 40 basis point (“bp”) decline in average yields earned on interest earning assets over the comparable prior year period and a 53 bp decline in average rates paid on our interest-bearing liabilities. The decrease in net interest income for the first half of 2011 reflects a 47 bp decline in average yields earned on interest earning assets over the comparable prior year period, which exceeded the 43 bp decline in average rates paid on our interest-bearing liabilities. The decrease in average yields earned on our interest earning assets was directly attributable to the depressed interest rate environment, reductions in our higher yielding commercial real estate loan portfolios and the corresponding increase in our lower yielding investment securities portfolio.
Interest Income
Taxable-equivalent interest income of $34.3 million for the second quarter of 2011 decreased by $5.9 million, or 14.7%, from the second quarter of 2010. The current quarter decrease was primarily attributable to a significant decline in average loans and leases, partially offset by an increase in average taxable investment securities as described above. Average loans and leases decreased by $728.4 million in the current quarter compared to the second quarter of 2010, contributing to approximately $9.3 million of the current quarter interest income decline, while average taxable investment securities increased by $785.9 million in the current quarter compared to the second quarter of 2010, offsetting the decline of interest income by approximately $6.8 million. Average yields earned on taxable investment securities decreased by 108 bp in the current quarter, contributing to approximately $1.1 million of the current quarter interest income decline.
Consistent with the above, the year-to-date decrease in taxable-equivalent interest income was primarily attributable to a significant decline in average loans and leases, partially offset by an increase in average taxable investment securities. During the first half of 2011, average loans and leases decreased by $792.7 million from the first half of 2010, reducing interest income by approximately $19.9 million during the period, while average taxable investment securities increased by $436.3 million, offsetting the decline of interest income by approximately $8.4 million. Average yields earned on taxable investment securities for the first half of 2011 decreased by 146 bp, resulting in a reduction in interest income of approximately $4.5 million, while average yields on loans and leases increased by 16 bp, offsetting the decline in interest income by approximately $2.3 million.
Interest Expense
Interest expense of $5.2 million for the second quarter of 2011 decreased by $5.7 million, or 52.3%, from the comparable prior year quarter. The decrease in interest expense during the current quarter was attributable to the overall decline in both average balances and rates paid on interest-bearing liabilities. The 37 bp decline in average rates on savings and money market deposits contributed to $1.0 million of the current quarter decrease in interest expense, the 58 bp decline in average rates on time deposits under $100,000 contributed to $0.8 million of the current quarter decrease, the 77 bp decline in average rates on time deposits $100,000 and over contributed to $0.8 million of the current quarter decrease, the 61 bp decline on average rates on short-term borrowings contributed to $0.3 million of the current quarter decrease and the 53 bp decline on average rates on long-term debt contributed to $0.9 million of the current quarter decrease. Additionally, the current quarter decrease in average balances of all time deposits, short-term borrowings and long-term debt also resulted in lower interest expense of $0.5 million, $0.3 million and $1.9 million, respectively.
For the first half of 2011, interest expense decreased by $10.7 million, or 48.6%, from the first half of 2010. The 35 bp decline in average rates on savings and money market deposits contributed to $1.9 million of the decrease in interest expense, declines of 49 bp and 35 bp in average rates on time deposits under $100,000 and time deposits $100,000 and over contributed to $1.3 million and $0.9 million, respectively, of the decrease in interest expense, and the 59 bp decline on average rates on long-term debt contributed to $1.9 million of the decrease in interest expense from the comparable prior year period. Additionally, the overall decrease in average balances of all time deposits, short-term borrowings and long-term debt also resulted in a decrease in interest expense of $1.8 million, $0.4 million and $3.6 million, respectively, compared to the first half of 2010.
Net Interest Margin
Our net interest margin was 3.04% for the second quarter of 2011, compared to 2.90% in the comparable year-ago quarter. As described above, the increase was primarily attributable to the redeployment of a portion of our excess liquidity into higher yielding investment securities and an overall reduction in our funding costs.
Our net interest margin for the first half of 2011 was 3.04% compared to 3.06% in the comparable year-ago period. The year-over-year compression was primarily due to lower yields on our interest earning assets as we continued our efforts to reduce our higher yielding commercial real estate loan portfolio to improve our credit risk profile and our efforts to maximize balance sheet liquidity by maintaining elevated levels of lower yielding cash and cash equivalent accounts through the first quarter of 2011. Additionally, as part of our recovery plan, we sold available for sale securities for gross proceeds of $439.4 million during the latter part of March 2010. A significant amount of these proceeds were held as cash and cash equivalents until the first quarter of 2011.
Nonperforming Assets, Accruing Loans Delinquent for 90 Days or More, Restructured Loans Still Accruing Interest
The following table sets forth nonperforming assets, accruing loans delinquent for 90 days or more and restructured loans still accruing interest as of the dates indicated.
| | June 30, | | | December 31, | |
| | 2011 | | | 2010 | |
| | (Dollars in thousands) | |
| Nonperforming Assets | | | | | |
| Nonaccrual loans (including loans held for sale): | | | | | |
| Commercial, financial and agricultural | $ | 578 | | | $ | 982 | |
| Real estate: | | | | | | | |
| Construction | | 129,275 | | | | 182,073 | |
| Mortgage-residential | | 58,204 | | | | 47,560 | |
| Mortgage-commercial | | 18,428 | | | | 14,464 | |
| Consumer | | - | | | | 225 | |
| Total nonaccrual loans | | 206,485 | | | | 245,304 | |
| Other real estate | | 42,863 | | | | 57,507 | |
| Total nonperforming assets | | 249,348 | | | | 302,811 | |
| | | | | | | | |
| Accruing loans delinquent for 90 days or more: | | | | | | | |
| Real estate: | | | | | | | |
| Construction | | - | | | | 6,550 | |
| Mortgage-residential | | - | | | | 1,800 | |
| Consumer | | 4 | | | | 181 | |
| Total accruing loans delinquent for 90 days or more | | 4 | | | | 8,531 | |
| | | | | | | | |
| Restructured loans still accruing interest: | | | | | | | |
| Real estate: | | | | | | | |
| Mortgage-residential | | 1,813 | | | | 13,401 | |
| Total restructured loans still accruing interest | | 1,813 | | | | 13,401 | |
| | | | | | | | |
| Total nonperforming assets, accruing loans delinquent for 90 | | | | | | | |
| days or more and restructured loans still accruing interest | $ | 251,165 | | | $ | 324,743 | |
| | | | | | | | |
| Total nonperforming assets as a percentage of loans and leases, | | | | | | | |
| loans held for sale and other real estate | | 11.81 | % | | | 13.18 | % |
| | | | | | | | |
| Total nonperforming assets and accruing loans delinquent for 90 | | | | | | | |
| days or more as a percentage of loans and leases, loans held for sale | | | | | | | |
| and other real estate | | 11.81 | % | | | 13.56 | % |
| | | | | | | | |
| Total nonperforming assets, accruing loans delinquent for 90 days or more | | | | | | | |
| and restructured loans still accruing interest as a percentage of loans | | | | | | | |
| and leases, loans held for sale and other real estate | | 11.89 | % | | | 14.14 | % |
Nonperforming assets, which includes nonaccrual loans and leases, nonperforming loans classified as held for sale and foreclosed real estate, totaled $249.3 million at June 30, 2011, compared to $302.8 million at December 31, 2010. The decrease from fiscal 2010 was primarily attributable to sales of nonperforming loans classified as held for sale and foreclosed properties of $27.6 million and $24.7 million, respectively, paydowns of $46.5 million and charge-offs and write-downs of $17.0 million. Offsetting these decreases were the following significant additions to nonperforming assets: Hawaii residential mortgage loans and foreclosed properties of $27.6 million, Hawaii construction and development loans totaling $18.9 million, Mainland commercial mortgage loans totaling $6.8 million, Hawaii commercial mortgage loans totaling $3.5 million and Mainland construction and development loans totaling $2.6 million.
Restructured loans included in nonperforming assets at June 30, 2011 consisted of 116 Hawaii residential mortgage loans with a combined principal balance of $47.6 million, seven Hawaii construction and development loans with a combined principal balance of $37.2 million, and one Hawaii commercial loan with a principal balance of $0.4 million. Concessions made to the original contractual terms of these loans consisted primarily of the deferral of interest and/or principal payments due to deterioration in the borrowers’ financial condition. The principal balances on these restructured loans matured and/or were in default at the time of restructuring and we have no commitments to lend additional funds to any of these borrowers. There were $1.8 million of restructured loans still accruing interest at June 30, 2011, none of which were more than 90 days delinquent.
Provision and Allowance for Loan and Lease Losses
The following table sets forth certain information with respect to the Allowance as of the dates and for the periods indicated:
| | Three Months Ended | | | Six Months Ended | |
| | June 30, | | | June 30, | |
| | 2011 | | | 2010 | | | 2011 | | | 2010 | |
| | (Dollars in thousands) | |
| Allowance for loan and lease losses: | | | | | | | | | | | |
| Balance at beginning of period | $ | 178,010 | | | $ | 211,646 | | | $ | 192,854 | | | $ | 205,279 | |
| | | | | | | | | | | | | | | | |
| Provision (credit) for loan and lease losses | | (8,784 | ) | | | 20,412 | | | | (10,359 | ) | | | 79,249 | |
| | | | | | | | | | | | | | | | |
| Charge-offs: | | | | | | | | | | | | | | | |
| Commercial, financial and agricultural | | 455 | | | | 3,823 | | | | 1,861 | | | | 5,981 | |
| Real estate: | | | | | | | | | | | | | | | |
| Construction | | 3,000 | | | | 20,800 | | | | 16,858 | | | | 48,774 | |
| Mortgage-residential | | 1,263 | | | | 4,059 | | | | 3,299 | | | | 15,223 | |
| Mortgage-commercial | | 879 | | | | 1,462 | | | | 1,105 | | | | 19,192 | |
| Consumer | | 597 | | | | 598 | | | | 1,202 | | | | 1,539 | |
| Leases | | - | | | | - | | | | - | | | | 1 | |
| Total charge-offs | | 6,194 | | | | 30,742 | | | | 24,325 | | | | 90,710 | |
| | | | | | | | | | | | | | | | |
| Recoveries: | | | | | | | | | | | | | | | |
| Commercial, financial and agricultural | | 854 | | | | 179 | | | | 1,286 | | | | 1,740 | |
| Real estate: | | | | | | | | | | | | | | | |
| Construction | | 2,549 | | | | 107 | | | | 5,915 | | | | 5,608 | |
| Mortgage-residential | | 231 | | | | 48 | | | | 931 | | | | 75 | |
| Mortgage-commercial | | 3 | | | | 12 | | | | 42 | | | | 14 | |
| Consumer | | 265 | | | | 297 | | | | 590 | | | | 663 | |
| Leases | | - | | | | - | | | | - | | | | 41 | |
| Total recoveries | | 3,902 | | | | 643 | | | | 8,764 | | | | 8,141 | |
| | | | | | | | | | | | | | | | |
| Net charge-offs | | 2,292 | | | | 30,099 | | | | 15,561 | | | | 82,569 | |
| | | | | | | | | | | | | | | | |
| Balance at end of period | $ | 166,934 | | | $ | 201,959 | | | $ | 166,934 | | | $ | 201,959 | |
| | | | | | | | | | | | | | | | |
| Annualized ratio of net charge-offs to average loans | | 0.44 | % | | | 4.26 | % | | | 1.45 | % | | | 5.63 | % |
Our Allowance at June 30, 2011 totaled $166.9 million, a decrease of $25.9 million, or 13.4%, from year-end 2010. The decrease in our Allowance was a direct result of $15.6 million in net loan charge-offs and a credit to the Provision of $10.4 million.
Our Provision was a credit of $8.8 million during the second quarter of 2011, compared to a charge of $20.4 million in the second quarter of 2010. The decrease was due to continued improvement in our credit risk profile as evidenced by further declines in nonperforming assets and net charge-offs during the second quarter of 2011, compared to the comparable prior year quarter.
Our Allowance as a percentage of our total loan portfolio decreased from 8.89% at December 31, 2010 to 8.16% at June 30, 2011. Our Allowance as a percentage of our nonperforming assets increased from 63.69% at December 31, 2010 to 66.95% at June 30, 2011.
The decrease in the Allowance is consistent with the sequential quarter decrease in our nonperforming assets, lower net loan charge-off activity, and is consistent with our belief that we have begun to see signs of stabilization in certain sectors of our loan portfolio, the overall economy and the commercial real estate markets both in Hawaii and on the Mainland.
Depending on the overall performance of the local and national economies, the strength of the Hawaii and California commercial real estate markets and the accuracy of our assumptions and judgments concerning our loan portfolio, further adverse credit migration is possible due to the upcoming maturity of additional loans, the possibility of further declines in collateral values and the potential impact of continued financial stress on our borrowers, sponsors and guarantors as they attempt to endure the challenges of the current economic environment. While we have seen preliminary signs of stabilization, we cannot determine when, or if, the challenging economic conditions that we experienced over the past three years will improve and whether or not recent signs of an economic recovery will continue.
In accordance with GAAP, loans held for sale and other real estate assets are not included in our assessment of the Allowance.
Other Operating Income
Total other operating income of $10.9 million for the second quarter of 2011 decreased by $1.8 million, or 14.1%, from the comparable prior year period. The decrease was primarily due to lower unrealized gains on outstanding interest rate locks of $1.0 million and lower income from bank-owned life insurance of $0.9 million.
For the six months ended June 30, 2011, total other operating income of $23.4 million decreased by $2.1 million, or 8.1%, over the comparable prior year period. The decrease was primarily due to lower service charges on deposit accounts of $1.1 million, lower unrealized gains on outstanding interest rate locks of $0.9 million, lower income from bank-owned life insurance of $0.9 million and lower gains on trading securities of $0.7 million. These decreases were partially offset by higher other service charges and fees of $1.2 million and a non-cash gain on the change in fair value of a derivative liability of $1.0 million.
Other Operating Expense
Total other operating expense for the second quarter of 2011 was $40.5 million, compared to $37.6 million in the comparable prior year period. The increase was primarily attributable to a higher provision for repurchased residential mortgage loans of $2.1 million, higher credit-related charges (which include write-downs of loans held for sale, foreclosed asset expense, and changes in the reserve for unfunded commitments) of $1.2 million and higher salaries and employee benefits of $1.0 million. These increases were partially offset by lower legal and professional services of $1.8 million.
For the six months ended June 30, 2011, other operating expense of $78.1 million decreased by $108.7 million, or 58.2%, from the comparable prior year period. The decrease was primarily attributable to the $102.7 million non-cash goodwill impairment charge recorded in the first quarter of 2010, lower legal and professional services of $5.0 million and lower credit-related charges (which include write-downs of loans held for sale, foreclosed asset expense, and changes in the reserve for unfunded commitments) of $3.0 million. These decreases were partially offset by a higher provision for repurchased residential mortgage loans of $2.7 million and higher salaries and employee benefits of $1.2 million.
Income Taxes
We did not recognize any income tax expense in the first half of 2011 or 2010, as we continue to recognize a full valuation allowance against our net DTAs, which was first established in the third quarter of 2009. The establishment of the valuation allowance was primarily based upon our recent net operating losses and the existence of a three-year cumulative loss, which led to our conclusion that it was more likely than not that our DTAs would not be fully realized. In determining the extent of the valuation allowance, management also considered, among other things, carryback/carryforward periods available to us and trends in our historical and projected earnings.
In the second quarter of 2011, we decreased our valuation allowance against our net DTAs by $6.4 million to $172.4 million at June 30, 2011 from $178.8 million at December 31, 2010. Of the total decrease to the valuation allowance, $2.2 million was recognized as a non-cash credit to income tax expense, while the remaining $4.2 million was credited against accumulated other comprehensive loss (“AOCL”).
Financial Condition
Total assets at June 30, 2011 were $4.1 billion, compared to $3.9 billion at December 31, 2010.
Loans and Leases
Loans and leases, net of unearned income, of $2.0 billion at June 30, 2011, decreased by $122.7 million, or 5.7%, from December 31, 2010. The decrease was primarily due to net reductions in the construction and development, commercial mortgage and commercial loan portfolios totaling $72.3 million, $47.4 million and $9.9 million, respectively, partially offset by a net increase in the residential mortgage portfolio of $14.5 million. The net decreases in these portfolios reflect transfers to other real estate totaling $8.5 million, net charge-offs of $15.6 million and paydowns.
Construction and Development Loans
At June 30, 2011, the construction and development loan portfolio (excluding owner-occupied loans) totaled $226.5 million, or 11.1% of the total loan portfolio. Of this amount, $140.1 million were located in Hawaii and $86.4 million were located on the Mainland. This portfolio decreased by $73.5 million from December 31, 2010.
The allowance for loan and lease losses allocated for these loans was $41.6 million at June 30, 2011, or 18.4% of the total outstanding balance. Of this amount, $31.1 million related to construction and development loans in Hawaii and $10.5 million related to construction and development loans on the Mainland.
Nonperforming construction and development assets in Hawaii totaled $107.7 million at June 30, 2011, or 2.6% of total assets. At June 30, 2011, this balance was comprised of portfolio loans totaling $93.0 million and foreclosed properties totaling $14.7 million. Nonperforming assets related to this sector totaled $159.3 million at December 31, 2010.
Nonperforming construction and development assets on the Mainland totaled $57.4 million at June 30, 2011, or 1.4% of total assets. At June 30, 2011, this balance was comprised of portfolio loans totaling $33.6 million and foreclosed properties totaling $23.8 million. Nonperforming assets related to this sector totaled $72.1 million at December 31, 2010.
Deposits
Total deposits of $3.2 billion at June 30, 2011 reflected an increase of $97.4 million, or 3.1%, from December 31, 2010. The increase was primarily attributable to increases in non-interest bearing demand deposits, savings and money market deposits and time deposits of $75.7 million, $25.5 million and $114.6 million, respectively. These increases were partially offset by a decrease in interest-bearing demand deposits of $118.5 million. The decrease in our interest-bearing demand deposits was primarily due to the expiration of the Transaction Account Guarantee Program on December 31, 2010, which resulted in some of our customers transferring balances from interest-bearing demand deposits to non-interest bearing demand deposits to remain fully insured by the FDIC. Also contributing to the decrease in interest-bearing demand deposits was a transfer of approximately $35.0 million in government deposits from interest-bearing demand deposits to time deposits in March 2011.
Core deposits, which we define as demand deposits, savings and money market deposits, and time deposits less than $100,000, totaled $2.7 billion at June 30, 2011 and decreased by $82.7 million from December 31, 2010. The decrease was primarily due to the aforementioned expiration of the Transaction Account Guarantee Program and transfer of government deposits.
Capital Resources
Common Stock
Shareholders’ equity totaled $423.8 million at June 30, 2011, compared to $66.1 million at December 31, 2010. The increase in total shareholders’ equity was a direct result of the completion of the aforementioned Private Placement, TARP Exchange and Rights Offering.
Trust Preferred Securities
We have five statutory trusts, CPB Capital Trust I, CPB Capital Trust II, CPB Statutory Trust III, CPB Capital Trust IV and CPB Statutory Trust V, which issued a total of $105.0 million in trust preferred securities. Our obligations with respect to the issuance of the trust preferred securities constitute a full and unconditional guarantee by the Company of each trust’s obligations with respect to its trust preferred securities. Subject to certain exceptions and limitations, we may elect from time to time to defer subordinated debenture interest payments, which would result in a deferral of dividend payments on the related trust preferred securities, for up to 20 consecutive quarterly periods without default or penalty. We began deferring interest and dividend payments on the subordinated debentures and the trust preferred securities in the third quarter of 2009. During the deferral period, which currently stands at eight consecutive quarters, the respective trusts are likewise suspending the declaration and payment of dividends on the trust preferred securities. Also during the deferral period, we may not, among other things and with limited exceptions, pay cash dividends on or repurchase our common stock or make any payment on outstanding debt obligations that rank equally with or junior to the junior subordinated debentures. During the deferral period, we will continue to accrue, and reflect in our consolidated financial statements, the deferred interest payments on our junior subordinated debentures. At June 30, 2011, accrued interest on our outstanding junior subordinated debentures relating to our trust preferred securities was $6.7 million. With the recent completion of our recapitalization, we may seek regulatory approval to pay all deferred payments under our trust preferred securities.
The FRB has determined that certain cumulative preferred securities having the characteristics of trust preferred securities to qualify as non-controlling interest, and are included in CPF’s Tier 1 capital.
Holding Company Capital Resources
CPF is required to act as a source of strength to the bank under the Bank Holding Company Act. The majority of the funds that we received upon completion of the Private Placement were contributed by CPF to the bank as capital. CPF is obligated to pay its expenses, including payments on its outstanding trust preferred securities. In the past, CPF has primarily relied upon dividends from the bank for its cash flow needs. However, as a Hawaii state-chartered bank, it is prohibited from declaring or paying dividends greater than its retained earnings. As of June 30, 2011, the bank had an accumulated deficit of $468.0 million. The bank will need to eliminate the deficit and generate positive retained earnings before it can pay any dividends. As a result, we do not anticipate receiving dividends from the bank in the foreseeable future. On a stand alone basis, as of June 30, 2011, CPF had approximately $46.4 million of cash available to meet its ongoing obligations.
Capital Ratios
General capital adequacy regulations adopted by the FRB and FDIC require an institution to maintain a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%. In addition to the risk-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage ratio. For a banking organization to be rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets must be 3%. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios.
FDIC-insured institutions must maintain leverage, Tier 1 and total risk-based capital ratios of at least 5%, 6% and 10%, respectively, and not be subject to a regulatory capital directive to be considered “well capitalized” under the prompt corrective action provisions of the FDIC Improvement Act of 1991. The Company’s and the bank’s leverage capital, Tier 1 and total risk-based capital ratios as of June 30, 2011 were above the levels required for a “well capitalized” regulatory designation and the bank is currently in compliance with the Bank MOU which requires that it maintain a leverage capital ratio of at least 8%.
The following table sets forth the Company’s and the bank’s capital ratios, as well as the minimum capital adequacy requirements applicable to all financial institutions as of the dates indicated.
| | | | | | | | | | Minimum Required | | | Minimum Required |
| | | | | | | | | | for Capital | | | to be |
| | | Actual | | | Adequacy Purposes | | | Well Capitalized |
| (Dollars in thousands) | | Amount | | | Ratio | | | Amount | | | Ratio | | | Amount | | | Ratio |
| | | | |
| Company | | | | | | | | | | | | | | | | | | | | |
| At June 30, 2011: | | | | | | | | | | | | | | | | | | | | |
| Leverage capital | | $ | 528,096 | | | 13.1 | % | | | $ | 160,909 | | | 4.0 | % | | | $ | 201,136 | | | 5.0 | % |
| Tier 1 risk-based capital | | | 528,096 | | | 22.5 | | | | | 93,982 | | | 4.0 | | | | | 140,973 | | | 6.0 | |
| Total risk-based capital | | | 559,240 | | | 23.8 | | | | | 187,964 | | | 8.0 | | | | | 234,955 | | | 10.0 | |
| | | | | | | | | | | | | | | | | | | | | | | | |
| At December 31, 2010: | | | | | | | | | | | | | | | | | | | | | | | |
| Leverage capital | | $ | 180,626 | | | 4.4 | % | | | $ | 163,454 | | | 4.0 | % | | | $ | 204,318 | | | 5.0 | % |
| Tier 1 risk-based capital | | | 180,626 | | | 7.6 | | | | | 94,544 | | | 4.0 | | | | | 141,815 | | | 6.0 | |
| Total risk-based capital | | | 212,259 | | | 9.0 | | | | | 189,087 | | | 8.0 | | | | | 236,359 | | | 10.0 | |
| | | | | | | | | | | | | | | | | | | | | | | | |
| Central Pacific Bank | | | | | | | | | | | | | | | | | | | | | | | |
| At June 30, 2011: | | | | | | | | | | | | | | | | | | | | | | | |
| Leverage capital | | $ | 496,556 | | | 12.3 | % | | | $ | 160,966 | | | 4.0 | % | | | $ | 201,208 | | | 5.0 | % |
| Tier 1 risk-based capital | | | 496,556 | | | 21.1 | | | | | 94,052 | | | 4.0 | | | | | 141,078 | | | 6.0 | |
| Total risk-based capital | | | 527,712 | | | 22.4 | | | | | 188,103 | | | 8.0 | | | | | 235,129 | | | 10.0 | |
| | | | | | | | | | | | | | | | | | | | | | | | |
| At December 31, 2010: | | | | | | | | | | | | | | | | | | | | | | | |
| Leverage capital | | $ | 197,626 | | | 4.8 | % | | | $ | 163,500 | | | 4.0 | % | | | $ | 204,376 | | | 5.0 | % |
| Tier 1 risk-based capital | | | 197,626 | | | 8.4 | | | | | 94,592 | | | 4.0 | | | | | 141,888 | | | 6.0 | |
| Total risk-based capital | | | 229,271 | | | 9.7 | | | | | 189,183 | | | 8.0 | | | | | 236,479 | | | 10.0 | |
Liquidity and Borrowing Arrangements
Our objective in managing liquidity is to maintain a balance between sources and uses of funds in order to economically meet the cash requirements of customers for loans and deposit withdrawals and participate in lending and investment opportunities as they arise. We monitor our liquidity position in relation to changes in loan and deposit balances on a daily basis to ensure maximum utilization, maintenance of an adequate level of readily marketable assets and access to short-term funding sources.
Core deposits have historically provided us with a sizeable source of relatively stable and low cost funds, but are subject to competitive pressure in our market. In addition to core deposit funding, we also have access to a variety of other short-term and long-term funding sources, which include proceeds from maturities of our investment securities, as well as secondary funding sources such as the FHLB, secured repurchase agreements, federal funds borrowings and the Federal Reserve discount window, available to meet our liquidity needs. While we historically have had access to these alternative funding sources, access to these sources is not guaranteed and may be influenced by market conditions, our financial position, and the terms of the respective agreements with such sources, as discussed below.
The bank is a member of and maintained a $646.7 million line of credit with the FHLB as of June 30, 2011. At June 30, 2011, we did not have any short-term borrowings outstanding under this arrangement and our long-term borrowings totaled $300.8 million. At December 31, 2010, we had $200.0 million of short-term borrowings outstanding and our long-term borrowings totaled $351.3 million. In March 2011, the $200.0 million in short-term borrowings matured and were paid off. As of June 30, 2011, approximately $345.9 million was undrawn under this arrangement. The FHLB has no obligation to make future advances to the bank.
In accordance with the collateral provisions of the Advances, Security and Deposit Agreement with the FHLB, as of June 30, 2011, all outstanding FHLB advances were secured by investment securities with a fair value of $320.6 million and certain real estate loans totaling $576.3 million.
Besides its line of credit with the FHLB, the bank also maintained a $30.9 million line of credit with the Federal Reserve discount window. There were no borrowings under this arrangement at June 30, 2011 and December 31, 2010. Advances under this arrangement would have been secured by certain commercial real estate loans with a carrying value of $123.8 million at June 30, 2011.
As of June 30, 2011, the entire $30.9 million line amount was available to the bank for future borrowings; however, the Federal Reserve has the right to decline to make advances under this line of credit. Since September 2009, the bank was no longer eligible to access the Federal Reserve’s primary credit facility but maintained access to its secondary facility. There was no change in the level of credit available to the bank. However, future advances will have higher borrowing costs under the secondary facility. Furthermore, all terms and maturities of advances under this arrangement are at the discretion of the Federal Reserve and are generally limited to overnight borrowings.
Our ability to maintain adequate levels of liquidity is dependent on us continuing to execute our recovery plan, and more specifically, our ability to continue to improve our credit risk profile, maintain our capital base, and comply with the provisions of our agreements with regulators. Beyond the challenges specific to our situation, our liquidity may also be negatively impacted by weakness in the financial markets and industry-wide reductions in liquidity.
Contractual Obligations
Information regarding our contractual obligations is provided in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the year ended December 31, 2010. There have been no material changes in our contractual obligations since December 31, 2010.
