Our capacity to estimate repurchase losses is advancing as we record additional experience. Repurchase losses depend upon economic factors and other external conditions that may change over the life of the underlying loans. Additionally, lack of access to the servicing records of loans sold on a service released basis adds difficulty to the estimation process, thus 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.
Other Intangible Assets
Other intangible assets include a core deposit premium and mortgage servicing rights.
We utilize the amortization method to measure our mortgage servicing rights. Under the amortization method, we amortize our mortgage servicing rights in proportion to and over the period of net servicing income. Income generated as the result of new mortgage servicing rights is reported as gains on sales of loans. Amortization of the servicing rights is reported as amortization of other intangible assets in our consolidated statements of operations. Ancillary income is recorded in other income. Mortgage servicing rights are recorded when loans are sold to third-parties with servicing of those loans retained and we classify our entire mortgage servicing rights into one class.
Initial fair value of the servicing right is calculated by a discounted cash flow model prepared by a third party service provider based on market value assumptions at the time of origination and we assess the servicing right for impairment using current market value assumptions at each reporting period. Critical assumptions used in the discounted cash flow model include mortgage prepayment speeds, discount rates, costs to service and ancillary income. Variations in our assumptions could materially affect the estimated fair values. Changes to our assumptions are made when current trends and market data indicate that new trends have developed. Current market value assumptions based on loan product types (fixed rate, adjustable rate and balloon loans) include average discount rates and national prepayment speeds. Many of these assumptions are subjective and require a high level of management judgment. Our mortgage servicing rights portfolio and valuation assumptions are periodically reviewed by management.
Prepayment speeds may be affected by economic factors such as home price appreciation, market interest rates, the availability of other credit products to our borrowers and customer payment patterns. Prepayment speeds include the impact of all borrower prepayments, including full payoffs, additional principal payments and the impact of loans paid off due to foreclosure liquidations. Because of the depressed interest rate environment, prepayment speeds have increased as customers continue to refinance existing mortgages under more favorable interest rate terms. The increased prepayment speeds reduced the amount of cash flows we expected to realize from our mortgage servicing rights and increased the amount of amortization expense that we incurred during the nine months ended September 30, 2012.
We 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 assessments 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 judgment and often involves the use of significant estimates and assumptions. The variability of the factors we use to perform our impairment tests depend on a number of conditions, including the 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.
During the second quarter of 2012, we evaluated the recoverability of the intangible assets related to our customer relationships and non-compete agreements. Upon completion of this review, we determined that the intangible assets related to our customer relationships and non-compete agreements were both fully impaired, and thus, we recorded impairment charges to other operating expense totaling $0.9 million during the second quarter of 2012.
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 full valuation allowance against our net DTAs. See “— Results of Operations — Income Taxes” below. As noted in “— Recovery Plan Progress —,” we have reported seven consecutive quarters of profitability since our recapitalization in February of 2011. If we are able to maintain this positive trend, we may be able to begin reversing the valuation allowance sometime in fiscal 2013.
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, 2011, we used a weighted-average discount rate of 4.8% 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 2011 and the amount of pension expense to be recorded in 2012. 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 2012, 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 2012 pension expense by less than $0.1 million and year-end 2011 pension liability by $0.9 million, while a 0.25% change in the asset return rate would impact 2012 pension expense by less than $0.1 million.
Impact of Recently Issued Accounting Pronouncements on Future Filings
In December 2011, the FASB issued ASU 2011-11, “Disclosures About Offsetting Assets and Liabilities.” ASU 2011-11 expands the disclosure requirements for financial instruments and derivatives that may be offset in accordance with enforceable master netting agreements or similar arrangements. The disclosures are required regardless of whether the instruments have been offset (or netted) in the balance sheet. Under ASU 2011-11, companies must describe the nature of offsetting arrangements and provide quantitative information about those agreements, including the gross and net amounts of financial instruments that are recognized in the balance sheet. ASU 2011-11 is effective for the Company’s reporting period beginning on January 1, 2013, with retrospective application required. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.
In July 2012, the FASB issued ASU 2012-02, “Testing Indefinite-Lived Intangible Assets for Impairment.” The provisions of ASU 2012-02 permit an entity to first assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform a quantitative impairment test, as is currently required by GAAP. ASU 2012-02 is effective for annual and interim impairment tests performed for the Company’s reporting period beginning on January 1, 2013. As the Company does not have any indefinite-lived assets, we do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.
Material Trends
While there remains continued uncertainty in the global macroeconomic environment, the U.S. economy has continued to show signs of stabilization following the economic downturn caused by disruptions in the financial system in 2008.
Despite recent signs of stabilization, concerns about the global and U.S. economies still remain, including concerns over the European sovereign debt crisis and the pending “fiscal cliff” at the beginning of 2013 when federal tax hikes and spending cuts are scheduled to take effect together. Growing U.S. government indebtedness, a large budget deficit, and concerns over the federal debt ceiling continue to add to the uncertainty surrounding a sustained economic recovery. In addition, downgrades of ratings in United States and foreign debt instruments could raise borrowing costs and adversely impact the mortgage and housing markets.
The majority of our operations are concentrated in the state of Hawaii. As a result, our performance is significantly influenced by conditions in the banking industry, macro economic conditions and the real estate markets in Hawaii. 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 the reverse.
According to the Hawaii Department of Business Economic Development & Tourism (“DBEDT”), based on the recent developments in the national and global economy, the performance of Hawaii’s tourism industry, the labor market conditions in the state, and growth of personal income and tax revenues, Hawaii’s economy is expected to continue positive growth for the rest of 2012 and into 2013. Tourism continues to be Hawaii’s center of strength and its most significant economic driver. Hawaii’s visitor industry is expected to break records for arrivals and visitor spending this year. According to the Hawaii Tourism Authority (“HTA”), 6.0 million visitors visited the state in the nine months ended September, 2012. This was an increase of 9.6% from the number of visitor arrivals in the nine months ended September 30, 2011, with growth from all visitor markets. The HTA also reported that total visitor spending increased to $10.67 billion in the nine months ended September 30, 2012, an increase of $1.75 billion, or 19.5%, from the nine months ended September 30, 2011. According to a report from the University of Hawaii Economic Research Organization, total visitor arrivals and visitor spending are expected to end the year up 9.3% and 15.7%, respectively, from 2011. For 2013, the growth rates for total visitor arrivals and visitor spending are expected to be more moderate with gains of 3% and 8%, respectively.
The Department of Labor and Industrial Relations reported that Hawaii’s seasonally adjusted annual unemployment rate improved to 5.7% in September 2012, compared to 6.8% during the same month a year ago. In addition, Hawaii’s unemployment rate in September 2012 of 5.7% remained below the national seasonally adjusted unemployment rate of 7.8%, compared to 9.0% during the same month a year ago. DBEDT projects real personal income to grow by 1.5% and 2.1% in 2012 and 2013, respectively, and real gross state product to grow by 1.5% and 2.3% in 2012 and 2013, respectively.
Historically, real estate lending has been a primary focus for CPF, including all segments, 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 increased by 2.40% for single-family homes and by 1.96% for condominiums for the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011. The median sales price for single-family homes on Oahu for the month ended September 30, 2012 was $637,000, representing an increase of 11.8% from the same prior year period. The median sales price for condominiums on Oahu for the month ended September 30, 2012 increased by 0.9% to $319,500, compared to the same prior year period. As part of our plans to reduce our nonperforming assets, we have taken and will continue to take, steps to reduce certain aspects of our commercial real estate and construction loan portfolios. While some economists and real estate professionals remain optimistic that the Hawaii real estate market will continue to show improvement through the summer, there can be no assurance that this will occur.
While our operations are predominantly concentrated in the state of Hawaii, our performance is also influenced by economic conditions in California. California, like the rest of the nation, appears to be in the midst of an uneven economic recovery as some sectors of the economy are doing well and others are not. Most of the indicators that affect the nation, both positive and negative, also affect California. In 2011, personal income grew but these gains and many others like them paled in comparison to the losses incurred during the recession. The outlook for the California economy is guardedly positive for 2012, followed by stronger growth in 2013 and 2014. The California Association of Realtors (“CAR”) reported that for the nine months ended September 30, 2012 unit single family home sales were down 1.2% from the same period a year ago due to tight housing inventory. However, the median sales price for single family homes in California for the month ended September 30, 2012 increased by 19.5% from year ago levels to $345,000. CAR anticipates California 2012 single family home resales to improve by 5.1% to 523,300 units from 497,900 units in 2011 and forecasts a gain of 1.3% from 2012 levels to 530,000 units in 2013. The California median home price is projected to increase 10.9% to $317,000 in 2012 and 5.7% to $335,000 in 2013.
According to the California Department of Finance, average personal income for 2012 is expected to increase 3.7% from 2011. Labor markets within the state improved since the year ago period but remained weak in the nine months ended September 30, 2012. The State of California Employment Development Department reported California’s seasonally adjusted unemployment rate in September 2012 decreased to 10.2% from 11.7% in the prior year, but continues to be well above the national unemployment rate of 7.8%.
As we have seen over the past few years, our operating results are significantly impacted by the economy in Hawaii, and to a lesser extent, in California due to the composition of our loan portfolio. Loan demand, deposit growth, Provision, 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 nine months ended September 30, 2012 and 2011 is set forth below.
