UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C. 20549
FORM 10-Q
X QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
- --- OF 1934
For the quarter ended June 30, 1995
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
- --- ACT OF 1934
For the transition period from to
-------- --------
Commission File Number 0-1100
HAWTHORNE FINANCIAL CORPORATION
--------------------------------------
(Exact Name of Registrant as Specified in its Charter)
DELAWARE 95-2085671
-------------------------------------------------------------------
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
2381 ROSECRANS AVENUE, EL SEGUNDO, CA 90245
------------------------------------------------------------------------
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE (310) 725-5000
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
---- ----
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date: The Registrant had 2,599,275
shares outstanding of Common stock, $1.00 par value per share, as of
August 1, 1995.
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
FORM 10-Q INDEX
FOR THE QUARTER ENDED JUNE 30, 1995
Page
----
PART I - FINANCIAL INFORMATION
ITEM 1. Financial Statements
Condensed Consolidated Statements of Financial Condition
at June 30, 1995 (Unaudited) and December 31, 1994 3
Condensed Consolidated Statements of Operations (Unaudited)
for the Three and Six Months Ended June 30, 1995 and 1994 4
Condensed Consolidated Statements of Stockholders' Equity (Unaudited)
for the Six Months Ended June 30, 1995 and 1994 5
Condensed Consolidated Statements of Cash Flows (Unaudited)
for the Three and Six Months Ended June 30, 1995 and 1994 6
Notes to Condensed Consolidated Financial Statements (Unaudited) 7
ITEM 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 8
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings 25
ITEM 2. Changes in Securities 25
ITEM 3. Defaults upon Senior Securities 25
ITEM 4. Submission of Matters to Vote of Security Holders 25
ITEM 5. Other Materially Important Events 25
ITEM 6. Exhibits and Reports on Form 8-K 25
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(DOLLARS ARE IN THOUSANDS)
ASSETS
JUNE 30, DECEMBER 31,
1995 1994
(UNAUDITED) (AUDITED)
---------- -----------
Cash and cash equivalents $ 18,277 $ 18,063
Investment securities at amortized cost (estimated market
value of $29,321 (1994)) 30,190
Investment securities at market value 13,726
Mortgage-backed securities at amortized cost (estimated
market value of $52,249 (1995) and $53,993 (1994)) 52,980 57,395
Loans receivable (net of allowance for estimated losses of
$20,690 (1995) and $21,461 (1994)) 546,576 537,020
Real estate owned (net of allowance for estimated losses of
$13,507 (1995) and $33,517 (1994)) 63,509 62,613
Office premises and equipment - at cost, net 10,133 10,538
Investment in capital stock of Federal Home Loan Bank - at cost 6,156 6,995
Accrued interest receivable 3,212 3,542
Income tax receivables 2,630 2,630
Other assets 1,624 1,081
---------- -----------
$ 705,097 $ 743,793
========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Deposit accounts $ 670,019 $ 649,382
Reverse repurchase agreements 47,141
Accounts payable and other liabilities 5,901 6,078
Income taxes payable 365
---------- -----------
675,920 702,966
Stockholders' equity 29,177 40,827
---------- -----------
$ 705,097 $ 743,793
========== ===========
The accompanying notes are integral part of these financial statements.
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(DOLLARS ARE IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------ --------------------
1995 1994 1995 1994
------- ------- -------- --------
Interest revenues
Loans $11,387 $12,099 $ 22,725 $ 24,886
Investment securities 492 968 1,468 1,961
Mortgage-backed securities 839 726 1,739 1,152
------- ------- -------- --------
12,718 13,793 25,932 27,999
------- ------- -------- --------
Interest costs
Deposits (8,349) (7,232) (15,815) (14,722)
Borrowings (138) (585)
------- ------- -------- --------
(8,487) (7,232) (16,400) (14,722)
------- ------- -------- --------
Gross interest margin 4,231 6,561 9,532 13,277
Credit losses on loans
Accrued interest on nonaccrual loans (677) (1,595) (1,407) (3,249)
Loan principal (1,063) (12,745) (1,147)
------- ------- -------- --------
Net interest margin 3,554 3,903 (4,620) 8,881
Non-interest revenues 364 450 1,047 1,197
Operating costs (4,918) (5,151) (10,039) (10,195)
Real estate operations, net 650 (125) 816 (1,307)
Securities gains, net 147 3,049
Loan sale gains, net 68 68
------- ------- -------- --------
Pretax loss (135) (923) (9,679) (1,424)
Income taxes (45) (585) (126)
------- ------- -------- --------
NET (LOSS) $ (135) $ (968) $(10,264) $ (1,550)
======= ======= ======== ========
Net loss per share $ (0.05) $ (0.37) $ (3.95) $ (0.60)
======= ======= ======== ========
Dividends paid per share N/A N/A N/A N/A
======= ======= ======== ========
Average shares of common stock outstanding 2,599 2,599 2,599 2,599
======= ======= ======== ========
Dividend payout ratio N/A N/A N/A N/A
======= ======= ======== ========
The accompanying notes are an integral part of these financial statements.
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (UNAUDITED)
(DOLLARS ARE IN THOUSANDS)
SIX MONTHS ENDED
JUNE 30,
------------------------
1995 1994
---------- ---------
Balance at beginning of period $ 40,827 $ 43,949
Change in unrealized gain/(loss) on
available for sale securities (1,394) 289
Net loss for the period (10,264) (1,550)
Repayment of ESOP loan 8 10
-------- --------
Balance at end of period $ 29,177 $ 42,698
======== ========
The accompanying notes are an integral part of these financial statements.
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(DOLLARS ARE IN THOUSANDS)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------------- -------------------------
1995 1994 1995 1994
------------ ------------ ------------ -----------
OPERATING ACTIVITIES
Net Loss $ (135) $ (968) $ (10,264) $ (1,550)
Adjustments
Decrease in income tax receivable 7,495 15,513
Depreciation and amortization 470 161 1,011 319
FHLB stock dividends (77) (73) (177) (141)
Decrease (increase) in interest receivable 661 382 330 95
Decrease in income taxes payable (399)
Amortization of loan fees (415) (343) (1,348) (714)
Decrease (increase) in other assets (35) 831 (507) (25)
Decrease (increase) in other liabilities 918 (238) (132) (1,260)
Provision for estimated credit losses 1,000 12,700 1,000
Provision for other asset disposal 182 403
Net cash provided by operating activities 1,569 8,247 1,617 13,237
-------- -------- -------- --------
INVESTING ACTIVITIES
Investment securities
Purchases 13 (10,053) (111) (10,053)
Maturities 32,000 34,000
Sales--available for sale securities 29,984 42,472
Mortgage-backed securities
Principal amortization 1,513 1,198 2,975 1,953
Sales 1,438
Purchases (14,593) (24,549)
Lending
New loans funded (40,353) (64,710) (237)
Disbursements on construction loans (2,231) (1,439) (2,600) (2,596)
Principal payments by borrowers 5,282 4,025 9,142 7,636
Payoffs 5,164 13,928 12,255 29,764
Sales 19,282 19,282
Other, net (2,349) 694 (3,689) 540
Real estate owned
Proceeds from sales of properties 6,769 17,141 14,330 32,016
Past-foreclosure disbursements (3,716) (6,294) (6,448) (9,175)
Other, net 311 (1,169) 132 (1,789)
Redemption of FHLB stock 1,015 1,015 802
Fixed asset additions (502) (1,747) (1,134) (2,129)
Fixed asset sales 744 744
-------- -------- --------- --------
Net cash provided by investing activities 20,926 33,691 25,093 56,183
-------- -------- --------- --------
FINANCING ACTIVITIES
Net (decrease) increase in deposits (11,402) (16,210) 20,637 (47,574)
Net repayment of reverse repurchase agreements (8,585) (47,141)
Repayment of ESOP loan 2 6 8 10
-------- -------- --------- --------
Net cash used in financing activities (19,985) (16,204) (26,496) (47,564)
-------- -------- --------- --------
NET CHANGE IN CASH AND CASH EQUIVALENTS 2,510 25,734 214 21,856
BEGINNING CASH AND CASH 15,767 39,023 18,063 42,901
------- -------- --------- --------
ENDING CASH AND CASH EQUIVALENTS $ 18,277 $ 64,757 $ 18,277 $ 64,757
======== ======== ========= ========
Supplemental disclosures of cash flow information
Cash paid during the period for
Interest $ 8,770 $ 7,232 $ 17,008 $ 14,787
Non-cash investing and financing activities
Real estate owned additions $ 14,792 $ 24,890 $ 22,629 $ 2,771
Loans originated to finance property sales 231 5,255 446 8,040
Transfer of held to maturity securities to
available for sale 30,168
The accompanying notes are an integral part of these financial statements.
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
JUNE 30, 1995
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The consolidated financial statements include the accounts of Hawthorne
Financial Corporation and its wholly-owned subsidiary, Hawthorne Savings,
F.S.B. ("Bank"), collectively referred to as the "Company". All material
intercompany transactions and accounts have been eliminated.
In the opinion of management, the unaudited condensed consolidated
financial statements contain all adjustments (consisting solely of normal
recurring accruals) necessary to present fairly the Company's financial
position as of June 30, 1995 and December 31, 1994 and the results of its
operations and its cash flows for the six months ended June 30, 1995 and
1994. Certain information and note disclosures normally included in
financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted pursuant to the rules
and regulations of the Securities and Exchange Commission ("SEC"). Operating
results for the six months ended June 30, 1995 are not necessarily indicative
of the results that may be expected for the full year ending December 31,
1995.
These unaudited condensed consolidated financial statements should be
read in conjunction with the audited consolidated financial statements and
notes thereto included in the Company's Annual Report on Form 10-K for the
year ended December 31, 1994.
LOAN IMPAIRMENT
A loan is identified as impaired when it is probable that interest and
principal will not be collected according to the contractual terms of the
loan agreement. The accrual of interest is discontinued on such loans and no
income is recognized until all recorded amounts of interest and principal are
recovered in full.
2. RECENT ACCOUNTING PRONOUNCEMENTS
The Financial Accounting Standards Board ("FASB") has issued Statement of
Financial Accounting Standards Number 114 "Accounting by Creditors for
Impairment of a Loan," ("SFAS 114") that requires impaired loans be
measured based on the present value of expected future cash flows discounted
at the effective interest rate of the loan, at the observable market price of
the loan, or at the fair value of the collateral if the loan is collateral
dependent.
FASB has issued Statement of Financial Accounting Standards Number 118
"Accounting by Creditors for Impairment of a Loan -- Income Recognition and
Disclosures -- an amendment of FASB Statement No. 114," ("SFAS 118") which
amends SFAS 114, to allow a creditor to use existing methods for recognizing
interest income on an impaired loan. To accomplish that, it eliminates the
provisions in SFAS 114 that described how a creditor should report income on
an impaired loan.
The Company adopted SFAS 114 and 118 as of January 1, 1995, and the
effect on the Company's financial statements was insignificant.
FASB issued Statement of Financial Accounting Standards Number 119
"Disclosure about Derivative Financial Instruments and Fair Value of
Financial Instruments," ("SFAS 119") which requires improved disclosures
about derivative financial instruments, such as futures, forwards, options,
swaps, and other financial instruments with similar characteristics. SFAS
119 also amends existing requirements of FASB Statement No. 105, "Disclosure
of Information about Financial Instruments with Off-Balance Sheet Risk and
Financial Instruments with Concentrations of Credit Risk," and FASB Statement
No. 107, "Disclosures about Fair Value of Financial Instruments". The
Company adopted SFAS 119 as of December 31, 1994.
3. RECLASSIFICATIONS
Certain amounts in the 1994 consolidated financial statements have been
reclassified to conform with classifications in 1995.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
The Company reported a net loss of $135,000 for the second quarter of
1995, compared to net losses of $10.1 million and $1.0 million for the first
quarter of 1995 and the second quarter of 1994, respectively. For the six
months ended June 30, 1995 and 1994, the Company reported net losses of $10.3
million and $1.6 million, respectively. For the years ended December 31, 1994
and 1993, respectively, the Company reported net losses of $3.0 million and
$29.6 million. The net loss for 1995 resulted from provisions of $12.7
million to increase the Company's classified loan and property loss reserves.
No such provisions were recorded during the second quarter of 1995. Most of
the 1995 provisions were attributable to an increase in reserves allocated to
the Company's foreclosed apartment buildings and for its apartment loan
collateral. The higher reserve levels now maintained for these portfolios
reflect management's application of capitalization rates higher than those
utilized in 1994 to value property cash flows. The higher capitalization
rates reflects the increase, since mid-1994, in the cost of market financing
of apartment buildings and, in turn, the higher cash flow returns commanded
by purchasers of such buildings.
Partially offsetting the credit loss provisions during the first half of
1995 were securities gains which, net of tax adjustments, totalled $2.5 million
and which resulted from the liquidation of all of the Company's
available-for-sale securities portfolio, which totaled $42 million. During
the second quarter, the Company also sold of $20 million in FNMA-qualified,
single family fixed rate mortgage loans. These sales increased the Company's
capital, provided liquidity to repay wholesale borrowings and for future loan
financings and substantially reduced the Company's interest rate risk.
Notwithstanding the improvements in operating results during the second
quarter of 1995 as compared to the prior quarter and the prior year period,
the Company continues to be burdened with the high costs associated with
foreclosed properties and nonperforming loans. At June 30, 1995,
nonperforming assets, net of reserves, totaled $81 million, or 11% of total
assets. By comparison, the related balances and ratios to total assets as of
December 31, 1994 and June 30, 1994 were $94 million and 13%, and $135
million and 16%, respectively. During July 1995, the Company commenced
marketing certain of its foreclosed apartment buildings for sale. The
Company's investment in this portfolio approximates 45% of its entire
forclosed property portfolio and approximates 35% of all assets classified as
nonperformning. The portfolio owned at June 30, 1995 has been accumulated
over a two-year period, during which time the Company has substantially
increased property cash flows and invested the funds necessary to cure
deferred maintenance and to make needed capital improvements. This portfolio
currently produces cash flow returns of over 10% on the Company's
written-down investment.
The 1995 second quarter included the first significant new loan
production since 1992. For the three and six-month periods ended June 30,
1995, the Company originated $46 million and $74 million, respectively, of
new loans, including construction commitments. Less than $1.0 million of
these totals were related to the financing of previously owned properties.
Since 1992, the Company has almost exclusively focused its attention on
resolving its portfolio of problem assets. With this portfolio now
substantially reduced from its levels in 1992 through 1994, the Company
launched several new financing business in January 1995, principally to
provide financing to owners and purchasers of existing apartment buildings
and expensive, estate homes. To a lesser extent, the Company's new loans
are secured by commercial income properties, individual homes under
construction, and affordable homes within its local markets. Generally,
the Company has focused on specialized niche markets requiring high levels
of service and flexibility in structuring specific transactions. Accordingly,
the Company is compensated for its financing activities by receiving margins
on its loans well in excess of the margins typically commanded by other
lenders. The loan production to date is now of sufficient magnitude to begin
to positively and measurably impact the Company's interest margins. These
results, as well as the benefits realized from the upward repricing of the
Company's adjustable-rate loan portfolio, should continue to gradually improve
the Company's net interest margin during the next several quarters, absent a
significant or prolonged rise in market interest rates.
At June 30, 1995, the Bank had core and risk-based capital ratios of
3.94% and 7.57%, respectively, as compared with the minimum requirements for
such ratios at that date of 4% and 8%, respectively. Under the Federal
Deposit Insurance Corporation Improvement Act ("FDICIA"), the Office of Thrift
Supervision ("OTS") has issued "prompt corrective action" regulations with
specific capital ranking tiers for thrift institutions. Progressively more
stringent operational limitations and other corrective actions are required
as an institution declines in the
capital ranking tiers. With the loss recorded during the first half of 1995,
the Bank's capital designation has declined from "adequately capitalized" to
"under capitalized". On June 30, 1995, the Bank and its Board of Directors
stipulated and consented to the issuance of a prompt corrective action
directive (the "Directive") issued by the OTS, the Bank's primary regulator.
The Directive was issued as a condition of acceptance by the OTS of the
Bank's capital restoration plan. The Directive requires the Bank, among other
things, (i) to comply with the terms of the revised business plan, (ii) to
achieve a capital infusion of between $15 million and $20 million by December
15, 1995, (iii) to retain an investment banking firm to assist in the
recapitalization of the Bank, (iv) to comply with all of the mandatory prompt
corrective action provisions automatically applicable to the Bank based on
its prompt corrective action capital category, and (v) to maintain its total
assets at a level not to exceed its total assets as of year end 1994. Unless
otherwise approved by the OTS, the Directive also requires that the Bank
comply with an OTS-approved time schedule specifying dates between the
execution of the Directive and December 15, 1995, by which the Bank must
complete specific intermediate steps toward achievement of the capital
infusion required by the Directive. Failure to comply with the Directive
could result in a forced sale of the Bank at a distressed price under
regulatory compulsion or the appointment of a conservator or receiver for the
Bank. In addition, the Directive states that it does not prevent the OTS
from taking any other type of supervisory, enforcement or resolution action
that the OTS determines to be appropriate.
The Company has engaged an investment banking firm and has been actively
assessing the types of capital instruments available, and the requirements of
the investment community given the Company's financial condition.
The Company had total assets at June 30, 1995 of $705 million, down from
$744 million at December 31, 1994 and $831 million at June 30, 1994. The
Company's continuing efforts to expand its core retail deposit base have
generated positive results, with deposits totaling $671 million at June 30,
1995, an increase from $649 million at year end 1994. Deposits at June 30,
1994 were $782 million, which included deposits of $187 million associated
with several offices which were subsequently sold to other institutions.
OPERATING RESULTS
INTEREST MARGIN
The Company's net interest margin, or the difference between the yield
earned on loans, mortgage-backed securities and investment securities and the
cost of funds to support those earning assets, is affected by several
factors, including (1) the level of, and the relationship between, the dollar
amount of interest-earning assets and interest-bearing liabilities, (2) the
relationship between repricing of the Company's adjustable-rate loans and
short-term investment securities and its funding sources, (3) the
relationship between market interest rates and local deposit rates offered by
competing institutions, and (4) the magnitude of the Company's nonperforming
assets.
The table below set forth average interest-earning assets and
interest-bearing liabilities, and their related effective yields and costs,
for the six months ended June 30, 1995 and 1994, and for the year ended
December 31, 1994, and for the same periods, as adjusted to reflect the
impact of nonaccrual loans (dollars in thousands).
JUNE 30, 1995 DECEMBER 31, 1994 JUNE 30, 1994
----------------- ------------------- ------------------
YIELD/ YIELD/ YIELD/
AMOUNT COST AMOUNT COST AMOUNT COST
-------- ------ --------- ------- --------- ------
INTEREST-EARNING ASSETS
Loans $566,915 8.02%(1) $ 608,651 7.85%(1) $ 640,906 7.77%(1)
Cash and investment
securities 48,031 6.11% 97,442 4.64% 99,456 3.94%
Mortgage-backed
securities 54,999 6.32% 45,810 6.47% 36,179 6.37%
-------- --------- ---------
669,945 7.74% 751,903 7.35% 776,541 7.21%
-------- ------ --------- ------- --------- ------
INTEREST-BEARING LIABILITIES
Deposits 666,084 4.79% 763,302 3.89% 802,041 3.66%
Borrowings 19,212 6.06% 14,333 5.23%
-------- --------- ---------
685,296 4.83% 777,635 3.91% 802,041 3.66%
-------- ------ --------- ------- --------- ------
Interest-bearing gap/
Gross interest margin (15,350) 2.85% (25,732) 3.30% (25,500) 3.42%
NONACCRUAL LOANS (34,159) (-0.42%) (76,386) (-0.75%) (92,899) (-0.84%)
-------- ------ --------- ------- --------- ------
Adjusted interest-bearing
gap/Net interest margin $(49,509) 2.43% $(102,118) 2.55% $(118,399) 2.58%
======== ====== ========= ======= ========= =====
<FN>
- ------------
(1) Effective yield, inclusive of deferred fees.
The table below sets forth the balances of interest-earning assets and
interest-bearing liabilities and their contractual yields and costs, at
period end and as of the dates indicated (dollars in thousands).
1995 1994
---------------------- -----------------------------------
JUNE 30, MARCH 31, DEC 31 SEPT 30 JUNE 30
--------- --------- --------- --------- ---------
BALANCES
Interest-earning assets $ 641,652 $ 672,932 $ 683,637 $ 697,814 $ 748,141
Interest-bearing liabilities (670,019) (690,006) (696,523) (715,578) (783,485)
--------- --------- --------- --------- ---------
Interest-bearing gap (28,367) (17,074) (12,886) (17,764) (35,344)
Non-accrual loans (23,222) (34,220) (39,396) (63,563) (75,897)
--------- --------- --------- --------- ---------
Adjusted interest-bearing
gap $ (51,589) $ (51,294) $ (52,282) $ (81,327) $(111,241)
========= ========= ========= ========= =========
YIELDS AND COSTS
Interest-earning assets 7.49%(1) 7.19%(1) 6.97%(1) 6.96%(1) 6.87%(1)
Interest-bearing liabilities (-5.06%) (-4.79%) (-4.40%) (-4.18%) (-3.82%)
Gross interest margin 2.20% 2.28% 2.48% 2.68% 2.87%
Nonaccrual loans (-0.28%) (-0.37%) (-0.41%) (-0.95%) (-0.74%)
Net interest margin 1.92% 1.91% 2.07% 1.73% 2.13%
<FN>
- ------------
(1) Contractual yield, exclusive of deferred fees.
The amount of the Company's adjusted interest-bearing gap has steadily
improved over the past five quarters because foreclosed properties have been
sold at a rate in excess of net new defaults, and to a lesser extent, the
change in composition of the balance sheet as lower yielding assets were
converted to cash to support new
financing activities and retire wholesale borrowings. In particular, for the
six months ended June 30, 1995, net new defaults amounted to $5.0 million,
while net property sales from foreclosed assets amounted to $14.3 million.
The Company's gross interest margin, expressed as a percentage of
interest-earning assets, has steadily declined since 1993 due to the high
volume of foreclosures and nonperforming assets, the rapid and significant
rise in interest rates since early 1994 and its affect on funding costs, the
lag in repricing of adjustable-rate assets, and the lack of any measurable
new loan production. During the second quarter of 1995, new loan production
began to have a marginal benefit to the overall yield on earning assets and
the adjustable-rate loan portfolio, principally indexed to the 11th DCOFI,
began to reprice. The Company's deposits generally have maturities of less
than one year. Accordingly, a majority of the Companys deposits repriced
during 1994 at interest rates reflective of the rise in market interest rates.
A significant portion of the liability portfolio was further impacted by a
spike in market interest rates during the first quarter of 1995. Subsequently,
market interest rates have generally declined and have begun to be reflected
in the Company's deposit portfolio as accounts mature. At year end 1994,
the Company's cost of funds was 4.40%, and increased to 4.79% and 5.06%, for
the quarters ended March and June, respectively. The 11th DCOFI was 4.59% at
year end 1994, and increased to 5.01% and 5.18% for the quarters ended March
and June, respectively. Though the Company maintains a modest funding advantage
to the 11th DCOFI, its cost of funds increased by 66 basis points during the
first six months of 1995. This compares unfavorably to the 11th DCOFI's rate
of change for the same period, which was 59 basis points.
During the second half of 1995, management expects that the yield on the
Company's interest-earning assets will continue to gradually rise as the 11th
DCOFI incorporates its proportionate share of the recent rise in market
interest rates, and the Company's new financing activities begin to represent
an increasing percentage of total loans. The Company's net interest margin is
also expected to improve as its cost of funds begins to level off and the
Company continues its resolution of nonperforming assets.
OPERATING COSTS
The table below sets forth the Company's operating costs for the
three-month and six-month periods indicated. The compensatory and legal
costs directly associated with the Company's property management and
disposal operations are excluded from the table below and are included in
Real Estate Operations (see REAL ESTATE OPERATIONS) (dollars are in thousands).
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
---------------------------- ------------------------------
1995 1994 CHANGE 1995 1994 CHANGE
------ ------ ------ ------- ------- ------
Employee-related ($2,469) ($1,974) ($ 495) ($ 5,043) ($ 4,343) ($ 700)
Occupancy (675) (672) (3) (1,463) (1,424) (39)
Operating (845) (1,439) 594 (1,674) (2,334) 660
Professional fees (387) (388) 1 (768) (737) (31)
------ ------ ------ ------- ------- -----
(4,376) (4,473) 97 (8,948) (8,838) (110)
SAIF premiums and
OTS assessments (542) (678) 136 (1,091) (1,357) 266
------ ------ ------ ------- ------- -----
($4,918) ($5,151) $233 ($10,039) ($10,195) $156
====== ====== ====== ======= ======= =====
Direct compensation and incentives represent approximately 75% of all
employees-related expenses. Management believes it has a full complement of
staff currently in place to effectively complete the bank-wide structuring.
The reduction in operating expenses during the current year is principally
associated with reduced expenditures in marketing and advertising, and the
benefit derived from deferral of loan origination costs over the life of the
new financing activities. The reduction in SAIF premiums during 1995 reflect
the benefit from several branch deposit sales which occurs during the last
half of 1994.
NON-INTEREST REVENUES
The table below sets forth the Companys noninterest revenues for the
periods indicated (dollars are in thousands).
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------------------------- ------------------------------------
1995 1994 CHANGE 1995 1994 CHANGE
----------- ---------- ----------- ---------- ---------- ----------
Loan and escrow fees $ 137 $ 163 $ (26) $ 233 $ 387 $ (154)
Deposit account fees 139 126 13 319 301 18
Other income 88 161 (73) 495 509 (14)
----------- ---------- ----------- ---------- ---------- ----------
$ 364 $ 450 $ (86) $ 1,047 $ 1,197 $ (150)
=========== ========== =========== ========== ========== ==========
Loan and escrow fees in 1994 were higher than current period amounts
due to prepayments on existing mortgage loans subject to refinancing.
REAL ESTATE OPERATIONS
The table below sets forth the revenues and costs attributable to the
Companys real estate operations for the three-month periods indicated.
The compensatory and legal costs directly associated with the Companys
property management and disposal operations are included in the table
below in Operating Costs (dollars are in thousands).
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------------------------- ------------------------------------
1995 1994 CHANGE 1995 1994 CHANGE
----------- ---------- ----------- ---------- ---------- ----------
EXPENSES ASSOCIATED WITH REAL ESTATE OWNED
Operating costs
Employee $ (172) $ (587) $ 415 $ (360) $ (957) $ 597
Operating (25) (140) 115 (51) (189) 138
Professional (102) (227) 125 (188) (426) 238
----------- ---------- ----------- ---------- ---------- ----------
(299) (954) 655 (599) (1,572) 973
Holding costs
Property Taxes (9) (35) 26 (32) (1,485) 1,453
Repairs, maintenance and renovation (80) (186) 106 (208) (402) 194
Insurance (52) (69) 17 (89) (102) 13
----------- ---------- ----------- ---------- ---------- ----------
(440) (1,244) 804 (928) (3,561) 2,633
NET RECOVERIES FROM PROPERTY SALES 324 832 (508) 503 1,680 (1,177)
RENTAL INCOME, NET 766 287 479 1,241 574 667
----------- ---------- ----------- ---------- ---------- ----------
$ 650 $ (125) $ 775 $ 816 $(1,307) $ 2,123
=========== ========== =========== ========== ========== ==========
Commencing in August 1993 and continuing through the second quarter of 1995,
the Company established and staffed a separate group to manage the Company's
property management, construction, property disposal and restructuring
operations. The costs included in the table above (and, therefore, excluded
from operating costs (see OPERATING COSTS)), include employee compensation,
benefits, and outside legal fees directly attributable to the assets under
management by this group.
Net revenues from owned properties principally include the net operating
income (collected rental revenues less operating expenses) from foreclosed
apartment buildings or receipt, following foreclosure, of similar funds held
by receivers during the period the original loan was in default. Net operating
income is reduced by provisions for depreciation of owned improvements for
the 1995 periods.
As of June 30, 1995, the Company's portfolio of properties consisted of 301
individual homes, apartment buildings and land parcels. In addition, as of
that date the Company's defaulted loan portfolio was represented by 116
loans and its portfolio of performing project concentration loans
secured 530 individual homes. Because of the large aggregate number of units
represented by these risk portfolios, management expects that the costs
incurred to
manage the property disposal and loan restructuring operations of
the Company, plus the holding costs associated with these portfolios (other
than interest lost following a loans' default and subsequent foreclosure),
will continue to be significant for the next several quarters.
ASSET QUALITY
GENERAL
The Company's loan portfolio is exclusively concentrated in Southern
California real estate. At June 30, 1995 and 1994, respectively, 55.0% and
56.9% of the Company's loan portfolio consisted of permanent loans secured
by single family residences, 40.3% and 38.0% consisted of permanent loans
secured by multi-unit residential properties, and 4.7% and 4.2% consisted of
loans to finance commercial properties, the acquisition of land and the
construction of single family housing.
Historically, the Company actively financed the construction of residential
properties, principally small-to-medium sized tracts of detached single
family homes and condominiums, and small apartment buildings (generally, less
than 37 units). With respect to for-sale housing developments, the Company
typically provided permanent financing to buyers of individual homes and
condominiums within projects for which it provided the construction
financing. In addition, the Company generally provided a permanent loan
commitment following its financing for the construction of apartment
buildings.
With respect to its past construction financing activities, the Company had
long-standing customer relationships with a small group of builders and
developers within its lending markets. Many of these builders were
affiliated with one another, either by marriage or business association. A
significant portion of the Company's nonperforming loans and foreclosed
properties are associated with this group of builders and developers.
The Company's performance continues to be adversely affected by the weakness
evident in its loan portfolio and a high volume of foreclosures, though
declining at a steady rate over the past two quarters. These asset quality
trends reflect the continuing weakness of the Southern California economy,
and the direct translation of this weakness to local real estate markets.
These factors have been, and will continue to be, exacerbated by several
factors unique to the Company's loan portfolio, including (1) its portfolio
of land and construction loans and properties, with respect to which
development, construction and/or sales are incomplete, (2) its portfolio of
loans secured by apartment buildings, for which property cash flows are, or
may become, inadequate to meet borrowers' debt service requirements, (3) the
concentration within the Company's loan and property portfolios of multiple
permanent loans and foreclosed properties within a single integrated
development, and (4) the concentration within the Company's portfolio of
loans to one or more individuals, or groups of individuals, which are
affiliated and with respect to which there remain limited financial resources
to fund debt service payments where property cash flows (either from sales of
homes or from income property cash flows) are, or may become, inadequate.
CLASSIFIED ASSETS
At June 30, 1995 the Company's problem asset ratios were far higher than
those of most lenders within its lending markets. The table below sets forth
the composition, measured by gross and net investment, of the Company's Risk
Asset portfolio. Risk Assets include owned properties, nonaccrual loans, and
performing loans which have been adversely classified pursuant to OTS
regulations ("Performing/Classified" loans) and guidelines. Loans
categorized as Special Mention are not classified pursuant to regulatory
guidelines, but are included in these tables as an indication of migration
trends (dollars are in thousands).
JUNE 30, DECEMBER 31, JUNE 30,
1995 1994 1994
---------------- ---------------- ----------------
NONPERFORMING ASSETS
Properties $ 77,016 $ 99,119 $ 133,622
Nonaccrual loans 23,222 39,396 75,897
---------------- ---------------- ----------------
100,238 138,515 209,519
Performing loans classified Doubtful or Substandard 58,592 61,289 63,578
---------------- ---------------- ----------------
GROSS INVESTMENT IN CLASSIFIED ASSETS 158,830 199,804 273,097
CREDIT LOSSES
Specific reserves and writedowns (23,522) (43,749) (64,861)
Allocated general reserves (3,458) (8,167) (13,077)
---------------- ---------------- ----------------
NET INVESTMENT IN CLASSIFIED ASSETS $ 131,850 $ 147,888 $ 195,159
================ ================ ================
PERFORMING LOANS DESIGNATED AS SPECIAL MENTION GROSS $ 63,655 $ 80,385 $ 49,024
================ ================ ================
The Company currently places loans on nonaccrual status when (1)
they become one or more payment delinquent and (2) management believes that,
with respect to performing loans, continued collection of principle and
interest from the borrower is not reasonable assured.
The performance of the asset portfolio during the quarter continued to
demonstrate positive results from the restructuring efforts of the past
eighteen months. At June 30, 1995, the Company had foreclosed properties and
nonaccrual loans with a carrying value of $81 million, or 11% of total
assets. By comparison, the carrying value of nonperforming assets at December
31, 1994, was $94 million, or 13% of total assets and at December 31, 1993
was $153 million or 17% of total assets. The migration of new loan defaults
has slowed measurably, and successful collection efforts and disposition of
foreclosures have reduced the overall levels accordingly. Loans in default of
their contractual terms and conditions, and subsequently categorized as
nonaccrual, at June, 1995, amounted to $23 million. This compares favorably
to the year end 1994 level of $39 million, a June 30, 1994 balance of $76
million and a December 31, 1993 balance of $80 million. Within the June 30,
1995 total of nonaccrual loans, $12 million in principal balances were
delinquent less than three payments.
The table below sets forth the composition, measured by gross and net
investment, of the Companys Risk Asset portfolio by type of property (dollars
are in thousand).
PERFORMING/CLASSIFIED
---------------------------- %
NONACCRUAL SPECIAL TO TOTAL
PROPERTIES LOANS SUBSTANDARD MENTION TOTAL PORTFOLIO
----------- ------------- ------------- ----------- --------- -------------
GROSS INVESTMENT
Existing housing
Single family homes
Non-Project $ 3,638 $ 8,324 $ 7,907 $ 20,884 $ 40,753 17.7%
Project concentrations 10,916 5,866 14,368 22,962 54,112 53.7%
Apartment buildings 34,103 8,861 35,726 16,774 95,464 35.8%
Acquisition and Development
Construction 20,294 20,294 62.3%
Land 7,719 171 466 917 9,273 80.6%
Commercial properties 346 125 2,118 2,589 33.4%
--------- --------- --------- --------- ---------
77,016 23,222 58,592 63,655 222,485 34.2%
CREDIT LOSSES
Specific reserves and writedowns (13,361) (4,965) (5,196) (23,522)
Allocated general reserves (146) (943) (2,369) (3,376) (6,834)
--------- --------- --------- --------- ---------
NET INVESTMENT $ 63,509 $ 17,314 $ 51,027 $ 60,279 $ 192,129 29.6%
========= ========= ========= ========= =========
SINGLE FAMILY (NON-PROJECT)
In the preceding table, non-project single family homes consist
of foreclosed properties and defaulted and performing/classified loans
secured by single family homes which are not part of an integrated
development, with respect to which the Company financed the construction of
the development or financed the purchase of homes from the developer by
individuals. At June 30, 1995, the Company (1) owned 13 homes which were
being actively marketed for sale, (2) had 41 defaulted loans secured by
single family (non-project) homes, (3) had 30 loans which were performing but
had been classified Substandard, and (4) had 103 loans which were performing
but had been designated Special Mention. The Company has valued its
owned single family homes at their estimated liquidation values. The
defaulted loan portfolio secured by single family homes (non-project) has
been valued, in the aggregate, consistently with the actual recovery rates
achieved through sales of foreclosed homes since 1993.
PROJECT CONCENTRATIONS
The Company made thirty-year, fully-amortizing permanent loans to a
large number of purchasers of individual units from developers in
for-sale housing developments with respect to which the Company financed
construction ("project concentrations"). A majority of these permanent
"takeout" loans were originated during the period 1989 through 1992 and were
made on terms that fell outside the parameters normally associated with
conforming or conventional single family home loans. In some instances,
as a means to pay-off a matured, troubled construction loan, the
Company made permanent loans to the developer, collateralized
individually by the remaining unsold units within the development.
Through June 1995, management had identified 63 separate
project concentrations. The table below summarizes certain information
about the Company's project concentrations as of June 30, 1995 (dollars are
in thousands). The table includes the Company's gross investment (1) in
individual takeout loans within project concentrations, (2) related to
unsold units previously foreclosed upon, and (3) related to unsold units
which secure a construction loan outstanding at June 30, 1995, and with
respect to which the Company also made individual takeout loans.
GROSS INVESTMENT/LOAN PRINCIPAL
-------------------------------------------------
NUMBER OF NUMBER OF INDIVIDUAL CONSTRUCTION
LOANS OR PROPERTIES UNITS TAKEOUTS LOAN TOTAL % TO TOTAL
------------------- --------- ---------- ------------- ------- ----------
Performing loans 444 530 $69,770 $3,679 $73,449 81.7%
Loans in default 60 74 5,867 5,867 6.5%
Properties 44 44 8,414 2,171 10,585 11.8%
--- --- ------- ------ ------- -----
548 648 84,051 5,850 89,901 100.0%
=== === ======= ====== ======= =====
The table below summarizes the percentage of all units within
project concentrations for which Hawthorne retains a continuing investment.
NUMBER OF
UNITS % TO TOTAL
----------- -----------
FINANCED BY HAWTHORNE
Sold units 492 35.4%
Unsold units 156 11.2%
----- -----
648 46.6%
Financed by others 743 53.4%
Total number of units 1,391 100.0%
===== =====
In addition to the inherent risks associated with real estate loans,
project concentration loans pose additional risks of default, foreclosure
and loss. As illustrated in the preceding tables, approximately 18% of the
number of units originally financed by the Company are either in default or
have been foreclosed upon. Many of these units have never been sold by the
developer and have either been rented during the interim or remain
vacant. The factors which will significantly influence the ultimate
recovery of the Company's gross investment in performing project
concentration loans include (1) the condition and overall management of a
development (by the homeowner's association), (2) the selling prices which
can be achieved for the units foreclosed upon, or expected to be
foreclosed upon, and resold in the current market, and their relation to
the outstanding principal balance of individual performing loans, and (3) the
extent to which the original sales of units to end buyers were financed, in
part, by the developer, minimizing the initial cash investment
required from the purchaser.
The Company has established specific and general reserves to address
the risk factors enumerated above and the resulting uncertainties.
Reserves are established separately for each project concentration.
The table below summarizes the basis for establishing reserves for
project concentrations (dollars are in thousands).
NUMBER OF GROSS
BASIS OF VALUATION DEVELOPMENTS INVESTMENT
- ------------------ ----------------- -----------
Recent sales history within project 24 $56,196
% of original appraisal 34 25,549
Current appraisal/no recent sales history 5 8,155
-- -------
All project concentrations 63 $89,900
== =======
For all other projects, the significant majority of which are
not classified, percentages ranging from 65% to 90% of original appraised
value have been utilized to establish the Companys net investment.
Management considers reliable recent sales history to exist when the
Company has sold two or more units within a project for cash (financing to
the purchaser having been provided by another lender) during 1994. The per
unit values at which the Company has
established its net investment for these projects are net of expected
selling costs. Where no recent sales history exists, current appraisals,
less expected selling costs, are utilized to establish the Company's net
investment.
APARTMENT BUILDINGS
At June 30, 1995, the Company owned 61 apartment buildings and loans
secured by 28 apartment buildings were in default. With respect to
these combined portfolios, the buildings are predominantly located in the
South Bay region of Los Angeles, are between five and ten years old and
average 15 units in size. The Company's owned apartment buildings have been
operated for their current cash flow yield and the holding period was
used to stabilize rental income and perform deferred maintenenace. The
average holding period for this portfolio approximates 15 months. The
carrying value of this portfolio has been determined based upon
management's projections of the stabilized cash flow returns commanded
by investors in such properties, assuming conventional financing terms
presently available in the marketplace.
The gross investment value of the foreclosed properties portfolio at
June 30, 1995, was $34 million. The Company records these properties
at their fair market values, by establishing and adjusting, as appropriate,
specific and general valuation allowances on these properties. During the
first quarter of 1995, the Company recorded provisions for credit losses
totaling $12.7 million, the majority of which was attributable to an
increase in the capitalization rates utilized by the Company to value
its portfolio of owned operating apartment buildings and classified
apartment loan collateral. These higher capitalization rates resulted
primarily from increases in the cost to finance apartment building
acquisitions. Management has recently concluded that the maximum benefit
to the Company is now for the orderly liquidation of this portfolio.
These properties, now stabilized and reflective of recovering market
conditions, are expected to be liquidated without any material impact to
earnings.
The carrying value of the defaulted apartment loan portfolio has
been determined on the same basis as for owned apartment
buildings, where property-specific information is available, or based upon
the average per unit valuation for owned buildings of similar unit size and
unit mix. For performing apartment loans classified either Substandard or
designated Special Mention, reserves have been established based upon
property-specific valuations which utilize current and stabilized cash
flows and incorporate management's assessment of future event risk.
RESIDENTIAL CONSTRUCTION
The table below sets forth, as of June 30, 1995, the unit composition
and gross investment associated with owned developments (dollars are
in thousands).
NUMBER OF UNITS
NUMBER OF --------------- REMAINING AT
DEVELOPMENTS ORIGINAL SOLD JUNE 30, 1995
------------- -------- ---- -------------
Units 5 261 (134) 127
Gross investment $20,294
-------
Net investment 16,977
=======
The Company's owned residential construction projects consist of 5
projects with a total of 261 units. During the first half of 1995, the
Company sold 52 units at minimal gains, and financed only 2 of these sales.
complete on this property and, based on the current fair market value of
the property, management does not anticipate any material losses in
connection with the disposal of this property.
LAND
The Company's portfolio of owned land parcels consists of 16 properties
with a gross investment of $7.0 million. Three parcels totaling $1.1
million were sold in July.
The Company's investment in land has been valued by reference to
comparable land sales (where available), current appraisals and discounted
cash flow land residual analyses.
RESERVES
The Company maintains reserves against specific assets, in those
instances in which it believes that full recovery of the Company's gross
investment is unlikely. As of June 30, 1995, the Company had established
specific reserves based upon (1) management's strategy in managing and
disposing of the asset and the corresponding financial consequences,
(2) current indications of property values from (a) completed, recent
sales from the Company's property portfolio, (b) real estate brokers,
and (c) potential buyers of the Company's properties, and (3) current
property appraisals. In addition, management establishes general reserves
against its loan and property portfolios when sufficient information does
not exist to support establishing specific reserves. The loss factors
utilized to establish general reserves are based upon (1) the actual
loss experience for similar loans and properties within the Company's
portfolio, when such loss experience is available and representative of
the assets being valued in, or (2) estimates of current liquidation
values for collateral serving performing loans for a representative sampling
of each portfolio segment.
During the first quarter of 1995, the OTS and the FDIC completed
an examination of the Company and the Bank. As previously mentioned, the
Company increased its reserves for potential losses on the classified loan
and property portfolios by $12.7 million during the first quarter of
1995. The increased reserves are reflective of higher capitalization rates
utilized by the Company and the regulatory agencies to value collateral
supporting apartment loans and foreclosed properties, and were not
associated with actual losses within the portfolio.
The table below sets forth the amounts and percentages of general
and specific credit losses for the Company's loan and property portfolios as
of June 30, 1995 (dollars are in thousands).
LOANS
------------------------
PERFORMING NONACCRUAL PROPERTIES TOTAL
----------- ----------- ----------- ---------
AMOUNTS
Specific reserves $ 5,196 $4,965 $13,361 $23,522
General reserves 9,586 943 146 10,675
------- ------ ------- -------
Total credit losses $14,782 $5,908 $13,507 $34,197
======= ====== ======= =======
PERCENTAGES
% of total credit losses to gross investment 2.7% 25.4% 17.5% 5.3%
% of general reserves to gross investment 1.8% 4.1% 0.2% 1.7%
The table below summarize the activity of the Company's reserves for the
periods indicated (dollars are in thousands).
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
---------------------------------------- ----------------------------------------
1995 1994 1995 1994
------------------- ------------------- ------------------- -------------------
PROPERTIES LOANS PROPERTIES LOANS PROPERTIES LOANS PROPERTIES LOANS
---------- ------- ---------- ------- ---------- ------- ---------- -------
RESERVE ACTIVITY
Beginning balance $35,045 $26,019 $49,208 $35,465 $33,517 $21,461 $39,457 $46,628
Provision for losses 1,000 12,700 1,000
Charge-offs (24,334) (2,535) (6,933) (493) (29,417) (4,066) (8,345) (493)
Recoveries 2 2
Transfers 2,796 (2,796) 9,399 (9,399) 9,407 (9,407) 20,562 (20,562)
------- ------- ------- ------- ------- ------- ------- -------
Ending balance $13,507 $20,690 $51,674 $26,573 $13,507 $20,690 $51,674 $26,573
======= ======= ======= ======= ======= ======= ======= =======
LENDING OPERATIONS
During the second half of 1994, the Bank re-entered its lending markets,
principally the South Bay area of Los Angeles County, after completely
rebuilding its lending infrastructure with new products, services, processing
systems, appraisal practices and credit management. For the first half of
1995, the Bank was able to increase its net loan outstanding by $9.5 million
through new originations totaling $74 million. This represented the Bank's
first period of significant production during the past eighteen months. The
new loan production was centered in multi-family properties (42.5%), single
family loans (41.6%), and construction financing and land within the South
Bay market (15.9%). The Company considers these three segments its pricing
sources of new business (see ASSET GENERATION).
CAPITAL
The Financial Institutions Reform, Recovery and Enforcement Act of
1989 ("FIRREA") and implementing capital regulations require the Bank to
maintain (1) Tangible Capital of at least 1.5% of Adjusted Total Assets (as
defined in the regulations); (2) Core Capital of at least 3.0% of adjusted
total assets (as defined in the regulations); and (3) Total Risk-based
Capital equal to 8.0% of Total Risk-weighted Assets (as defined in the
regulations).
The following table summarizes the regulatory capital requirements
under FIRREA for the Bank at June 30, 1995, but does not reflect future
phasing out of certain assets, including investments in, and loans to,
subsidiaries which presently engage in activities not permitted for national
banks (the impact is immaterial). As indicated in the table, the Bank's
capital levels exceed all three of the currently applicable minimum FIRREA
capital requirements (dollars are in thousands).
TANGIBLE CAPITAL CORE CAPITAL RISK-BASED CAPITAL
-------------------- ------------------- -------------------
BALANCE % BALANCE % BALANCE %
--------- ----- ---------- ----- --------- -----
Stockholder's equity $ 27,947 $ 27,947 $27,947
Adjustments
General valuation allowances 5,564
Core deposits intangibles (203) (203) (203)
Interest rate risk component (1)
-------- -------- -------- -----
Regulatory capital (2) 27,744 3.94% 27,744 3.94% 33,308 7.57%
Required minimum 10,561 1.50% 21,121 3.00% 35,212 8.00%
-------- ----- -------- ----- -------- -----
Excess (deficient) capital $ 17,183 2.44% 6,623 0.94% 1,904 (0.43)%
======== ===== ======== ===== ======== =====
Adjusted assets (3) $704,047 $704,047 $440,148
======== ======== ========
<FN>
(1) At June 30, 1995, the OTS had temporarily suspended the application of
its interest rate risk regulation but anticipated that it would become
effective again as of September 30, 1995. Had the regulation been in
effect at June 30, 1995, the Bank would have been required to deduct
from risk-based capital an interest rate risk exposure component of
$865,000 (unaudited) as computed by the OTS as one-half of the excess
of the estimated change in the Bank's net portfolio value (determined in
accordance with OTS regulations) over a
normal change in net portfolio value (2%) assuming an immediate and
sustained 200 basis point increase in interest rates, using the Bank's
reported balance sheet information as of December 31, 1994. The Bank's
risk-based capital ratio would have been 7.37% as of June 30, 1995 had
the deduction been required.
(2) At periodic intervals, both the OTS and the FDIC routinely examine the
Bank as part of their legally prescribed oversight of the industry. Based
on their examinations, the regulators can direct that the Bank's financial
statements be adjusted in accordance with their findings.
(3) The term "adjusted assets" refers to the term "adjusted total assets" as
defined in 12 C.F.R. Section 567.1(a) for purposes of tangible and core
capital requirements, and for purposes of risk-based capital requirements,
refers to the term "risk-weighted assets" as defined in 12 C.F.R. Section
567.1(b)
Under the Federal Deposit Insurance Corporation Improvement Act
("FDICIA"), which supplemented FIRREA, the OTS has issued "prompt
corrective action" regulations with specific capital ranking tiers for
thrift institutions. Progressively more stringent operational limitations and
other corrective actions are required as an institution declines in the
capital ranking tiers. The five qualifying tiers are set forth below.
RATIO OF RATIO OF
RATIO OF TOTAL CAPITAL CORE CAPITAL
CORE CAPITAL TO RISK-WEIGHTED TO RISK-WEIGHTED
TO ASSETS ASSETS ASSETS
------------ ---------------- ----------------
Well capitalized 6% or above 5% or above 10% or above
Adequately capitalized 4% or above 4% or above 8% or above
Under capitalized Under 4% Under 4% Under 8%
Significantly undercapitalized Under 3% Under 3% Under 6%
Critically undercapitalized Ratio of tangible equity to adjusted total assets
of 2% or less
The Bank's ratios at June 30, 1995
are set forth below.
Ratio of Core Capital to Total Assets 3.94%
Ratio of Core Capital to Risk-weighted Assets (Leverage ratio) 6.30%
Ratio of Total Capital to Risk-weighted Assets 7.57%
Based upon the foregoing, the Bank is classified as an "under capitalized"
institution.
The thrift industry is exposed to economic trends and fluctuations in
real estate values. In recent periods, those trends have been recessionary
in nature, particularly in Southern California. Accordingly, the trends have
adversely affected both the delinquencies being experienced by institutions
such as the Bank and the ability of such institutions to recoup principal and
accrued interest through acquisition and sale of the underlying collateral.
No assurances can be given that such trends will not continue in future
periods, creating increasing downward pressure on the earnings and capital of
thrift institutions.
CAPITAL RESOURCES AND LIQUIDITY
The Bank's liquidity position refers to the extent to which the
Bank's funding sources are sufficient to meet its current and long-term cash
requirements. Federal regulations currently require a savings institution to
maintain a monthly average daily balance of liquid and short-term liquid
assets equal to at least 5.0% and 1.0%, respectively, of the average daily
balance of its net withdrawalable accounts and short-term borrowings during
the preceding calendar month. The Bank had liquidity and short-term
liquidity ratios of 6.4% and 2.7%, respectively, as of June 1995, and 9.6%
and 4.0%, respectively, as of December 31, 1994.
The Bank's current primary funding resources are deposit accounts,
principal payments on loans, proceeds from property sales and cash flows from
operations. Other possible sources of liquidity available to the Bank
include reverse repurchase transactions involving the Bank's investment
securities, mortgage-backed securities or whole loans, FHLB advances,
commercial bank lines of credit, and direct access, under certain conditions,
to borrowings from the Federal Reserve System. The cash needs of the Bank
are principally for the payment of interest on and withdrawals of deposit
accounts, the funding of loans, operating costs and expenses, and holding and
refurbishment costs on foreclosed properties.
To supplement its funding needs, the Company enters into reverse
repurchase agreements, in which it sells securities with an agreement to
repurchase the same securities at a specific future date (overnight to 90
days). The Company enters into such transactions only with dealers
determined by management to be financially strong and who are recognized as
primary dealers in U.S. Treasury securities by the Federal Reserve Board.
The following table summarizes information relating to the Company's reverse
repurchase agreements for the period ended June 30, 1995 (dollars are in
thousands):
1995
-------
Average balance during period $19,370
Average interest rate during period 6.07%
Maximum month-end balance during period 47,141
There were no outstanding reverse repurchase agreements at June 30,1995.
INTEREST RATE RISK MANAGEMENT
The objective of interest rate risk management is to stabilize the
Company's net interest income ("NII") while limiting the change in its net
portfolio value ("NPV") from interest rate fluctuations. The Company seeks
to achieve this objective by matching its interest sensitive assets and
liabilities, and maintaining the maturity and repricing of these assets and
liabilities at appropriate levels given the interest rate environment. When
the amount of rate sensitive liabilities exceeds rate sensitive assets, the
net interest income will generally be negatively impacted during a rising
rate environment as has been the situation during the past eighteen months.
The speed and velocity of the repricing of assets and liabilities will also
contribute to the effects on net interest income.
The Company utilizes two methods for measuring interest rate risk. Gap
analysis is the first method, with a focus on measuring absolute dollar
amounts subject to repricing given certain periods of time. A negative gap
occurs when interest sensitive liabilities exceed interest sensitive assets,
with the majority of the focus typically at the one-year maturity horizon.
The negative one-year maturity gap indicates, absent offsetting factors, that
the Company has more exposure to interest rate risk in an increasing interest
rate environment. This is the situation in which the Company has operated in
during the past year.
In addition to utilizing gap analysis in measuring interest rate risk,
the Company performs a monthly interest rate simulation. This simulation
provides the Company with an estimate of both the dollar amount and
percentage change in net interest income under various interest rate
scenarios. All assets and liabilities are subjected to tests of up to 400
basis points in increases and decreases in interest rates. Under each
interest rate scenario, the Company projects its net interest income and net
portfolio value of market equity of the current balance sheet. From these
results, the Company can then develop alternatives to dealing with the
tolerance thresholds.
A principal mechanism used by the Company in the past for interest rate
risk management was the origination of ARMs tied to the 11th DCOFI. The basic
premise was that the Company's actual cost of funds would parallel the 11th
DCOFI, and as such, the net interest margins would generate the desired
operating results.
ARMs tied to 11th DCOFI are slower in responding to current interest
rate environments than other types of variable rate loans because the index
is a compilation of the average rates paid by member institutions of the 11th
District of the FHLB. This index typically lags market rate changes in both
directions. If interest rates on deposit accounts increase due to market
conditions and competition, it may be anticipated that the Company will,
absent offsetting factors, experience a decline in the percentage of net
interest income to average interest-earning assets (the "Net Interest
Margin"). A contributing factor would be the lag in upward pricing of the
ARMs tied to the 11th DCOFI. However, the lag inherent in the 11th DCOFI will
also cause the ARMs to remain at a higher rate for a longer period after
interest rates on deposits begin to decline. The 11th DCOFI lag during a
falling rate environment should benefit, in the short-term, the Company's Net
Interest Margin, but the actual dynamics of prepayments and the fact that
ARMs reprice at various intervals may somewhat alter this expected benefit.
Effective September 30, 1995, the OTS will require that institutions
complete an Interest Rate Risk Exposure Report. This report will measure
an institution's interest rate risk given the effect of large interest rate
movements. If, based upon the results of this calculation, the institution's
interest rate risk falls outside of the permitted range, the institution will
be required to deduct certain amounts from its risk-based capital. In response
to this OTS requirement, the Company has implemented a strategy to reduce its
interest rate exposure. This strategy includes, among other things, an interest
rate cap. In March 1995, the Company purchased a six-month cap with a notional
amount of $450 million with a strike price of approximately 110 basis points
above current market rates. This cap was intended to reduce the impact of a
sharp increase in interest rates on the Company's liabilities, which tend to
reprice faster than the Company's loan portfolio.
PROSPECTS
FINANCIAL
For the three-year period ended December 31, 1994, the Company reported
cumulative net losses of $55 million, reducing its equity capital by 58%.
For the six months ended June 30, 1995, the Company lost $10.3 million.
The six months loss was generated by provisions for credit losses of $12.7
million during the first quarter, which was partially offset by net gains on
sales of securities (net of tax adjustments) of $2.5 million. As described
more fully elsewhere herein, the Company's operating margins have been
significantly impacted because of the high volume of foreclosures and the rapid
and significant rise in interest rates since early 1994. Commencing with the
1995 second quarter, the Company's operating margins began to improve with
the continued disposition of foreclosed assets, its origination of new
financing activities, and favorable repricing of its adjustable-rate
loan portfolio. Conversely, since mid-1993, operating costs have increased
from their pre-1993 levels as new management has (1) aggressively pursued
the retention of highly qualified people to restructure the Company's
existing operations, to manage its portfolio of Risk Assets and to establish
new lines of business, (2) made significant investments in the Company's
remaining facilities, (3) made significant investments to improve the Company's
information management systems, and (4) spent heavily to promote the
Company's products and services. As a consequence, the Company's current
level of fixed costs cannot be profitably spread over its diminished asset
base ($704 million at June 30, 1995 as compared with $980 million at June
30, 1993).
The factors enumerated above may result in a continuation of operating
losses. Based upon current projections, which assume (1) no change in the
current level of market interest rates, (2) significant new asset generation
(see below) initiated principally in the second quarter of 1995, and (3) the
current level of operating costs, the Company may become profitable by the
end of 1995.
RISK ASSETS
Notwithstanding the significant progress made in disposing of foreclosed
properties during 1994 and the first half of 1995, the Company's
portfolios of Risk Assets remain at very significant and highly dilutive
levels. As previously reported, management does not expect that these
portfolios will be reduced to levels approaching those normally associated
with "healthy" financial institutions until at least the end of 1995 or
early 1996. To date, recoveries from property sales have comported with the
reserves previously established since 1993 and virtually all of the Company's
multiple unit, for-sale housing projects have experienced multiple unit sales
during 1994 (without being financed by the Company), providing a solid,
empirical basis for the current carrying values of such projects. However,
management cannot predict with certainty the future performance of the
Company's remaining portfolio of performing loans, much of which has been
classified. Accordingly, additional provisions for credit losses may be
required in the future should the performance of its loan portfolio
deteriorate further.
BRANCH RESTRUCTURING
During the 1994 third quarter, management largely completed its
restructuring of the Company's retail branch network. The Company now
operates 9 savings branches with average deposits of $75 million per branch.
At September 30, 1993, the Company operated 21 branches, with average
deposits per branch of $44 million.
During the next several quarters, deposit growth is expected to be
generated from the Company's existing locations. The Company has initiated
certain activities that are intended to increase its core deposit base, while
reducing its average cost of funds. These initiatives will include
introducing greater emphasis on building upon lower costing transactional
accounts, such as checking, savings, NOW and money market accounts. The
Company will also seek to shorten the average maturity of certificates of
deposits as general interest rates continue to moderate.
ASSET GENERATION
The Company reestablished its real estate financing operation very late
in 1994 and competes with numerous financial intermediaries for new loans.
The Company's new financing programs are targeted to owners and purchasers of
medium-sized apartment buildings, single family development sites and
expensive single family residences. In addition, the Company continues to
offer competitive loan programs to all home buyers within its immediate
market areas. Internal projections call for the Company's aggregate
financing volume to grow gradually throughout 1995. Management contemplates
that new loan originations will be held in portfolio rather than being sold
in the secondary mortgage markets.
REGULATORY
As described elsewhere herein (see OVERVIEW), the Bank remains
under the intense scrutiny of the OTS and the FDIC. Until such time
as the Bank (1) receives an infusion of capital sufficient to meet current
and future balance sheet requirements, (2) satisfies the OTS that the
operating and compliance deficiencies accumulated prior to 1993 have been
adequately and permanently addressed, (3) achieves a further significant
reduction to its portfolios of Risk Assets, and (4) can demonstrate
sustainable profitability, management believes that regulatory scrutiny of
its business activities, including lending programs, and branch and entity
acquisitions, will continue to be intense. Such scrutiny could result in the
OTS not permitting the Company to proceed with one or more of the strategic
initiatives described above.
Should the Company not be permitted to engage in certain higher margin
business activities (with respect to which the Company has, or will have,
demonstrated competence), future balance sheet growth will either fall short
of management's targets or consist of lower margin assets. In this event,
the Company's future profitability will not only be retarded but may in fact
be pushed out indefinitely into the future.
GENERAL REGULATION
The OTS has enforcement authority over savings institutions and their
holding companies, including, among other things, the ability to assess civil
money penalties, to issue cease and desist orders, to initiate removal and
prohibition orders against officers, directors and certain other persons, and
the authority to appoint a conservator or receiver. In general, these
enforcement actions may be initiated for violations of laws and regulations,
violations of cease and desist orders and "unsafe or unsound" conditions or
practices, which are not limited to cases of inadequate
On August 8, 1995, the FDIC substantially reduced the deposit insurance
premium assessment rate to be paid by commercial banks and other institutions
whose deposits are insured by the Bank Insurance Fund (the "BIF") but did not
reduce the rates for savings institutions, such as the Bank, whose deposits
are insured by the FDIC's Savings Association Insurance Fund (the "SAIF").
Following this reduction, the FDIC estimates that BIF-insured institutions
will pay an average assessment rate of .044%, compared to the current average
rate for SAIF-insured institutions of .237%. (The FDIC has established the
Bank's deposit insurance premium at the level of 0.3% of deposits for 1995.)
The FDIC action was taken in recognition of the fact that the BIF has reached
its statutorily prescribed ratio of reserves to deposits insured, whereas the
SAIF is not currently expected to do so for at least several more years.
The deposit rate premium disparity between BIF-insured
institutions and SAIF-insured institutions resulting from the BIF premium
reduction could place SAIF-insured institutions at a significant competitive
disadvantage due to their higher premium costs and worsen the financial
condition of the SAIF by leading to a shrinkage in its deposit base.
A number of proposals to permit SAIF deposit insurance premiums to be reduced
to levels at or near those paid by BIF-insured institutions are under
discussion be various of the affected parties, relevant government
agencies and in Congress. These proposals include a Clinton
Administration proposal to assess a one-time surcharge on SAIF-insured
institutions of up to 90 basis points on SAIF-insured deposits and
thereafter to merge the SAIF and BIF insurance funds, as well as other
proposals that would include these elements and would also eliminate the
federal thrift institution charter and replace it with a single charter
for both commercial banks and thrift institution. The Company cannot
predict whether or in what form any of these proposals will be adopted
or the effect that such adoption will have on the Company's operations.
capital. FIRREA requires, except under certain circumstances, public
disclosure of final enforcement actions by the OTS.
The FDIC has authority to recommend that the OTS take any authorized
enforcement action with respect to any federally insured savings institution.
If the OTS does not take the recommended action or provide an acceptable
plan for addressing the FDIC's concerns within 60 days after receipt of a
recommendation from the FDIC, the FDIC may take such action if the FDIC board
of directors determines that the institution is in an unsafe or unsound
condition or that failure to take such action will result in the continuation
of unsafe or unsound practices in conducting the business of the institution.
The FDIC may also take action prior to the expiration of the 60-day time
period in exigent circumstances after notifying the OTS.
The FDIC may terminate the deposit insurance of any insured depository
if the FDIC determines, after a hearing, that the institution has engaged or
is engaging in unsafe or unsound practices, which, as with OTS authority, are
not limited to cases of capital inadequacy, is in an unsafe or unsound
condition to continue operations or has violated any applicable law,
regulation or order or any condition imposed in writing by the FDIC. In
addition, FDIC regulations provide that any insured institution that falls
below a 2% minimum leverage ratio will be subject to FDIC deposit insurance
termination proceedings unless it has submitted, and is in compliance with, a
capital plan with its primary federal regulator and the FDIC. The FDIC may
also suspend deposit insurance temporarily during the hearing process if the
institution has no tangible capital. The FDIC is additionally authorized by
statute to appoint itself as conservator or receiver of an insured
institution (in addition to the powers of the institution's primary federal
regulatory authority) in cases, among others and upon compliance with certain
procedures, of unsafe or unsound conditions or practices or willful
violations of cease and desist orders.
PART II -- OTHER INFORMATION
ITEM 1. Legal Proceedings - None
ITEM 2. Changes in Securities - None
ITEM 3. Defaults upon Senior Securities - None
ITEM 4. Submission of Matters to Vote of Security Holders - None
The Annual Meeting of Stockholders of the Company was held on June 12, 1995.
The eight nominees for Director, Marilyn Garton Amato, Scott A. Braly, Vernon
D. Herbst, Timothy R. Chrisman, Richard E. Giles, Charles S. Jacobs and
Robert C. Troost, were all elected to a one year term.
At the Annual Meeting, the stockholders voted on the following two proposals,
the first of which did not receive the required vote of a majority of total
shares outstanding and was therefore not approved. The second proposal was
approved.
1. APPROVAL OF AMENDMENT TO ARTICLE FOURTH OF THE COMPANY'S CERTIFICATE OF
INCORPORATION. Votes in the affirmative were 1,276,844, votes against the
proposal were 495,970 and votes abstaining were 211,983.
2. APPROVAL OF REVERSE STOCK SPLIT TO REDUCE THE CURRENT NUMBER OF SHARES OF
OUTSTANDING COMMON STOCK BY COMBINING EVERY THREE (3) SHARES INTO ONE (1)
SHARE OF COMMON STOCK. Votes in the affirmative were 1,572,709, votes
against were 665,329 and votes abstaining were 91,322.
ITEM 5. Other Materially Important Events - None
ITEM 6. Exhibits and Reports on Form 8-K - None
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to signed on its behalf by the
undersigned thereunto duly authorized.
HAWTHORNE FINANCIAL CORPORATION
Dated August 10, 1995 /s/ SCOTT A. BRALY
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Scott A. Braly
President and
Chief Executive Officer
Dated August 10, 1995 /s/ NORMAN A. MORALES
--------------- -----------------------------------
Norman A. Morales
Executive Vice President
and Chief Financial Officer