------------------------------
B. F. SAUL
REAL ESTATE INVESTMENT TRUST
ANNUAL REPORT 1996
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TABLE OF CONTENTS
BUSINESS .............................................................. 1
General ........................................................... 1
Real Estate .................................................. 3
Banking ...................................................... 16
Properties ........................................................ 59
Legal Proceedings ................................................. 63
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ................... 64
MARKET FOR REGISTRANT'S COMMON EQUITY AND
RELATED STOCKHOLDER MATTERS ....................................... 64
SELECTED FINANCIAL DATA ............................................... 64
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS ..................... 67
Financial Condition ............................................... 67
Real Estate .................................................. 67
Banking ...................................................... 67
Liquidity and Capital Resources ................................... 87
Real Estate .................................................. 87
Banking ...................................................... 89
Liquidity ............................................... 89
Capital ................................................. 93
Results of Operations ............................................. 97
Fiscal 1996 Compared to Fiscal 1995 .......................... 97
Real Estate ............................................. 97
Banking ................................................. 101
Fiscal 1995 Compared to Fiscal 1994 .......................... 107
Real Estate ............................................. 107
Banking ................................................. 108
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ........................... F-1
Management's Statement on Responsibility .......................... 112
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE ............................... 112
BUSINESS
GENERAL
B.F. Saul Real Estate Investment Trust (the "Trust") operates as a
Maryland real estate investment trust. The Trust began its operations in
1964 as an unincorporated business trust organized under a Declaration of
Trust governed by District of Columbia law. The Trust terminated its status
as a qualified real estate investment trust for federal income tax purposes
in 1978 and is now taxable as a corporation. On October 24, 1988, the Trust
amended its Declaration of Trust to qualify the Trust as a statutory real
estate investment trust under Maryland law.
The principal business activity of the Trust and its real estate
subsidiaries is the ownership and development of income-producing properties.
The Trust owns 80% of the outstanding common stock of Chevy Chase Bank,
F.S.B. ("Chevy Chase" or the "Bank"), whose assets accounted for 95% of the
Trust's consolidated assets at September 30, 1996. The Trust is a thrift
holding company by virtue of its ownership of a majority interest in Chevy
Chase. See "Real Estate - Holding Company Regulation."
The Trust recorded a net loss of $78,000 in the fiscal year ended
September 30, 1996, compared to net income of $10.9 million in the fiscal
year ended September 30, 1995 and net income of $23.1 million in the fiscal
year ended September 30, 1994.
The Trust has prepared its financial statements and other disclosures
on a fully consolidated basis. The Term "Trust" used in the text and
the financial statements included herein refers to the combined entity,
which includes B. F. Saul Real Estate Trust and its subsidiaries,
including Chevy Chase and Chevy Chase's subsidiaries. "Real Estate Trust"
refers to B. F. Saul Real Estate Investment Trust and its subsidiaries,
excluding Chevy Chase and Chevy Chase's subsidiaries. The operations
conducted by the Real Estate Trust are designated as "Real Estate," while the
business conducted by Chevy Chase and its subsidiaries is identified by
"Banking."
The principal offices of the Trust are located at 8401 Connecticut
Avenue, Chevy Chase, Maryland 20815, and the Trust's telephone number is
(301) 986-6000.
REAL ESTATE. The Real Estate Trust's long-term objectives are to increase
cash flow from operations and to maximize capital appreciation of its real
estate. The properties owned by the Real Estate Trust are located
predominantly in the Mid-Atlantic and Southeastern regions of the United
States and consist principally of hotels, office and industrial projects, and
undeveloped land parcels.
BANKING. Chevy Chase Bank is a federally chartered and federally insured
stock savings bank which at September 30, 1996 was conducting business from
107 full service offices and 529 automated teller machines ("ATMs") in
Maryland, Virginia and the District of Columbia. The Bank has its home
office in McLean, Virginia and its executive offices in Montgomery County,
Maryland, both suburban communities of Washington, D.C. The Bank also
maintains 22 mortgage loan production offices in the mid-Atlantic region, 21
of which are operated by a wholly-owned mortgage banking subsidiary. The
Bank also maintains 18 consumer
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loan production offices, 11 of which are owned by a wholly-owned finance
subsidiary of the Bank. At September 30, 1996, the Bank had total assets of
$5.7 billion and total deposits of $4.2 billion. Based on total
consolidated assets at September 30, 1996, Chevy Chase is the largest bank
headquartered in the Washington, D.C. metropolitan area.
Chevy Chase is a consumer oriented, full service banking institution,
principally engaged in the business of attracting deposits from the public
and using such deposits, together with borrowings and other funds, to make
loans secured by real estate, primarily residential mortgage loans, and
credit card and other types of consumer loans. The Bank is also developing on
active commercial lending program. The Bank's principal deposit and lending
markets are located in the Washington, D.C. metropolitan area. As a
complement to its basic deposit and lending activities, the Bank provides a
number of related financial services to its customers, including securities
brokerage and insurance products offered through its subsidiaries.
Chevy Chase recorded operating income of $46.1 million for the year ended
September 30, 1996, compared to operating income of $55.7 million for the
year ended September 30, 1995. At September 30, 1996, the Bank's tangible,
core, tier 1 risk-based and total risk-based regulatory capital ratios were
5.21%, 5.21%, 5.80% and 10.14%, respectively. The Bank's capital ratios
exceeded the requirements under the Financial Institutions Reform, Recovery,
and Enforcement Act of 1989 ("FIRREA") as well as the standards established
for "adequately capitalized" institutions under the prompt corrective action
regulations established pursuant to the Federal Deposit Insurance Corporation
Improvement Act of 1991 ("FDICIA"). See "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Financial
Condition - Banking - Capital." Chevy Chase's fiscal 1996 earnings reflect a
$26.5 million charge for the special assessment imposed by Congress to
recapitalize the Savings Association Insurance Fund (the "SAIF"). See
"Banking Regulation - Deposit Insurance Premiums." Excluding the one-time
SAIF assessment, Chevy Chase would have reported operating income of $72.6
million for the year ended September 30, 1996, and its regulatory capital
ratios would have exceeded those established for well-capitalized
institutions under the prompt corrective action standards.
On December 3, 1996, the Bank sold $100.0 million of 9 1/4% Subordinated
Debentures due 2008 (the "1996 Debentures"), the principal amount of which is
includable in the Bank's supplementary capital. In addition, on December 3,
1996, a new real estate investment trust subsidiary of the Bank sold $150.0
million of its Noncumulative Exchangeable Preferred Stock, Series A (the
"REIT Preferred Stock), which is eligible for inclusion as core capital of
the Bank in an amount up to 25% of the Bank's total core capital. If these
transactions had occurred at September 30, 1996, the Bank's tangible, core,
tier 1 risk-based and total risk-based regulatory capital ratios would have
been 6.67%, 6.67%, 7.65% and 15.15%, respectively, which would have exceeded
the ratios established for "well-capitalized" institutions.
Chevy Chase is subject to comprehensive regulation, examination and
supervision by the Office of Thrift Supervision ("OTS") and, to lesser
extent, by the Federal Deposit Insurance Corporation (the "FDIC"). The
Bank's deposit accounts are fully insured up to $100,000 per insured
depositor by the SAIF, which is administered by the FDIC.
2
REAL ESTATE
REAL ESTATE INVESTMENTS
The following tables set forth, at and for the periods indicated, certain
information regarding the properties in the Real Estate Trust's investment
portfolio at September 30, 1996.
3
HOTELS
AVERAGE OCCUPANCY (2) AVERAGE ROOM RATE
------------------------ ------------------------
YEAR ENDED SEPTEMBER 30, YEAR ENDED SEPTEMBER 30,
AVAILABLE ------------------------ ------------------------
LOCATION NAME ROOMS(1) 1996 1995 1994 1996 1995 1994
- -------------- -------------------------------- ---------- ------------------------ ------------------------
COLORADO
Pueblo Holiday Inn - Pueblo 193 75% 81% 79% $54.84 $50.97 $48.75
MARYLAND
Gaithersburg Holiday Inn - Gaithersburg 303 61% 65% 57% $68.93 $61.76 $60.12
MICHIGAN
Auburn Hills Holiday Inn - Auburn Hills (3) 190 75% 77% -- $86.52 $75.17 $ --
NEW YORK
Rochester Holiday Inn - Rochester Airport 280 68% 73% 64% $66.51 $65.38 $64.24
OHIO
Cincinnati Holiday Inn - Cincinnati 277 49% 52% 52% $66.67 $62.37 $58.77
VIRGINIA
Arlington Howard Johnsons - National Airport 279 71% 66% 70% $66.37 $66.08 $65.27
McLean Holiday Inn - Tysons Corner 316 73% 72% 74% $78.98 $72.23 $64.41
Sterling Hampton Inn - Dulles Airport (4) 127 77% 75% 73% $62.87 $58.06 $54.10
Sterling Holiday Inn - Dulles Airport 296 76% 71% 65% $63.86 $59.53 $56.84
----- --- --- --- ------ ------ ------
Totals 2,261 68% 69% 66% $68.79 $63.79 $59.85
- -------------------------------------------------------------------------------
(1) Available rooms as of September 30, 1996. On October 30, 1996 the Real
Estate Trust acquired a 115 - room Holiday Inn Express in Herndon,
Virginia.
(2) Average occupancy is calculated by dividing the rooms occupied by the
rooms available.
(3) Acquired November 30, 1994.
(4) A Real Estate Trust subsidiary owns a 99% interest in this hotel.
4
OFFICE AND INDUSTRIAL
EXPIRING LEASES (1)
-------------------
LEASING PERCENTAGES YEAR ENDING
GROSS ------------------------- -------------------
SEPTEMBER 30, SEPTEMBER 30,
LEASABLE ------------------------- -------------------
LOCATION NAME AREA (1) 1996 1995 1994 1997 1998
- ----------------- -------------------------- -------- ------------------------- -------------------
FLORIDA
Fort Lauderdale Commerce Center - Phase II 60,959 92% 83% 72% 13,720 17,115
GEORGIA
Atlanta 900 Circle 75 Parkway 345,502 95% 94% 100% 34,283 92,602
Atlanta 100 Circle 75 Parkway 89,412 100% 100% 96% 25,785 21,976
Atlanta 1100 Circle 75 Parkway 268,779 100% 100% 98% 44,644 48,898
LOUISIANA
Metairie Metairie Tower 91,372 99% 98% 92% 33,356 29,790
VIRGINIA
Chantilly Dulles South (2) 38,502 100% 74% 63% 16,378 4,293
McLean 8201 Greensboro Drive 353,742 85% 59% 98% 14,048 39,646
Sterling Dulles North (3) 59,886 81% 100% 87% 31,306 16,943
--------- ---- ---- ---- ------- -------
Totals 1,308,154 93% 85% 95% 213,520 271,263
- --------------------------------------------------------------------------------
(1) Square feet
(2) A Real Estate Trust subsidiary owns a 50% interest in this office building
(3) A Real Estate Trust subsidiary owns a 99% interest in this office building
5
LAND PARCELS
LOCATION NAME ACRES ZONING
- ------------------ -------------------------------- -------- -----------------------------
FLORIDA
Boca Raton Arvida Park of Commerce (1) 20 Mixed Use
Fort Lauderdale Commerce Center 14 Office & Warehouse
GEORGIA
Atlanta Circle 75 (2) 133 Office & Industrial
KANSAS
Overland Park Overland Park 162 Residential, Office & Retail
MARYLAND
Gaithersburg Avenel Business Park 8 Commercial
Rockville Flagship Centre 8 Commercial
NEW YORK
Rochester Holiday Inn - Rochester Airport 3 Commercial
VIRGINIA
Loudoun County Church Road 40 Office & Industrial
Loudoun County Sterling Boulevard (3) 48 Industrial
---
Total 436
- --------------------------------------------------------------------------------
(1) A Real Estate Trust subsidiary owns a 50% interest in 11 acres of this
parcel.
(2) Includes land parcel formerly identified as Perimeter Way.
(3) A Real Estate Trust subsidiary owns a 99% interest in this parcel.
6
OTHER REAL ESTATE INVESTMENTS
LOCATION NAME
--------------- ------------------------
PURCHASE - LEASEBACK PROPERTIES (1)
APARTMENTS
NUMBER
OF UNITS
--------
LOUISIANA
Metairie Chateau Dijon 336
TENNESSEE
Knoxville Country Club 232
---
Total 568
SHOPPING CENTERS
GROSS
LEASABLE
AREA (2)
--------
GEORGIA
Atlanta Old National 160,000
Warner Robbins Houston Mall 264,000
WYOMING
Casper Beverly Plaza 150,000
-------
Total 574,000
APARTMENT PROJECT
NUMBER
OF UNITS
--------
TEXAS
Dallas San Simeon 124
MISCELLANEOUS PROPERTY (RETAIL)
GROSS
LEASABLE
AREA (2)
--------
MARYLAND
Oxon Hill Wheeler Road 24,000
- -------------------------------------------------------------------------------
(1) The Trust owns the ground under certain income-producing properties and
receives fixed ground rent, which is subject to periodic escalation, from
the owners of the improvements. In certain instances, the Real Estate
Trust also receives percentage rent based upon the income generated by
the properties.
(2) Square feet.
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The investment portfolio consists principally of seasoned operating
properties. The Real Estate Trust expects to hold its properties as
long-term investments and has no maximum period for retention of any
investment. It may acquire additional income-producing properties, expand
and improve its properties, or sell such properties, as and when
circumstances warrant. The Real Estate Trust also may participate with other
entities in property ownership, through joint ventures or other types of
co-ownership.
INVESTMENT IN SAUL HOLDINGS LIMITED PARTNERSHIP
On August 26, 1993 the Real Estate Trust consummated a series of
transactions (together with related transactions, the "Formation
Transactions") in which it transferred its 22 shopping center properties and
one of its office properties (the "Transferred Properties"), together with
the debt associated with such properties, to a newly organized limited
partnership, Saul Holdings Limited Partnership ("Saul Holdings Partnership"),
and one of two newly organized subsidiary limited partnerships of Saul
Holdings Partnership (the "Subsidiary Partnerships" and, collectively with
Saul Holdings Partnership, the "Partnerships"). In exchange for the
Transferred Properties, the Real Estate Trust received securities
representing a 21.5% limited partnership interest in Saul Holdings
Partnership, which it holds directly and through two wholly owned
subsidiaries. Saul Centers, Inc. ("Saul Centers"), a newly organized,
publicly held real estate investment trust, received a 73.0% general
partnership interest in Saul Holdings Partnership in exchange for the
contribution of approximately $220.7 million to Saul Holdings Partnership.
Entities under common control with the Trust (the "Trust Affiliates")
received limited partnership interests collectively representing a 5.5%
partnership interest in Saul Holdings Partnership in exchange for the
transfer of property management functions (the "Management Functions") and
certain other properties to the Partnerships. In addition, the Trust
Affiliates received certain cash distributions from Saul Holdings Partnership
and purchased 4.0% of the common stock of Saul Centers in a private offering
consummated concurrently with the initial public offering of such common
stock. B. Francis Saul II, the Chairman of the Board of Trustees and Chief
Executive Officer of the Trust, also serves as Chairman of the Board of
Directors and Chief Executive Officer of Saul Centers.
The Real Estate Trust and the Trust Affiliates own rights (the "Rights")
enabling them to convert their limited partnership interests in Saul Holdings
Partnership into shares of Saul Centers common stock on the basis of one
share of Saul Centers common stock for each partnership unit at the end of a
36-month period commencing after the initial public offering, provided that
they do not own rights to the extent that they collectively would be treated
as owning, directly or indirectly, more than 24.9% of the value of the
outstanding equity securities of Saul Centers. The shares of Saul Centers
common stock are listed on the New York Stock Exchange (trading symbol "BFS").
In July 1994, Saul Centers established Saul QRS, Inc. and SC Finance
Corporation, as wholly owned subsidiaries of Saul Centers. Saul QRS, Inc.
was established to succeed to the interest of Saul Centers as the sole
general partner of one of the Subsidiary Partnerships, Saul Subsidiary I
Limited Partnership, and SC Finance Corporation was established for the
purpose of issuing $128 million of collateralized floating rate mortgage
notes (the "Mortgage Notes"). In connection with these transactions, Saul
Holdings Partnership transferred ten shopping centers previously owned by it
to Saul Subsidiary I Limited Partnership as an additional capital
contribution and the second Subsidiary Partnership, Saul Subsidiary II
Limited Partnership,
8
transferred one shopping center previously owned by it to Saul Subsidiary I
Limited Partnership as an initial capital contribution in return for a
limited partnership interest in Saul Subsidiary I Limited Partnership. As a
consequence of these transfers, Saul Subsidiary I Limited Partnership
currently owns a total of 17 shopping centers (the "Mortgaged Properties").
The Mortgaged Properties, which continue to be managed by Saul Holdings
Partnership, secure the mortgage purchased with the proceeds of issuance of
the Mortgage Notes.
As a consequence of the Formation Transactions and the later
transactions described above undertaken in connection with the Mortgage Note
financing, Saul Centers serves as the sole general partner of Saul Subsidiary
II Limited Partnership, and Saul QRS, Inc. serves as the sole general partner
of Saul Subsidiary I Limited Partnership. Each such general partner holds a
1% general partnership interest in the applicable Subsidiary Partnership.
The remaining 99% interest in Saul Subsidiary II Limited Partnership is held
by Saul Holdings Partnership as the sole limited partner. The remaining 99%
interest in Saul Subsidiary I Limited Partnership is held by Saul Holdings
Partnership and Saul Subsidiary II Limited Partnership as limited partners.
At September 30, 1996, Saul Holdings Partnership owned, directly or
indirectly through the Subsidiary Partnerships, 30 community and neighborhood
shopping centers (including the 22 shopping centers transferred by the Real
Estate Trust) located in seven states and the District of Columbia, one
office property and one office/retail property located in the District of
Columbia and one research park located in a Maryland suburb of Washington,
D.C.(collectively, the "Portfolio Properties).
SAUL CENTERS. Saul Centers made an election to be treated as a real
estate investment trust ("REIT") for federal income tax purposes under
Sections 856 through 860 of the Internal Revenue Code commencing with the
year ended December 31, 1993. Under the Internal Revenue Code, REITs are
subject to numerous organizational and operational requirements. If Saul
Centers continues to qualify, it generally will not be subject to federal
income tax, provided it makes certain distributions to its stockholders and
meets certain organizational and other requirements. Saul Centers has
announced that it intends to make regular quarterly dividend distributions to
its stockholders.
MANAGEMENT OF THE PROPERTIES. The Partnerships manage the Portfolio
Properties and any subsequently acquired properties through the Management
Functions, which include personnel and such functions as property management,
leasing, design, renovation, development and accounting. The Management
Functions provide the Partnerships with a fully integrated property
management capability through approximately 150 professionals and staff
personnel and with an extensive and mature network of relationships with
tenants and potential tenants as well as with members of the brokerage and
property owners' communities.
Saul Centers shares with the Trust Affiliates certain ancillary functions
at cost, such as computer and payroll services, benefit administration and
in-house legal services, and shares insurance expense on a pro rata basis.
The Trust Affiliates sublease office space to Saul Centers at their cost.
The terms of all sharing arrangements, including payments related thereto,
are reviewed periodically by the independent directors of Saul Centers, who
9
constitute five of the nine members of the board of directors.
EXCLUSIVITY AGREEMENT AND RIGHT OF FIRST REFUSAL. The Real Estate Trust
has entered into an Exclusivity Agreement (the "Exclusivity Agreement") with,
and has granted a right of first refusal (the "Right of First Refusal") to,
Saul Centers and the Partnerships (collectively, the "Company"). The purpose
of these agreements is to minimize potential conflicts of interest between
the Real Estate Trust and the Company. The Exclusivity Agreement and Right
of First Refusal generally require the Real Estate Trust to conduct its
shopping center business exclusively through the Company and to grant the
Company a right of first refusal to purchase commercial properties and
development sites that become available to the Real Estate Trust in the
District of Columbia or adjacent suburban Maryland. Subject to the
Exclusivity Agreement and Right of First Refusal, the Real Estate Trust will
continue to develop, acquire, own and manage commercial properties and own
land suitable for development as, among other things, shopping centers and
other commercial properties.
ALLOCATIONS AND DISTRIBUTIONS OF SAUL HOLDINGS PARTNERSHIP. The net
income or net loss of Saul Holdings Partnership for tax purposes generally
will be allocated to Saul Centers and the limited partners in accordance with
their percentage interests, subject to compliance with the applicable
provisions of the Internal Revenue Code and the regulations promulgated
thereunder. Net cash flow after reserves of Saul Holdings Partnership and
after reimbursement of specified expenses will be distributed quarterly to
the partners in proportion to their respective partnership interests.
REIMBURSEMENT AGREEMENT. Pursuant to a reimbursement agreement among the
partners of the Partnerships, the Real Estate Trust and two of its
subsidiaries that are partners in the Partnerships have agreed to reimburse
Saul Centers and the other partners in the event the Partnerships fail to
make payments with respect to certain portions of the Partnerships' debt
obligations and Saul Centers or any such other partners personally make
payments with respect to such debt obligations. The maximum potential
obligations of the Real Estate Trust and its subsidiaries under this
agreement total $115.5 million. See Note 2 to the Consolidated Financial
Statements in this report. The Real Estate Trust believes that the
Partnerships will be able to make all payments due with respect to their debt
obligations.
TAX CONFLICTS. The fair market value of each of the properties
contributed to the Partnerships by the Real Estate Trust and its subsidiaries
at the date of the Formation Transactions (the "FMV" of each such property)
exceeded the tax basis of such property (with respect to each property, such
excess is referred to as the "FMV-Tax Difference"). In the event Saul
Centers or Saul QRS, Inc., acting as general partner of a Partnership, causes
such Partnership to dispose of, or there is an involuntary disposition of,
one or more of such properties, a disproportionately large share of the total
gain for federal income tax purposes would be allocated to the Real Estate
Trust or its subsidiaries as a result of the property disposition. In
general, if the gain recognized by the Partnership on such a property
disposition is less than or equal to the FMV-Tax Difference for such property
(as previously reduced by the amounts of special tax allocations of
depreciation deductions to the partners), all such gain will be allocated to
the Real Estate Trust or its subsidiaries. To the extent the gain recognized
by the Partnerships on the property disposition exceeds the FMV-Tax
10
Difference (as adjusted), such excess generally will be allocated among all
partners in Saul Holdings based on their relative percentage interests. In
general, the amount of federal income tax liability in respect of gain
allocated to the Real Estate Trust or its subsidiaries in the event of such a
property disposition is likely to exceed, perhaps substantially, the amount
of cash, if any, distributable to the Real Estate Trust or its subsidiaries
as a result of the property disposition. In addition, future reductions in
the level of the Partnerships' debt, any release of the guarantees of such
debt by the Real Estate Trust or its subsidiaries (described above under
"Reimbursement Agreement") or any refinancings in which the Real Estate Trust
or its subsidiaries do not assume a comparable obligation to that contained
in the Reimbursement Agreement could cause the Real Estate Trust or its
subsidiaries to have taxable constructive distributions without the receipt
of any corresponding amounts of cash. See Note 2 to the Consolidated
Financial Statements in this report.
REGISTRATION RIGHTS. Saul Centers has granted the Real Estate Trust and
the Trust Affiliates certain "demand" and "piggyback" registration rights
(collectively, the "Registration Rights") with respect to the shares of Saul
Centers common stock acquired in connection with the Formation Transactions
or as a consequence of exercise of the Rights (the "Registration Shares").
Subject to certain limitations, the Registration Rights grant the holders of
Registration Shares the opportunity to cause Saul Centers to register all or
any portion of their respective Registration Shares once in each calendar
year and to have such Shares registered incidentally to any registration, by
Saul Centers, of shares of common stock or other securities substantially
similar to common stock. Except with respect to the Registration Rights
incident to a pledge of Registration Shares or Saul Holdings Partnership
interests, the demand Registration Rights may be exercised only prior to such
time, if any, as the holder is permitted to sell the Registration Shares
pursuant to Rule 144 (k) under the Securities Act of 1933. Saul Centers will
bear expenses incident to its registration obligations upon exercise of the
Registration Rights, except that it will not bear any underwriting discounts
or commissions, Securities and Exchange Commission or state Blue Sky
registration fees, or transfer taxes relating to registration of Registration
Shares.
COMPETITION
As an owner of, or investor in, commercial real estate properties, the
Real Estate Trust is subject to competition from a variety of other owners of
similar properties in connection with their sale, lease or other disposition
and use. Management believes that success in such competition is dependent
upon the geographic location of the property, the performance of property
managers, the amount of new construction in the area and the maintenance and
appearance of the property. Additional competitive factors with respect to
commercial and industrial properties are the ease of access to the property,
the adequacy of related facilities such as parking, and the ability to
provide rent concessions and additional tenant improvements without
increasing rent. Management believes that general economic circumstances and
trends and new properties in the vicinity of each of the Real Estate Trust's
properties also will be competitive factors.
ENVIRONMENTAL MATTERS
The Real Estate Trust's properties are subject to various laws and
regulations relating to environmental and pollution controls. The Real Estate
Trust requires an environmental study to be performed with respect to a
property
11
that may be subject to possible environmental hazards prior to its
acquisition to ascertain that there are no material environmental hazards
associated with such property. Although the effect upon the Real Estate
Trust of the application of environmental and pollution laws and regulations
cannot be predicted with certainty, management believes that their
application either prospectively or retrospectively will not have a material
adverse effect on the Real Estate Trust's property operations.
RELATIONSHIPS WITH THE B. F. SAUL COMPANY
The Real Estate Trust has significant relationships with B. F. Saul
Company (the "Saul Company") and two of the Saul Company's wholly owned
subsidiaries, B. F. Saul Advisory Company (the "Advisor") and Franklin
Property Company ("Franklin"). The Saul Company, founded in 1892,
specializes in real estate investment services, including acquisitions,
financing, management and leasing, and insurance. B. Francis Saul II,
Chairman of the Board of Trustees and Chief Executive Officer of the Trust,
is Chairman of the Board and President of the Saul Company and the Advisor.
The Advisor acts as the Real Estate Trust's investment advisor and
manages the day-to-day financial, accounting, legal and administrative
affairs of the Real Estate Trust. Franklin acts as leasing and management
agent for most of the income-producing properties owned by the Real Estate
Trust, and plans and oversees the development of new properties and the
expansion and renovation of existing properties.
The Trustees, including the two independent Trustees, review the fees and
compensation arrangements between the Real Estate Trust and the Saul Company
and its related entities and affiliates and believe that such fees and
compensation arrangements are as favorable to the Real Estate Trust as would
be obtainable from unaffiliated sources. See "Certain Relationships and
Related Transactions."
HOLDING COMPANY REGULATION
The Trust and the Saul Company, by virtue of their direct and indirect
control of the Bank, and Chevy Chase Property Company ("CCPC") and CCPC's
wholly-owned subsidiary, Westminster Investing Corporation ("Westminster"),
by virtue of Westminster's direct and indirect ownership of 24.9% of the
common stock of the Trust (collectively the "Holding Companies"), are
"savings and loan holding companies" subject to regulation, examination and
supervision by the OTS. The Bank is prohibited from making or guaranteeing
loans or advances to or for the benefit of the Holding Companies or other
affiliates engaged in activities beyond those permissible for bank holding
companies and from investing in the securities of the Holding Companies or
other affiliates. Further, transactions between the Bank and the Holding
Companies must be on terms substantially the same, or at least as favorable
to the Bank , as those that would be available to non-affiliates.
The Holding Companies must obtain the prior approval of the OTS before
acquiring by merger, consolidation or purchase of assets any federally
insured savings institution or any savings and loan holding company. As
unitary savings and loan holding companies, the Holding Companies are
virtually unrestricted in
12
the types of business activities in which they may engage, provided the Bank
continues to meet the qualified thrift lender test. See "Banking -
Regulation -Qualified Thrift Lender ("QTL") Test." If the Holding Companies
were to acquire one or more federally insured institutions and operate them
as separate subsidiaries rather than merging them into the Bank, the Holding
Companies would become "multiple" savings and loan holding companies. As
multiple savings and loan holding companies, the Holding Companies would be
subject to limitations on the types of business activities in which they
would be permitted to engage, unless the additional thrifts were troubled
institutions acquired pursuant to certain emergency acquisition provisions
and all subsidiary thrifts met the QTL test. The Holding Companies may
acquire and operate additional savings institution subsidiaries outside of
Maryland and Virginia only if the laws of the target institution's state
specifically permit such acquisitions or if the acquisitions are made
pursuant to emergency acquisition provisions.
The Trust and the Saul Company entered into an agreement with OTS's
predecessor, the Federal Savings and Loan Insurance Corporation, to maintain
the Bank's regulatory capital at the required levels, and, if necessary, to
infuse additional capital to enable the Bank to meet those requirements.
Since the execution of this agreement, the OTS has changed its policy and now
accepts more limited agreements from those acquiring thrift institutions. In
addition, the regulatory capital requirements applicable to the Bank have
changed significantly as a result of FIRREA. The OTS has stated that capital
maintenance agreements entered into prior to such modification of OTS policy
and the enactment of FIRREA were not affected by such changes. The Trust and
the Saul Company have not sought to modify the existing agreement. To the
extent the Bank is unable to meet regulatory capital requirements in the
future, the OTS could seek to enforce the obligations of the Trust and the
Saul Company under the agreement. The Bank's business plan does not
contemplate any future capital contributions from the Trust or the Saul
Company.
If the Bank were to become "undercapitalized" under the prompt corrective
action regulations, it would be required to file a capital restoration plan
with the OTS setting forth, among other things, the steps the Bank would take
to become "adequately capitalized." The OTS could not accept the plan unless
the Holding Companies guaranteed in writing the Bank's compliance with that
plan. The aggregate liability of the Holding Companies under such a
commitment would be limited to the lesser of (I) an amount equal to 5.0% of
the Bank's total assets at the time the Bank became "undercapitalized" and
(ii) the amount necessary to bring the Bank into compliance with all
applicable capital standards as of the time the Bank fails to comply with its
capital plan. If the holding companies refused to provide the guarantee, the
Bank would be subject to the more restrictive supervisory actions applicable
to "significantly undercapitalized" institutions.
FEDERAL TAXATION
The Trust terminated its status as a real estate investment trust for
federal income tax purposes in 1978 and is now taxable as a corporation. The
Trust's real estate operations have generated sizable depreciation, interest
and other deductions in excess of its total income and, as a result, the
Trust has had substantial net operating loss carryovers for federal income
tax purposes ("NOLs"). The Trust and its subsidiaries join in the filing of
a consolidated federal income tax return using the accrual method of
accounting on the basis of a fiscal year ending September 30.
13
Since June 28, 1990 the Bank and its subsidiaries have joined in the
consolidated federal income tax returns filed by the Trust on a fiscal year
basis. Prior to June 28, 1990, the Bank and its subsidiaries filed a
consolidated federal income tax return on a calendar-year basis.
Savings institutions such as the Bank generally are taxed in the same
manner as other corporations. There are, however, several special rules that
apply principally to savings institutions (and, in some cases, other
financial institutions). Certain significant aspects of the federal income
taxation of the Bank are discussed below.
The Internal Revenue Service ("IRS") is currently conducting audits of
the federal income tax returns of the Trust for the taxable years ended
September 30, 1992 and September 30, 1993.
BAD DEBT RESERVE. Savings institutions that satisfy certain requirements
(so-called "qualifying institutions" as defined by the Internal Revenue Code)
are permitted to establish reserves for bad debts and to deduct each year
reasonable additions to those reserves in lieu of taking a deduction for bad
debts actually sustained during the taxable year. To qualify for this
treatment, at least 60% of a savings institution's assets must be "qualifying
assets," including cash, certain U.S. and state government securities,
obligations of certain deposit insurance corporations, loans secured by
interests in residential real property and loans made for the improvement of
residential real property.
The Bank has calculated the bad debt deduction for tax purposes under the
experience method since calendar year 1988. The experience method is based on
the institution's actual loan loss experience over a prescribed period. If
the Bank were not treated as a qualifying institution for any taxable year,
it would be required to recapture its bad debt reserve (for 1996,
approximately $114.8 million) into taxable income. In addition, the Bank
would be allowed to deduct only those bad debts that actually were sustained
during the taxable year. If the Bank were no longer permitted to use the
reserve method, the change would not have a significant adverse effect on the
Bank's reported earnings under generally accepted accounting principles.
Provisions that repealed the thrift bad debt provisions of the Internal
Revenue Code were included in the Small Business Act of 1996 and are
effective for tax years beginning after December 31, 1995. As a result, the
Bank will no longer be able to used the "reserve method" for computing its
bad debt deduction and will be allowed to deduct only those bad debts
actually incurred during the taxable year. The bad debt provisions of this
legislation also require thrifts to recapture and pay tax on bad debt
reserves accumulated since 1987 over a six year period, beginning with a
thrift's taxable year starting after December 31, 1995 (or, if the thrift
meets a loan origination test, beginning up to two years later). Bad debt
reserves accumulated prior to 1988 do not have to be recaptured under this
legislation. The tax liability related to the recapture of the bad debt
reserves accumulated since 1987 has been reflected in the Bank's financial
statements as of September 30, 1996.
CONSOLIDATED TAX RETURNS; TAX SHARING PAYMENTS. In recent years, the
operations of the Trust have generated significant NOL's. The Bank's taxable
income in the current year was sufficient to fully utilize all NOL
carryforwards and the current year tax loss of the Trust. Under the terms of
a tax sharing agreement dated June 28, 1990 (the "Tax Sharing Agreement"),
Chevy Chase is
14
obligated to make payments to the Trust based on its taxable income, as
explained more fully below. Under the terms of the Bank's board resolution,
the Bank is permitted to make tax sharing payments to the Trust of up to
$15.0 million relating to any fiscal year without OTS approval.
The Tax Sharing Agreement generally provides that each member of the
Trust's affiliated group is required to pay the Trust an amount equal to 100%
of the tax liability that the member would have been required to pay to the
IRS if the member had filed on a separate return basis. These amounts
generally must be paid even if the affiliated group has no tax liability or
the group's tax liability is less than the sum of such amounts. Under the
Tax Sharing Agreement, the Trust, in turn, is obligated to pay to the
applicable tax authorities the overall tax liability, if any, of the group.
In addition, to the extent the net operating losses or tax credits of a
particular member reduce the overall tax liability of the group, the Trust is
required to reimburse such member on a dollar-for-dollar basis, thereby
compensating the member for the group's use of its net operating losses or
tax credits.
The Bank made a tax sharing payment of $20.6 million in fiscal 1990, tax
sharing payments totaling $29.6 million in fiscal 1991 and a tax sharing
payment of $5.0 million in fiscal 1993. OTS approval of the $5.0 million
payment made in 1993 was conditioned on a pledge by the Trust of certain
Trust assets to secure certain of its obligations under the Tax Sharing
Agreement. Following execution of such a pledge, the OTS approved, and the
Bank made during fiscal 1994, 1995 and 1996, additional tax sharing payments
of $9.6, $20.5 and $25.0 million, respectively, to the Trust. It is expected
that the Bank will have taxable income in future years and additional
operating losses will be utilized to reduce the overall tax liability of the
group which would otherwise arise from such taxable income of the Bank (or
from the taxable income of other members of the Trust's affiliated group).
In general, if the Bank has net operating losses or unused tax credits in
any taxable year, under the Tax Sharing Agreement the Trust is obligated to
reimburse the Bank in an amount generally equal to (I) the tax benefit to the
group of using such tax losses or unused tax credits in the group's
consolidated federal income tax return for such year, plus (ii) to the extent
such losses or credits are not used by the group in such year, the amount of
the tax refunds which the Bank would otherwise have been able to claim if it
were not being included in the consolidated federal income tax return of the
group (but not in excess of the net amount paid by the Bank to the Trust
pursuant to the Tax Sharing Agreement). There is no assurance that the
Trust would be able to fulfill this obligation. If the Trust did not make
the reimbursement, the OTS could attempt to characterize such nonpayment as
an unsecured extension of credit by the Bank to the Trust which, as described
above under "Regulation - Holding Company Regulation," is prohibited under
current law. The Tax Sharing Agreement itself does not provide for any
remedies upon a breach by any party of its obligations under the Agreement.
STATE TAXATION
Maryland law does not allow the filing of consolidated income tax
returns, and thus the Trust and its subsidiaries, which includes the Bank,
subject to Maryland income tax are required to file separately in Maryland.
The Trust and its subsidiaries are also subject to income taxes in other
states, some of which allow or require combined or consolidated filing.
The Commonwealth of Virginia is currently conducting audits of the
consolidated state income tax returns of the Trust for the taxable years
ended September 30, 1991, September 30, 1992 and September 30, 1993.
15
BANKING
REGULATION
FEDERAL HOME LOAN BANK SYSTEM. The Bank is a member of the Federal Home
Loan Bank ("FHLB") of Atlanta. The 12 FHLBs are administered by the Federal
Housing Finance Board, an independent agency within the executive branch of
the federal government. The FHLBs serve as a central credit facility for
their members. Their primary credit mission is to enhance the availability of
residential mortgages. From time to time, the Bank obtains advances from the
FHLB. At September 30, 1996, the Bank had outstanding $269.1 million of
advances from the FHLB of Atlanta. See Note 18 to the Consolidated Financial
Statements in this report and "Deposits and Other Sources of Funds -
Borrowings."
As a member of the FHLB of Atlanta, the Bank is required to acquire and
hold shares of capital stock in that bank in an amount equal to the greater
of: (I) 1.0% of mortgage-related assets (i.e., home mortgage loans,
home-purchase contracts and similar obligations); (ii) 0.3% of total assets;
(iii) $500; or (iv) 5.0% of outstanding advances. Pursuant to this
requirement, the Bank had an investment of $31.9 million in FHLB stock at
September 30, 1996. The Bank earned dividends of $2.3 million during each of
the years ended September 30, 1996 and 1995.
LIQUIDITY REQUIREMENTS. The Bank is required to maintain a daily average
balance of liquid assets (including cash, federal funds, certain time
deposits, certain bankers' acceptances, certain corporate debt securities and
commercial paper, securities of certain mutual funds and specified U.S.
Government, state government and federal agency obligations) equal to a
specified percentage of its average daily balance of deposits (based upon the
preceding month's average balances), plus borrowings (or portions thereof)
payable in one year or less. This liquidity requirement is currently 5.0%.
Federal regulations also require that each institution maintain an average
daily balance of short-term liquid assets equal to at least 1.0% of its
average daily balance of deposits, plus borrowings payable in one year or
less. If an institution's liquid assets or short-term liquid assets at any
time do not at least equal (on an average daily basis for the month) the
amount required by the OTS, the institution could be subject to various
monetary penalties imposed by the OTS. At September 30, 1996, the Bank was
in compliance with both requirements, with a liquid assets ratio of 13.1% and
a short-term liquid assets ratio of 8.8%.
DEPOSIT INSURANCE PREMIUMS. Under FDIC insurance regulations, the Bank
is required to pay premiums to SAIF for insurance of its accounts. The FDIC
utilizes a risk-based premium system in which an institution pays premiums
for deposit insurance on its SAIF-insured deposits that range based on
supervisory evaluations and on the institution's capital category under the
OTS's prompt corrective action regulations. See "Prompt Corrective Action."
16
Although the FDIC insures commercial banks as well as thrifts, the
insurance reserve funds for commercial banks and thrifts have been segregated
into the Bank Insurance Fund ("BIF") and the SAIF, respectively. The FDIC is
required to maintain the reserve levels of both the BIF and the SAIF at 1.25%
of insured deposits. The BIF reserve reached the mandated 1.25% of insured
deposits during fiscal 1995. Legislation was enacted on September 30, 1996
that, among other things, imposed on thrift institutions a one-time
assessment of 65.7 cents for every $100 of SAIF-insured deposits to
recapitalize the SAIF to the 1.25% level. Pursuant to this legislation,
effective January 1, 1997, the FDIC has lowered the risk-based schedule for
SAIF assessment rates so that the rates for SAIF members are identical to the
rates for BIF members. In addition, commercial banks will be required to
share in the payment of interest due on Financing Corporation ("FICO") bonds
used to rescue the savings and loan industry in the 1980s. For the first
semi-annual period of 1997, annualized FICO assessments to be added to
deposit insurance premiums will equal 6.48 basis points for SAIF members and
1.3 basis points for BIF members. This differential is expected to remain in
effect through December 31, 1999, after which BIF and SAIF members will pay
identical FICO assessments, which are expected to be approximately 2.4 basis
points. Thus, the Bank and other institutions with SAIF-assessable deposits
will continue to pay somewhat higher deposit insurance premiums than
institutions with BIF-assessable deposits, which could lead to a competitive
disadvantage in the pricing of loans and deposits and additional operating
expenses. In addition, regulators have recently begun approving applications
by several thrift organizations to establish or acquire BIF-insured
affiliates and prolonged continuation of the disparity in deposit insurance
premiums could lead to more widespread efforts to shift insured deposits from
SAIF to BIF, thus further destabilizing the SAIF. However, the new
legislation contains provisions designed to prohibit deposit transfers from
SAIF to BIF under certain circumstances.
SAIF insurance may be terminated by the FDIC, after notice and a 30-day
corrective period, upon a finding by the FDIC that the institution has
engaged in unsafe or unsound practices, is in an unsafe or unsound condition
to continue operations, or has violated any applicable law, regulation, rule,
order or condition imposed by the FDIC. The 30-day period may be eliminated
by the FDIC with the approval of the OTS.
REGULATORY CAPITAL. Under OTS regulations implementing the capital
requirements imposed by FIRREA, savings institutions, such as the Bank, are
subject to a minimum tangible capital requirement, a minimum core (or
leverage) capital requirement, and a minimum total risk-based capital
requirement. Each of these requirements generally must be no less stringent
than the capital standards for national banks. At September 30, 1996, the
Bank's tangible, core and total risk-based regulatory capital ratios were
5.21%, 5.21% and 10.14%, respectively, compared to the minimum requirements
under FIRREA of 1.50%, 3.00% and 8.00%, respectively, in effect at that date.
Under FIRREA's minimum leverage ratio, Chevy Chase must maintain a ratio
of "core capital" to tangible assets of not less than 3.0%. However, under
the OTS "prompt corrective action" regulations, an institution that is not in
the highest supervisory category must maintain a minimum leverage ratio of
4.0% to be considered an "adequately capitalized" institution. See "Prompt
Corrective Action." "Core capital" generally includes common shareholders'
equity, noncumulative perpetual preferred stock and minority interests in
consolidated subsidiaries, less investments in certain subsidiaries and
certain intangible
17
assets, except that purchased mortgage servicing rights and originated
mortgage servicing rights (collectively "MSRs") and purchased credit card
relationships ("PCCRs") may be included up to an aggregate amount of 50% of
core capital. PCCRs are also subject to a sublimit of 25% of core capital.
For these purposes, MSRs and PCCRs are valued at the lesser of 90% of fair
market value or 100% of the current unamortized book value. At September 30,
1996, the Bank had qualifying MSRs of $32.1 million, which constituted 10.8%
of core capital at that date, and had no PCCRs.
Deductions from capital apply for investments in, and loans to,
subsidiaries engaged in activities not permissible for national banks, for
equity investments that are not permissible for national banks and for the
portion of land loans and non-residential construction loans in excess of an
80% loan-to-value ratio. All such deductions were fully phased-in as of July
1, 1996.
The tangible capital requirement adopted by the OTS requires a savings
institution to maintain "tangible capital" in an amount not less than 1.5% of
tangible assets, which is the minimum ratio required by FIRREA. "Tangible
capital" is defined as core capital less investments in certain subsidiaries
and any intangible assets (including supervisory goodwill), plus qualifying
MSRs valued at the amount includable in core capital.
The risk-based capital requirements issued by the OTS provide that the
capital ratio applicable to an asset is adjusted to reflect the degree of
credit risk associated with that asset and that the asset base for computing
a savings institution's capital requirement includes off-balance-sheet
assets. Capital must be maintained against assets sold with recourse despite
the fact that the assets are treated as having been sold under GAAP.
However, the amount of capital required need not exceed the amount of
recourse retained.
There are currently four categories of risk-weightings: 0% for cash and
similar assets, 20% for qualifying mortgage-backed securities, 50% for
qualifying residential permanent real estate loans and 100% for other assets,
including credit card loans, commercial real estate loans and loans more than
90 days past due and for real estate acquired in settlement of loans.
Savings institutions generally are required to maintain risk-based capital
equal to 8.0% of risk-weighted assets, with at least half of that amount in
the form of core capital.
A savings institution's supplementary capital may be used to satisfy the
risk-based capital requirement only to the extent of the institution's core
capital. Supplementary capital includes cumulative perpetual preferred
stock, qualifying non-perpetual preferred stock, qualifying subordinated
debt, nonwithdrawable accounts and pledged deposits, and allowances for loan
and lease losses (up to a maximum of 1.25% of risk-weighted assets). At
September 30, 1996, the Bank had $88.0 million in allowances for loan and
lease losses, of which $64.2 million was includable as supplementary capital.
Subordinated debt may be included in supplementary capital with OTS
approval subject to a phase-out based on its term to maturity. The phase-out
established for such maturing capital instruments by the OTS permits an
institution to include such instruments in supplementary capital under one of
two phase-out options: (i) at the beginning of each of the last five years
prior to
18
the maturity date of the instrument, the institution may reduce the amount
eligible to be included by 20% of the original amount or (ii) the institution
may include only the aggregate amount of maturing capital instruments that
mature in any one year during the seven years immediately prior to an
instrument's maturity that does not exceed 20% of the institution's capital.
Once an institution selects either the first or second option, it must
continue to select the same option for all subsequent issuances of maturing
capital instruments as long as there is any outstanding balance of such
instruments for which an option has been selected. At September 30, 1996,
the Bank had a $10.0 million capital note outstanding which was treated in
accordance with the rules in effect at November 7, 1989, the date of issuance
of the new regulation, none of which was included in supplementary capital
and an additional $150.0 million in maturing subordinated capital
instruments, all of which was includable as supplementary capital. See
"Deposits and Other Sources of Funds - Borrowings."
FDICIA required OTS and the other regulators to revise their risk-based
capital standards to take into account interest-rate risk, concentration of
credit risk and the risks of non-traditional activities. The OTS amended its
risk-based capital rules to incorporate interest-rate risk measures to
complement measures already established for credit risk. An institution that
would experience a change in "portfolio equity" in an amount in excess of
2.0% of the institution's assets as a result of a 200 basis point increase or
decrease in the general level of interest rates would be required to maintain
additional amounts of risk-based capital based on the lowest interest rate
exposure at the end of the three previous quarters. In August 1995, the OTS
indefinitely delayed implementation of its interest-rate risk regulation
pending the testing of an OTS appeals process. At September 30, 1996, the
Bank would not have been required to maintain additional amounts of
risk-based capital had the interest-rate risk component of the capital
regulations been in effect.
The OTS also considers concentration of credit risk and risks arising
from non-traditional activities, as well as a thrift's ability to manage
these risks, in evaluating whether the thrift should be subject to an
individual minimum capital requirement.
OTS regulations contain special rules affecting savings institutions with
certain kinds of subsidiaries. For purposes of determining compliance with
each of the capital standards, a savings institution's investments in, and
extensions of credit to, subsidiaries engaged in activities not permissible
for a national bank ("non-includable subsidiaries") are, with certain
exceptions, deducted from the savings institution's capital. At September
30, 1996, investments in non-includable subsidiaries were fully deducted from
all three FIRREA capital requirements. All or a portion of the assets of
each of a savings institution's subsidiaries are generally consolidated with
the assets of the savings institution for regulatory capital purposes unless
all of the savings institution's investments in, and extensions of credit to,
such subsidiary are deducted from capital. Chevy Chase's real estate
development subsidiaries are its only subsidiaries engaged in activities not
permissible for a national bank. At September 30, 1996, the Bank's
investments in, and extensions of credit to, its non-includable subsidiaries
totaled approximately $3.8 million, of which $3.6 million constituted a
deduction from tangible capital.
OTS capital regulations also require the 100% deduction from total
capital of all equity investments that are not permissible for national banks
and the portion of land loans and non-residential construction loans in
excess of
19
an 80% loan-to-value ratio. The Bank's only equity investments at September
30, 1996 were certain properties classified as real estate held for sale
which the Bank has agreed to treat as equity investments for regulatory
capital purposes. At September 30, 1996, the book value of these properties
after subsequent valuation allowances, was $20.7 million, of which $19.7
million was required to be deducted from total capital. The Bank had no land
loans or non-residential construction loans with loan-to-value ratios greater
than 80% at September 30, 1996. The Bank has $1.2 million of general
valuation allowances maintained against its non-includable subsidiaries and
equity investments which, pursuant to OTS guidelines, is available as a
"credit" against the deductions from capital otherwise required.
OTS capital regulations provide a five-year holding period (or such
longer period as may be approved by the OTS) for real estate acquired in
settlement of loans ("REO" or "real estate held for sale") to qualify for an
exception from treatment as an equity investment. If an REO property is
considered an equity investment, its then-current book value is deducted from
total risk-based capital. Accordingly, if the Bank is unable to dispose of
any REO property (through bulk sales or otherwise) prior to the end of its
applicable five-year holding period and is unable to obtain an extension of
such five-year holding period from the OTS, the Bank could be required to
deduct the then-current book value of such REO property from risk-based
capital. In November 1996, the Bank received from the OTS extensions through
November 12, 1997 of the holding periods for certain of its REO properties
acquired through foreclosure in fiscal 1990, 1991 and 1992. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Financial Condition - Banking - Capital - Regulatory Action and
Requirements."
The Bank's ability to maintain capital compliance is dependent on a
number of factors, including, for example, general economic conditions and
the condition of local real estate markets. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Financial
Condition - Banking - Capital - Regulatory Action and Requirements."
The OTS has the authority to require an institution to maintain capital
at levels above the minimum levels generally required, but has not indicated
any intention to exercise its authority to do so with respect to the Bank.
PROMPT CORRECTIVE ACTION. Pursuant to FDICIA, the OTS and the other
federal agencies regulating financial institutions have adopted regulations
which apply to every FDIC-insured commercial bank and thrift institution a
system of mandatory and discretionary supervisory actions which generally
become more severe as the capital levels of an individual institution
decline. The regulations establish five capital categories to which
institutions are assigned for purposes of determining their treatment under
these prompt corrective action provisions. An institution is categorized as
"well capitalized" under the regulations if (I) it has a leverage ratio of at
least 5.0%, a tier 1 risk-based capital ratio of at least 6.0% and a total
risk-based capital ratio of at least 10.0%, and (ii) is not subject to any
written agreement, order, capital directive or prompt corrective action
directive issued by the OTS to meet and maintain a specific capital level.
An institution is considered "adequately capitalized" if such capital ratios
are at least 4.0% (3.0% if rated in the highest supervisory category), 4.0%
and 8.0%, respectively. An institution with a leverage ratio below 4.0%
(3.0% if rated in the highest supervisory category), a tier 1 risk-based
capital ratio below 4.0% or a total risk-based capital ratio
20
below 8.0% is considered "undercapitalized" and an institution with ratios
under 3.0%, 3.0% or 6.0%, respectively, is considered "significantly
undercapitalized." Finally, an institution is considered "critically
undercapitalized," and subject to provisions mandating appointment of a
conservator or receiver, if its ratio of "tangible equity" (generally defined
by the OTS as core capital plus cumulative perpetual preferred stock) to
total assets is 2.0% or less. An institution's classification category could
be downgraded if, after notice and an opportunity for a hearing, the OTS
determined that the institution is in an unsafe or unsound condition or has
received and has not corrected a less than satisfactory examination rating
for asset quality, management, earnings or liquidity.
At September 30, 1996, the Bank's leverage, tier 1 risk-based and total
risk-based regulatory capital ratios were 5.21%, 5.80% and 10.14%,
respectively, which exceeded the minimum ratios established for
"adequately-capitalized" institutions. If the sales of the 1996 Debentures
and the REIT Preferred Stock had occurred at September 30, 1996, the Bank's
tangible, core, tier 1 risk-based and total risk-based regulatory capital
ratios would have been 6.67%, 6.67%, 7.65% and 15.15%, respectively, which
would have exceeded the ratios established for "well capitalized"
institutions.
REGULATORY AGREEMENT. On March 29, 1996, the OTS released the Bank from
its September 30, 1991 written agreement with the OTS, as amended in October
1993, and from regulatory restrictions on asset growth. In connection with
the termination of the written agreement and at the request of the OTS, the
Board of Directors of the Bank adopted a resolution which addressed certain
issues previously addressed by the written agreement. Among other things,
the resolution permits the Bank: (I) to make tax sharing payments without
OTS approval to the B.F. Saul Real Estate Investment Trust (the "Trust"),
which owns 80% of the Bank's Common Stock, of up to $15.0 million relating to
any single fiscal year; and (ii) to declare dividends on its common stock in
any quarterly period up to the lesser of (A) 50% of its after tax net income
for the immediately preceding quarter or (B) 50% of the average quarterly
after tax net income for the immediately preceding four quarter period, minus
(in either case) dividends declared on the Bank's preferred stock during that
quarterly period. The resolution also provides that the Bank will present a
plan annually to the OTS detailing anticipated consumer loan securitization
activity.
QUALIFIED THRIFT LENDER ("QTL") TEST. Insured savings institutions like
the Bank must meet a QTL test to avoid imposition of certain restrictions.
The QTL test requires thrifts to maintain a "thrift investment percentage"
equal to a minimum of 65%. The numerator of such percentage is the thrift's
"qualified thrift investments" and the denominator is the thrift's "portfolio
assets." "Portfolio assets" is defined as total assets minus (I) the thrift's
premises and equipment used to conduct its business, (ii) liquid assets, as
defined, and (iii) intangible assets, including goodwill. The QTL test must
be met on a monthly average basis in nine out of every 12 months.
At September 30, 1996, the Bank had 83.4% of its portfolio assets
invested in qualified thrift investments. Additionally, the Bank met the QTL
test in each of the previous 12 months.
21
Legislation was enacted on September 30, 1996 that, among other things,
significantly liberalizes the current QTL test by, among other things,
permitting inclusion of credit card and educational loans as qualified thrift
investments without limits (previously, such loans could be included only up
to 10% of the institution's assets). As a result of this provision, the
Bank's entire credit card portfolio is now eligible for inclusion as a
qualified thrift investment, thus substantially reducing the QTL test's
impact as a constraint on the Bank's business strategies.
A thrift's "qualified thrift investments" consist of residential housing
loans (including home equity loans and manufactured housing loans),
mortgage-backed securities FHLB and Federal National Mortgage Association
stock and, beginning September 30, 1996, credit card and educational loans.
Portions of other assets are also includable, provided that the total of
these assets does not exceed 20% of portfolio assets. Assets in this
category include 50% of residential housing loans originated and sold within
90 days, investments in real estate-oriented service corporations, 200% of
mortgage loans for residences, churches, schools, nursing homes and small
businesses in areas with unmet credit needs (low or moderate income areas
where credit demand exceeds supply). Intangible assets, including goodwill,
are specifically excluded from qualified thrift investments.
An institution that fails to meet the QTL test is subject to significant
penalties. Immediately after an institution ceases to be a QTL, it (I) may
not make any new investment or engage directly or indirectly in any other new
activity unless the investment or activity would be permissible for a
national bank, (ii) may not establish any new branch office at any location
at which a national bank could not establish a branch office, (iii) may not
obtain new advances from the applicable FHLB and (iv) may not pay dividends
beyond the amounts permissible if it were a national bank. One year
following an institution's failure to meet the test, the institution's
holding company parent must register and be subject to supervision as a bank
holding company. Three years after failure to remain a QTL, an institution
may not retain any investments or engage in any activities that would be
impermissible for a national bank, and must repay any outstanding FHLB
advances as promptly as possible consistent with the safe and sound operation
of the institution. Failure to meet the QTL test also could limit the Bank's
ability to establish and maintain branches outside of its home state of
Virginia.
Because Chevy Chase is engaged in activities that are not currently
permissible for national banks, such as investing in subsidiaries that engage
in real estate development activities, failure to satisfy the QTL test would
require Chevy Chase to terminate these activities and divest itself of any
prohibited assets held at such time. Based on a review of the Bank's current
activities, management of the Bank believes that compliance with these
restrictions would not have a significant adverse effect on the Bank. In
addition, because the Trust is engaged in real estate ownership and
development, which are activities that are currently prohibited for bank
holding companies, failure by Chevy Chase to remain a QTL, in the absence of
a significant restructuring of the Trust's operations, would, in effect,
require the Trust to reduce its ownership of Chevy Chase to a level at which
it no longer would be deemed to control the Bank.
The Bank has taken, and will continue to take, steps to meet the QTL test
by structuring its balance sheet to include the required percentage of
qualified thrift investments.
22
DIVIDENDS AND OTHER CAPITAL DISTRIBUTIONS. Under OTS regulations, the
ability of thrift institutions such as the Bank to make "capital
distributions" (defined to include payment of dividends, stock repurchases,
cash-out mergers and other distributions charged against the capital accounts
of an institution) varies depending primarily on the institution's earnings
and regulatory capital levels. The regulations do not apply to interest or
principal payments on debt, including interest or principal payments on the
Bank's outstanding subordinated debentures.
Institutions are divided into three tiers for purposes of these
regulations. Tier 1 institutions are those in compliance with their "fully
phased-in" capital requirements and which have not been notified by the OTS
that they are "in need of more than normal supervision." Tier 1 institutions
may make capital distributions without regulatory approval in amounts up to
the greater of (I) 100% of net income for the calendar year to date, plus up
to one-half of the institution's surplus capital (i.e., the excess of capital
over the fully phased-in requirements) at the beginning of the calendar year
in which the distribution is made or (ii) 75% of net income for the most
recent four quarters. Tier 1 institutions that make capital distributions
under the foregoing rules must continue to meet the applicable capital
requirements on a pro forma basis after giving effect to such distributions.
Tier 1 institutions may seek OTS approval to pay dividends beyond these
amounts.
Tier 2 institutions are defined as institutions that are in compliance
with their current, but not their fully phased-in capital requirements, and
depending on their specific capital levels, are authorized to make capital
distributions without regulatory approval in amounts not to exceed 75% of net
income for the most recent four quarters. However, all deductions from
capital requirements have been fully phased-in as of July 1, 1996, resulting
in all institutions being classified on the basis of their capital levels as
either Tier 1 or Tier 3 institutions since that date.
Tier 3 institutions have capital levels below their current required
minimum levels and may not make any capital distributions without the prior
written approval of the OTS.
At September 30, 1996, the Bank had sufficient levels of capital to be a
Tier 1 institution for purposes of the capital distribution regulation.
However, the OTS retains discretion under its capital distribution regulation
to treat an institution that is in need of more than normal supervision
(after written notice) as a Tier 2 or Tier 3 institution.
In December 1994, the OTS proposed to amend its capital distribution
regulation to simplify it and to conform it to the system of "prompt
corrective action" established by FDICIA. The proposal would replace the
current "tiered" approach with one that, in accordance with the OTS's "prompt
corrective action" rule, would allow associations to make only those capital
distributions that would not cause capital to drop below the level required
to remain adequately capitalized. Those associations that are held by a
savings and loan holding company, such as the Bank, or that receive a
composite supervisory rating lower than "2" would continue to be required to
notify the OTS prior to making any capital distributions. Those associations
that are undercapitalized or that would be undercapitalized following a
capital distribution, or that are not undercapitalized but are in "troubled
condition" (defined generally to include institutions subject to a formal
written agreement relating to safety and soundness), could make a capital
distribution only upon application to and approval by the OTS. The proposal
would delete from the OTS regulations the current numerical restrictions on
23
the amount of permissible capital distributions, but the OTS has indicated
that it would continue to use them as general guidelines.
The OTS retains general discretion to prohibit any otherwise permitted
capital distributions on general safety and soundness grounds and must be
given 30 days advance notice of all capital distributions. The OTS has
approved the payment of dividends on the Bank's outstanding 13% Noncumulative
Perpetual Preferred Stock, Series A (the "13% Preferred Stock"), provided
that (I) immediately after giving effect to the dividend payment, the Bank's
core and risk-based regulatory capital ratios would not be less than 4.0% and
8.0%, respectively; (ii) dividends are earned and payable in accordance with
the OTS capital distribution regulation; and (iii) the Bank continues to make
progress in the disposition and reduction of its non-performing loans and
real estate owned.
Although the Bank believes that dividends paid on the REIT Preferred
Stock issued by Chevy Chase Preferred Capital Corporation (the "REIT
Subsidiary") should not be considered "capital distributions" for this
purpose, there can be no assurances that the OTS would agree with this
position. Without addressing the issue of whether dividends on the REIT
Preferred Stock are "capital distributions" subject to the regulations, the
OTS has indicated that it would not object to the REIT Subsidiary's payment
of quarterly dividends on the REIT Preferred Stock in an amount up to the
amount of the REIT Subsidiary's net income for that quarter. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Financial Condition - Banking - Capital - Regulatory Action and
Requirements." The REIT Subsidiary currently expects that its net income
will be in excess of amounts needed to pay dividends on the REIT Preferred
Stock. However, dividends paid on the REIT Preferred Stock in excess of the
REIT Subsidiary's net income could be treated as "capital distributions" by
the OTS, in which case the REIT Subsidiary's payment of such dividends would
be subject to restrictions under the OTS capital distribution regulations.
Moreover, if dividends on the REIT Preferred Stock were treated as "capital
distributions," they would be included, together with dividends paid on the
13% Preferred Stock and the common stock of the Bank, in calculating the
amount of "capital distributions" that could be paid by the Bank without
obtaining OTS approval. The Bank currently intends to seek clarification of
these issues from the OTS.
In May 1988, in connection with the merger of a Virginia thrift into the
Bank, the B.F. Saul Company (the "Saul Company") and the Trust entered into a
capital maintenance agreement in which they agreed not to cause the Bank
without prior written approval of its federal regulator to pay "dividends" in
any fiscal year in excess of 50% of the Bank's net income for that fiscal
year, provided that any dividends permitted under such limitation could be
deferred and paid in a subsequent year. However, under both the current and
the proposed OTS capital distribution rule, with the approval of the OTS, the
Bank could substitute the requirements of the OTS capital distribution rule
for any more stringent requirements imposed on it by a previous written
agreement.
The Bank is subject to other limitations on its ability to pay dividends.
The indenture pursuant to which $150 million principal amount of the Bank's
9 1/4% Subordinated Debentures due 2005 was issued in 1993 (the "1993
Indenture")
24
provides that the Bank may not pay dividends on its capital stock unless,
after giving effect to the dividend, no event of a continuing default shall
have occurred and the Bank is in compliance with its regulatory capital
requirements. In addition, the amount of the proposed dividend may not exceed
the sum of (I) $15 million, (ii) 66 2/3% of the Bank's consolidated net
income (as defined) accrued on a cumulative basis commencing on October 1,
1993, and (iii) the aggregate net cash proceeds received by the Bank after
October 1, 1993 from the sale of qualified capital stock or certain debt
securities, minus the aggregate amount of any restricted payments made by the
Bank. Notwithstanding these restrictions on dividends, provided no event of
default has occurred or is continuing under the 1993 Indenture, the 1993
Indenture does not restrict the payment of dividends on the 13% Preferred
Stock or any payment-in-kind preferred stock issued in lieu of cash dividends
on the 13% Preferred Stock or the redemption of any such payment-in-kind
preferred stock. The indenture pursuant to which $100 million principal
amount of the Bank's 1996 Debentures was issued provides that the proposed
dividend may not exceed the sum of the restrictions discussed above for the
1993 Indenture and the aggregate liquidation preference of the Chevy Chase
Bank, F.S.B. 10 3/8% Noncumulative Preferred Stock, Series B (the "Series B
Preferred Stock"), if issued in exchange for the outstanding REIT Preferred
Stock. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Financial Condition - Banking - Capital - Regulatory
Action and Requirements".
In connection with the termination of the written agreement and at the
request of the OTS, the Board of Directors of the Bank adopted a resolution
which permits the Bank to declare dividends on its common stock in any
quarterly period up to the lesser of (I) 50% of its after tax net income for
the immediately preceding quarter or (ii) 50% of the average quarterly after
tax net income for the immediately preceding four quarter period, minus (in
either case) dividends declared on the Bank's preferred stock during that
quarterly period.
The payment of any dividends on the Bank's common stock and preferred
stock will be determined by the Board of Directors based on the Bank's
liquidity, asset quality profile, capital adequacy and recent earnings
history, as well as economic conditions and other factors deemed relevant by
the Board of Directors, including applicable government regulations and
policies. See "- Deposits and Other Sources of Funds - Borrowings." After
consideration of these factors, on December 18, 1996, the Board of Directors
declared a $300 per share dividend on the Bank's common stock. The dividend
meets the requirements of the OTS' capital distribution rules; however, the
Board's prior resolution would effectively preclude payment of any dividends
for the quarter based on the Bank's financial results for the September 1996
quarter. The Bank has asked the OTS for confirmation that it would not object
to the payment of the dividend.
LENDING LIMITS. With certain exceptions, the Bank is prohibited from
lending to one borrower (including certain related entities of the borrower)
amounts in excess of 15% of the institution's unimpaired capital and
unimpaired surplus, plus an additional 10% for loans fully secured by readily
marketable collateral. The Bank's loans-to-one-borrower limit was
approximately $80.7 million at September 30, 1996, and no group relationships
exceeded this limit at that date.
SAFETY AND SOUNDNESS STANDARDS. FDICIA requires the federal financial
institution regulators to devise standards to evaluate the operations of
depository institutions, as well as standards relating to asset quality,
earnings and compensation. The operational standards cover internal controls
and
25
audit systems, loan documentation, credit underwriting, interest rate
exposure, asset growth and employee compensation. An institution that fails
to meet a standard that is imposed through regulation may be required to
submit a plan for corrective action within 30 days. If a savings association
fails to submit or implement an acceptable plan, the OTS must order it to
correct the deficiency, and may restrict its rate of asset growth, prohibit
asset growth entirely, require the institution to increase its ratio of
tangible equity to assets, restrict the interest rate paid on deposits to the
prevailing rates of interest on deposits of comparable amounts and
maturities, or require the institution to take any other action the OTS
determines will better carry out the purpose of prompt corrective action.
Imposition of these sanctions is within the discretion of the OTS in most
cases, but is mandatory if the savings institution commenced operations or
experienced a change in control during the 24 months preceding the
institution's failure to meet these standards, or underwent extraordinary
growth during the preceding 18 months.
In August 1996, the OTS and the federal bank regulators jointly issued
final safety and soundness standards for asset quality and earnings effective
October 1, 1996. The asset quality standards require that an insured
depository institution establish and maintain a system to identify problem
assets and prevent deterioration in those assets. The earnings standards
require that an insured depository institution establish and maintain a
system to evaluate and monitor earnings and ensure that earnings are
sufficient to maintain adequate capital and reserves. Based on its review,
management does not believe that these new requirements, will have a material
adverse effect on the Bank's operations.
REGULATORY ASSESSMENTS. Pursuant to authority under FIRREA, the OTS has
adopted the following fees to fund its operations: (I) asset-based
assessments for all savings institutions, (ii) examination fees for certain
affiliates of savings associations, (iii) application fees, (iv) securities
filing fees, and (v) publication fees. Of these fees, the semi-annual
asset-based assessments (which for the Bank totaled $361,000 for the
six-month period ending December 31, 1996) are the most significant.
OTHER REGULATIONS AND LEGISLATION. As a thrift institution, Chevy Chase
continues to be subject to a requirement that it obtain prior approval of the
OTS before merging with another institution or before increasing its insured
accounts through merger, consolidation, purchase of assets or assumption of
liabilities. Also, as a SAIF-insured institution, the Bank is subject to
limitations on its ability to buy or sell deposits from or to, or to combine
with, a BIF-insured institution. Despite these restrictions, SAIF-insured
thrifts may be acquired by banks or by bank holding companies under certain
circumstances.
The federal agencies regulating financial institutions possess broad
enforcement authority over the institutions they regulate, including the
authority to impose civil money penalties of up to $1 million per day for
violations of laws and regulations.
Federally chartered thrifts like Chevy Chase generally are permitted to
establish new branches anywhere in the United States, provided that they (I)
meet their regulatory capital requirements; (ii) either have a satisfactory
record under the OTS's regulations implementing the Community Reinvestment
Act ("CRA") or have committed to improve their investment-related practices
and
26
performance to the satisfaction of the OTS; (iii) meet the domestic building
and loan test of section 7701(a)(19) of the Internal Revenue Code, or the
asset composition test of subparagraph -C- of that section or, effective
September 30, 1996, the QTL test; and (iv) meet the domestic building and
loan test, the asset composition test or, effective September 30, 1996, the
QTL test, with respect to each state outside of its home state where the
association has established branches.
Under legislation adopted in 1993, amounts realized by the FDIC from the
liquidation or other resolution of any insured depository institution must be
distributed to pay claims (other than secured claims to the extent of any
such security) in the following order of priority: (I) administrative
expenses of the receiver, (ii) any deposit liability of the institution,
(iii) any other general or senior liability of the institution (which is not
an obligation described in clause (iv) or (v)), (iv) any obligation
subordinated to depositors or general creditors (which is not an obligation
described in clause (v)), and (v) any obligation to stockholders arising as a
result of their status as stockholders.
PENDING LEGISLATION
THRIFT CHARTER LEGISLATION. During the past year, Congress has been
considering legislation in various forms that would require federal thrifts,
like the Bank, to convert their charters to national or state bank charters.
Recent legislation requires the merger of the BIF and the SAIF into a single
Deposit Insurance Fund on January 1, 1999, but only if the thrift charter is
eliminated by that date. The Treasury Department is required to submit a
comprehensive study on thrift charter issues by March 31, 1997. In the
absence of appropriate "grandfather" provisions, such legislation could have
a material adverse effect on the Bank and the Trust because, among other
things, the Trust engages in activities that are not permissible for bank
holding companies and the regulatory capital and accounting treatment for
banks and thrifts differs in certain significant respects. The Bank cannot
determine whether, or in what form, such legislation will eventually be
enacted and there can be no assurances that any such legislation that is
enacted will contain adequate grandfather rights for the Bank and the Trust.
FEDERAL RESERVE SYSTEM
The Federal Reserve Board (the "FRB") requires depository institutions,
including federal savings banks, to maintain reserves against their
transaction accounts and certain non-personal deposit accounts. Because
reserves generally must be maintained in cash or non-interest-bearing
accounts, the effect of the reserve requirement is to decrease the Bank's
earning asset base. FRB regulations generally require that reserves be
maintained against net transaction accounts. Prior to December 17, 1996, the
first $4.3 million of a depository institution's transaction accounts were
subject to a 0% reserve requirement. The next $47.7 million in net
transaction accounts were subject to a 3.0% reserve requirement and any net
transaction accounts over $52.0 million were subject to a 10.0% reserve
requirement. Effective December 17, 1996, the FRB increased the amount of
transaction accounts subject to a 0% reserve requirement from $4.3 million to
$4.4 million and decreased the "low reserve tranche" from $47.7 million to
$44.9 million. The Bank met its reserve requirements for each period during
the year ended September 30, 1996. The balances maintained to meet the
reserve
27
requirements imposed by the FRB also may be used to satisfy liquidity
requirements which are imposed by the OTS.
Savings institutions may borrow from the FRB "discount window," although
FRB regulations require these institutions to exhaust all reasonable
alternate sources of funds, including FHLB sources, before borrowing from the
FRB. FDICIA imposes additional limitations on the ability of the FRB to lend
to undercapitalized institutions through the discount window.
COMMUNITY REINVESTMENT ACT
Under the CRA and the OTS's implementing regulations, a savings
association has a continuing and affirmative obligation to help meet the
credit needs of its local communities, including low- and moderate-income
neighborhoods, consistent with the safe and sound operation of the
institution. In connection with its examination of a savings association,
the OTS is required to assess the institution's record in satisfying the
intent of the CRA. In addition, the OTS is required to take into account the
institution's record of meeting the credit needs of its community in
determining whether to grant approval for certain types of applications.
The Bank is committed to fulfilling its CRA obligation by providing
access to a full range of credit-related products and services to all
segments of its community.
Recent amendments to the CRA regulations are designed to focus the CRA
examination process on an institution's actual performance in meeting the
credit needs of low- and moderate-income neighborhoods rather than on its CRA
compliance procedures. Specifically, institutions like the Bank, with more
than $250 million in assets, will be evaluated on the basis of their lending
and investment in, and provision of services, to low- and moderate-income
areas unless they request designation and receive approval as wholesale or
limited purpose institutions or have been approved for evaluation under a
strategic plan. The Bank does not contemplate employing any of these
options. Additionally, large retail banks are required to collect and will be
required to report additional data concerning small business loans. Data
collection was effective January 1, 1996, and reporting requirements will
become effective on January 1, 1997. The Bank is not required to be
evaluated under the new examination procedures until July 1, 1997.
OTHER ASPECTS OF FEDERAL LAW
The Bank is also subject to federal statutory provisions covering other
items, including security procedures, currency transactions reporting,
insider and affiliated party transactions, management interlocks,
truth-in-lending, electronic funds transfers, funds availability and equal
credit opportunity. The Economic Development Regulatory Paperwork Reduction
Act of 1996, which was signed into law on September 30, 1996, contains
several provisions designed to reduce regulatory burdens associated with
compliance with various consumer and other laws applicable to the Bank,
including for example, provisions designed to coordinate the disclosure and
other requirements under the Truth-in-Lending and Real Estate Settlement
Procedures Acts, modify certain insider lending restrictions, permit OTS to
allow exemptions to anti-tying prohibitions and exempt certain transactions
and simplify certain disclosures under the Truth-in-Lending Act.
28
RECENT ACCOUNTING PRONOUNCEMENTS
Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be
Disposed Of" ("SFAS 121"), was issued in March 1995. SFAS 121 establishes
accounting standards for the impairment of long-lived assets, certain
identifiable intangibles, and goodwill related to those assets, to be held
and used and for long-lived assets and certain identifiable intangibles to be
disposed of. It addresses how impairment losses should be measured and when
such losses should be recognized. Under SFAS 121, long-lived assets and
certain identifiable intangibles to be held and used shall be reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. If the sum of the
expected cash flows (undiscounted and without interest charges) is less than
the carrying amount of the asset, the entity shall recognize an impairment
loss. Measurement of an impairment loss for long-lived assets and
identifiable intangibles that an entity expects to hold and use should be
based on the fair value of the asset. Long-lived assets and certain
identifiable intangibles to be disposed of should generally be reported at
the lower of carrying amount or fair value less the cost to sell. SFAS 121 is
effective for financial statements for fiscal years beginning after December
15, 1995. The adoption of SFAS 121 is not anticipated to have a material
impact on the Bank's financial condition or the results of operations. See
Note 1 to the Consolidated Financial Statements in this report.
SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities" ("SFAS 125"), was issued in June 1996.
SFAS 125 provides accounting and reporting standards for transfers and
servicing of financial assets and extinguishments of liabilities. Those
standards are based on consistent application of a "financial-components
approach" that focuses on control. Under that approach, upon the transfer of
financial assets, an entity recognizes the financial and servicing assets it
controls and the liabilities it has incurred, derecognizes financial assets
when control has been surrendered, and derecognizes liabilities when
extinguished. SFAS 125 supersedes SFAS No. 76, "Extinguishment of Debt," and
SFAS No. 77, "Reporting by Transferors for Transfers of Receivables with
Recourse." It amends SFAS No. 115, "Accounting for Certain Investments in
Debt and Equity Securities," to clarify that a debt security may not be
classified as held-to-maturity if it can be prepaid or otherwise settled in
such a way that the holder of the security would not recover substantially
all of its recorded investment. SFAS 125 amends and extends to all servicing
assets and liabilities the accounting standards for mortgage servicing rights
now in SFAS No. 65, "Accounting for Certain Mortgage Banking Activities," and
supersedes SFAS No. 122, "Accounting for Mortgage Servicing Rights." SFAS 125
is effective for transfers and servicing of financial assets and
extinguishments of liabilities occurring after December 31, 1996. The impact
of the adoption of SFAS 125 on the Bank's financial statements has not yet
been determined.
29
MARKET AREA
The Bank's principal deposit and lending markets are located in the
Washington, D.C. metropolitan area. Service industries and federal, state
and local governments employ a significant portion of the Washington, D.C.
area labor force, while a substantial number of the nation's 500 largest
corporations have some presence in the area. The Washington, D.C. area's
seasonally unadjusted unemployment rate is generally below the national rate
and was 3.8% in September 1996, compared to the national rate of 5.0%.
Chevy Chase historically has relied on retail deposits originated in its
branch network as its primary funding source. See "Deposits and Other
Sources of Funds." Chevy Chase's principal market for deposits consists of
Montgomery and Prince George's Counties in Maryland and, to a lesser extent,
Fairfax County in Virginia. Approximately 26.1% of the Bank's deposits at
September 30, 1996 were obtained from depositors residing outside of
Maryland, primarily in Northern Virginia. Chevy Chase had the largest market
share of deposits in Montgomery County at June 30, 1995, according to the
most recently published industry statistics. The per capita income of each
of Montgomery and Fairfax Counties ranks among the highest of counties and
equivalent jurisdictions nationally. These two counties are also the
Washington, D.C. area's largest suburban employment centers, with a
substantial portion of their labor force consisting of federal, state and
local government employees. Private employment is concentrated in services
and retail trade centers. Unemployment in Montgomery and Fairfax Counties in
September 1996 (2.7% and 2.8%, respectively) was below the national rate
(5.0%) and state rates (4.9% for Maryland and 4.2% for Virginia) for the same
month.
The Bank historically has concentrated its lending activities in the
Washington, D.C. metropolitan area. See "Lending Activities."
INVESTMENT AND OTHER SECURITIES
The Bank is required by OTS regulations to maintain a specific minimum
amount of liquid assets and short-term liquid assets invested in certain
qualifying types of investments. See "Regulation - Liquidity Requirements."
To meet these requirements, the Bank maintains a portfolio of cash, federal
funds and mortgage-backed securities with final maturities of five years or
less. The balance of investments in excess of regulatory requirements
reflects management's objective of maintaining liquidity at a level
sufficient to assure adequate funds to meet expected and unexpected balance
sheet fluctuations.
During fiscal 1995, the Bank transferred at fair value all of its
investment securities and mortgage-backed securities previously classified as
available-for-sale to held-to-maturity and, as a result, all such securities
are classified as held-to-maturity at September 30, 1996. Net unrealized
holding losses, net of the related income tax effect, continue to be reported
as a separate component of stockholders' equity and are being amortized to
income over the remaining lives of the securities.
The OTS guidelines require that investments in securities be accounted
for in accordance with generally accepted accounting principles ("GAAP"),
summarize the applicable accounting principles and provide guidance regarding
the application of GAAP in determining whether securities are properly
classified as held-to-maturity, available-for-sale or trading.
30
LENDING ACTIVITIES
LOAN PORTFOLIO COMPOSITION. At September 30, 1996, the Bank's loan
portfolio totaled $3.4 billion, which represented 59.4% of its total assets.
(All references in this report to the Bank's loan portfolio refer to loans,
whether they are held for sale and/or securitization or for investment, and
exclude mortgage-backed securities.) Loans collateralized by single-family
residences constituted 48.3% of the loan portfolio at that date.
The following table sets forth information concerning the Bank's loan
portfolio (net of unfunded commitments) for the periods indicated.
31
LOAN PORTFOLIO
(DOLLARS IN THOUSANDS)
SEPTEMBER 30,
----------------------------------------------------------------------------------------------------------
1996 1995 1994 1993 1992
--------------------- ------------------ ------------------ ------------------ ---------------
% OF % OF % OF % OF % OF
BALANCE TOTAL BALANCE TOTAL BALANCE TOTAL BALANCE TOTAL BALANCE TOTAL
---------- ------- ---------- ------- ---------- ----- --------- ------ -------- -----
Residential (1) $1,601,483 47.4% $1,391,694 47.3% $1,369,571 53.8% $1,287,333 53.6% $933,867 41.6%
Home equity (1) 32,052 0.9 29,024 1.0 34,708 1.4 60,549 2.5 223,148 9.9
Commercial real estate
and multifamily 78,866 2.3 85,781 2.9 84,210 3.3 94,079 3.9 61,522 2.7
Real estate
construction and
ground 63,907 1.9 32,652 1.1 52,350 2.0 62,637 2.6 92,215 4.1
Credit card (1) 1,118,271 33.1 1,012,548 34.4 650,199 25.5 754,520 31.4 872,672 38.9
Automobile (1) 297,560 8.8 239,217 8.1 289,346 11.4 106,725 4.4 19,910 0.9
Home improvement and
and other consumer (1) 94,316 2.8 112,705 3.9 37,526 1.4 8,255 0.3 8,735 0.4
Commercial 56,567 1.7 13,223 0.4 1,219 0.1 -- -- -- --
Other 38,410 1.1 26,969 0.9 28,106 1.1 29,793 1.3 33,284 1.5
--------- ------- --------- ----- -------- ----- -------- ---- ------- ---
3,381,432 100.0% 2,943,813 100.0% 2,547,235 100.0% 2,403,891 100.0% 2,245,353 100.0%
--------- ------- ---------- ----- -------- ----- ---------- ------ ---------- -----
------- ----- ----- ------ -----
Less:
Unearned premiums
and discounts 836 1,103 1,438 1,543 2,589
Deferred loan
origination
fees (costs) (13,958) (13,687) (10,604) (3,472) 1,889
Reserve for loan
losses 95,523 60,496 50,205 68,040 78,818
--------- -------- ------- ------- -------
82,401 47,912 41,039 66,111 83,296
--------- -------- ------- ------- -------
Total loans
receivable $3,299,031 $2,895,901 $2,506,196 $2,337,780 $2,162,057
---------- ---------- ----------- ----------- -----------
---------- ---------- ----------- ----------- -----------
- -----------------
(1) Includes loans held for sale and/or securitization, if any.
32
The Bank adjusts the composition of its loan portfolio in response to a
variety of factors, including regulatory requirements and asset and liability
management objectives. See "- Regulation - Regulatory Capital," and "-
Qualified Thrift Lender ("QTL") Test" and "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Financial
Condition - Banking - Asset and Liability Management."
CONTRACTUAL PRINCIPAL REPAYMENTS OF LOANS. The following table shows the
scheduled contractual principal repayments of the Bank's loans at September
30, 1996. The entire balance of loans held for sale and/or securitization is
shown in the year ending September 30, 1997, because such loans are expected
to be sold in less than one year.
33
CONTRACTUAL PRINCIPAL REPAYMENTS
(IN THOUSANDS)
PRINCIPAL APPROXIMATE PRINCIPAL REPAYMENTS
BALANCE DUE IN YEARS ENDING SEPTEMBER 30,
OUTSTANDING AT ------------------------------------------------------------------------
SEPTEMBER 30, 2012 AND
1996 (1) 1997 1998 1999 2000-2001 2002-2006 2007-2011 THEREAFTER
------------- ---------- ------- -------- --------- --------- --------- -----------
Residential $ 1,525,322 $ 28,520 $ 26,363 $ 28,946 $ 137,636 $ 153,828 $ 236,418 $ 913,611
Home equity 32,052 5,774 -- -- -- -- 7,021 19,257
Commercial real estate and multifamily 78,866 8,594 5,309 5,123 10,281 30,429 19,130 --
Real estate construction and ground 63,907 26,906 11,829 5,907 12,362 6,903 -- --
Credit card (2) 893,271 41,690 39,744 37,889 73,352 149,517 117,735 433,344
Automobile 72,560 14,303 16,097 18,116 24,044 -- -- --
Home improvement and other consumer 94,316 13,728 12,501 11,394 19,891 16,637 20,165 --
Commercial 56,567 29,148 5,943 6,435 10,428 4,613 -- --
Other 38,410 8,691 8,340 8,452 3,084 9,843 -- --
Loans held for sale 76,161 76,161 -- -- -- -- -- --
Loans held for securitization and sale 450,000 450,000 -- -- -- -- -- --
------------ ---------- -------- -------- -------- -------- -------- ----------
Total loans receivable (3) $ 3,381,432 $ 703,515 $126,126 $122,262 $291,078 $371,770 $400,469 $1,366,212
------------ ---------- -------- -------- -------- -------- -------- ----------
------------ ---------- -------- -------- -------- -------- -------- ----------
Fixed-rate loans $ 402,993 $ 70,394 $ 54,334 $ 56,506 $158,885 $ 40,523 $ 22,064 $ 287
Adjustable-rate loans 2,452,278 106,960 71,792 65,756 132,193 331,247 378,405 1,365,925
Loans held for sale 76,161 76,161 -- -- -- -- -- --
Loans held for securitization and sale 450,000 450,000 -- -- -- -- -- --
------------ ---------- -------- -------- -------- -------- -------- ----------
Total loans receivable (3) $ 3,381,432 $ 703,515 $126,126 $122,262 $291,078 $371,770 $400,469 $1,366,212
------------ ---------- -------- -------- -------- -------- -------- ----------
------------ ---------- -------- -------- -------- -------- -------- ----------
- ---------------------------------------------------
(1) Of the total amount of loans outstanding at September 30, 1996 which were
due after one year, an aggregate principal balance of approximately
$332.6 million had fixed interest rates and an aggregate principal balance
of approximately $2.3 billion had adjustable interest rates.
(2) Estimated repayments of credit card loans reflect the required minimum
payments.
(3) Before deduction of reserve for loan losses, unearned discounts and
deferred loan origination fees (costs).
34
Actual payments may not reflect scheduled contractual principal
repayments due to the effect of loan refinancings, prepayments and
enforcement of due-on-sale clauses, which give the Bank the right to declare
a "conventional loan" -- one that is neither insured by the Federal Housing
Administration ("FHA") nor partially guaranteed by the Veterans'
Administration ("VA") -- immediately due and payable in the event, among
other things, that the borrower sells the real property subject to the
mortgage and the loan is not repaid. Although the Bank's single-family
residential loans historically have had stated maturities of generally 30
years, such loans normally have remained outstanding for substantially
shorter periods because of these factors. At September 30, 1996, principal
repayments of $177.4 million are contractually due within the next year. Of
this amount, $70.4 million is contractually due on fixed-rate loans and
$107.0 million is contractually due on adjustable-rate loans.
Origination, Purchase and Sale of Real Estate Loans. The following table
shows changes in the composition of the Bank's real estate loan portfolio and
the net change in mortgage-backed securities.
35
ORIGINATION, PURCHASE AND SALE OF REAL ESTATE LOANS
(IN THOUSANDS)
FOR THE YEAR ENDED SEPTEMBER 30,
-----------------------------------
1996 1995 1994
---- ---- ----
Real estate loan originations and
purchases: (1)
Residential and home equity $1,321,951 $742,560 $1,570,155
Commercial, real estate and
multifamily 345 4,023 9,582
Real estate construction and ground 72,655 37,510 47,693
---------- -------- ----------
Total originations and purchases 1,394,951 784,093 1,627,430
---------- -------- ----------
Principal repayments (381,365) (245,376) (389,847)
Sales (2) (407,200) (374,414) (800,506)
Loans transferred to real estate
acquired in settlement of loans (5,972) (9,822) (4,106)
Other -- -- (541)
---------- -------- ----------
(794,537) (629,612) (1,195,000)
Transfers to mortgage-backed
securities (3) (363,257) (156,169) (396,189)
---------- -------- ----------
Increase (decrease) in real estate
loans $237,157 $ (1,688) $ 36,241
---------- -------- ----------
---------- -------- ----------
(1) Excludes unfunded commitments.
(2) Includes securitization and sale of home equity credit line receivables
of $96.5 million, $150.5 million and $181.9 million for the years ended
September 30, 1996, 1995 and 1994, respectively.
(3) Represents real estate loans which were pooled and exchanged for FHLMC
and FNMA mortgage-backed securities.
36
As a federally chartered savings institution, the Bank has general
authority to make loans secured by real estate located throughout the United
States. Approximately 92.4% of the Bank's single-family residential real
estate loans at September 30, 1996 by principal balance were secured by
properties located in Maryland, Virginia or the District of Columbia.
The Bank originates VA, FHA and a wide variety of conventional
residential mortgage loans through its wholly-owned mortgage banking
subsidiary, B.F. Saul Mortgage Company, and through Chevy Chase Mortgage, a
division of the Bank. Commercial, real estate construction and ground and
home equity credit line loans are originated directly by the Bank.
The Bank maintains a wholesale network of correspondents, including loan
brokers and financial institutions, in order to supplement its direct
origination of single-family residential mortgage loans. The Bank determines
the specific loan products and rates under which the correspondents originate
the loans, and subjects the loans to the Bank's underwriting criteria and
review. During the year ended September 30, 1996, approximately $394.4
million of loans settled under the correspondent program.
Loan sales provide the Bank with liquidity and additional funds for
lending, enabling the Bank to increase the volume of loans originated and
thereby increase loan interest and fee income, and in recent periods have
produced additional non-interest income in the form of gains on sales of
loans. In fiscal 1996, sales of mortgage loans originated or purchased for
sale by the Bank totaled $317.3 million. The marketability of loans, loan
participations and mortgage-backed securities depends on purchasers'
investment limitations, general market and competitive conditions, mortgage
loan demand and other factors. The Bank originates fixed-rate, single-family
loans on terms which conform to Federal Home Loan Mortgage Corporation
("FHLMC") and Federal National Mortgage Association ("FNMA") guidelines in
order to ensure the salability of the loan in the public secondary mortgage
market. In order to manage its interest-rate exposure, the Bank hedges its
fixed-rate mortgage loan pipeline by entering into whole loan and
mortgage-backed security forward sale commitments. Sales of residential
mortgage loans are generally made without recourse to the Bank. At September
30, 1996, the Bank had $76.1 million of single-family residential loans held
for sale to investors.
When the Bank sells a whole loan or loan participation and retains
servicing, or purchases mortgage servicing rights from third parties, it
continues to collect and remit loan payments, inspect the properties, make
certain insurance and tax payments on behalf of borrowers and otherwise
service the loans. The normal servicing fee, generally ranging from 0.25% to
0.50% of the outstanding loan principal amount per annum, is recognized as
income over the life of the loans. The Bank also typically derives income
from temporary investment for its own account of loan collections pending
remittance to the participation or whole loan purchaser. At September 30,
1996, the Bank was servicing residential permanent loans totaling $3.0
billion for other investors.
37
SALES OF MORTGAGE-BACKED SECURITIES. A significant portion of the
Bank's sales of mortgage-backed securities involve sales pursuant to the
Bank's normal mortgage banking operations. Generally, the Bank's policy is
to sell its fixed-rate mortgage production which, in the case of most
conforming fixed-rate loans, is accomplished by first pooling such loans into
mortgage-backed securities. The mortgage-backed securities sold as part of
the Bank's mortgage banking operations are generally issued in the same month
as the sale of such securities. The securities are formed from conforming
fixed-rate loans originated for sale or from conforming fixed-rate loans
resulting from the borrower's election to convert from a variable-rate loan
to a fixed-rate loan. Mortgage-backed securities held for sale in conjunction
with mortgage banking activities are classified as trading securities. As a
result of the sale of trading securities in the month such securities are
formed, the Consolidated Statements of Cash Flows in this report reflect
significant proceeds from the sales of trading securities, even though there
are no balances of such securities at September 30, 1996. Fixed-rate loans
are designated as held for sale in the Consolidated Statements of Financial
Condition in this report.
SINGLE-FAMILY RESIDENTIAL REAL ESTATE LENDING. The Bank originates a
variety of loans secured by single-family residential structures. At
September 30, 1996, $1.6 billion (or 48.3%) of the Bank's loan portfolio
consisted of loans secured by first or second mortgages on such properties,
including $40.0 million of FHA-insured or VA-guaranteed loans.
Chevy Chase currently offers fixed-rate loans with maturities of 15 to 30
years and adjustable-rate residential mortgage loans ("ARMs"), principally
with maturities of 30 years. At September 30, 1996, 40.1% of the Bank's
residential mortgage loans consisted of ARMs scheduled to have interest rate
adjustments within five years. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Financial Condition - Banking
- - - Asset and Liability Management." Interest rates on the majority of the
Bank's ARMs are adjusted based on changes in yields on U.S. Treasury
securities of varying maturities. The interest rate adjustment provisions of
the Bank's ARMs contain limitations on the frequency and maximum amount of
interest rate adjustments, although such limitations are not required by law.
These limitations are determined by a variety of factors, including mortgage
loan competition in the Bank's markets. The ARMs currently offered by the
Bank are generally subject to a limitation on the annual increase in the
interest rate of 2.0% and a limitation on the increase in the interest rate
over the term of the loan ranging from 6.0% to 9.0%.
During the current fiscal year, the Bank continued to fulfill its 1994
$1.0 billion five-year mortgage loan commitment to meet the credit needs of
low- and moderate-income borrowers in the various communities which it
serves. As part of this commitment, the Community Development Mortgage
Program is providing $140.0 million of mortgage financing over a five-year
period, with $7.0 million in subsidies for below-market mortgage loans, to
families in minority neighborhoods in the District of Columbia and Prince
George's County, Maryland.
The Bank's home equity credit line loan provides revolving credit secured
principally by a second mortgage on the borrower's home. Home equity credit
line loans bear interest at a variable rate that adjusts quarterly based on
changes in the applicable interest rate index and generally are subject to a
maximum annual interest rate of between 18.0% and 24.0%. Except for any
38
amortization of principal that may occur as a result of monthly payments,
there are no required payments of principal until maturity. In order to
promote its home equity credit line loan program, the Bank currently offers
prospective borrowers a below-market interest rate for an introductory period
and settlement without closing costs.
Securitizations of home equity credit line receivables have been an
integral element of the Bank's strategies to enhance liquidity and to
maintain compliance with regulatory capital requirements. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Financial Condition." The Bank transferred $96.5 million, $150.5 million and
$181.9 million of home equity credit line receivables in fiscal 1996, fiscal
1995 and fiscal 1994, respectively, to trusts for securitization and sale to
investors. Gains of $4.7 million, $7.6 million and $9.5 million were
recognized by the Bank as a result of these transactions. The Bank continues
to service the underlying accounts.
COMMERCIAL REAL ESTATE AND CONSTRUCTION LENDING. Aggregate balances of
residential construction, commercial construction, ground and commercial real
estate and multifamily loans increased 20.6% in fiscal 1996 to $142.8 million
at September 30, 1996, from $118.4 million at September 30, 1995. In the
past four fiscal years, the Bank has provided financing, generally at market
rates, to certain purchasers of its REO. Additionally, the Bank finances the
construction of residential real estate, principally single-family detached
homes and townhouses, but generally only when a home is under contract for
sale by the builder to a consumer.
COMMERCIAL LENDING. Beginning in July 1994, the Bank began developing an
active commercial lending program. Commercial loans are defined as any loans
made to a business entity for commercial purposes. Such purposes may include
the financing of working capital, the acquisition of machinery and equipment
or other assets, and the financing of cash flow needs. Loans for the
acquisition, construction or permanent financing of real estate used in the
borrower's business are considered commercial loans. All commercial loans are
underwritten, originated and managed by the Bank's Business Banking Group. A
wide variety of products is offered, including revolving lines of credit for
working capital or seasonal needs; term loans for the financing of fixed
assets; letters of credit; corporate credit cards; cash management services;
and other deposit and investment products. Business development efforts have
been concentrated in the major industry groups in the metropolitan
Washington, D.C. area, as well as a broad base of small businesses and
community service organizations. Commercial loans increased $43.3 million
during fiscal 1996 to $56.6 million at September 30, 1996 and will continue
to grow as the Bank continues to expand this aspect of its business.
Under legislation signed into law on September 30, 1996, the authority of
federal thrifts, like Chevy Chase, to make commercial loans was increased
from 10% to 20% of assets, provided that the additional 10% consists of small
business loans.
CREDIT CARD LENDING. Chevy Chase provides consumer credit through its
credit card program, which offers VISA (Registered Trademark) and MasterCard
(Registered Trademark) credit cards and includes Gold and Classic cards.
Chevy Chase issues the credit cards and receives interest income on credit
extended, a fee based on a percentage of credit sales paid by merchants
accepting card purchases, and generally, an annual membership fee for use of
the cards. Chevy Chase's credit card loan portfolio accounted for 33.1% of
Chevy Chase's total loans at September 30, 1996. According to statistics
published in the American Banker, Chevy Chase is the largest issuer of credit
39
cards among thrift institutions, based on managed credit card loans
outstanding at March 31, 1996. At September 30, 1996, credit card loans
outstanding totaled $1.1 billion and managed credit card receivables,
including receivables owned by the Bank and receivables securitized, sold and
serviced by the Bank, totaled $5.0 billion.
The Bank emphasizes credit card lending because the shorter term and
normally higher interest rates on such loans help it maintain a profitable
spread between the average loan yield and the cost of funds. In addition,
credit card accounts typically may be sold at a premium over their
receivables balances, thus further enhancing their potential value to the
Bank. Chevy Chase also believes its credit card program contributes to
market share growth in its local markets by attracting new depositors,
promoting a high degree of customer loyalty and providing opportunities to
cross-market other products of the Bank. For this reason, the Bank has not
sold any credit card accounts maintained by cardholders having addresses in
Maryland, Virginia or the District of Columbia, the Bank's primary market
area.
Chevy Chase's internal data processing systems are capable of handling a
broad range of credit card program operations, including processing of credit
applications and collection functions. Certain data processing and
administrative functions associated with the servicing of the credit card
accounts are performed on behalf of the Bank by First Data Resources
Incorporated from its facilities in Omaha, Nebraska.
Changes in credit card use and payment patterns by cardholders, including
increased defaults, may result from a variety of social, legal and economic
factors. Chevy Chase currently offers introductory and promotional periodic
interest rates for varying initial and promotional periods which, at the
conclusion of such periods, revert to the Bank's regular variable interest
rate. If account holders choose to utilize competing sources of credit, the
rate at which new receivables are generated may be reduced and certain
purchase and payment patterns with respect to the receivables may be
affected. Economic factors affecting credit card use include the rate of
inflation and relative interest rates offered for various types of loans.
Adverse changes in economic conditions could have a direct impact on the
timing and amount of payments by borrowers. During times of economic
recession, default rates on credit card loans generally may be expected to
exceed default rates on residential mortgage loans. During 1995 and 1996,
the number of individuals declaring bankruptcy has increased. Although the
Bank cannot predict with certainty the level of bankruptcies that may occur
among cardholders, the Bank has adjusted its underwriting procedures in an
attempt to mitigate losses incurred as a result of a cardholder declaring
bankruptcy. The Bank can make no assurances as to the level of bankruptcies
that may occur among cardholders in the future. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations - Financial
Condition - Banking - Asset Quality - Delinquent Loans" and "- Allowances for
Losses."
Certain issuers of credit cards have adjusted their pricing to provide
for the different credit risks among customers based upon card usage,
repayment habits and other criteria. The Bank has implemented such
risk-based pricing by increasing the interest rates charged to high-risk
customers and by continuing to allow premium-credit customers a more
favorable rate. Periodically, the Bank offers promotional discounts to
certain customers to encourage increased usage of the Bank's credit cards.
40
Certain jurisdictions and their residents may attempt to require
out-of-state credit card issuers to comply with such jurisdictions' consumer
protection laws that impose requirements on the making, enforcement and
collection of consumer loans. For example, in recent years, a number of
lawsuits and administrative actions have been filed in several states against
out-of-state credit card issuers (including both federally and state
chartered insured institutions) challenging various fees and charges (such as
late fees, over-the-limit fees, returned check fees and annual membership
fees) assessed against residents of the states in which such lawsuits were
filed, based on restrictions or prohibitions under the laws of such states.
The Supreme Court recently ruled that national banks may export late fees on
credit cards as interest regardless of states' usury laws, however the law is
not settled with respect to all types of fees and charges. If it were
determined that out-of-state credit card issuers must comply with a
jurisdiction's laws limiting the charges imposed by credit card issuers, such
action could have an adverse impact on the Bank's credit card operations.
Securitizations of credit card receivables and sales of credit card
relationships have been integral elements of the Bank's strategies to enhance
liquidity, to further asset and liability management objectives and to
maintain compliance with regulatory capital requirements. In fiscal 1994,
1992 and 1991, the Bank sold approximately 150,000 credit card relationships
at a premium over their receivables balances of $96.5 million, $14.9 million
and $273.4 million, respectively. No such sales occurred during fiscal 1996,
1995 and 1993. The Bank transferred $919.0 million, $1.6 billion, $1.4
billion, $350.0 million and $280.0 million of credit card receivables in
fiscal 1996, fiscal 1995, fiscal 1994, fiscal 1993 and fiscal 1992,
respectively, to trusts for securitization and sale to investors. No gain or
loss was recognized by the Bank as a result of these transactions; however,
the Bank continues to service the underlying accounts, and excess spread
income is recognized over the related lives of the transactions. This excess
spread income represents the contractual interest and fees, including
interchange fees, paid by the cardholders less certificate interest paid to
the certificate holders, and administrative fees paid to providers of
services to the trusts, and is net of charge-offs on credit card loans in the
trusts.
Chevy Chase plans to securitize an additional $825.0 million of credit
card receivables during the first and second quarters of fiscal 1997.
Certain of these receivables at September 30, 1996 were classified as loans
held for securitization and sale in the Consolidated Statements of Financial
Condition in this report.
Credit card loans are not subject to those provisions of federal laws and
regulations that limit to 35% of an institution's total assets the amount of
consumer loans that a federally chartered savings institution may make.
OTHER CONSUMER LENDING. Chevy Chase currently offers a variety of
consumer loans other than credit card loans, including automobile loans,
overdraft lines of credit, home improvement loans and other unsecured loans
for traditional consumer purchases and needs. In addition, through a
wholly-owned subsidiary, the Bank began offering "non-prime" automobile loans
in fiscal 1995. "Non-prime"
41
refers to a category of loans made to applicants who have experienced certain
adverse credit events, but who meet certain other creditworthiness tests.
See "Other Consumer Loan Underwriting." The Bank's portfolio of automobile
loans, home improvement loans and other consumer loans and other loans
totaled $297.6 million, $94.3 million and $38.4 million, respectively, at
September 30, 1996, which accounted for a combined 12.7% of total loans at
that date. The largest areas of recent growth have been in automobile loans
and home improvement loans. During fiscal 1996, the Bank purchased or
originated $591.2 and $153.4 million of automobile loans and home improvement
loans, respectively, which was offset in part by the transfers of $475.3
million and $153.5 million, respectively, of receivables to trusts for
securitization and sale to investors.
Federal laws and regulations permit a federally chartered savings
institution to make secured and unsecured consumer loans up to 35% of the
institution's total assets. In addition, a federally chartered savings
institution has lending authority above the 35% limit for certain consumer
loans which include, in addition to credit card loans, home improvement,
secured deposit account and educational loans.
REAL ESTATE LOAN UNDERWRITING. In the loan approval process, Chevy Chase
assesses both the borrower's ability to repay the loan and, in appropriate
cases, the adequacy of the proposed security. Credit approval is vested with
the Board of Directors and delegated to the Executive Loan Committee and
certain senior officers in accordance with the credit authorizations approved
by the Board of Directors. All construction and commercial real estate loans
are reviewed and approved by the Executive Loan Committee. Any significant
loan not conforming to the Bank's approved policies must be approved by the
Executive Loan Committee or the Chief Executive Officer. All loans of $15
million or more are presented to the Board of Directors for final approval.
The approval process for all types of real estate loans includes on-site
appraisals of the properties securing such loans and a review of the
applicant's financial statements and credit, payment and banking history,
financial statements of any guarantors, and tax returns of guarantors of
construction and commercial real estate loans.
In an effort to minimize the increased risk of loss associated with
construction and development loans, Chevy Chase considers the reputation of
the borrower and the contractor, reviews pre-construction sale and leasing
information, and requires an independent inspecting engineer or architect to
review the progress of multifamily and commercial real estate projects. In
addition, the Bank generally requires personal guarantees of developers for
all development loans and, if a general contractor is used by the developer,
may require the posting of a performance bond.
The Bank generally lends up to 95% of the appraised value of
single-family residential dwellings to be owner-occupied. The Bank also
lends up to 85% of the appraised value of the completed project to finance
the construction of such dwellings, and, on a case-by-case basis, the Bank
occasionally may lend up to 90% of such appraised value when such financing
is limited to pre-sold units. The loan-to-value ratio generally applied by
the Bank to commercial real estate loans and multifamily residential loans
has been 80% of the appraised value of the completed project. Currently, the
Bank generally does not originate a second mortgage loan (excluding home
equity credit line loans) if the aggregate loan-to-value ratio of the second
loan and the related first mortgage loan exceeds 80% of the appraised value
of the property. Currently, the Bank offers home equity credit line loans up
to a 100% maximum loan-to-value ratio. Private mortgage insurance is
generally obtained for the amount over 80% of the value of the underlying
property. Loan-to-value
42
ratios are determined at the time a loan is originated. Consequently,
subsequent declines in the value of the loans' collateral could expose the
Bank to losses.
OTS regulations require institutions to adopt internal real estate
lending policies, including loan-to-value limitations conforming to specific
guidelines established by the OTS. The Bank's current lending policies
conform to these regulations.
On all loans secured by real estate (other than certain home equity
credit line loans), Chevy Chase requires title insurance policies protecting
the priority of the Bank's liens. The Bank requires fire and casualty
insurance for permanent loans (including home equity credit line loans) and
fire, casualty and builders' risk insurance for construction loans. The
borrower selects the insurance carrier, subject to Chevy Chase's approval.
Generally, for any residential loan (including home equity credit line loans)
in an amount exceeding 80% of the appraised value of the security property,
Chevy Chase currently requires mortgage insurance from an independent
mortgage insurance company. The majority of the Bank's mortgage insurance is
placed with four carriers.
Substantially all fixed-rate mortgage loans originated by the Bank
contain a "due on sale" clause providing that the Bank may declare a loan
immediately due and payable in the event, among other things, that the
borrower sells the property securing the loan without the consent of the
Bank. The Bank's ARMs generally are assumable.
COMMERCIAL LOAN UNDERWRITING. All commercial loan requests are
underwritten and approved under authorities granted to specified committees
and individuals as outlined in the Bank's credit policies. The scope and
depth of the underwriting for a particular request are generally dictated by
the size of the proposed transaction. Generally, larger requests are subject
to a full narrative credit analysis of the borrower's financial condition and
performance. Credit analyses are generally performed by the Bank's credit
analysis group. On intermediate size loans the credit analysis group produces
an automated narrative analysis utilizing software incorporating expert
systems and the underwriting is then performed by the loan officer.
Microbusinesses (generally businesses with sales of $1.0 million or less) are
underwritten by the loan officer utilizing automated analysis software
designed to reduce underwriting costs and to improve customer responsiveness.
All commercial loans greater than $100,000 are assigned a risk rating at
inception, utilizing a risk-rating system as defined in the Bank's credit
policies.
CREDIT CARD LOAN UNDERWRITING. The Bank generates new credit card
accounts through various methods, including direct mail and other
distribution channels. The Bank identifies potential cardholders for
preapproved solicitations by supplying a list of credit criteria to a credit
bureau, which generates a list of individuals who meet such criteria. When
the Bank receives an acceptance certificate from an individual that received
a preapproved solicitation, the Bank obtains a credit report on such
individual issued by an independent credit reporting agency, and the credit
limit and terms of the account are subject to certain post-screening
underwriting reviews performed by the Bank.
The Bank's underwriting approach to account approval supplements a
computerized credit scoring system with an individual evaluation of each
completed application for creditworthiness. In the underwriting process, the
Bank considers the prospective cardholder's income, credit history, and other
43
factors intended to provide a general indication of the applicant's
willingness and ability to repay his obligations. The Bank also reviews a
credit report on each applicant issued by an independent credit reporting
agency and, for certain applicants, independently verifies employment, income
or other information contained in the credit application.
If an application is approved, the Bank establishes an initial credit
limit on the cardholder's account based on the Bank's evaluation of the
cardholder's creditworthiness. This credit limit is adjusted from time to
time based on the Bank's continuing evaluation of the cardholder's repayment
ability as evidenced by the cardholder's payment history and other factors.
The Bank also may increase the credit limit at the cardholder's request after
completion of an evaluation comparable to that performed during the initial
underwriting.
Management reviews credit losses on a monthly basis and adjusts the
Bank's underwriting standards as appropriate.
OTHER CONSUMER LOAN UNDERWRITING. Other consumer loans (which include
automobile loans and home improvement loans) are originated or purchased by
the Bank after a review by the Bank in accordance with its established
underwriting procedures.
The underwriting procedures are designed to provide a basis for assessing
the borrower's ability and willingness to repay the loan. In conducting this
assessment, the Bank considers the borrower's ratio of debt to income and
evaluates the borrower's credit history through a review of a written credit
report compiled by a recognized consumer credit reporting bureau. The
borrower's equity in the collateral and the terms of the loan are also
considered. The Bank's guidelines are intended only to provide a basis for
lending decisions, and exceptions to such guidelines may, within certain
limits, be made based upon the credit judgment of the Bank's lending officer.
The Bank periodically conducts quality audits to ensure compliance with its
established policies and procedures.
The Bank also makes automobile loans through one of its operating
subsidiaries. The underwriting guidelines for this subsidiary apply to a
category of lending in which loans may be made to applicants who have
experienced certain adverse credit events (and therefore would not
necessarily meet all of the Bank's guidelines for its traditional loan
program), but who meet certain other creditworthiness tests. Such loans may
experience higher rates of delinquencies, repossessions and losses,
especially under adverse economic conditions, compared with loans originated
pursuant to the Bank's traditional lending program. See "Subsidiaries -
Operating Subsidiaries."
LOAN SERVICING. In addition to interest earned on loans, the Bank
receives income through servicing of loans and fees in connection with loan
origination, loan modification, late payments, changes of property ownership
and miscellaneous services related to its loans. Loan servicing income,
principally servicing income earned on the Bank's securitized credit card,
home equity credit line, automobile and home loan receivables portfolios, has
been a source of substantial earnings for the Bank in recent periods. Income
from these activities varies with the volume and type of loans originated and
sold.
44
The following table sets forth certain information relating to the Bank's
servicing income as of or for the years indicated.
AS OF OR FOR THE YEAR ENDED SEPTEMBER 30,
------------------------------------------------
1996 1995 1994
-------------- ------------- -------------
(In thousands)
Residential............... $ 3,045,650 $ 1,350,423 $ 1,495,120
Credit Card............... 3,889,704 3,226,316 1,953,792
Home Equity............... 416,365 455,791 485,428
Automobile................ 505,638 218,287 9,506
Home Loans................ 141,106 -- --
------------ ------------- -------------
Total amount of
loans serviced
for others (1).......... $ 7,998,463 $ 5,250,817 $ 3,943,846
============= ============= =============
Loan servicing fee
income (2).............. $ 264,096 $ 184,275 $ 69,878
============= ============= =============
- ----------------------------------------
(1) The Bank's basis in its servicing rights at September 30, 1996, 1995 and
1994 was $75.4 million, $54.2 million and $40.5 million, respectively.
(2) In each of the years ended September 30, 1996, 1995 and 1994, loan
servicing fee income as a percentage of net interest income before
provision for loan losses was 132.9%, 104.6% and 41.4%, respectively.
The Bank earns fees in connection with the servicing of home equity
credit line loans, credit card loans, home loans, automobile loans and
single-family residential mortgage loans. The Bank's level of servicing fee
income increases or decreases with increases or decreases in securitized
balances of these loan types. The increase in loan servicing fee income in
fiscal 1996 from the level achieved in fiscal 1995 was principally
attributable to an increase in securitized credit card receivables
outstanding. The Bank's level of servicing fee income declines upon
repayment of assets previously securitized and sold and repayment of mortgage
loans serviced for others. As the Bank securitizes and sells assets,
acquires mortgage servicing rights either through purchase or origination, or
sells mortgage loans and retains the servicing rights on those loans, the
level of servicing fee income increases. During fiscal 1996, the Bank
securitized and sold $919.0 million of credit card receivables, $96.5 million
of home equity credit line receivables, $475.3 million of automobile loan
receivables and $153.5 million of home loan receivables. In fiscal 1996, the
Bank also sold the rights to service mortgage loans with an aggregate
principal balance of $59.7 million, which were originated by the Bank in
connection with its mortgage banking activities.
The Bank's investment in loan servicing rights (including MSR's and
excess spread assets), and the amortization of such rights, are periodically
evaluated for impairment. Excess spread assets are evaluated quarterly based
on the
45
discounted value of estimated future net cash flows to be generated by the
underlying loans. The excess of the book value of these assets over the
discounted value is recorded as a valuation adjustment in the period in which
the change occurs. Several estimates are used when determining the
discounted value, the most significant of which is the estimated rate of
repayment of the underlying loans. The Bank evaluates its MSRs for
impairment based on fair value. To measure fair value of its MSRs, the Bank
uses either quoted market prices or discounted cash flow analyses using
appropriate assumptions for servicing fee income, servicing costs, prepayment
rates and discount rates. Additionally, the Bank stratifies its capitalized
MSRs for purposes of evaluating impairment by taking into consideration
relevant risk characteristics, including loan type, note rate and date of
acquisition. See Note 1 to the Consolidated Financial Statements in this
report.
The Bank prices its single-family mortgage loans to achieve a competitive
yield. Loan origination and commitment fees, and the related costs associated
with making the loans, are deferred. For fully amortizing loans originated
for the Bank's portfolio, the net deferred fees are accreted to interest
income over the estimated life of the loans using the level-yield method.
Fees deferred on revolving credit lines or loans which have no scheduled
amortization originated for the Bank's portfolio are accreted to income over
the estimated lives of the underlying loans using the straight-line method.
Fees deferred on loans originated and held for sale are not accreted to
income but instead are used in determining the gain or loss on the sale of
the loans
DELINQUENCIES, FORECLOSURES AND ALLOWANCES FOR LOSSES
DELINQUENCIES AND FORECLOSURES. When a borrower fails to make a required
payment on a mortgage loan, the loan is considered delinquent and, after
expiration of the applicable cure period, the borrower is charged a late fee.
The Bank follows practices customary in the banking industry in attempting to
cure delinquencies and in pursuing remedies upon default. Generally, if the
borrower does not cure the delinquency within 90 days, the Bank initiates
foreclosure action. If the loan is not reinstated, paid in full or
refinanced, the security property is sold. In some instances, the Bank may
be the purchaser. Thereafter, such acquired property is listed in the Bank's
account for real estate acquired in settlement of loans until the property is
sold. Deficiency judgments generally may be enforced against borrowers in
Maryland, Virginia and the District of Columbia, but may not be available or
may be subject to limitations in other jurisdictions in which loans are
originated by the Bank.
The total outstanding balance of a credit card loan (the largest category
of the Bank's consumer loans) is considered contractually delinquent if the
minimum payment indicated on the cardholder's statement is not received by
the due date indicated on such statement. Efforts to collect contractually
delinquent credit card receivables currently are made by the Bank's service
center personnel or the Bank's designees. Collection activities include
statement messages, formal collection letters and telephone calls. The Bank
may, at its option, enter into arrangements with cardholders to extend or
46
otherwise change payment schedules.
Delinquency levels are monitored by
collection managers, and information is reported regularly to senior
management. Accounts are charged off when they become 180 days contractually
delinquent, although the Bank continues to attempt to collect balances due
and, in some cases, may refer the accounts to outside collection agencies.
See "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Financial Condition - Banking - Asset Quality -
Delinquent Loans" for a discussion of the Bank's delinquent loan portfolio at
September 30, 1996.
ALLOWANCES FOR LOSSES. It is the Bank's policy to maintain adequate
allowances for estimated losses on loans and real estate. Generally, the
allowances are based on, among other things, historical loan loss experience,
evaluation of economic conditions in general and in various sectors of the
Bank's customer base, and periodic reviews of loan portfolio quality by Bank
personnel. Allowances for losses on loans and real estate are based on
current events or facts that may ultimately lead to future losses. The
Bank's actual losses may vary from management's current estimates. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Financial Condition - Banking - Asset Quality - Allowances for
Losses."
The Bank's specific methods for establishing the appropriate levels of
allowances vary depending upon the assets involved. The Bank's allowance on
credit card loans is based on a number of factors, including historical
charge-off and repayment experience and the age of the portfolio. The Bank
has developed a roll rate model to extrapolate its allowance needs based on
an analysis of the characteristics of the portfolio and trends at any
particular time. In this regard, the Bank considers various historical
information relative to origination date, borrower profiles, age of accounts,
delinquencies, bankruptcies and other factors. Although industry standards
are considered, they are given comparatively less weight due to management's
belief that comparisons among different institutions' portfolios are
potentially misleading because of significant differences in underwriting
standards, curing and re-aging procedures and charge-off policies. Chevy
Chase's policy is to charge off credit card receivables at the earlier of
when they become 180 days contractually delinquent or during the month
following receipt of notice of the death or bankruptcy filing of the
borrower. The Bank's actual charge-off experience for credit card loans may
vary from the levels forecasted by the Bank's roll rate model because credit
card loans typically are more sensitive to general economic conditions than
certain other types of loans. For example, an unforeseen decline in economic
activity may result in increased bankruptcy losses which the model is unable
to forecast. Nevertheless, because the Bank's model employs a rolling
12-month base, such unforeseen losses are incorporated into the model as they
occur and allowances are adjusted accordingly. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations - Financial
Condition - Banking - Asset Quality - Allowances for Losses."
The Bank's methods for determining the allowance on loans secured by
real estate vary depending on whether the loans are secured by residential
homes or by other real estate. For residential mortgage loans, management
computes the allowance by stratifying residential permanent loans on a state
by state and ownership (i.e., investor or homeowner) basis. After the
47
residential permanent portfolio has been stratified by state, historical loss
ratios (as adjusted for predictable or quantifiable trends, if known) for the
specific states are applied to delinquent loans. The sum of these
calculations is the component assigned to residential permanent loans. In
the Bank's experience, this approach has resulted in timely recognition of
necessary allowances, which has been generally supported by the Bank's
favorable results on the ultimate disposition of the underlying collateral.
The Bank assesses the adequacy of its general valuation allowances on
non-residential (i.e., other than single-family residential) mortgage loans,
REO and real estate held for investment based primarily on an ongoing
evaluation of individual assets. This evaluation takes into consideration a
variety of factors, including cash flow analyses, independent appraisals,
market studies, economic trends and management's knowledge of the market and
experience with particular borrowers. The Bank obtains current appraisals
when properties are classified as REO. The Bank periodically reviews
appraisals and orders new appraisals as appropriate based on a number of
factors, including the date of the previous appraisal, changes in market
conditions and regulatory requirements.
The Bank regularly reviews its overall loan portfolio consisting of
performing non-classified assets and, based on such review, establishes
additional allowances for losses.
In addition to the general valuation allowances described above,
valuation allowances are provided for individual loans where the ultimate
collection is considered questionable by management after reviewing the
current status of loans which are contractually past due and considering the
net realizable value of the collateral or guarantees, if applicable.
Beginning October 1, 1994, the Bank has been providing additional general
valuation allowances, which are equal to, or exceed, the net earnings
generated by the development and sale of land in the Communities. See
"Managements' Discussion and Analyses of Financial Condition and Results of
Operations - Financial Condition - Banking - Asset Quality - Allowances for
Losses."
REO is carried at the lower of cost or fair value. To date, sales of
REO, non-residential mortgage loans and loans classified as investments in
real estate have resulted in no material additional aggregate loss to the
Bank above the amounts already reserved. However, these results do not
necessarily assure that the Bank will not suffer losses in the future beyond
its level of allowances.
The Bank's individualized asset review takes place within its Asset
Review Committee and the Asset Classification Committee (the "Committee").
The Asset Review Committee accumulates and analyzes data relating to
classified and potential problem assets of $5.0 million or more and makes
appropriate recommendations regarding asset classifications to the Committee.
The Committee meets on a regular basis to discuss classifications of such
assets and to review the allowances for losses. The Committee generally
reviews the status of various projects, including, for example, data on
recent lot sales for residential development projects. Actual progress is
compared to projections made when the related loan was underwritten. Local
economic conditions and known trends are also reviewed. The Committee also
considers steps being taken
48
by borrowers to address problems, and reviews financial information relating
to borrowers and guarantors as well as reports by loan officers who are
responsible for continually evaluating the projects. The actions of the
Committee are reported to the Board of Directors.
The Federal Financial Institution Examination Council, which is composed
of the OTS and the other federal banking agencies, has issued guidelines
regarding the appropriate levels of general valuation allowances that should
be maintained by insured institutions. The Bank believes that its levels of
general valuation allowances at September 30, 1996 comply with the guidelines.
The Bank's assets are subject to review and classification by the OTS and
the FDIC upon examination. Based on such examinations, the Bank could be
required to establish additional valuation allowances or incur additional
charge-offs.
DEPOSITS AND OTHER SOURCES OF FUNDS
GENERAL. Deposits are the primary source of the Bank's funds for use in
lending and for other general business purposes. In addition to deposits,
Chevy Chase receives funds from loan repayments and loan sales. Loan
repayments are a relatively stable source of funds, while deposit inflows and
outflows are influenced by general interest rates and money-market
conditions. Borrowings may be used to compensate for reductions in normal
sources of funds, such as deposit inflows at less than projected levels or
deposit outflows, or to support the Bank's operating or investing activities.
DEPOSITS. Chevy Chase currently offers a variety of deposit accounts
with a range of interest rates and maturities designed to attract both
long-term and short-term deposits. Deposit programs include Super Statement
Savings, Super NOW, Insured Money Fund, Checking, Simple Statement Savings,
Young Savers, Certificate, and special programs for Individual Retirement and
Keogh self-employed retirement accounts. All jumbo certificates of deposit
are sold directly by the Bank to depositors, either through its branches or
through its money desk operation.
Chevy Chase attracts deposits through its branch network and
advertisements, and offers depositors access to their accounts through 529
ATMs, including 129 ATMs located in Safeway Inc. stores and 58 ATMs located
in Superfresh Food Markets. The Bank also has the right to install ATMs in
Safeway stores in the greater Washington, D.C./Baltimore/Richmond area which
do not currently have ATM service. These ATMs and installation rights
significantly enhance the Bank's position as a leading provider of convenient
ATM service in its primary market area. The Bank is a member of the regional
"MOST"(Registered Trademark) ATM network which offers over 8,900 locations in
the middle-Atlantic region. The Bank is also a member of the
"PLUS"(Registered Trademark) ATM network, which offers over 306,000 locations
worldwide.
The Bank obtains deposits primarily from customers residing in Montgomery
and Prince George's Counties in Maryland and Northern Virginia.
Approximately 26.1% of the Bank's deposits at September 30, 1996 were
obtained from depositors residing outside of Maryland, with approximately
13.7% of the Bank's deposits being obtained from depositors residing in
Northern Virginia.
The following table shows the amounts of Chevy Chase's deposits by type
of account at the dates indicated.
49
DEPOSIT ANALYSIS
(DOLLARS IN THOUSANDS)
--------------------------------------------------------------------------------------------------
SEPTEMBER 30,
--------------------------------------------------------------------------------------------------
1996 1995 1994 1993 1992
------------------- ------------------- ------------------- ------------------- ------------------
% OF % OF % OF % OF % OF
BALANCE TOTAL BALANCE TOTAL BALANCE TOTAL BALANCE TOTAL BALANCE TOTAL
---------- ------ --------- ------- ---------- ------- ---------- ------ ---------- -----
Demand and NOW accounts $1,007,902 24.2% $ 950,118 22.8% $ 918,227 22.9% $ 835,084 21.6% $ 743,214 19.0%
Money market deposit accounts 1,002,688 24.1 984,257 23.7 1,104,730 27.6 1,196,690 30.9 1,292,779 33.0
Statement savings accounts 881,285 21.2 872,366 21.0 1,201,141 30.0 941,289 24.3 690,328 17.6
Jumbo certificate accounts 125,847 3.0 219,304 5.3 85,110 2.1 56,218 1.5 42,423 1.1
Other certificate accounts 1,077,828 25.9 1,072,196 25.8 641,857 16.0 790,465 20.4 1,099,833 28.1
Other deposit accounts 68,487 1.6 61,011 1.4 57,696 1.4 50,277 1.3 47,381 1.2
---------- ------ ---------- ------ ---------- ------ ---------- ------ ---------- -----
Total deposits $4,164,037 100.0% $4,159,252 100.0% $4,008,761 100.0% $3,870,023 100.0% $3,915,958 100.0%
---------- ------ ---------- ------ ---------- ------ ---------- ------ ---------- -----
---------- ------ ---------- ------ ---------- ------ ---------- ------ ---------- -----
AVERAGE COST OF DEPOSITS
YEAR ENDED SEPTEMBER 30,
---------------------------------------------
1996 1995 1994
----- ----- -----
Demand and NOW accounts 2.51% 2.71% 2.74%
Money market accounts 3.87% 3.96% 3.24%
Statement savings and
other deposit accounts 3.38% 3.35% 3.37%
Certificate accounts 5.48% 5.17% 3.96%
Total deposit accounts 3.95% 3.84% 3.31%
----- ----- -----
----- ----- -----
50
The range of deposit account products offered by the Bank through its
extensive branch and ATM network allows the Bank to be competitive in
obtaining funds from its local retail deposit market. At the same time,
however, as customers have become increasingly responsive to changes in
interest rates, the Bank has experienced some fluctuations in deposit flows.
Chevy Chase's ability to attract and maintain deposits and its cost of funds
will continue to be significantly affected by market conditions and its
pricing strategy. During fiscal 1996, the Bank did not actively solicit
brokered deposits. Under FDIC regulations, the Bank is permitted to accept
brokered deposits as long as it meets the capital standards established for
"well-capitalized" or with a waiver from the FDIC, "adequately-capitalized"
institutions, under the prompt corrective action regulations. As a result of
the Bank's capital levels dropping below the levels established for
"well-capitalized" institutions as of September 30, 1996, the Bank has filed
a waiver request with the FDIC to permit retention of approximately $8.5
million in brokered deposits held at September 30, 1996, which were acquired
in prior years.
The following table sets forth Chevy Chase's deposit flows during the
periods indicated.
DEPOSIT FLOWS
YEAR ENDED SEPTEMBER 30,
---------------------------------------------
(IN THOUSANDS)
1996 1995 1994
-------------- ------------- -------------
Deposits....................... $ 15,312,125 $ 14,086,575 $ 12,308,342
Withdrawals from
accounts..................... (15,475,215) (14,089,444) (12,305,196)
-------------- ------------- -------------
Net cash from
accounts..................... (163,090) (2,869) (3,146)
Interest credited to
accounts..................... 167,875 153,360 135,592
-------------- ------------- -------------
Net increase (decrease)
in deposit balances $ 4,785 $ 150,491 $ (138,738)
============== ============= =============
Deposit growth may be moderated by the Bank from time to time either to
take advantage of lower cost funding alternatives or in response to more
modest expectations for loan and other asset growth.
The following table sets forth, by weighted average interest rates, the
types and amounts of deposits as of September 30, 1996 which will mature
during the fiscal years indicated.
51
WEIGHTED AVERAGE INTEREST RATES OF DEPOSITS
AS OF SEPTEMBER 30, 1996
(DOLLARS IN THOUSANDS)
--------------------------------------------
DEMAND, NOW
AND MONEY MARKET STATEMENT PASSBOOK AND OTHER CERTIFICATE
DEPOSIT ACCOUNTS SAVINGS ACCOUNTS CORE ACCOUNTS ACCOUNTS TOTAL
--------------------- -------------------- -------------------- -------------------- -------------------
MATURING DURING WEIGHTED WEIGHTED WEIGHTED WEIGHTED WEIGHTED
YEAR ENDING AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE
SEPTEMBER 30, AMOUNT RATE AMOUNT RATE AMOUNT RATE AMOUNT RATE AMOUNT RATE
- ---------------- ---------- --------- ---------- --------- ---------- -------- ---------- -------- ---------- --------
1997 $2,010,590 2.96% $881,285 3.47% $68,487 2.98% $ 897,768 5.17% $3,858,130 3.59%
1998 -- -- -- -- -- -- 147,836 5.38 147,836 5.38
1999 -- -- -- -- -- -- 51,381 5.26 51,381 5.26
2000 -- -- -- -- -- -- 89,516 6.68 89,516 6.68
2001 -- -- -- -- -- -- 17,174 5.46 17,174 5.46
---------- -------- -------- ---------- ----------
Total $2,010,590 2.96% $881,285 3.47% $68,487 2.98% $1,203,675 5.32% $4,164,037 3.75%
---------- -------- -------- ---------- ----------
---------- -------- -------- ---------- ----------
52
The following table summarizes maturities of certificate accounts in
amounts of $100,000 or greater as of September 30, 1996.
YEAR ENDING SEPTEMBER 30, AMOUNT WEIGHTED AVERAGE RATE
- -------------------------- ------ ---------------------
(Dollars in thousands)
1997 .................... $ 150,193 5.32%
1998 .................... 7,092 5.43%
1999 .................... 4,281 5.27%
2000 .................... 9,936 6.77%
2001 .................... 1,772 5.44%
----------
Total................... $ 173,274 5.41%
========== =====
The following table represents the amounts of deposits by various
interest rate categories as of September 30, 1996 maturing during the fiscal
years indicated.
53
MATURITIES OF DEPOSITS BY INTEREST RATES
AS OF SEPTEMBER 30, 1996
(IN THOUSANDS)
ACCOUNTS MATURING DURING YEAR ENDING SEPTEMBER 30,
----------------------------------------------------------------------
INTEREST RATE 1997 1998 1999 2000 2001 TOTAL
- ------------------ ---- ---- ---- ---- ---- -----
Demand deposits (0%) $ 156,517 $ -- $ -- $ -- $ -- $ 156,517
0.01% to 1.99% 558 -- -- -- -- 558
2.00% to 2.99% 884,225 -- -- -- -- 884,225
3.00% to 3.99% 1,232,603 -- -- -- -- 1,232,603
4.00% to 4.99% 1,121,541 62,438 12,982 471 -- 1,197,432
5.00% to 5.99% 300,545 46,562 34,379 2,920 17,174 401,580
6.00% to 7.99% 162,141 38,805 4,020 6,125 -- 291,091
8.00% to 9.99% -- 31 -- -- -- 31
----------- -------- -------- ------- ------- ----------
Total $3,858,130 $147,836 $ 51,381 $89,516 $17,174 $4,164,037
----------- -------- -------- ------- ------- ----------
----------- -------- -------- ------- ------- ----------
54
BORROWINGS. The FHLB system functions as a central reserve bank
providing credit for member institutions. As a member of the FHLB of
Atlanta, Chevy Chase is required to own capital stock in the FHLB of Atlanta
and is authorized to apply for advances on the security of such stock and
certain of its mortgages and other assets (principally securities which are
obligations of, or guaranteed by, the United States or its agencies),
provided certain standards related to creditworthiness have been met.
Under the credit policies of the FHLB of Atlanta, credit may be extended
to creditworthy institutions based upon the financial condition, and the
adequacy of collateral pledged to secure the extension of credit. Such
extensions of credit or borrowings may be obtained pursuant to several
different credit programs, each of which has its own rate and range of
maturities. Advances from the FHLB of Atlanta must be secured by certain
types of collateral with a value, as determined by the FHLB of Atlanta, at
least equal to 100% of the borrower's outstanding advances. The Bank had
outstanding FHLB advances of $269.1 million at September 30, 1996.
From time to time, the Bank enters into repurchase agreements, which are
treated as financings. The Bank sells securities (usually mortgage-backed
securities) to a dealer and agrees to buy back the same securities at a
specified time (generally within seven to 90 days). The Bank pays a stated
interest rate for the use of the funds for the specified time period to the
dealer. The obligation to repurchase the securities sold is reflected as a
liability and the securities underlying the agreements are included in assets
in the Consolidated Statements of Financial Condition in this report. These
arrangements are, in effect, borrowings by the Bank secured by the securities
sold. The Bank had outstanding repurchase agreements of $576.6 million at
September 30, 1996, which were used to fund the purchase of $629.6 million of
mortgage-backed securities during fiscal 1996.
The following table sets forth a summary of the repurchase agreements of
the Bank as of the dates and for the years indicated.
SEPTEMBER 30,
-----------------------
1996 1995
---------- ---------
(Dollars in thousands)
Securities sold under repurchase agreements:
Balance at year-end ............................ $576,576 $ --
Average amount outstanding at any month-end..... 57,644 159,044
Maximum amount outstanding at any
month-end.................................... 576,576 353,615
Weighted average interest rate during year...... 5.51% 6.02%
Weighted average interest rate on year-end
balance...................................... 5.41% --
In December 1986, the Bank issued an unsecured ten-year subordinated
capital note in the original principal amount of $10.0 million to BACOB Bank,
s.c., a foreign private savings bank. On November 15, 1996, the Bank
redeemed this note at par.
55
On November 23, 1993, the Bank sold $150 million principal amount of its
9 1/4% Subordinated Debentures due 2005 (the "1993 Debentures"). Interest on
the 1993 Debentures is payable semiannually on December 1 and June 1 of each
year. The OTS approved the inclusion of the principal amount of the 1993
Debentures in the Bank's supplementary capital for regulatory capital
purposes. On or after December 1, 1998, the 1993 Debentures will be
redeemable, in whole or in part, at any time at the option of the Bank.
On December 3, 1996, the Bank sold $100 million principal amount of its
9 1/4% Subordinated Debentures due 2008. Interest on the 1996 Debentures is
payable semiannually on December 1 and June 1 of each year. The OTS approved
the inclusion of the principal amount of the 1996 Debentures in the Bank's
supplementary capital for regulatory capital purposes. On or after December
1, 2001, the 1996 Debentures will be redeemable, in whole or in part, at any
time at the option of the Bank.
Under the OTS capital regulations, redemption of the 1993 Debentures or
the 1996 Debentures prior to their stated maturity would be subject to prior
approval of the OTS unless the Debentures are redeemed with the proceeds of,
or replaced by, a like amount of "a similar or higher quality" capital
instrument.
SUBSIDIARIES
OTS regulations generally permit the Bank to make investments in service
corporation subsidiaries in an amount not to exceed 3.0% of the Bank's
assets, provided that any investment in excess of 2.0% of assets serves
primarily community, inner city or community development purposes. Such
regulations also permit the Bank to make "conforming loans" to such
subsidiaries and joint ventures in an amount not to exceed 50% of the Bank's
regulatory capital. At September 30, 1996, 2.0% and 3.0% of the Bank's
assets was equal to $114.5 million and $171.8 million, respectively, and the
Bank had $12.0 million invested in its service corporation subsidiaries, $5.0
million of which was in the form of conforming loans. The Bank is required
to provide 30 days advance notice to the OTS and to the FDIC before
establishing a new subsidiary or conducting a new activity in an existing
subsidiary. With prior written approval from the OTS, the Bank may also
establish operating subsidiaries to engage in any activities in which the
Bank may engage directly.
During fiscal 1996, Chevy Chase formed two new subsidiaries for the
purpose of holding 100% of the stock in the Bank's special purpose
subsidiaries and financial services subsidiaries. Chevy Chase Real Estate
Corporation ("CCRC") holds stock in all special purpose subsidiaries. Chevy
Chase Financial Services Corporation ("CCFS") holds stock in both Chevy Chase
Securities, Inc. and Chevy Chase Insurance Agency, Inc. The Bank engages in
other activities through its subsidiaries, including those described below.
REAL ESTATE DEVELOPMENT ACTIVITIES. Manor Investment Company ("Manor")
previously engaged in certain real estate development activities as the
result of activities commenced prior to the enactment of FIRREA and continues
to manage the two remaining properties it holds. As a result of the
stringent capital requirements that FIRREA applies to investments in
subsidiaries, such as Manor, that engage in activities impermissible for
national banks, Manor has not entered, and does not intend to enter, into any
new real estate development arrangements. In fiscal 1995, Manor sold two of
its largest projects. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations - Financial Condition - Banking - Asset
Quality."
56
SECURITIES BROKERAGE SERVICES. Chevy Chase Securities, Inc., a
subsidiary of CCFS, is a licensed broker-dealer, selling securities on a
retail basis to the general public, including customers and depositors of the
Bank.
INSURANCE SERVICES. Chevy Chase Insurance Agency, Inc., a subsidiary of
CCFS, is a licensed insurance broker offering a variety of "personal line"
insurance programs in the property and casualty field (primarily homeowner
and automobile insurance) and in the life insurance field (primarily mortgage
and credit card life and disability programs).
SPECIAL PURPOSE SUBSIDIARIES. At September 30, 1996, CCRC held 100% of
the common stock of 29 subsidiaries (16 of which are active) that were formed
for the sole purpose of acquiring title to various real estate projects
pursuant to foreclosure or deed-in-lieu of foreclosure. The Bank's
investment in the subsidiaries was $158.4 million at September 30, 1996. The
Bank's investment in CCRC is not subject to the 3.0% service corporation
investment limit discussed above. See "Regulation - Regulatory Capital."
OPERATING SUBSIDIARIES. Chevy Chase engages in significant activities
through B.F. Saul Mortgage Company ("BFSMC"). See "Lending Activities".
During fiscal 1996, the Bank received OTS approval to treat BFSMC as an
operating subsidiary. CCB Holding Corporation ("CCBH") is a Delaware
corporation created by the Bank as an operating subsidiary in September 1994
in connection with its asset securitization activities. CCBH owns certain
certificates issued by two credit card trusts formed by the Bank and certain
other related assets. Consumer Finance Corporation was formed as an
operating subsidiary in December 1994 to engage in automobile lending. Chevy
Chase Preferred Capital Corporation was formed in November 1996 to issue the
REIT Preferred Stock.
EMPLOYEES
The Bank and its subsidiaries had 3,380 full-time and 779 part-time
employees at September 30, 1996. The Bank provides its employees with a
comprehensive range of employee benefit programs, including group health
benefits, life insurance, disability insurance, paid sick leave and an
employee loan program. The Bank offers home mortgage and credit card loans
to employees at prevailing market rates, but waives up to one point of any
loan origination fees on home mortgage loans and the annual fee on credit
card loans, and provides a yearly rebate equal to 0.5% of the outstanding
loan balance of home mortgage loans at calendar year-end. The Bank also
offers employees a one percent discount on the interest rate on overdraft
lines of credit. See "Executive Compensation and Other Information" for a
discussion of certain compensation programs available to the Bank's executive
officers. None of the Bank's employees is represented by a collective
bargaining agent. The Bank believes that its employee relations are good.
57
COMPETITION
Chevy Chase encounters strong competition both in attracting deposits and
making real estate and other loans in its markets. The Bank's most direct
competition for deposits has come from other thrift institutions, commercial
banks and credit unions, as well as from money market funds and corporate and
government securities. In addition to offering competitive interest rates,
Chevy Chase offers a variety of services, convenient ATM locations and
convenient office locations and hours to attract deposits. Competition for
real estate and other loans comes principally from other thrifts, banks,
mortgage banking companies, insurance companies and other institutional
lenders. Chevy Chase competes for loans through interest rates, loan fees
and the variety and quality of services provided to borrowers and brokers.
The Bank's major competition historically has come from local depository
institutions, but deregulation of the financial services industry and
changing market demands in recent years have eroded distinctions between
providers of financial services. In addition, both depository and
non-depository institutions have greater nationwide access to attractive
markets, such as the Washington, D.C. area, than they have had in past years.
Chevy Chase now competes with regional financial institutions and national
providers of investment alternatives, as well as with a number of large money
center and regional banks that have acquired subsidiary institutions in the
area.
The Bank estimates that it competes principally with approximately 11
depository institutions in its deposit-taking activities, with approximately
ten institutions in the origination of single-family residential mortgage
loans (other than home equity credit line loans) and with approximately six
depository institutions in the origination of home equity credit line loans.
According to the most recently published industry statistics, Chevy Chase had
the largest market share (approximately 19.6%) of deposits in Montgomery
County, Maryland, and ranked third in market share of deposits in Prince
George's County, Maryland at June 30, 1995. Based on publicly available
information, Chevy Chase estimates that, in the Washington, D.C. metropolitan
area, it maintains a significant market share of single-family residential
mortgage loans and the leading market share of home equity credit line loans.
The credit card industry is highly competitive and characterized by
increasing use of advertising, target marketing, pricing competition in
interest rates and annual membership fees, and other features (such as buyer
protection plans), as both established and new credit card issuers seek to
expand or to enter the market. Management anticipates that competitive
pressures will continue to require adjustments, from time to time, to the
pricing of the Bank's credit card products.
Interstate banking laws enacted by Congress and various states have
intensified the competition faced by the Bank in attracting deposits and
making loans. A number of large out-of-state financial institutions have
established or acquired banking operations in Maryland, Virginia and the
District of Columbia pursuant to these provisions.
58
PROPERTIES
REAL ESTATE
A list of the investment properties of the Real Estate Trust is set forth
under "Business - Real- Estate - Real Estate Investments."
The Trust conducts its principal business from its executive offices at
8401 Connecticut Avenue, Chevy Chase, Maryland. The Trust sells its
unsecured notes due one year to ten years from date of issue from a sales
office located at 7200 Wisconsin Avenue, Suite 903, Bethesda, Maryland. The
Saul Company leases both office facilities on behalf of the Trust.
BANKING
At September 30, 1996, the Bank conducted its business from its home
office at 7926 Jones Branch Drive, McLean, Virginia and its executive offices
at 8401 Connecticut Avenue, Chevy Chase, Maryland; its operations centers at
6151 and 6200 Chevy Chase Drive, Laurel, Maryland, 7215 Corporate Court,
Frederick, Maryland, 5300, 5310 and 5340 Spectrum Drive, Frederick, Maryland
and 7430 New Technology Way, Frederick, Maryland; its office facilities at
7700 Old Georgetown Road, Bethesda, Maryland; and 107 full-service offices
located in Maryland, Virginia and the District of Columbia. On that date,
the Bank owned the building and land for 21 of its branch offices and leased
its remaining 86 branch offices. Chevy Chase leases the office facilities at
8401 Connecticut Avenue, 6200 Chevy Chase Drive and 7215 Corporate Court and
the land at 7700 Old Georgetown Road. Chevy Chase owns the building at 7700
Old Georgetown Road. In addition, the Bank leases office space in which its
subsidiaries are housed. The office facility leases have various terms
expiring from 1997 to 2019 and the ground leases have terms expiring from
2029 to 2080. See Note 11 to the Consolidated Financial Statements in this
report for lease expense and commitments.
As of November 1996, the Bank has received OTS approval to open six
branches and is awaiting OTS approval to open another six branches. The
branches, six in Virginia, four in Maryland and two in the District of
Columbia, are scheduled to open during fiscal 1997.
The following table sets forth the location of the Bank's 107
full-service offices at September 30, 1996.
1 Catoctin Circle 14245-R Centreville Square
Leesburg, VA 22075 Centreville, VA 20121
8251 Greensboro Drive 1100 W. Broad Street
McLean, VA 22102 Falls Church, VA 22046
234 Maple Avenue East 3941 Pickett Road
McLean, VA 22180 Fairfax, VA 22031
8436 Old Keene Mill Road 1439 Chain Bridge Road
Springfield, VA 22152 McLean, VA 22101
75 West Lee Highway 12002 N. Shore Drive
Warrenton, VA 22186 Reston, VA 22090
6212 Leesburg Pike 8120 Sudley Road
Falls Church, VA 22044 Manassas, VA 22110
59
11800 Sunrise Valley Drive 1100 S. Hayes Street
Reston, VA 22091 Arlington, VA 22202
2952-H Chain Bridge Road 13344-A Franklin Farms Road
Oakton, VA 22124 Herndon, VA 22071
6756 Richmond Highway 20970 Southbanks Street
Alexandria, VA 22306 Sterling, VA 20165
5613 Stone Road 21800 Towncenter Plaza
Centreville, VA 22020 Sterling, VA 20164
44151 Ashburn Village Way 7030 Little River Turnpike
Ashburn, VA 22011 Annandale, VA 22003
3690-A King Street 3095 Nutley Street
Alexandria, VA 22302 Fairfax, VA 22031
6609 Springfield Mall 4700 Lee Highway
Springfield, VA 22150 Arlington, VA 22207
500 South Washington Street 5851 Crossroads Center Way
Alexandria, VA 22314 Falls Church, VA 22041
3537 S. Jefferson Street 7340 Westlake Terrace
Baileys Crossroads, VA 22041 Bethesda, MD 20817
8401 Connecticut Avenue 11261 New Hampshire Avenue
Chevy Chase, MD 20815 Silver Spring, MD 20904
5424 Western Avenue 1327 Lamberton Drive
Chevy Chase, MD 20815 Silver Spring, MD 20902
13641 Connecticut Avenue 1609-B Rockville Pike
Wheaton, MD 20906 Rockville, MD 20852
8315 Georgia Avenue 2215 Bel Pre Road
Silver Spring, MD 20910 Wheaton, MD 20906
4701 Sangamore Road 2807 University Blvd. West
Bethesda, MD 20816 Kensington, MD 20895
Landover Mall 11301 Rockville Pike
Landover, MD 20785 Kensington, MD 20895
60
11325 Seven Locks Road 7500 Old Georgetown Road
Potomac, MD 20854 Bethesda, MD 20814
6200 Annapolis Road 26001 Ridge Road
Landover Hills, MD 20784 Damascus, MD 20872
33 West Franklin Street 5370 Westbard Avenue
Hagerstown, MD 21740 Bethesda, MD 20816
6400 Belcrest Road 3601 St. Barnabas Road
Hyattsville, MD 20782 Silver Hill, MD 20746
8740 Arliss Street 17831 Georgia Avenue
Silver Spring, MD 20901 Olney, MD 20832
2409 Wootton Parkway 6107 Greenbelt Road
Rockville, MD 20850 Berwyn Heights, MD 20740
8889 Woodyard Road 4 Bureau Drive
Clinton, MD 20735 Gaithersburg, MD 20878
1181 University Boulevard 19610 Club House Road
Langley Park, MD 20783 Gaithersburg, MD 20879
12921 Wisteria Drive 812 Muddy Branch Road
Germantown, MD 20874 Gaithersburg, MD 20878
1009 West Patrick Street 10211 River Road
Frederick, MD 21701 Potomac, MD 20854
7937 Ritchie Highway 12331-C Georgia Avenue
Glen Burnie, MD 21061 Wheaton, MD 20906
19781-83 Frederick Road 14113 Baltimore Avenue
Germantown, MD 20876 Laurel, MD 20707
16823 Crabbs Branch Way 7290-A Cradlerock Way
Rockville, MD 20855 Columbia, MD 21045
2331-A Forest Drive 1151 Maryland Route 3 North
Annapolis, MD 21401 Gambrills, MD 21054
3244 Superior Lane 12228 Viers Mill Road
Bowie, MD 20715 Silver Spring, MD 20906
61
20000 Goshen Road 317 Kentlands Blvd.
Gaithersburg, MD 20879 Gaithersburg, MD 20878
12097 Rockville Pike 215 N. Washington Street
Rockville, MD 20852 Rockville, MD 20850
10159 New Hampshire Avenue 1336 Crain Highway South
Hillandale, MD 20903 Mitchellville, MD 20716
6264 Central Avenue 543 Ritchie Highway
Seat Pleasant, MD 20743 Severna Park, MD 21146
7700 Old Georgetown Road 4745 Dorsey Hall Drive
Bethesda, MD 20814 Ellicott City, MD 21042
15777 Columbia Pike 1130 Smallwood Drive
Burtonsville, MD 20866 Waldorf, MD 20603
18104 Town Center Drive 10800 Baltimore Avenue
Olney, MD 20832 Beltsville, MD 20705
6197 Oxon Hill Road 1040 Largo Center Drive
Oxon Hill, MD 20745 Landover, MD 20785
980 E. Swan Creek Road 6335 Marlboro Pike
Fort Washington, MD 20744 District Heights, MD 20747
115 University Blvd. West 7530 Annapolis Road
Silver Spring, MD 20901 Lanham, MD 20784
3828 International Drive 10821 Connecticut Avenue
Silver Spring, MD 20906 Kensington, MD 20895
9707 Old Georgetown Road 18006 Mateny Road
Bethesda, MD 20814 Germantown, MD 20874
3400 Crain Highway 7406 Baltimore Avenue
Bowie, MD 20716 College Park, MD 20740
11241 Georgia Avenue 10400 Old Georgetown Road
Wheaton, MD 20902 Bethesda, MD 20814
13484 New Hampshire Avenue 210 Michigan Avenue, N.E.
Silver Spring, MD 20904 Washington, D.C. 20017
2626-T Naylor Road 4455 Connecticut Avenue, N.W.
Washington, D.C. 20020 Washington, D.C. 20008
4860 Massachusetts Avenue, N.W. 320 Riggs Road, N.E.
Washington, D.C. 20016 Washington, D.C. 20011
4000 Wisconsin Avenue
Washington, D.C. 20016
At September 30, 1996, the net book value of the Bank's office facilities
(including leasehold improvements) was $144.3 million. See Note 16 to the
Consolidated Financial Statements in this report.
62
The Bank currently is building a facility in Frederick, Maryland to
consolidate the Bank's employees and operations in that area. At September
30, 1996, the Bank had invested $3.5 million in the land and $17.8 million
for capital expenditures relating to this facility, of which $0.7 million
represents capitalized interest.
During fiscal 1995, the Bank transferred an office building, which was
previously classified as real estate held for investment, to property and
equipment and the Bank began to occupy a portion of the building during
fiscal 1996 in order to satisfy its need for additional office space.
In fiscal 1991, the Bank purchased an historic office building and the
underlying land in downtown Washington, D.C. with plans to establish a
deposit branch office and a trust office in the building. Although the Bank
terminated its trust business in fiscal 1991, it still plans to establish a
branch in the building.
The Bank owns additional assets, including furniture and data processing
equipment. At September 30, 1996, these other assets had a net book value of
$80.8 million. The Bank also has operating leases, primarily for certain
automobiles and data processing equipment and software. The leases for
automobiles are generally for periods of less than four years; the leases for
the data processing equipment and software have month-to-month or
year-to-year terms.
LEGAL PROCEEDINGS
In the normal course of business, the Trust is involved in certain
litigation, including litigation arising out of the collection of loans, the
enforcement or defense of the priority of its security interests, and the
continued development and marketing of certain of its real estate properties,
and certain employment claims. In the opinion of management, litigation
which is currently pending will not have a material adverse impact on the
financial condition or future operations of the Trust.
In August 1994, Chevy Chase and its subsidiary, B. F. Saul Mortgage
Company (together, the "Companies"), entered into an agreement with the
Unites States Department of Justice (the "Department") which commits them to
continue the types of lending practices, branching strategies and promotional
programs that are designed to increase the level of banking services
available to traditionally underserved areas of the Washington, D.C.
metropolitan area. Specifically, the Companies have agreed to invest $11.0
million in the African-American community of the Washington D.C. metropolitan
area over a five-year period. This commitment obligates the Companies to:
(i) provide $7.0 million over the five-year period in subsidies for
below-market mortgage loans to residents of designated majority
African-American neighborhoods in Washington, D.C. and Prince George's
County, Maryland; (ii) open two additional mortgage offices in majority
African-American neighborhoods in the metropolitan Washington, D.C. area; and
(iii) open one new deposit branch in the Anacostia area of Washington, D.C.
The Companies also have agreed over the same five-year period, among other
things, to continue efforts to increase their promotional efforts targeted to
residents of African-American neighborhoods, to continue efforts to recruit
African-Americans for loan production positions, and to continue various
employee training programs. The Companies view these efforts as
continuations of their existing programs.
63
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year ended September 30, 1996.
MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
There currently is no established public trading market for the Trust's
Common Shares of Beneficial Interest (the "Common Shares"). At December 2,
1996, there were nine corporate or individual holders of record of Common
Shares. All holders of Common Shares at such date were affiliated with the
Trust. See "Security Ownership of Certain Beneficial Owners and Management."
SELECTED FINANCIAL DATA
The selected financial data of the Trust herein have been derived from
the Consolidated Financial Statements of the Trust. The data should be read
in conjunction with "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and the Consolidated Financial
Statements included elsewhere in this report.
64
SELECTED FINANCIAL DATA
=================================================================================================================================
YEAR ENDED SEPTEMBER 30
----------------------------------------------------------------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS AND OTHER DATA) 1996 1995 1994 1993 1992
- ---------------------------------------------------------------------------------------------------------------------------------
STATEMENT OF OPERATIONS DATA:
Real Estate:
Revenues $ 76,839 $ 77,285 $ 66,044 $ 93,245 $ 100,179
Operating expenses 104,321 109,971 102,087 137,256 127,936
Equity in earnings (losses) of partnership investments 3,374 3,681 1,738 (668) (208)
Gain (loss) on sales of property (68) 1,664 -- 184 (546)
------------------------------------------------------------------------
Real estate operating loss (24,176) (27,341) (34,305) (44,495) (28,511)
------------------------------------------------------------------------
Banking:
Interest income 387,511 365,315 334,464 348,814 403,033
Interest expense 188,836 189,114 165,544 167,518 214,761
------------------------------------------------------------------------
Net interest income 198,675 176,201 168,920 181,296 188,272
Provision for loan losses (115,740) (54,979) (29,222) (60,372) (89,062)
------------------------------------------------------------------------
Net interest income after provision for loan losses 82,935 121,222 139,698 120,924 99,210
------------------------------------------------------------------------
Other income:
Credit card, loan servicing and deposit service fees 324,761 218,572 111,279 91,216 92,291
Earnings (loss) on real estate held for investment
or sale, net (24,413) (5,549) 835 (12,722) (50,649)
Gain on sales of assets 24,400 12,282 32,217 40,270 44,259
Gain on sales of mortgage servicing rights -- 1,397 5,833 4,828 3,750
Other 19,713 5,923 9,885 7,161 10,766
------------------------------------------------------------------------
Total other income 344,461 232,625 160,049 130,753 100,417
------------------------------------------------------------------------
Operating expenses 381,285 298,164 246,560 187,828 156,218
------------------------------------------------------------------------
Banking operating income 46,111 55,683 53,187 63,849 43,409
------------------------------------------------------------------------
Total Company:
Operating income before income taxes, 21,935 28,342 18,882 19,354 14,898
extraordinary items, cumulative effect of change in
accounting principle, and minority interest
Provision for income taxes 8,301 2,021 7,025 11,703 7,385
------------------------------------------------------------------------
Income before extraordinary items, cumulative
effect of change in accounting principle and
minority interest 13,634 26,321 11,857 7,651 7,513
Extraordinary items:
Adjustment for tax benefit of operating loss
carryovers -- -- -- 7,738 3,817
Loss on early extinguishment of debt, net of taxes -- -- (11,315) -- (132)
------------------------------------------------------------------------
Income before cumulative effect of change in
accounting principle and minority interest 13,634 26,321 542 15,389 11,198
Cumulative effect of change in accounting principle -- -- 36,260 -- --
------------------------------------------------------------------------
Income before minority interest 13,634 26,321 36,802 15,389 11,198
Minority interest held by affiliates (3,962) (5,721) (3,963) (6,582) (5,261)
Minority interest -- other (9,750) (9,750) (9,750) (4,334) --
------------------------------------------------------------------------
Total company net income (loss) $ (78) $ 10,850 $ 23,089 $ 4,473 $ 5,937
========================================================================
Net income (loss) available to common shareholders $ (5,498) $ 5,430 $ 17,669 $ (947) $ 517
Net income (loss) per common share:
Income before extraordinary items, cumulative
effect of change in accounting principle and
minority interest $ 1.70 $ 4.33 $ 1.33 $ 0.46 $ 0.43
Extraordinary items:
Adjustment for tax benefit of operating loss
carryovers -- -- -- 1.60 0.79
Loss on early extinguishment of debt, net of taxes -- -- (2.34) -- (0.03)
------------------------------------------------------------------------
Income (loss) before cumulative effect of change in
accounting principle and minority interest 1.70 4.33 (1.01) 2.06 1.19
Cumulative effect of change in accounting principle -- -- 7.51 -- --
------------------------------------------------------------------------
Income before minority interest 1.70 4.33 6.50 2.06 1.19
Minority interest held by affiliates (0.82) (1.19) (0.82) (1.36) (1.08)
Minority interest -- other (2.02) (2.02) (2.02) (0.90) --
------------------------------------------------------------------------
Total company net income (loss) $ (1.14) $ 1.12 $ 3.66 $ (0.20) $ 0.11
========================================================================
- -
- -----------------------------------------------------------------------------------------------------------------------------------
65
SELECTED FINANCIAL DATA
(Continued)
===================================================================================================================================
YEAR ENDED SEPTEMBER 30
----------------------------------------------------------------------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS AND OTHER DATA) 1996 1995 1994 1993 1992
- -----------------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET DATA:
Assets:
Real estate assets $ 294,503 $ 313,412 $ 327,739 $ 220,556 $ 334,378
Income-producing properties, net 156,115 163,787 159,529 162,356 254,700
Land parcels 41,580 38,458 38,455 38,411 50,981
Banking assets 5,693,074 4,911,536 4,666,298 4,872,771 4,998,756
Total company assets 5,987,577 5,224,948 4,994,037 5,093,327 5,333,134
Liabilities:
Real estate liabilities 578,092 555,814 558,109 450,153 522,760
Mortgage notes payable 173,345 184,502 185,730 264,776 429,968
Notes payable - secured 177,500 175,500 175,000 -- --
Notes payable - unsecured 42,367 41,057 40,288 38,661 50,417
Banking liabilities 5,388,444 4,619,451 4,413,832 4,634,001 4,885,189
Minority interest held by affiliates 46,065 43,556 35,632 34,495 27,912
Minority interest - other 74,307 74,307 74,307 74,307 --
Total company liabilities 6,086,908 5,293,128 5,081,880 5,192,956 5,435,861
Shareholders' deficit (99,331) (68,180) (87,843) (99,629) (102,727)
- -----------------------------------------------------------------------------------------------------------------------------------
CASH FLOW DATA:
Net cash flows provided by (used in)
operating activities:
Real estate $ 9,782 $ 4,324 $ (10,859) $ (3,149) $ (884)
Banking 1,745,593 2,095,663 2,218,262 1,137,686 1,026,705
----------------------------------------------------------------------------
Total Company 1,755,375 2,099,987 2,207,403 1,134,537 1,025,821
----------------------------------------------------------------------------
Net cash flows provided by (used in)
investing activities:
Real estate (4,907) (17,143) (29,118) (2,999) (1,333)
Banking (2,565,469) (2,269,444) (1,777,281) (879,178) (1,224,100)
----------------------------------------------------------------------------
Total Company (2,570,376) (2,286,587) (1,806,399) (882,177) (1,225,433)
----------------------------------------------------------------------------
Net cash flows provided by (used in)
financing activities:
Real estate (6,714) (271) 75,723 3,230 169
Banking 727,019 160,966 (260,094) (190,850) 157,183
----------------------------------------------------------------------------
Total Company 720,305 160,695 (184,371) (187,620) 157,352
----------------------------------------------------------------------------
Net increase (decrease) in cash and
cash equivalents (94,696) (25,905) 216,633 64,740 (42,260)
- -----------------------------------------------------------------------------------------------------------------------------------
OTHER DATA:
Hotels:
Number of hotels 9 10 9 9 9
Number of guest rooms 2,261 2,608 2,415 2,356 2,400
Average occupancy 68% 67% 62% 68% 63%
Average room rate $68.79 $60.82 $57.57 $54.02 $56.54
Shopping centers:
Number of properties N/A N/A N/A 23 23
Leasable area (square feet) N/A N/A N/A 4,408,000 4,416,000
Average occupancy N/A N/A N/A 95% 95%
Office properties:
Number of properties (1) 8 9 9 10 10
Leasable area (square feet) (1) 1,308,000 1,368,000 1,363,000 1,537,000 1,537,000
Leasing percentages (1) 93% 84% 93% 85% 92%
Land parcels:
Number of parcels 9 10 10 12 12
Total acreage 446 433 433 1,496 9,529
(1) Includes Dulles South Office Building which is owned by a subsidiary in
which the Trust has a 50% interest.
- -------------------------------------------------------------------------------
66
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The Trust has prepared its financial statements and other disclosures on
a fully consolidated basis. The term "Trust" used in the text and the
financial statements included herein refers to the combined entity, which
includes B. F. Saul Real Estate Investment Trust and its subsidiaries,
including Chevy Chase and Chevy Chase's subsidiaries. "Real Estate Trust"
refers to B. F. Saul Real Investment Trust and its subsidiaries, excluding
Chevy Chase and Chevy Chase's subsidiaries. The operations conducted by the
Real Estate Trust are designated as "Real Estate," while the business
conducted by the Bank and its subsidiaries is identified by the term
"Banking."
FINANCIAL CONDITION
REAL ESTATE
The Real Estate Trust's investment portfolio at September 30, 1996
consisted primarily of hotels, office and industrial projects, and land
parcels. See "Business - Real Estate - Real Estate Investments." In August
1993, the Real Estate Trust transferred its 22 shopping center properties and
one of its office properties, together with the debt associated with such
properties, to Saul Holdings Partnership and a subsidiary limited partnership
of Saul Holding Partnership in exchange for securities representing a 21.5%
limited partnership interest in Saul Holdings Partnership. See "Business -
Real Estate - - Investment in Saul Holdings Limited Partnership."
Office space in the Real Estate Trust's office property portfolio was 93%
leased at September 30, 1996, compared to a leasing rate of 85% at September
30, 1995. At September 30, 1996, the Real Estate Trust's office property
portfolio had a total gross leasable area of approximately 1.3 million
square feet, of which 214,000 square feet (16%) and 271,000 square feet
(21%) are subject to leases whose terms expire in fiscal 1997 and fiscal
1998, respectively.
The eight hotel properties owned by the Real Estate Trust throughout
fiscal 1996 and fiscal 1995 experienced average occupancy rates of 68% and
69%, and average room rates of $66.98 and $62.80, respectively. Four of the
hotels registered improved occupancy rates and all eight of the hotels
registered higher average room rates in the most recent fiscal year.
Overall, the hotel portfolio experienced an average room rate of $68.70 and
an average occupancy rate of 68% during the most recent fiscal year. At
September 30, 1996, the Real Estate Trust owned nine hotels containing 2,261
rooms. On October 31, 1996, the Real Estate Trust purchased a 115-room
Holiday Inn Express hotel in Herndon, Virginia, approximately three miles
from the Washington Dulles International Airport.
BANKING
GENERAL. The Bank recorded operating income of $46.1 million during
fiscal 1996, compared to operating income of $55.7 million in fiscal 1995.
The decrease in income for fiscal 1996 was primarily attributable to a $60.8
million increase in the provision for loan losses and an $83.1 million
increase in non-interest expense (which included the $26.5 million SAIF
assessment discussed below), the effect of which was primarily offset by a
$111.8 million increase in non-interest income and a $22.5 million increase
in net interest income. See "Results of Operations - Fiscal 1996 Compared to
Fiscal 1995 - Banking."
67
Legislation was enacted on September 30, 1996 that, among other things,
imposed on thrift institutions a one-time assessment of 65.7 basis points on
their SAIF-insured deposits to recapitalize the SAIF. At September 30, 1996,
the Bank accrued an expense amounting to approximately $26.5 million for the
SAIF assessment.
Because of the continued improvement in the financial condition of the
Bank, on March 29, 1996, the OTS released the Bank from its written agreement
with the OTS, and the Board of Directors of the Bank adopted a resolution
addressing certain issues previously addressed by the written agreement. See
"Capital."
Real estate owned, net of valuation allowances, declined 45.3% during
fiscal 1996 to $119.9 million at September 30, 1996, from $219.2 million at
September 30, 1995. This reduction was primarily due to sales of residential
lots or units in the Communities and other smaller residential properties.
See "REO."
The Bank securitized and sold $1.6 billion of receivables pursuant to its
funding strategy during fiscal 1996, of which $919.0 million, $96.5 million,
$475.3 million and $153.5 million, related to securitizations and sales of
credit card, home equity, automobile and home loan receivables, respectively.
In addition, the Bank securitized and sold $42.1 million of amounts on
deposit in certain spread accounts established in connection with certain of
the Bank's outstanding credit card securitizations. See "Capital."
At September 30, 1996, the Bank's tangible, core, tier 1 risk-based and
total risk-based regulatory capital ratios were 5.21%, 5.21%, 5.80% and
10.14%, respectively. The Bank's capital ratios exceeded the requirements
under FIRREA as well as the standards established for
"adequately-capitalized" institutions under the prompt corrective action
regulations issued pursuant to FDICIA. In the September 30, 1996 quarter,
the Bank's capital ratios fell below the ratios established for
"well-capitalized" institutions for the first time since June 1993. If the
SAIF assessment discussed above had not been accrued in the quarter ended
September 30, 1996, the Bank's capital ratios would have continued to be
sufficient to meet the standards established for "well-capitalized
institutions." See "Capital."
On December 3, 1996, the Bank sold $100 million principal amount of its
9 1/4% Subordinated Debentures due 2008, the principal amount of which is
includable in the Bank's supplementary capital. In addition, on December 3,
1996, the REIT Subsidiary sold $150 million of REIT Preferred Stock, which is
eligible for inclusion as core capital of the Bank in an amount up to 25% of
the Bank's total core capital. If these transactions had occurred at
September 30, 1996, the Bank's tangible, core, tier 1 risk-based and total
risk-based regulatory capital ratios would have been 6.67%, 6.67%, 7.65%, and
15.15%, respectively, which would have exceeded the ratios established for
"well-capitalized" institutions.
The Bank's assets are subject to review and classification by the OTS
upon examination. The OTS concluded its most recent annual examination of
the Bank in December 1995.
ASSET QUALITY. Non-Performing Assets. The Bank's level of
non-performing assets continued to decline during fiscal 1996. The following
table sets forth information concerning the Bank's non-performing assets at
the dates indicated. The figures shown are after charge-offs and, in the case
of real estate acquired in settlement of loans, after all valuation
allowances.
68
NON-PERFORMING ASSETS
(DOLLARS IN THOUSANDS)
SEPTEMBER 30,
----------------------------------------------------------
1996 1995 1994 1993 1992
---------- ---------- ---------- ---------- ----------
Non-performing assets:
Non-accrual loans:
Residential $ 8,200 $ 8,593 $ 8,306 $ 9,108 $ 12,865
Commercial and multifamily -- 194 -- -- 3,694
Residential construction and ground -- -- -- -- 11,196
Commercial construction and ground -- -- -- -- 3,413
--------- --------- --------- --------- ---------
Total non-accrual real estate loans 8,200 8,787 8,306 9,108 31,168
Credit card 25,350 18,569 16,229 20,557 26,780
Consumer and other 1,239 595 498 314 3,572
--------- --------- --------- --------- ---------
Total non-accrual loans (1) 34,789 27,951 25,033 29,979 61,520
--------- --------- --------- --------- ---------
Non-accrual real estate held for investment (1) -- -- 8,915 8,898 8,892
--------- --------- --------- --------- ---------
Real estate acquired in settlement of loans 246,380 354,277 387,024 434,616 541,352
Reserve for losses on real estate acquired in settlement of loans (126,519) (135,043) (109,074) (101,462) (94,125)
--------- --------- --------- --------- ---------
Real estate acquired in settlement of loans, net 119,861 219,234 277,950 333,154 447,227
--------- --------- --------- --------- ---------
Total non-performing assets $ 154,650 $247,185 $ 311,898 $ 372,031 $ 517,639
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Reserve for losses on loans $ 95,523 $60,496 $ 50,205 $ 68,040 $ 78,818
Reserve for losses on real estate held for investment 191 193 9,899 10,182 14,919
Reserve for losses on real estate acquired in settlement of loans 126,519 135,043 109,074 101,462 94,125
--------- --------- --------- --------- ---------
Total reserves for losses $ 222,233 $195,732 $ 169,178 $ 179,684 $187,862
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
- -------------------
(1) Before deduction of reserves for losses.
69
NON-PERFORMING ASSETS (CONTINUED)
SEPTEMBER 30,
-----------------------------------------------------
1996 1995 1994 1993 1992
------- ------ ------ ------ ------
Ratios:
Non-performing assets, net to total assets (1) 1.04% 3.80% 5.40% 6.03% 8.48%
Reserve for losses on real estate loans to non-accrual
real estate loans (2) 134.44% 123.82% 169.58% 219.29% 53.16%
Reserve for losses on credit card loans to non-accrual
credit card loans (2) 314.32% 249.47% 212.77% 228.08% 214.96%
Reserve for losses on consumer and other loans to
non-accrual consumer and other loans (2) 388.86% 553.11% 319.28% 376.11% 131.10%
Reserve for losses on loans to non-accrual loans (2) 274.58% 216.44% 200.56% 226.96% 128.12%
Reserve for losses on loans to total loans receivable (3) 2.81% 2.05% 1.97% 2.83% 3.52%
- ----------------
(1) Non-performing assets is presented after all reserves for losses on
loans and real estate held for investment or sale.
(2) Before deduction of reserves for losses.
(3) Includes loans receivable and loans held for sale and/or securitization,
before deduction of reserve for losses.
70
Non-performing assets include non-accrual loans (loans contractually past
due 90 days or more or with respect to which other factors indicate that full
payment of principal and interest is unlikely), non-accrual real estate held
for investment ("non-accrual REI"), and REO, acquired either through
foreclosure or deed-in-lieu of foreclosure, or pursuant to in-substance
foreclosure (prior to the adoption of SFAS No. 114, "Accounting by Creditors
for Impairment of a Loan," in fiscal 1994).
Non-performing assets totaled $154.6 million, after valuation allowances
on REO of $126.5 million, at September 30, 1996, compared to $247.2 million,
after valuation allowances on REO of $135.0 million, at September 30, 1995.
In addition to the valuation allowances on REO, the Bank maintained $26.1
million and $2.3 million of valuation allowances on its non-accrual loans at
September 30, 1996, and September 30, 1995, respectively. The decrease in
non-performing assets was primarily attributable to a net decrease in REO of
$99.4 million.
Non-accrual Loans. The Bank's non-accrual loans totaled $34.8 million at
September 30, 1996, compared to $28.0 million at September 30, 1995. At
September 30, 1996, non-accrual loans consisted primarily of $8.2 million of
non-accrual real estate loans and $25.4 million of non-accrual credit card
loans. The $6.8 million increase in non-accrual loans was primarily due to
an increase in non-accrual credit card loans, reflecting an industry-wide
decline in the performance of such loans.
At September 30, 1996, the $25.4 million of non-accrual credit card loans
were classified for regulatory purposes as substandard and disclosed as
non-performing assets because they were 90 days or more past due. At that
date, the Bank also had $16.4 million of credit card loans classified for
regulatory purposes as substandard which were not either non-performing
assets (i.e., credit card loans which are 90 days or more past due) or
potential problem assets. The amount classified as substandard but not
non-performing assets ($16.4 million) primarily related to accounts for which
the customers have agreed to modified payment terms, but which were 30-89
days past due. Of the $16.4 million, $2.3 million was current, $7.8 million
was 30-59 days past due and $6.3 million was 60-89 days past due at September
30, 1996. All delinquent amounts are included in the table of delinquent
loans under "Delinquent Loans."
REO. At September 30, 1996, the Bank's REO totaled $119.9 million, after
valuation allowances on such assets of $126.5 million as set forth in the
following table.
71
BALANCE BALANCE
BEFORE ALL AFTER
# OF VALUATION VALUATION VALUATION PERCENT
PROPERTIES ALLOWANCES ALLOWANCES ALLOWANCES OF TOTAL
---------- ---------- ---------- ---------- --------
(Dollars in thousands)
Communities 5 $209,573 $114,561 $95,012 79.3%
Residential
ground 3 11,207 5,944 5,263 4.4%
Commercial
ground 8 23,203 5,894 17,309 14.4%
Single-family
residential
properties 17 2,397 120 2,277 1.9%
-- --------- --------- --------- ------
Total REO 33 $246,380 $126,519 $119,861 100.0%
== ========= ========= ========= ======
During fiscal 1996, REO decreased $99.4 million, which was primarily
comprised of $96.3 million in proceeds from REO sales.
The $96.3 million in REO sales proceeds consisted of five residential
ground properties ($21.9 million), 2,295 residential lots in the Communities
($62.2 million), approximately 30.2 acres of commercial land in four of the
Communities ($6.6 million), three partial sales of commercial ground ($1.3
million) and various single-family residential properties ($4.3 million).
Included in the activity discussed above is one transaction in which the
Bank sold the remaining residential lots (approximately 2,000) in two of its
Communities and two other residential properties at an amount that
approximated the net carrying value, after utilization of applicable
valuation allowances. The impact of this transaction was to reduce REO, net
of all valuation allowances, by $49.2 million. The Bank provided financing
of $33.4 million, net of participations, in connection with this sale.
At September 30, 1996, the Bank had executed contracts to sell one of the
residential ground properties at its book value of $1.8 million at that date.
The Bank's objective with respect to its REO is to sell such properties
as expeditiously as possible and in a manner which will best preserve the
value of the Bank's assets. In accordance with this objective, management of
the Bank continues to pursue several strategies. First, the Bank has focused
its efforts on marketing residential building lots directly to homebuilders,
and is proceeding with lot development to meet the requirements of existing
and new contracts with builders. Second, the Bank continues to seek and
negotiate with potential purchasers of remaining retail and commercial
ground. Third, the Bank
72
continues to seek potential investors concerning the possibility of larger
scale or bulk purchases of remaining ground at the Communities. The Bank's
ability to achieve this objective will depend on a number of factors, some of
which are beyond its control, such as the general economic conditions in the
Washington, D.C. metropolitan area.
The principal component of REO consists of the five Communities, four of
which are under active development. At September 30, 1996, two of the active
Communities had 2,554 remaining residential lots, of which 367 lots (14.4%)
were under contract and pending settlement. Four of the active Communities
had approximately 294 remaining acres of land designated for commercial use,
of which 17.9 acres (6.1%) were under contract and pending settlement. In
addition, at September 30, 1996, the Bank was engaged in discussions with
potential purchasers regarding the sale of additional residential units and
retail land.
In addition to the four active Communities, REO includes a fifth
Community, consisting of approximately 2,400 acres, in Loudoun County,
Virginia, which is in the pre-development stage and was to be developed into
approximately 6,200 residential units at September 30, 1996. At September
30, 1996, this property had a book value of $18.9 million, after valuation
allowances.
The Bank has continued to make financing available to homebuilders and
home purchasers in an attempt to facilitate sales of lots in the two
Communities under active residential development. The following table
presents, at the periods indicated, the outstanding balances of loans
provided by the Bank (subsequent to its acquisition of title to the
properties) to facilitate sales of lots in such Communities.
YEAR ENDED SEPTEMBER 30,
------------------------------------
1996 1995 1994
-------- --------- --------
(In thousands)
Residential construction loans ........... $49,623 $12,615 $13,367
Single-family permanent loans(1) ......... 43,297 50,096 54,642
------- ------- -------
Total .................................. $92,920 $62,711 $68,009
======= ======= =======
- --------------------------------
(1) Includes $1.2 million, $2.3 million and $4.4 million of loans classified as
held for sale at September 30, 1996, September 30, 1995 and September 30,
1994, respectively.
The Bank anticipates that it will provide construction financing for a
portion of the remaining unsold lot inventory in the Communities. The Bank
also expects that it will provide permanent financing for a portion of the
homes to be sold in the Communities. The Bank's current policy is to sell
all such single-family loans for which it provides permanent financing. At
73
September 30, 1996, $1.2 million of such loans are classified as held for
sale and generally are expected to be sold in the first quarter of fiscal
1997.
In furtherance of its objective of facilitating sales, the Bank has
continued development efforts in the Communities. The following table
presents the net decrease in the balances of the five Communities for the
periods indicated.
YEAR ENDED SEPTEMBER 30,
---------------------------------------
1996 1995 1994
-------- -------- --------
(In thousands)
Sales proceeds $ 71,023 $ 65,211 $ 78,057
Development costs 17,931 32,626 44,264
-------- -------- --------
Net cash flow 53,092 32,585 33,793
Increase (decrease) in reserves
and other non-cash items 13,870 16,884 (4,337)
-------- -------- --------
Net decrease in balances of the
Communities $ 66,962 $ 49,469 $ 29,456
======== ======== ========
The Bank currently anticipates that sales proceeds will continue to
exceed development costs in future periods. In the event development costs
exceed sales proceeds in future periods, the Bank believes that adequate
funds will be available from its primary liquidity sources to fund such
costs. See "Liquidity."
The Bank capitalizes costs relating to development and improvement of
REO. Interest costs are capitalized on real estate properties under
development. During fiscal 1996, the Bank capitalized interest in the amount
of $2.8 million relating to its four active Communities.
In accordance with the OTS extensions of the holding periods for certain
of its REO, the Bank is required to submit a quarterly status report on its
large REO properties. See "Capital - Regulatory Action and Requirements."
The Bank will continue to monitor closely its major non-performing and
potential problem assets in light of current and anticipated market
conditions. The Bank's asset workout group focuses its efforts in resolving
these problem assets as expeditiously as possible. The Bank does not
anticipate any significant increases in non-performing and potential problem
assets.
Potential Problem Assets. Although not considered non-performing assets,
primarily because the loans are not 90 or more days past due and the
borrowers have not abandoned control of the properties, potential problem
assets are experiencing problems sufficient to cause management to have
serious doubts as to the ability of the borrowers to comply with present
repayment terms. The majority of the Bank's potential problem assets involve
borrowers or properties experiencing cash flow problems.
74
At September 30, 1996, potential problem assets totaled $5.9 million,
before valuation allowances of $1.1 million, as compared to $8.2 million,
before valuation allowances of $1.5 million, at September 30, 1995. The $2.3
million decrease in potential problem assets was primarily attributable to
net principal reductions on such assets.
Delinquent Loans. At September 30, 1996, delinquent loans totaled $51.6
million (or 1.6% of loans) compared to $39.7 million (or 1.3% of loans) at
September 30, 1995. The following table sets forth information regarding the
Bank's delinquent loans at September 30, 1996.
PRINCIPAL BALANCE
--------------------------------------------- TOTAL AS A
MORTGAGE NON-MORTGAGE PERCENTAGE OF
LOANS LOANS TOTAL LOANS (1)
------------ --------------- ------------ ------------
(DOLLARS IN THOUSANDS)
Loans delinquent for:
30-59 days ...... $ 5,013 $ 28,717 $ 33,730 1.0%
60-89 days ...... 839 17,004 17,843 0.6%
------- -------- -------- ----
Total $ 5,852 $ 45,721 $ 51,573 1.6%
======= ======== ======== ====
- ---------------------
(1) Includes loans held for sale and/or securitization, before deduction of
valuation allowances.
Mortgage loans classified as delinquent 30-89 days consists entirely of
single-family permanent residential mortgage loans and home equity credit
line loans. Total delinquent mortgage loans decreased to $5.9 million at
September 30, 1996, from $6.0 million at September 30, 1995.
Non-mortgage loans (principally credit card loans) delinquent 30-89 days
increased to $45.7 million at September 30, 1996 from $33.7 million at
September 30, 1995, and increased as a percentage of total non-mortgage loans
outstanding to 2.9% at September 30, 1996 from 2.4% at September 30, 1995.
The increased percentage of delinquent non-mortgage loans to total
non-mortgage loans outstanding resulted primarily from the increase in
delinquent credit card loans, which reflects the industry-wide decline in the
performance of such loans.
Troubled Debt Restructurings. A troubled debt restructuring occurs when
the Bank agrees to modify significant terms of a loan in favor of the
borrower when the borrower is experiencing financial difficulties. The
following table sets forth loans accounted for as troubled debt
restructurings, before deduction of valuation allowances, at the dates
indicated.
75
SEPTEMBER 30,
--------------------------
1996 1995
----------- -----------
(IN THOUSANDS)
Troubled debt restructurings..... $13,618 $17,344
=========== ===========
At September 30, 1996, loans accounted for as troubled debt
restructurings included two commercial permanent loans with principal
balances totaling $13.2 million and one commercial collateralized loan with a
principal balance of $0.4 million. The $3.7 million decrease in loans
accounted for as troubled debt restructurings from September 30, 1995,
resulted from the principal repayment of one residential ground loan with a
principal balance of $3.4 million, which was accounted for as a troubled-debt
restructuring at September 30, 1995, and other net principal reductions. At
September 30, 1996, the Bank had commitments to lend $0.1 million of
additional funds on loans that have been restructured.
Real Estate Held for Investment. At September 30, 1996 and 1995, real
estate held for investment consisted of two properties with an aggregate book
value of $3.6 million, net of valuation allowances of $0.2 million.
Allowances for Losses. The following tables show loss experience by
asset type and the components of the allowance for losses on loans and the
allowance for losses on real estate held for investment or sale. These
tables reflect charge-offs taken against assets during the years indicated
and may include charge-offs taken against assets which the Bank disposed of
during such years.
76
ANALYSIS OF ALLOWANCE FOR AND CHARGE-OFFS OF LOANS
(DOLLARS IN THOUSANDS)
YEAR ENDED SEPTEMBER 30,
-------------------------------------------------------
1996 1995 1994 1993 1992
-------- ------- ------ ------ ------
Balance at beginning of year $ 60,496 $50,205 $68,040 $78,818 $89,745
-------- ------- ------- ------- -------
Provision for loan losses 115,740 54,979 29,222 60,372 86,453
-------- ------- ------- ------- -------
Charge-offs:
Residential 867 1,174 1,641 45 581
Commercial and multifamily -- -- 112 766 1,855
Ground -- 1,768 2,027 4,274 1,650
Residential construction -- -- -- -- 1,971
Commercial construction -- -- 447 -- 1,431
Credit card 84,805 50,172 55,754 76,141 100,391
Consumer and other 6,375 3,463 1,058 3,664 1,898
-------- ------- ------- ------- -------
Total charge-offs 92,047 56,577 61,039 84,890 109,777
-------- ------- ------- ------- -------
Recoveries:
Residential 32 20 -- -- --
Credit card 10,720 11,219 13,525 13,438 12,038
Other 582 650 457 302 359
-------- ------- ------- ------- -------
Total recoveries 11,334 11,889 13,982 13,740 12,397
-------- ------- ------- ------- -------
Charge-offs, net of recoveries 80,713 44,688 47,057 71,150 97,380
-------- ------- ------- ------- -------
Balance at end of year $ 95,523 $60,496 $50,205 $68,040 $78,818
-------- ------- ------- ------- -------
-------- ------- ------- ------- -------
Provision for loan losses to average loans (1) 3.94% 1.85% 1.08% 2.83% 3.59%
Net loan charge-offs to average loans (1) 2.75% 1.51% 1.74% 3.33% 4.04%
Ending reserve for losses on loans to total loans (1) (2) 2.81% 2.05% 1.97% 2.83% 3.52%
(1) Includes loans held for sale and/or securitization.
(2) Before deduction of reserves.
77
COMPONENTS OF ALLOWANCE FOR LOSSES ON LOANS BY TYPE
(DOLLARS IN THOUSANDS)
SEPTEMBER 30,
---------------------------------------------------------------------
1996 1995 1994
----------------------- --------------------- --------------------
PERCENT OF PERCENT OF PERCENT OF
LOANS TO LOANS TO LOANS TO
AMOUNT TOTAL LOANS AMOUNT TOTAL LOANS AMOUNT TOTAL LOANS
------- ----------- ------ ----------- ------ -----------
Balance at end of year allocated to:
Residential permanent $ 925 47.4% $ 929 47.3% $ 1,384 53.8%
Home equity 446 0.9 164 1.0 133 1.4
Commercial and multifamily 8,398 2.3 8,523 2.9 8,506 3.3
Residential construction 823 0.6 1,159 0.8 1,455 1.2
Commercial construction 15 0.1 56 0.2 245 0.2
Ground 417 1.2 49 0.1 2,362 0.6
Credit card 79,681 33.1 46,325 34.4 34,530 25.5
Consumer and other 4,818 14.4 3,291 13.3 1,590 14.0
------- ------- -------
Total $95,523 $60,496 $50,205
------- ------- -------
------- ------- -------
SEPTEMBER 30,
-------------------------------------------
1993 1992
--------------------- --------------------
PERCENT OF PERCENT OF
LOANS TO LOANS TO
AMOUNT TOTAL LOANS AMOUNT TOTAL LOANS
------ ----------- ------ -----------
Balance at end of year allocated to:
Residential permanent $ 4,235 53.6% $ 2,335 41.6%
Home equity 250 2.5 504 9.9
Commercial and multifamily 9,606 3.9 5,907 2.7
Residential construction 4,125 1.5 4,470 2.6
Commercial construction 345 0.4 729 0.5
Ground 1,412 0.7 2,624 1.0
Credit card 46,886 31.4 57,566 38.9
Consumer and other 1,181 6.0 4,683 2.8
------- -------
Total $68,040 $78,818
------- -------
------- -------
78
ANALYSIS OF ALLOWANCE FOR AND CHARGE-OFFS OF
REAL ESTATE HELD FOR INVESTMENT OR SALE
(IN THOUSANDS)
YEAR ENDED SEPTEMBER 30,
----------------------------------------------------
1996 1995 1994 1993 1992
-------- -------- -------- -------- --------
Balance at beginning of year:
Real estate held for investment $ 193 $ 9,899 $ 10,182 $ 14,919 $ 4,161
Real estate held for sale 135,043 109,074 101,462 94,125 53,337
-------- -------- -------- -------- --------
Total 135,236 118,973 111,644 109,044 57,498
-------- -------- -------- -------- --------
Provision for real estate losses:
Real estate held for investment (2) (6,974) (283) 1,470 12,673
Real estate held for sale 26,343 33,295 14,335 28,945 47,923
-------- -------- -------- -------- --------
Total 26,341 26,321 14,052 30,415 60,596
-------- -------- -------- -------- --------
Charge-offs:
Real estate held for investment:
Commercial ground -- 2,732 -- -- 1,550
Commercial permanent -- -- -- -- 365
Commercial construction -- -- -- 6,207 --
-------- -------- -------- -------- --------
Total -- 2,732 -- 6,207 1,915
-------- -------- -------- -------- --------
Real estate held for sale:
Residential -- -- -- -- 3,002
Residential construction -- 1,924 911 79 --
Residential ground 34,867 103 -- 259 348
Commercial ground -- 2,827 -- 1,353 3,785
Commercial permanent -- -- 5,812 761 --
Commercial construction -- 2,472 -- 19,156 --
-------- -------- -------- -------- --------
Total 34,867 7,326 6,723 21,608 7,135
-------- -------- -------- -------- --------
Total charge-offs on real estate
held for investment or sale 34,867 10,058 6,723 27,815 9,050
-------- -------- -------- -------- --------
Balance at end of year
Real estate held for investment 191 193 9,899 10,182 14,919
Real estate held for sale 126,519 135,043 109,074 101,462 94,125
-------- -------- -------- -------- --------
Total $126,710 $135,236 $118,973 $111,644 $109,044
-------- -------- -------- -------- --------
-------- -------- -------- -------- --------
79
COMPONENTS OF ALLOWANCE FOR LOSSES
ON REAL ESTATE HELD FOR INVESTMENT OR SALE
(IN THOUSANDS)
SEPTEMBER 30,
---------------------------------------------------------------------------
1996 1995 1994 1993 1992
---------- ---------- ---------- ---------- ----------
Allowance for losses on real estate
held for investment:
Commercial and multifamily $ -- $ -- $ 7,793 $ 7,945 $ 8,037
Commercial construction -- -- -- -- 4,995
Ground -- -- 1,975 1,972 1,682
Other 191 193 131 265 205
--------- ---------- ---------- ---------- ----------
Total 191 193 9,899 10,182 14,919
--------- ---------- ---------- ---------- ----------
Allowance for losses on real estate
held for sale:
Residential 112 184 66 102 447
Home equity 8 2 4 53 21
Commercial and multifamily -- -- 142 4,678 1,705
Commercial construction -- -- 1,216 1,387 15,439
Residential construction -- -- 1,942 2,924 2,294
Ground 126,399 134,857 105,704 92,318 74,219
--------- ---------- ---------- ---------- ----------
Total 126,519 135,043 109,074 101,462 94,125
--------- ---------- ---------- ---------- ----------
Total allowance for losses on real
estate held for investment or sale $ 126,710 $ 135,236 $ 118,973 $ 111,644 $ 109,044
--------- ---------- ---------- ---------- ----------
--------- ---------- ---------- ---------- ----------
80
The Bank maintains valuation allowances for estimated losses on loans
and real estate. The Bank's total valuation allowances for losses on loans
and real estate held for investment or sale increased by $26.5 million from
the level at September 30, 1995, to $222.2 million at September 30, 1996.
The $26.5 million increase was primarily attributable to increased valuation
allowances on credit card loans.
The following table shows valuation allowances for losses on performing
and non-performing assets at the dates indicated.
SEPTEMBER 30, 1996
----------------------------------------------------
PERFORMING NON-PERFORMING TOTAL
------------ ---------------- -----------
(In Thousands)
Allowances for losses on:
Loans:
Real estate ................ $ 10,293 $ 731 $ 11,024
Credit card ................ 54,331 25,350 79,681
Consumer and other ......... 4,802 16 4,818
-------- -------- ------
Total allowance for losses
and loans ................. 69,426 26,097 95,523
-------- -------- ------
Real estate held for
investment ................ 191 -- 191
Real estate held for sale .. -- 126,519 126,519
-------- -------- -------
Total allowance for losses
on real estate held for
investment or sale ....... 191 126,519 126,710
-------- -------- -------
Total allowance for losses ...$ 69,617 $ 152,616 $ 222,233
======== ======== =========
81
SEPTEMBER 30, 1995
-----------------------------------------------------
PERFORMING NON-PERFORMING TOTAL
------------ ------------------ ----------------
(In Thousands)
Allowances for losses on:
Loans:
Real estate ................ $ 10,441 $ 439 $ 10,880
Credit card ................ 44,468 1,857 46,325
Consumer and other ......... 3,287 4 3,291
-------- -------- ------
Total allowance for losses
and loans 58,196 2,300 60,496
-------- -------- ------
Real estate held for
investment ................ 193 -- 193
Real estate held for sale .... -- 135,043 135,043
-------- -------- -------
Total allowance for losses on real
estate held for investment or
sale ........................ 193 135,043 135,236
-------- -------- -------
Total allowance for losses $58,389 $137,343 $195,732
======== ======== =======
The allowance for losses on loans secured by real estate and real
estate held for investment or sale totaled $137.7 million at September 30,
1996, which constituted 54.1% of total non-performing real estate assets,
before valuation allowances. This amount represented an $8.4 million
decrease from the September 30, 1995 level of $146.1 million, or 40.2% of
total non-performing real estate assets, before valuation allowances at that
date.
Beginning October 1, 1994, the Bank has provided additional general
valuation allowances which are equal to, or exceed, the amount of the net
earnings generated by the development and sale of land in the Communities.
During fiscal 1996, the Bank provided an additional $6.4 million of general
valuation allowances against its Communities pursuant to this policy.
When real estate collateral securing an extension of credit is initially
recorded as REO, it is recorded at the lower of cost or written down to fair
value, less estimated selling costs, on the basis of an appraisal. Such
initial write-downs represent management's best estimate of exposure to the
Bank at the time that the collateral becomes REO and in effect substitutes
for valuation allowances that would otherwise be recorded if the collateral
had not become REO. As circumstances change, it may be necessary to provide
additional valuation allowances based on new information. Depending on the
nature of the information, these new valuation allowances may be valuation
allowances, which reflect additional impairment with respect to a specific
asset, or may be unallocated valuation allowances, which provide protection
against changes in asset valuation factors. The allowance for losses on real
estate held for sale at September 30, 1996 is in addition to approximately
82
$50.8 million of cumulative charge-offs previously taken against assets
remaining in the Bank's portfolio at September 30, 1996.
The Bank from time to time obtains updated appraisals on its real estate
acquired in settlement of loans. As a result of such updated appraisals, the
Bank could be required to increase its valuation allowances.
Net charge-offs of credit card loans for fiscal 1996 were $74.1 million,
compared to $39.0 million for fiscal 1995. The increase in net charge-offs
resulted primarily from continued maturation of the Bank's portfolio and
reflects the industry-wide decline in the performance of credit card loans.
The allowance at any balance sheet date relates only to receivable balances
that exist as of that date. Because of the nature of a revolving credit card
account, the cardholder may enter into transactions (such as retail purchases
and cash advances) subsequent to a balance sheet date which increase the
outstanding balance of the account. Accordingly, charge-offs in any fiscal
period relate both to balances and conditions or events that existed at the
beginning of the period and to balances created during the period, and may
therefore exceed the levels of valuation allowances established at the
beginning of the fiscal period.
The allowance for losses on credit card loans increased to $79.7 million
at September 30, 1996 from $46.3 million at September 30, 1995, primarily
because of a $56.7 million increase in the provision for losses on such
loans. The increase in the provision for losses on credit card loans
reflected an industry-wide decline in the performance of credit card loans.
The ratios of the allowance for such losses to non-performing credit card
loans and to outstanding credit card loans increased to 314.3% and 7.1%,
respectively, at September 30, 1996, from 249.5% and 4.6%, respectively, at
September 30, 1995.
The allowance for losses on consumer and other loans increased to $4.8
million at September 30, 1996 from $3.3 million at September 30, 1995,
primarily because of the increased volume of consumer and other loans. The
ratios of the allowances for losses on consumer and other loans to
non-performing consumer and other loans and to outstanding consumer and other
loans were 388.9% and 1.0%, respectively, at September 30, 1996 compared to
553.1% and 0.8%, respectively, at September 30, 1995.
ASSET AND LIABILITY MANAGEMENT. A key element of banking is the
monitoring and management of liquidity risk and interest-rate risk. The
process of planning and controlling asset and liability mixes, volumes and
maturities to stabilize the net interest spread is referred to as asset and
liability management. The objective of asset and liability management is to
maximize the net interest yield within the constraints imposed by prudent
lending and investing practices, liquidity needs and capital planning.
The Bank is pursuing an asset-liability management strategy to control
its risk from changes in market interest rates principally by originating
interest-sensitive loans for its portfolio. In furtherance of this strategy,
the Bank emphasizes the origination and retention of ARMs, adjustable-rate
home equity credit line loans and adjustable-rate credit card loans. At
September 30, 1996, adjustable-rate loans accounted for 78.6% of total loans,
of which 63.7% will adjust in one year or less.
In recent periods, the Bank's policy has generally been to sell all of
its long-term fixed-rate mortgage production, thereby reducing its exposure
to market interest rate fluctuations typically associated with long-term
fixed-rate lending.
83
A traditional measure of interest-rate risk within the banking industry
is the interest sensitivity "gap," which is the sum of all interest-earning
assets minus all interest-bearing liabilities subject to repricing within the
same period. A negative gap like that shown below for the Bank implies that,
if market interest rates rise, the Bank's average cost of funds will increase
more rapidly than the concurrent increase in the average yield on
interest-earning assets. In a period of rising market interest rates, a
negative gap implies that the differential effect on the average yield on
interest-earning assets and the average cost of interest-bearing liabilities
will decrease the Bank's net interest spread and thereby adversely affect the
Bank's operating results. Conversely, in a period of declining interest
rates, a negative gap may result in an increase in the Bank's net interest
spread. This analysis assumes a parallel shift in interest rates for
instruments of different maturities and does not reflect the possibility that
retail deposit pricing changes may lag behind those of wholesale market funds
which, in a period of rising interest rates, might serve to mitigate the
decline in net interest spread.
The Bank views control over interest rate sensitivity as a key element in
its financial planning process and monitors its interest rate sensitivity
through its forecasting system. The Bank manages its interest rate exposure
and will narrow or widen its gap, depending on its perception of interest
rate movements and the composition of its balance sheet. For the reasons
discussed above, the Bank might take action to narrow its gap if it believes
that market interest rates will experience a significant prolonged increase,
and might widen its gap if it believes that market interest rates will
decline or remain relatively stable. A number of asset and liability
management strategies are available to the Bank in structuring its balance
sheet. These include selling or retaining certain portions of the Bank's
current residential mortgage loan production; altering the Bank's pricing on
certain deposit products to emphasize or de-emphasize particular maturity
categories; altering the type and maturity of securities acquired for the
Bank's investment portfolio when replacing securities following normal
portfolio maturation and turnover; lengthening or shortening the maturity or
repricing terms for any current period asset securitizations; and altering
the maturity or interest rate reset profile of borrowed funds, if any,
including funds borrowed from the FHLB of Atlanta.
The following table presents the interest rate sensitivity of the Bank's
interest-earning assets and interest-bearing liabilities at September 30,
1996, which reflects management's estimate of mortgage loan prepayments and
amortization and provisions for adjustable interest rates. Adjustable and
floating rate loans are included in the period in which their interest rates
are next scheduled to adjust, and prepayment rates are assumed for the Bank's
loans based on recent actual experience. Statement savings and passbook
accounts with balances under $20,000 are classified based upon management's
assumed attrition rate of 17.5%, and those with balances of $20,000 or more,
as well as all NOW accounts, are assumed to be subject to repricing within
six months or less.
84
INTEREST RATE SENSITIVITY TABLE (GAP)
(DOLLARS IN THOUSANDS)
MORE THAN MORE THAN MORE THAN
SIX MONTHS ONE YEAR THREE YEARS
SIX MONTHS THROUGH THROUGH THROUGH MORE THAN
OR LESS ONE YEAR THREE YEARS FIVE YEARS FIVE YEARS TOTAL
---------- ---------- ---------- ---------- ---------- ---------
As of September 30, 1996
Mortgage loans:
Adjustable-rate $ 305,001 $ 369,435 $ 706,341 $114,247 $ 7,645 $1,502,669
Fixed-rate 11,719 7,381 32,808 86,417 29,406 167,731
Loans held for sale 76,064 -- -- -- -- 76,064
Home equity credit lines and second mortgages 39,223 238 788 578 1,495 42,322
Credit card and other 962,605 23,637 58,166 42,723 68,748 1,155,879
Loans held for securitization and sale 450,000 -- -- -- -- 450,000
Mortgage-backed securities 313,926 764,195 206,981 4,792 16,523 1,306,417
Other investments 218,958 -- 4,996 -- -- 223,954
---------- ---------- ---------- -------- -------- ----------
Total interest-earning assets 2,377,496 1,164,886 1,010,080 248,757 123,817 4,925,036
Total non-interest earning assets -- -- -- -- 768,038 768,038
---------- ---------- ---------- -------- -------- ----------
Total assets $2,377,496 $1,164,886 $1,010,080 $248,757 $891,855 $5,693,074
---------- ---------- ---------- -------- -------- ----------
---------- ---------- ---------- -------- -------- ----------
Deposits:
Fixed maturity deposits $ 661,743 $ 236,079 $ 203,411 $102,439 $ -- $1,203,672
NOW, statement and passbook accounts 1,344,738 39,811 132,596 90,248 192,329 1,799,722
Money market deposit accounts 1,002,688 -- -- -- -- 1,002,688
Borrowings:
Capital notes -- subordinated 10,000 -- -- -- 150,000 160,000
Other 892,039 1,964 8,881 5,434 5,165 913,483
---------- ---------- ---------- -------- -------- ----------
Total interest-bearing liabilities 3,911,208 277,854 344,888 198,121 347,494 5,079,565
Total non-interest bearing liabilities -- -- -- -- 308,879 308,879
Stockholders' equity -- -- -- -- 304,630 304,630
---------- ---------- ---------- -------- -------- ----------
Total liabilities & stockholders' equity $3,911,208 $ 277,854 $ 344,888 $198,121 $961,003 $5,693,074
---------- ---------- ---------- -------- -------- ----------
---------- ---------- ---------- -------- -------- ----------
Gap $(1,533,712) $ 887,032 $ 665,192 $ 50,636 $(223,677)
Cumulative gap $(1,533,712) $ (646,680) $ 18,512 $ 69,148 $(154,529)
Adjustment for interest rate caps (1) $ 475,000 $ 375,000 $ 193,750 $ -- $ --
Adjusted cumulative gap $(1,058,712) $ (271,680) $ 212,262 $ 69,148 $(154,529)
Adjusted cumulative gap as a percentage
of total assets (18.6)% (4.8)% 3.7% 1.2% (2.7)%
- ---------------------
(1) At September 30, 1996, the Bank had $500,000 notional amount of interest
rate caps. The adjustments reflect the average notional amount outstanding
for each period until the last cap expires June 30, 1999.
85
The one-year gap, adjusted for the effect of the Bank's interest rate
caps, as a percentage of total assets, was a negative 4.8% at September 30,
1996, compared to a negative 5.3% at September 30, 1995. As noted above, the
Bank's negative one-year gap might adversely affect the Bank's net interest
spread and earnings if interest rates rise and the Bank is unable to take
steps to reduce its gap. The improvement in the Bank's one-year gap was
primarily attributable to an increase in short-term assets at September 30,
1996 resulting from the scheduled maturity of mortgage-backed balloon
securities as well as an increase in one year ARM mortgage-backed securities.
During fiscal 1995, the Bank purchased a series of interest rate caps
which management believes will limit significantly its exposure to rising
short-term interest rates during a four-year period which began July 1, 1995
and will end June 30, 1999. The Bank's Interest Rate Sensitivity Table
reflects the reduction in risk provided by these caps. The initial level of
the protection was a notional principal amount of $600 million, and such
protection declined to $500 million at September 30, 1996, and will decline
to $200 million by March 31, 1998. The remaining $200 million of protection
will expire on June 30, 1999. In the event that the one-month London
Inter-Bank Offered Rate ("LIBOR") exceeds 7.00% on certain predetermined
dates, the Bank is entitled to receive compensatory payments from the cap
provider, which is a counterparty receiving the highest investment rating
from Standard & Poor's Corporation. Such payments would be equal to the
product of (a) the amount by which one-month LIBOR exceeds 7.00% and (b) the
then outstanding notional principal amount for a predetermined period of
time. The Bank has no obligation to make payments to the provider of the cap
or any other party.
In addition to gap measurements, the Bank measures and manages
interest-rate risk with the extensive use of computer simulation. This
simulation includes calculations of Market Value of Portfolio Equity and Net
Interest Margin as promulgated by the OTS's Thrift Bulletin 13.
At September 30, 1996, the Bank would not have been required to maintain
additional amounts of risk-based capital had the interest-rate risk component
of the OTS capital regulations been in effect. See "Business - Banking -
Regulation - Regulatory Capital."
INFLATION. The impact of inflation on the Bank is different from the
impact on an industrial company, because substantially all of the assets and
liabilities of the Bank are monetary in nature. The most direct impact of an
extended period of inflation would be to increase interest rates, and to
place upward pressure on the operating expenses of the Bank. However, the
actual effect of inflation on the net interest income of the Bank would
depend on the extent to which the Bank was able to maintain a spread between
the average yield on interest-earning assets and the average cost of
interest-bearing liabilities, which would depend to a significant extent on
its asset-liability sensitivity. The effect of inflation on the Bank's
results of operations for the past three fiscal years has been minimal.
DEFERRED TAX ASSET. At September 30, 1996, the Bank recorded a net
deferred tax asset of $42.6 million, which generally represents the
cumulative excess of the Bank's actual income tax liability over its income
tax expense for financial reporting purposes.
TAX SHARING PAYMENTS. During fiscal 1996, after receiving OTS approval,
the Bank made tax sharing payments totaling $25.0 million to the Trust. See
Note 32 to the Consolidated Financial Statements in this report.
86
LIQUIDITY AND CAPITAL RESOURCES
REAL ESTATE
GENERAL. The Real Estate Trust's primary cash requirements fall into
four categories: operating expenses (exclusive of interest on outstanding
debt), capital improvements, interest on outstanding debt and repayment of
outstanding debt.
Historically, the Real Estate Trust's total cash requirements have
exceeded the cash generated by its operations. This condition is expected
to continue for the foreseeable future. The Real Estate Trust's internal
sources of funds, primarily cash flow generated by its income-producing
properties, generally have been sufficient to meet its cash needs other than
the repayment of principal on outstanding debt, including outstanding
unsecured notes ("Unsecured Notes") sold to the public, the payment of
interest on its Senior Secured Notes, and the payment of capital improvement
costs. In the past, the Real Estate Trust had funded such shortfalls through
a combination of external funding sources, primarily new financings
(including the sale of Unsecured Notes), refinancings of maturing mortgage
debt, asset sales and tax sharing payments from the Bank. See the
Consolidated Statements of Cash Flows included in the Consolidated Financial
Statements in this report.
The Real Estate Trust's current program of public Unsecured Note sales
was initiated in the 1970's as a vehicle for supplementing other external
funding sources. In fiscal 1996, the Real Estate Trust sold $7.4 million of
Unsecured Notes. The table under "Recent Liquidity Trends" below provides
information at September 30, 1996 with respect to the maturities of
Unsecured Notes outstanding at such date.
RECENT LIQUIDITY TRENDS. In fiscal 1994, the Real Estate Trust
refinanced a significant portion of its outstanding secured indebtedness with
the proceeds of the issuance of $175.0 million aggregate principal amount of
11 5/8% Senior Secured Notes due 2002 (the "Senior Secured Notes"). See Note
4 to the Consolidated Financial Statements in this report. The Indenture
pursuant to which the Senior Secured Notes were issued contains covenants
that, among other things, restrict the ability of the Trust and/or its
subsidiaries (excluding, in most cases, the Bank and the Bank's subsidiaries)
to incur additional indebtedness, make investments, sell assets or pay
dividends and make other distributions to holders of the Trust's capital
stock.
Through December 1, 1996, the Trust has purchased either in the open
market or through dividend reinvestment 1,487,430 shares of common stock of
Saul Centers (representing 12.3% of such company's outstanding common stock).
These shares have been deposited with the Trustee for the Senior Secured
Notes to satisfy in part the collateral requirements for those securities,
thereby permitting release to the Trust of a portion of the cash on deposit
with the Trustee.
The Real Estate Trust is currently selling Unsecured Notes, with a
maturity ranging from one to ten years, principally to provide funds to pay
outstanding Unsecured Notes as they mature. In paying maturing Unsecured
Notes with proceeds of Unsecured Note sales, the Real Estate Trust
effectively is refinancing its outstanding Unsecured Notes with similar new
unsecured debt at the lower interest rates prevailing in today's market. To
the degree that the Real Estate Trust does not sell new Unsecured Notes in an
amount sufficient to finance completely the scheduled repayment of
outstanding Unsecured Notes as they mature, it will finance such repayments
from other sources of funds.
87
In fiscal 1995, the Real Estate Trust established a $15.0 million secured
revolving credit line with an unrelated bank. This facility is for a
two-year period and may be extended for one or more additional one-year
terms. Interest is computed by reference to a floating rate index. At
September 30, 1996, borrowings under the facility were $2.5 million and
unrestricted availability was $4.6 million.
In the first quarter of fiscal 1996, the Real Estate Trust established an
$8.0 million secured revolving credit line with an unrelated bank. This
facility is for a one -year term, after which the loan amount amortizes over
a two-year period. Interest in computed by reference to the floating rate
index. At September 30, 1996, availability under this facility was entirely
restricted pending the delivery of collateral by the Real Estate Trust. In
November 1996, the Real Estate Trust deposited collateral with the bank,
enabling it to have unrestricted availability of $5.9 million.
The maturity schedule for the Real Estate Trust's outstanding debt at
September 30, 1996 for fiscal years commencing October 1, 1996 is set forth
in the following table:
DEBT MATURITY SCHEDULE
(IN THOUSANDS)
- ---------------------------------------------------------------------------------
MORTGAGE NOTES PAYABLE- NOTES PAYABLE-
FISCAL YEAR NOTES SECURED UNSECURED TOTAL
- ------------ ---------- --------------- ---------------- ----------
1997 $ 17,994 $ 2,500 $ 5,751 $ 26,245
1998 7,413 -- 7,413 14,826
1999 17,076 -- 15,986 33,062
2000 18,856 -- 6,080 24,936
2001 5,075 -- 3,822 8,897
Thereafter 106,931 175,000 3,315 285,246
---------- --------- ----------- -----------
Total $ 173,345 $ 177,500 $ 42,367 $ 393,212
========== ========= =========== ===========
- ---------------------------------------------------------------------------------
Of the $173.3 million of mortgage debt outstanding at September 30, 1996,
$133.7 million was nonrecourse to the Real Estate Trust.
The Real Estate Trust believes that its capital improvement costs in the
next several fiscal years will be in range of $5.0 to $8.0 million per year.
The Real Estate Trust's ability to meet its liquidity needs, including
debt service payments in fiscal 1996 and subsequent years, will depend in
significant part on its receipt of dividends from the Bank and tax sharing
payments from the Bank pursuant to the tax sharing agreement among the Trust,
the Bank, and their subsidiaries. The availability and amount of tax sharing
payments and dividends in future periods is dependent upon, among other
things, the Bank's operating performance and income, regulatory restrictions
on such payments, including availability of Trust collateral to support such
payments, and (in the case of tax sharing payments) the continued
consolidation of the Bank and the Bank's subsidiaries with the Trust for
federal income tax purposes.
88
The Real Estate Trust believes that the financial condition and operating
results of the Bank in recent periods, as well as the Bank's board resolution
adopted in connection with the release of the written agreement with the OTS
(see "Banking - Regulation - Regulatory Capital") should enhance prospects
for the Real Estate Trust of receiving tax sharing payments and dividends
from the Bank. The Bank made tax sharing payments of $25.0 million to the
Real Estate Trust during fiscal 1996; however, the Real Estate Trust does not
expect to receive tax sharing payments of such magnitude in the future.
During fiscal 1996, the Real Estate Trust received $6.8 million in
dividends from the Bank. OTS regulations tie Chevy Chase's ability to pay
dividends to specific levels of regulatory capital and earnings. See
"Business - Banking - Regulation - Dividends and Other Capital Distributions."
As the owner, directly and through two wholly-owned subsidiaries, of
a 21.5% limited partnership interest in Saul Holdings Partnership, the Real
Estate Trust will share in cash distributions from operations and from
capital transactions involving the sale or refinancing of the properties of
Saul Holdings Partnership. The partnership agreement of Saul Holdings
Partnership provides for quarterly cash distributions to the partners out of
net cash flow. See "Business - Real Estate - Investment in Saul Holdings
Limited Partnership." In fiscal 1996, the Real Estate Trust received total
cash distributions $5.5 million from Saul Holdings Partnership.
BANKING
LIQUIDITY. The standard measure of liquidity in the savings industry is
the ratio of cash and short-term U.S. Government and other specified
securities to net withdrawable accounts and borrowings payable in one year or
less.
The OTS has established a minimum liquidity requirement, which may vary
from time to time depending upon economic conditions and deposit flows. The
required liquidity level is currently 5.0%. The Bank's average liquidity
ratio for the month ended September 30, 1996 was 13.1%, compared to 17.5% for
the month ended September 30, 1995. The Bank met the liquidity level
requirements for each month of fiscal 1996.
The Bank's primary sources of funds historically have consisted of (i)
principal and interest payments on loans and mortgage-backed securities, (ii)
savings deposits, (iii) sales of loans and trading securities, (iv)
securitizations and sales of loans and (v) borrowed funds (including funds
borrowed from the FHLB of Atlanta). The Bank's holdings of readily
marketable securities constitute another important source of liquidity. At
September 30, 1996, the Bank's portfolio included mortgage loans, U.S.
Government securities and mortgage-backed securities with outstanding
principal balances of $1.0 billion, $10.0 million and $1.3 billion,
respectively. The estimated borrowing capacity against mortgage loans, U.S.
Government securities and mortgage-backed securities that are available to be
pledged to the FHLB of Atlanta and various security dealers totaled $1.0
billion at September 30, 1996, after market-value and other adjustments.
Chevy Chase has accessed the capital markets as an additional means of
funding its operations and managing its capital ratios and asset growth.
Specifically, the Bank has securitized financial assets, including credit
card, home equity credit line, home loan and automobile loan receivables,
because such securitizations provide the Bank with a source of financing at
competitive rates and assist the Bank in maintaining compliance with
regulatory capital requirements. Additionally, the securitizations have
permitted the Bank to limit the credit risk associated with these assets
89
while continuing to earn servicing fees and other income associated with the
securitized assets.
Since 1988, the Bank has securitized approximately $8.6 billion of credit
card, home equity credit line, automobile and home loan receivables. These
transactions depend on sophisticated back-office systems to service complex
securitization structures and on personnel with the experience to design,
install and manage those systems. At September 30, 1996, the Bank serviced
$3.9 billion, $416.4 million, $505.6 million and $141.1 million of
securitized credit card, home equity credit line, automobile and home loan
receivables, respectively. Chevy Chase derives fee-based income from
servicing these securitized portfolios. However, such fee-based income may
be adversely affected by increases in delinquencies and charge-offs related
to the receivables placed in these securitized pools.
The Bank's securitization transactions transfer the risk of repayment on
securitized assets to a trust which holds the receivables and issues the
asset-backed certificates and ultimately the risk of repayment is transferred
to the holders of those certificates. The Bank retains risk with respect to
the assets transferred to the trust only to the extent that it retains
recourse based on the performance of the assets or holds certificates issued
by the trust (such as a "seller certificate"). In its securitizations, the
Bank typically retains a limited amount of recourse through one or more
means. Most often, limited recourse is retained through the establishment of
"spread accounts." Occasionally other structures, such as
overcollateralization, are used. Spread accounts are funded by initial
deposits, if required, and by amounts generated by the securitized assets
over and above the amount required to pay interest, defaults and other
charges and fees on the investors' interest in the securitization
transaction. Because amounts on deposit in the spread accounts are at risk
depending upon performance of the securitized receivables, those amounts
represent recourse to the Bank.
Pursuant to OTS's "low level recourse rule" (which sets capital
requirements for assets sold with recourse at the lower of the applicable
capital requirement or the amount of recourse retained), the Bank maintains
dollar-for-dollar capital against the securitized assets in the amount of the
recourse retained up to the otherwise applicable capital requirement. Even
if defaults on outstanding receivables significantly exceed projected and
historical levels so that a "pay out event" is triggered, the immediate
consequence is that investors will begin receiving payments of principal from
the securitized assets earlier than originally scheduled. Even if payments
are insufficient to repay investors in full, the Bank's assets are not
exposed to risk of loss beyond the relevant amount of recourse retained
(including amounts outstanding in the spread accounts and the amount of any
subordinated interest), which, as noted above, constitute a dollar-for-dollar
capital requirement for the Bank. The Bank also retains risk through the
Bank's interest in any seller certificate. Seller certificates share
collections on the securitized assets on an unsubordinated basis with the
investor certificates (unless and to the extent recourse is retained through
an express subordination) and are on-balance sheet assets against which the
Bank must maintain capital.
In recent periods, the proceeds from the securitization and sale of
credit card, home equity credit line, automobile and home loan receivables
have been significant sources of liquidity for the Bank. The Bank
securitized and sold $919.0 million of credit card receivables, $475.3
million of automobile loan receivables, $96.5 million of home equity credit
line receivables and $153.5 million of home loan receivables during fiscal
1996. Additionally, during fiscal 1996, the Bank securitized and sold $42.1
90
million of amounts on deposit in certain spread accounts established in
connection with certain of the Bank's outstanding credit card
securitizations. At September 30, 1996, the Bank was considering the
securitization and sale of (I) approximately $950.0 million of credit card
receivables, including $225.0 million of receivables outstanding at September
30, 1996 and $725.0 million of receivables which the Bank expects to become
available, either through additional fundings or amortization of existing
trusts, during the six months ending March 31, 1997; and (ii) approximately
$325.0 million of automobile loan receivables, including $225.0 million of
receivables outstanding at September 30, 1996 and $100.0 million of
receivables which the Bank expects to become available through additional
fundings during the six months ending March 31, 1997.
Another significant source of liquidity for the Bank during fiscal 1996
was proceeds from the sales of trading securities in the amount of $363.4
million. As part of its operating strategy, the Bank will continue to explore
opportunities to sell assets and to securitize and sell credit card, home
equity credit line, automobile and home loan receivables to meet liquidity
and other balance sheet objectives.
The Bank uses its liquidity primarily to meet its commitments to fund
maturing savings certificates and deposit withdrawals, fund existing and
continuing loan commitments, repay borrowings and meet operating expenses.
For fiscal 1996, the Bank used the cash provided by operating, investing and
financing activities primarily to meet its commitments to fund maturing
savings certificates and deposit withdrawals of $15.3 billion, repay
borrowings of $3.2 billion, fund existing and continuing loan commitments
(including real estate held for investment or sale) of $2.6 billion, purchase
investments and loans of $1.1 billion and meet operating expenses, before
depreciation and amortization, of $347.1 million. These commitments were
funded primarily through proceeds from customer deposits and sales of
certificates of deposit of $15.3 billion, proceeds from borrowings of $3.9
billion, proceeds from sales of loans, trading securities and real estate of
$2.4 billion, and principal and interest collected on investments, loans, and
securities of $831.0 million.
The Bank is obligated under various recourse provisions related to the
securitization and sale of credit card, home equity credit line, automobile
and home loan receivables and amounts on deposit in certain spread accounts
through the asset-backed securitizations. Of the $5.1 billion of outstanding
trust certificate balances at September 30, 1996, the primary recourse to the
Bank was approximately $128.0 million.
The Bank also is obligated under various recourse provisions related to
the swap of single-family residential loans for participation certificates
issued to the Bank by FHLMC. At September 30, 1996, recourse to the Bank
under these arrangements was approximately $4.3 million.
The Bank's commitments at September 30, 1996 are set forth in the
following table:
91
(IN THOUSANDS)
Commitments to originate loans $ 78,781
----------
Loans in process (collateralized loans):
Home equity ......................... 522,168
Real estate construction ............ 22,377
Commercial and multifamily .......... 27,589
----------
572,134
----------
Loans in process (unsecured loans):
Credit cards ........................ 14,749,181
Overdraft lines ..................... 69,821
Commercial .......................... 845
----------
14,819,847
----------
Total commitments to extend credit.. 15,470,762
Letters of credit ..................... 24,694
Recourse arrangements on asset-backed
securitizations ...................... 128,029
Recourse arrangements on mortgage-
backed securities 4,268
-----------
Total commitments ..................... $15,627,753
===========
Based on historical experience, the Bank expects to fund substantially
less than the total amount of its outstanding credit card and home equity
credit line commitments, which together accounted for 97.7% of commitments at
September 30, 1996.
At September 30, 1996, repayments of borrowed money scheduled to occur
during the next 12 months were $793.4 million. Certificates of deposit
maturing during the next 12 months amounted to $897.8 million, of which a
substantial portion is expected to remain with the Bank.
There were no material commitments for capital expenditures at September
30, 1996.
The Bank's liquidity requirements in years subsequent to fiscal 1996 will
continue to be affected both by the asset size of the Bank, the growth of
which may be constrained by capital requirements, and the composition of the
asset portfolio. Management believes that the Bank's primary sources of
funds, described above, will be sufficient to meet the Bank's foreseeable
long-term liquidity needs. The mix of funding sources utilized from time to
time will be determined by a number of factors, including capital planning
objectives,
92
lending and investment strategies and market conditions.
CAPITAL. At September 30, 1996, the Bank was in compliance with all of
its regulatory capital requirements under FIRREA, and its capital ratios
exceeded the ratios established for "adequately capitalized" institutions
under OTS prompt corrective action regulations. In the September 30, 1996
quarter, the Bank's capital ratios fell below the ratios established for
"well-capitalized" institutions for the first time since June 1993. If the
SAIF assessment discussed below had not been made in the quarter ended
September 30, 1996, the Bank's capital ratios would have continued to be
sufficient to meet the standards established for well-capitalized
institutions.
The following table shows the Bank's regulatory capital levels at
September 30, 1996, in relation to the regulatory requirements in effect at
that date. The information below is based upon the Bank's understanding of
the regulations and interpretations currently in effect and may be subject to
change.
93
REGULATORY CAPITAL
(DOLLARS IN THOUSANDS)
MINIMUM EXCESS
ACTUAL CAPITAL REQUIREMENT CAPITAL
------------------------- ------------------------- -------------------
AS A % AS A % AS A %
AMOUNT OF ASSETS (4) AMOUNT OF ASSETS AMOUNT OF ASSETS
--------- -------------- --------- ----------- -------- ----------
Capital per financial statements $ 339,160
Net unrealized holding losses (1) 1,875
----------
Adjusted capital 341,035
Adjustments for tangible and core capital:
Intangible assets (41,051)
Non-includable subsidiaries (2) (4) (3,622)
Non-qualifying purchased/originated
loan servicing --
------------
Total tangible capital 296,362 5.21% $ 85,255 1.50% $ 211,107 3.71%
------------ ------ --------- ----- --------- -----
------------ ------ --------- ----- --------- -----
Total core capital (3) (4) 296,362 5.21% $ 227,346 4.00% $ 69,016 1.21%
------------ ------ --------- ----- --------- -----
------ --------- ----- --------- -----
Tier 1 risk-based capital (3) 296,362 5.80% $ 204,519 4.00% $ 91,843 1.80%
------------ ------ --------- ----- --------- -----
------ --------- ----- --------- -----
Adjustments for risk-based capital:
Subordinated capital debentures 150,000
Allowance for general loan losses 87,953
-----------
Total supplementary capital 237,953
Excess allowance for loan losses (23,744)
-----------
Adjusted supplementary capital 214,209
-----------
Total available capital 510,571
Equity investments (2) (19,657)
-----------
Total risk-based capital (4) $ 490,914 10.14% $ 409,038 8.00% $ 81,876 2.14%
------------ ------ --------- ----- --------- -----
------------ ------ --------- ----- --------- -----
- ---------------------------------
(1) Pursuant to OTS policy, net unrealized holding gains (losses) are
excluded from regulatory capital.
(2) Reflects an aggregate offset of $1.2 million representing the allowance
for general loan losses maintained against the Bank's equity investments
and non-includable subsidiaries which, pursuant to OTS guidelines, is
available as a "credit" against the deductions from capital otherwise
required for such investments.
(3) Under the OTS "prompt corrective action" regulations, the standards for
classification as "well capitalized" are a leverage (or "core capital")
ratio of at least 5.0%, a tier 1 risk-based capital ratio of at least
6.0% and a total risk-based capital ratio of at least 10.0%.
(4) Effective July 1, 1996, the percentage of non-includable subsidiaries
phased-out from core capital increased from 60% to 100%.
94
Regulatory Action and Requirements. In connection with the termination
of the Bank's written agreement, the Board of Directors of the Bank adopted a
resolution which, among other things, authorizes the Bank: (I) to make tax
sharing payments to the Trust of up to $15 million relating to any single
fiscal year without OTS approval; and (ii) to declare dividends on its common
stock in any quarterly period up to the lesser of (A) 50% of its after tax
net income for the immediately preceding quarter or (B) 50% of the average
quarterly after tax net income for the immediately preceding four quarter
period, minus (in either case) dividends declared on the Bank's preferred
stock during that quarterly period. The resolution also provides that the
Bank will present a plan annually to the OTS detailing anticipated consumer
loan securitization activity.
The Bank has been able to maintain capital compliance in recent periods
despite the gradual phase-out of various assets from regulatory capital. As
of September 30, 1996, the Bank had $40.2 million in supervisory goodwill,
all of which was excluded from core capital, $20.7 million in equity
investments, after subsequent valuation allowances, all of which were fully
deducted from total risk-based capital, and $3.8 million, after subsequent
valuation allowances, of extensions of credit to, and investments in,
non-includable subsidiaries, all of which were fully deducted from all three
FIRREA capital requirements. Pursuant to OTS guidelines, $1.2 million of
general valuation allowances maintained against the Bank's non-includable
subsidiaries and equity investments is available as a "credit" against the
deduction from capital otherwise required for such investments.
OTS capital regulations provide a five-year holding period (or such
longer period as may be approved by the OTS) for REO to qualify for an
exception from treatment as an equity investment. If an REO property is
considered an equity investment, its then-current book value is deducted from
total risk-based capital. Accordingly, if the Bank is unable to dispose of
any REO property (through bulk sales or otherwise) prior to the end of its
applicable five-year holding period and is unable to obtain an extension of
such five-year holding period from the OTS, the Bank could be required to
deduct the then-current book value of such REO property from total risk-based
capital. In November 1996, the Bank received from the OTS a one-year
extension of the holding periods for certain of its REO properties. The
following table sets forth the Bank's REO at September 30, 1996, after
valuation allowances of $126.5 million, by the fiscal year in which the
property was acquired through foreclosure.
FISCAL YEAR (IN THOUSANDS)
----------- ------------
1990(1)(2) ................. $ 30,236
1991(2) .................... 68,910
1992(2) .................... 3,339
1993 ....................... 4,903
1994 ....................... 1,811
1995 ....................... 7,503
1996 ....................... 3,159
---------
Total REO .................... $ 119,861
=========
- ---------------------------------------------
(1) Includes REO with an aggregate net book value of $19.7 million, which the
Bank treats as equity investments for regulatory capital purposes.
(2) Includes REO, with an aggregate net book value of $82.8 million, for which
the Bank received an extension of the holding periods through November 12,
1997.
95
Under the OTS prompt corrective action regulations, an institution is
categorized as "well capitalized" if it has a leverage (or core capital)
ratio of at least 5.0%, a tier 1 risk-based capital ratio of at least 6.0%, a
total risk-based capital ratio of at least 10.0% and is not subject to any
written agreement, order, capital directive or prompt corrective action
directive to meet and maintain a specific capital level. At September 30,
1996, the Bank's leverage, tier 1 risk-based and total risk-based capital
ratios were 5.21%, 5.80% and 10.14%, respectively, which exceeded the ratios
established for "adequately capitalized" institutions. The OTS has the
discretion to reclassify an institution from one category to the next lower
category, for example from "well capitalized" to "adequately capitalized," or
from "adequately capitalized" to "undercapitalized" if, after notice and an
opportunity for a hearing, the OTS determines that the institution is in an
unsafe or unsound condition or has received and has not corrected a less than
satisfactory examination rating for asset quality, management, earnings or
liquidity.
On December 3, 1996, the Bank sold $100 million principal amount of its
9 1/4% Subordinated Debentures due 2008. The Bank received net proceeds of
$96.3 million from the sale of the 1996 Debentures which will be used for
general corporate purposes. The Bank has received OTS approval to include
the principal amount of the 1996 Debentures in the Bank's supplementary
capital for regulatory capital purposes.
In addition, on December 3, 1996, the REIT Subsidiary sold $150.0 million
of its REIT Preferred Stock and received net cash proceeds of $144.0 million
Cash dividends on the REIT Preferred Stock are payable quarterly in arrears
at an annual rate of 10 3/8%. The REIT Preferred Stock is automatically
exchangeable for a new series of preferred stock of the Bank upon the
occurrence of certain events (specifically, if the appropriate federal
regulatory agency directs in writing an exchange of the REIT Preferred Stock
for Series B Preferred Stock because (I) the Bank becomes "undercapitalized"
under prompt corrective action regulations established pursuant to FDICIA,
(ii) the Bank is placed into conservatorship or receivership, or (iii) the
appropriate federal regulatory agency, in its sole discretion and even if the
Bank is not "undercapitalized", anticipates the Bank becoming
"undercapitalized" in the near term). The Bank has received OTS approval to
include the proceeds received from the sale of the REIT Preferred Stock in
the core capital of the Bank for regulatory capital purposes in an amount up
to 25% of the Bank's core capital. The REIT Preferred Stock is not redeemable
until January 15, 2007, and is redeemable thereafter at the option of the
Reit Subsidiary. If these transactions had occurred at September 30, 1996,
the Bank's tangible, core, tier 1 risk-based and total risk-based capital
ratios would have been 6.67%, 6.67%, 7.65% and 15.15%, respectively.
The Bank's ability to maintain or increase its capital levels in future
periods will be subject to general economic conditions, particularly in the
Bank's local markets. Adverse general economic conditions or a renewed
downturn in local real estate markets could require further additions to the
Bank's allowances for losses and further charge-offs. Any such developments
would adversely affect the Bank's earnings and thus its regulatory capital
levels.
96
RESULTS OF OPERATIONS
The Real Estate Trust's ability to generate revenues from property
ownership and development is significantly influenced by a number of factors,
including national and local economic conditions, the level of mortgage
interest rates, governmental actions (such as changes in real estate tax
rates) and the type, location, size and stage of development of the Real
Estate Trust's properties. Debt service payments and most of the operating
expenses associated with income-producing properties are not decreased by
reductions in occupancy or rental income. Therefore, the ability of the Real
Estate Trust to produce net income in any year from its income-producing
properties is highly dependent on the Real Estate Trust's ability to maintain
or increase the properties' levels of gross income. The relative illiquidity
of real estate investments tends to limit the ability of the Real Estate
Trust to vary its portfolio promptly in response to changes in economic,
demographic, social, financial and investment conditions.
The Bank's operating results historically have depended primarily on its
"net interest spread," which is the difference between the rates of interest
earned on its loans and securities investments and the rates of interest paid
on its deposits and borrowings. In the last three fiscal years, non-interest
income from securitizations of credit card and home equity credit line
receivables and income from gains on sales of credit card accounts (or
"relationships"), loans and mortgage-backed securities have had a significant
effect on net income. In addition to interest paid on its interest-bearing
liabilities, the Bank's principal expenses are operating expenses.
FISCAL 1996 COMPARED TO FISCAL 1995
REAL ESTATE
The following table sets forth, for the fiscal years ended September 30,
1996, 1995 and 1994, direct operating results for the Real Estate Trust's (I)
hotel properties and (ii) commercial properties (consisting of office and
industrial properties).
97
YEAR ENDED SEPTEMBER 30,
-------------------------------
1996 1995 1994
-------------------------------
(In Thousands)
HOTELS (1)
Revenue
Room sales.................................. $ 38,932 $ 37,984 $ 31,676
Food sales ................................. 9,804 10,235 8,696
Beverage sales.............................. 2,570 2,739 2,648
Other ...................................... 2,939 3,146 3,026
------- ------- -------
Total revenues ........................ 54,245 51,104 46,046
------- ------- -------
Direct operating expenses
Payroll .................................... 15,140 16,687 14,989
Cost of sales ............................. 4,439 4,645 4,269
Utilities .................................. 2,734 3,216 3,181
Repairs and maintenance .................... 2,624 2,836 2,468
Advertising and promotion .................. 2,848 2,510 2,276
Property taxes ............................. 1,410 1,354 943
Insurance .................................. 590 624 583
Other ...................................... 6,290 6,166 5,165
------- ------- -------
Total direct operating expenses ....... 36,075 38,038 33,874
------- ------- -------
Income after direct operating expenses ......... $ 18,170 $ 16,066 $ 12,172
======== ========= =========
98
COMMERCIAL PROPERTIES (2)
(Office and Industrial Properties)
Revenue
Base rent .................................. $ 16,374 $ 17,490 $ 15,345
Expense recoveries ......................... 874 930 967
Other ...................................... 342 392 503
------- ------- -------
Total revenues ........................ 17,590 18,812 16,815
------- ------- -------
Direct operating expenses
Utilities .................................. 2,133 2,364 2,324
Repairs and maintenance .................... 2,037 2,028 1,792
Real estate taxes .......................... 1,425 1,337 1,383
Payroll .................................... 599 579 566
Insurance .................................. 236 263 256
Other ...................................... 821 838 651
------- ------- -------
Total direct operating expenses ....... 7,251 7,409 6,972
------- ------- -------
Income after direct operating expenses ......... $ 10,339 $ 11,403 $ 9,843
======= ======= =======
- ---------------------------------------------
(1) Includes the results of the Real Estate Trust's acquisition
of a 192-room hotel on November 30, 1994 and results of a
344-room hotel until it was sold on October 6, 1995.
(2) Includes the results of an office project until it was reclassified
as a land parcel on December 31, 1995.
99
The Real Estate Trust recorded a loss before depreciation and
amortization of debt expense of $13.5 million and an operating loss of $24.2
million for fiscal 1996, compared to a loss before depreciation and
amortization of debt expense of $17.2 million and an operating loss of $27.3
million for fiscal 1995. Of the $3.1 million positive variance in the
operating loss, approximately $2.1 million was due to improved results from
operations in fiscal 1996, and $1.0 million reflected the net change from
fiscal 1995 results which included a $2.7 million writedown of real estate to
net realizable value and a $1.7 gain on sale of property.
Income after direct operating expenses from hotel properties increased
$2,104,000 (13.1%) from such income in fiscal 1995. Room sales increased by
$948,000 (2.5%) as a result of higher room rates. Food, beverage, and
miscellaneous sales were down by a total of $807,000 and payroll expense was
lower by $1,547,000, largely due to the sale of the Norfolk hotel early in
October 1995. Other operating expenses reflected decreases of $416,000, also
due to the sale.
Income after direct operating expenses from commercial properties
decreased $1,064,000 (9.9%) in fiscal 1996. Gross income declined $1,222,000
(6.8%) largely due to vacancies at 8201 Greensboro Drive. Partially
offsetting this reduction in income was a decline in operating expenses of
$158,000 (2.2%). The leasing percentage of 8201 Greensboro Drive at
September 30, 1996, was 85%.
Interest expense decreased $724,000 (1.8%) in fiscal 1996 as a result of
lower average borrowings, which were $395.6 million in fiscal 1996 as
compared to the prior year's average borrowings of $403.7 million. The
average cost of borrowings increased slightly to 10.31% in fiscal 1996 from
10.25% during the prior year.
Amortization of debt expense increased $198,000 (41.6%) due to the
expense of a new $8.0 million line of credit which was obtained in fiscal
1996 and the first full year of expense for the $15.0 million line of credit
which had been obtained during fiscal 1995.
Depreciation increased $306,000 (3.2%) in fiscal 1996 as a result of new
tenant improvements and property renovations in excess of the reduction in
depreciation caused by the sale of a hotel.
Advisory, management and leasing fees paid to related parties increased
$47,000 (0.6%) in fiscal 1996. The monthly advisory fee in fiscal 1996 was
$301,000 for the period October 1995 through March 1996 and $306,000 for the
period April 1996 through September 1996 as compared to $292,000 throughout
fiscal 1995, which represented an aggregate increase of $141,000 (4.0%).
Management and leasing fees were lower in the current year by $94,000 (2.4%)
as a result of lower gross income on which fees are based.
General and administrative expense decreased $918,000 (39.6%) in fiscal
1996, principally as a result of high legal costs incurred in fiscal 1995 in
litigation with a tenant.
The fiscal 1995 write-down of real estate to net realizable value
reflected as $1.2 million reduction in the carrying value of a hotel property
and a $1.5 million write-off of restaurant assets. The Real Estate Trust
sold the hotel property on October 6, 1995. There were no comparable
write-downs or write-offs during fiscal 1996.
100
Equity in earnings of unconsolidated entities represents the Real Estate
Trust's share of earnings in its partnership investments. For fiscal 1996,
the Real Estate Trust recorded earnings of $3.4 million from such investments
compared to earnings of $3.7 million in the prior year.
BANKING
OVERVIEW. The Bank recorded operating income of $46.1 million for the
year ended September 30, 1996 ("fiscal 1996"), compared to operating income
of $55.7 million for the year ended September 30, 1995 ("fiscal 1995"). The
decrease in pre-tax income for fiscal 1996 was primarily attributable to a
$60.8 million increase in the provision for loan losses and an $83.1 million
increase in non-interest expenses (which included the $26.5 million SAIF
assessment discussed previously - see "Business - Banking - Regulation -
Deposit Insurance Premiums"), the effect of which was partially offset by a
$111.8 million increase in non-interest income and a $22.5 million increase
in net interest income.
NET INTEREST INCOME. Net interest income, before the provision for loan
losses, increased $22.5 million (or 12.8%) in fiscal 1996. The Bank would
have recorded additional interest income of $9.1 million in fiscal 1996 if
the Bank's non-accrual assets and restructured loans had been current in
accordance with their original terms. Interest income of $1.3 million was
actually recorded on non-accrual assets and restructured loans during the
fiscal year. The Bank's net interest income in future periods will continue
to be adversely affected by the Bank's non-performing assets. See "Financial
Condition - Banking - Asset Quality -Non-Performing Assets."
The following table sets forth, for the periods indicated, information
regarding the total amount of income from interest-earning assets and the
resulting yields, the interest expense associated with interest-bearing
liabilities, expressed in dollars and rates, and the net interest spread and
net yield on interest-earning assets.
101
NET INTEREST MARGIN ANALYSIS
(DOLLARS IN THOUSANDS)
YEAR ENDED SEPTEMBER 30,
-----------------------------------------------------------
1996 1995
---------------------------- ----------------------------
SEPTEMBER 30
1996 AVERAGE YIELD/ AVERAGE YIELD/
YIELD/RATE BALANCES INTEREST RATE BALANCES INTEREST RATE
------------ -------- -------- ------ -------- -------- ------
Assets:
Interest-earning assets:
Loans receivable, net (1) 11.41% $2,940,242 $317,847 10.81% $2,968,376 $294,554 9.92%
Mortgage-backed securities 6.05 834,198 50,955 6.11 981,253 60,623 6.18
Federal funds sold and
securities purchased under
agreements to resell -- 185,794 10,195 5.49 65,865 3,756 5.70
Trading securities -- 13,477 953 7.07 4,843 373 7.70
Investment securities 5.68 6,033 315 5.22 4,405 194 4.40
Other interest-earning
assets 5.34 164,783 7,246 4.40 126,792 5,815 4.59
--------- ------- --------- -------
Total 9.70 4,144,527 387,511 9.35 4,151,534 365,315 8.80
------ ------- ----- ------- -----
Non-interest earning assets:
Cash 161,925 131,345
Real estate held for
investment or sale 161,092 287,564
Property and equipment, net 197,351 161,109
Cost in excess of net assets
acquired, net 3,289 5,470
Other assets 248,870 156,172
---------- ----------
Total assets $4,917,054 $4,893,194
---------- ----------
---------- ----------
Liabilities and stockholders' equity:
Interest-bearing liabilities:
Deposit accounts:
Demand deposits 2.42 $921,704 23,137 2.51 $ 875,551 23,721 2.71
Savings deposits 3.43 944,211 31,936 3.38 1,048,783 35,125 3.35
Time deposits 5.32 1,261,685 69,179 5.48 1,025,111 53,033 5.17
Money market deposits 3.88 990,392 38,317 3.87 1,070,531 42,420 3.96
--------- ------ --------- ------
Total deposits 3.90 4,117,992 162,569 3.95 4,019,976 154,299 3.84
Borrowings 6.04 369,831 26,267 7.10 496,938 34,815 7.01
--------- ------ --------- -------
Total liabilities 4.35 4,487,823 188,836 4.21 4,516,914 189,114 4.19
---- ------- ----- ------- -----
Non interest-bearing items:
Non-interest bearing deposits 74,250 69,734
Other liabilities 51,338 48,702
Stockholders' equity 303,643 257,844
---------- ----------
Total liabilities and
stockholders' equity $4,917,054 $4,893,194
---------- ----------
---------- ----------
Net interest income $198,675 $176,201
-------- --------
-------- --------
Net interest spread (2) 5.14 4.61
----- -----
----- -----
Net yield on interest-earning
assets (3) 4.79 4.24%
----- -----
----- -----
Interest-earning assets to
interest-bearing liabilities 92.35 91.91%
----- -----
----- -----
- ------------------
(1) Includes loans held for sale and/or securitization.
Interest on non-accruing loans has been included only to the extent
reflected in the consolidated statements of operations; however,
the loan balance is included in the average amount outstanding
until transferred to real estate acquired in settlement of loans.
Includes ($7,980), ($10,062), and ($4,097) of amortized loan fees,
premiums and discounts in interest income for the years ended
September 30, 1996, 1995 and 1994.
(2) Equals weighted average yield on total interest-earning
assets less weighted average rate on total interest-bearing
liabilities.
(3) Equals net interest income divided by the average balances
of total interest-earning assets.
102
The following table presents certain information regarding changes in
interest income and interest expense of the Bank during the periods
indicated. For each category of interest-earning assets and interest-bearing
liabilities, information is provided on changes attributable to changes in
volume (change in volume multiplied by old rate); changes in rate (change in
rate multiplied by old volume); and changes in rate and volume.
103
VOLUME AND RATE CHANGES IN NET INTEREST INCOME
(IN THOUSANDS)
YEAR ENDED SEPTEMBER 30, 1996 YEAR ENDED SEPTEMBER 30, 1995
COMPARED TO COMPARED TO
YEAR ENDED SEPTEMBER 30, 1995 YEAR ENDED SEPTEMBER 30, 1994
INCREASE (DECREASE) INCREASE (DECREASE)
DUE TO CHANGE IN (1) DUE TO CHANGE IN (1)
----------------------------- ----------------------------
TOTAL TOTAL
VOLUME RATE CHANGE VOLUME RATE CHANGE
------ ---- ------ ------ ---- ------
Interest income:
Loans (2) $(2,823) 26,116 $23,293 $25,727 $13,499 $39,226
Mortgage-backed securities (8,989) (679) (9,668) (15,094) 4,780 (10,314)
Federal funds sold and
securities purchased under
agreements to resell 6,582 (143) 6,439 106 1,373 1,479
Trading securities 613 (33) 580 (405) (241) (646)
Investment securities 80 41 121 (8) 5 (3)
Other interest-earning
assets 1,681 (250) 1,431 (413) 1,522 1,109
-------- ------- -------- ------- ------ -------
Total interest income (2,856) 25,052 22,196 9,913 20,938 30,851
-------- ------- -------- ------- ------ -------
Interest expense:
Deposit accounts 3,803 4,467 8,270 2,139 21,236 23,375
Borrowings (8,991) 443 (8,548) (7,752) 7,947 195
-------- ------- -------- ------- ------ -------
Total interest expense (5,188) 4,910 (278) (5,613) 29,183 23,570
-------- ------- -------- ------- ------ -------
Increase (decrease) in
net interest income $2,332 $20,142 $22,474 $15,526 $(8,245) $7,281
-------- ------- -------- ------- ------ -------
-------- ------- -------- ------- ------ -------
- ------------------------------------
(1) The net change attributable to the combined impact of volume and rate has
been allocated in proportion to the absolute value of the change due to
volume and the change due to rates.
(2) Includes loans held for sale and/or securitization.
104
Interest income in fiscal 1996 increased $22.2 million from the level in
fiscal 1995, primarily as a result of higher average yields earned by the
Bank on its loan portfolio. Higher average balances of federal funds sold
and securities purchased under agreements to resell and other
interest-earning assets also contributed to the increase in interest income.
The effect on interest income of higher average yields on the loan portfolio
and higher average balances was offset in part by lower average balances of
mortgage-backed securities and loans receivable.
The Bank's net yield on interest-earning assets increased to 4.79% in
fiscal 1996 from 4.24% in fiscal 1995. The increase primarily reflected the
upward adjustment of interest rates on certain of the Bank's adjustable rate
products and higher yields on other consumer loans. The positive effect of
the increase on the Bank's net yield was offset in part by increased interest
rates on the Bank's interest-bearing liabilities.
Interest income on loans, the largest category of interest-earning
assets, increased by $23.3 million (or 7.9%) from fiscal 1995 primarily
because of higher average yields on the loan portfolio, which were partially
offset by lower average balances. The average yield on the loan portfolio in
fiscal 1996 increased by 89 basis points (to 10.81% from 9.92%) from the
average yield in fiscal 1995. The higher yields were primarily due to
increases in the average net yield on credit card loans from 13.94% to 15.50%
and on automobile loans from 8.84% to 11.75%. The increase in the yield on
credit card loans was primarily a result of risk management strategies that
have repriced upward the yield on higher risk credit card accounts and the
expiration of promotional introductory rates. The increase was primarily
responsible for a $17.0 million (or 12.2%) increase in interest income from
credit card loans. The increase in the net yield on automobile loans was
primarily due to higher yields earned on loans originated by one of the
Bank's operating subsidiaries. Higher average balances of consumer loans
other than automobile loans, which increased $61.3 million (or 50.9%), also
contributed to the increase in interest income on loans. The increased
average balances of other consumer loans resulted primarily from the higher
origination volume of home improvement and commercial loans during fiscal
1996, and was largely responsible for an $11.2 million (or 102.5%) increase
in interest income on other consumer loans. The effect on interest income of
higher average net yields and higher average balances of certain consumer
loans was offset in part by an $84.3 million decrease in the average balances
of automobile loan receivables due to the securitization and sale of $475.3
million of such receivables during fiscal 1996.
Interest income on mortgage-backed securities decreased $9.7 million (or
15.9%) primarily because of lower average balances. The reduced
mortgage-backed securities balances in fiscal 1996 reflected the effects of
scheduled principal paydowns and unscheduled principal prepayments. The
negative effect of the lower average balances was compounded by a decrease in
the average interest rates on these securities from 6.18% to 6.11%.
Other interest income increased $7.9 million (or 82.2%) in fiscal 1996
primarily as a result of higher average balances on federal funds sold and
securities purchased under agreements to resell which increased by $119.9
million (or 182.1%) and, to a lesser extent, higher average balances on other
interest-earning assets.
105
Interest expense decreased $0.3 million in fiscal 1996 primarily because
of a decrease of $127.1 million (or 25.6%) in the average balances of the
Bank's borrowings, which resulted in an $8.5 million decrease in interest
expense during fiscal 1996 for such liabilities. The decrease in interest
expense on borrowings is primarily due to a $6.2 million, a $1.3 million and
a $0.7 million decrease in interest expense on securities sold under
repurchase agreements, bonds payable and FHLB advances, respectively,
resulting from lower average balances. The decrease in interest expense on
securities sold under repurchase agreements was primarily a result of a
$101.9 million decrease in the average balances of such liabilities as the
Bank's deposit base has increased in recent periods. The decrease in
interest expense on bonds payable was due to the assumption of bonds payable
in April 1995 by the purchaser of two residential apartment buildings that
were securing the bonds. A $6.6 million decline in the average balances of
FHLB advances contributed to the $0.7 million decrease in the interest
expense on such liabilities. The positive effect of such lower average
balances was offset in part by an increase in the average borrowing rate (to
7.10% from 7.01%).
The decrease in interest on borrowings was partially offset by an $8.3
million increase in interest expense on deposits, the largest category of
interest-bearing liabilities. Interest expense on deposits increased
primarily as a result of an increase in average rates (to 3.95% from 3.84%),
which reflected a shift in the composition of the Bank's deposits to higher
yielding certificates of deposit and, to a lesser extent, an increase in
average deposit balances of $98.0 million.
PROVISION FOR LOAN LOSSES. The Bank's provision for loan losses
increased to $115.7 million in fiscal 1996 from $55.0 million in fiscal 1995.
The $60.8 million increase over the prior year was primarily attributable to
a $56.7 million increase in the provision for losses on credit card loans
primarily because of increased charge-offs of such loans, reflecting an
industry-wide decline in the performance of credit card loans. See
"Financial Condition - Banking - Asset Quality - Allowances for Losses."
OTHER INCOME. The increase in other (non-interest) income to $344.5
million in fiscal 1996 from $232.6 million in fiscal 1995 was primarily
attributable to increases in loan servicing fees, credit card fees and gain
on sales of loans. The positive effect of these items on other income was
partially offset by an increase in loss on real estate held for investment or
sale.
An increase of $49.0 million in excess spread income and $20.8 million of
servicing fees earned by the Bank for servicing its portfolios of securitized
credit card loans contributed to an increase of $79.8 million (or 43.3%) in
loan servicing fees. Such excess spread income and servicing fees have
increased in recent periods as a result of greater securitization activity by
the Bank.
Credit card fees, consisting of membership fees, late charges,
over-the-limit fees, interchange fees and cash advance charges, increased
$20.9 million (or 212.2%) in fiscal 1996 from the level in fiscal 1995. The
increase was primarily attributable to changes in the fee structure for the
Bank's credit card programs during fiscal 1996.
Gain on sales of loans increased by $10.4 million (or 80.4%) primarily
because of additional gains recognized on the securitization and sales of
automobile, home equity credit line and home loan receivables during fiscal
1996.
106
The $19.2 million increase in loss on real estate held for investment or
sale was primarily attributable to a decrease of $4.5 million in the equity
earnings in partnership income and a decrease of $12.5 million in the gain
recorded on sales of the Bank's real estate held for investment or sale.
OPERATING EXPENSES. Operating expenses for fiscal 1996 increased $83.1
million (27.9%) from the level in fiscal 1995. The primary reason for the
increase was the $26.5 million SAIF assessment included in deposit insurance
premiums. Other expense categories with increases include salaries and
employee benefits, loan and data processing. The $19.2 million increase in
salaries and employee benefits resulted primarily from the addition of staff
to the Bank's credit card, consumer lending and branch operations. The $12.5
million increase in loan expenses was primarily attributable to an increase
in the amortization of capitalized mortgage servicing rights, which resulted
from acquisitions of single-family residential mortgage servicing rights in
recent periods, and a $3.1 million valuation allowance against mortgage
servicing rights. The $8.8 million increase in data processing expenses was
principally attributable to an increase in the number of credit card accounts
outstanding and the activity generated by such accounts during fiscal 1996.
FISCAL 1995 COMPARED TO FISCAL 1994
REAL ESTATE
The Real Estate Trust recorded a loss before depreciation and
amortization of debt expense of $17.2 million and an operating loss of $27.3
million for fiscal 1995, compared to a loss before depreciation and
amortization of debt expense of $24.0 million and an operating loss of $34.3
million for fiscal 1994. The improvement was largely attributable to higher
income after direct operating expenses for hotels and office and industrial
properties, increased income from Saul Holdings Partnership and other
partnership investments, and recognition of gain on the condemnation of a
portion of a land parcel.
Income after direct operating expenses from hotel properties increased
$3.9 million (31.9%) in fiscal 1995. Room sales increased by $6.3 million
(19.9%) as a result of increases in both average room rates and average
occupancy rates. The higher occupancy rates contributed to an increase of
$1.6 million (14.4%) in food and beverage sales. Total revenues increased by
$8.1 million (17.5%), while expenses were higher by $4.2 million (12.3%).
Income after direct operating expenses from commercial properties
increased $1.6 million (15.8%) from such income in fiscal 1994. Gross income
increased $2.0 million (11.9%) in fiscal 1995, while expenses increased $0.4
million (6.3%). The performance of the office and industrial portfolio was
adversely affected during the first half of fiscal 1994 by vacancies at one
of the Atlanta properties.
Interest expense increased $1.2 million (3.0%) in fiscal 1995, largely as
result of higher average borrowings, which were $403.7 million in fiscal
1995, compared to $358.4 million during fiscal 1994.
Amortization of debt expense decreased $730,000 (60.5%) in fiscal 1995,
largely due to the amortization of a credit arising from a lender's
forgiveness of debt for a full year as compared to a partial year in fiscal
1994.
Depreciation increased $669,000 (7.4%) in fiscal 1995 as a result of new
tenant improvements, acquisition of a new hotel property and property
renovations.
107
Advisory, management and leasing fees paid to related parties increased
$583,000 (8.6%) in fiscal 1995. The advisory fee in fiscal 1995 was $292,000
per month, compared to fiscal 1994 monthly fees of $250,000 from October
1993 through March 1994 and $292,000 from April through September 1994.
Higher gross income from hotels and office and industrial properties in
fiscal 1995 also resulted in higher management fees.
General and administrative expense increased $292,000 (14.4%) in fiscal
1995, largely as a result of higher legal costs incurred in litigation with a
tenant.
The fiscal 1995 write-down of real estate to net realizable value
reflects a $1.2 million reduction in the carrying value of a hotel property
and a $1.5 million write-off of restaurant assets. The Real Estate Trust
sold the hotel property on October 6, 1995.
Equity in earnings of unconsolidated entities represents the Real Estate
Trust's share of earnings in its partnership investments. For fiscal 1995,
the Real Estate Trust recorded earnings of $3.7 million from such
investments compared to earnings of $1.8 million in the prior year.
BANKING
OVERVIEW. The Bank recorded operating income of $55.7 million for the
year ended September 30, 1995 ("fiscal 1995"), compared to operating income
of $53.2 million for the year ended September 30, 1994 ("fiscal 1994"). The
increase in income for fiscal 1995 was primarily attributable to a $72.6
million increase in other (non-interest) income resulting primarily from an
increase in loan servicing fees and a $7.3 million increase in net interest
income. The positive effect of these items on income was partially offset by
a $51.6 million increase in operating expenses and a $25.8 million increase
in the provision for loan losses.
NET INTEREST INCOME. Net interest income, before the provision for loan
losses, increased $7.3 million (or 4.3%) in fiscal 1995. The Bank would have
recorded additional interest income of $7.2 million in fiscal 1995 if the
Bank's non-accrual assets and restructured loans had been current in
accordance with their original terms. Interest income of $2.0 million was
actually recorded on non-accrual assets and restructured loans during the
fiscal year. The Bank's net interest income in future periods will continue
to be adversely affected by the Bank's non-performing assets. See "Financial
Condition - Banking - Asset Quality - Non-Performing Assets."
Interest income in fiscal 1995 increased $30.9 million from the level in
fiscal 1994, primarily as a result of higher average balances of loans
receivable. Higher average yields earned by the Bank on all of its
interest-earning asset categories also contributed to the increase in
interest income. The effect on interest income of higher average balances of
loans and higher average yields was offset in part by lower average balances
of mortgage-backed securities.
The Bank's net yield on interest-earning assets increased to 4.24% in
fiscal 1995 from 4.06% in fiscal 1994. The increase primarily resulted from
the upward adjustment of interest rates on certain of the Bank's
adjustable-rate products to reflect increases in market interest rates to
which rates on such products are indexed. The effect of higher yields was
offset in part by an increase in the rates paid by the Bank on its
interest-bearing liabilities.
108
Interest income on loans, the largest category of interest-earning
assets, increased by $39.2 million (or 15.4%) from fiscal 1994. The increase
in interest income on loans was primarily attributable to higher average
balances. Average balances of consumer loans (other than credit card loans),
principally automobile loans, increased $150.7 million (or 63.6%) in fiscal
1995. The higher balances were largely responsible for the increase of $15.2
million (or 78.5%) in interest income on consumer loans. Average balances of
credit card loans increased $84.7 million (or 9.2%) during fiscal 1995,
largely as a result of new account originations. The increase in balances of
such loans contributed to a $14.2 million (or 11.4%) increase in interest
income from these assets. Average balances of single-family residential
permanent loans increased $70.2 million (or 5.3%) as a result of increased
originations of such loans during the current year. Interest income on these
loans increased $9.8 million (or 10.8%) from fiscal 1994. Average balances
of home equity credit line loans declined in fiscal 1995, largely as a result
of the Bank's securitization and sale activity. The securitization and sale
of $181.9 million and $150.5 million of home equity credit line receivables
in September 1994 and 1995, respectively, more than offset the originations
of $128.9 million of such loans during fiscal 1995, and resulted in a decline
of $25.4 million (or 18.0%) in average balances of home equity credit line
receivables.
Higher average net yields on the loan portfolio also contributed to the
increase in interest income on loans. The average yield on the loan
portfolio in fiscal 1995 increased by 48 basis points (to 9.92% from 9.44%)
from the average yield in fiscal 1994. An increase in the average yield on
credit card loans to 13.94% from 13.67% and on automobile loans to 8.84% from
7.37% contributed to the increase in loan portfolio interest income.
Increases in the average yields on single-family residential permanent loans
(to 7.28% from 6.92%), home equity credit line loans (to 8.74% from 6.96%),
commercial permanent loans (to 6.95% from 6.66%) and construction loans (to
11.53% from 8.27%) also contributed to the increased income on such assets.
The increase in the average yields on these loans reflected the upward
adjustment of interest rates on such loans to reflect increases in market
interest rates to which rates on such products are indexed.
Interest income on mortgage-backed securities decreased $10.3 million (or
14.5%) primarily because of lower average balances. The reduced balances in
fiscal 1995 reflected the effects of scheduled principal paydowns and
unscheduled principal prepayments. The negative effect of the lower average
balances was offset in part by an increase in the average interest rates on
these securities to 6.18% from 5.77%, primarily as a result of higher market
interest rates in fiscal 1995.
Other interest income increased by $2.6 million (or 37.1%) in fiscal 1995
primarily as a result of higher average yields on federal funds sold and
securities purchased under agreements to resell, and, to a lesser extent,
Federal Home Loan Bank stock.
Interest expense increased $23.6 million in fiscal 1995 primarily because
of an increase of $23.4 million in interest expense on deposits, the largest
category of interest-bearing liabilities. Interest expense on deposits
increased as a result of an increase in average rates (to 3.84% from 3.31%),
which reflected higher market interest rates in fiscal 1995 and a shift in
the composition of the Bank's deposits to higher yielding certificates of
deposit (average rates on certificates of deposits increased 30.6%, to 5.17%
from 3.96%) as well as, to a lesser extent, an increase in average deposit
balances of $63.8 million. See "Financial Condition - Banking - Asset and
Liability Management."
109
The increase in interest expense paid on borrowings was primarily
attributable to an increase in the average cost of these borrowings (to 7.01%
from 5.57%), which reflected higher market interest rates in fiscal 1995.
This was particularly true for securities sold under repurchase agreements
for which the weighted average interest rate increased 226 basis points over
the rate for fiscal 1994. The increase in interest expense resulting from
higher interest rates was partially offset by a $125.1 million decrease in
the average balances of borrowings from $622.0 million for fiscal 1994 to
$496.9 million for fiscal 1995.
PROVISION FOR LOAN LOSSES. The Bank's provision for loan losses
increased to $55.0 million in fiscal 1995 from $29.2 million in fiscal 1994.
The $25.8 million increase over the prior year was attributable to increases
of $20.9 million in the provision for losses on credit card loans, $3.5
million in the provision for losses on consumer loans and $1.4 million in the
provision for losses on real estate loans. The higher provisions on credit
card and consumer loans resulted from increased origination volume of such
loans. See "Financial Condition - Banking - Asset Quality - Allowances for
Losses."
OTHER INCOME. The increase in other (non-interest) income to $232.6
million in fiscal 1995 from $160.0 million in fiscal 1994 was primarily
attributable to an increase in loan servicing fees. The positive effect of
this item on other income was partially offset by decreases in most other
categories of non-interest income.
An increase of $77.7 million in excess servicing fees and $32.6 million
of servicing fees earned by the Bank for servicing its portfolios of
securitized credit card loans contributed to an increase of $114.4 million
(or 163.7%) in loan servicing fees. Such excess servicing fees and servicing
fees have increased in recent periods as a result of greater securitization
activity by the Bank.
Credit card fees, consisting of membership fees, late charges,
interchange fees and cash advance charges, decreased $11.2 million (53.2%) in
fiscal 1995 from the level in fiscal 1994. The decrease was primarily
attributable to a $3.0 million and $9.2 million decrease in late charges and
interchange fees, respectively. The decrease was partially offset by an
increase in cash advance charges as a result of increased account activity,
which reflects the increase in new account originations.
Gain on sales of credit card relationships and loans, net decreased by
$17.6 million primarily because the Bank realized a significant gain from the
sale of credit card relationships (or accounts) in fiscal 1994, but did not
consummate any such sale in fiscal 1995.
Gain on sales of mortgage servicing rights decreased by $4.4 million as a
result of a decline in the volume of mortgage servicing rights sold during
the current period. During fiscal 1995 and 1994, the Bank sold the rights to
service mortgage loans with principal balances of approximately $148.1
million and $383.9 million, respectively.
The $6.4 million decrease in earnings on real estate held for investment
or sale was primarily attributable to an increase of $12.3 million in the
provision for losses on such assets and a decrease of $1.6 million in the
operating income generated by the REO properties. See "Financial Condition -
Asset Quality - Allowances for Losses." Partially offsetting these items was
a $4.1 million increase in partnership earnings recorded on real estate held
for investment and a $3.4 million increase in the gain recorded on sales of
110
the Bank's REO properties.
The $4.0 million decline in other income was primarily a result of the
establishment of a reserve on a fixed asset. A $6.2 million reserve,
previously established as a reserve against an REI property, was transferred
with such property to property and equipment. See "Financial Condition -
Banking - Real Estate Held for Investment."
OPERATING EXPENSES. Operating expenses for fiscal 1995 increased $51.6
million (20.9%) from the level in fiscal 1994. The main components of the
higher operating expenses were increases in salaries and employee benefits,
data processing and other expenses. The $21.0 million increase in salaries
and employee benefits resulted primarily from the addition of staff to the
Bank's credit card operations. The $12.5 million increase in data processing
expenses was principally attributable to an increase in the number of credit
card accounts outstanding and the activity generated by such accounts during
fiscal 1995. The $15.6 million increase in other operating expenses was
primarily a result of increased credit card fraud losses during fiscal 1995.
111
MANAGEMENT'S STATEMENT ON RESPONSIBILITY
The Consolidated Financial Statements and related financial information
in this report have been prepared by the Advisor (management) in accordance
with generally accepted accounting principles appropriate in the
circumstances, based on best estimates and judgments, with consideration
given to materiality.
The Trust maintains a system of internal accounting control supported by
documentation to provide reasonable assurance that the books and records
reflect authorized transactions of the Trust, and that the assets of the
Trust are safeguarded.
The Board of Trustees exercises its responsibility for the Trust's
financial statements through its Audit Committee, which is composed of two
outside Trustees who meet periodically with the Trust's independent
accountants and management. The Committee considers the audit scope,
discusses financial and reporting subjects, and reviews management actions on
these matters. The independent accountants have full access to the Audit
Committee.
The independent accountants are recommended by the Audit Committee and
confirmed by the Board of Trustees. They provide an objective assessment of
the fairness and accuracy of the financial statements, consider the adequacy
of the system of internal accounting controls, and perform such tests and
other procedures as they deem necessary to express an opinion on the fairness
of the financial statements. Management believes that the policies and
procedures it has established provide reasonable assurance that its
operations are conducted in conformity with law and a high standard of
business conduct.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
112
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
ON FINANCIAL STATEMENT SCHEDULES
To the Trustees and Shareholders of
B.F. Saul Real Estate Investment Trust
We have audited the consolidated financial statements of B.F. Saul Real
Estate Investment Trust (the "Trust") as of September 30, 1996 and 1995 and
for the years then ended in accordance with generally accepted auditing
standards, and have issued our report thereon dated December 3, 1996. Our
audit was made for the purpose of forming an opinion on the basic financial
statements taken as a whole. The schedules listed in Item 14 are the
responsibility of the Trust's management and are presented for purposes of
complying with the Securities and Exchange Commission's rules and are not
part of the basic financial statements. This information has been subjected
to the auditing procedures applied in our audit of the basic financial
statements and, in our opinion, is fairly stated in all material respects the
financial data required to be set forth therein in relation to the basic
financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Washington, D.C.
December 3, 1996
113
B.F. SAUL REAL ESTATE INVESTMENT TRUST
CONDENSED FINANCIAL INFORMATION SCHEDULE I
(a) Required condensed financial information on the Trust is disclosed in
the audited consolidated financial statements included herewith.
(b) Amounts of cash dividends paid to the Trust by consolidated subsidiaries
were as follows:
Year Ended September 30
---------------------------------------
1996 1995 1994
$6,800,000 None None
114
Consolidated Schedule of Investment Properties - Real Estate Trust Schedule III
September 30, 1996
(Dollars in Thousands)
COSTS
CAPITALIZED BASIS AT CLOSE OF PERIOD
----------------------------------------------------------
INITIAL SUBSEQUENT BUILDINGS
BASIS TO TO AND LEASEHOLD
HOTELS TRUST ACQUISITION LAND IMPROVEMENTS INTERESTS TOTAL
- ------------------------------------------- ------------ -------------------------- ---------------- ----------------------------
Hampton Inn-Dulles, Sterling VA $ -- $ 5,886 $ 290 $ 5,596 $ -- $ 5,886
Holiday Inn, Auburn Hills MI 10,450 641 1,028 10,063 -- 11,091
Holiday Inn, Cincinnati OH 6,859 2,319 245 8,933 -- 9,178
Holiday Inn, Dulles VA 6,950 19,446 862 25,534 -- 26,396
Holiday Inn, Gaithersburg MD 3,849 14,658 1,781 16,726 -- 18,507
Holiday Inn, Pueblo CO 3,458 1,995 561 4,892 -- 5,453
Holiday Inn, Rochester NY 3,340 9,360 605 12,095 -- 12,700
Holiday Inn, Tysons Corner VA 6,976 12,415 3,107 16,284 -- 19,391
Howard Johnsons, Arlington VA 10,187 2,628 1,183 11,632 -- 12,815
------------ -------------------------- ---------------- ----------------------------
Subtotal - Hotels $ 52,069 $ 69,348 $ 9,662 $ 111,755 $ -- $121,417
------------ -------------------------- ---------------- ----------------------------
COMMERCIAL
- -------------------------------------------
900 Circle 75 Pkway, Atlanta GA $ 33,434 $ 398 $ 563 $ 33,269 $ -- $ 33,832
1000 Circle 75 Pkway, Atlanta GA 2,820 870 248 3,442 -- 3,690
1100 Circle 75 Pkway, Atlanta GA 22,746 1,796 419 24,123 -- 24,542
8201 Greensboro, Tysons Corner VA 28,890 1,925 1,633 29,182 -- 30,815
Commerce Ctr-Ph II, Ft Lauderdale FL 4,266 587 782 4,071 -- 4,853
Dulles North, Loudon County VA -- 5,502 421 5,081 -- 5,502
Metairie Tower, Metairie LA 2,729 533 403 2,859 -- 3,262
------------ -------------------------- ---------------- ----------------------------
Subtotal - Commercial $ 94,885 $ 11,611 $ 4,469 $ 102,027 $ -- $106,496
------------ -------------------------- ---------------- ----------------------------
BUILDINGS
AND
IMPROVEMENTS
ACCUMULATED RELATED DATE OF DATE DEPRECIABLE
HOTELS DEPRECIATION DEBT CONSTRUCTION ACQUIRED LIVES (YEARS)
- ------------------------------------------- ------------------- --------------------------------- --------------- ----------------
Hampton Inn-Dulles, Sterling VA $ 2,035 $ 1,896 1987 4/87 31.5
Holiday Inn, Auburn Hills MI 640 7,482 1989 11/94 31.5
Holiday Inn, Cincinnati OH 4,289 2,927 1975 2/76 40
Holiday Inn, Dulles VA 10,031 12,573 1971 11/84 28
Holiday Inn, Gaithersburg MD 6,274 7,308 1972 6/75 45
Holiday Inn, Pueblo CO 2,341 3,994 1973 3/76 40
Holiday Inn, Rochester NY 5,244 13,805 1975 3/76 40
Holiday Inn, Tysons Corner VA 6,513 16,274 1971 6/75 47
Howard Johnsons, Arlington VA 4,859 9,395 1973 11/83 30
------------------- ------------------
Subtotal - Hotels $ 42,226 $ 75,654
------------------- ------------------
COMMERCIAL
- -------------------------------------------
900 Circle 75 Pkway, Atlanta GA $ 10,898 $ 21,520 1985 12/85 35
1000 Circle 75 Pkway, Atlanta GA 1,771 2,230 1974 4/76 40
1100 Circle 75 Pkway, Atlanta GA 9,476 15,810 1982 9/82 40
8201 Greensboro, Tysons Corner VA 8,307 35,669 1985 4/86 35
Commerce Ctr-Ph II, Ft Lauderdale FL 1,221 1,340 1986 1/87 35
Dulles North, Loudon County VA 932 1,319 1990 10/90 31.5
Metairie Tower, Metairie LA 1,416 -- 1974 11/76 40
------------------- ------------------
Subtotal - Commercial $ 34,021 $ 77,888
------------------- ------------------
115
Consolidated Schedule of Investment Properties - Real Estate Trust (Continued)
Schedule III-Continued
September 30, 1996
(Dollars in Thousands)
COSTS
CAPITALIZED BASIS AT CLOSE OF PERIOD
----------------------------------------------------------
INITIAL SUBSEQUENT BUILDINGS
BASIS TO TO AND LEASEHOLD
PURCHASE-LEASEBACKS TRUST ACQUISITION LAND IMPROVEMENTS INTERESTS TOTAL
- ------------------------------------------- ------------ -------------------------- ---------------- ----------------------------
Beverly Plaza, Casper, WY $ 500 $ -- $ 500 $ -- $ -- $ 500
Chateau di Jon, Metairie, LA 1,125 -- 1,125 -- -- 1,125
Country Club, Knoxville, TN 500 -- 500 -- -- 500
Houston Mall, Warner Robbins, GA 650 -- 650 -- -- 650
Old National, Atlanta, GA 550 -- 550 -- -- 550
------------ -------------------------- ---------------- ----------------------------
Subtotal - Purchase-Leasebacks $ 3,325 $ -- $ 3,325 $ -- $ -- $ 3,325
------------ -------------------------- ---------------- ----------------------------
Miscellaneous investments $ 633 $ 757 $ 250 $ 991 $ 149 $ 1,390
------------ -------------------------- ---------------- ----------------------------
Total Income-Producing Properties $150,912 $ 81,716 $17,706 $ 214,773 $ 149 $232,628
------------ -------------------------- ---------------- ----------------------------
LAND PARCELS
- -------------------------------------------
Arvida Park of Commerce,
Boca Raton, FL $ 7,378 143 $ 7,521 $ -- $ -- $ 7,521
Avenel, Gaithersburg, MD 361 8 369 -- -- 369
Church Road, Loudoun Co., VA 2,586 2,272 4,858 -- -- 4,858
Circle 75, Atlanta, GA 12,927 4,264 17,191 -- -- 17,191
Flagship Centre, Rockville, MD 1,729 39 1,768 -- -- 1,768
Holiday Inn - Rochester, Roch., NY 68 -- 68 -- -- 68
Overland Park, Overland Park, KA 3,771 397 4,168 -- -- 4,168
Prospect Indust. Pk, Ft. Laud., FL 2,203 9 2,212 -- -- 2,212
Sterling Blvd., Loudoun Co., VA -- 3,425 3,425 -- -- 3,425
------------ -------------------------- ---------------- ----------------------------
Subtotal $ 31,023 $ 10,557 $41,580 $ -- $ -- $ 41,580
------------ -------------------------- ---------------- ----------------------------
Total Investment Properties $181,935 $ 92,273 $59,286 $ 214,773 $ 149 $274,208
============ ========================== ================ ============================
BUILDINGS
AND
IMPROVEMENTS
ACCUMULATED RELATED DATE OF DATE DEPRECIABLE
PURCHASE-LEASEBACKS DEPRECIATION DEBT CONSTRUCTION ACQUIRED LIVES (YEARS)
- ------------------------------------------- ------------------- --------------------------------- --------------- ----------------
Beverly Plaza, Casper, WY $ -- $ -- 4/74
Chateau di Jon, Metairie, LA -- -- 11/73
Country Club, Knoxville, TN -- -- 5/76
Houston Mall, Warner Robbins, GA -- -- 2/72
Old National, Atlanta, GA -- -- 8/71
------------------- ------------------
Subtotal - Purchase-Leasebacks $ -- $ --
------------------- ------------------
Miscellaneous investments $ 266 $ --
------------------- ------------------
Total Income-Producing Properties $ 76,513 $ 153,542
------------------- ------------------
LAND PARCELS
- -------------------------------------------
Arvida Park of Commerce,
Boca Raton, FL $ -- $ 19,000 12/84 & 5/85
Avenel, Gaithersburg, MD -- -- 12/76
Church Road, Loudoun Co., VA -- -- 9/84 & 4/85
Circle 75, Atlanta, GA -- 4,312 2/77 & 1/84
Flagship Centre, Rockville, MD -- -- 8/85
Holiday Inn - Rochester, Roch., NY -- -- 9/86
Overland Park, Overland Park, KA -- -- 1/77 & 2/85
Prospect Indust. Pk, Ft. Laud., FL -- 350 10/83 & 8/84
Sterling Blvd., Loudoun Co., VA -- -- 4/84
------------------- ------------------
Subtotal $ -- $ 23,662
------------------- ------------------
Total Investment Properties $ 76,513 $ 177,204
=================== ==================
116
CONSOLIDATED SCHEDULE OF INVESTMENT PROPERTIES - REAL ESTATE TRUST
NOTES:
(1) See Summary of Significant Accounting Policies for basis of recording
investment properties and computing depreciation. Investment properties are
discussed in Note 3 to Consolidated Financial Statements.
(2) A reconciliation of the basis of investment properties and accumulated
depreciation follows.
BASIS OF INVESTMENT PROPERTIES AND ACCUMULATED DEPRECIATION
(In thousands)
FOR THE YEAR ENDED SEPTEMBER 30
--------------------------------------------------------------
1996 1995 1994
-------------------- -------------------- --------------------
BASIS OF INVESTMENT PROPERTIES
- --------------------------------------------------------------------
Balance at beginning of period $ 277,385 $ 266,095 $ 263,393
Additions (reductions) during the period:
Capital expenditures 7,408 16,462 6,717
Sales - nonaffiliates (5,382) -- --
Write-down of assets to net realizable value -- (2,727) (1,380)
Other (5,203) (2,445) (2,635)
-------------------- -------------------- --------------------
Balance at end of period $ 274,208 $ 277,385 $ 266,095
==================== ==================== ====================
ACCUMULATED DEPRECIATION
- --------------------------------------------------------------------
Balance at beginning of period $ 75,140 $ 68,111 $ 62,626
Additions (reductions) during the period:
Depreciation expense 10,020 9,714 9,082
Sales - nonaffiliates (3,441) -- --
Other (5,206) (2,685) (3,597)
-------------------- -------------------- --------------------
Balance at end of period $ 76,513 $ 75,140 $ 68,111
==================== ==================== ====================
117
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Page
----
Report of Independent Public Accountant. F-2
Consolidated Balance Sheets - As of September 30, F-3
1996 and 1995.
Consolidated Statements of Operations - For the F-4
years ended September 30, 1996, 1995 and 1994.
Consolidated Statements of Shareholders' Deficit - For the F-6
years ended September 30, 1996, 1995 and 1994.
Consolidated Statements of Cash Flows - For the
years ended September 30, 1996, 1995 and 1994. F-7
Notes to Consolidated Financial Statements. F-9
F-1
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Trustees and Shareholders of
B.F. Saul Real Estate Investment Trust
We have audited the accompanying consolidated balance sheets of B.F. Saul
Real Estate Investment Trust (the "Trust") and subsidiaries as of September
30, 1996 and 1995, and the related consolidated statements of operations,
shareholders' deficit, and cash flows for the years then ended. These
financial statements are the responsibility of the Trust's management. Our
responsibility is to express an opinion on these financial statements based
on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of B.F. Saul Real Estate
Investment Trust and subsidiaries as of September 30, 1996 and 1995, and the
results of their operations and their cash flows for the years then ended in
conformity with generally accepted accounting principles.
As explained in the Organization and Summary of Significant Accounting
Policies in the notes to the financial statements, effective October 1, 1993,
the Trust changed its method of accounting for income taxes, impaired loans,
and investments in securities and mortgage-backed securities. In addition, as
explained in the note to the financial statements, effective July 1, 1995,
the Trust changed its method of accounting for mortgage servicing rights.
Arthur Andersen LLP
Washington, D.C.
December 3, 1996
F-2
CONSOLIDATED BALANCE SHEETS
B. F. SAUL REAL ESTATE INVESTMENT TRUST
===================================================================================================================================
September 30
------------------------------
(In thousands) 1996 1995
- -----------------------------------------------------------------------------------------------------------------------------------
ASSETS
Real Estate
Income-producing properties
Hotel $ 121,417 $ 122,649
Commercial 106,496 111,646
Other 4,715 4,632
-------------- --------------
232,628 238,927
Accumulated depreciation (76,513) (75,140)
-------------- --------------
156,115 163,787
Land parcels 41,580 38,458
Cash and cash equivalents 15,516 17,355
Other assets 81,292 93,812
-------------- --------------
Total real estate assets 294,503 313,412
- -----------------------------------------------------------------------------------------------------------------------------------
Banking
Cash and due from banks 213,394 198,096
Interest-bearing deposits 53,031 51,186
Securities purchased under agreements to resell -- 110,000
Loans held for sale 76,064 68,679
Loans held for securitization and sale 450,000 500,000
Investment securities (market value $9,820 and $4,371, respectively) 9,818 4,370
Mortgage-backed securities (market value $1,307,838 and $879,720, respectively) 1,306,417 880,208
Loans receivable (net of allowance for losses of $95,523 and $60,496, respectively) 2,772,967 2,327,222
Federal Home Loan Bank stock 31,940 31,940
Real estate held for investment or sale (net of allowance for losses of $126,710
and $135,236, respectively) 123,489 222,860
Property and equipment, net 225,135 180,438
Cost in excess of net assets acquired, net 2,399 4,173
Excess spread assets, net 42,602 25,640
Mortgage servicing rights, net 32,790 28,573
Other assets 353,028 278,151
-------------- --------------
Total banking assets 5,693,074 4,911,536
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $ 5,987,577 $ 5,224,948
- -----------------------------------------------------------------------------------------------------------------------------------
LIABILITIES
Real Estate
Mortgage notes payable $ 173,345 $ 184,502
Notes payable - secured 177,500 175,500
Notes payable - unsecured 42,367 41,057
Deferred gains - real estate 112,883 112,883
Accrued dividends payable - preferred shares of beneficial interest 31,563 --
Other liabilities and accrued expenses 40,434 41,872
-------------- --------------
Total real estate liabilities 578,092 555,814
- -----------------------------------------------------------------------------------------------------------------------------------
Banking
Deposit accounts 4,164,037 4,159,252
Securities sold under repurchase agreements and other short-term borrowings 637,141 10,435
Notes payable 7,277 7,514
Federal Home Loan Bank advances 269,065 155,052
Custodial accounts 7,415 7,413
Amounts due to banks 44,423 32,240
Other liabilities 99,086 87,545
Capital notes -- subordinated 160,000 160,000
-------------- --------------
Total banking liabilities 5,388,444 4,619,451
- -----------------------------------------------------------------------------------------------------------------------------------
Commitments and contingencies
Minority interest held by affiliates 46,065 43,556
Minority interest -- other 74,307 74,307
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES 6,086,908 5,293,128
- -----------------------------------------------------------------------------------------------------------------------------------
SHAREHOLDERS' DEFICIT
Preferred shares of beneficial interest, $10.50 cumulative, $1 par value, 90 million shares
authorized, 516,000 shares issued and outstanding, liquidation value $51.6 million 516 516
Common shares of beneficial interest, $1 par value, 10 million shares authorized,
6,641,598 shares issued 6,642 6,642
Paid-in surplus 92,943 92,943
Deficit (156,084) (123,943)
Net unrealized holding loss (1,500) (2,490)
-------------- --------------
(57,483) (26,332)
Less cost of 1,814,688 common shares of beneficial interest in treasury (41,848) (41,848)
-------------- --------------
TOTAL SHAREHOLDERS' DEFICIT (99,331) (68,180)
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' DEFICIT $ 5,987,577 $ 5,224,948
- -----------------------------------------------------------------------------------------------------------------------------------
The Notes to Consolidated Financial Statements are an integral part of these
statements.
F-3
CONSOLIDATED STATEMENTS OF OPERATIONS
B. F. SAUL REAL ESTATE INVESTMENT TRUST
===================================================================================================================================
For the Year Ended September 30
----------------------------------------------
(In thousands, except per share amounts) 1996 1995 1994
- -----------------------------------------------------------------------------------------------------------------------------------
REAL ESTATE
Income
Hotels $ 54,245 $ 54,104 $ 46,046
Commercial properties 17,590 18,812 16,815
Other 5,004 4,369 3,183
-------------- -------------- --------------
Total income 76,839 77,285 66,044
- -----------------------------------------------------------------------------------------------------------------------------------
Expenses
Direct operating expenses:
Hotels 36,075 38,038 33,874
Commercial properties 7,251 7,409 6,972
Land parcels and other 1,637 1,348 1,383
Interest expense 39,840 40,564 39,370
Amortization of debt expense 674 476 1,206
Depreciation 10,020 9,714 9,082
Advisory, management and leasing fees - related parties 7,423 7,376 6,793
General and administrative 1,401 2,319 2,027
Write-down of real estate to net realizable value -- 2,727 1,380
-------------- -------------- --------------
Total expenses 104,321 109,971 102,087
- -----------------------------------------------------------------------------------------------------------------------------------
Equity in earnings of unconsolidated entities 3,374 3,681 1,738
Gain (loss) on sale of property (68) 1,664 --
- -----------------------------------------------------------------------------------------------------------------------------------
REAL ESTATE OPERATING LOSS $ (24,176) $ (27,341) $ (34,305)
- -----------------------------------------------------------------------------------------------------------------------------------
BANKING
Interest income
Loans $ 317,847 $ 294,554 $ 255,328
Mortgage-backed securities 50,955 60,623 70,937
Trading securities 953 373 1,019
Investment securities 315 194 197
Other 17,441 9,571 6,983
-------------- -------------- --------------
Total interest income 387,511 365,315 334,464
- -----------------------------------------------------------------------------------------------------------------------------------
Interest expense
Deposit accounts 162,569 154,299 130,924
Short-term borrowings 10,407 18,094 11,439
Long-term borrowings 15,860 16,721 23,181
-------------- -------------- --------------
Total interest expense 188,836 189,114 165,544
-------------- -------------- --------------
Net interest income 198,675 176,201 168,920
Provision for loan losses (115,740) (54,979) (29,222)
- -----------------------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 82,935 121,222 139,698
- -----------------------------------------------------------------------------------------------------------------------------------
Other income
Credit card fees 30,765 9,855 21,054
Loan servicing fees 264,096 184,275 69,878
Deposit servicing fees 29,900 24,442 20,347
Gain (loss) on sales of trading securities, net 1,158 (600) 1,695
Earnings (loss) on real estate held for investment or sale, net (24,413) (5,549) 835
Gain on sales of credit card relationships and loans, net 23,242 12,882 30,522
Gain on sales of mortgage servicing rights, net -- 1,397 5,833
Other 19,713 5,923 9,885
-------------- -------------- --------------
Total other income 344,461 232,625 160,049
- -----------------------------------------------------------------------------------------------------------------------------------
Continued on following page.
F-4
CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
B. F. SAUL REAL ESTATE INVESTMENT TRUST
===================================================================================================================================
For the Year Ended September 30
----------------------------------------------
(In thousands, except per share amounts) 1996 1995 1994
- -----------------------------------------------------------------------------------------------------------------------------------
BANKING (Continued)
Operating expenses
Salaries and employee benefits $ 127,597 $ 108,432 $ 87,390
Loan 28,241 15,745 14,870
Property and equipment 34,362 28,799 25,729
Marketing 53,705 46,117 46,441
Data processing 52,021 43,270 30,766
Deposit insurance premiums 37,362 10,749 11,527
Amortization of cost in excess of net assets acquired 1,775 2,411 2,801
Other 46,222 42,641 27,036
-------------- -------------- --------------
Total operating expenses 381,285 298,164 246,560
- -----------------------------------------------------------------------------------------------------------------------------------
BANKING OPERATING INCOME $ 46,111 $ 55,683 $ 53,187
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL COMPANY
Operating income before income taxes, extraordinary item, cumulative effect of
change in accounting principle,
and minority interest $ 21,935 $ 28,342 $ 18,882
Income tax provision 8,301 2,021 7,025
-------------- -------------- --------------
Income before extraordinary item, cumulative effect
of change in accounting principle and minority interest 13,634 26,321 11,857
Extraordinary item:
Loss on early extinguishment of debt, net of taxes -- -- (11,315)
-------------- -------------- --------------
Income before cumulative effect of change in accounting
principle and minority interest 13,634 26,321 542
Cumulative effect of change in accounting principle -- -- 36,260
-------------- -------------- --------------
Income before minority interest 13,634 26,321 36,802
Minority interest held by affiliates (3,962) (5,721) (3,963)
Minority interest -- other (9,750) (9,750) (9,750)
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL COMPANY NET INCOME (LOSS) $ (78) $ 10,850 $ 23,089
- -----------------------------------------------------------------------------------------------------------------------------------
NET INCOME (LOSS) AVAILABLE TO COMMON
SHAREHOLDERS $ (5,498) $ 5,430 $ 17,669
NET INCOME (LOSS) PER COMMON SHARE
Income before extraordinary item, cumulative
effect of change in accounting principle and minority interest $ 1.70 $ 4.33 $ 1.33
Extraordinary item:
Loss on early extinguishment of debt, net of taxes -- -- (2.34)
-------------- -------------- --------------
Income (loss) before cumulative effect of change in accounting
principle and minority interest 1.70 4.33 (1.01)
Cumulative effect of change in accounting principle -- -- 7.51
-------------- -------------- --------------
Income before minority interest 1.70 4.33 6.50
Minority interest held by affiliates (0.82) (1.19) (0.82)
Minority interest -- other (2.02) (2.02) (2.02)
- -----------------------------------------------------------------------------------------------------------------------------------
NET INCOME (LOSS) PER COMMON SHARE $ (1.14) $ 1.12 $ 3.66
- -----------------------------------------------------------------------------------------------------------------------------------
The Notes to Consolidated Financial Statements are an integral part of these
statements.
F-5
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' DEFICIT
B. F. SAUL REAL ESTATE INVESTMENT TRUST
===================================================================================================================================
For the Year Ended September 30
----------------------------------------------
(Dollars in thousands, except per share amounts) 1996 1995 1994
- -----------------------------------------------------------------------------------------------------------------------------------
PREFERRED SHARES OF BENEFICIAL INTEREST
Beginning and end of year (516,000 shares) $ 516 $ 516 $ 516
-------------- -------------- --------------
COMMON SHARES OF BENEFICIAL INTEREST
Beginning and end of year (6,641,598 shares) 6,642 6,642 6,642
-------------- -------------- --------------
PAID-IN SURPLUS
Beginning and end of year 92,943 92,943 92,943
-------------- -------------- --------------
DEFICIT
Beginning of year (123,943) (134,793) (157,882)
Net income (loss) (78) 10,850 23,089
Dividends:
Real Estate Trust preferred shares of beneficial interest:
Distributions ($0.97 per share) (500) -- --
Distributions payable ($61.17 per share) (31,563) -- --
-------------- -------------- --------------
End of year (156,084) (123,943) (134,793)
-------------- -------------- --------------
Net unrealized holding losses (1,500) (2,490) (11,303)
-------------- -------------- --------------
TREASURY SHARES
Beginning and end of year (1,814,688 shares) (41,848) (41,848) (41,848)
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL SHAREHOLDERS' DEFICIT $ (99,331) $ (68,180) $ (87,843)
- -----------------------------------------------------------------------------------------------------------------------------------
The Notes to Consolidated Financial Statements are an integral part of these
statements.
F-6
CONSOLIDATED STATEMENTS OF CASH FLOWS
B. F. SAUL REAL ESTATE INVESTMENT TRUST
===================================================================================================================================
For the Year Ended September 30
----------------------------------------------
(In thousands) 1996 1995 1994
- -----------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Real Estate
Net income (loss) $ (15,924) $ (12,032) $ 7,239
Adjustments to reconcile net income (loss) to net cash provided by (used in)
operating activities:
Depreciation 10,020 9,714 9,082
(Gain) loss on sale of property 68 (1,654) --
Write-down of real estate to net realizable value -- 2,727 1,380
Increase in accounts receivable and accrued income (4,869) (224) (516)
(Increase) decrease in deferred tax asset 1,881 10,836 (19,028)
(Increase) decrease in accounts payable and accrued expenses 430 317 (5,473)
(Increase) decrease in tax sharing receivable 14,533 (5,685) (12,015)
Amortization of debt expense 674 476 1,206
Equity in earnings of unconsolidated entities (3,374) (3,681) (1,738)
Loss on early extinguishment of debt -- -- 4,982
Other 6,343 3,530 4,022
-------------- -------------- --------------
9,782 4,324 (10,859)
-------------- -------------- --------------
Banking
Net income 15,846 28,603 15,850
Adjustments to reconcile net income to net cash provided by (used in)
operating activities:
Amortization (accretion) of premiums, discounts and net deferred loan fees 112 (435) (1,301)
Depreciation and amortization 24,635 21,690 18,292
Amortization of cost in excess of net assets acquired and mortgage
servicing rights 9,575 4,590 8,857
Capitalized interest on real estate held for investment or sale (3,462) (4,512) (4,386)
Originations of mortgage servicing rights (6,205) (1,514) --
Loss on extinguishment of debt -- -- 10,476
Provision for loan losses 115,740 54,979 29,222
Net fundings of loans held for sale and/or securitization (690,589) (390,634) (874,917)
Proceeds from sales of trading securities 363,364 239,147 688,811
Proceeds from sales of loans held for sale and/or securitization 1,984,484 2,188,531 2,276,391
Proceeds from sales of spread accounts 42,140 59,200 --
Provision for losses on real estate held for investment or sale 26,341 26,321 14,052
Earnings on real estate (2,278) (18,882) (11,366)
(Gain) loss on sales of trading securities, net (1,158) 600 (1,695)
Gain on sales of credit card relationships and loans, net (23,242) (12,882) (30,522)
Minority interest held by affiliates 3,962 -- 3,963
Minority interest - other 9,750 9,750 9,750
(Increase) decrease in excess spread assets (16,962) (442) 2,375
(Increase) decrease in other assets (103,211) (145,918) 25,441
Increase in other liabilities 23,724 23,981 18,125
Increase (decrease) in tax sharing payable (14,533) 5,685 12,015
Other operating activities, net (12,440) 1,779 4,443
-------------- -------------- --------------
1,745,593 2,089,637 2,213,876
-------------- -------------- --------------
Net cash provided by operating activities 1,755,375 2,093,961 2,203,017
- -----------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Real Estate
Capital expenditures - properties (7,408) (6,270) (6,717)
Property acquisitions -- (10,193) --
Property sales 1,812 -- --
Equity investment in unconsolidated entities 639 (733) (9,769)
Notes receivable - affiliates -- -- (12,675)
Other investing activities 50 53 43
-------------- -------------- --------------
(4,907) (17,143) (29,118)
-------------- -------------- --------------
Banking
Proceeds from maturities of investment securities 4,410 100 300
Net proceeds from sales of real estate held for investment or sale 58,874 133,300 94,308
Net proceeds from sales of mortgage servicing rights 947 2,232 5,833
Net fundings of loans receivable (1,702,926) (2,295,069) (1,700,831)
Principal collected on mortgage-backed securities 221,698 183,166 447,666
Purchases of investment securities (10,000) -- --
Purchases of mortgage-backed securities (649,688) (107,127) (291,335)
Purchases of loans receivable (391,878) (88,518) (256,608)
Purchases of property and equipment (69,749) (55,924) (22,503)
Purchases of mortgage servicing rights (9,902) (3,847) (888)
Disbursements for real estate held for investment or sale (14,447) (32,834) (53,677)
Other investing activities, net (2,808) 1,103 4,840
-------------- -------------- --------------
(2,565,469) (2,263,418) (1,772,895)
-------------- -------------- --------------
Net cash used in investing activities (2,570,376) (2,280,561) (1,802,013)
- -----------------------------------------------------------------------------------------------------------------------------------
Continued on following page.
F-7
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
B. F. SAUL REAL ESTATE INVESTMENT TRUST
===================================================================================================================================
For the Year Ended September 30
----------------------------------------------
(In thousands) 1996 1995 1994
- -----------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Real Estate
Proceeds from mortgage financing $ -- $ 11,400 $ 461
Principal curtailments and repayments of mortgages (8,573) (12,424) (66,169)
Proceeds from advances on secured notes 2,500 500 175,000
Repayments of secured notes (500) -- --
Proceeds from sales of unsecured notes 3,708 4,428 9,619
Repayments of unsecured notes (2,398) (3,659) (7,992)
Financing proceeds placed in liquidity maintenance escrow -- -- (25,792)
Costs of obtaining financings (201) (516) (9,404)
Cash dividends paid on preferred shares of beneficial interest (1,250) -- --
-------------- -------------- --------------
(6,714) (271) 75,723
-------------- -------------- --------------
Banking
Proceeds from customer deposits and sales of certificates of deposit 15,312,125 14,086,575 12,308,342
Customer withdrawals of deposits and payments for maturing certificates of deposit (15,307,340) (13,936,084) (12,169,604)
Net increase (decrease) in securities sold under repurchase agreements 574,400 777 (81,504)
Advances from the Federal Home Loan Bank 429,459 992,073 824,300
Repayments of advances from the Federal Home Loan Bank (315,446) (937,021) (1,136,300)
Proceeds from other borrowings 2,469,675 793,261 461,385
Repayments of other borrowings (2,417,606) (816,755) (460,011)
Cash dividends paid on preferred stock (9,750) (9,750) (9,750)
Cash dividends paid on common stock (8,500) -- --
Repayment of capital notes - subordinated -- -- (134,153)
Net proceeds received from capital notes - subordinated -- -- 143,603
Other financing activities, net 2 (12,110) (6,402)
-------------- -------------- --------------
727,019 160,966 (260,094)
-------------- -------------- --------------
Net cash provided by (used in) financing activities 720,305 160,695 (184,371)
- -----------------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents (94,696) (25,905) 216,633
Cash and cash equivalents at beginning of year 376,637 402,542 185,909
-------------- -------------- --------------
Cash and cash equivalents at end of year $ 281,941 $ 376,637 $ 402,542
- -----------------------------------------------------------------------------------------------------------------------------------
Supplemental disclosures of cash flow information: Cash paid during the year
for:
Interest (net of amount capitalized) $ 237,568 $ 217,186 $ 213,888
Income taxes 4,356 (1,327) (93)
Supplemental schedule of noncash investing and financing activities:
Rollovers of notes payable - unsecured 3,725 3,588 6,062
Loans held for sale exchanged for trading securities 363,257 133,014 396,189
Mortgage-backed securities available-for-sale transferred to mortgage-backed
securities held-to-maturity -- 942,085 --
Mortgage-backed securities transferred to mortgage-backed securities
available-for-sale -- -- 1,501,192
Investment securities transferred to investment securities available-for-sale -- -- 4,789
Investment securities available-for-sale transferred to investment securities
held-to-maturity -- 4,354 --
Real estate held for investment transferred to real estate held for sale -- 9,273 --
Loans receivable transferred to loans held for sale and/or securitization 1,594,262 2,387,690 1,446,924
Loans made in connection with the sale of real estate 46,537 10,826 16,401
Loans receivable transferred to real estate acquired in settlement of loans 5,972 9,822 4,106
Loans receivable exchanged for mortgage-backed securities held-to-maturity -- 23,155 --
Loans held for sale and/or securitization transferred to loans receivable -- 50,000 3,507
Loans classified as in-substance foreclosed transferred to loans receivable -- -- 15,008
Loans held for sale transferred to loans receivable 3,146 -- --
- -----------------------------------------------------------------------------------------------------------------------------------
The Notes to Consolidated Financial Statements are an integral part of these
statements.
F-8
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
GENERAL
B.F. Saul Real Estate Investment Trust and its wholly owned subsidiaries
(collectively, the "Real Estate Trust") operate as a Maryland real estate
investment trust. The principal business activity of the Real Estate Trust is
the ownership and development of income-producing properties. The properties
owned by the Real Estate Trust are located predominantly in the Mid-Atlantic and
Southeastern regions of the United States and consist principally of hotels,
office projects, and various undeveloped land parcels.
B.F. Saul Real Estate Investment Trust also owns 80% of the outstanding common
stock of Chevy Chase Bank, F.S.B. and its subsidiaries (collectively the "Bank"
or the "Corporations"), whose assets accounted for approximately 95% of the
consolidated assets of the B.F. Saul Real Estate Investment Trust and its
consolidated subsidiaries (the "Trust") at September 30, 1996. The Bank is a
federally chartered and federally insured stock savings bank. The B. F. Saul
Real Estate Investment Trust is a thrift holding company by virtue of its
ownership of a majority interest in the Bank and is subject to regulation by the
Office of Thrift Supervision ("OTS"). The accounting and reporting practices of
the Trust conform to generally accepted accounting principles and, as
appropriate, predominant practices within the real estate and banking
industries.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Real Estate
Trust and its subsidiaries. Accordingly, the accompanying financial statements
reflect the assets, liabilities, operating results, and cash flows for two
business segments: Real Estate and Banking. Entities in which the Trust holds a
non-controlling interest (generally 50% or less) are accounted for on the equity
method. See Note 2.
USE OF ESTIMATES
The financial statements have been prepared in conformity with generally
accepted accounting principles. In preparing the financial statements,
management is required to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent
liabilities as of the date of the balance sheet and revenues and expenses for
the reporting period. Actual results could differ from those estimates.
INCOME TAXES
The Trust files a consolidated federal income tax return which includes
operations of all 80% or more owned subsidiaries. It voluntarily terminated its
qualification as a real estate investment trust under the Internal Revenue Code
during fiscal 1978.
In February 1992, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 109 "Accounting for Income Taxes" ("SFAS
109"). SFAS 109 establishes financial accounting and reporting standards for the
effects of income taxes that result from the Trust's activities during the
current and preceding years. It requires an asset and liability approach in
accounting for income taxes versus the deferred method previously used under
Accounting Principles Board Opinion No. 11, "Accounting for Income Taxes" ("APB
11"). Under SFAS 109, deferred income taxes are recorded using currently enacted
tax laws and rates. To the extent that realization of deferred tax assets is
more likely than not, such assets are recognized. The Trust adopted SFAS 109 on
October 1, 1993 and recorded a cumulative effect of a change in accounting
principle of approximately $36.3 million.
F-9
NET INCOME (LOSS) PER COMMON SHARE
Net income (loss) per common share is determined by dividing net income (loss),
after deducting preferred share dividend requirements, by the weighted average
number of common shares outstanding during the year. For fiscal years 1996, 1995
and 1994, the weighted average number of shares used in the calculation was
4,826,910.
RECLASSIFICATIONS
Certain reclassifications have been made to the consolidated financial
statements for the years ended September 30, 1995 and 1994 to conform with the
presentation used for the year ended September 30, 1996.
ACCOUNTING STANDARDS ISSUED BUT NOT YET ADOPTED
SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of" ("SFAS 121"), was issued in March 1995.
SFAS 121 establishes accounting standards for the impairment of long-lived
assets, certain identifiable intangibles, and goodwill related to those assets,
to be held and used and for long-lived assets and certain identifiable
intangibles to be disposed of. It addresses how impairment losses should be
measured and when such losses should be recognized. Under SFAS 121, long-lived
assets and certain identifiable intangibles to be held and used shall be
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. If the sum of the
expected cash flows (undiscounted and without interest charges) is less than the
carrying amount of the asset, the entity shall recognize an impairment loss.
Measurement of an impairment loss for long-lived assets and identifiable
intangibles that an entity expects to hold and use should be based on the fair
value of the asset. Long-lived assets and certain identifiable intangibles to be
disposed of should generally be reported at the lower of carrying amount or fair
value less the cost to sell. SFAS 121 is effective for financial statements for
fiscal years beginning after December 15, 1995. The adoption of SFAS 121 is not
anticipated to have a material impact on the Trust's financial condition or the
results of operations.
F-10
B. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - REAL ESTATE TRUST
CASH EQUIVALENTS
The Real Estate Trust considers all highly liquid, temporary investments with an
original maturity of three months or less to be cash equivalents.
PROPERTIES
Income-producing properties are stated at the lower of depreciated cost (except
those which were acquired through foreclosure or equivalent proceedings, the
carrying amounts of which are based on the lower of cost or fair value at the
time of acquisition) or net realizable value.
Interest, real estate taxes and other carrying costs are capitalized on projects
under construction. Once construction is completed and the assets are placed in
service, rental income, direct operating expenses, and depreciation associated
with such properties are included in current operations. The Real Estate Trust
considers a project to be substantially complete and held available for
occupancy upon completion of tenant improvements, but no later than one year
from the cessation of major construction activity. Substantially completed
portions of a project are accounted for as separate projects. Expenditures for
repairs and maintenance are charged to operations as incurred.
Depreciation is calculated using the straight-line method and estimated useful
lives of 31.5 to 47 years for buildings and up to 20 years for certain other
improvements. Tenant improvements are amortized over the lives of the related
leases using the straight-line method.
INCOME RECOGNITION
The Real Estate Trust derives room and other revenues from the operations of its
hotel properties. The Real Estate Trust derives rental income under
noncancelable long-term leases from tenants at its commercial properties.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value of
each class of financial instruments.
CASH AND CASH EQUIVALENTS
The carrying amount approximates fair value because of the short-term maturity
of these instruments.
LIABILITIES
The carrying amount of mortgage notes payable and notes payable - secured
approximates their fair value since most of the debt has been financed in recent
periods at prevailing market interest rates. The fair value of Notes payable -
unsecured is based on the rates currently offered by the Real Estate Trust for
similar notes. At September 30, 1996 and 1995 the fair value of Notes payable -
unsecured was $43.8 and $42.6 million, respectively.
F-11
C. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - THE BANK
The Bank is a federally chartered and federally insured stock savings bank and,
as such, is subject to comprehensive regulation, examination and supervision by
the Office of Thrift Supervision ("OTS") and by the Federal Deposit Insurance
Corporation ("FDIC"). The Bank is principally engaged in the business of
attracting deposits from the public and using such deposits, together with
borrowings and other funds, to make loans secured by real estate, primarily
residential mortgage loans, and various types of consumer loans, primarily
credit card loans. The Bank's principal deposit market is the Washington, D.C.
metropolitan area.
CASH AND CASH EQUIVALENTS
For purposes of reporting cash flows, cash and cash equivalents include cash and
due from banks, interest-bearing deposits, federal funds sold and securities
purchased under agreements to resell.
The Bank is required to maintain reserves in accordance with Regulation D of the
Federal Reserve Act. The total average reserve balances maintained were $105.1,
$87.8 and $83.8 million during the years ended September 30, 1996, 1995 and
1994, respectively.
LOANS HELD FOR SALE
The Bank engages in mortgage banking activities. At September 30, 1996 and 1995,
loans held for sale are composed of single-family residential loans originated
or purchased for sale in the secondary market and are carried at aggregate cost
which is lower than aggregate market value. Single-family residential loans held
for sale will either be sold or will be exchanged for mortgage-backed securities
and then sold. Gains and losses on sales of whole loans held for sale are
determined using the specific identification method. See "Trading Securities."
LOANS HELD FOR SECURITIZATION AND SALE
The Bank periodically securitizes and sells certain pools of loan receivables in
the public and private markets. These securitizations are recorded as sales.
Gains on the sale of loans are limited to amounts related to loans existing at
the date of sale and do not include amounts related to future loans expected to
be sold during the reinvestment period, if any. In the case of credit card
receivables, because of the relatively short average life of the loans, no gain
or loss is recorded at the time of sale. Rather, loan servicing fees are
recognized over the life of the transaction when earned and transaction expenses
are deferred and amortized over the reinvestment period of the transaction as a
reduction of loan servicing fees. In the case of home equity credit line,
automobile and home loan receivables, gains or losses, net of related
transaction expenses, are recorded at the time of the sale and the resultant
excess spread and mortgage servicing assets are amortized over the life of the
transaction.
Loans held for securitization and sale are the lesser of loans eligible for
securitization or loans that management contemplates to securitize within six
months. Such loans held for securitization and sale are reported at the lower of
aggregate cost or aggregate market value for each asset type.
F-12
INVESTMENT SECURITIES AND MORTGAGE-BACKED SECURITIES
The Bank classifies its investment and mortgage-backed securities as either
"held-to-maturity," "available-for-sale" or "trading" at the time such
securities are acquired. Effective October 1, 1993, in connection with the
adoption of Statement of Financial Accounting Standards ("SFAS") No. 115,
"Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"),
the Bank classified all of its investment and mortgage-backed securities as
available-for-sale.
During fiscal 1995, the Bank transferred all of its investment securities and
mortgage-backed securities previously classified as available-for-sale to
held-to-maturity and, as a result, all investment securities and mortgage-backed
securities are classified as held-to-maturity at September 30, 1996 and 1995.
These securities were transferred at their fair value. Net unrealized holding
losses, net of the related income tax effect, amounting to $3.5 million as of
the date of the transfer, and $1.9 million as of September 30, 1996, continue to
be reported as a separate component of stockholders' equity and are being
amortized to income over the remaining lives of the securities using the
level-yield method.
Premiums and discounts on investment securities and mortgage-backed securities
are amortized or accreted using the level-yield method. Realized gains and
losses are determined using the specific identification method.
TRADING SECURITIES
As part of its mortgage banking activities, the Bank exchanges loans held for
sale for mortgage-backed securities and then sells the mortgage-backed
securities, which are classified as trading securities, to third party investors
in the month of issuance. Proceeds from sales of trading securities were $363.4,
$239.1 and $688.8 million during the years ended September 30, 1996, 1995 and
1994, respectively. The Bank realized a net gain of $1.2 million, a net loss of
$600,000 and a net gain of $1.7 million on the sales of trading securities for
the years ended September 30, 1996, 1995 and 1994, respectively. Gains and
losses on sales of trading securities are determined using the specific
identification method. There were no securities classified as trading securities
at September 30, 1996 and 1995.
LOAN ORIGINATION AND COMMITMENT FEES
Nonrefundable loan fees, such as origination and commitment fees, and
incremental loan origination costs relating to loans originated or purchased are
deferred. Net deferred fees (costs) related to loans held for investment are
amortized over the life of the loan using the level-yield or straight-line
method. Net fees (costs) related to loans held for sale are deferred until such
time as the loan is sold, at which time the net deferred fees (costs) become a
component of the gain or loss on sale.
CREDIT CARD FEES AND COSTS
Credit card membership fees are deferred and recognized as income on a
straight-line basis over the period the fee entitles the cardholder to use the
card, which is one year. Credit card origination costs are deferred and
recognized as a reduction of income on a straight-line basis over the privilege
period which is generally one year.
F-13
IMPAIRED LOANS
A loan is considered impaired when, based on all current information and events,
it is probable that the Bank will be unable to collect all amounts due according
to the contractual terms of the agreement, including all scheduled principal and
interest payments. Such impaired loans are measured based on the present value
of expected future cash flows, discounted at the loan's effective interest rate
or, as a practical expedient, impairment may be measured based on the loan's
observable market price, or, if the loan is collateral-dependent, the fair value
of the collateral. When the measure of the impaired loan is less than the
recorded investment in the loan, the impairment is recorded through a valuation
allowance. Loans for which foreclosure is probable continue to be accounted for
as loans. Certain credit card loans for which customers have agreed to modified
payment terms are also classified as impaired loans.
Each impaired real estate loan is evaluated individually to determine the income
recognition policy. Generally, payments received are applied in accordance with
the contractual terms of the note or as a reduction of principal. Interest
income on impaired credit card loans is recognized using the current interest
rate of the loan and the accrual method. When loans become 90 days past due, all
accrued interest is reserved and the loan is placed on non-accrual status.
Interest income on non-accrual credit card loans is recognized when received.
At September 30, 1996, the Bank had two impaired real estate loans with an
aggregate book value of $1.3 million, before the related allowance for losses of
$364,000. At September 30, 1995, the Bank had one impaired real estate loan with
a book value of $698,000. At September 30, 1996, the Bank had impaired credit
card loans with a carrying value of $55.9 million, before the related allowance
for losses of $4.0 million. At September 30, 1995, the Bank had impaired credit
card loans with a carrying value of $36.7 million, before the related allowance
for losses of $3.7 million, respectively. The average recorded investment in
impaired credit card and real estate loans for the years ended September 30,
1996, 1995 and 1994 was $49.8, $33.5 and $39.0 million, respectively. The Bank
recognized interest income of $7.3, $5.3 and $2.4 million on its impaired loans
for the years ended September 30, 1996, 1995 and 1994, respectively.
ALLOWANCES FOR LOSSES
Management reviews the loan, real estate held for investment and real estate
held for sale portfolios to establish allowances for estimated losses. The
allowances for losses are reviewed periodically, and allowances are provided
after consideration of the borrower's financial condition and/or the estimated
value of collateral or real estate, including estimated selling and holding
costs. Allowances are also provided by management after considering such factors
as the economy in lending areas, delinquency statistics, past loss experience
and estimated future losses.
The allowances for losses are based on estimates, and ultimate losses may vary
from current estimates. As adjustments to the allowances become necessary,
provisions for losses are reported in operations in the periods they are
determined to be necessary.
ACCRUED INTEREST RECEIVABLE ON LOANS
Loans are reviewed on a monthly basis and are placed on non-accrual status when,
in the opinion of management, the full collection of principal or interest has
become unlikely. Uncollectible accrued interest receivable on non-accrual loans
is charged against current period interest income.
F-14
REAL ESTATE HELD FOR INVESTMENT OR SALE
REAL ESTATE HELD FOR INVESTMENT
At September 30, 1996 and 1995, real estate held for investment consists of
developed land owned by one of the Bank's subsidiaries. Real estate held for
investment is carried at the lower of aggregate cost or net realizable value.
See Note 12.
REAL ESTATE HELD FOR SALE
Real estate held for sale consists of real estate acquired in settlement of
loans ("REO") and is carried at the lower of cost or fair value. Costs relating
to the development and improvement of property, including interest, are
capitalized, whereas costs relating to the holding of property are expensed.
Capitalized interest amounted to $3.5, $4.5 and $4.4 million for the years ended
September 30, 1996, 1995 and 1994, respectively.
PROPERTY AND EQUIPMENT
Property and equipment is stated at cost, net of accumulated depreciation and
amortization. Depreciation and amortization are computed using the straight-line
method which allocates the cost of the applicable assets over their estimated
useful lives. Major improvements and alterations to office premises and
leaseholds are capitalized. Leasehold improvements are amortized over the
shorter of the terms of the respective leases (including renewal options that
are expected to be exercised) or 20 years. Maintenance and repairs are charged
to operating expenses as incurred.
COST IN EXCESS OF NET ASSETS ACQUIRED
Cost in excess of net assets acquired is stated net of accumulated amortization
and is being amortized using the straight-line method generally over a period of
15 years. Accumulated amortization was $35.2 and $33.3 million at September 30,
1996 and 1995, respectively.
MORTGAGE SERVICING RIGHTS
Effective July 1, 1995, the Bank adopted SFAS No. 122, "Accounting for Mortgage
Servicing Rights" ("SFAS 122"), an amendment of SFAS No. 65, "Accounting for
Certain Mortgage Banking Activities." SFAS 122 requires that a mortgage banking
enterprise recognize, as separate assets, rights to service mortgage loans for
others, however those servicing rights are acquired. Under previous accounting
guidance, separate mortgage servicing assets were generally recognized only when
purchased. A mortgage banking enterprise that acquires mortgage servicing rights
through either purchase or origination of mortgage loans and sells or
securitizes those loans with servicing rights retained must allocate the total
cost of the mortgage loans to the mortgage servicing rights and the loans
(without the mortgage servicing rights) based on their relative fair values.
Mortgage servicing rights, which are stated net of accumulated amortization, are
being amortized in proportion to the remaining net revenues estimated to be
generated by the underlying mortgage servicing rights. Amortization of these
assets amounted to $7.8, $2.2 and $6.1 million for the years ended September 30,
1996, 1995 and 1994, respectively. Accumulated amortization was $47.7 and $39.9
million at September 30, 1996 and 1995, respectively. During fiscal 1996, 1995
and 1994, the Bank capitalized $16.1, $16.3 and $0.9 million respectively,
related to the acquisition of mortgage servicing rights.
During fiscal 1996, the Bank sold $947,000 of rights to service mortgage loans
with principal balances of $59.7 million which were originated by the Bank in
connection with its mortgage banking activities. In fiscal 1995 and 1994, the
Bank sold the rights to service mortgage loans with principal balances of $148.1
and $383.9 million, respectively, which were originated by the Bank in
connection with its mortgage banking activities, and recognized gains of $1.4
and $5.8 million, respectively.
F-15
The Bank periodically evaluates its mortgage
servicing rights for impairment based upon fair value. To measure fair value of
its mortgage servicing rights, the Bank uses either quoted market prices or
discounted cash flow analyses using appropriate assumptions for servicing fee
income, servicing costs, prepayment rates and discount rates. Additionally, the
Bank stratifies its capitalized mortgage servicing rights for purposes of
evaluating impairment taking into consideration relevant risk characteristics
including loan type, note rate and date of acquisition. The aggregate fair value
of capitalized mortgage servicing rights at September 30, 1996 was $37.7
million. The Bank recorded valuation allowances on its mortgage servicing rights
of $3.1 million during fiscal 1996. No valuation allowances were recorded during
fiscal 1995.
EXCESS SPREAD ASSETS
When loans are sold with the servicing rights retained by the Bank, the net
present value of estimated future spread income in excess of normal servicing
income is recorded as an adjustment to the sales price of the loans. Estimated
future losses are deducted in the computation of such excess spread income. The
resulting assets are amortized using the level-yield ("interest") method over
the estimated lives of the underlying loans. Amortization of these assets
amounted to $17.8, $14.5 and $13.5 million for the years ended September 30,
1996, 1995 and 1994, respectively. Accumulated amortization was $98.3 and $80.5
million at September 30, 1996 and 1995, respectively. Excess spread assets
capitalized in fiscal 1996, 1995 and 1994 of $34.7, $15.0 and $11.1 million,
respectively, were the result of the excess spread retained upon the
securitization and sale of home equity credit line, automobile and home loan
receivables. See Note 15.
Management periodically evaluates the carrying value of excess spread assets
taking into consideration current portfolio factors such as prepayment rates.
The Bank's analyses are performed on a discounted cashflow basis. Any
adjustments to the carrying value of such assets as a result of this evaluation
are recorded as a valuation adjustment.
INTEREST RATE CAP AGREEMENTS
Premiums paid for interest rate cap agreements are included in other assets in
the Consolidated Balance Sheets and are amortized to expense over the terms of
the interest rate caps on a straight-line basis. Funds payable to the Bank are
recognized as income in the month such funds are earned. At September 30, 1996
and 1995, unamortized premiums amounted to $6.2 and $10.0 million, respectively.
See Note 27.
ACCOUNTING STANDARDS ISSUED BUT NOT YET ADOPTED
SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities" ("SFAS 125"), was issued in June 1996. SFAS 125
provides accounting and reporting standards for transfers and servicing of
financial assets and extinguishments of liabilities. Those standards are based
on consistent application of a "financial-components approach" that focuses on
control. Under that approach, upon the transfer of financial assets, an entity
recognizes the financial and servicing assets it controls and the liabilities it
has incurred, derecognizes financial assets when control has been surrendered,
and derecognizes liabilities when extinguished.
SFAS 125 supersedes SFAS No. 76, "Extinguishment of Debt," and SFAS No. 77,
"Reporting by Transferors for Transfers of Receivables with Recourse." It amends
SFAS 115, to clarify that a debt security may not be classified as
held-to-maturity if it can be prepaid or otherwise settled in such a way that
the holder of the security would not recover substantially all of its recorded
investment. SFAS 125 amends and extends to all servicing assets and liabilities
the accounting standards for mortgage servicing rights now in SFAS No. 65,
"Accounting for Certain Mortgage Banking Activities," and supersedes SFAS 122.
SFAS 125 is effective for transfers and servicing of financial assets and
extinguishments of liabilities occurring after December 31, 1996. The impact of
the adoption of SFAS 125 on the Trust's financial statements has not yet been
determined.
F-16
1. LIQUIDITY AND CAPITAL RESOURCES - REAL ESTATE TRUST
Historically, the Real Estate Trust's total cash requirements have exceeded the
cash generated by its operations. As described below, this condition persisted
in 1996 and is expected to continue for the foreseeable future. The cash flow
generated by the Real Estate Trust's income-producing properties has been
sufficient to meet its cash needs other than the repayment of principal on
outstanding debt, the payment of interest on the Senior Secured Notes (as
defined below), and the payment of capital improvement costs. In the past, the
Real Estate Trust funded such shortfalls through a combination of external
funding sources, primarily new financings (including sale of Unsecured Notes),
refinancings of maturing mortgage debt, asset sales and tax sharing payments
from the Bank.
The Real Estate Trust's ability to meet its liquidity needs will depend in
significant part on its receipts of tax sharing payments and dividends from the
Bank. The availability and amount of dividends and tax sharing payments in
future periods, is dependent upon, among other things, the Bank's operating
performance, regulatory restrictions on such payments and (in the case of tax
sharing payments) the continued consolidation of the Bank and the Trust for
federal income tax purposes.
Management anticipates that the Trust will continue to file a consolidated
federal income tax return and that the Bank will operate in a profitable manner
enabling it to generate tax sharing payments. Management also anticipates that
such tax sharing payments will be approved by the OTS in amounts sufficient to
enable the Real Estate Trust to meet its liquidity needs. Nonetheless, should
tax sharing payments not be paid during the next twelve months, management
estimates that the Real Estate Trust has adequate liquidity to fund its cash
flow requirements.
On March 30, 1994 the Real Estate Trust issued $175.0 million principal amount
of 11 5/8% Senior Secured Notes due 2002 (the "Senior Secured Notes"). After
paying offering expenses of $8.9 million, third-party mortgage indebtedness of
$74.1 million, and affiliate indebtedness of $8.9 million, the Real Estate Trust
retained $83.1 million of the net proceeds of the offering for application to
general corporate purposes, including a loan to an affiliate of $15.0 million.
Approximately $25.8 million was deposited with the Trustee for the Senior
Secured Notes to satisfy one of the initial collateral requirements. See Note 4.
Concurrently with the application of the net proceeds of the offering to repay
third-party mortgage indebtedness, the terms of certain of the mortgage loans
repaid in part were modified to waive deferred interest, reduce interest rates
and extend maturities. After the application of such net proceeds and the
modification of such loans, the final maturity of loans with total balances of
$111.1 million was 12 years and the final maturity of a loan with a balance of
$15.1 million was 15 years.
During fiscal 1994, 1995 and 1996, the Trust purchased either in the open market
or through dividend reinvestment 1,445,132 shares of common stock of Saul
Centers, Inc. (representing 12.0% of such company's outstanding common stock).
All of these shares have been deposited with the Trustee for the Senior Secured
Notes to satisfy in part the collateral requirements for those securities,
thereby permitting release to the Trust of a portion of the cash on deposit with
the Trustee.
The Senior Secured Notes are secured, general obligations of the Trust ranking
pari passu with all other unsubordinated obligations of the Trust, including the
Unsecured Notes. The Senior Secured Notes are secured by a first-priority
perfected security interest in the Trust's 80% interest in the Bank. The Senior
Secured Note Indenture contains convenants that, among other things, restrict
the ability of the Trust and/or its subsidiaries (excluding, in most cases, the
Bank and the Bank's subsidiaries) to incur additional indebtedness, make loans
to affiliates, make investments, sell assets, pay dividends or make
distributions to holders of the Trust's capital stock.
The Real Estate Trust's current program of public Unsecured Note sales was
initiated in the 1970's as a vehicle for supplementing other external funding
sources. The Real Estate Trust is currently selling Unsecured Notes principally
to pay outstanding Unsecured Notes as they mature. In paying maturing Unsecured
Notes with proceeds of new Unsecured Note sales, the Real Estate Trust
effectively is refinancing its outstanding Unsecured Notes with similar new
unsecured debt. To the degree that the Real Estate Trust does not sell new
Unsecured Notes in an amount sufficient to finance completely the scheduled
repayment of outstanding Unsecured Notes as they mature, it will be required to
finance such repayments from other sources of funds.
F-17
The Bank has agreed not to make any additional tax sharing payments to the Real
Estate Trust without the prior approval of the OTS. In June 1993, after
receiving approval of the OTS, the Bank made a $5.0 million payment to the Real
Estate Trust pursuant to the tax sharing agreement between the Bank and the Real
Estate Trust. OTS approval of this payment was conditioned on a pledge by or on
behalf of the Real Estate Trust of certain assets to secure certain of its
obligations under the Tax Sharing Agreement. Following execution of the pledge,
the OTS approved, and the Bank made tax sharing payments to the Real Estate
Trust of $9.6, $20.5 and $25.0 million during fiscal 1994, 1995 and 1996,
respectively.
The Real Estate Trust received no cash dividends from the Bank during fiscal
1994 or fiscal 1995. In fiscal 1996 the Real Estate Trust received $6.8 million
in cash dividends from the Bank. Receipt of cash dividends in the future will
depend on the Bank's earnings and regulatory capital levels, among other
factors. The Bank's written agreement with the OTS was amended in October 1993
to eliminate the requirement that the Bank obtain the written approval of the
OTS before declaring or paying any dividends on its common stock. Nonetheless,
the OTS must be notified regarding dividends declared or paid.
As the owner, directly and through a wholly owned subsidiary, of a 21.5% limited
partnership interest in Saul Holdings Limited Partnership, the Real Estate Trust
shares in cash distributions from operations and from capital transactions
involving the sale of properties. See Note 2. The partnership agreement provides
for quarterly cash distributions to the partners out of net cash flow. During
fiscal 1994, 1995 and 1996, the Real Estate Trust received distributions in the
amount of $4.6, $5.5 and $5.5 million, respectively, from Saul Holdings Limited
Partnership.
In fiscal 1995, the Real Estate Trust established a $15.0 million secured
revolving credit line to provide it with additional liquidity. In fiscal 1996,
the Real Estate Trust established a second secured revolving credit line for
$8.0 million. See Note 4.
While the Real Estate Trust's ability to satisfy its liquidity requirements is
contingent on future events, which include the sale of new Unsecured Notes in
amounts sufficient to finance most of the scheduled maturities of outstanding
Unsecured Notes and the Bank's ability to pay tax sharing payments and
dividends, the Real Estate Trust believes it will be able to consummate the
transactions described above as well as explore other financing opportunities in
order to raise sufficient proceeds to fund its liquidity requirements.
F-18
2. SAUL HOLDINGS LIMITED PARTNERSHIP - REAL ESTATE TRUST
In late August 1993, the Real Estate Trust entered into a series of transactions
undertaken in connection with an initial public offering of common stock of a
newly organized corporation, Saul Centers, Inc. ("Saul Centers"). The Real
Estate Trust transferred its 22 shopping centers and one of its office
properties together with the debt associated with such properties to a newly
formed partnership, Saul Holdings Limited Partnership ("Saul Holdings"), in
which the Real Estate Trust owns (directly or through one of its wholly owned
subsidiaries) a 21.5% interest, other entities affiliated with the Real Estate
Trust own a 5.5% interest, and Saul Centers owns a 73.0% interest. B. Francis
Saul II, Chairman of the Board of Trustees of the Trust, is also Chairman of the
Board of Directors and Chief Executive Officer of Saul Centers, which is the
sole general partner of Saul Holdings. The Real Estate Trust has pledged 54% of
its interest in Saul Holdings to the Bank related to payments under the Tax
Sharing Agreement.
In connection with the transfer of its properties to Saul Holdings, the Real
Estate Trust was relieved of approximately $196 million in mortgage debt and
deferred interest. Pursuant to a reimbursement agreement among the partners of
Saul Holdings and its subsidiary limited partnerships (collectively, the
"Partnerships"), the Real Estate Trust and its subsidiaries that are partners in
the Partnerships have agreed to reimburse Saul Centers and the other partners in
the event the Partnerships fail to make payments with respect to certain
portions of the Partnerships' debt obligations and Saul Centers or any such
other partners personally make payments with respect to such debt obligations.
At September 30, 1996, the maximum potential obligations of the Real Estate
Trust and its subsidiaries under this agreement totaled approximately $115.5
million.
The fair market value of each of the properties contributed to the Partnerships
by the Real Estate Trust at the date of transfer (the FMV of each such property)
exceeded the tax basis of such property (with respect to each property, such
excess is referred to as the FMV-Tax Difference). In the event Saul Centers, as
general partner of the Partnerships, causes the Partnerships to dispose of one
or more of such properties, a disproportionately large share of the total gain
for federal income tax purposes would be allocated to the Real Estate Trust or
its subsidiaries. In general, if the gain recognized by the Partnerships on a
property disposition is less than or equal to the FMV-Tax Difference for such
property (as previously reduced by the amounts of special tax allocations of
depreciation deductions to the partners), a gain equal to the FMV-Tax Difference
(as adjusted) will be allocated to the Real Estate Trust. To the extent the gain
recognized by the Partnerships on the property disposition exceeds the FMV-Tax
Difference (as adjusted), such excess generally will be allocated among all the
partners in Saul Holdings based on their relative percentage interests. In
general, the amount of gain allocated to the Real Estate Trust in the event of
such a property disposition is likely to exceed, perhaps substantially, the
amount of cash, if any, distributable to the Real Estate Trust as a result of
the property disposition. In addition, future reductions in the level of the
Partnerships' debt, or any release of the guarantees of such debt by the Real
Estate Trust, could cause the Real Estate Trust to have taxable constructive
distributions without the receipt of any corresponding amounts of cash.
Currently, management does not intend to seek a release of or a reduction in the
guarantees or to convert its limited partner units in Saul Holdings into shares
of Saul Centers common stock.
At the date of transfer of the Real Estate Trust properties to Saul Holdings,
liabilities exceeded assets transferred by approximately $104.3 million on an
historical cost basis. The assets and liabilities were recorded by Saul Holdings
and Saul Centers at their historical cost rather than market value because of
affiliated ownership and common management and because the assets and
liabilities were the subject of the business combination between Saul Centers
and Saul Holdings, newly formed entities with no prior operations.
Immediately subsequent to the business combination and initial public offering
of common stock by Saul Centers, Saul Centers had total owners' equity of
approximately $16.4 million of which approximately $3.5 million related to the
Real Estate Trust's 21.5% ownership interest. Recognition by the Real Estate
Trust of the change in its investment in the properties of approximately $107.8
million has been deferred due to the Real Estate Trust's guarantee of $115.5
million under the Saul Centers reimbursement agreement. The deferred gain of
$107.8 million is included in "Deferred gains - real estate" in the financial
statements. The gain will be recognized in future periods to the extent the Real
Estate Trust's obligations are terminated under the reimbursement agreement.
F-19
The management of Saul Centers has adopted a strategy of maintaining a ratio of
total debt to total asset value, as estimated by management, of fifty percent or
less. The management of Saul Centers has concluded at September 30, 1996 that
the total debt of Saul Centers remains below fifty percent of total asset value.
As a result, the management of the Real Estate Trust has concluded that fundings
under the reimbursement agreement are remote.
In addition to the deferred gains, as of September 30, 1996, the Real Estate
Trust's investment in the consolidated entities of Saul Centers, which is
accounted for under the equity method, consisted of the following.
(In thousands)
- ---------------------------------------------------------------------
Saul Holdings:
Distributions in excess of allocated net income $ (4,221)
Saul Centers:
Acquisition of common shares 22,916
Distributions in excess of allocated net income (2,258)
-------------
Total $ 16,437
=============
The $16.4 million balance is included in "Other assets" in the financial
statements.
As of September 30, 1996, the Real Estate Trust, through its partnership
interest in Saul Holdings and its ownership of 1,445,132 common shares of Saul
Centers, effectively owns 30.0% of the consolidated entities of Saul Centers.
The Condensed Consolidated Balance Sheet at September 30, 1996 and 1995, and the
Condensed Consolidated Statements of Operations for the twelve-month periods
ended September 30, 1996, 1995 and 1994 of Saul Centers follow.
F-20
SAUL CENTERS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
September 30,
-----------------------------------------
(IN THOUSANDS) 1996 1995
-------------------- --------------------
ASSETS
Real estate investments $ 335,137 $ 315,221
Accumulated depreciation (99,349) (89,871)
Other assets 33,986 44,181
-------------------- --------------------
TOTAL ASSETS $ 269,774 $ 269,531
==================== ====================
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Notes payable $ 276,981 $ 268,100
Other liabilities 15,583 13,882
-------------------- --------------------
Total liabilities 292,564 281,982
Total stockholders' equity (deficit) (22,790) (12,451)
-------------------- --------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) $ 269,774 $ 269,531
==================== ====================
SAUL CENTERS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
For the Twelve Months Ended September 30
--------------------------------------------------------------
(IN THOUSANDS) 1996 1995 1994
-------------------- -------------------- --------------------
REVENUE
Base rent $ 49,646 $ 46,606 $ 42,757
Other revenue 13,727 14,173 13,192
-------------------- -------------------- --------------------
TOTAL REVENUE 63,373 60,779 55,949
-------------------- -------------------- --------------------
EXPENSES
Operating expenses 14,407 13,703 14,496
Interest expense 18,200 17,271 12,213
Amortization of deferred debt expense 2,921 2,254 2,599
Depreciation and amortization 10,978 9,996 9,101
General and administrative 3,071 2,967 2,789
-------------------- -------------------- --------------------
TOTAL EXPENSES 49,577 46,191 41,198
-------------------- -------------------- --------------------
Operating income before extraordinary
item and minority interest 13,796 14,588 14,751
Extraordinary item - loss on early
extinguishment of debt (998) -- (3,341)
-------------------- -------------------- --------------------
Net income before minority interest 12,798 14,588 11,410
Minority interest (6,852) (6,855) (3,524)
-------------------- -------------------- --------------------
NET INCOME $ 5,946 $ 7,733 $ 7,886
==================== ==================== ====================
F-21
3. INVESTMENT PROPERTIES - REAL ESTATE TRUST
The following table summarizes the cost basis of income-producing properties and
land parcels together with their related debt.
Buildings and Leasehold Related
(Dollars in thousands) No. Land Improvements Interests Total Debt
- --------------------------------- ------- ---------------- --------------- ---------------- --------------- ----------------
September 30, 1996:
Income-producing properties
Hotels 9 $ 9,662 $ 111,755 $ -- $ 121,417 $ 75,654
Commercial 7 4,469 102,027 -- 106,496 77,888
Other 7 3,575 991 149 4,715 --
------- ---------------- --------------- ---------------- --------------- ----------------
23 $ 17,706 $ 214,773 $ 149 $ 232,628 $ 153,542
======= ================ =============== ================ =============== ================
Land Parcels 9 $ 41,580 $ -- $ -- $ 41,580 $ 23,662
======= ================ =============== ================ =============== ================
September 30, 1995:
Income-producing properties
Hotels 10 $ 9,885 $ 112,764 $ -- $ 122,649 $ 79,745
Commercial 8 5,670 105,976 -- 111,646 81,871
Other 7 3,575 908 149 4,632 308
------- ---------------- --------------- ---------------- --------------- ----------------
25 $ 19,130 $ 219,648 $ 149 $ 238,927 $ 161,924
======= ================ =============== ================ =============== ================
Land Parcels 10 $ 38,548 $ -- $ -- $ 38,458 $ 26,202
======= ================ =============== ================ =============== ================
F-22
4. DEBT - REAL ESTATE TRUST
Mortgage notes payable are secured by various income-producing properties and
land parcels. Almost all mortgage notes are payable in monthly installments,
have maturity dates ranging to 2009 and accrue interest at annual rates from
7.6% to 10.0%. Certain mortgages contain a number of restrictions, including
cross default provisions.
The Real Estate Trust obtained a $5.0 million secured loan from an affiliate in
August 1992. Interest accrued at prime plus 1.5%. The loan was repaid during
fiscal 1994.
In December 1992, the Trust completed the sale to an institutional investor, for
$25 million, of 100% of the preferred stock of a newly organized Trust
subsidiary to which the Trust contributed certain real estate and other assets.
The assets contributed included six shopping centers and one office building,
several parcels of unencumbered raw land, and a capital note in the amount of
$58 million secured by a junior lien on 30% of the Bank's stock. The net
proceeds of the transaction were lent by the subsidiary to the Trust in exchange
for notes of the Trust secured by specified real estate properties and other
assets of the Trust (the "Trust Notes"). Such proceeds were applied by the Trust
for its general corporate purposes, with approximately $2.3 million of such
proceeds being reserved for capital improvements to certain of the real estate
properties contributed to the new subsidiary. In late August 1993, the Real
Estate Trust was relieved of approximately $196 million in mortgage debt and
deferred interest in connection with the formation of Saul Holdings (See Note
2). As a part of this transaction, the preferred stock issued to the
institutional investor was redeemed in exchange for the Trust Notes and the
pledge of all of the stock of the Trust subsidiary, together with $60 million,
at their then-market value, of the Real Estate Trust's partnership interests in
Saul Holdings. During fiscal 1994, the Trust Notes were repaid and the
collateral was released.
On March 30, 1994, the Real Estate Trust issued $175.0 million aggregate
principal amount of its Senior Secured Notes. The Senior Secured Notes are
general obligations of the Real Estate Trust ranking pari passu with all other
unsubordinated obligations of the Trust and are secured by a first priority
perfected security interest in 80% (8,000 shares) of the issued and outstanding
common stock of the Bank and by certain other assets of the Trust as described
herein. After paying offering expenses of $8.9 million, third-party mortgage
indebtedness of $74.1 million, and affiliate indebtedness of $8.9 million, the
Real Estate Trust retained $83.1 million of the net proceeds of the offering for
application to general corporate purposes, including a loan to an affiliate of
$15.0 million. Of the remaining amount, approximately $25.8 million was
deposited with the Trustee for the Senior Secured Notes to satisfy one of the
initial collateral requirements with respect to such securities. This collateral
requirement, which will remain in effect as long as any Senior Secured Notes are
outstanding, will be recalculated each calendar quarter based on the estimated
amount of one year's interest payments on then outstanding Senior Secured Notes
and Unsecured Notes. Concurrently with the application of the net proceeds of
the offering to repay third-party mortgage indebtedness, the terms of certain of
the mortgage loans repaid in part were modified to waive deferred interest,
reduce interest rates and extend maturities. After the application of such net
proceeds and the modification of such loans, the final maturity of loans with
total balances of $111.1 million was 12 years and the final maturity of a loan
with a balance of $15.1 million was 15 years. The Real Estate Trust has
deposited all of its 1,445,132 shares of common stock of Saul Centers (See Note
1) with the Trustee for the Senior Secured Notes to satisfy in part the
collateral requirements for those securities. The Senior Secured Notes may be
redeemed in whole or in part at any time on or after April 1, 1998, subject to,
among other things, prepayment premiums.
In the fourth quarter of fiscal 1995, the Real Estate Trust established a $15.0
million secured revolving credit line with a bank. This facility is for a
two-year period and may be extended for one or more additional one-year terms.
Interest is computed by reference to a floating rate index. As collateral for
the facility, the Real Estate Trust has pledged 30.5% of its interest in Saul
Holdings. Borrowings under the facility at year end totaled $2.5 million and
unrestricted availability amounted to $4.6 million.
In the first quarter of fiscal 1996, the Real Estate Trust established an $8.0
million secured revolving credit line with a bank. This facility is for a
one-year period, after which the loan amount amortizes over a two-year period.
Interest is computed by reference to a floating index. At September 30, 1996,
availability under this facility was entirely restricted pending the delivery of
collateral by the Real Estate Trust.
F-23
Notes payable - unsecured includes notes which have been sold by the Real Estate
Trust directly to investors at varying interest rates with maturities of one to
ten years. These notes do not contain any provisions for conversion, sinking
fund or amortization. Notes sold after November 14, 1986, are subject to a
provision permitting the Real Estate Trust to call them prior to maturity. The
weighted average interest rates at September 30, 1996 and 1995 were 10.4% and
10.5%, respectively. During fiscal 1996 and 1995, the Real Estate Trust sold
notes amounting to approximately $7.4 and $8.0 million, respectively.
The maturity schedule for the Real Estate Trust's outstanding debt at September
30, 1996 for the fiscal years commencing October 1, 1996 is set forth in the
following table.
DEBT MATURITY SCHEDULE
(In thousands)
------------------------------------------------------------------------------
Notes Notes
Fiscal Mortgage Payable - Payable -
Year Notes Secured Unsecured Total
- -------------- -------------- ------------- -------------- --------------
1997 $ 17,994 $ 2,500 $ 5,751 $ 26,245
1998 7,413 -- 7,413 14,826
1999 17,076 -- 15,986 33,062
2000 18,856 -- 6,080 24,936
2001 5,075 -- 3,822 8,897
Thereafter 106,931 175,000 3,315 285,246
-------------- ------------- -------------- --------------
Total $ 173,345 $ 177,500 $ 42,367 $ 393,212
- ------------------------------------------------------------------------------
5. LONG-TERM LEASE OBLIGATIONS - REAL ESTATE TRUST
The Real Estate Trust has one noncancelable long-term lease which provides for
periodic adjustments of the basic annual rent. This lease will expire in 2061.
The minimum future rental commitments under this lease amount to $101,000 per
year for the next five fiscal years; thereafter, the total commitment is $5.9
million.
The Real Estate Trust paid minimum ground rent expense of $101,000, $101,000 and
$102,000 in fiscal 1996, 1995 and 1994, respectively. In addition to the minimum
ground rent payments, real estate taxes on the land are an obligation of the
Real Estate Trust.
6. INCOME FROM COMMERCIAL PROPERTIES - REAL ESTATE TRUST
Income from commercial properties consists of minimum rent arising from
noncancelable commercial leases. Minimum rent for fiscal years 1996, 1995, and
1994 amounted to $16.8, $17.9 and $15.9 million, respectively. Future minimum
rentals as of September 30, 1996 under noncancelable leases are as follows:
Fiscal
Year (In thousands)
---------------------------------------
1997 $ 16,945
1998 14,453
1999 11,272
2000 8,098
2001 6,002
Thereafter 11,417
---------------------------------------
F-24
7. TRANSACTIONS WITH RELATED PARTIES - REAL ESTATE TRUST
TRANSACTIONS WITH B. F. SAUL COMPANY AND ITS SUBSIDIARIES
The Real Estate Trust is managed by B. F. Saul Advisory Company (the Advisor), a
wholly-owned subsidiary of B. F. Saul Company ("Saul Co."). All of the Real
Estate Trust officers and three Trustees of the Trust are also officers and/or
directors of Saul Co. The Advisor is paid a fixed monthly fee which is subject
to annual review by the Trustees. The monthly fee was $250,000 during the period
October 1993 through March 1994, $292,000 during the period April 1994 through
September 1995, $301,000 during the period October 1995 through March 1996, and
$306,000 during the period April 1996 through September 1996. The advisory
contract has been extended until September 30, 1997, and will continue
thereafter unless canceled by either party at the end of any contract year.
Certain loan agreements prohibit termination of this contract.
Saul Co. and Franklin Property Company ("Franklin"), a wholly-owned subsidiary
of Saul Co., provide services to the Real Estate Trust through commercial
property management and leasing, hotel management, development and construction
management, and acquisitions, sales and financings of real property. Fees paid
to Saul Co. and Franklin amounted to $4.8, $4.8 and $4.5 million in fiscal 1996,
1995 and 1994, respectively.
The Real Estate Trust reimburses the Advisor and Franklin for costs and expenses
incurred in connection with the acquisition and development of real property on
behalf of the Real Estate Trust, in-house legal expenses, and for all travel
expenses incurred in connection with the affairs of the Real Estate Trust.
The Real Estate Trust pays the Advisor fees equal to 1% of the principal amount
of the unsecured notes as they are issued to offset its costs of administering
the program. These payments amounted to $74,000, $80,000 and $157,000 in fiscal
1996, 1995 and 1994, respectively.
A subsidiary of Saul Co. is a general insurance agency which receives
commissions and countersignature fees in connection with the Real Estate Trust's
insurance program. Such commissions and fees amounted to approximately $152,000,
$158,000 and $157,000 in fiscal 1996, 1995 and 1994, respectively.
The Real Estate Trust had a working capital loan from the Saul Co. of
approximately $3.3 million as of September 30, 1993, bearing interest of 1/2
percent over prime per annum. The funds were repaid in March 1994.
Interest paid on this loan in fiscal 1994 amounted to $139,000.
In April 1994 the Real Estate Trust made an unsecured loan to the Saul Company
of $15.0 million bearing interest at 1/2 percent over prime and due on demand.
In fiscal 1995 the loan balance was reduced to $12.7 million. In fiscal 1996,
the Real Estate Trust made new loans aggregating $3.5 million to the Saul
Company. Interest accrued on these loans in fiscal 1996, 1995 and 1994 amounted
to $1,369,000, $1,180,000 and $565,000, respectively. At September 30, 1996, the
total principal due the Real Estate Trust was $16.2 million.
TRANSACTIONS WITH OTHER AFFILIATES
The Real Estate Trust obtained a $5.0 million secured loan from The Klingle
Corporation in August 1992. It accrued interest at a rate of prime plus 1.5% and
was repaid during fiscal 1994. The Real Estate Trust incurred interest expense
of $193,000 during fiscal 1994.
F-25
REMUNERATION OF TRUSTEES AND OFFICERS
For fiscal years 1996, 1995, and 1994, the Real Estate Trust paid the Trustees
$79,000, $81,000 and $76,000, respectively, for their services. No compensation
was paid to the officers of the Real Estate Trust for acting as such; however,
one Trustee was paid by the Bank for his services as Chairman and Chief
Executive Officer of the Bank, and two received payments for their services as
directors of the Bank. Three of the Trustees and all of the officers of the Real
Estate Trust receive compensation from Saul Co. as directors and/or officers.
LEGAL SERVICES
The law firm in which one of the Trustees is a partner received $0.1, $0.8 and
$1.3 million, excluding expense reimbursements, during fiscal 1996, 1995, and
1994, respectively, for legal services to the Real Estate Trust and its
wholly-owned subsidiaries.
SALE OF AVENEL BUSINESS PARK-PHASE I
In 1984, the Real Estate Trust sold Avenel Business Park-Phase I to an
affiliate, Avenel Associates Limited Partnership (the "Partnership"), for $8.9
million based on an independent appraisal. The managing general partner of the
Partnership was a subsidiary of Saul Co., and a subsidiary of the Bank owned a
45% interest in the Partnership. The Real Estate Trust received the sales price
for the property in the form of cash, a purchase money note in the amount of
$1,735,000 and the assumption of a first trust loan. The net gain realized upon
the sale was $3,023,000, after deducting a $781,000 discount of the purchase
money note due to its below market interest rate. The Real Estate Trust has
continued to defer recognition of this gain pending a sale of the property to an
unaffiliated entity.
In late August 1993, the Partnership sold Avenel Business Park-Phase I to Saul
Holdings and redeemed the purchase money note held by the Real Estate Trust. The
gain has continued to be deferred in accordance with the accounting policy for
gain recognition described in Note 2.
SAUL HOLDINGS LIMITED PARTNERSHIP
The Real Estate Trust accounts for this investment under the equity method. The
Real Estate Trust's share of earnings for fiscal 1996, 1995 and 1994 were $2.7,
$3.1 and $2.4 million, respectively. See Note 2.
OTHER TRANSACTIONS
The Real Estate Trust leases space to the Bank and Franklin at one of its
income-producing properties. Minimum rents and recoveries paid by these
affiliates amounted to approximately $143,000, $55,000 and $51,000, in fiscal
1996, 1995 and 1994, respectively.
F-26
8. LOANS HELD FOR SECURITIZATION AND SALE - THE BANK
Loans held for securitization and sale are composed of the following:
(In thousands) September 30,
- --------------------------------------------------------------------- ------------------------------------
1996 1995
----------------- -----------------
Credit card receivables $ 225,000 $ 300,000
Automobile loan receivables 225,000 200,000
----------------- -----------------
Total $ 450,000 $ 500,000
================= =================
9. INVESTMENT SECURITIES - THE BANK
At September 30, 1996 and 1995, all investment securities are classified as
held-to-maturity. Gross unrealized holding gains and losses on the Bank's
investment securities at September 30, 1996 and 1995 are as follows:
Gross Gross
Unrealized Unrealized Aggregate
Amortized Holding Holding Fair
(In thousands) Cost Gains Losses Value
- -------------------------------------------------- ---------------- ----------------- ----------------- ----------------
September 30, 1996
U.S. Government securities
Maturing within one year $ 4,822 $ 3 $ -- $ 4,825
Maturing after one year,
but within five years 4,996 -- (1) 4,995
---------------- ----------------- ----------------- ----------------
Total U.S. Government securities $ 9,818 $ 3 $ (1) $ 9,820
================ ================= ================= ================
Gross Gross
Unrealized Unrealized Aggregate
Amortized Holding Holding Fair
(In thousands) Cost Gains Losses Value
- -------------------------------------------------- ---------------- ----------------- ----------------- ----------------
September 30, 1995
U.S. Government securities
Maturing within one year $ 4,370 $ 1 $ -- $ 4,371
================ ================= ================= ================
There were no sales of investment securities during the years ended September
30, 1996, 1995 and 1994.
F-27
10. MORTGAGE-BACKED SECURITIES - THE BANK
At September 30, 1996 and 1995, all mortgage-backed securities are classified as
held-to-maturity. Gross unrealized holding gains and losses on the Bank's
mortgage-backed securities at September 30, 1996 and 1995 are as follows:
Gross Gross
Unrealized Unrealized Aggregate
Amortized Holding Holding Fair
(In thousands) Cost Gains Losses Value
- -------------------------------------------------- ---------------- ----------------- ----------------- ----------------
September 30, 1996
FNMA $ 432,527 $ 2,253 $ (162) $ 434,618
FHLMC 792,752 1,266 (2,802) 791,216
Private label, AA-rated 81,138 866 -- 82,004
---------------- ----------------- ----------------- ----------------
Total $ 1,306,417 $ 4,385 $ (2,964) $ 1,307,838
================ ================= ================= ================
Gross Gross
Unrealized Unrealized Aggregate
Amortized Holding Holding Fair
(In thousands) Cost Gains Losses Value
- -------------------------------------------------- ---------------- ----------------- ----------------- ----------------
September 30, 1995
FNMA $ 27,182 $ 50 $ (13) $ 27,219
FHLMC 718,640 833 (1,689) 717,784
Private label, AA-rated 134,386 364 (33) 134,717
---------------- ----------------- ----------------- ----------------
Total $ 880,208 $ 1,247 $ (1,735) $ 879,720
================ ================= ================= ================
There were no sales of mortgage-backed securities from the available-for-sale or
the held-to-maturity portfolios during the years ended September 30, 1996, 1995
and 1994. See Summary of Significant Accounting Policies - The Bank - "Trading
Securities."
Accrued interest receivable on mortgage-backed securities totaled $8.1 and $5.7
million at September 30, 1996 and 1995, respectively, and is included in other
assets in the Consolidated Balance Sheets.
At September 30, 1996, certain mortgage-backed securities were pledged as
collateral for securities sold under repurchase agreements, other short-term
borrowings and other recourse arrangements. See Notes 19 and 27. Other
mortgage-backed securities with a book value of $22.9 million were pledged as
collateral primarily for credit card settlement obligations.
F-28
11. LOANS RECEIVABLE - THE BANK
Loans receivable is composed of the following:
September 30,
------------------------------------
(In thousands) 1996 1995
- --------------------------------------------------------------------- ----------------- ----------------
Single-family residential $ 1,525,322 $ 1,322,772
Home equity 32,052 29,024
Commercial and multifamily 78,951 86,007
Real estate construction 41,561 46,848
Ground 44,723 6,892
Credit card 893,271 712,548
Automobile 72,560 39,217
Overdraft lines of credit 21,296 15,049
Home improvement and other consumer 94,316 112,705
Other 102,030 31,975
----------------- ----------------
2,906,082 2,403,037
----------------- ----------------
Less:
Undisbursed portion of loans 50,811 28,147
Unearned discounts 836 1,101
Net deferred loan origination costs (14,055) (13,929)
Reserve for losses on loans 95,523 60,496
----------------- ----------------
133,115 75,815
----------------- ----------------
Total $ 2,772,967 $ 2,327,222
================= ================
The Bank serviced loans owned by others amounting to $8,010.9 and $5,250.8
million at September 30, 1996 and 1995, respectively.
Accrued interest receivable on loans totaled $33.2 and $21.9 million at
September 30, 1996 and 1995, respectively, and is included in other assets in
the Consolidated Balance Sheets.
F-29
12. REAL ESTATE HELD FOR INVESTMENT OR SALE - THE BANK
Real estate held for investment or sale is composed of the following:
September 30,
------------------------------------
(In thousands) 1996 1995
- --------------------------------------------------------------------- ----------------- ----------------
Real estate held for investment $ 3,819 $ 3,819
----------------- ----------------
Real estate held for sale 246,380 354,277
----------------- ----------------
Less:
Reserve for losses on real estate held
for investment 191 193
Reserve for losses on real estate held for sale 126,519 135,043
----------------- ----------------
126,710 135,236
----------------- ----------------
Total real estate held for investment or sale $ 123,489 $ 222,860
================= ================
Earnings (loss) on real estate held for investment or sale is composed of the
following:
September 30,
-------------------------------------------------------
(In thousands) 1996 1995 1994
- --------------------------------------------------------------------- ----------------- ----------------- ----------------
Provision for losses $ (26,341) $ (26,321) $ (14,052)
Net income (loss) from operating properties (350) 1,890 3,521
Equity earnings from investments in
limited partnerships -- 4,470 391
Net gain on sales 2,278 14,412 10,975
----------------- ----------------- ----------------
Total $ (24,413) $ (5,549) $ 835
================= ================= ================
During fiscal 1995, the Bank sold two residential apartment buildings which were
previously classified as real estate held for investment and had an aggregate
net book value of $25.3 million and recognized a net gain of $5.3 million. Also
during fiscal 1995, an office building, previously classified as real estate
held for investment, which had a book value of $24.5 million at September 30,
1995, was transferred to property and equipment and the Bank began to occupy a
portion of the building during fiscal 1996 in order to satisfy its need for
additional office space. In addition, during fiscal 1995, the investment in real
estate venture was transferred to REO and the Bank sold its limited partnership
interest in an office building at an amount that exceeded its net carrying
value.
During fiscal 1994, the Bank sold its interests in three limited partnerships to
other partners at an aggregate amount that exceeded the net carrying values of
these assets.
F-30
13. ALLOWANCES FOR LOSSES - THE BANK
Activity in the allowances for losses on loans receivable and real estate held
for investment or sale is summarized as follows:
Real Estate
Held for
Loans Investment
(In thousands) Receivable or Sale
- --------------------------------------------------------------------- ----------------- ----------------
Balance, September 30, 1993 $ 68,040 $ 111,644
Provision for losses 29,222 14,052
Charge-offs (61,039) (6,723)
Recoveries 13,982 --
----------------- ----------------
Balance, September 30, 1994 50,205 118,973
Provision for losses 54,979 26,321
Charge-offs (56,577) (10,058)
Recoveries 11,889 --
----------------- ----------------
Balance, September 30, 1995 60,496 135,236
Provision for losses 115,740 26,341
Charge-offs (92,047) (34,867)
Recoveries 11,334 --
----------------- ----------------
Balance, September 30, 1996 $ 95,523 $ 126,710
================= ================
The allowances for losses at September 30, 1996 are based on management's
estimates of the amount of allowances required to reflect the risks in the loan
and real estate portfolios based on circumstances and conditions known at the
time. As adjustments to the allowances become necessary, provisions for losses
are reported in operations in the periods they are determined to be necessary.
14. NON-PERFORMING ASSETS - THE BANK
Non-performing assets are composed of the following at September 30, 1996:
Non-accrual Real
(Dollars in thousands) Loans Estate (1) Total
- --------------------------------------------------------------------- ----------------- ----------------- ----------------
Single-family residential $ 8,200 $ 2,277 $ 10,477
Residential land, development and construction -- 100,275 100,275
Commercial land -- 17,309 17,309
----------------- ----------------- ----------------
Total real estate assets 8,200 119,861 128,061
Credit card 25,350 -- 25,350
Other 1,239 -- 1,239
----------------- ----------------- ----------------
Total non-performing assets $ 34,789 $ 119,861 $ 154,650
================= ================= ================
Reserves for Losses
Real estate $ 11,024 $ 126,710 $ 137,734
Credit card 79,681 -- 79,681
Other 4,818 -- 4,818
----------------- ----------------- ----------------
Total $ 95,523 $ 126,710 $ 222,233
================= ================= ================
Reserves for Losses as a Percentage of
Non-Performing Assets (2)
Real estate 134.44% 51.43% 54.10%
Credit card 314.32% -- 314.32%
Other 388.86% -- 388.86%
----------------- ----------------- ----------------
Total 274.58% 51.43% 79.04%
================= ================= ================
- -------------------------------------------------------------------------------------------------------------------------------
(1) Real estate acquired in settlement of loans is shown net of valuation allowances.
(2) The ratio of reserves for losses to non-performing assets is calculated before the deduction of such
reserves.
F-31
Approximately 28.4% of the Bank's non-performing credit card loans are located
in the Washington, D.C. metropolitan area. In general, the Bank's remaining
non-performing assets are located in the Washington, D.C. metropolitan area,
including approximately 57.9% located in Loudoun County, Virginia.
The ultimate collection or realization of the Bank's non-performing assets will
be primarily dependent on the general economic conditions in the Washington,
D.C. metropolitan area. Based upon current economic conditions and other
factors, the Bank has provided loss allowances and initial write-downs for real
estate acquired in settlement of loans. See Note 13. As circumstances change, it
may be necessary to provide additional allowances based on new information.
At September 30, 1996 and 1995, the Bank had $13.6 and $17.3 million,
respectively, of loans accounted for as troubled debt restructurings, all of
which were performing loans. At September 30, 1996, the Bank had commitments to
lend $85,000 of additional funds on loans which have been restructured.
The amount of interest income that would have been recorded if non-accrual
assets and restructured loans had been current in accordance with their original
terms was $6.1, $7.2 and $9.1 million for the years ended September 30, 1996,
1995 and 1994, respectively. The amount of interest income that was recorded on
these loans was $0.7, $2.0 and $2.7 million for the years ended September 30,
1996, 1995 and 1994, respectively.
15. SIGNIFICANT SALES TRANSACTIONS - THE BANK
The Bank periodically sells credit card receivables through asset-backed
securitizations, in which credit card receivables are transferred to trusts, and
the Bank sells certificates to investors representing ownership interests in the
trusts. The Bank sold credit card receivables and received gross proceeds of
$919.0, $1,550.0 and $1,350.0 million during the years ended September 30, 1996,
1995 and 1994, respectively. No gains or losses were recorded on the
transactions; however, excess servicing fees are recognized over the related
lives of the transactions. Outstanding trust certificate balances related to
these and previous securitizations were $3,890.0 and $3,226.3 million at
September 30, 1996 and 1995, respectively. The related receivable balances
contained in the trusts were $4,587.1 and $3,776.9 million at September 30, 1996
and 1995, respectively. The Bank continues to service the underlying loans and
is contingently liable under various credit enhancement facilities related to
these transactions. See Note 27.
The Bank periodically sells amounts on deposit in certain spread accounts
associated with certain outstanding credit card securitizations through
asset-backed securitizations, in which such amounts are transferred to trusts,
and the Bank sells certificates to investors representing ownership interests in
the trusts. The Bank sold such amounts on deposit and received gross proceeds of
$42.1 and $59.2 million during fiscal 1996 and 1995, respectively. No such sales
occurred during the year ended September 30, 1994. No gains or losses were
recorded on the transactions. Outstanding trust certificate balances related to
these securitizations were $91.8 and $58.7 million at September 30, 1996 and
1995, respectively.
During fiscal 1994, the Bank sold credit card relationships with related
outstanding receivable balances of $96.5 million. Gains of $16.9 million were
recorded in connection with this sale for the year ended September 30, 1994, and
the Bank is no longer servicing these relationships. No such sales occurred
during the years ended September 30, 1996 and 1995.
F-32
The Bank periodically sells home equity credit line receivables through
asset-backed securitizations, in which home equity credit line receivables are
transferred to trusts, and the Bank sells certificates to investors representing
ownership interests in the trusts. The amount of home equity credit line
receivables sold and gross proceeds received was $96.5, $150.5 and $181.9
million, during the years ended September 30, 1996, 1995 and 1994, respectively.
Gains recognized on these transactions were $4.7, $7.6 and $9.5 million, during
the years ended September 30, 1996, 1995 and 1994, respectively, and the Bank
continues to service the underlying loans. The outstanding trust certificate
balances and the related receivable balances contained in the trusts were $416.4
and $440.4 million, respectively, at September 30, 1996. The outstanding trust
certificate balances and the related receivable balances contained in the trusts
were $455.8 and $464.7 million, respectively, at September 30, 1995. The Bank is
contingently liable under various credit enhancement facilities related to these
transactions. See Note 27.
The Bank periodically sells automobile loan receivables through asset-backed
securitizations, in which automobile loan receivables are transferred to trusts,
and the Bank sells certificates to investors representing ownership interests in
the trusts. The amount of automobile loan receivables sold and gross proceeds
received was $475.3 and $252.2 million during fiscal 1996 and 1995,
respectively. Gains recognized on these transactions were $7.3 and $4.0 million,
respectively, and the Bank continues to service the underlying loans. The
outstanding trust certificate balances and the related receivable balances
contained in the trusts were $505.6 and $218.2 million at September 30, 1996 and
1995, respectively. The Bank is contingently liable under various credit
enhancement facilities related to these transactions. See Note 27.
During the year ended September 30, 1996, the Bank sold home loan receivables
through an asset-backed securitization, in which the home improvement and other
consumer loan receivables were transferred to a trust, and the Bank sold
certificates to investors representing ownership interests in the trust. The
amount of home loan receivables sold and gross proceeds received was $153.5
million. The gain recognized on this transaction was $9.5 million, and the Bank
continues to service the underlying loans. The outstanding trust certificate
balances and the related receivable balances contained in the trust were $153.5
million at September 30, 1996. The Bank is contingently liable under a credit
enhancement facility related to this transaction. See Note 27.
16. PROPERTY AND EQUIPMENT - THE BANK
Property and equipment is composed of the following:
Estimated
Useful September 30,
------------------------------------
(Dollars in thousands) Lives 1996 1995
- --------------------------------------------------------------------- -------------- ----------------- ----------------
Land - $ 45,211 $ 38,616
Construction in progress - 18,596 6,446
Buildings and improvements 10-45 years 88,362 72,099
Leasehold improvements 5-20 years 65,467 57,133
Furniture and equipment 5-10 years 149,470 131,001
Automobiles 3-5 years 1,964 1,801
----------------- ----------------
369,070 307,096
Less:
Accumulated depreciation and amortization 143,935 126,658
----------------- ----------------
Total $ 225,135 $ 180,438
================= ================
Depreciation expense amounted to $24.4, $19.1 and $18.5 million for the years
ended September 30, 1996, 1995 and 1994, respectively.
During fiscal 1995, an office building previously classified as real estate held
for investment was transferred to property and equipment and the Bank began to
occupy a portion of the building during fiscal 1996 in order to satisfy its need
for additional office space. This asset had a net book value of $16.1 million at
September 30, 1996.
F-33
17. LEASES - THE BANK
The Bank has noncancelable, long-term leases for office premises and retail
space, which have a variety of terms expiring from 1997 to 2019 and ground
leases which have terms expiring from 2029 to 2080. These leases are accounted
for as operating leases. Some of the leases are subject to rent adjustments in
the future based upon changes in the Consumer Price Index and some also contain
renewal options. The following is a schedule by years of future minimum lease
payments required at September 30, 1996:
Year Ending
September 30, (In thousands)
----------------------------- -----------------
1997 $ 13,426
1998 12,053
1999 9,885
2000 8,985
2001 7,785
Thereafter 69,099
-----------------
Total $ 121,233
=================
Future minimum sublease rental income at September 30, 1996 totaled $394,000.
Rent expense totaled $13.5, $11.2 and $9.7 million for the years ended September
30, 1996, 1995 and 1994, respectively.
18. DEPOSIT ACCOUNTS - THE BANK
An analysis of deposit accounts and the related weighted average effective
interest rates at year-end are as follows:
September 30,
--------------------------------------------------------------------------
1996 1995
------------------------------------ ------------------------------------
Weighted Weighted
Average Average
(Dollars in thousands) Amount Rate Amount Rate
- -------------------------------------------------- ---------------- ----------------- ----------------- ----------------
Demand accounts $ 156,517 - $ 123,141 -
NOW accounts 851,385 2.42% 826,977 2.91%
Money market deposit accounts 1,002,688 3.88% 984,257 4.02%
Statement savings accounts 881,285 3.47% 872,366 3.48%
Other deposit accounts 68,487 2.98% 61,011 2.98%
Certificate accounts, less than $100 1,030,401 5.30% 1,112,817 5.80%
Certificate accounts, $100 or more 173,274 5.41% 178,683 5.99%
---------------- -----------------
Total $ 4,164,037 3.75% $ 4,159,252 4.11%
================ =================
Interest expense on deposit accounts is composed of the following:
Year Ended September 30,
-------------------------------------------------------
(In thousands) 1996 1995 1994
- -------------------------------------------------- -------------------------------------------------------
NOW accounts $ 23,044 $ 23,692 $ 23,147
Money market deposit accounts 38,317 42,420 37,305
Statement savings accounts 30,034 33,394 39,147
Other deposit accounts 1,901 1,731 1,573
Certificate accounts 69,180 53,033 29,723
---------------- ----------------- -----------------
162,476 154,270 130,895
Custodial accounts 93 29 29
---------------- ----------------- -----------------
Total $ 162,569 $ 154,299 $ 130,924
================ ================= =================
F-34
Outstanding certificate accounts at September 30, 1996 mature in the years
indicated as follows:
Year Ending
September 30, (In thousands)
- --------------------------- -----------------
1997 $ 897,768
1998 147,836
1999 51,381
2000 89,516
2001 17,174
-----------------
Total $ 1,203,675
=================
At September 30, 1996, certificate accounts of $100,000 or more have contractual
maturities as indicated below:
(In thousands)
-----------------
Three months or less $ 86,063
Over three months through six months 28,890
Over six months through 12 months 35,240
Over 12 months 23,081
-----------------
Total $ 173,274
=================
19. SECURITIES SOLD UNDER REPURCHASE AGREEMENTS AND OTHER
SHORT-TERM BORROWINGS - THE BANK
Short-term borrowings are summarized as follows:
September 30,
-------------------------------------------------------
(Dollars in thousands) 1996 1995 1994
- --------------------------------------------------------------------- ------------------ ------------------- ----------------
Securities sold under repurchase agreements:
Balance at year-end $ 576,576 $ -- $ --
Average amount outstanding during the year 57,644 159,044 103,299
Maximum amount outstanding at any month-end 576,576 353,615 202,256
Amount maturing within 30 days 576,576 -- --
Weighted average interest rate during the year 5.51% 6.02% 3.78%
Weighted average interest rate on year-end
balances 5.41% -- --
Other short-term borrowings:
Balance at year-end $ 60,565 $ 10,435 $ 8,907
Average amount outstanding during the year 15,684 20,451 13,336
Maximum amount outstanding at any month-end 60,565 53,242 51,992
Amount maturing within 30 days 60,317 10,435 8,907
Weighted average interest rate during the year 5.08% 5.59% 3.42%
Weighted average interest rate on year-end
balances 5.63% 5.70% 4.87%
The investment and mortgage-backed securities underlying the repurchase
agreements had a book value of $599.1 million at September 30, 1996. The
securities underlying these agreements were delivered to the dealers who
arranged the transactions. The dealers may have loaned such securities to other
parties in the normal course of their operations and agreed to resell to the
Bank the identical securities at the maturities of the agreements.
At September 30, 1996, the Bank had pledged mortgage-backed securities with a
book value of $77.6 million to secure certain other short-term borrowings.
F-35
20. NOTES PAYABLE - THE BANK
Notes payable bear interest at rates ranging from 8.9% to 13.0% and are due in
varying installments through 2011.
Scheduled repayments of notes payable at September 30, 1996 are as follows:
Year Ending
September 30, (In thousands)
----------------------------- -----------------
1997 $ 260
1998 286
1999 314
2000 346
2001 380
Thereafter 5,691
-----------------
Total $ 7,277
=================
21. FEDERAL HOME LOAN BANK ADVANCES - THE BANK
At September 30, 1996, the advances from the Federal Home Loan Bank of Atlanta
("FHLB") totaled $269.1 million. Of the total advances at September 30, 1996,
$250.0 million have a weighted average interest rate of 5.43%, adjust quarterly
based on the three-month London Interbank Offered Rate ("LIBOR") and mature over
varying periods between May 1997 and February 1998. The weighted average
interest rate on the remaining $19.1 million is 6.78% which is fixed for the
term of the advances and matures over varying periods between December 1996 and
September 2006.
Under a Specific Collateral Agreement with the FHLB, advances are secured by all
of the Bank's FHLB stock, qualifying first mortgage loans with a total principal
balance of $515.7 million and mortgage-backed securities with a book value of
$114.2 million. The FHLB requires that members maintain qualifying collateral at
least equal to 100% of the member's outstanding advances at all times.
The collateral held by the FHLB in excess of the September 30, 1996 advances is
available to secure additional advances from the FHLB, subject to its
collateralization guidelines.
22. CAPITAL NOTES - SUBORDINATED - THE BANK
Capital notes, which are subordinated to the interest of deposit account
holders, are composed of the following:
September 30,
------------------------- Interest
(Dollars in thousands) 1996 1995 Rate
- ---------------------------------------- ----------- ----------- -------------
Private placement:
BACOB Bank, s.c.,
due December, 1996 $ 10,000 $ 10,000 LIBOR + 3.0%
Public placement:
Subordinated debentures due 2005 150,000 150,000 9 1/4%
----------- -----------
Total $ 160,000 $ 160,000
=========== ===========
On November 23, 1993, the Bank sold $150.0 million 9 1/4% Subordinated
Debentures due 2005 (the "Debentures"). The Bank received net proceeds of $143.6
million from the sale of the Debentures, of which approximately $134.2 million
was used to redeem $78.5 million of debentures due in 2002 and $50.0 million of
debentures due in 2003 on December 23, 1993 and December 24, 1993, respectively.
The remaining net proceeds were used for general corporate purposes. The Bank
incurred a loss of $6.3 million, after related income taxes, in connection with
the redemption of these debentures. The OTS approved the inclusion of the
principal amount of the Debentures in the Bank's supplementary capital for
regulatory capital purposes.
F-36
The indenture pursuant to which the Debentures were sold ("the Indenture")
provides that the Bank may not pay dividends on its capital stock unless,
after giving effect to the dividend, no event of default shall have occurred
and be continuing and the Bank is in compliance with its regulatory capital
requirements. In addition, the amount of the proposed dividend may not exceed
the sum of (i) $15.0 million, (ii) 66 2/3% of the Bank's consolidated net
income (as defined in the Indenture) accrued on a cumulative basis commencing
on October 1, 1993 and (iii) the aggregate net cash proceeds received by the
Bank after October 1, 1993 from the sale of qualified capital stock or
certain debt securities, minus the aggregate amount of any restricted
payments made by the Bank. Notwithstanding the above restrictions on
dividends, provided no event of default has occurred or is continuing, the
Indenture does not restrict the payment of dividends on the Preferred Stock
or any payment-in-kind preferred stock issued in lieu of cash dividends on
the Preferred Stock or the redemption of any such payment-in-kind preferred
stock.
Deferred debt issuance costs, net of accumulated amortization, amounted to
$5.6 and $5.9 million at September 30, 1996 and 1995, respectively, and are
included in other assets in the Consolidated Balance Sheets.
On November 15, 1996, the Bank redeemed the $10.0 million private placement
note.
23. PREFERRED STOCK - THE BANK
In April 1993, the Bank sold $75.0 million of its Noncumulative Perpetual
Preferred Stock, Series A ("Preferred Stock") in a private offering. Cash
dividends on the Preferred Stock are payable quarterly in arrears at an annual
rate of 13%. If the Board of Directors does not declare the full amount of the
noncumulative cash dividend accrued in respect of any quarterly dividend period,
in lieu thereof the Board of Directors will be required to declare (subject to
regulatory and other restrictions) a stock dividend in the form of a new series
of payment-in-kind preferred stock of the Bank.
The OTS has approved the inclusion of the Preferred Stock as tier 1 or core
capital and has approved the payment of dividends on the Preferred Stock,
provided certain conditions are met. The Preferred Stock is not redeemable
until May 1, 2003 and is redeemable thereafter at the option of the Bank. The
holders of the Preferred Stock have no voting rights, except in certain
limited circumstances.
Holders of the Preferred Stock will be entitled to receive a liquidating
distribution in the amount of $25 per share, plus accrued and unpaid dividends
for the then-current dividend period in the event of any voluntary liquidation
of the Bank, after payment of the deposit accounts and other liabilities of the
Bank, and out of the assets available for distribution to shareholders. The
Preferred Stock ranks superior and prior to the issued and outstanding common
stock of the Bank with respect to dividend and liquidation rights.
24. RETIREMENT PLAN - THE BANK
The Bank participates in a defined contribution profit sharing retirement
plan (the "Plan") which covers those full-time employees who meet the
requirements as specified in the Plan. The Plan, which can be modified or
discontinued at any time, requires participating employees to contribute 2.0%
of their compensation. Corporate contributions, at the discretionary amount
of three times the employee contribution, were $4.7, $3.9 and $3.5 million
for the years ended September 30, 1996, 1995 and 1994, respectively. There
are no past service costs associated with the Plan and the Bank has no
liability under the Plan other than its current contributions. The Plan owns
4.0% of the Bank's common stock.
F-37
25. REGULATORY MATTERS - THE BANK
Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989
("FIRREA"), the Bank's regulatory capital requirements at September 30, 1996
were a 1.5% tangible capital requirement, a 3.0% core capital requirement and an
8.0% total risk-based capital requirement. Under the OTS "prompt corrective
action" regulations, the Bank must maintain minimum leverage, tier 1 risk-based
and total risk-based capital ratios of 4.0%, 4.0% and 8.0%, respectively, to
meet the ratios established for "adequately capitalized" institutions. At
September 30, 1996, the Bank was in compliance with its tangible, core and total
risk-based regulatory capital requirements and exceeded the capital standards
established for "adequately capitalized" institutions under the "prompt
corrective action" regulations. The information below is based upon the Bank's
understanding of the applicable FIRREA and "prompt corrective action"
regulations and related interpretations.
MINIMUM EXCESS
ACTUAL CAPITAL REQUIREMENT CAPITAL
---------------------- ---------------------- -----------------------
As a % of As a % of As a % of
(Dollars in thousands) Amount Assets (4) Amount Assets Amount Assets
- ----------------------------------- ---------- ---------- ---------- ---------- ---------- ----------
Capital per Bank's financial
statements $ 339,160
Net unrealized holding losses (1) 1,875
----------
Adjusted capital 341,035
Adjustments for tangible and core
capital:
Intangible assets (41,051)
Non-includable subsidiaries (2)(4) (3,622)
----------
Total tangible capital 296,362 5.21% $ 85,255 1.50% $ 211,107 3.71%
---------- ========== ========== ========== ========== ==========
Total core capital (3)(4) 296,362 5.21% $ 227,346 4.00% $ 69,016 1.21%
---------- ========== ========== ========== ========== ==========
Tier 1 risk-based capital (3) 296,362 5.80% $ 204,519 4.00% $ 91,843 1.80%
---------- ========== ========== ========== ========== ==========
Adjustments for risk-based
capital:
Subordinated capital debentures 150,000
Allowance for general loan losses 87,953
----------
Total supplementary capital 237,953
Excess allowance for loan losses (23,744)
----------
Adjusted supplementary capital 214,209
----------
Total available capital 510,571
Equity investments (2) (19,657)
----------
Total risk-based capital (4) $ 490,914 10.14% $ 409,038 8.00% $ 81,876 2.14%
========== ========== ========== ========== ========== ==========
- --------------------------------------------------------------------------------------------------------------
(1) Pursuant to OTS policy, net unrealized holding gains (losses) are excluded
from regulatory capital.
(2) Reflects an aggregate offset of $1.2 million representing the allowance for
general loan losses maintained against the Bank's equity investments and
non-includable subsidiaries which, pursuant to OTS guidelines, is available
as a "credit" against the deductions from capital otherwise required for
such investments.
(3) Under the OTS "prompt corrective action" regulations, the standards for
classification as "well capitalized" are a leverage (or "core capital")
ratio of at least 5.0%, a tier 1 risk-based capital ratio of at least 6.0%
and a total risk-based capital ratio of at least 10.0%.
(4) Effective July 1, 1996, the percentage of non-includable subsidiaries
phased-out from core capital increased from 60% to 100%.
F-38
At September 30, 1996, the Bank had $3.8 million in loans to and investments in
subsidiaries engaged in activities impermissible for national banks
("non-includable subsidiaries") which were fully deducted from all three capital
requirements. At September 30, 1996, the Bank also had two equity investments
with an aggregate balance, after subsequent valuation allowances, of $20.7
million which were fully deducted from total risk-based capital.
As of September 30, 1996, the Bank had $40.2 million in supervisory goodwill,
all of which was excluded from core capital pursuant to statutory provisions.
OTS capital regulations provide a five-year holding period (or such longer
period as may be approved by the OTS) for REO to qualify for an exception from
treatment as an equity investment. If an REO property is considered an equity
investment, its then-current book value is deducted from total risk-based
capital. Accordingly, if the Bank is unable to dispose of any REO property
(through bulk sales or otherwise) prior to the end of its applicable five-year
holding period and is unable to obtain an extension of such five-year holding
period from the OTS, the Bank could be required to deduct the then-current book
value of such REO property from total risk-based capital. In November 1996, the
Bank received from the OTS an extension of the holding periods for certain of
its REO properties. The following table sets forth the Bank's REO at September
30, 1996, after valuation allowances of $126.5 million, by the fiscal year in
which the property was acquired through foreclosure.
Fiscal Year (In thousands)
---------------- ---------------------
1990 $ 30,236 (1)(2)
1991 68,910 (2)
1992 3,339 (2)
1993 4,903
1994 1,811
1995 7,503
1996 3,159
-------------
Total REO $ 119,861
===============
- --------------------------------------------------------------------
(1) Includes REO with an aggregate net book value of $19.7 million,
which the Bank treats as equity investments for regulatory
capital purposes.
(2) Includes REO, with an aggregate net book value of $82.8 million,
for which the Bank received an extension of the holding periods
through November 12, 1997.
On March 29, 1996, the OTS released the Bank from its September 30, 1991 written
agreement with the OTS, as amended in October 1993, and from regulatory
restrictions on asset growth. In connection with the termination of the written
agreement and at the request of the OTS, the Board of Directors of the Bank has
adopted a resolution which addressed certain issues previously addressed by the
written agreement. Among other things, the resolution permits the Bank: (i) to
make tax sharing payments without OTS approval to the Trust of up to $15.0
million relating to any single fiscal year; and (ii) to declare dividends on its
common stock in any quarterly period up to the lesser of (A) 50% of its after
tax net income for the immediately preceding quarter or (B) 50% of the average
quarterly after tax net income for the immediately preceding four quarter
period, minus (in either case) dividends declared on the Bank's preferred stock
during that quarterly period. The resolution also provides that the Bank will
present a plan annually to the OTS detailing anticipated consumer loan
securitization activity.
F-39
Legislation was enacted on September 30, 1996 that, among other things, imposes
on thrift institutions a one-time assessment of 65.7 basis points on their
SAIF-insured deposits to capitalize the SAIF. Following such legislation, the
Bank and other SAIF-insured institutions will continue to pay higher deposit
insurance premiums than commercial banks, which could lead to a competitive
disadvantage in the pricing of loans and deposits and additional operating
expenses. At September 30, 1996, the Bank accrued approximately $26.5 million
for the SAIF assessment which is included in deposit insurance premiums on the
Consolidated Statements of Operations and other liabilities on the Consolidated
Balance Sheets.
26. TRANSACTIONS WITH RELATED PARTIES - THE BANK
LOANS RECEIVABLE:
From time to time, in the normal course of business, the Bank may make loans to
executive officers and directors, their immediate family members or companies
with which they are affiliated. These loans are on substantially the same terms
as similar loans with unrelated parties. An analysis of activity with respect to
these loans for the year ended September 30, 1996 is as follows:
(In thousands)
--------------------
Balance, September 30, 1995 $ 3,905
Additions 31
Reductions (1,199)
--------------------
Balance, September 30, 1996 $ 2,737
====================
SERVICES:
B. F. Saul Company, which is a shareholder of the Trust, and its subsidiaries
provide certain services to the Bank. These services include property
management, cafeteria management, insurance brokerage and leasing. Fees for
these services were $366,000, $460,000 and $548,000 for the years ended
September 30, 1996, 1995 and 1994, respectively.
The law firm in which one director of the Bank is a partner received $3.2, $2.8
and $2.4 million for legal services rendered to the Bank during the years ended
September 30, 1996, 1995 and 1994, respectively.
For the years ended September 30, 1996, 1995 and 1994, one of the directors of
the Bank was paid $37,000, $30,000 and $30,000, respectively, for consulting
services rendered to the Bank. Another director of the Bank was paid total fees
of $100,000, $75,000 and $50,000 for the years ended September 30, 1996, 1995
and 1994, respectively, for consulting services.
TAX SHARING AGREEMENT:
The Bank and the other companies in the Trust's affiliated group are parties to
a tax sharing agreement dated June 28, 1990 (the "Tax Sharing Agreement"). The
Tax Sharing Agreement provides for payments to be made by members of the Trust's
affiliated group to the Trust based on their separate company tax liabilities.
The Tax Sharing Agreement also provides that, to the extent net operating losses
or tax credits of a particular member are used to reduce the overall tax
liability of the Trust's affiliated group, such member will be reimbursed by the
other members of the affiliated group that have taxable income in an amount
equal to such tax reduction. The Bank paid $25.0, $20.5 and $9.6 million to the
Trust during fiscal 1996, 1995 and 1994, respectively, under the Tax Sharing
Agreement. OTS approval of the tax sharing payments during fiscal 1996, 1995 and
1994 was conditioned on a pledge by the Trust of certain assets to secure
certain of its obligations under the Tax Sharing Agreement. Under the terms of
the Bank's board resolution, the Bank is permitted to make tax sharing payments
to the Trust of up to $15.0 million relating to any fiscal year without OTS
approval. See Note 25.
F-40
OTHER:
The Bank paid $4.5, $4.2 and $3.9 million for office space leased from or
managed by companies affiliated with the Bank or its directors during the years
ended September 30, 1996, 1995 and 1994, respectively.
The Trust, the B. F. Saul Company and Chevy Chase Lake Corporation ("Lake"), an
affiliate of the Bank, from time to time maintain interest-bearing deposit
accounts with the Bank. Those accounts totaled $24.0 million at September 30,
1996. The Bank paid interest on the accounts amounting to $1.1 million in fiscal
1996.
During fiscal 1995, the Bank purchased land and building plans from Lake for
$1.3 million. During fiscal 1996, construction was completed and the Bank began
occupying the building.
During fiscal 1994, the Bank sold 12.70 acres of retail land to Saul Holdings,
L.P., at an amount equal to its net carrying value. During fiscal 1996,
construction was completed and the Bank began to occupy the building.
27. FINANCIAL INSTRUMENTS - THE BANK
The Bank, in the normal course of business, is a party to financial instruments
with off-balance-sheet risk and other derivative financial instruments to meet
the financing needs of its customers and to reduce its own exposure to
fluctuations in interest rates. These financial instruments include commitments
to extend credit at both fixed and variable rates, letters of credit,
interest-rate cap agreements and assets sold with limited recourse. All such
financial instruments are held or issued for purposes other than trading.
These instruments involve, to varying degrees, elements of credit and
interest-rate risk in excess of the amount recognized in the Consolidated
Balance Sheets.
The contract or notional amounts of these instruments reflect the extent of
involvement the Bank has in particular classes of financial instruments. The
Bank's exposure to credit loss in the event of nonperformance by the other party
is represented by the contractual notional amount of these instruments. The Bank
uses the same credit policies in making commitments and conditional obligations
as it does for on-balance-sheet instruments. The Bank is also a party to
derivative financial instruments that do not have off-balance-sheet risk (e.g.
interest-rate cap agreements).
COMMITMENTS TO EXTEND CREDIT:
The Bank had $15,627.8 million of commitments to extend credit at September 30,
1996. Commitments to extend credit are agreements to lend to a customer as long
as there is no violation of any condition established in the contract.
Commitments generally have fixed expiration dates or other termination clauses
and may require payment of a fee. Because many of the commitments are expected
to expire without being drawn upon, the total commitment amounts do not
necessarily represent future cash requirements. These commitments are subject to
the Bank's normal underwriting and credit evaluation policies and procedures.
Loans approved but not closed are commitments for fixed or adjustable-rate
residential loans which are secured by real estate. The Bank currently requires
borrowers to obtain private mortgage insurance on all loans where the
loan-to-value ratio exceeds 80%.
F-41
FORWARD COMMITMENTS:
To manage the potentially adverse impact of interest rate movements on the
fixed-rate mortgage loan pipeline, the Bank hedges its pipeline by entering into
whole loan and mortgage-backed security forward sale commitments. Forward sale
commitments are used to sell specific financial instruments (whole loans or
mortgage-backed securities) at a future date for a specified price. Forward sale
commitments generally settle within 90 days. Gains and losses are deferred and
recorded as a component of the gain on sales of loans at the time the forward
sale commitment matures. At September 30, 1996, the Bank had whole loan and
mortgage-backed security forward sale commitments of $1.2 and $132.5 million,
respectively. In addition, at September 30, 1996, the Bank had $36.2 million in
mortgage-backed security forward purchase commitments related to its hedging
activities.
LETTERS OF CREDIT:
Letters of credit are conditional commitments issued by the Bank to guarantee
the performance of a customer to a third party. At September 30, 1996, the Bank
had written letters of credit in the amount of $24.7 million, which were issued
to guarantee the performance of and irrevocably assure payment by customers
under construction projects.
Of the total, $16.7 million will expire in fiscal 1997 and the remainder will
expire over time through fiscal 2001. The credit risk involved in issuing
letters of credit is essentially the same as that involved in extending loan
commitments to customers. Investment and mortgage-backed securities with a book
value of $2.3 million were pledged as collateral for certain of these letters of
credit at September 30, 1996.
RECOURSE ARRANGEMENTS:
The Bank is obligated under various recourse provisions (primarily related to
credit losses) related to the securitization and sale of credit card
receivables, home equity credit line receivables, automobile loan receivables,
home loan receivables and amounts on deposit in certain spread accounts through
the asset-backed securitizations described in Note 15. At September 30, 1996 and
1995, the primary recourse to the Bank was $128.0 and $93.1 million,
respectively. As a result of these recourse provisions, the Bank maintained
restricted cash accounts amounting to $128.2 and $98.1 million, at September 30,
1996 and 1995, respectively, which are included in other assets in the
Consolidated Balance Sheets.
The Bank is obligated under various recourse provisions related to the swap of
single-family residential loans for participation certificates and
mortgage-backed securities issued to the Bank by FHLMC and FNMA. At September
30, 1996, recourse to the Bank under these arrangements was $4,268. As security
for the payment of funds due under certain of the FHLMC recourse obligations,
the Bank is required to post collateral. At September 30, 1996, mortgage-backed
securities pledged as collateral under these obligations had a book value of
$3.5 million. In addition, the Bank maintained a restricted cash account
amounting to $325,000 at September 30, 1996 and 1995 which is included in other
assets in the Consolidated Balance Sheets.
F-42
INTEREST RATE CAP AGREEMENTS:
Interest rate cap agreements are used to limit the Bank's exposure to rising
short-term interest rates related to certain of its asset-backed
securitizations. At September 30, 1996, the Bank was a party to seven interest
rate cap agreements with an aggregate notional amount of $500.0 million with
maturity dates ranging from December 31, 1996 through June 30, 1999. The
interest rate cap agreements entitle the Bank to receive compensatory payments
from the cap provider, which is a AAA-rated (by Standard & Poor's) counterparty,
equal to the product of (a) the amount by which the one-month LIBOR exceeds
7.00% and (b) the then outstanding notional principal amount for a predetermined
period of time. The Bank has no obligation to make payments to the provider of
the cap or any other party. The Bank is exposed to credit losses in the event of
nonperformance by the counterparty, but does not expect the counterparty to fail
to meet its obligation given its credit rating.
CONCENTRATIONS OF CREDIT:
The Bank's principal real estate lending market is the metropolitan Washington,
D.C. area. In addition, a significant portion of the Bank's consumer loan
portfolio, including credit cards, was generated by customers residing in the
metropolitan Washington, D.C. area. Service industries and Federal, state and
local governments employ a significant portion of the Washington, D.C. area
labor force. Adverse changes in economic conditions could have a direct impact
on the timing and amount of payments by borrowers.
F-43
28. ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS - THE BANK
The majority of the Bank's assets and liabilities are financial instruments;
however, certain of these financial instruments lack an available trading
market. Significant estimates, assumptions and present value calculations were
therefore used for the purposes of the following disclosure, resulting in a
great degree of subjectivity inherent in the indicated fair value amounts. Since
the fair value is estimated as of the balance sheet date, the amount which will
actually be realized or paid upon settlement or maturity could be significantly
different. Comparability among financial institutions may be difficult due to
the wide range of permitted valuation techniques and the numerous estimates and
assumptions which must be made. The estimated fair values of the Bank's
financial instruments at September 30, 1996 and 1995 are as follows:
September 30,
------------------------------------------------------------------------
1996 1995
---------------------------------- ---------------------------------
Carrying Fair Carrying Fair
(In thousands) Amount Value Amount Value
- -------------------------------------------------- -------------- -------------- -------------- -------------
Financial assets:
Cash, due from banks,
interest-bearing deposits
and securities purchased
under agreements to resell $ 266,425 $ 266,425 $ 359,282 $ 359,282
Loans held for sale 76,064 76,064 68,679 68,729
Loans held for securitization and sale 450,000 450,000 500,000 500,000
Investment securities 9,818 9,820 4,370 4,371
Mortgage-backed securities 1,306,417 1,307,838 880,208 879,720
Loans receivable, net 2,772,969 2,834,726 2,327,222 2,351,729
Interest rate cap agreements 6,179 1,832 9,986 3,255
Other financial assets 392,265 393,748 298,077 299,561
Financial liabilities:
Deposit accounts with
no stated maturities 2,960,362 2,960,362 2,867,752 2,867,752
Deposit accounts with
stated maturities 1,203,675 1,210,497 1,291,500 1,295,816
Securities sold under repurchase agreements
and other short-term borrowings,
notes payable and Federal Home Loan
Bank advances 913,483 914,418 173,001 173,813
Capital notes-subordinated 154,383 (1) 161,875 154,102 (1) 159,250
Other financial liabilities 80,760 80,760 80,149 80,149
- -------------------------------------------------------------------------------------------------------------------------------
(1) Net of deferred debt issuance costs which are included in other assets in
the Consolidated Balance Sheets.
The following methods and assumptions were used to estimate the fair value
amounts at September 30, 1996 and 1995:
Cash, due from banks, interest-bearing deposits, securities purchased under
agreements to resell and federal funds sold: Carrying amount approximates fair
value.
Loans held for sale: Fair value is determined using quoted prices for loans, or
securities backed by loans with similar characteristics, or outstanding
commitment prices from investors.
Loans held for securitization and sale: The carrying value of loans held for
securitization and sale approximates fair value because such receivables are
sold at face value.
F-44
Investment securities: Fair value is based on quoted market prices.
Mortgage-backed securities: Fair value is based on quoted market prices,
dealer quotes or estimates using dealer quoted market prices for similar
securities.
Loans receivable, net: Fair value of certain homogeneous groups of loans (e.g.,
single-family residential, automobile loans, home improvement loans and
fixed-rate commercial and multifamily loans) is estimated using discounted cash
flow analyses based on contractual repayment schedules. The discount rates used
in these analyses are based on either the interest rates paid on U.S. Treasury
securities of comparable maturities adjusted for credit risk and non-interest
operating costs, or the interest rates currently offered by the Bank for loans
with similar terms to borrowers of similar credit quality. For loans which
reprice frequently at market rates (e.g., home equity, variable-rate commercial
and multifamily, real estate construction and ground loans), the carrying amount
approximates fair value. Because credit card receivables are generally sold at
face value through the Bank's securitization program, such face value is used as
the estimated fair value of these receivables. The fair value of the Bank's loan
portfolio as presented above does not include the value of established credit
card and home equity credit line customer relationships, or the value relating
to estimated cash flows from future receivables and the associated fees
generated from existing customers.
Interest rate cap agreements: Fair value is based on dealer quotes.
Other financial assets: The carrying amount of Federal Home Loan Bank stock,
accrued interest receivable, excess servicing assets, interest-bearing deposits
maintained pursuant to various asset securitizations and other short-term
receivables approximates fair value. The fair value of one of the Bank's
investments is based on quoted market prices.
Deposit accounts with no stated maturities: Deposit liabilities payable on
demand, consisting of NOW accounts, money market deposits, statement savings and
other deposit accounts, are assumed to have an estimated fair value equal to
carrying value. The indicated fair value does not consider the value of the
Bank's established deposit customer relationships.
Deposit accounts with stated maturities: Fair value of fixed-rate certificates
of deposit is estimated based on discounted cash flow analyses using the
remaining maturity of the underlying accounts and interest rates currently
offered on certificates of deposit with similar maturities.
Borrowings: These instruments consist of securities sold under repurchase
agreements and other short-term borrowings, notes payable and Federal Home Loan
Bank advances. For borrowings which either reprice frequently to market interest
rates or are short-term in duration, the carrying amount approximates fair
value. Fair value of the remaining amounts borrowed is estimated based on
discounted cash flow analyses using interest rates currently charged by the
lender for comparable borrowings with similar remaining maturities.
Capital notes-subordinated: Fair value of the Debentures is based on quoted
market prices. The carrying amount of the $10.0 million private placement
capital note approximates fair value.
Other financial liabilities: The carrying amount of custodial accounts, amounts
due to banks, accrued interest payable and other short-term payables
approximates fair value.
Off-balance sheet instruments: The difference between the original fees charged
by the Bank for commitments to extend credit and letters of credit and the
current fees charged to enter into similar agreements is immaterial. Fair value
of forward commitments is based on the estimated amount that the Bank would pay
to terminate the arrangements at the reporting date, taking into account the
remaining terms of the arrangements and the counterparties' credit standing,
where applicable, which is immaterial.
F-45
29. LITIGATION - THE BANK
During the normal course of business, the Bank is involved in certain
litigation, including litigation arising out of the collection of loans, the
enforcement or defense of the priority of its security interests, the continued
development and marketing of certain of its real estate properties and certain
employment claims. Although the amounts claimed in some of these suits in which
the Bank is a defendant are material, the Bank denies liability and, in the
opinion of management, litigation which is currently pending will not have a
material impact on the financial condition or future operations of the Bank.
30. SUBSEQUENT EVENTS - THE BANK
On December 3, 1996, the Bank sold $100.0 million of 9 1/4% Subordinated
Debentures due 2008 (the "1996 Debentures"). The Bank received net proceeds of
$96.3 million from the sale of the 1996 Debentures which will be used for
general corporate purposes. The Bank received OTS approval to include the
principal amount of the 1996 Debentures in the Bank's supplementary capital for
regulatory capital purposes.
In addition, on December 3, 1996, a new real estate
investment trust subsidiary of the Bank (the "Company") sold $150.0 million of
its Noncumulative Exchangeable Perpetual Preferred Stock, Series A (the "REIT
Preferred Stock") and received net cash proceeds of $144.0 million. Cash
dividends on the REIT Preferred Stock are payable quarterly in arrears at an
annual rate of 10 3/8%. The REIT Preferred Stock is automatically exchangeable
for a new series of preferred stock of the Bank upon the occurrence of certain
events. The Bank has received OTS approval to include the proceeds received from
the sale of the REIT Preferred Stock in the core capital of the Bank for
regulatory capital purposes in an amount up to 25% of the Bank's core capital.
The REIT Preferred Stock is not redeemable until January 15, 2007, and is
redeemable thereafter at the option of the Company.
F-46
31. COMMITMENTS AND CONTINGENCIES - THE TRUST
The Trust is involved in a number of lawsuits arising from the normal course of
its business. On the basis of consultations with counsel, management does not
believe that any material loss will result.
32. INCOME TAXES - THE TRUST
The Trust voluntarily terminated its qualification as a real estate investment
trust under the Internal Revenue Code during fiscal 1978.
As discussed in Organization and Summary of Significant Accounting Policies, the
Trust adopted SFAS 109 effective October 1, 1993, which had the effect of
increasing the Trust's net deferred tax asset by approximately $36.3 million.
The provisions for income taxes for the years ended September 30, 1996, 1995 and
1994, consist of the following:
Year Ended September 30,
----------------------------------------------
(In thousands) 1996 1995 1994
- ------------------------------------------------------------------------------- -------------- -------------- --------------
Current provision (benefit):
Federal $ 5,628 $ (37) $ 13,480
State 2,799 (4,186) 4,421
-------------- -------------- --------------
8,427 (4,223) 17,901
-------------- -------------- --------------
Deferred provision (benefit):
Federal (513) 5,964 (10,390)
State 386 280 (486)
-------------- -------------- --------------
(127) 6,244 (10,876)
-------------- -------------- --------------
Subtotal 8,300 2,021 7,025
Tax effect of other items:
Cumulative effect of adoption of SFAS 109 -- -- (36,260)
Extraordinary item -- -- (6,160)
Tax effect of net unrealized holding gains (losses) reported in
stockholders' equity 809 7,207 (9,243)
-------------- -------------- --------------
Total $ 9,109 $ 9,228 $ (44,638)
============== ============== ==============
The Trust's effective income tax rate varies from the statutory Federal income
tax rate as a result of the following factors:
Year Ended September 30,
----------------------------------------------
(In thousands) 1996 1995 1994
- ------------------------------------------------------------------------------- -------------- -------------- --------------
Computed tax at statutory Federal income tax rate $ 7,003 $ 9,920 $ 6,609
Increase (reduction) in taxes resulting from:
Goodwill and other purchase accounting adjustments 1,626 1,164 1,311
Change in valuation allowance for deferred
tax asset allocated to income tax expense 8,883 -- --
State income taxes (12,277) (3,540) 2,570
Other 3,066 (5,523) (3,465)
-------------- -------------- --------------
$ 8,301 $ 2,021 $ 7,025
============== ============== ==============
F-47
Under SFAS 109, the components of the net deferred tax asset were as follows:
September 30,
------------------------------
(In thousands) 1996 1995
- ------------------------------------------------------------------------------------------------ -------------- --------------
Deferred tax assets:
Provision for losses in excess of deductions $ 51,166 $ 65,072
Deferred BIF/SAIF assessment 11,151 --
Unrealized losses on real estate owned 3,545 2,744
Property 7,211 8,079
Real estate mortgage investment conduit -- 675
State net operating losses 12,224 2,593
Partnership investments 2,288 1,328
Alternative minimum tax -- 1,979
Forgiveness of debt 4,375 4,822
Depreciation 1,973 2,015
Other 3,856 2,842
-------------- --------------
Gross deferred tax assets 97,789 92,149
-------------- --------------
Deferred tax liabilities:
Net unrealized holding gains on securities available-for-sale (5,806) (8,833)
Deferred loan fees (5,764) (4,691)
Asset securitizations (3,125) --
Saul Holdings (7,682) (7,685)
Real estate taxes -- (335)
Depreciation (5,750) (8,970)
FHLB stock dividends (5,375) (5,376)
Other (2,804) (3,955)
-------------- --------------
Gross deferred tax liabilities (36,306) (39,845)
-------------- --------------
Valuation allowance (12,283) (3,400)
-------------- --------------
Net deferred tax asset $ 49,200 $ 48,904
============== ==============
Under SFAS 109, a valuation allowance is provided when it is more likely than
not that some portion of the deferred tax asset will not be realized. As of
September 30, 1996, management has maintained a valuation allowance in part to
reduce the net deferred tax asset for net operating loss carryforwards related
to state taxes. Historically, the Bank has generated taxable income while the
Real Estate Trust has generated taxable losses. Net operating loss carryforwards
are realizable through future taxable income of the Bank since the Trust files a
consolidated tax return for federal purposes. The net operating loss
carryforwards are not expected to be realizable for state tax purposes since a
consolidated return is not filed with state tax authorities.
Management believes the existing net deductible temporary differences will
reverse during periods in which the Bank generates taxable income in excess of
Real Estate Trust taxable losses. Management believes that the positive
consolidated earnings will continue as a result of the Bank's earnings. See
further discussion in Notes 2 and 3.
F-48
TAX SHARING AGREEMENT
The Trust's affiliated group, including the Bank, entered into a tax sharing
agreement dated June 28, 1990. This agreement provides that payments be made by
members of the affiliated group to the Trust based on their respective allocable
shares of the overall federal income tax liability of the affiliated group for
taxable years and partial taxable years beginning on or after that date.
Allocable shares of the overall tax liability are prorated among the members
with taxable income calculated on a separate return basis. The agreement also
provides that, to the extent net operating losses or tax credits of a particular
member are used to reduce overall tax liability of the Trust's affiliated group,
such member will be reimbursed on a dollar-for-dollar basis by the other members
of the affiliated group that have taxable income in an amount equal to such tax
reduction. Under the tax sharing agreement, the Bank paid $25.0, $20.5 and $9.6
million, respectively, to the Trust during fiscal 1996, 1995 and 1994.
In recent years, the operations of the Trust have generated net operating losses
while the Bank has reported net income. It is anticipated that the Trust's
consolidation of the Bank's operations into the Trust's federal income tax
return will result in the use of the Trust's net operating losses to reduce the
federal income taxes the Bank would otherwise owe. If in any future year, the
Bank has taxable losses or unused credits, the Trust would be obligated to
reimburse the Bank for the greater of (i) the tax benefit to the group using
such tax losses or unused tax credits in the group's consolidated Federal income
tax returns or (ii) the amount of tax refund which the Bank would otherwise have
been able to claim if it were not being included in the consolidated Federal
income tax return of the group.
As of September 30, 1996, there was no alternative minimum tax carryforward.
33. SHAREHOLDERS' EQUITY - THE TRUST
In June 1990, the Trust acquired from affiliated companies an additional equity
interest in the Bank, which raised the Trust's ownership share of the Bank to
80%. In exchange for the interest acquired, the Trust issued 450,000 shares of a
new class of $10.50 cumulative preferred shares of beneficial interest with a
par value of $1 ("preferred shares"). The transaction has been accounted for at
historical cost in a manner similar to the pooling of interests method because
the entities are considered to be under common control. In addition, the Trust
acquired two real estate properties from an affiliate in exchange for 66,000
preferred shares.
At September 30, 1996, 1995, and 1994, the amount of dividends in arrears on the
preferred shares was $31,562,500 ($61.17 per share), $26,644,500 ($51.64 per
share) and $21,226,500 ($41.14 per share), respectively. Based on the
resumption of dividend payments on the preferred shares, the Trust recorded a
liability at September 30, 1996, equal to the total dividends in arrears on that
date.
F-49
34. QUARTERLY FINANCIAL DATA (UNAUDITED) - THE TRUST
Year Ended September 30, 1996
------------------------------------------------------------
(In thousands, except per share amounts) December March June September
- ------------------------------------------------------------------- ------------- ------------- -------------- -------------
Real Estate Trust:
Total income $ 18,159 $ 17,206 $ 20,696 $ 20,778
Operating loss (7,032) (7,430) (4,564) (5,150)
The Bank:
Interest income 93,589 91,230 99,254 103,438
Interest expense 48,269 46,800 45,401 48,366
Provision for loan losses (11,913) (28,850) (30,062) (44,915)
Other income 66,212 89,324 96,935 91,990
Operating income (loss) 15,984 21,341 31,617 (22,831)
Total Company:
Operating income (loss) before income taxes and
minority interest 8,952 13,911 27,053 (27,981)
Income (loss) before minority interest 5,199 7,842 15,621 (15,028)
Net income (loss) 1,294 3,225 10,054 (14,651)
Net income (loss) per common share (0.01) 0.39 1.80 (3.32)
- ---------------------------------------------------------------------------------------------------------------------------------
Year Ended September 30, 1995
------------------------------------------------------------
(In thousands, except per share amounts) December March June September
- ------------------------------------------------------------------- ------------- ------------- -------------- -------------
Real Estate Trust:
Total income $ 17,324 $ 17,541 $ 21,754 $ 20,666
Operating loss (7,217) (6,574) (4,581) (8,969)
The Bank:
Interest income 81,783 91,310 97,147 95,075
Interest expense 42,641 46,819 51,277 48,377
Provision for loan losses (8,607) (13,618) (13,604) (19,150)
Other income 43,107 55,304 67,950 66,756
Operating income 6,034 12,371 23,592 13,686
Total Company:
Operating income (loss) before income taxes and
minority interest (1,183) 5,797 19,011 4,717
Income (loss) before minority interest (742) 4,923 12,415 9,725
Net income (loss) (3,480) 1,135 7,379 5,816
Net income (loss) per common share (1.00) (0.05) 1.25 0.92
F-50
35. INDUSTRY SEGMENT INFORMATION - TRUST
Industry segment information with regard to the Real Estate Trust is presented
below. For information regarding the Bank, please refer to the "Banking"
sections of the accompanying financial statements.
Year Ended September 30
----------------------------------------------
(In thousands) 1996 1995 1994
- ---------------------------------------------------------------------- -------------- -------------- -------------
INCOME
Hotels $ 54,245 $ 54,104 $ 46,046
Commercial properties 17,590 18,812 16,815
Other 5,004 4,369 3,183
-------------- -------------- -------------
$ 76,839 $ 77,285 $ 66,044
============== ============== =============
OPERATING PROFIT (LOSS)
Hotels $ 12,635 $ 10,836 $ 7,488
Commercial properties 5,893 6,951 5,473
Other 6,702 6,670 3,510
-------------- -------------- -------------
25,230 24,457 16,471
Gain (loss) on sales of property (68) 1,664 --
Interest and debt expense (40,514) (41,040) (40,576)
Advisory fee, management and leasing fees - related parties (7,423) (7,376) (6,793)
General and administrative (1,401) (2,319) (2,027)
Write-down of assets to net realizable value -- (2,727) (1,380)
-------------- -------------- -------------
Operating loss $ (24,176) $ (27,341) $ (34,305)
============== ============== =============
IDENTIFIABLE ASSETS (AT YEAR END)
Hotels $ 84,255 $ 87,143 $ 79,183
Commercial properties 78,388 81,821 83,937
Other 129,923 144,448 164,619
-------------- -------------- -------------
$ 292,566 $ 313,412 $ 327,739
============== ============== =============
DEPRECIATION
Hotels $ 5,535 $ 5,230 $ 4,684
Commercial properties 4,446 4,452 4,370
Other 39 32 28
-------------- -------------- -------------
$ 10,020 $ 9,714 $ 9,082
============== ============== =============
CAPITAL EXPENDITURES
Hotels $ 4,769 $ 13,815 $ 3,586
Commercial properties 2,444 2,544 2,486
Other 195 103 645
-------------- -------------- -------------
$ 7,408 $ 16,462 $ 6,717
============== ============== =============
F-51
36. CONDENSED FINANCIAL STATEMENTS - THE TRUST
These condensed financial statements reflect the Real Estate Trust and all its
consolidated subsidiaries except for the Bank which has been reflected on the
equity method.
CONDENSED BALANCE SHEETS
September 30,
-----------------------------------------
(In thousands) 1996 1995
- ------------------------------------------------------------------- -----------------------------------------
ASSETS
Income-producing properties $ 232,628 $ 238,927
Accumulated depreciation (76,513) (75,140)
-----------------------------------------
156,115 163,787
Land parcels 41,580 38,458
Equity investment in bank 184,258 174,222
Cash and cash equivalents 15,516 17,355
Other assets 81,292 93,812
-----------------------------------------
TOTAL ASSETS $ 478,761 $ 487,634
=========================================
LIABILITIES
Mortgage notes payable $ 173,345 $ 184,502
Notes payable - secured 177,500 175,500
Notes payable - unsecured 42,367 41,057
Deferred gains - real estate 112,883 112,883
Other liabilities and accrued expenses 41,184 41,872
-----------------------------------------
Total liabilities 547,279 555,814
-----------------------------------------
TOTAL SHAREHOLDERS' DEFICIT* (68,518) (68,180)
-----------------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' DEFICIT $ 478,761 $ 487,634
=========================================
* See Consolidated Statements of Shareholders' Deficit
CONDENSED STATEMENTS OF OPERATIONS
For the Year Ended September 30
--------------------------------------------------------------
(In thousands) 1996 1995 1994
- ------------------------------------------------------------------- --------------------------------------------------------------
Total income $ 76,839 $ 77,285 $ 66,044
Total expenses (104,321) (109,971) (102,087)
Equity in earnings of partnership investments 3,374 3,681 1,738
Gain (loss) on sales of property (68) 1,664 --
--------------------------------------------------------------
Real estate operating loss (24,176) (27,341) (34,305)
Equity in earnings of bank 15,846 22,882 15,850
--------------------------------------------------------------
Total company operating loss (8,330) (4,459) (18,455)
Income tax benefit (8,252) (15,309) (15,369)
--------------------------------------------------------------
Income (loss) before extraordinary item and
cumulative effect of change in accounting principle (78) 10,850 (3,086)
Extraordinary item: loss on early extinguishment of debt -- -- (4,982)
--------------------------------------------------------------
Income (loss) before cumulative effect of change in
accounting principle (78) 10,850 (8,068)
Cumulative effect of change in accounting principle -- -- 31,157
--------------------------------------------------------------
TOTAL COMPANY NET INCOME (LOSS) $ (78) $ 10,850 $ 23,089
==============================================================
F-52
CONDENSED STATEMENTS OF CASH FLOWS
For the Year Ended September 30
--------------------------------------------------------------
(In thousands) 1996 1995 1994
- ------------------------------------------------------------------- --------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) $ (78) $ 10,850 $ 23,089
Adjustments to reconcile net income (loss) to net cash provided
by (used in) operating activities:
Depreciation 10,020 9,714 9,082
Write-down of real estate to net realizable value -- 2,727 1,380
Loss (gain) on sales of property 68 (1,654) --
Equity in earnings of bank (15,846) (22,882) (15,850)
(Increase) decrease in deferred tax asset (192) 10,836 (19,028)
Loss on early extinguishment of debt -- -- 4,982
Decrease (increase) in accounts receivable and accrued income (4,869) (224) (516)
Increase (decrease) in accounts payable and accrued expenses 430 317 (5,473)
Decrease (increase) in tax sharing receivable 16,606 (5,685) (12,015)
Other 3,643 325 3,490
--------------------------------------------------------------
Net cash provided by (used in) operating activities 9,782 4,324 (10,859)
--------------------------------------------------------------
CASH FLOW FROM INVESTING ACTIVITIES
Capital expenditures - properties (7,408) (6,270) (6,717)
Property acquisitions -- (10,193) --
Property sales 1,812 -- --
Equity investment in unconsolidated entities 639 (733) (17,780)
Notes receivable - affiliates -- -- (12,675)
Other investing activities 50 53 43
--------------------------------------------------------------
Net cash used in investing activities (4,907) (17,143) (37,129)
--------------------------------------------------------------
CASH FLOW FROM FINANCING ACTIVITIES
Proceeds from long-term debt 6,208 16,328 185,080
Repayments of long-term debt (11,471) (16,083) (74,161)
Financing proceeds placed in liquidity maintenance escrow -- -- (25,792)
Costs of obtaining financings (201) (516) (9,404)
Dividends paid (1,250) -- --
--------------------------------------------------------------
Net cash provided by (used in) financing activities (6,714) (271) 75,723
--------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents (1,839) (13,090) 27,735
Cash and cash equivalents at beginning of year 17,355 30,445 2,710
--------------------------------------------------------------
Cash and cash equivalents at end of year $ 15,516 $ 17,355 $ 30,445
==============================================================
F-53
EXECUTIVE OFFICES OF TRUST TRUSTEES PRINCIPAL OFFICERS
- ------------------------------------ --------------------------------- ----------------------------------------
B. F. Saul Real Estate Garland J. Bloom, Jr.(A) B. Francis Saul II
Investment Trust Real Estate Consultant CHAIRMAN OF THE BOARD
8401 Connecticut Avenue Chairman of the Board
Chevy Chase, Maryland 20815 Gilbert M. Grosvenor(A) and President, Chevy Chase
(301) 986-6000 Chairman Bank, F.S.B., B.F. Saul
National Geographic Company and B.F. Saul
NOTE SALES OFFICE Society Advisory Company, Chairman &
7200 Wisconsin Avenue, Suite 903 Chief Executive Officer,
Bethesda, Maryland 20814 George M. Rogers, Jr.(E,N) Saul Centers, Inc.
(301) 986-6207 Partner, Shaw, Pittman,
Potts & Trowbridge Philip D. Caraci
ADVISOR (Attorneys at Law) SENIOR VICE PRESIDENT AND
B.F. Saul Advisory Company SECRETARY
8401 Connecticut Avenue B. Francis Saul II(E) Executive Vice President, B.F. Saul
Chevy Chase, Maryland 20815 Chairman of the Board and Company, Senior Vice President,
(301) 986-6000 President, Chevy Chase B.F. Saul Advisory Company,
Savings Bank, F.S.B., President Franklin Property Company,
REAL ESTATE MANAGER B.F. Saul Company and and Saul Centers, Inc.
Franklin Property Company B.F. Saul Advisory Company,
8401 Connecticut Avenue Chairman & Chief Executive Stephen R. Halpin, Jr.
Chevy Chase, Maryland 20815 Officer, Saul Centers, Inc. VICE PRESIDENT AND
(301) 986-6000 CHIEF FINANCIAL OFFICER
John R. Whitmore(E,N) Executive Vice President
GENERAL COUNSEL President and Chief and Chief Financial
Shaw, Pittman, Potts & Trowbridge Executive Officer Officer, Chevy Chase Bank,
Washington, DC 20037 The Bessemer Group, FSB and B.F. Saul Company
Incorporated
INDEPENDENT ACCOUNTANTS Ross E. Heasley
Arthur Andersen, LLP (A) Audit Committee Member VICE PRESIDENT
Washington, DC 20006 (E) Executive Committee Member Vice President, B.F. Saul
(N) Nonissuing Committee Member Company, B.F. Saul Advisory Company,
INDENTURE TRUSTEE Franklin Property Company, and
Unsecured Notes Saul Centers, Inc.
The Riggs National Bank of
Washington, DC Henry Ravenel, Jr.
Washington, DC 20013 VICE PRESIDENT
Vice President, B.F. Saul Company,
INDENTURE TRUSTEE B.F. Saul Advisory Company and Saul
Senior Secured Notes Centers, Inc.
Norwest Bank Minnesota, NA
Minneapolis, MN 55479 William K. Albright
VICE PRESIDENT AND TREASURER
Vice President and Treasurer,
10-K REPORT TO SEC B.F. Saul Company, B.F. Saul
The Trust's Annual Report to the Advisory Company, Franklin
Securities and Exchange Commission Property Company, Vice President &
(Form 10-K), which includes a Assistant Treasurer, Saul Centers, Inc.
consolidated schedule of investment
properties, is available without
charge from the Secretary of the Trust
at the address and telephone number
indicated above.