O c e a n F i n a n c i a l C o r p . [PHOTO] 1 9 9 8 A n n u a l R e p o r t [MAP] Our Mission Statement --------------------- Ocean Financial Corp. develops shareholder value as a community-focused financial services organization. [PHOTO] Ocean Federal Savings Bank, the subsidiary of Ocean Financial Corp., is located in the central coastal area of New Jersey between the major metropolitan cities of New York and Philadelphia. With administrative offices in Toms River, New Jersey (shown above), Ocean Federal provides financial services to retail and business customers throughout the Jersey Shore market. Table of Contents - ------------------------------------------------------------ Financial Highlights 1 - ------------------------------------------------------------ Letter to our Shareholders 2 - ------------------------------------------------------------ Board of Directors 5 - ------------------------------------------------------------ Bank Services 6 - ------------------------------------------------------------ Selected Financial Data 11 - ------------------------------------------------------------ Management's Discussion and Analysis 13 - ------------------------------------------------------------ Consolidated Financial Statements 21 - ------------------------------------------------------------ Directors and Senior Officers 38 - ------------------------------------------------------------ Shareholder Information Inside Back Cover - ------------------------------------------------------------ Financial Highlights - ------------------------------------------------------------------------------- (dollars in thousands, except per share amounts) At or For The Year Ended December 31, 1998 1997 1996 - ----------------------------------------------------------------------------------------------------- Total assets $ 1,561,744 $ 1,510,947 $ 1,303,865 - ----------------------------------------------------------------------------------------------------- Loans receivable, net 941,011 783,695 678,728 - ----------------------------------------------------------------------------------------------------- Deposits 1,035,251 976,764 934,730 - ----------------------------------------------------------------------------------------------------- Stockholders' equity 197,740 215,544 252,789 - ----------------------------------------------------------------------------------------------------- Net interest income 44,158 43,048 36,379 - ----------------------------------------------------------------------------------------------------- Provision for loan losses 900 900 700 - ----------------------------------------------------------------------------------------------------- Net income before non-recurring items 13,525 13,825 11,576 - ----------------------------------------------------------------------------------------------------- Net income (loss) 12,972 13,825 (1,729) - ----------------------------------------------------------------------------------------------------- Diluted earnings per share (3) 0.95 0.88 N/A - ----------------------------------------------------------------------------------------------------- Stockholders' equity per common share (3) 13.52 13.72 13.95 - ----------------------------------------------------------------------------------------------------- Stockholders' equity to total assets at end of year 12.66% 14.27% 19.39% - ----------------------------------------------------------------------------------------------------- Performance Ratios (1): - ----------------------------------------------------------------------------------------------------- Return on average assets 0.88% 0.97% 1.00% - ----------------------------------------------------------------------------------------------------- Return on average stockholders' equity 6.63 6.00 6.91 - ----------------------------------------------------------------------------------------------------- Average interest rate spread 2.39 2.39 2.61 - ----------------------------------------------------------------------------------------------------- Net interest margin 2.98 3.12 3.22 - ----------------------------------------------------------------------------------------------------- Operating expenses to average assets 1.66 1.63 1.73 - ----------------------------------------------------------------------------------------------------- Operating efficiency ratio 53.69 50.80 51.11 - ----------------------------------------------------------------------------------------------------- Actual contributions to stockholders' equity and resultant cash earnings data (2) (before non-recurring items): - ----------------------------------------------------------------------------------------------------- Cash earnings $ 16,688 $ 16,823 $ 12,456 - ----------------------------------------------------------------------------------------------------- Diluted cash earnings per share (3) 1.22 1.08 N/A - ----------------------------------------------------------------------------------------------------- Return on average assets 1.09% 1.19% 1.07% - ----------------------------------------------------------------------------------------------------- Return on average stockholders' equity 8.18 7.30 7.43 - ----------------------------------------------------------------------------------------------------- Operating efficiency ratio 44.60 41.76 47.87 - ----------------------------------------------------------------------------------------------------- (1) Performance ratios are calculated to exclude the effect of non-recurring charges in 1998 relating to the loss on the sale of mortgage-backed securities and in 1996 for a charitable donation and the special Savings Association Insurance Fund assessment. (2) Cash earnings are determined by adding (net of taxes) to reported earnings the non-cash expenses stemming from the amortization and appreciation of allocated shares in the Company's stock-related benefit plans and the amortization of a premium relating to a deposit acquisition. (3) Per share amounts for prior periods have been adjusted for the two-for-one stock split effected in the form of a 100% stock dividend paid on May 15, 1998. Ocean Federal Savings Bank, the sole subsidiary of Ocean Financial Corp., founded in 1902, is a federally chartered stock savings bank with ten branches located in Ocean County and one in Middlesex County. It is the oldest and largest community-based financial institution headquartered in Ocean County, New Jersey. Letter to our Shareholders - -------------------------------------------------------------------------------- March, 1999 Dear Fellow Shareholders, Of the goals established for 1998, enhancing the value of your shares in Ocean Financial Corp. was, as always, preeminent. While we can claim to have added value to your Ocean Financial investment during the past twelve months, we believe that consistent attention to this goal over time argues for a reflection on how shareholder value is actually enhanced. In our view, with Ocean Federal Savings Bank, the subsidiary of the Ocean Financial Corp., positioned as the Community Bank of choice in one of New Jersey's fastest growing markets, shareholder value is principally built from the intrinsic, franchise value accorded to the Bank. It therefore follows that to succeed in building shareholder value over time, it is paramount to make the Bank a more profitable, yet attractive institution to both the community and its employees. This strategic objective has become a key focus of the Company's current mission. For Ocean Financial Corp., 1998 was more than the transition into the third year of operations for a parent Holding Company of a Financial Institution with nearly 100 years experience. It marked the next step in the Company's long-term plan for building shareholder value: o Diluted earnings per common share for the year amounted to $.95, an 8% increase over the $.88 earned in 1997. o Cash earnings (the amount by which stockholder equity changes solely by virtue of operating results) grew to $1.22 from $1.08 per diluted share in 1997, a 13% increase. o In May, the cash dividend on the common stock was increased 20% and the stock was split two-for-one. o The Board of Directors authorized the fourth and fifth stock repurchase programs. When completed, all five repurchase programs will have resulted in the Company repurchasing over four million shares, amounting to 22.6% of the common stock originally issued in 1996. o Stock repurchases have been invaluable in reducing the healthy, though inflated, capital ratio of the Company from over 20% in 1996, to 14.3% and 12.7% at the respective 1997 and 1998 year ends. [PHOTO] The Ocean Federal Savings Bank senior management team (from left to right) John R. Garbarino, President and Chief Executive Officer; Karl E. Reinheimer; Michael J. Fitzpatrick; Michael E. Barrett and John K. Kelly. Cash earnings (the amount by which stockholder equity changes solely by virtue of operating results) grew to $1.22 from $1.08 per diluted share in 1997, a 13% increase. 2 . Ocean Financial Corp. . OCFC o The $.12 per share paid to stockholders of record early in 1999 marks the eighth consecutive quarterly dividend declared by the Board. Throughout the year additional shareholder value was thus created through the activities of Ocean Financial Corp. Similarly, among significant benchmarks for the subsidiary Bank: o Deposits surpassed $1 billion, representing 6% growth entirely in core accounts, as CD balances remained essentially unchanged in the low interest rate environment. o The Bank's loan portfolio grew over 20%, topping $941 million at year end. Commercial loan growth was solid for the year. o As a pleasant consequence of this growth mix, the Bank's loan-to-deposit ratio increased dramatically from 80% to 91%. o At midyear, the Bank purchased the branch deposits of the Whiting office closed by Summit Bank. These deposits were successfully transferred to the existing Ocean Federal branch across the street. o A new branch office was also opened in the Lake Ridge section of Toms River, attracting $13 million in deposits in only nine months. With 11 current branches, and more planned for 1999, Ocean Federal Savings Bank is the only well-established community bank headquartered in Ocean County serving the Jersey shore. This has extended Ocean Federal the unique opportunity to essentially "redefine" community banking in the area. Through these activities, franchise value was added to the Bank, further enhancing Ocean Financial Corp. shareholder value. As the Corporate mission statement (see inside cover) clearly sets forth, the Company is focused on shareholder value built in a community banking niche. The Company is NOT a nationwide or statewide banking organization and has no international exposure. Neither is planned growth driven by a voracious appetite for acquisitions and the need to expand operations or market reach at all costs. At the other end of the spectrum, the Company is far more than a de novo, start-up community bank, devoid of essential financial products or the technology and capital resources required to deliver efficient, effective service. Ocean Federal Savings Bank is purely and simply, clearly focused on the communities served since the turn of the last century. As Money Magazine noted recently, Monmouth and Ocean Counties remain among the "most desirable regions" in which to live in the entire nation, based on economic stability, employment opportunities, and other quality-of-life factors. We certainly agree with those editors, and feel fortunate indeed to conduct our business in such a desirable market. In the coming year, the Bank will seek to continue to grow franchise value by pursuing a more diverse customer base and providing new products and services through expanded delivery systems: o Plans for two new branch offices are well under way in Spring Lake Heights and Wall Township, broadening the reach into southern Monmouth County. o Extended service hours for customers to conduct their banking more conveniently will be introduced. o A Web site will be launched to further facilitate the delivery of the Bank's financial services to the customer who chooses a computer banking option. Year Over Year Loan Growth [BAR CHART APPEARS HERE] 1995 1996 1997 1998 ---- ----- ----- ----- 3.4% 10.8% 15.5% 20.1% Loan-to-Deposit Ratio [BAR CHART APPEARS HERE] 1995 1996 1997 1998 ---- ----- ----- ----- 66.1% 72.6% 80.2% 90.9% Ocean Financial Corp. . OCFC . 3 Letter to our Shareholders - -------------------------------------------------------------------------------- o Commercial loans and core deposits will be targeted to become a greater percentage of the balance sheet as the Bank seeks to capture a more significant portion of the underserved small business market. o Trust and Asset Management services will be implemented as a community financial services business line. o The Bank's non-traditional deposit product program and related services, "Investment Services at the Ocean", will support the Company's plans to grow non-interest income, while fulfilling the community's expectations of the Bank as a trusted resource providing a full range of financial services. These improvements establish a greater competitive edge for the Community Bank, and once realized, provide the Company with a stronger capacity for enhancing future franchise and ultimately, shareholder value. These plans will be implemented with a clear focus on the most important remaining event of this century, the coming of the new millennium. At your company, "Y2K" is not merely a new buzzword in the 1999 vocabulary, rather for some time at Ocean Financial, it has represented a very important, potential problem which every employee has been focused on addressing. Ocean Financial has been getting ready for the year 2000, technologically, since early in 1997. We're looking forward to successfully serving the financial needs of our community in the new century... and so are our computers. Despite the ambitious plans and past success, however, the personal satisfaction we realize in "making a difference" is often life's greatest reward. We continue to take great pride in our active involvement with local charities, schools, and social service agencies, fulfilling our commitment to the community. Through the operations of The Ocean Federal Foundation, established and fully expensed by the Bank in 1996, nearly $3 million in grants has been awarded to needy and deserving organizations throughout our local communities, $1.2 million in 1998 alone. As important, though perhaps less visible, were the quiet efforts of individual Ocean Federal employees unselfishly volunteering their own time to community activities too numerous to document here. At Ocean Financial Corp., we encourage such extra effort -- but not merely for its good corporate citizenship and benefits to society. It is because, above all, we believe in just that: Extra effort. Only by working smarter... trying harder... and planning ahead to reach each well-defined community banking goal... can we build value for your investment and help you, our shareholders, reach your goals. And that, more than anything else, is what we value most. On behalf of the employees, officers, and Directors of Ocean Financial Corp. and Ocean Federal Savings Bank, I thank you for your trust in us -- and look forward to seeing you at the Annual Meeting on April 22, 1999. Sincerely, /s/ John R. Garbarino John R. Garbarino Chairman, President and Chief Executive Officer We're looking forward to successfully serving the financial needs of our community in the new century ...and so are our computers. 4 . Ocean Financial Corp. . OCFC Board of Directors - -------------------------------------------------------------------------------- [PHOTO] Pictured from top right, clockwise: John R. Garbarino - Chairman, President and Chief Executive Officer Donald E. McLaughlin - Audit Committee Chairman Thomas F. Curtin - Human Resources/Compensation Committee Chairman Michael E. Barrett - Executive Vice President Frederick E. Schlosser - Audit Committee, Human Resources/Compensation Committee Robert E. Kuemoller - Audit Committee Budget and Planning Committee Diane F. Rhine - Human Resources/ Compensation Committee Carl Feltz Jr. - Budget and Planning Committee James T. Snyder - Budget and Planning Committee Chairman Ocean Financial Corp. . OCFC . 5 The Value of Personal Service - -------------------------------------------------------------------------------- Financial experts have been predicting it for years: The age of consolidation. An era of megamergers, economies of scale, and growth through insatiable acquisitions. At Ocean Financial Corp., we believe in "consolidating" too. Except our efforts are concentrated on bringing everything together locally. As THE Community Bank in our local market, thinking first about those who live, work, bank and invest here is not just being "responsive." It's our responsibility. Which is why such careful thought went into the 1998 introduction of new products designed to serve our customers better, and to ultimately build value for our shareholders. Offering a wider choice in retail checking -- including a spectrum of interest- [PHOTO] Assistant Manager, Ruth D. Louis, at our Toms River branch, greets each customer with a smile. bearing accounts and a VISA(R) check card -- allowed us to broaden relationships with existing customers while attracting over 9,000 new checking accounts. Our investment services, including mutual funds, annuities and other non-traditional products, also encouraged a full-service connection that might otherwise have been lost to competition. On that note, retaining customers, enhancing branch traffic and cross-selling bank services were a major focus in 1998 and will continue to be emphasized going forward. Our Retail Division is designed to cater to customer needs with a team approach to service that provides one-stop decision making and even faster responses to their requests. We believe these efforts, and other aggressive measures, will give the Bank a competitive edge in 1999 and beyond. For example, stronger penetration into the consumer loan, equity loan and line of credit markets will be pursued in 1999, along with our sustained emphasis on originating residential mortgage loans. Retail deposit growth will also continue to be a priority, improving the mix of core deposits vs. lower-margin funding such as CDs. Traditional fee income enhancement will also be sought, as will the analysis of office support functions to provide maximum operating efficiencies. Finally, to increase the Bank's market presence, two new branches will open in 1999, representing our first entree into Monmouth County. Our Spring Lake Heights office is scheduled for the third quarter, followed by our Wall Township office slated for the fourth quarter. Overall, these efforts are built on the belief that thoughtful planning serves us far better than a philosophy of quick fixes. In an age when consolidations can alter relationships overnight, remaining true to our community bank strengths will not just ensure we survive "merger mania." We will thrive because of it. Checking Account Growth - -------------------------------------------------------------------------------- [BAR CHART APPEARS HERE] 6 . Ocean Financial Corp. . OCFC "I live here... and work here. But most banks [PHOTO] seem to do neither. Why should I 'reach high' or 'climb mountains' when there's someone around the corner who wants to help me?" Ocean Financial Corp. . OCFC . 7 "Our old bank said a loan was 'out of the question.' so I [PHOTO] asked them one: How can you make a lending decision about my main office when your's isn't even in the state?" 8 . Ocean Financial Corp. . OCFC The Value of Relationships - -------------------------------------------------------------------------------- A marina owner in Ocean County was content with his large regional bank. That is, until his business line of credit matured, and his loan officer wouldn't return calls. After being "stood up" for a scheduled meeting without even receiving an apology, he called the Commercial Lending team at Ocean Federal instead. Shortly after, a new $1.2 million line was all his, along with merchant services to help his business grow faster. A local doctor's practice in Monmouth County was expanding, with plans to add an office in Ocean County. Yet his commercial mortgage application had been lingering for a month throughout his bank's vast loan department. With time running out to acquire the perfect location, he asked Ocean Federal for help. Our team responded with a verbal commitment in 24 hours, resulting in a mortgage for the new office and refinancing the mortgage on the original location. Now he is looking forward to the opening of our new branch office in Wall Township later this year. These are true stories with real, happy endings. Yet for those who've become disenchanted with the lending policies of larger, non-community-based banks, they are actually happy beginnings. The new relationships developed through our loan officers provide solid proof that no one knows Jersey Shore businesses better, or understands their unique challenges quite so well. Which is why the newly expanded Commercial Lending division has seen such impressive growth in its short history, improving in sales and shareholder value each year. In 1998, over $26 million in total loans were originated, representing a 41.8% increase from the prior year. Working closely with our retail branch managers and residential lending officers, our team shared referrals -- and success stories -- with commercial customers in promising markets like commercial real estate, manufacturing, and healthcare. Also in 1998, we expanded our commercial product menu, including new enhancements to Cash Management services like Account Analysis and Sweep Investment Accounts. Adding to our core business banking services like deposit accounts, escrow management and employee retirement plans, we will continue to roll out new products in 1999. For example, business customers can look forward to Internet account access in 1999, providing added speed and convenience for their company banking needs. With an ever present emphasis on quality, loan growth remains a priority. Our focus will be to capitalize on current relationships by providing in-depth local knowledge and prompt, responsive service -- then cross-selling whenever possible over business lines. Additionally, Ocean Federal's growing branch network, including our upcoming Monmouth County offices, will also open more avenues. Of course, our most important "address" isn't located in any one branch. It is in how we address each customer: With the respect they deserve as successful members of our business community. And with the friendliness one shares with a good neighbor. [PHOTO] Mary Huff, Vice President Commercial Lending, visits a local -- and loyal -- business customer to discuss financing options for the company's expansion. Ocean Financial Corp. . OCFC . 9 The Value of Commitment - -------------------------------------------------------------------------------- You could call it "investing in our future" with a positive "return on equity" that Ocean Financial Corp. shares in the community. We prefer to think of it as "giving back" to those who've supported us. In 1998, our commitment to the community was stronger than ever, especially in support of the service organizations and programs that make our neighborhoods a better place to live. This was perhaps most obvious through the continued activities of The Ocean Federal Foundation, the private nonprofit foundation established and fully expensed in 1996 by Ocean Federal Savings Bank to provide assistance to charitable endeavors in our communities. Over $1.2 million was awarded by the Foundation last year -- including grants to such deserving efforts as programs to support the arts, education, not-for- profit medical organizations, and housing for the disadvantaged. [PHOTO] From funding for the disadvantaged to support for the arts, the Foundation continues to help improve quality of life in our community. Cerebral Palsy of Monmouth and Ocean, for example, obtained over $100,000 to help build a home for individuals with physical handicaps. Coastal Caregivers and Caregivers of Toms River received over $37,000 in funding for their ongoing efforts to provide services for the elderly. A grant for $73,000 made it possible to establish a local Big Brothers Big Sisters chapter. In addition, cultural programs such as the "Festival of the Atlantic" and Brick Township's Summerfest were able to continue with the assistance of the Foundation. These popular summer concert series on our beaches are enjoyed by thousands of residents and vacationers. On a related note, as most of America cheered them on to a World Championship, we took special pride in the accomplishments of the 1998 Toms River East Little League team. Although our loan to finance their all-season practice facility may not be the only reason our "home team" enjoyed such success -- it felt good to be one of their earliest fans. Fans, who like all loyal supporters, are with the team through thick and thin. Just as we've been for our neighbors for nearly 100 years. [PHOTO] Crowned World Champion in 1998, the Toms River East Little League team brought pride and more than a few smiles to all of us here in Ocean County. In 1998, our commitment to the community was stronger than ever, especially in support of the service organizations and programs that make our neighborhoods a better place to live. 10 . Ocean Financial Corp. . OCFC Selected Consolidated Financial and Other Data of the Company - -------------------------------------------------------------------------------- The selected consolidated financial and other data of the Company set forth below is derived in part from, and should be read in conjunction with the Consolidated Financial Statements of the Company and Notes thereto presented elsewhere in this Annual Report. At December 31, 1998 1997 1996 1995 1994 - ----------------------------------------------------------------------------------------------------------------------------- (dollars in thousands) Selected Financial Condition Data: - ----------------------------------------------------------------------------------------------------------------------------- Total assets $ 1,561,744 $ 1,510,947 $ 1,303,865 $ 1,036,445 $ 971,651 - ----------------------------------------------------------------------------------------------------------------------------- Investment securities held to maturity -- -- -- -- 127,451 - ----------------------------------------------------------------------------------------------------------------------------- Investment securities available for sale 137,405 207,357 174,028 114,881 -- - ----------------------------------------------------------------------------------------------------------------------------- FHLB-NY stock 16,800 14,980 8,457 7,723 7,323 - ----------------------------------------------------------------------------------------------------------------------------- Mortgage-backed securities held to maturity -- -- -- -- 224,569 - ----------------------------------------------------------------------------------------------------------------------------- Mortgage-backed securities available for sale 381,840 457,148 395,542 265,113 -- - ----------------------------------------------------------------------------------------------------------------------------- Loans receivable, net 941,011 783,695 678,728 612,696 592,315 - ----------------------------------------------------------------------------------------------------------------------------- Mortgage loans held for sale 25,140 -- 727 1,894 -- - ----------------------------------------------------------------------------------------------------------------------------- Deposits 1,035,251 976,764 934,730 926,558 867,420 - ----------------------------------------------------------------------------------------------------------------------------- Federal Home Loan Bank borrowings 30,000 20,400 8,800 10,400 -- - ----------------------------------------------------------------------------------------------------------------------------- Securities sold under agreements to repurchase 282,108 288,200 99,322 -- -- - ----------------------------------------------------------------------------------------------------------------------------- Stockholders' equity 197,740 215,544 252,789 92,351 82,334 - ----------------------------------------------------------------------------------------------------------------------------- For the Year Ended December 31, 1998 1997 1996 1995 1994 - ----------------------------------------------------------------------------------------------------------------------------- (dollars in thousands except per share amounts) Selected Operating Data: - ----------------------------------------------------------------------------------------------------------------------------- Interest income $ 105,557 $ 98,656 $ 80,236 $ 70,210 $ 63,683 - ----------------------------------------------------------------------------------------------------------------------------- Interest expense 61,399 55,608 43,857 40,004 32,373 - ----------------------------------------------------------------------------------------------------------------------------- Net interest income 44,158 43,048 36,379 30,206 31,310 - ----------------------------------------------------------------------------------------------------------------------------- Provision for loan losses 900 900 700 950 1,129 - ----------------------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 43,258 42,148 35,679 29,256 30,181 - ----------------------------------------------------------------------------------------------------------------------------- Other income 2,411 2,509 2,881 1,356 2,057 - ----------------------------------------------------------------------------------------------------------------------------- Operating expenses 25,457 23,145 39,206 18,006 17,104 - ----------------------------------------------------------------------------------------------------------------------------- Income (loss) before provision for income taxes 20,212 21,512 (646) 12,606 15,134 - ----------------------------------------------------------------------------------------------------------------------------- Provision for income taxes 7,240 7,687 1,083 4,659 5,405 - ----------------------------------------------------------------------------------------------------------------------------- Net income (loss) $ 12,972 $ 13,825 $ (1,729) $ 7,947 $ 9,729 - ----------------------------------------------------------------------------------------------------------------------------- Basic earnings (loss) per share $ .97 $ .90 $ (.39) N/A N/A - ----------------------------------------------------------------------------------------------------------------------------- Diluted earnings (loss) per share $ .95 $ .88 $ (.39) N/A N/A - ----------------------------------------------------------------------------------------------------------------------------- Net income before non-recurring items (2) $ 13,525 $ 13,825 $ 11,576 $ 7,947 $ 9,729 - ----------------------------------------------------------------------------------------------------------------------------- Earnings (loss) per share for 1996 is for the period from July 2, 1996 (date of conversion) to December 31, 1996 Per share amounts for prior periods have been adjusted for the two-for-one stock split effected in the form of a 100% stock dividend paid on May 15, 1998. Selected Consolidated Financial and Other Data (continued) Ocean Financial Corp. . OCFC . 11 At or for the Year Ended December 31, 1998 1997 1996 1995 1994 - ----------------------------------------------------------------------------------------------------------------------------- Selected Financial Ratios and Other Data (1): - ----------------------------------------------------------------------------------------------------------------------------- Performance Ratios: - ----------------------------------------------------------------------------------------------------------------------------- Return on average assets 0.85% 0.97% (.15)% 0.80% 1.02% - ----------------------------------------------------------------------------------------------------------------------------- Return on average assets, as adjusted (2) 0.88 0.97 1.00 0.80 1.02 - ----------------------------------------------------------------------------------------------------------------------------- Return on average stockholders' equity 6.36 6.00 (1.03) 9.44 12.54 - ----------------------------------------------------------------------------------------------------------------------------- Return on average stockholders' equity, as adjusted (2) 6.63 6.00 6.91 9.44 12.54 - ----------------------------------------------------------------------------------------------------------------------------- Average stockholders' equity to average assets 13.33 16.25 14.42 8.51 8.11 - ----------------------------------------------------------------------------------------------------------------------------- Stockholders' equity to total assets at end of year 12.66 14.27 19.39 8.91 8.47 - ----------------------------------------------------------------------------------------------------------------------------- Average interest rate spread (3) 2.39 2.39 2.61 2.79 3.07 - ----------------------------------------------------------------------------------------------------------------------------- Net interest margin (4) 2.98 3.12 3.22 3.13 3.34 - ----------------------------------------------------------------------------------------------------------------------------- Average interest-earning assets to average - ----------------------------------------------------------------------------------------------------------------------------- interest-bearing liabilities 114.35 117.95 115.84 107.98 107.71 - ----------------------------------------------------------------------------------------------------------------------------- Operating expenses to average assets 1.66 1.63 3.37 1.82 1.79 - ----------------------------------------------------------------------------------------------------------------------------- Operating expenses to average assets, as adjusted (2) 1.66 1.63 1.73 1.82 1.79 - ----------------------------------------------------------------------------------------------------------------------------- Operating efficiency ratio (5) 54.67 50.80 99.86 57.05 51.26 - ----------------------------------------------------------------------------------------------------------------------------- Operating efficiency ratio, as adjusted (2)(5) 53.69 50.80 51.11 57.05 51.26 - ----------------------------------------------------------------------------------------------------------------------------- Regulatory Capital Ratios (Bank Only): - ----------------------------------------------------------------------------------------------------------------------------- Tangible capital 10.78 11.91 12.69 8.72 8.43 - ----------------------------------------------------------------------------------------------------------------------------- Core capital 10.78 11.91 12.69 8.72 8.43 - ----------------------------------------------------------------------------------------------------------------------------- Risk-based capital 22.77 29.88 32.04 21.34 20.34 - ----------------------------------------------------------------------------------------------------------------------------- Asset Quality Ratios: - ----------------------------------------------------------------------------------------------------------------------------- Non-performing loans as a percent of total loans receivable (6)(7) 0.56 0.70 1.12 1.40 1.83 - ----------------------------------------------------------------------------------------------------------------------------- Non-performing assets as a percent of total assets (7) 0.35 0.45 0.71 0.97 1.29 - ----------------------------------------------------------------------------------------------------------------------------- Allowance for loan losses as a percent of total loans receivable (6) 0.76 0.83 0.88 0.97 0.94 - ----------------------------------------------------------------------------------------------------------------------------- Allowance for loan losses as a percent of total non-performing loans (7) 137.54 119.03 78.23 69.21 51.27 - ----------------------------------------------------------------------------------------------------------------------------- Number of full-service customer facilities 11 10 9 8 8 - ----------------------------------------------------------------------------------------------------------------------------- (1) With the exception of end of year ratios, all ratios are based on average daily balances for 1998, 1997, 1996 and 1995 and average monthly balances for 1994. (2) Performance ratios are calculated to exclude the effect of non-recurring charges in 1998 relating to the loss on the sale of mortgage-backed securities and in 1996 relating to a charitable donation and the special Savings Association Insurance Fund assessment. (3) The average interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities. (4) The net interest margin represents net interest income as a percentage of average interest-earning assets. (5) Operating efficiency ratio represents the ratio of operating expenses to the aggregate of other income and net interest income. (6) Total loans receivable includes loans receivable and loans held for sale, less undisbursed loan funds, deferred loan fees and unamortized discounts/premiums. (7) Non-performing assets consist of non-performing loans and real estate acquired through foreclosure ("REO"). Non-performing loans consist of all loans 90 days or more past due and other loans in the process of foreclosure. It is the Company's policy to cease accruing interest on all such loans. 12 . Ocean Financial Corp. . OCFC Management's Discussion and Analysis of Financial Condition and Results of Operations - -------------------------------------------------------------------------------- General Ocean Financial Corp. (the "Company") was incorporated on November 21, 1995, and is the holding company for Ocean Federal Savings Bank (the "Bank"). On August 17, 1995, the Board of Directors of the Bank adopted a Plan of Conversion, as amended, to convert from a federally chartered mutual savings bank to a federally chartered capital stock savings bank with the concurrent formation of a holding company ("the Conversion"). The Conversion was completed on July 2, 1996 with the issuance by the Company of 16,776,156 shares of its common stock in a public offering to the Bank's eligible depositors and the Bank's employee stock ownership plan (the "ESOP"). The purchase of 1,342,092 shares of common stock (8% of the total shares offered) by the ESOP was funded by a loan of $13.4 million from the Company. In exchange for 50% of the net conversion proceeds ($81.6 million), the Company acquired 100% of the stock of the Bank and retained the remaining net conversion proceeds at the holding company level. Concurrent with the close of the Conversion, an additional 1,342,092 shares of common stock (8% of the offering) were issued and donated by the Company to the Ocean Federal Foundation (the "Foundation"), a private foundation dedicated to charitable purposes within Ocean County, New Jersey and its neighboring communities. The fair market value of the contribution of $13.4 million was reflected as an expense in the Company's 1996 operating results and as an increase to capital stock and paid in capital for the same amount. The Company had no operations prior to July 2, 1996 and, accordingly, the results of operations prior to that date reflect only those of the Bank and its subsidiaries. The Company conducts business, primarily through its ownership of the Bank which operates its administrative/branch office located in Toms River and ten other branch offices. Ten of the eleven branch offices are located in Ocean County, New Jersey with the eleventh branch in Middlesex County. The Company has historically operated as a consumer-oriented federal savings bank, with a focus on offering traditional savings deposit and loan products to its local community. In recent years, the Company's strategy has been to maintain profitability while limiting its credit and interest rate risk exposure. To accomplish these objectives, the Company has sought to: (1) control credit risk by emphasizing the origination of single-family, owner-occupied residential mortgage loans and consumer loans, consisting primarily of home equity loans and lines of credit; (2) offer superior service and competitive rates to increase the core deposit base consistent with its capital management goals; (3) invest funds in excess of loan demand in mortgage-backed and investment securities; and (4) control operating expenses. The Company expects to continue to capitalize on its strengths -- the delivery of traditional thrift products and services (primarily single-family mortgages) with a high level of customer service, thereby maintaining its community orientation. Despite this emphasis, the Company took steps from 1996 to 1998 to modify its historical operating strategy. With industry consolidation eliminating most locally headquartered competitors, the Company saw an opportunity to fill a perceived void for locally delivered commercial loan and deposit services. As such, in the second half of 1996 the Company assembled an experienced team of commercial lending professionals and began offering commercial loan and deposit services and merchant credit card services to businesses in Ocean County and surrounding communities. Management believes that the diversification of the Company's loan products may expose the Company to a higher degree of credit risk than is involved in the Company's one- to four-family residential mortgage lending activity. As a consequence of this strategy, management has developed a well-defined credit policy focusing on quality underwriting and close management and Board monitoring. With the significant increase in capital arising from the stock conversion, the Company adopted a leverage strategy in late 1996 to improve returns on capital. The strategy included the retention of most 30-year fixed rate mortgage loans, most of which had previously been sold and the use of wholesale borrowings to fund purchases of investment and mortgage-backed securities. The adoption of this strategy may increase the Company's interest rate risk exposure. As noted below, management seeks to carefully monitor and assess the Company's interest rate risk exposure while actively managing the balance sheet composition. Management is also seeking to increase the Company's market share in its primary market area by expanding the Bank's branch network. During 1996, the Company opened a branch office in Toms River at the site of its new administrative offices. In February 1997, a new branch opened in Lacey Township. In 1998, the Company opened an additional branch office in Toms River during the second quarter. Branches in Wall Township and Spring Lake Heights, both in Southern Monmouth County, are expected to open during the latter part of 1999. The Company is also evaluating additional office sites within its existing market area. Management is also seeking to diversify its retail product line. During 1998, the Company began offering alternative investment products (annuities and mutual funds) for sale through its retail branch network. The products are non- proprietary, sold through a third party vendor, and provide the Company with fee income opportunities. In 1999, the menu of alternative investment products will be expanded to include life insurance. The Company is also planning the introduction of trust and asset management services during 1999. The Company's results of operations are dependent primarily on net interest income, which is the difference between the interest income earned on the Company's interest-earning assets, such as loans and investments, and the interest expense on its interest-bearing liabilities, such as deposits and borrowings. The Company also generates non-interest income such as income from secondary marketing activities, loan servicing and other fees. The Company's operating expenses primarily consist of compensation and employee benefits, general and administrative expenses, federal deposit insurance premiums, occupancy and equipment expenses, marketing expenses and other operating expenses. The Company's results of operations are also significantly affected by general economic and competitive conditions, particularly changes in market interest rates, government policies and actions of regulatory agencies. Ocean Financial Corp. - OCFC Page 13 - -------------------------------------------------------------------------------- Management of Interest Rate Risk Market risk is the risk of loss from adverse changes in market prices and rates. The Company's market risk arises primarily from interest rate risk inherent in its lending, investment and deposit taking activities. The Company's profitability is affected by fluctuations in interest rates. A sudden and substantial increase in interest rates may adversely impact the Company's earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent or on the same basis. To that end, management actively monitors and manages its interest rate risk exposure. The principal objectives of the Company's interest rate risk management function are to evaluate the interest rate risk included in certain balance sheet accounts; determine the level of risk appropriate given the Company's business focus, operating environment, capital and liquidity requirements and performance objectives; and manage the risk consistent with Board approved guidelines. Through such management, the Company seeks to reduce the vulnerability of its operations to changes in interest rates. The Company monitors its interest rate risk as such risk relates to its operating strategies. The Company's Board of Directors has established an Asset/Liability Committee ("ALCO Committee") consisting of members of the Company's management, responsible for reviewing the Company's asset/liability policies and interest rate risk position. The ALCO Committee meets monthly and reports trends and the Company's interest rate risk position to the Board of Directors on a quarterly basis. The extent of the movement of interest rates, higher or lower, is an uncertainty that could have a negative impact on the earnings of the Company. In recent years, the Company has utilized the following strategies to manage interest rate risk: (i) emphasizing the origination for portfolio of fixed-rate mortgage loans having terms to maturity of not more than fifteen years, adjustable-rate loans, and consumer loans consisting primarily of home equity loans and lines of credit; (ii) holding primarily short-term and/or adjustable- rate mortgage-backed and investment securities; and (iii) attempting to reduce the overall interest rate sensitivity of liabilities by emphasizing core and longer-term deposits. The Company also periodically sells 30-year fixed-rate mortgage loans into the secondary market. In determining whether to retain 30- year fixed-rate mortgages, management considers the Company's overall interest rate risk position, the volume of such loans, the loan yield and the types and amount of funding sources. During 1997 and 1998 the Company began retaining most of its 30-year fixed rate mortgage loan production in order to improve yields and increase balance sheet leverage. Management felt that the significant capital position of the Company resulting from the Conversion, mitigated the additional interest rate risk associated with retaining these mortgages. Additionally, the Company extended the maturity on part of its wholesale borrowings for up to ten years. The matching of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are "interest rate sensitive" and by monitoring an institution's interest rate sensitivity "gap." An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within that time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. Accordingly, during a period of rising interest rates, an institution with a negative gap position generally would not be in as favorable a position, compared to an institution with a positive gap, to invest in higher yielding assets. This may result in the yield on the institution's assets increasing at a slower rate than the increase in its cost of interest-bearing liabilities. Conversely, during a period of falling interest rates, an institution with a negative gap might experience a repricing of its assets at a slower rate than its interest-bearing liabilities, which, consequently, may result in its net interest income growing at a faster rate than an institution with a positive gap position. At December 31, 1998 the Company's one year gap was negative 10.6%. In performing this calculation, except as stated below, the amount of assets and liabilities which reprice or mature during a particular period were determined in accordance with the earlier of term to repricing or the contractual maturity of the asset or liability. Loans receivable reflect principal balances expected to be redeployed and/or repriced as a result of contractual amortization and anticipated prepayments of adjustable-rate loans and fixed-rate loans, and as a result of contractual rate adjustments on adjustable-rate loans. Loans on residential properties were projected to repay at rates between 6% and 30% annually. Mortgage-backed securities were projected to prepay at rates between 20% and 30% annually. Passbook accounts, negotiable order of withdrawal ("NOW") and money market accounts were assumed to decay at 3.33% per month. Prepayment and decay rates can have a significant impact on the Company's estimated gap. There can be no assurance that projected prepayment rates for loans and mortgage-backed securities will be achieved or that projected decay rates will be realized. 14 . Ocean Financial Corp. . OCFC - ------------------------------------------------------------------------------- Certain shortcomings are inherent in gap analysis. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as adjustable-rate loans, have features which restrict changes in interest rates both on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, prepayment and decay rates would likely deviate significantly from those assumed in the calculation. Finally, the ability of many borrowers to service their adjustable-rate loans may be impaired in the event of an interest rate increase. Another method of analyzing an institution's exposure to interest rate risk is by measuring the change in the institution's net portfolio value ("NPV") and net interest income under various interest rate scenarios. NPV is the difference between the net present value of assets, liabilities and off-balance sheet contracts. The NPV ratio, in any interest rate scenario, is defined as the NPV in that scenario divided by the market value of assets in the same scenario. The Company's interest rate sensitivity is monitored by management through the use of an interest rate risk ("IRR") model which measures IRR by modeling the change in NPV and net interest income over a range of interest rate scenarios. The Office of Thrift Supervision ("OTS") also produces an NPV only analysis using its own model, based upon data submitted on the Bank's quarterly Thrift Financial Reports, the results of which may vary from the results provided by the Company's model, primarily due to differences in the assumptions utilized including estimated loan prepayment rates, reinvestment rates and deposit decay rates. The table below sets forth the Company's NPV and net interest income as of December 31, 1998 and 1997, as calculated by the Company. As is the case with the gap calculation, certain shortcomings are inherent in the methodology used in the NPV and net interest income IRR measurements. The model requires the making of certain assumptions which may tend to oversimplify the manner in which actual yields and costs respond to changes in market interest rates. First, the model assumes that the composition of the Company's interest sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured. Second, the model assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration to maturity or repricing of specific assets and liabilities. Third, the model does not take into account the Company's business or strategic plans. Accordingly, although the measurements below do provide an indication of the Company's IRR exposure at a particular point in time, such measurements are not intended to provide a precise forecast of the effect of changes in market interest rates on the Company's net interest income and can be expected to differ from actual results. December 31, 1998 December 31, 1997 Change in ----------------------------------------------------------------------------------------------------------------------- Interest Net Portfolio Value Net Interest Income Net Portfolio Value Net Interest Income Rates in --------------------------------- --------------------- -------------------------------- ---------------------- Basis Points NPV NPV (Rate Shock) Amount % Change Ratio Amount % Change Amount % Change Ratio Amount % Change - ------------------------------------------------------------------------------------------------------------------------------------ (dollars in thousands) 400 $ 140,420 (42.6)% 10.0 $ 40,490 (16.1)% $ 148,630 (40.7)% 10.9 $ 36,892 (22.1)% - ------------------------------------------------------------------------------------------------------------------------------------ 300 170,890 (30.1) 11.8 43,131 (10.6) 181,482 (27.6) 12.9 40,423 (14.6) - ------------------------------------------------------------------------------------------------------------------------------------ 200 202,431 (17.2) 13.5 45,347 (6.0) 213,613 (14.8) 14.7 44,085 (6.9) - ------------------------------------------------------------------------------------------------------------------------------------ 100 225,510 (7.8) 14.7 46,979 (2.7) 234,059 (6.6) 15.8 45,959 (2.9) - ------------------------------------------------------------------------------------------------------------------------------------ Static 244,538 -- 15.5 48,260 -- 250,697 -- 16.5 47,342 -- - ------------------------------------------------------------------------------------------------------------------------------------ (100) 256,618 4.9 15.9 49,023 1.6 255,243 1.8 16.5 48,446 2.3 - ------------------------------------------------------------------------------------------------------------------------------------ (200) 261,974 7.1 15.9 49,392 2.3 256,799 2.4 16.3 49,072 3.7 - ------------------------------------------------------------------------------------------------------------------------------------ (300) 264,595 8.2 15.9 49,336 2.2 258,282 3.0 16.1 50,261 6.2 - ------------------------------------------------------------------------------------------------------------------------------------ (400) 264,239 8.1 15.6 48,951 1.4 258,579 3.1 15.8 51,310 8.4 - ------------------------------------------------------------------------------------------------------------------------------------ Ocean Financial Corp. . OCFC . 15 Analysis of Net Interest Income Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income also depends upon the relative amounts of interest-earning assets and interest- bearing liabilities and the interest rate earned or paid on them. The following table sets forth certain information relating to the Company at December 31, 1998 and for each of the years ended December 31, 1998, 1997, and 1996. The yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods shown except where noted otherwise. Average balances are derived from average daily balances. The yields and costs include fees which are considered adjustments to yields. At December 31, Years Ended December 31, - ------------------------------------------------------------------------------------------------------------------------------ 1998 1998 1997 - ------------------------------------------------------------------------------------------------------------------------------ Average Average Average Yield/ Average Yield/ Average Yield/ Balance Cost Balance Interest Cost Balance Interest Cost - ------------------------------------------------------------------------------------------------------------------------------ Assets: - ------------------------------------------------------------------------------------------------------------------------------ Interest-earning assets: - ------------------------------------------------------------------------------------------------------------------------------ Interest-earning deposits and short-term investments $ 7,424 2.94% $ 5,375 $ 295 5.49% $ 2,852 $ 155 5.43% - ------------------------------------------------------------------------------------------------------------------------------ Investment securities (1) 137,405 6.50 173,158 11,461 6.62 196,650 13,302 6.76 - ------------------------------------------------------------------------------------------------------------------------------ Loans receivable, net (2) 966,151 7.55 863,172 67,038 7.77 725,866 57,540 7.93 - ------------------------------------------------------------------------------------------------------------------------------ Mortgage-backed securities (3) 381,840 6.32 423,516 25,669 6.06 442,500 26,907 6.08 - ------------------------------------------------------------------------------------------------------------------------------ FHLB stock 16,800 7.00 15,096 1,094 7.25 11,271 752 6.67 - ------------------------------------------------------------------------------------------------------------------------------ Total interest-earning assets 1,509,620 7.11 1,480,317 105,557 7.13 1,379,139 98,656 7.15 - ------------------------------------------------------------------------------------------------------------------------------ Non-interest-earning assets 52,124 49,428 38,829 - ------------------------------------------------------------------------------------------------------------------------------ Total assets $1,561,744 $1,529,745 $1,417,968 - ------------------------------------------------------------------------------------------------------------------------------ Liabilities and Equity: - ------------------------------------------------------------------------------------------------------------------------------ Interest-bearing liabilities: - ------------------------------------------------------------------------------------------------------------------------------ Money market deposit accounts $ 77,690 2.59% $ 71,800 2,026 2.82% $ 68,972 2,028 2.94% - ------------------------------------------------------------------------------------------------------------------------------ Savings accounts 172,036 2.03 167,058 3,442 2.06 168,733 3,877 2.30 - ------------------------------------------------------------------------------------------------------------------------------ NOW accounts 106,363 1.59 89,679 1,517 1.69 77,785 1,388 1.78 - ------------------------------------------------------------------------------------------------------------------------------ Time deposits 657,008 5.35 663,483 36,819 5.55 637,425 35,667 5.60 - ------------------------------------------------------------------------------------------------------------------------------ Total 1,013,097 4.18 992,020 43,804 4.42 952,915 42,960 4.51 - ------------------------------------------------------------------------------------------------------------------------------ FHLB borrowings 30,000 5.13 19,947 1,061 5.32 7,207 414 5.74 - ------------------------------------------------------------------------------------------------------------------------------ Securities sold under agreements to repurchase 282,108 5.33 282,590 16,534 5.85 209,089 12,234 5.85 - ------------------------------------------------------------------------------------------------------------------------------ Total interest-bearing liabilities 1,325,205 4.45 1,294,557 61,399 4.74 1,169,211 55,608 4.76 - ------------------------------------------------------------------------------------------------------------------------------ Non-interest-bearing liabilities 38,799 31,222 18,395 - ------------------------------------------------------------------------------------------------------------------------------ Total liabilities 1,364,004 1,325,779 1,187,606 - ------------------------------------------------------------------------------------------------------------------------------ Stockholders' equity 197,740 203,966 230,362 - ------------------------------------------------------------------------------------------------------------------------------ Total liabilities and equity $1,561,744 $1,529,745 $1,417,968 - ------------------------------------------------------------------------------------------------------------------------------ Net interest income $44,158 $43,048 - ------------------------------------------------------------------------------------------------------------------------------ Net interest rate spread (4) 2.66% 2.39% 2.39% - ------------------------------------------------------------------------------------------------------------------------------ Net interest margin (5) 3.20% 2.98% 3.12% - ------------------------------------------------------------------------------------------------------------------------------ Ratio of interest-earning assets to interest-bearing liabilities 113.92% 114.35% 117.95% - ------------------------------------------------------------------------------------------------------------------------------ - --------------------------------------------------------------------------- 1996 - --------------------------------------------------------------------------- Average Average Yield/ Balance Interest Cost - --------------------------------------------------------------------------- Assets: - --------------------------------------------------------------------------- Interest-earning assets: - --------------------------------------------------------------------------- Interest-earning deposits and short-term investments $ 4,872 $ 251 5.15% - --------------------------------------------------------------------------- Investment securities (1) 148,378 9,710 6.54 - --------------------------------------------------------------------------- Loans receivable, net (2) 637,453 50,324 7.89 - --------------------------------------------------------------------------- Mortgage-backed securities (3) 331,669 19,413 5.85 - --------------------------------------------------------------------------- FHLB stock 8,323 538 6.46 - --------------------------------------------------------------------------- Total interest-earning assets 1,130,695 80,236 7.10 - --------------------------------------------------------------------------- Non-interest-earning assets 31,810 - --------------------------------------------------------------------------- Total assets $1,162,505 - --------------------------------------------------------------------------- Liabilities and Equity: - --------------------------------------------------------------------------- Interest-bearing liabilities: - --------------------------------------------------------------------------- Money market deposit accounts $ 70,209 1,994 2.84% - --------------------------------------------------------------------------- Savings accounts 175,060 4,069 2.32 - --------------------------------------------------------------------------- NOW accounts 72,265 1,371 1.90 - --------------------------------------------------------------------------- Time deposits 609,620 33,555 5.50 - --------------------------------------------------------------------------- Total 927,154 40,989 4.42 - --------------------------------------------------------------------------- FHLB borrowings 30,000 39,135 2,298 5.87 - --------------------------------------------------------------------------- Securities sold under agreements to repurchase 9,803 570 5.81 - --------------------------------------------------------------------------- Total interest-bearing liabilities 976,092 43,857 4.49 - --------------------------------------------------------------------------- Non-interest-bearing liabilities 18,778 - --------------------------------------------------------------------------- Total liabilities 994,870 - --------------------------------------------------------------------------- Stockholders' equity 167,635 - --------------------------------------------------------------------------- Total liabilities and equity $ 1,162,505 - --------------------------------------------------------------------------- Net interest income $36,379 - --------------------------------------------------------------------------- Net interest rate spread (4) 2.61% - --------------------------------------------------------------------------- Net interest margin (5) 3.22% - --------------------------------------------------------------------------- Ratio of interest-earning assets to interest-bearing liabilities 115.84% - --------------------------------------------------------------------------- (1) Includes investment securities available for sale. (2) Amount is net of deferred loan fees, undisbursed loan funds, discounts and premiums and estimated loan loss allowances and includes loans held for sale and non-performing loans. (3) Includes mortgage-backed securities available for sale. (4) Net interest rate spread represents the difference between the yield on interest-earning assets and the cost of interest-bearing liabilities. (5) Net interest margin represents net interest income divided by average interest-earning assets. 16 . Ocean Financial Corp. . OCFC Rate Volume Analysis. The following table presents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company's interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volume (changes in volume multiplied by prior rate); (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionally to the changes due to volume and the changes due to rate. Year Ended December 31, 1998 Year Ended December 31, 1997 Compared to Compared to Year Ended December 31, 1997 Year Ended December 31, 1996 --------------------------------------------------------------------- Increase (Decrease) Increase (Decrease) Due to Due to --------------------------------------------------------------------- Volume Rate Net Volume Rate Net - ------------------------------------------------------------------------------------------------------------------------------ Interest-earning assets: - ------------------------------------------------------------------------------------------------------------------------------ Interest-earning deposits and short-term investments $ 138 $ 2 $ 140 $ (109) $ 13 $ (96) - ------------------------------------------------------------------------------------------------------------------------------ Investment securities (1,569) (272) (1,841) 3,256 336 3,592 - ------------------------------------------------------------------------------------------------------------------------------ Loans receivable, net 10,681 (1,183) 9,498 6,962 254 7,216 - ------------------------------------------------------------------------------------------------------------------------------ Mortgage-backed securities (1,150) (88) (1,238) 6,705 789 7,494 - ------------------------------------------------------------------------------------------------------------------------------ FHLB stock 272 70 342 196 18 214 - ------------------------------------------------------------------------------------------------------------------------------ Total interest-earning assets 8,372 (1,471) 6,901 17,010 1,410 18,420 - ------------------------------------------------------------------------------------------------------------------------------ Interest-bearing liabilities: - ------------------------------------------------------------------------------------------------------------------------------ Money market deposit accounts 82 (84) (2) (35) 69 34 - ------------------------------------------------------------------------------------------------------------------------------ Savings accounts (38) (397) (435) (155) (37) (192) - ------------------------------------------------------------------------------------------------------------------------------ NOW accounts 202 (73) 129 104 (87) 17 - ------------------------------------------------------------------------------------------------------------------------------ Time deposits 1,469 (317) 1,152 1,510 602 2,112 - ------------------------------------------------------------------------------------------------------------------------------ Total 1,715 (871) 844 1,424 547 1,971 - ------------------------------------------------------------------------------------------------------------------------------ FHLB borrowings 679 (32) 647 (1,834) (50) (1,884) - ------------------------------------------------------------------------------------------------------------------------------ Securities sold under agreements to repurchase 4,300 -- 4,300 11,660 4 11,664 - ------------------------------------------------------------------------------------------------------------------------------ Total interest-bearing liabilities 6,694 (903) 5,791 11,250 501 11,751 - ------------------------------------------------------------------------------------------------------------------------------ Net change in net interest income $ 1,678 $ (568) $ 1,110 $ 5,760 $ 909 $ 6,669 - ------------------------------------------------------------------------------------------------------------------------------ Comparison of Financial Condition at December 31, 1998 and December 31, 1997 Total assets at December 31, 1998 were $1.562 billion, an increase of $50.8 million, compared to $1.511 billion at December 31, 1997. Investment securities available for sale decreased by $70.0 million, to a balance of $137.4 million at December 31, 1998, compared to a balance of $207.4 million at December 31, 1997, and mortgage-backed securities available for sale decreased by $75.3 million, to $381.8 million at December 31, 1998, from $457.1 million at December 31, 1997. The investment and mortgage-backed securities available for sale portfolios decreased in order to fund growth in the Bank's loans receivable. In December 1998, the Bank also sold $51.3 million of adjustable-rate mortgage-backed securities with high prepayment speeds. The sale proceeds funded the purchase of $28.9 million in whole loans. Loans receivable, net, increased by $157.3 million, or 20.1%, to a balance of $941.0 million at December 31, 1998, compared to a balance of $783.7 million at December 31, 1997. The increase was largely attributable to robust residential loan growth (including mortgage refinance activity) in the Bank's market area, as well as commercial lending (including commercial real estate) initiatives which accounted for $20.4 million of this growth. Included in the residential loan growth is $125.7 million of 30-year fixed-rate mortgage loans which the Bank retained in portfolio, while $16.1 million of 30-year fixed-rate mortgage loans were sold. The Company is also holding $25.1 million of mortgage loans held for sale at December 31, 1998, all of which were 30-year fixed rate mortgage loans. The sale was completed in January 1999 at an after-tax gain of $328,000. In the past, the Bank has often sold most of its fixed-rate 30-year loan production into the secondary market. For the loans retained, the Bank acquired funding with terms of three to ten years, mitigating part of the interest rate risk associated with retaining these mortgages. Total deposits at December 31, 1998 were $1.035 billion, an increase of $58.5 million, compared to $976.8 million at December 31, 1997. On June 29, 1998, the Company completed the purchase of $10.7 million in deposit balances from Summit Bank's Whiting, New Jersey branch, for a deposit premium of $1.0 million. Stockholders' equity at December 31, 1998 was $197.7 million, compared to $215.5 million at December 31, 1997. The Company repurchased 1.1 million shares of common stock during the year ended December 31, 1998 for $18.6 million, fully completing the remainder of a 5% repurchase program announced in October 1997; another 5% repurchase program announced in July 1998; and partially completing an additional 5% repurchase program announced in November 1998. Additionally, during the second quarter of 1998, the Company loaned $8.2 million to the Bank's Employee Stock Ownership Plan ("ESOP" or the "Plan") which enabled the ESOP trustee to purchase 422,500 shares of common stock. Allocations during the initial 12 year ESOP term which expires in year 2008, will not be affected by the purchase of these shares and, therefore, no compensation expense will be recognized by the Company relating to the allocation of these shares to plan participants until at least the year 2009. Results of Operations General Net income decreased to $13.0 million for the year ended December 31, 1998 as compared to net income of $13.8 million for the year ended December 31, 1997. Diluted earnings per share, however, increased 8.0%, to $.95 for the year ended December 31, 1998, as compared to $.88 for the year ended December 31, 1997. Ocean Financial Corp. . OCFC . 17 The increase in earnings per share is the result of the Company's repurchase program and the additional ESOP purchases, both of which reduced the number of shares outstanding for purposes of calculating earnings per share. Interest Income Interest income for the year ended December 31, 1998 was $105.6 million, compared to $98.7 million for the year ended December 31, 1997, an increase of $6.9 million or 7.0%. The increase in interest income was the result of an increase in the average balance of loans receivable which increased by $137.3 million for the year ended December 31, 1998. The increase in the year-over-year average balance of loans receivable more than offset a $42.5 million decrease in the average balance of investment and mortgage-backed securities. Overall interest-earning assets increased $101.2 million for the year ended December 31, 1998, as compared to the year ended December 31, 1997. The average yield declined slightly to 7.13% for the year ended December 31, 1998, as compared to 7.15% for the year ended December 31, 1997. Interest Expense Interest expense for the year ended December 31, 1998 was $61.4 million, compared to $55.6 million for the year ended December 31, 1997, an increase of $5.8 million, or 10.4%. The increase in interest expense was primarily the result of an increase in the average outstanding balance of total borrowings (Federal Home Loan Bank and securities sold under agreements to repurchase) which increased by $86.2 million for the year ended December 31, 1998, as compared to the same prior year period and an additional increase in average interest-bearing deposits of $39.1 million for the year ended December 31, 1998, as compared to the same prior year period. The increase in wholesale borrowings was part of a leverage strategy adopted in late 1996 to improve returns on invested capital. Proceeds from the borrowings were invested in mortgage loans and investment and mortgage-backed securities. The average cost of interest-bearing liabilities decreased to 4.74% for the year ended December 31, 1998, as compared to 4.76% for the same prior year period. Provision for Loan Losses For the year ended December 31, 1998, the Company's provision for loan losses was $900,000, unchanged from the same prior year period. The Company's non- performing assets declined by $1.3 million at December 31, 1998, as compared to December 31, 1997 allowing for stable provisions despite loan growth. Management of the Company is responsible for the determination of the level of the allowance for loan losses. The allowance for loan losses is maintained at a level sufficient to provide for estimated losses based on evaluating known and inherent risks in the loan portfolio and upon management's continuing analysis of the factors underlying the quality of the loan portfolio. These factors include changes in the size and composition of the loan portfolio, actual loan loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loan. Additions to this allowance are charged to earnings. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require the Bank to provide additions to the allowance based upon information available to them at the time of their examination. Although management uses the best information available, future adjustments to the allowance may be necessary due to economic, operating, regulatory and other conditions beyond the Company's control. Other Income Other income decreased to $2.4 million for the year ended December 31, 1998, compared to $2.5 million for the same prior year period. The decrease was due to the recognition of a $850,000 loss on the sale of mortgage-backed securities. Excluding the loss, other income increased $752,000, or 30.0% for the year ended December 31, 1998, as compared to the prior year. The increase was primarily due to gains recognized on the sale of 30-year fixed-rate mortgage loans, which the Company periodically sells as part of the management of interest rate risk. These gains amounted to $228,000 for the year ended December 31, 1998. Additionally, deposit related fees (part of fees and service charges) increased by $476,000 for the year ended December 31, 1998, as compared to the same prior year period, due to growth in commercial account services and retail core account balances. The Company also realized $104,000 in fee income during 1998 from the sale of alternative investment products, a service the Company introduced late in this year's second quarter. The growth in these fees was partly offset by reductions in loan servicing fees due to prepayments of the loans underlying the servicing portfolio. Total servicing fee income declined by $424,000 for the year ended December 31, 1998, as compared to the prior year. Operating Expenses Operating expenses were $25.5 million for the year ended December 31, 1998, an increase of $2.3 million compared to the same prior year period. For the year ended December 31, 1998, marketing expense increased $677,000 as the Bank aggressively promoted its new retail checking products. The Bank also opened its eleventh branch office in early April of 1998. Out-of-pocket expenses associated with readying the Company's data processing systems for the Year 2000 amounted to $102,000 during 1998. Provision for Income Taxes Income tax expense was $7.2 million for the year ended December 31, 1998, compared to $7.7 million for the year ended December 31, 1997. The effective tax rate was relatively stable at 35.8% for the year ended December 31, 1998, as compared to 35.7% for the same prior year period. Comparison of operating results for the years ended December 31, 1997 and December 31, 1996 General Net income increased to $13.8 million for the year ended December 31, 1997, as compared to a net loss of $1.7 million for the year ended December 31, 1996. Prior year amounts were adversely affected by a charge of $5.7 million ($3.7 million after tax) representing the Bank's share of a special assessment to recapitalize the Savings Association Insurance Fund ("SAIF") of the FDIC. Additionally, concurrent with the close of the Company's stock offering on July 2, 1996, the Company funded The Ocean Federal Foundation with a one-time donation of 1,342,092 shares of common stock, resulting in a charge of $13.4 million ($9.7 million after tax). Interest Income Interest income for the year ended December 31, 1997 was $98.6 million, compared to $80.2 million for the year ended December 31, 1996, an increase of $18.4 million, or 23.0%. The increase in interest income was the result of increases in the average size of the investment and mortgage-backed securities available for sale portfolios, due to the investment, in 1997, of funds received from wholesale borrowings. Also, the average balance of loans receivable increased $88.4 million for the year ended December 31, 1997, as compared to the same prior year period. The increase in interest income was further augmented by an increase in the yield on average interest earning assets, which improved to 7.15% on average in 1997, from 7.10% on average in 1996. Interest Expense Interest expense for the year ended December 31, 1997 was $55.6 million, compared to $43.9 million for the year ended December 31, 1996, an increase of $11.7 million or 26.8%. The 18 . Ocean Financial Corp. . OCFC increase in interest expense was primarily the result of an increase in the average outstanding balance of total borrowings, as previously discussed, and a smaller average increase in deposits. The average cost of interest-bearing liabilities also increased to 4.76% for the year ended December 31, 1997, as compared to 4.49% for the same prior year period due to a greater percentage increase in higher cost wholesale funding over retail deposit funding. Provision for Loan Losses For the year ended December 31, 1997, the Company's provision for loan losses was $900,000, compared to $700,000 for the same prior year period. The increase was due to overall loan growth and the introduction of commercial business loans which generally carry greater credit risk than the 1-4 family mortgage loans which have been the Bank's historical focus. Other Income Other income was $2.5 million for the year ended December 31, 1997, compared to $2.9 million for the same prior year period. Income from the net gain (loss) on sales of loans and securities decreased $410,000 for the year ended December 31, 1997, compared to the same prior year period. The decrease was due to the recognition of a loss of $142,000 in 1997 on the sale of a mortgage-backed security. Additionally, the Company sold $2.7 million of 30-year fixed rate mortgage loans in 1997, a decrease of $21.5 million as compared to $24.2 million sold in 1996. Management determined that the significant capital position of the Company mitigated the additional interest rate risk associated with retaining these mortgages. Operating Expenses Operating expenses were $23.1 million and $39.2 million for the year ended December 31, 1997, a decrease of $16.1 million compared to the same prior year period. The charitable donation to The Ocean Federal Foundation in the third quarter of 1996 accounted for $13.4 million of the decrease. Additionally, federal deposit insurance expense declined by $7.3 million for the year ended December 31, 1997, compared to the same prior year period due to the special SAIF assessment of $5.7 million recorded in the third quarter of 1996. As a result of the special assessment insurance premiums on SAIF-insured deposits declined to 6.5 basis points per $100 of deposits effective January 1, 1997, as compared to 23 basis points in 1996. The increase in compensation and employee benefits expense of $3.7 million for the year ended December 31, 1997, as compared to the same prior year period, was due to the expense associated with the amortization, beginning in February 1997, of incentive stock awards and the higher expense associated with the Bank's Employee Stock Ownership Plan as a result of the increase in the Company's stock price over its initial $10 per share cost. The ESOP expense was partly offset by eliminating matching contributions under the Bank's 401K Plan. Equipment expense increased by $426,000 for the year ended December 31, 1997, compared to the same prior year period due to the establishment of two new branch offices and the upgrade of computer equipment. General and administrative expenses increased by $386,000 for the year ended December 31, 1997, compared to the same prior year period due to expenses associated with operating as a publicly-owned holding company. Provision for Income Taxes Income tax expense was $7.7 million for the year ended December 31, 1997, compared to $1.1 million for the year ended December 31, 1996 due to the significant increase in income before income taxes. Liquidity and Capital Resources The Company's primary sources of funds are deposits, principal and interest payments on loans and mortgage-backed securities, FHLB and other borrowings and, to a lesser extent, investment maturities and proceeds from the sale of loans and securities. While scheduled amortization of loans are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. The Company has other sources of liquidity if a need for additional funds arises, including an overnight line of credit and advances from the FHLB. At December 31, 1998, the Company had $30.0 million of outstanding overnight borrowings from the FHLB, representing an increase from $20.4 million at December 31, 1997. The Company utilizes the overnight line from time to time to fund short-term liquidity needs. The Company also borrowed $282.1 million at December 31, 1998 through securities sold under agreements to repurchase, a decrease from $288.2 million at December 31, 1997. These borrowings were used to fund a wholesale leverage strategy designed to improve returns on invested capital. The Company's cash needs for the year ended December 31, 1998, were principally provided by maturities of investment securities available for sale, principal payments on loans and mortgage-backed securities, proceeds from the sale of mortgage-backed securities, and increased deposits, including a deposit acquisition. The cash provided was principally used for investing activities, which included the purchase of investment and mortgage-backed securities, the origination of loans and the purchase of treasury stock. For the year ended December 31, 1997, the cash needs of the Company were primarily satisfied by principal payments on loans and mortgage-backed securities, securities sold under agreements to repurchase and increased deposits. The cash provided was principally utilized for loan originations, purchases of investment and mortgage-backed securities and the purchase of treasury stock. Federal regulations require the Bank to maintain minimum levels of liquid assets. The required percentage has varied from time to time based upon economic conditions and savings flows and is currently 4% of net withdrawable savings deposits and borrowings payable on demand or in one year or less during the preceding calendar month. Liquid assets for purposes of this ratio include cash, accrued interest receivable, certain time deposits, U.S. Treasury and Government agencies and other securities and obligations generally having remaining maturities of less than five years. The levels of these assets are dependent on the Bank's operating, financing, lending and investing activities during any given period. As of December 31, 1998 and 1997, the Bank's liquidity ratios were 12.5% and 9.8%, respectively, both in excess of the minimum regulatory requirement. At December 31, 1998, the Bank exceeded all of its regulatory capital requirements with tangible capital of $167.9 million, or 10.8%, of total adjusted assets, which is above the required level of $23.4 million or 1.5%; core capital of $167.9 million or 10.8% of total adjusted assets, which is above the required level of $46.8 million, or 3.0%; and risk-based capital of $175.1 million, or 22.8% of risk-weighted assets, which is above the required level of $61.5 million or 8.0%. The Bank is considered a "well capitalized" institution under the Office of Thrift Supervision's prompt corrective action regulations. Impact of Year 2000 The Company has developed a formal project plan to prepare its systems, hardware and facilities for the Year 2000. The project plan has been in place since 1997 and was developed following guidelines set forth by the Federal Financial Institutions Examination Council. These guidelines mandate that the Year 2000 project address five specific phases: awareness, assessment, renovation, validation (testing), and implementation. During the first quarter of 1998, the Bank completed the awareness and assessment phases by identifying all potentially impacted systems and vendors. During the fourth quarter of Ocean Financial Corp. . OCFC . 19 1998, vendors were carefully monitored to ensure that Year 2000 compliant software and hardware was delivered on schedule to meet testing time frames. As a result, the renovation phase was substantially complete at December 31, 1998. In September 1998 BISYS, the Bank's data processing agent and the primary provider of mission critical services, delivered remediated software and provided a testing facility for Year 2000 validation purposes. In conjunction with BISYS, scheduled testing commenced in November 1998 and is expected to continue through March of 1999. During that time, all mission critical systems and functions that BISYS provides will be tested by Company personnel to ensure compliance. A formal reporting structure between BISYS and the Company has been designed to ensure the timely correction of any issues found during testing. In the event that the validation process proves existing services to be non-compliant, a contingency agreement with BISYS allows the Company the option to convert to a fully compliant system by the end of 1999. All other primary service providers have completed the Year 2000 reprogramming. Testing with these vendors is underway and is also expected to be completed by March 1999. The Company has completed inventories of all mission critical functions, funds takers and funds providers, and is making every effort to ensure compliance in each of these areas. In the case of failure caused by a Year 2000 problem, the Bank has documented contingency plans that will be initiated to resolve mission critical issues. The Company has established a formal process for measuring potential credit risk associated with the Year 2000. Major customers in the Residential and Commercial Loan portfolios have been assessed to determine an appropriate risk rating and the Company is monitoring the progress of these borrowers towards Year 2000 compliance on an ongoing basis. Expenses related to the Bank's Year 2000 effort in 1998 totaled $327,000. This expense consists of $102,000 in costs associated with the renovation of software, hardware purchases and consulting charges and $225,000 representing an estimate of the direct cost for compensation and fringe benefits of internal employees working on the Year 2000 project. The Bank expects to spend an additional $400,000 to $600,000 in 1999. This figure represents costs associated with initiating customer awareness programs, testing, implementation and consulting expenses and includes $125,000 to $175,000 for the direct cost of internal employees. Estimated expenses and completion dates associated with this project are based upon all known facts and available resources. The Company expects that the represented estimates will not change materially, but there can be no guarantee that the estimates will be achieved. Factors that may influence changes in estimates include, but are not limited to, expenses associated with obtaining qualified personnel, ability to correctly identify and renovate all functions related to the Year 2000 and other similar items. The Company believes that it is taking all reasonable steps to prepare for the Year 2000, especially in the case of mission critical functions. However, management cannot make representations that all systems and especially those of significant third parties will be Year 2000 compliant or that they will not be adversely affected by Year 2000 issues. Impact of Inflation and Changing Prices The consolidated financial statements and notes thereto presented herein have been prepared in accordance with GAAP, which require the measurement of financial position and operating results in terms of historical dollar amounts without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Company's operations. Unlike industrial companies, nearly all of the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a greater impact on the Company's performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the price of goods and services. Impact of New Accounting Pronouncements In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information (SFAS 131). SFAS 131 establishes standards for the way public business enterprises are to report information about operating segments in annual financial statements and requires those enterprises to report selected financial information about operating segments in interim financial reports to shareholders. SFAS 131 is effective for financial statements for periods beginning after December 15, 1997. Based upon the current operations of the Company and established reporting mechanisms, the Company does not have separate reportable operating segments and, therefore, the adoption of SFAS 131 did not have an impact on the company's financial disclosures. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes accounting and reporting standards for derivative instruments, and for hedging activities. SFAS No. 133 supersedes the disclosure requirements in SFAS No. 80, 105 and 119. This statement is effective for fiscal years beginning after June 15, 1999. The adoption of SFAS No. 133 is not expected to have a material impact on the financial position or results of operations of the Company. In October 1998, the FASB issued SFAS No. 134 "Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise." This Statement amends FASB Statement 65 "Accounting for Certain Mortgage Banking Activities" to require that after the securitization of mortgage loans held for sale, an entity engaged in mortgage banking activities classify the resulting mortgage-backed securities or other retained interests based on its ability and intent to sell or hold those investments. This Statement is effective for the first fiscal quarter beginning after December 15, 1998. The adoption of this Statement is not expected to have a material impact on the financial position or results of operations of the Company. Private Securities Litigation Reform Act Safe Harbor Statement In addition to historical information, this annual report may include certain forward looking statements based on current management expectations. The Company's actual results could differ materially from those management expectations. Factors that could cause future results to vary from current management expectations include, but are not limited to, general economic conditions, legislative and regulatory changes, monetary and fiscal policies of the federal government, changes in tax policies, rates and regulations of federal and state tax authorities, changes in interest rates, deposit flows, the cost of funds, demand for loan products, demand for financial services, competition, changes in the quality or composition of the Bank's loan and investment portfolios, changes in accounting principles, policies or guidelines, and other economic, competitive, governmental and technological factors affecting the Company's operations, markets, products, services and prices. Further description of the risks and uncertainties to the business are included in Item 1, BUSINESS of the Company's 1998 Form 10-K. 20 . Ocean Financial Corp. . OCFC Consolidated Statements of Financial Conditions - -------------------------------------------------------------------------------- December 31, 1998 and 1997 1998 1997 - ------------------------------------------------------------------------------------------------------------------------------ (dollars in thousands, except per share amounts) Assets - ------------------------------------------------------------------------------------------------------------------------------ Cash and due from banks $ 10,295 $ 2,225 - ------------------------------------------------------------------------------------------------------------------------------ Investment securities available for sale (notes 4, 11 and 15) 137,405 207,357 - ------------------------------------------------------------------------------------------------------------------------------ Federal Home Loan Bank of New York stock, at cost (note 15) 16,800 14,980 - ------------------------------------------------------------------------------------------------------------------------------ Mortgage-backed securities available for sale (notes 5, 11 and 15) 381,840 457,148 - ------------------------------------------------------------------------------------------------------------------------------ Loans receivable, net (notes 6 and 15) 941,011 783,695 - ------------------------------------------------------------------------------------------------------------------------------ Mortgage loans held for sale 25,140 -- - ------------------------------------------------------------------------------------------------------------------------------ Interest and dividends receivable (note 7) 9,820 11,064 - ------------------------------------------------------------------------------------------------------------------------------ Real estate owned, net (note 9) 43 1,198 - ------------------------------------------------------------------------------------------------------------------------------ Premises and equipment, net (note 8) 13,947 14,279 - ------------------------------------------------------------------------------------------------------------------------------ Other assets (note 12) 25,443 19,001 - ------------------------------------------------------------------------------------------------------------------------------ Total assets $ 1,561,744 $ 1,510,947 - ------------------------------------------------------------------------------------------------------------------------------ Liabilities and Stockholders' Equity - ------------------------------------------------------------------------------------------------------------------------------ Deposits (note 10) $ 1,035,251 $ 976,764 - ------------------------------------------------------------------------------------------------------------------------------ Federal Home Loan Bank borrowings (note 15) 30,000 20,400 - ------------------------------------------------------------------------------------------------------------------------------ Securities sold under agreements to repurchase (note 11) 282,108 288,200 - ------------------------------------------------------------------------------------------------------------------------------ Advances by borrowers for taxes and insurance 5,096 4,773 - ------------------------------------------------------------------------------------------------------------------------------ Other liabilities (notes 12 and 13) 11,549 5,266 - ------------------------------------------------------------------------------------------------------------------------------ Total liabilities 1,364,004 1,295,403 - ------------------------------------------------------------------------------------------------------------------------------ Stockholders' Equity (notes 2, 3, 12, 13 and 14): - ------------------------------------------------------------------------------------------------------------------------------ Preferred stock, $.01 par value, 5,000,000 shares authorized, no shares issued -- -- - ------------------------------------------------------------------------------------------------------------------------------ Common stock, $.01 par value, 55,000,000 shares authorized, 18,118,248 shares issued and 14,629,776 and 15,705,720 shares outstanding at December 31, 1998 and 1997, respectively 181 181 - ------------------------------------------------------------------------------------------------------------------------------ Additional paid-in capital 178,309 177,223 - ------------------------------------------------------------------------------------------------------------------------------ Retained earnings-substantially restricted 103,982 97,487 - ------------------------------------------------------------------------------------------------------------------------------ Accumulated other comprehensive (loss) income (1,226) 989 - ------------------------------------------------------------------------------------------------------------------------------ Less: Unallocated common stock held by - ------------------------------------------------------------------------------------------------------------------------------ Employee Stock Ownership Plan (17,376) (10,903) - ------------------------------------------------------------------------------------------------------------------------------ Unearned Incentive Awards (5,963) (7,897) - ------------------------------------------------------------------------------------------------------------------------------ Treasury stock, 3,488,472 and 2,412,528 shares at December 31, 1998 and 1997, respectively (60,167) (41,536) - ------------------------------------------------------------------------------------------------------------------------------ Total stockholders' equity 197,740 215,544 - ------------------------------------------------------------------------------------------------------------------------------ Commitments and contingencies (note 15) - ------------------------------------------------------------------------------------------------------------------------------ Total liabilities and stockholders' equity $ 1,561,744 $ 1,510,947 - ------------------------------------------------------------------------------------------------------------------------------ See accompanying notes to consolidated financial statements. Ocean Financial Corp. . OCFC . 21 Consolidated Statements of Income and Comprehensive Income - -------------------------------------------------------------------------------- Years Ended December 31,1998, 1997 and 1996 1998 1997 1996 - ------------------------------------------------------------------------------------------------------------- (in thousands, except per share amounts) Interest income: - ------------------------------------------------------------------------------------------------------------- Loans $ 67,038 $ 57,540 $ 50,324 - ------------------------------------------------------------------------------------------------------------- Mortgage-backed securities 25,669 26,907 19,413 - ------------------------------------------------------------------------------------------------------------- Investment securities and other 12,850 14,209 10,499 - ------------------------------------------------------------------------------------------------------------- Total interest income 105,557 98,656 80,236 - ------------------------------------------------------------------------------------------------------------- Interest expense: - ------------------------------------------------------------------------------------------------------------- Deposits (note 10) 43,804 42,960 40,989 - ------------------------------------------------------------------------------------------------------------- Borrowed funds 17,595 12,648 2,868 - ------------------------------------------------------------------------------------------------------------- Total interest expense 61,399 55,608 43,857 - ------------------------------------------------------------------------------------------------------------- Net interest income 44,158 43,048 36,379 - ------------------------------------------------------------------------------------------------------------- Provision for loan losses (note 6) 900 900 700 - ------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 43,258 42,148 35,679 - ------------------------------------------------------------------------------------------------------------- Other income: - ------------------------------------------------------------------------------------------------------------- Fees and service charges 2,087 1,905 1,819 - ------------------------------------------------------------------------------------------------------------- Net (loss) gain on sales of loans and securities available for sale (note 5) (622) (132) 278 - ------------------------------------------------------------------------------------------------------------- Net income from other real estate operations 209 223 355 - ------------------------------------------------------------------------------------------------------------- Other 737 513 429 - ------------------------------------------------------------------------------------------------------------- Total other income 2,411 2,509 2,881 - ------------------------------------------------------------------------------------------------------------- Operating expenses: - ------------------------------------------------------------------------------------------------------------- Compensation and employee benefits (notes 13 and 14) 14,604 13,969 10,296 - ------------------------------------------------------------------------------------------------------------- Occupancy (note 15) 1,936 1,919 1,882 - ------------------------------------------------------------------------------------------------------------- Equipment 1,362 1,288 862 - ------------------------------------------------------------------------------------------------------------- Marketing 1,427 750 818 - ------------------------------------------------------------------------------------------------------------- Federal deposit insurance (note 18) 865 719 8,051 - ------------------------------------------------------------------------------------------------------------- Data processing 1,278 1,243 941 - ------------------------------------------------------------------------------------------------------------- General and administrative 3,985 3,257 2,937 - ------------------------------------------------------------------------------------------------------------- Charitable donation (notes 2 and 12) -- -- 13,419 - ------------------------------------------------------------------------------------------------------------- Total operating expenses 25,457 23,145 39,206 - ------------------------------------------------------------------------------------------------------------- Income (loss) before provision for income taxes 20,212 21,512 (646) - ------------------------------------------------------------------------------------------------------------- Provision for income taxes (note 12) 7,240 7,687 1,083 - ------------------------------------------------------------------------------------------------------------- Net income (loss) 12,972 13,825 (1,729) - ------------------------------------------------------------------------------------------------------------- Other Comprehensive Income: - ------------------------------------------------------------------------------------------------------------- Unrealized (loss) gain on securities available for sale arising during period (4,370) 1,952 (3,762) - ------------------------------------------------------------------------------------------------------------- Reclassification adjustment for losses included in net income 850 142 -- - ------------------------------------------------------------------------------------------------------------- Unrealized (loss) gain on securities available for sale (3,520) 2,094 (3,762) - ------------------------------------------------------------------------------------------------------------- Income tax (benefit) expense (1,305) 770 (1,357) - ------------------------------------------------------------------------------------------------------------- Other comprehensive (loss) income (2,215) 1,324 (2,405) - ------------------------------------------------------------------------------------------------------------- Comprehensive income (loss) $ 10,757 $ 15,149 $ (4,134) - ------------------------------------------------------------------------------------------------------------- Basic earnings (loss) per share $ .97 $ .90 $ (.39) - ------------------------------------------------------------------------------------------------------------- Diluted earnings (loss) per share $ .95 $ .88 $ (.39) - ------------------------------------------------------------------------------------------------------------- Average basic shares outstanding (note 1) 13,335 15,344 16,860 - ------------------------------------------------------------------------------------------------------------- Average diluted shares outstanding (note 1) 13,677 15,638 16,860 - ------------------------------------------------------------------------------------------------------------- Earnings (loss) per share and shares outstanding for 1996 cover the period from July 2, 1996 (date of conversion) to December 31, 1996 See accompanying notes to consolidated financial statements. 22 . Ocean Financial Corp. . OCFC Consolidated Statements of Changes in Stockholders' Equity - -------------------------------------------------------------------------------- Accumulated Employee Other Stock Additional Compre- Owner- Unearned Common Paid-In Retained hensive ship Incentive Treasury For The Years Ended 31, 1998, 1997 and 1996 Stock Capital Earnings (Loss)Income Plan Awards Stock Total - ------------------------------------------------------------------------------------------------------------------------------------ (dollars in thousands, except per share amounts) Balance at December 31, 1995 $ -- $ -- $ 90,281 $ 2,070 $ -- $ -- $ -- $ 92,351 - ------------------------------------------------------------------------------------------------------------------------------------ Sale of 16,776,156 shares of common stock in conversion 168 163,216 (84) -- -- -- -- 163,300 - ------------------------------------------------------------------------------------------------------------------------------------ Donation of 1,342,092 shares of common stock to the Ocean Federal Foundation at par value 13 13,414 (6) -- -- -- -- 13,421 - ------------------------------------------------------------------------------------------------------------------------------------ Acquisition of 1,342,092 shares of stock by ESOP -- -- -- -- (13,421) -- -- (13,421) - ------------------------------------------------------------------------------------------------------------------------------------ Allocation of ESOP stock -- -- -- -- 1,090 -- -- 1,090 - ------------------------------------------------------------------------------------------------------------------------------------ ESOP adjustment -- 182 -- -- -- -- -- 182 - ------------------------------------------------------------------------------------------------------------------------------------ Net loss -- -- (1,729) -- -- -- -- (1,729) - ------------------------------------------------------------------------------------------------------------------------------------ Other comprehensive income net of tax, unrealized loss on securities available for sale -- -- -- (2,405) -- -- -- (2,405) - ------------------------------------------------------------------------------------------------------------------------------------ Balance at December 31, 1996 181 176,812 88,462 (335) (12,331) -- -- 252,789 - ------------------------------------------------------------------------------------------------------------------------------------ Acquisition of 671,046 shares of common stock for Incentive Awards -- (506) -- -- -- (9,670) -- (10,176) - ------------------------------------------------------------------------------------------------------------------------------------ Earned Incentive Awards -- -- -- -- -- 1,773 -- 1,773 - ------------------------------------------------------------------------------------------------------------------------------------ Purchase 2,412,528 shares of common stock -- -- -- -- -- -- (41,536) (41,536) - ------------------------------------------------------------------------------------------------------------------------------------ Allocation of ESOP stock -- -- -- -- 1,428 -- -- 1,428 - ------------------------------------------------------------------------------------------------------------------------------------ ESOP adjustment -- 917 -- -- -- -- 917 - ------------------------------------------------------------------------------------------------------------------------------------ Cash dividend - $.30 per share -- -- (4,800) -- -- -- -- (4,800) - ------------------------------------------------------------------------------------------------------------------------------------ Net income -- -- 13,825 -- -- -- -- 13,825 - ------------------------------------------------------------------------------------------------------------------------------------ Other comprehensive income net of tax, unrealized gain on securities available for sale -- -- -- 1,324 -- -- -- 1,324 - ------------------------------------------------------------------------------------------------------------------------------------ Balance at December 31, 1997 181 177,223 97,487 989 (10,903) (7,897) (41,536) 215,544 - ------------------------------------------------------------------------------------------------------------------------------------ Earned Incentive Awards - -- -- -- -- 1,934 1,934 - ------------------------------------------------------------------------------------------------------------------------------------ Tax benefit of stock plans -- 463 -- -- -- -- -- 463 - ------------------------------------------------------------------------------------------------------------------------------------ Purchase 1,078,292 shares of common stock -- -- -- -- -- -- (18,672) (18,672) - ------------------------------------------------------------------------------------------------------------------------------------ Allocation of ESOP stock -- -- -- -- 1,727 -- -- 1,727 - ------------------------------------------------------------------------------------------------------------------------------------ ESOP adjustment -- 623 -- -- -- -- 623 - ------------------------------------------------------------------------------------------------------------------------------------ Cash dividend - $.46 per share -- -- (6,470) -- -- -- -- (6,470) - ------------------------------------------------------------------------------------------------------------------------------------ Acquisition of 422,500 shares of common stock by ESOP -- -- -- -- (8,200) -- -- (8,200) - ------------------------------------------------------------------------------------------------------------------------------------ Exercise of stock options - 2,348 shares -- -- (7) -- -- -- 41 34 - ------------------------------------------------------------------------------------------------------------------------------------ Net income -- -- 12,972 -- -- -- -- 12,972 - ------------------------------------------------------------------------------------------------------------------------------------ Other comprehensive income net of tax, unrealized loss on securities available for sale -- -- -- (2,215) -- -- -- (2,215) - ------------------------------------------------------------------------------------------------------------------------------------ Balance at December 31, 1998 $ 181 $178,309 $103,982 $ (1,226) $(17,376) $ (5,963) $(60,167) $ 197,740 - ------------------------------------------------------------------------------------------------------------------------------------ See accompanying notes to consolidated financial statements. Ocean Financial Corp. . OCFC . 23 Consolidated Statements of Cash Flows - -------------------------------------------------------------------------------- Years Ended December 31, 1998, 1997 and 1996 1998 1997 1996 - -------------------------------------------------------------------------------------------------------------- (dollars in thousands) Cash flows from operating activities: - -------------------------------------------------------------------------------------------------------------- Net income (loss) $ 12,972 $ 13,825 $ (1,729) - -------------------------------------------------------------------------------------------------------------- Adjustments to reconcile net income (loss) to net cash provided by operating activities: - -------------------------------------------------------------------------------------------------------------- Donation of 1,342,092 shares of common stock to the Ocean Federal Foundation -- -- 13,419 - -------------------------------------------------------------------------------------------------------------- Depreciation and amortization of premises and equipment 1,472 1,354 760 - -------------------------------------------------------------------------------------------------------------- Amortization of Incentive Awards 1,934 1,773 -- - -------------------------------------------------------------------------------------------------------------- Amortization of ESOP 1,727 1,428 1,090 - -------------------------------------------------------------------------------------------------------------- ESOP adjustment 623 917 182 - -------------------------------------------------------------------------------------------------------------- Tax benefit of stock plans 463 -- -- - -------------------------------------------------------------------------------------------------------------- Amortization of servicing asset 572 197 204 - -------------------------------------------------------------------------------------------------------------- Amortization of deposit premium 52 -- -- - -------------------------------------------------------------------------------------------------------------- Net premium amortization in excess of discount accretion on securities 3,190 3,498 1,761 - -------------------------------------------------------------------------------------------------------------- Net accretion of deferred fees and discounts in excess of premium amortization on loans (533) (382) (487) - -------------------------------------------------------------------------------------------------------------- Provision for loan losses 900 900 700 - -------------------------------------------------------------------------------------------------------------- Deferred taxes 1,749 529 (3,263) - -------------------------------------------------------------------------------------------------------------- Net gain on sales of real estate owned (173) (457) (507) - -------------------------------------------------------------------------------------------------------------- Net loss (gain) on sales of loans and securities available for sale 622 132 (278) - -------------------------------------------------------------------------------------------------------------- Proceeds from sales of mortgage loans held for sale 16,301 2,705 24,173 - -------------------------------------------------------------------------------------------------------------- Mortgage loans originated for sale (41,604) (2,008) (23,453) - -------------------------------------------------------------------------------------------------------------- Decrease (increase) in interest and dividends receivable 1,244 (1,307) (2,277) - -------------------------------------------------------------------------------------------------------------- Increase in other assets (6,092) (4,865) (830) - -------------------------------------------------------------------------------------------------------------- Increase in other liabilities 6,283 874 577 - -------------------------------------------------------------------------------------------------------------- Total adjustments (11,270) 5,288 11,771 - -------------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 1,702 19,113 10,042 - -------------------------------------------------------------------------------------------------------------- Cash flows from investing activities: - -------------------------------------------------------------------------------------------------------------- Net increase in loans receivable (129,468) (107,948) (68,429) - -------------------------------------------------------------------------------------------------------------- Loans purchased (29,207) -- -- - -------------------------------------------------------------------------------------------------------------- Proceeds from sales of mortgage-backed securities available for sale 47,974 19,006 -- - -------------------------------------------------------------------------------------------------------------- Purchase of investment securities available for sale (128,751) (51,154) (105,006) - -------------------------------------------------------------------------------------------------------------- Purchase of mortgage-backed securities available for sale (181,095) (248,917) (251,004) - -------------------------------------------------------------------------------------------------------------- Proceeds from maturities of investment securities available for sale 195,216 20,300 43,858 - -------------------------------------------------------------------------------------------------------------- Principal payments on mortgage-backed securities available for sale 204,359 164,291 117,048 - -------------------------------------------------------------------------------------------------------------- Purchases of Federal Home Loan Bank of New York stock (1,820) (6,523) (734) - -------------------------------------------------------------------------------------------------------------- Proceeds from sales of real estate owned 2,320 3,277 2,503 - -------------------------------------------------------------------------------------------------------------- Purchases of premises and equipment (1,140) (1,533) (7,219) - -------------------------------------------------------------------------------------------------------------- Net cash used in investing activities (21,612) (209,201) (268,983) - -------------------------------------------------------------------------------------------------------------- Cash flows from financing activities: - -------------------------------------------------------------------------------------------------------------- Acquisition of deposits 10,732 -- -- - -------------------------------------------------------------------------------------------------------------- Deposit premium (1,030) -- -- - -------------------------------------------------------------------------------------------------------------- Increase in deposits 47,755 42,034 8,172 - -------------------------------------------------------------------------------------------------------------- Increase (decrease) in Federal Home Loan Bank borrowings 9,600 11,600 (1,600) - -------------------------------------------------------------------------------------------------------------- (Decrease) increase in securities sold under agreements to repurchase (6,092) 188,878 99,322 - -------------------------------------------------------------------------------------------------------------- Increase in advances by borrowers for taxes and insurance 323 941 511 - -------------------------------------------------------------------------------------------------------------- Net proceeds of common stock issuance -- -- 149,886 - -------------------------------------------------------------------------------------------------------------- Purchase of Incentive Award shares -- (10,176) -- - -------------------------------------------------------------------------------------------------------------- Exercise of stock options 34 -- -- - -------------------------------------------------------------------------------------------------------------- Dividends paid (6,470) (4,800) -- - -------------------------------------------------------------------------------------------------------------- Purchase of ESOP shares (8,200) -- -- - -------------------------------------------------------------------------------------------------------------- Purchase of treasury stock (18,672) (41,536) -- - -------------------------------------------------------------------------------------------------------------- Net cash provided by financing activities 27,980 186,941 256,291 - -------------------------------------------------------------------------------------------------------------- Net increase (decrease) in cash and due from banks 8,070 (3,147) (2,650) - -------------------------------------------------------------------------------------------------------------- Cash and due from banks at beginning of year 2,225 5,372 8,022 - -------------------------------------------------------------------------------------------------------------- Cash and due from banks at end of year $ 10,295 $ 2,225 $ 5,372 - -------------------------------------------------------------------------------------------------------------- Supplemental Disclosure of Cash Flow Information: - -------------------------------------------------------------------------------------------------------------- Cash paid during the year for: - -------------------------------------------------------------------------------------------------------------- Interest $ 60,658 $ 54,863 $ 43,624 - -------------------------------------------------------------------------------------------------------------- Income taxes 30 7,246 4,231 - -------------------------------------------------------------------------------------------------------------- Non cash investing activities: - -------------------------------------------------------------------------------------------------------------- Transfer of loans receivable to real estate owned 992 2,463 2,184 - -------------------------------------------------------------------------------------------------------------- Mortgage loans securitized into mortgage-backed securities $ 16,082 $ 2,025 $ 23,392 - -------------------------------------------------------------------------------------------------------------- See accompanying notes to consolidated financial statements. 24 . Ocean Financial Corp. . OCFC Notes to Consolidated Financial Statements - -------------------------------------------------------------------------------- December 31, 1998 and 1997 (1) Summary of Significant Accounting Policies As more fully described in note 2, Ocean Federal Savings Bank (the "Bank") converted from a mutual savings bank to a capital stock savings bank on July 2, 1996. As part of the conversion, Ocean Financial Corp. (the "Company") was formed, acquired all of the Bank's conversion stock, and issued its common stock in a subscription offering. The acquisition of the Bank's conversion stock was accounted for similar to a pooling of interests and, therefore, the financial condition and results of operations of the Bank prior to July 2, 1996 became the financial condition and results of operations of the Company. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Ocean Federal Savings Bank, and its wholly-owned subsidiaries, Ocean Federal Realty, Inc. and Ocean Investment Services Corp. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain amounts previously reported have been reclassified to conform to the current year's presentation. Business The Bank provides a range of banking services to customers through a network of branches in Ocean and Middlesex counties in New Jersey. The Bank is subject to competition from other financial institutions; it is also subject to the regulations of certain regulatory agencies and undergoes periodic examinations by those regulatory authorities. Basis of Financial Statement Presentation The consolidated financial statements have been prepared in conformity with generally accepted accounting principles. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated statement of financial condition and revenues and expenses for the period then ended. Actual results could differ significantly from those estimates and assumptions. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and the valuation of real estate acquired in connection with foreclosures or in settlement of loans. In connection with the determination of the allowances for loan losses and Real Estate Owned (REO), management obtains independent appraisals for significant properties. Cash Equivalents Cash equivalents consist of interest-bearing deposits in other financial institutions and loans of Federal funds. For purposes of the consolidated statements of cash flows, the Company considers all highly liquid debt instruments with original maturities of three months or less to be cash equivalents. Investment and Mortgage-Backed Securities Investment and mortgage-backed securities identified as held to maturity are carried at cost, adjusted for amortization of premiums and accretion of discounts, which are recognized as adjustments to interest income using a method which approximates a level yield over the estimated average life of the security and adjusted, in the case of mortgage-backed securities, for actual prepayments. Management determines the appropriate classification of securities at the time of purchase. If management has the intent and the Company has the ability at the time of purchase to hold securities until maturity, they are classified as held to maturity. Debt securities not intended to be held to maturity are classified as available for sale. Securities available for sale include securities that management intends to use as part of its asset/liability management strategy. Such securities are carried at fair value and unrealized gains and losses, net of related tax effect, are excluded from earnings, but are included as a separate component of stockholders' equity. Gains or losses on the sale of such securities are included in other income using the specific identification method. Loans Receivable Loans receivable, other than loans held for sale, are stated at unpaid principal balance, plus unamortized premiums less unearned discounts, net of deferred loan origination and commitment fees, and the allowance for loan losses. Discounts and premiums are recognized in income using the level-yield method over the estimated lives of the loans. Loan origination and commitment fees and certain direct loan origination costs are deferred and the net fee or cost is recognized in interest income using the level-yield method over the contractual life of the specifically identified loans, adjusted for actual prepayments. Loans in which interest is more than 90 days past due, including impaired loans, and other loans in the process of foreclosure are placed on nonaccrual status. Interest income previously accrued on these loans, but not yet received, is reversed in the current period. Any interest subsequently collected is credited to income in the period of recovery. A loan is returned to accrual status when all amounts due have been received and the remaining principal balance is deemed collectible. A loan is considered impaired when it is deemed probable that the Company will not collect all amounts due according to the contractual terms of the loan agreement. The Company has defined the population of impaired loans to be all non-accrual commercial real estate, multi-family and land loans. Impaired loans are individually assessed to determine that the loan's carrying value is not in excess of the fair value of the collateral or the present value of the loan's expected future cash flows. Smaller balance homogeneous loans that are collectively evaluated for impairment, such as residential mortgage loans and installment loans, are specifically excluded from the impaired loan portfolio. Mortgage Loans Held for Sale The Company may periodically sell all or part of its conforming loan originations. Mortgage loans intended for sale are carried at the lower of unpaid principal balance, net, or market value on an aggregate basis. Allowance for Loan Losses The adequacy of the allowance for loan losses is based on management's evaluation of the Company's past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and current economic conditions. Additions to the allowance arise from charges to operations through the provision for loan losses or from the recovery of amounts previously charged off. The allowance is reduced by loan charge-offs. Loans are charged-off when management believes such loans are uncollectible. Management believes that the allowance for losses on loans is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions in the Company's market area. In addition, various regulatory agencies, as an integral part of their routine examination process, periodically review the Bank's allowance for losses on loans. Such agencies may require the Bank to recognize additions to the allowances based on their judgments about information available to them at the time of their examination. Ocean Financial Corp. . OCFC . 25 - -------------------------------------------------------------------------------- Real Estate Owned Real estate owned is carried at the lower of cost or fair value, less estimated costs to sell. When a property is acquired, the excess of the loan balance over fair value is charged to the allowance for loan losses. A reserve for real estate owned has been established to provide for subsequent declines in the fair values of properties. Real estate owned is carried net of the related reserve. Operating results from real estate owned, including rental income, operating expenses, and gains and losses realized from the sales of real estate owned are recorded as incurred. Premises and Equipment Land is carried at cost and premises and equipment, including leasehold improvements, are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets or leases. Repair and maintenance items are expensed and improvements are capitalized. Gains and losses on dispositions are reflected in current operations. Income Taxes The Company utilizes the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Pension Plan Pension plan costs for 1997 and 1996 are charged to expense based on the actuarial computation of current and future benefits for employees. The Plan was terminated on July 22, 1998 and all vested benefits were paid to participants. Stock Based Compensation The Company accounts for stock based compensation using the intrinsic value method under Accounting Principles Board No. 25 and accordingly has recognized no compensation expense under this method. The fair value pro forma disclosures required by Statement of Financial Accounting Standards No. 123 are included in note 14 -- Incentive Plan. Comprehensive Income Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS 130) which establishes standards for reporting and display of comprehensive income and its components in a full set of general purpose financial statements. Under SFAS 130, comprehensive income is divided into net income and other comprehensive income. Other comprehensive income includes items previously recorded directly in equity, such as unrealized gains or losses on securities available for sale. Comparative financial statements provided for earlier periods have been reclassified to conform with the provisions of this Statement. Stock Dividend Shares and related share amounts for prior periods have been adjusted for the 2-for-1 stock split effected in the form of a 100% stock dividend paid on May 15, 1998. Contributions Contributions made are recognized as expenses in the period made and as decreases of assets or increases of liabilities depending on the form of the benefits given. Contributions made are measured at the fair values of the asset given or, if made in the form of a settlement or cancellation of a donee's liabilities, at the fair value of the liabilities canceled. Earnings (Loss) Per Share Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding. Diluted earnings (loss) per share is calculated by dividing net income (loss) by the weighted average number of shares of common stock outstanding plus potential common stock, utilizing the treasury stock method. All share amounts exclude unallocated shares of stock held by the Employee Stock Ownership Plan (ESOP). Loss per share for 1996 was computed on net loss and average shares outstanding for the period from July 2, 1996 (conversion date) through December 31, 1996. The following reconciles shares outstanding for basic and diluted earnings per share for the years ended December 31, 1998 and 1997 and for the period from July 2, 1996 to December 31, 1996 (in thousands): For the period from July 2, 1996 to December Year Ended December 31, 1998 1997 31, 1996 - -------------------------------------------------------------------------------- Weighted average shares net of Treasury shares 15,174 17,112 18,118 - -------------------------------------------------------------------------------- Less: Unallocated ESOP shares (1,281) (1,160) (1,258) - -------------------------------------------------------------------------------- Unallocated incentive award shares (558) (608) -- - -------------------------------------------------------------------------------- Average basic shares outstanding 13,335 15,344 16,860 - -------------------------------------------------------------------------------- Add: Effect of dilutive securities: - -------------------------------------------------------------------------------- Stock options 171 144 -- - -------------------------------------------------------------------------------- Incentive awards 171 150 -- - -------------------------------------------------------------------------------- Average diluted shares outstanding 13,677 15,638 16,860 - -------------------------------------------------------------------------------- (2) Stock Form of Ownership On August 17, 1995, the Board of Directors of the Bank adopted a Plan of Conversion to convert from a federally chartered mutual savings bank to a federally chartered stock savings bank with the concurrent formation of a holding company. As part of the conversion, the Company was incorporated under Delaware law on November 21, 1995. The Company completed its initial public offering on July 2, 1996 with the issuance of 16,776,156 shares of common stock to the Bank's eligible depositors and the Bank's Employee Stock Ownership Plan (the "ESOP"), resulting in proceeds of $163.3 million (net of $4.5 million in costs). The Company retained $81.6 million of the net proceeds and used the remaining net proceeds to purchase all of the outstanding stock of the Bank. Concurrent with the close of the conversion, an additional 1,342,092 shares of common stock (8% of the offering) were issued and donated by the Company to The Ocean Federal Foundation (the "Foundation"), a private foundation dedicated to charitable purposes within Ocean County, New Jersey and its neighboring communities. The fair market value of the contribution of $13.4 million was reflected as a current expense and as an increase to capital stock and paid in capital for the same amount. The Company also recorded a related tax benefit of $3.7 million with a corresponding increase to the Company's deferred tax assets. At the time of the conversion, the Bank established a liquidation account with a balance equal to its retained earnings at March 31, 1996. The balance in the liquidation account at December 31, 1998 was approximately $22.9 million. The liquidation account will be maintained for the benefit of eligible account holders 26 . Ocean Financial Corp. . OCFC - -------------------------------------------------------------------------------- who continue to maintain their accounts at the Bank after the conversion. The liquidation account will be reduced annually to the extent that the eligible account holders have reduced their qualifying deposits as of each anniversary date. Subsequent increases will not restore an eligible account holder's interest in the liquidation account. In the event of a complete liquidation, each eligible account holder will be entitled to receive a distribution from the liquidation account in an amount proportionate to the current adjusted qualifying balances for accounts then held. The Company may not declare or pay cash dividends on or repurchase any of its shares of common stock if the effect thereof would cause stockholders' equity to be reduced below applicable regulatory capital maintenance requirements, the amount required for the liquidation account, or if such declaration and payment would otherwise violate regulatory requirements. (3) Regulatory Matters Office of Thrift Supervision (OTS) regulations require savings institutions to maintain minimum levels of regulatory capital. Under the regulations in effect at December 31, 1998, the Bank was required to maintain a minimum ratio of tangible capital to total adjusted assets of 1.5%; a minimum ratio of Tier 1 (core) capital to total adjusted assets of 3.0%; and a minimum ratio of total (core and supplementary) capital to risk-weighted assets of 8.0%. Under its prompt corrective action regulations, the OTS is required to take certain supervisory actions (and may take additional discretionary actions) with respect to an undercapitalized institution. Such actions could have a direct material effect on the institution's financial statements. The regulations establish a framework for the classification of savings institutions into five categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. Generally an institution is considered well-capitalized if it has a Tier 1 ratio of at least 6.0%; and a total risk-based capital ratio of at least 10.0%. At December 31, 1998 and 1997 the Bank was considered well-capitalized. The following is a summary of the Bank's actual capital amounts and ratios as of December 31, 1998 and 1997, compared to the OTS minimum capital adequacy requirements and the OTS requirements for classification as a well-capitalized institution (in thousands). To be well For capitalized capital under prompt adequacy corrective Actual purposes action - -------------------------------------------------------------------------------- Amount Ratio Amount Ratio Amount Ratio - -------------------------------------------------------------------------------- As of December 31, 1998: - -------------------------------------------------------------------------------- Tangible capital $167,881 10.8% $ 23,371 1.5% $ -- -% - -------------------------------------------------------------------------------- Core capital 167,881 10.8 46,742 3.0 77,903 5.0 - -------------------------------------------------------------------------------- Tier 1 risk-based capital 167,881 21.8 30,757 4.0 46,135 6.0 - -------------------------------------------------------------------------------- Risk-based capital 175,113 22.8 61,514 8.0 76,892 10.0 - -------------------------------------------------------------------------------- As of December 31, 1997: - -------------------------------------------------------------------------------- Tangible capital $178,592 11.9% $ 22,491 1.5% $ -- -% - -------------------------------------------------------------------------------- Core capital 178,592 11.9 44,982 3.0 74,969 5.0 - -------------------------------------------------------------------------------- Tier 1 risk-based capital 178,592 28.8 24,763 4.0 37,144 6.0 - -------------------------------------------------------------------------------- Risk-based capital 184,970 29.9 49,525 8.0 61,906 10.0 - -------------------------------------------------------------------------------- OTS regulations impose limitations upon all capital distributions by savings institutions, like the Bank, such as dividends and payments to repurchase or otherwise acquire shares. Based on these limitations, approximately $107,054,000 of the Bank's capital is unavailable for distribution to the Company. (4) Investment Securities Available for Sale The amortized cost and estimated market value of investment securities available for sale at December 31, 1998 and December 31, 1997 are as follows (in thousands): December 31, 1998 - -------------------------------------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value - -------------------------------------------------------------------------------- United States Government and agency obligations $ 59,983 $ 404 $ - $ 60,387 - -------------------------------------------------------------------------------- State and municipal obligations 1,946 7 (18) 1,935 - -------------------------------------------------------------------------------- Corporates 74,976 - (2,727) 72,249 - -------------------------------------------------------------------------------- Equity investments 3,226 - (392) 2,834 - -------------------------------------------------------------------------------- $140,131 $ 411 $ (3,137) $137,405 - -------------------------------------------------------------------------------- December 31, 1997 - -------------------------------------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value - -------------------------------------------------------------------------------- United States Government and agency obligations $204,992 $948 $(292) $ 205,648 - -------------------------------------------------------------------------------- State and municipal obligations 393 7 - 400 - -------------------------------------------------------------------------------- Equity investments 1,170 139 - 1,309 - -------------------------------------------------------------------------------- $ 206,555 $1,094 $(292) $ 207,357 - -------------------------------------------------------------------------------- The amortized cost and estimated market value of investment securities available for sale, excluding equity investments, at December 31, 1998 by contractual maturity, are shown below (in thousands). Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. At December 31, 1998, investment securities available for sale with an amortized cost and estimated market value of $136,706,000 and $134,365,000, respectively, were callable prior to the maturity date. December 31, 1998 - -------------------------------------------------------------------------------- Estimated Amortized Market Cost Value - -------------------------------------------------------------------------------- Due after one year through five years $ 35,182 $ 35,456 - -------------------------------------------------------------------------------- Due after five years through ten years 26,747 26,866 - -------------------------------------------------------------------------------- Due after 10 years 74,976 72,249 - -------------------------------------------------------------------------------- $136,905 $134,571 - -------------------------------------------------------------------------------- Ocean Financial Corp. . OCFC . 27 - -------------------------------------------------------------------------------- (5) Mortgage-Backed Securities Available for Sale The amortized cost and estimated market value of mortgage-backed securities available for sale at December 31, 1998 and December 31, 1997 are as follows (in thousands): December 31, 1998 - -------------------------------------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value - -------------------------------------------------------------------------------- FHLMC $106,762 $ 621 $(217) $107,166 - -------------------------------------------------------------------------------- FNMA 74,027 515 (108) 74,434 - -------------------------------------------------------------------------------- GNMA 63,041 81 (49) 63,073 - -------------------------------------------------------------------------------- Collaterized mortgage obligations 137,230 178 (241) 137,167 - -------------------------------------------------------------------------------- $381,060 $1,395 $(615) $381,840 - -------------------------------------------------------------------------------- December 31, 1997 - -------------------------------------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value - -------------------------------------------------------------------------------- FHLMC $ 245,414 $ 1,549 $(1,404) $ 245,559 - -------------------------------------------------------------------------------- FNMA 109,873 719 (601) 109,991 - -------------------------------------------------------------------------------- GNMA 97,714 465 (7) 98,172 - -------------------------------------------------------------------------------- Collaterized mortgage obligations 3,378 48 - 3,426 - -------------------------------------------------------------------------------- $ 456,379 $ 2,781 $(2,012) $ 457,148 - -------------------------------------------------------------------------------- Gross losses on the sale of mortgage-backed securities available for sale of $850,000 and $142,000 were realized in 1998 and 1997, respectively. Collateralized mortgage obligations issued by FHLMC, FNMA and private interests amounted to $15,705,000, $9,699,000 and $111,763,000, respectively, at December 31, 1998 and $2,274,000, $519,000 and $633,000, respectively, at December 31, 1997. The privately issued CMOs have generally been underwritten by large investment banking firms with the timely payment of principal and interest on these securities supported (credit enhanced) in varying degrees by either insurance issued by a financial guarantee insurer, letters of credit or subordination techniques. Substantially all such securities are triple "A" rated by one or more of the nationally recognized securities rating agencies. The privately-issued CMOs are subject to certain credit-related risks normally not associated with U.S. Government Agency CMOs. Among such risks is the limited loss protection generally provided by the various forms of credit enhancements as losses in excess of certain levels are not protected. Furthermore, the credit enhancement itself is subject to the credit worthiness of the enhancer. Thus, in the event a credit enhancer does not fulfill its obligations, the CMO holder could be subject to risk of loss similar to a purchaser of a whole loan pool. Management believes that the credit enhancements are adequete to protect the Company from losses and has, therefore, not provided an allowance for losses on it's privately-issued CMOs. The contractual maturities of mortgage-backed securities available for sale generally exceed 20 years; however, the effective lives are expected to be shorter due to anticipated prepayments. (6) Loans Receivable, Net A summary of loans receivable at December 31, 1998 and 1997 follows (in thousands): December 31, 1998 1997 Real estate mortgage: - -------------------------------------------------------------------------------- One to four-family $ 844,129 $ 710,880 - -------------------------------------------------------------------------------- Commercial real estate, multi-family and land 42,008 25,699 - -------------------------------------------------------------------------------- FHA insured & VA guaranteed 500 668 - -------------------------------------------------------------------------------- 886,637 737,247 - -------------------------------------------------------------------------------- Real estate construction 6,108 8,748 - -------------------------------------------------------------------------------- Consumer 51,785 45,417 - -------------------------------------------------------------------------------- Commercial 6,483 2,904 - -------------------------------------------------------------------------------- Total loans 951,013 794,316 - -------------------------------------------------------------------------------- Loans in process (1,996) (2,867) - -------------------------------------------------------------------------------- Deferred fees (608) (1,133) - -------------------------------------------------------------------------------- Unearned premium (discount) 62 (9) - -------------------------------------------------------------------------------- Allowance for loan losses (7,460) (6,612) - -------------------------------------------------------------------------------- (10,002) (10,621) - -------------------------------------------------------------------------------- $ 941,011 $ 783,695 - -------------------------------------------------------------------------------- At December 31, 1998, 1997 and 1996, loans in the amount of $5,424,000, $5,554,000 and $7,697,000, respectively, were three or more months delinquent or in the process of foreclosure and the Company was not accruing interest income. If these loans had continued to realize interest in accordance with their contractual terms, approximately $270,000, $278,000 and $345,000 of additional interest income would have been recognized for the years ended December 31, 1998, 1997 and 1996, respectively. The Company was not committed to lend additional funds on any nonaccrual loans at December 31, 1998. An analysis of the allowance for loan losses for the years ended December 31, 1998, 1997 and 1996 is as follows (in thousands): Year Ended December 31, 1998 1997 1996 - -------------------------------------------------------------------------------- Balance at beginning of year $ 6,612 $ 6,021 $ 6,001 - -------------------------------------------------------------------------------- Provision charged to operations 900 900 700 - -------------------------------------------------------------------------------- Charge-offs (65) (337) (692) - -------------------------------------------------------------------------------- Recoveries 13 28 12 - -------------------------------------------------------------------------------- Balance at end of year $ 7,460 $ 6,612 $ 6,021 - -------------------------------------------------------------------------------- At December 31, 1998, 1997 and 1996, the Company serviced loans for others in the amount of $132,334,000, $144,230,000 and $152,717,000, respectively. (7) Interest and Dividends Receivable A summary of interest and dividends receivable at December 31, 1998 and 1997 follows (in thousands): December 31, 1998 1997 - -------------------------------------------------------------------------------- Loans $ 4,644 $ 4,018 - -------------------------------------------------------------------------------- Investment securities 2,279 3,190 - -------------------------------------------------------------------------------- Mortgage-backed securities 2,897 3,856 - -------------------------------------------------------------------------------- $ 9,820 $11,064 - -------------------------------------------------------------------------------- 28 . Ocean Financial Corp. . OCFC - -------------------------------------------------------------------------------- (8) Premises and Equipment, Net Premises and equipment at December 31, 1998 and 1997 are summarized as follows (in thousands): December 31, 1998 1997 - -------------------------------------------------------------------------------- Land $ 3,195 $ 3,195 - -------------------------------------------------------------------------------- Buildings and improvements 11,038 10,922 - -------------------------------------------------------------------------------- Leasehold improvements 1,090 1,322 - -------------------------------------------------------------------------------- Furniture and equipment 6,532 5,613 - -------------------------------------------------------------------------------- Automobiles 144 150 - -------------------------------------------------------------------------------- Construction in progress 2 181 - -------------------------------------------------------------------------------- Total 22,001 21,383 - -------------------------------------------------------------------------------- Accumulated depreciation and amortization (8,054) (7,104) - -------------------------------------------------------------------------------- $13,947 $ 14,279 - -------------------------------------------------------------------------------- (9) Real Estate Owned, Net An analysis of the allowance for losses on real estate owned for the years ended December 31, 1998, 1997 and 1996 is as follows (in thousands): Year Ended December 31, 1998 1997 1996 - -------------------------------------------------------------------------------- Balance at beginning of year $ 367 $ 402 $ 411 - -------------------------------------------------------------------------------- Losses charged off (31) (35) (9) - -------------------------------------------------------------------------------- Balance at end of year $ 336 $ 367 $ 402 - -------------------------------------------------------------------------------- (10) Deposits Deposits, including accrued interest payable of $238,000 and $175,000 at December 31, 1998 and 1997, respectively, are summarized as follows (in thousands): December 31, 1998 1997 - -------------------------------------------------------------------------------- Weighted Weighted Average Average Amount Cost Amount Cost - -------------------------------------------------------------------------------- Non-interest bearing accounts $ 22,154 - % $ 13,149 - % - -------------------------------------------------------------------------------- NOW accounts 106,363 1.59 77,994 1.84 - -------------------------------------------------------------------------------- Money market deposit accounts 77,690 2.59 67,979 2.90 - -------------------------------------------------------------------------------- Savings accounts 172,036 2.03 163,202 2.28 - -------------------------------------------------------------------------------- Time deposits 657,008 5.35 654,440 5.69 - -------------------------------------------------------------------------------- $1,035,251 4.08% $976,764 4.52% - -------------------------------------------------------------------------------- Included in time deposits at December 31, 1998 and 1997, respectively, is $67,045,000 and $59,504,000 in deposits of $100,000 and over. Time deposits at December 31, 1998 mature as follows (in thousands): December 31, 1998 - ------------------------------------ 1999 $450,709 - ------------------------------------ 2000 119,432 - ------------------------------------ 2001 50,672 - ------------------------------------ 2002 22,668 - ------------------------------------ 2003 7,018 - ------------------------------------ Thereafter 6,509 - ------------------------------------ $657,008 - ------------------------------------ Interest expense on deposits for the years ended December 31, 1998, 1997 and 1996 was as follows (in thousands): Year ended December 31, 1998 1997 1996 - -------------------------------------------------------------------------------- NOW accounts $ 1,517 $ 1,388 $ 1,371 - -------------------------------------------------------------------------------- Money market deposit accounts 2,026 2,028 1,994 - -------------------------------------------------------------------------------- Savings accounts 3,442 3,877 4,069 - -------------------------------------------------------------------------------- Time deposits 36,819 35,667 33,555 - -------------------------------------------------------------------------------- $43,804 $42,960 $40,989 - -------------------------------------------------------------------------------- (11) Securities Sold Under Agreements to Repurchase Securities sold under agreements to repurchase are as follows (in thousands): 1998 1997 1996 - -------------------------------------------------------------------------------- Balance at December 31 $282,108 $288,200 $ 99,322 - -------------------------------------------------------------------------------- Average Balance 282,590 209,089 9,803 - -------------------------------------------------------------------------------- Maximum amount outstanding at any month end 302,736 294,826 99,322 - -------------------------------------------------------------------------------- Average interest rate: During the year 5.85% 5.85% 5.81% - -------------------------------------------------------------------------------- At December 31 5.33 6.01 5.69 - -------------------------------------------------------------------------------- At December 31, 1998, securities sold under agreements to repurchase matured as follows: $117,108,000 in 1999; $30,000,000 in 2002; $40,000,000 in 2003; $35,000,000 in 2004; $25,000,000 in 2005; and $35,000,000 in 2008. At December 31, 1998, $165,000,000 of the securities sold under agreements to repurchase were callable prior to the maturity date. Securities sold under agreements to repurchase are collateralized by U.S. Government agency and mortgage-backed securities with an amortized cost and a market value of $291,552,000 and $292,936,000, respectively, at December 31, 1998 and $301,117,000 and $301,231,000, respectively, at December 31, 1997. The securities underlying the agreements are not under the Company's control. (12) Income Taxes Legislation was enacted in August 1996 which repealed for tax purposes the percentage of taxable income bad debt reserve method. As a result, the Company must instead use the direct charge-off method to compute its bad debt deduction. The legislation also requires the Company to recapture its post-1987 additions to the tax bad debt reserve of $2,333,000. The Company has accrued for this liability in the consolidated financial statements. Retained earnings at December 31, 1998 includes approximately $10,750,000 for which no provision for income tax has been made. This amount represents an allocation of income to bad debt deductions for tax purposes only. Events that would result in taxation of these reserves include failure to qualify as a bank for tax purposes, distributions in complete or partial liquidation, stock redemptions and excess distributions to shareholders. At December 31, 1998 the Company had an unrecognized deferred tax liability of $3,870,000 with respect to this reserve. Ocean Financial Corp. . OCFC . 29 - -------------------------------------------------------------------------------- The provision for income taxes for the years ended December 31, 1998, 1997 and 1996 consists of the following (in thousands): Year Ended December 31, 1998 1997 1996 - -------------------------------------------------------------------------------- Current: Federal $ 5,460 $ 6,921 $ 4,001 - -------------------------------------------------------------------------------- State 31 237 345 - -------------------------------------------------------------------------------- Total Current 5,491 7,158 4,346 - -------------------------------------------------------------------------------- Deferred: Federal 1,746 584 (2,992) - -------------------------------------------------------------------------------- State 3 (55) (271) - -------------------------------------------------------------------------------- Total Deferred 1,749 529 (3,263) - -------------------------------------------------------------------------------- $ 7,240 $ 7,687 $ 1,083 - -------------------------------------------------------------------------------- A reconciliation between the provision for income taxes and the expected amount computed by multiplying income before provision for income taxes times the applicable statutory Federal income tax rate for the years ended December 31, 1998, 1997 and 1996 is as follows (in thousands): Year Ended December 31, 1998 1997 1996 - -------------------------------------------------------------------------------- Income (loss) before provision for income taxes $ 20,212 $ 21,512 $ (646) - -------------------------------------------------------------------------------- Applicable statutory Federal income tax rate 35.0% 35.0% 35.0% - -------------------------------------------------------------------------------- Computed "expected" Federal income tax expense (benefit) $ 7,074 $ 7,529 $ (226) - -------------------------------------------------------------------------------- Increase(decrease) in Federal income tax expense resulting from: Valuation allowance -- -- 1,166 - -------------------------------------------------------------------------------- ESOP adjustment 218 316 62 - -------------------------------------------------------------------------------- State income taxes net of Federal benefit 22 119 49 - -------------------------------------------------------------------------------- Other items, net (74) (277) 32 - -------------------------------------------------------------------------------- $ 7,240 $ 7,687 $ 1,083 - -------------------------------------------------------------------------------- Effective tax rate 35.8% 35.7% N/A - -------------------------------------------------------------------------------- Included in other assets at December 31, 1998 and 1997 is a net deferred tax asset of $3,750,000 and $4,194,000, respectively. In addition, included in other liabilities at December 31, 1998 and 1997 is a current tax payable of $5,387,000 and $491,000, respectively. The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1998 and 1997 are presented below (in thousands). December 31, 1998 1997 - -------------------------------------------------------------------------------- Deferred tax assets: Allowance for loan and real estate owned losses per books $ 2,913 $ 2,601 - -------------------------------------------------------------------------------- Reserve for uncollected interest 110 113 - -------------------------------------------------------------------------------- Deferred compensation 409 331 - -------------------------------------------------------------------------------- Accrued pension expense 3 194 - -------------------------------------------------------------------------------- Premises and equipment, differences in depreciation 244 286 - -------------------------------------------------------------------------------- Other reserves 199 173 - -------------------------------------------------------------------------------- Stock awards 677 652 - -------------------------------------------------------------------------------- Charitable donation 3,003 3,599 - -------------------------------------------------------------------------------- Unrealized loss on securities available for sale 727 -- - -------------------------------------------------------------------------------- Other 97 8 - -------------------------------------------------------------------------------- Total gross deferred tax assets 8,382 7,957 - -------------------------------------------------------------------------------- Less valuation allowance (1,166) (1,166) - -------------------------------------------------------------------------------- Deferred tax assets, net 7,216 6,791 - -------------------------------------------------------------------------------- Deferred tax liabilities: Allowance for loan and real estate owned losses for tax purposes (726) (858) - -------------------------------------------------------------------------------- Unrealized gain on securities available for sale -- (578) - -------------------------------------------------------------------------------- Excess servicing on sale of mortgage loans (130) (94) - -------------------------------------------------------------------------------- Investments, discount accretion (20) (26) - -------------------------------------------------------------------------------- Deferred loan and commitment fees (648) (371) - -------------------------------------------------------------------------------- Undistributed income of real estate investment trust subsidiary (1,942) (670) - -------------------------------------------------------------------------------- Total deferred tax liabilities (3,466) (2,597) - -------------------------------------------------------------------------------- Net deferred tax assets $ 3,750 $ 4,194 - -------------------------------------------------------------------------------- As disclosed in footnote 2, the Company, as part of the conversion, recorded a charitable donation expense of $13,419,000. Under the Internal Revenue Code, charitable donations are tax deductible subject to a limitation based on 10% of the Company's annual taxable income. The Company, however, is able to carry forward any unused portion of the deduction for five years following the year in which the contribution is made. Based on the Company's estimate of taxable income for 1996 and the carry forward period, $3,419,000 of the charitable donation expense was considered non-tax deductible as it was unlikely that the Company would realize sufficient earnings over the six year period to take the full deduction. As a result, the Company has established a deferred tax valuation allowance of $1,166,000 relating to the nondeductible expense. The Company has determined that it is not required to establish a valuation reserve for the remaining deferred tax asset account since it is "more likely than not" that the remaining deferred tax assets will be realized through future reversals of existing taxable temporary differences, future taxable income and tax planning strategies. The conclusion that it is "more likely than not" that the remaining deferred tax assets will be realized is based on the history of earnings and the prospects for continued growth. Management will continue to review the tax criteria related to the recognition of deferred tax assets. 30 . Ocean Financial Corp. . OCFC - -------------------------------------------------------------------------------- (13) Employee Benefit Plans Employee Stock Ownership Plan As part of the conversion, the Bank established an ESOP to provide retirement benefits for eligible employees. All full-time employees are eligible to participate in the ESOP after they attain age 21 and complete one year of service during which they work at least 1,000 hours. Beginning April 1, 1997, ESOP shares are first allocated to employees who also participate in the Bank's Incentive Savings (401K) Plan in an amount equal to 50% of the first 6% of the employee's contribution. During 1998 and 1997, 9,188 and 6,690 shares, respectively, were either released or committed to be released under this formula. The remaining ESOP shares are allocated among participants on the basis of compensation earned during the year. Employees are fully vested in their ESOP account after the completion of five years of credited service or completely if service was terminated due to death, retirement, disability, or change in control of the Company. ESOP participants are entitled to receive distributions from the ESOP account only upon termination of service, which includes retirement and death. The ESOP originally borrowed $13,421,000 from the Company to purchase 1,342,092 shares of common stock issued in the conversion. On May 12, 1998, the initial loan agreement was amended to allow the ESOP to borrow an additional $8,200,000 in order to fund the purchase of 422,500 shares of common stock. At the same time the term of the loan was extended from the initial twelve years to thirty years. The amended loan is to be repaid from discretionary contributions by the Bank to the ESOP trust. The Bank intends to make contributions to the ESOP in amounts at least equal to the principal and interest requirement of the debt, assuming a fixed interest rate of 8.25%. The Bank's obligation to make such contributions is reduced to the extent of any dividends paid by the Company on unallocated shares and any investment earnings realized on such dividends. As of December 31, 1998 and 1997, contributions to the ESOP, which were used to fund principal and interest payments on the ESOP debt, totaled $3,111,000 and $2,133,000, respectively. During 1998 and 1997, $601,000 and $368,000, respectively, of dividends paid on unallocated ESOP shares were used for debt service. At December 31, 1998 and 1997, the loan had an outstanding balance of $17,615,000 and $11,184,000, respectively, and the ESOP had unallocated shares of 1,373,814 and 1,087,884, respectively. At December 31, 1998, the unallocated shares had a fair value of $22,840,000. The unamortized balance of the ESOP is shown as unallocated common stock held by the ESOP and is reflected as a reduction of stockholders' equity. For the years ended December 31, 1998 and 1997, the Bank recorded compensation expense related to the ESOP of $2,350,000 and $2,345,000, respectively, including $623,000 and $917,000, respectively, representing adjustments to expense to reflect the increase in the average fair value of allocated shares in excess of cost. As of December 31, 1998, 261,109 shares had been allocated to participants and 129,669 shares were committed to be released. Pension Plan Effective June 7, 1996, the Company froze benefit accruals under a qualified noncontributory defined benefit pension plan (the "Plan") and subsequently terminated the Plan on July 22, 1998. As a result of these actions, the Company recognized a curtailment gain in 1996 of $24,000 and a termination loss in 1998 of $7,000. The following table sets forth the Plan's latest available funded status and amounts recognized at December 31, 1997 in the Company's consolidated statements of financial condition (in thousands): 1997 - -------------------------------------------------------------------------------- Actuarial present value of benefit obligations - - accumulated benefit obligation: - -------------------------------------------------------------------------------- Vested $(1,625) - -------------------------------------------------------------------------------- Non-vested (106) - -------------------------------------------------------------------------------- Projected benefit obligation for service rendered to date (1,731) - -------------------------------------------------------------------------------- Plan assets at fair value, primarily a group annuity contract 1,456 - -------------------------------------------------------------------------------- Plan assets less than projected benefit obligation (275) - -------------------------------------------------------------------------------- Unrecognized net loss 120 - -------------------------------------------------------------------------------- Unrecognized net transition asset (311) - -------------------------------------------------------------------------------- Accrued pension cost (included in other liabilities) $ (466) - -------------------------------------------------------------------------------- The components of net pension expense for the years ended December 31, 1997 and 1996 are as follows (in thousands): 1997 1996 - -------------------------------------------------------------------------------- Service cost - benefits earned during the year $-- $ 98 - -------------------------------------------------------------------------------- Interest cost on projected benefit obligation 113 136 - -------------------------------------------------------------------------------- Actual return on plan assets (81) (89) - -------------------------------------------------------------------------------- Net amortization and deferral (39) (42) - -------------------------------------------------------------------------------- Net pension (benefit) expense $ (7) $ 103 - -------------------------------------------------------------------------------- Assumptions used to develop the net periodic pension cost are: - -------------------------------------------------------------------------------- Discount rate 6.51% 6.51% - -------------------------------------------------------------------------------- Expected long-term rate of return on assets 6.75 6.75 - -------------------------------------------------------------------------------- Rate of increase in compensation level N/A 5.00 - -------------------------------------------------------------------------------- The Bank also maintains an incentive savings plan for eligible employees. An employee may make contributions to the plan of 1% to 15% of his or her compensation. Prior to July 1, 1996, the Bank contributed 75% of the first 6% of the employee's contribution to the employee's account. From to July 1, 1996 through March 31, 1997, the Bank contributed 50% of the first 6% of the employees contribution to the employee's account. Effective March 31, 1997, the Bank eliminated their matching obligation under this plan. The Bank's contributions under this plan were $53,000 and $161,000 for the years ended December 31, 1997 and 1996, respectively. (14) Incentive Plan On February 4, 1997, a special meeting of the Company's shareholders ratified the Ocean Financial Corp. 1997 Incentive Plan (the "Incentive Plan"). The Incentive Plan authorizes the granting of options to purchase Common Stock, option-related awards and awards of Common Stock. The purpose of the Incentive Plan is to attract and retain qualified personnel in key positions, provide officers, employees and non-employee directors ("Outside Directors") with a proprietary interest in the Company as an incentive to contribute to the success of the Company, promote the attention of management to other stockholder's concerns and reward employees for outstanding performance. All officers, other employees and Outside Directors of the Company and its affiliates are eligible to receive awards under the Incentive Plan. Ocean Financial Corp. . OCFC . 31 - -------------------------------------------------------------------------------- During 1997, the Company acquired 671,046 shares in the open market at a cost of $10,176,000. At December 31, 1998, 647,758 of these shares have been awarded to officers and directors. Such amounts represent deferred compensation and have been accounted for as a reduction of stockholders' equity. Awards vest at the rate of 20% per year except that the Company has determined that certain awards are also contingent upon attainment of certain performance goals by the Company, which performance goals would be established by a committee of outside directors ("Committee"). The first and second annual installments will vest on the first and second anniversary dates of the date of grant. Vesting of 25% of the third annual installment, and 50% of each of the fourth and fifth annual installments, will be subject to the attainment of performance goals established by the Committee. The performance goals may be set by the Committee on an individual basis, for all Stock Awards made during a given period of time, or for all Stock Awards for indefinite periods. No Stock Award that is subject to a performance goal is to be distributed to an employee until the Committee confirms that the underlying performance goal has been achieved. No Stock Award that is subject to a performance goal is to be distributed to an Outside Director until an independent third party confirms that the underlying performance goal has been achieved. The Company recorded compensation expense relating to stock awards of $1,934,000 and $1,773,000 for the years ended December 31, 1998 and 1997, respectively. Under the Incentive Plan, the Company is authorized to issue up to 1,677,614 shares, subject to option. All options expire 10 years from the date of grant and vest at the rate of 20% per year. The company accounts for stock option awards using the intrinsic value method and has recognized no compensation expense in 1998 and 1997. SFAS 123 permits the use of the intrinsic value method; however, requires the Company to disclose the pro forma net income and earnings per share as if the stock based compensation had been accounted for using the fair value method. Had the compensation costs for the Company's stock option plan been determined based on the fair value method, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below (in thousands except per share data): 1998 1997 - -------------------------------------------------------------------------------- Net income: - -------------------------------------------------------------------------------- As reported $ 12,972 $ 13,825 - -------------------------------------------------------------------------------- Pro forma 12,059 13,000 - -------------------------------------------------------------------------------- Basic earnings per share: - -------------------------------------------------------------------------------- As reported $ .97 $ .90 - -------------------------------------------------------------------------------- Pro forma .90 .85 - -------------------------------------------------------------------------------- Diluted earnings per share: - -------------------------------------------------------------------------------- As reported $ .95 $ .88 - -------------------------------------------------------------------------------- Pro forma .88 .83 - -------------------------------------------------------------------------------- Weighted average fair value of an option share granted during the year $ 4.35 $ 4.08 - -------------------------------------------------------------------------------- The fair value of stock options granted by the Company was estimated through the use of the Black-Scholes option pricing model applying the following assumptions: 1998 1997 - -------------------------------------------------------------------------------- Risk-free interest rate 5.21% 6.25% - -------------------------------------------------------------------------------- Expected option life 6 years 6 years - -------------------------------------------------------------------------------- Expected volatility 25% 25% - -------------------------------------------------------------------------------- Expected dividend yield 2.75% 2.50% - -------------------------------------------------------------------------------- A summary of option activity for the years ended December 31, 1998 and 1997 follows: 1998 1997 - --------------------------------------------------------------------------------------------- Weighted Weighted Number Average Number Average of Shares Exercise Price of Shares Exercise Price - --------------------------------------------------------------------------------------------- Outstanding at beginning of year 1,567,402 $ 14.46 -- -- - --------------------------------------------------------------------------------------------- Granted 112,402 17.23 1,621,758 $ 14.45 - --------------------------------------------------------------------------------------------- Exercised (2,348) 14.41 -- -- - --------------------------------------------------------------------------------------------- Forfeited (34,629) 14.41 (54,356) 14.41 - --------------------------------------------------------------------------------------------- Outstanding at end of year 1,642,827 $ 14.67 1,567,402 $ 14.46 - --------------------------------------------------------------------------------------------- At December 31, 1998 1997 - --------------------------------------------------------------------------------------------- Options exercisable 310,527 None - --------------------------------------------------------------------------------------------- Range of exercise prices $13.94 -- $19.88 $14.41 -- $18.56 - --------------------------------------------------------------------------------------------- Weighted average remaining contractual life 8.2 years 9.1 years - --------------------------------------------------------------------------------------------- (15) Commitments, Contingencies and Concentrations of Credit Risk The Company, in the normal course of business, is party to financial instruments and commitments which involve, to varying degrees, elements of risk in excess of the amounts recognized in the consolidated financial statements. These financial instruments and commitments include unused consumer lines of credit and commitments to extend credit. At December 31, 1998, the following commitments and contingent liabilities existed which are not reflected in the accompanying consolidated financial statements (in thousands): December 31, 1998 - -------------------------------------------------------------------------------- Unused consumer and construction loan lines of credit (primarily floating- rate) $16,363 - -------------------------------------------------------------------------------- Unused commercial loan lines of credit (primarily floating rate) 3,864 - -------------------------------------------------------------------------------- Other commitments to extend credit: - -------------------------------------------------------------------------------- Fixed Rate 34,938 - -------------------------------------------------------------------------------- Adjustable Rate 11,808 - -------------------------------------------------------------------------------- Floating Rate 560 - -------------------------------------------------------------------------------- The Company's fixed-rate loan commitments expire within 90 days of issuance and carried interest rates ranging from 6.00% to 7.00% at December 31, 1998. The Company's maximum exposure to credit losses in the event of nonperformance by the other party to these financial instruments and commitments is represented by the contractual amounts. The Company uses the same credit policies in granting commitments and conditional obligations as it does for financial instruments recorded in the consolidated statements of financial condition. These commitments and obligations do not necessarily represent future cash flow requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary, is based on management's assessment of risk. The unused consumer and construction loan lines of credit are collateralized by mortgages on real estate. 32 . Ocean Financial Corp. . OCFC - -------------------------------------------------------------------------------- The Bank has an available overnight line of credit with the Federal Home Loan Bank of New York ("FHLB") for $50,000,000 which expires November 20, 1999. The Bank also has available from the FHLB, a one-month overnight repricing line of credit for $50,000,000 which expires November 20, 1999. When utilized, both lines carry a floating interest rate of 1/8% over the current Federal funds rate and are secured by the Bank's mortgage loans, mortgage-backed securities, U.S. Government agency obligations and FHLB stock. As a member of the FHLB of New York, the Company is required to maintain a minimum investment in the capital stock of the Federal Home Loan Bank of New York, at cost, in an amount not less than 1% of its outstanding home loans (including mortgage-backed securities) or 5% of its outstanding notes payable to the FHLB. At December 31, 1998, the Company is obligated under noncancellable operating leases for premises and equipment. Rental expense under these leases aggregated approximately $573,000, $515,000 and $822,000 for the years ended December 31, 1998, 1997 and 1996 respectively. The projected minimum rental commitments as of December 31, 1998 are as follows (in thousands): December 31 December 31, 1998 - ------------------------------------------------- 1999 $504 - ------------------------------------------------- 2000 453 - ------------------------------------------------- 2001 377 - ------------------------------------------------- 2002 353 - ------------------------------------------------- 2003 279 - ------------------------------------------------- Thereafter 3,368 - ------------------------------------------------- $ 5,334 - ------------------------------------------------- The Company grants one to four-family first mortgage real estate loans and multi-family first mortgage real estate loans to borrowers primarily located in Ocean, Middlesex and Monmouth Counties, New Jersey. Its borrowers' abilities to repay their obligations are dependent upon various factors including the borrowers' income and net worth, cash flows generated by the underlying collateral, value of the underlying collateral and priority of the Company's lien on the property. Such factors are dependent upon various economic conditions and individual circumstances beyond the Company's control; the Company is, therefore, subject to risk of loss. The Company believes its lending policies and procedures adequately minimize the potential exposure to such risks and that adequate provisions for loan losses are provided for all known and inherent risks. Collateral and/or guarantees are required for all loans. Contingencies The Company is a defendant in certain claims and legal actions arising in the ordinary course of business. Management and its legal counsel are of the opinion that the ultimate disposition of these matters will not have a material adverse effect on the Company's consolidated financial condition, results of operations or liquidity. (16) Fair Value of Financial Instruments Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (SFAS 107), requires that the Company disclose estimated fair values for its financial instruments. Fair value estimates, methods and assumptions are set forth below for the Company's financial instruments. Cash and due from banks For cash and due from banks, the carrying amount approximates fair value. Investments and Mortgage-backed securities The fair value of investment and mortgage-backed securities is estimated based on bid quotations received from securities dealers, if available. If a quoted market price was not available, fair value was estimated using quoted market prices of similar instruments, adjusted for differences between the quoted instruments and the instruments being valued. Federal Home Loan Bank of New York stock The fair value for Federal Home Loan Bank of New York Stock is its carrying value since this is the amount for which it could be redeemed. There is no active market for this stock and the Company is required to maintain a minimum balance based upon the unpaid principal of home mortgage loans and mortgage-backed securities. Loans Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as residential mortgage, construction, land, consumer and commercial. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and non-performing categories. Fair value of performing loans was estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics, if applicable. Fair value for significant non-performing loans is based on recent external appraisals of collateral securing such loans, adjusted for the timing of anticipated cash flows. Deposits The fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, savings, and NOW and money market accounts, is equal to the amount payable on demand. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities. Federal Home Loan Bank borrowings Federal Home Loan Bank borrowings are short-term in nature and the carrying amount approximates fair value. Securities sold under agreements to repurchase Fair value estimates are based on discounting contractual cash flows using rates which approximate the rates offered for borrowings of similar remaining maturities. Commitments to extend credit, and to purchase or sell securities The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. Ocean Financial Corp. . OCFC . 33 - -------------------------------------------------------------------------------- The estimated fair values of the Bank's financial instruments as of December 31, 1998 and 1997 are presented in the following tables (in thousands). Since the fair value of off-balance sheet commitments approximate book value, these disclosures are not included. Book Fair December 31, 1998 Value Value - ----------------------------------------------------------------------------- Financial Assets: Cash and due from banks $ 10,295 $ 10,295 - ----------------------------------------------------------------------------- Investment securities available for sale 137,405 137,405 - ----------------------------------------------------------------------------- Mortgage-backed securities available for sale 381,840 381,840 - ----------------------------------------------------------------------------- Federal Home Loan Bank of New York stock 16,800 16,800 - ----------------------------------------------------------------------------- Loans receivable and mortgage loans held for sale 966,151 982,009 - ----------------------------------------------------------------------------- Financial Liabilities: Deposits 1,035,251 1,042,528 - ----------------------------------------------------------------------------- Federal Home Loan Bank borrowings 30,000 30,000 - ----------------------------------------------------------------------------- Securities sold under agreements to repurchase $ 282,108 281,437 - ----------------------------------------------------------------------------- Book Fair December 31, 1997 Value Value - ----------------------------------------------------------------------------- Financial Assets: Cash and due from banks $ 2,225 $ 2,225 - ----------------------------------------------------------------------------- Investment securities available for sale 207,357 207,357 - ----------------------------------------------------------------------------- Mortgage-backed securities available for sale 457,148 457,148 - ----------------------------------------------------------------------------- Federal Home Loan Bank of New York stock 14,980 14,980 - ----------------------------------------------------------------------------- Loans receivable and mortgage loans held for sale 783,695 807,651 - ----------------------------------------------------------------------------- Financial Liabilities: Deposits 976,764 978,631 - ----------------------------------------------------------------------------- Federal Home Loan Bank borrowings 20,400 20,400 - ----------------------------------------------------------------------------- Securities sold under agreements to repurchase $288,200 $288,547 - ----------------------------------------------------------------------------- Limitations Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on existing balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial assets or liabilities include the mortgage banking operation, deferred tax assets, and premises and equipment. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates. (17) Parent-Only Financial Information The following condensed statements of financial condition at December 31, 1998 and 1997 and condensed statements of operations and cash flows for the years ended December 31, 1998 and 1997 and for the period from July 2, 1996 (date of conversion) to December 31, 1996 for Ocean Financial Corp. (parent company only) reflects the Company's investment in its wholly-owned subsidiary, the Bank, using the equity method of accounting. The Company had no results of operations prior to July 2, 1996. CONDENSED STATEMENTS OF FINANCIAL CONDITION December 31, 1998 1997 - -------------------------------------------------------------------------------- (in thousands) Assets Cash and due from banks $ 7 $ 7 - -------------------------------------------------------------------------------- Advances to subsidiary Bank 7,639 9,931 - -------------------------------------------------------------------------------- Investment securities 2,834 10,780 - -------------------------------------------------------------------------------- ESOP loan receivable 17,615 11,184 - -------------------------------------------------------------------------------- Investment in subsidiary Bank 167,885 181,470 - -------------------------------------------------------------------------------- Other assets 2,143 3,320 - -------------------------------------------------------------------------------- Total Assets $198,123 $216,692 - -------------------------------------------------------------------------------- Liabilities and Stockholders' Equity Taxes payable $ 383 $ 1,148 - -------------------------------------------------------------------------------- Stockholders' Equity 197,740 215,544 - -------------------------------------------------------------------------------- Total Liabilities and Stockholders' Equity $198,123 $216,692 - -------------------------------------------------------------------------------- CONDENSED STATEMENTS OF OPERATIONS For the period from July 2, 1996 to December Year ended December 31, 1998 1997 31, 1996 - -------------------------------------------------------------------------------- (in thousands) Dividend income - Subsidiary Bank $ 18,000 $ -- $ -- - -------------------------------------------------------------------------------- Interest income - Investment securities 354 2,889 -- - -------------------------------------------------------------------------------- Interest income - Advances to subsidiary Bank 234 132 1,840 - -------------------------------------------------------------------------------- Interest income - ESOP loan receivable 1,342 1,015 547 - -------------------------------------------------------------------------------- Total dividend and interest income 19,930 4,036 2,387 - -------------------------------------------------------------------------------- Other income -- 2 -- - -------------------------------------------------------------------------------- Charitable donation -- -- 13,419 - -------------------------------------------------------------------------------- Other operating expenses 421 383 152 - -------------------------------------------------------------------------------- Income (loss) before income taxes and equity in (distribution in excess of) undistributed earnings of subsidiary Bank 19,509 3,655 (11,184) - -------------------------------------------------------------------------------- Provision (benefit) for income taxes 562 1,233 (2,755) - -------------------------------------------------------------------------------- Income (loss) before equity in (distribution in excess of) undistributed earnings of subsidiary Bank 18,947 2,422 (8,429) - -------------------------------------------------------------------------------- Equity in (distribution in excess of) undistributed earnings of subsidiary Bank (5,975) 11,403 1,817 - -------------------------------------------------------------------------------- Net income (loss) $ 12,972 $ 13,825 $ (6,612) - -------------------------------------------------------------------------------- 34 . Ocean Financial Corp. . OCFC - -------------------------------------------------------------------------------- CONDENSED STATEMENTS OF CASH FLOWS For the period from July 2, 1996 to December Year ended December 31, 1998 1997 31, 1996 - -------------------------------------------------------------------------------- (in thousands) Cash flows from operating activities: Net income (loss) $ 12,972 $ 13,825 $ (6,612) - -------------------------------------------------------------------------------- Donation of 1,342,092 shares of common stock to the Ocean Federal Foundation -- -- 13,419 - -------------------------------------------------------------------------------- Decrease (increase) in advances to subsidiary Bank 2,292 61,622 (71,553) - -------------------------------------------------------------------------------- Equity in (distribution in excess of) undistributed earnings of subsidiary Bank 5,975 (11,403) (1,817) - -------------------------------------------------------------------------------- Decrease (increase) in other assets 1,177 289 (3,470) - -------------------------------------------------------------------------------- (Decrease) increase in taxes payable (765) 458 690 - -------------------------------------------------------------------------------- Reduction in Incentive Awards 1,934 1,773 -- - -------------------------------------------------------------------------------- Net cash provided by (used in) operating activities 23,585 66,564 (69,343) - -------------------------------------------------------------------------------- Cash flows from investing activities: Purchase of investment securities (2,046) (71,170) -- - -------------------------------------------------------------------------------- Sale of investment securities 10,000 60,000 -- - -------------------------------------------------------------------------------- Funding of ESOP loan receivable, net of repayments (6,431) 1,118 (12,302) - -------------------------------------------------------------------------------- Payments for investments in subsidiary Bank -- -- (81,650) - -------------------------------------------------------------------------------- Net cash provided by (used in) investing activities 1,523 (10,052) (93,952) - -------------------------------------------------------------------------------- Cash flows from financing activities: Net proceeds of common stock issuance -- -- 163,302 - -------------------------------------------------------------------------------- Dividends paid (6,470) (4,800) -- - -------------------------------------------------------------------------------- Purchase of Incentive Award shares -- (10,176) -- - -------------------------------------------------------------------------------- Purchase of treasury stock (18,672) (41,536) -- - -------------------------------------------------------------------------------- Exercise of stock options 34 -- -- - -------------------------------------------------------------------------------- Net cash (used in) provided by financing activities (25,108) (56,512) 163,302 - -------------------------------------------------------------------------------- Net increase in cash and due from banks -- -- 7 - -------------------------------------------------------------------------------- Cash and due from banks at beginning of period 7 7 -- - -------------------------------------------------------------------------------- Cash and due from banks at end of period $ 7 $ 7 $ 7 - -------------------------------------------------------------------------------- (18) Recapitalization of Savings Association Insurance Fund (SAIF) On September 30, 1996, legislation was enacted which, among other things, imposed a special one-time assessment on Saving Association Insurance Fund (SAIF) member institutions, including the Bank, to recapitalize the SAIF and spread the obligations for payment of Financing Corporation (FICO) bonds across all SAIF and Bank Insurance Fund (BIF) members. The Federal Deposit Insurance Corporation (FDIC) special assessment amounted to 65.7 basis points on SAIF assessable deposits held as of March 31, 1995. The Company incurred a charge of $5,720,000 before taxes as a result of the FDIC special assessment. This legislation eliminated the substantial disparity between the amount that BIF and SAIF member institutions had been paying for deposit insurance premiums. Effective January 1, 1997, BIF members paid a portion of the FICO payment equal to 1.3 basis points on BIF-insured deposits compared to 6.5 basis points on SAIF-insured deposits, and will pay a pro rata share of the FICO payment on the earlier of January 1, 2000, or the date upon which the last savings association ceases to exist. The legislation also requires BIF and SAIF to be merged by January 1, 1999, provided that subsequent legislation is adopted to eliminate the savings association charter and no savings associations remain as of that time. Beginning January 1, 1997 SAIF assessment rates ranged from 0 to 27 basis points based upon an institutions risk classification and capital group. Based upon its current classification the rate applicable to the Bank is 0. Ocean Financial Corp. . OCFC . 35 - -------------------------------------------------------------------------------- Independent Auditors' Report - -------------------------------------------------------------------------------- The Board of Directors and Stockholders Ocean Financial Corp: We have audited the consolidated statements of financial condition of Ocean Financial Corp. and subsidiary as of December 31, 1998 and 1997, and the related consolidated statements of income and comprehensive income, changes in stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ocean Financial Corp. and subsidiary as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1998 in conformity with generally accepted accounting principles. /s/ KPMG LLP Short Hills, New Jersey January 21, 1999 36 . Ocean Financial Corp. . OCFC Selected Consolidated Quarterly Financial Data - -------------------------------------------------------------------------------- (Unaudited) Quarter ended Dec. 31 Sept. 30 June 30 March 31 - ------------------------------------------------------------------------------------------------ (dollars in thousands, except per share data) 1998 - ------------------------------------------------------------------------------------------------ Interest income $ 26,618 $ 26,494 $ 26,219 $ 26,226 - ------------------------------------------------------------------------------------------------ Interest expense 15,283 15,660 15,310 15,146 - ------------------------------------------------------------------------------------------------ Net interest income 11,335 10,834 10,909 11,080 - ------------------------------------------------------------------------------------------------ Provision for loan losses 225 225 225 225 - ------------------------------------------------------------------------------------------------ Net interest income after provision for loan losses 11,110 10,609 10,684 10,855 - ------------------------------------------------------------------------------------------------ Other income (loss) (139) 876 1,053 621 - ------------------------------------------------------------------------------------------------ Operating expenses 6,499 6,304 6,673 5,981 - ------------------------------------------------------------------------------------------------ Income before provision for income taxes 4,472 5,181 5,064 5,495 - ------------------------------------------------------------------------------------------------ Provision for income taxes 1,547 1,845 1,862 1,986 - ------------------------------------------------------------------------------------------------ Net income $ 2,925 $ 3,336 $ 3,202 $ 3,509 - ------------------------------------------------------------------------------------------------ Basic earnings per share $ .23 $ .25 $ .23 $ .26 - ------------------------------------------------------------------------------------------------ Diluted earnings per share $ .23 $ .25 $ .23 $ .24 - ------------------------------------------------------------------------------------------------ 1997 - ------------------------------------------------------------------------------------------------ Interest income $ 26,233 $ 25,568 $ 24,310 $ 22,545 - ------------------------------------------------------------------------------------------------ Interest expense 15,407 14,658 13,510 12,033 - ------------------------------------------------------------------------------------------------ Net interest income 10,826 10,910 10,800 10,512 - ------------------------------------------------------------------------------------------------ Provision for loan losses 225 225 225 225 - ------------------------------------------------------------------------------------------------ Net interest income after provision for loan losses 10,601 10,685 10,575 10,287 - ------------------------------------------------------------------------------------------------ Other income 776 572 575 586 - ------------------------------------------------------------------------------------------------ Operating expenses 6,116 5,724 5,845 5,460 - ------------------------------------------------------------------------------------------------ Income before provision for income taxes 5,261 5,533 5,305 5,413 - ------------------------------------------------------------------------------------------------ Provision for income taxes 1,781 1,993 1,889 2,024 - ------------------------------------------------------------------------------------------------ Net income $ 3,480 $ 3,540 $ 3,416 $ 3,389 - ------------------------------------------------------------------------------------------------ Basic earnings per share $ .24 $ .24 $ .22 $ .20 - ------------------------------------------------------------------------------------------------ Diluted earnings per share $ .24 $ .23 $ .21 $ .20 - ------------------------------------------------------------------------------------------------ Ocean Financial Corp. . OCFC . 37 Ocean Financial Corp. Ocean Federal Savings Bank - -------------------------------------------------------------------------------- Ocean Financial Corp. Ocean Federal Savings Bank BOARD OF DIRECTORS Michael E. Barrett Executive Vice President Ocean Federal Savings Bank Thomas F. Curtin Partner The Foristall Company. Carl Feltz, Jr. Principal Feltz Associates John R. Garbarino President and Chairman of the Board Robert E. Knemoller Retired, Executive Officer Ocean Federal Savings Bank Donald E. McLaughlin Owner Donald E. McLaughlin, CPA, P.C. Diane F. Rhine Owner Citta & Cobb, Inc. Frederick E. Schlosser Retired Steinbach & Co. James T. Snyder Retired Proprietor, Wallach's Inc. Roy M. Hyde Director Emeritus OCEAN FINANCIAL CORP. EXECUTIVE OFFICERS John R. Garbarino President and Chairman of the Board Michael J. Fitzpatrick Executive Vice President and Chief Financial Officer John K. Kelly Senior Vice President and Corporate Secretary Ocean Federal Savings Bank CORPORATE OFFICERS John R. Garbarino President and Chief Executive Officer Michael E. Barrett Executive Vice President Residential Loan Division Michael J. Fitzpatrick Executive Vice President and Chief Financial Officer Karl E. Reinheimer Executive Vice President and Chief Operating Officer John K. Kelly Senior Vice President and General Counsel Barbara A. Reitmeyer Corporate Secretary SENIOR VICE PRESIDENTS James J. Flynn Mortgage Lending William J. Ruckert, III Commercial Lending Kirby H. Wood Retail Banking Stephen J. Wilson Retail Banking VICE PRESIDENTS Philip J. Bailey Deposit Services M. Eileen Bergin Legal Jennifer Bizub Human Resources Victoria J. Bonavito Branch Administration Owen J. Bonner Loan Review and Quality Control William J. Glinski Treasurer Jill Apito Hewitt Marketing Mary C. Huff Commercial Lending Percy Keynton Internal Audit Frank J. Recca Loan Servicing Kevin B. Runyon Information Technology John Van Eenennaam Controller Barbara Yack Branch Administration Ocean Federal Savings Bank ASSISTANT VICE PRESIDENTS Elizabeth M. Alexander Douglas A. Blyth Christine B. Boldt Patricia A. Broadfoot Lorraine L. Campanile Sharon L. Danielson Judith A. DiLauro Edward R. Fryer Michael L. Frankovich Pauline A. Higgins Sharon Labash Jeanette M. Loftus Lilia C. Madero Karen A. Olsen Marvin L. Penn Lynn Rhoads Catherine R. Rollo Doreen L. Rowe M. Jane Ruhnke George E. Ryll Adrienne L. Sanchez Frank A. Scarpone Matthew J. Schwing Patricia M. Siciliano Lorraine P. Smith Peggy S. Staab Michael T. Stocko Nancy Uffer Lois A. Velardo ASSISTANT SECRETARY Geraldine J. LaBrutto 38 . Ocean Financial Corp. . OCFC Banking Offices - --------------- BERKELEY Holiday City Plaza (732)341-4100 Lois A. Velardo Manager Holiday City Plaza III (732)914-0137 Lorraine P. Smith Manager BRICK Main Office 321 Chambers Bridge Road (732)477-5151 Douglas A. Blyth Manager 70 Brick Boulevard (732)477-3800 Patricia M. Siciliano Manager CONCORDIA Concordia Shopping Mall (609)395-7080 Lorraine L. Campanile Manager LACEY 900 Lacey Road (609)242-1800 Jeanette M. Loftus Manager POINT PLEASANT BEACH 701 Arnold Avenue (732)892-8500 Sharon Labash Manager POINT PLEASANT BORO 2400 Bridge Avenue (732)899-2800 Frank A. Scarpone Manager TOMS RIVER 975 Hooper Avenue (732)244-8989 Lilia C. Madero Manager The Shoppes at Lake Ridge 147 Route 70, Suite 1 (732)363-2727 Judith A. DiLauro Manager WHITING Whiting Shopping Center (732)849-0500 Catherine R. Rollo Manager Shareholder Information - ----------------------- ADMINISTRATIVE OFFICES 975 Hooper Avenue Toms River, NJ 08754-2009 (732)240-4500 ANNUAL MEETING OF SHAREHOLDERS The Annual Meeting of Shareholders will be held on April 22, 1999 at 10 a.m. at the Crystal Point Yacht Club at 3900 River Road at the intersection of State Highway 70, Point Pleasant, New Jersey. INVESTOR RELATIONS Copies of the Company's earnings releases and financial publications, including the annual report on Form 10-K (without exhibits) filed with the Securities and Exchange Commission are available without charge by contacting: Sally Dennis Ocean Financial Corp. 975 Hooper Avenue Toms River, New Jersey 08754-2009 (732)240-4500, ext. 7516 STOCK TRANSFER AGENT AND REGISTRAR Shareholders wishing to change the name, address or ownership of stock, to report lost certificates or to consolidate accounts are asked to contact the Company's stock registrar and transfer agent directly: American Stock Transfer and Trust Co. Shareholder Relations Department 40 Wall Street, 46th Floor New York, NY 10005 (800)937-5449 INDEPENDENT AUDITORS KPMG LLP 150 John F. Kennedy Parkway Short Hills, NJ 07078 SECURITIES COUNSEL Muldoon, Murphy & Faucette LLP 5101 Wisconsin Avenue, NW Washington, DC 20016 Market Information for Common Stock - ----------------------------------- Ocean Financial Corp.'s common stock is traded on the Nasdaq National Market under the symbol OCFC. The stock is customarily listed as OCEANFIN in the Asbury Park Press and the Ocean County Observer. Shares of the common stock were made available to qualified subscribers at $10.00 per share during the initial offering. The table below shows the reported high and low sales prices of the common stock during the periods indicated in 1998 and 1997. Share prices for prior periods have been adjusted for the two-for-one stock split effected in the form of a 100% stock dividend paid on May 15, 1998. 1998 - ------------------------------------------------------------------- First Second Third Fourth Quarter Quarter Quarter Quarter - ------------------------------------------------------------------- High 19 20 19 9/16 16 5/8 Low 16 5/8 18 1/4 13 7/8 12 1997 - ------------------------------------------------------------------- First Second Third Fourth Quarter Quarter Quarter Quarter - ------------------------------------------------------------------- High 16 1/4 17 13/16 18 1/4 19 3/8 Low 12 11/16 13 7/16 16 1/8 17 1/16 As of December 31, 1998, the Company had approximately 6,000 shareholders of record, including the number of persons or entities holding stock in nominee or street name through various brokers and banks. Ocean Financial Corp. . OCFC . 39 Ocean Financial Corp. 975 Hooper Avenue Toms River, NJ 08754-2009 (732) 240-4500 NASDAQ . OCFC Member FDIC . Equal Housing Lender [LOGO] . Equal Opportunity Lender