1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON D.C. 20549 ---------- FORM 10-Q ---------- X QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE - ----- ACT OF 1934 For the quarter ended March 31, 1997 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES - ----- EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission File Number 0-1100 ---------- HAWTHORNE FINANCIAL CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 95-2085671 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification Number) 2381 ROSECRANS AVENUE, EL SEGUNDO, CA 90245 (Address of Principal Executive Offices) (Zip Code) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE (310) 725-5000 ---------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date: The Registrant had 2,629,275 shares of Common Stock, $0.01 par value per share outstanding, as of May 5, 1997. ================================================================================ 2 HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY FORM 10-Q INDEX FOR THE QUARTER ENDED MARCH 31, 1997 PART I - FINANCIAL INFORMATION Page ---- ITEM 1. Financial Statements Consolidated Statements of Financial Condition at March 31, 1997 (Unaudited) and December 31, 1996 3 Consolidated Statements of Operations (Unaudited) for the Three Months Ended March 31, 1997 and 1996 4 Consolidated Statement of Stockholders' Equity (Unaudited) for the Three Months Ended March 31, 1997 5 Consolidated Statements of Cash Flows (Unaudited) for the Three Months Ended March 31, 1997 and 1996 6 Notes to Consolidated Financial Statements (Unaudited) 8 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10 ITEM 3. Quantitative and Qualitative Disclosure About Market Risk 28 PART II - OTHER INFORMATION ITEM 1. Legal Proceedings 29 ITEM 2. Changes in Securities 29 ITEM 3. Defaults upon Senior Securities 29 ITEM 4. Submission of Matters to a Vote of Security Holders 29 ITEM 5. Other Information 29 ITEM 6. Exhibits and Reports on Form 8-K 29 FORWARD LOOKING STATEMENTS When used in this Form 10-Q or future filings by the Company with the Securities and Exchange Commission, in the Company's press releases or other public or stockholder communications, or in oral statements made with the approval of an authorized executive officer, the words or phrases "will likely result", "are expected to", "will continue", "is anticipated", "estimate", "project", "believe" or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. The Company wishes to caution readers that all forward-looking statements are necessarily speculative and not to place undue reliance on any such forward-looking statements, which speak only as of the date made, and to advise readers that various risks and uncertainties, including regional and national economic conditions, changes in levels of market interest rates, credit risks of lending activities, and competitive and regulatory factors, could affect the Company's financial performance and could cause the Company's actual results for future periods to differ materially from those anticipated or projected. The risks highlighted herein should not be assumed to be the only things that could affect future performance of the Company. The Company does not undertake, and specifically disclaims any obligation, to publicly release the result of any revisions which may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. 2 3 HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (DOLLARS ARE IN THOUSANDS) MARCH 31, DECEMBER 31, 1997 1996 (UNAUDITED) (AUDITED) --------- --------- ASSETS Cash and cash equivalents $ 16,024 $ 93,978 Investment securities available-for-sale, at market 77,633 38,371 Loans receivable (net of allowance for estimated credit losses of $13,657 in 1997 and $13,515 in 1996) 698,225 672,401 Real estate owned (net of allowance for estimated losses of $9,659 in 1997 and $11,871 in 1996) 20,977 20,140 Investment in capital stock of Federal Home Loan Bank - at cost 6,898 6,788 Office property and equipment - at cost, net 4,531 4,729 Accrued interest receivable 4,700 4,781 Deferred tax asset, net 4,935 4,243 Other assets 4,052 1,764 --------- --------- $ 837,975 $ 847,195 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Deposits $ 708,113 $ 717,809 Short-term borrowings 65,000 50,000 Senior notes 12,385 12,307 Accounts payable and other liabilities 8,353 23,157 --------- --------- 793,851 803,273 Stockholders' equity Preferred stock - $0.01 par value; authorized 10,000,000 shares Cumulative preferred stock, Series A: liquidation preference, $50 per share; authorized, 270 shares; outstanding, 270 shares Common stock - $0.01 par value; authorized, 20,000,000 shares; issued and outstanding, 2,634,675 shares in 1997 and 2,604,675 shares in 1996 26 26 Capital in excess of par value - cumulative preferred stock, series A 11,592 11,592 Capital in excess of par value - common stock 7,887 7,745 Unrealized gain (loss) on available-for-sale securities, net (829) (132) Retained earnings 25,608 24,858 --------- --------- 44,284 44,089 Less Treasury stock, at cost - 5,400 shares (48) (48) Loan to Employee Stock Ownership Plan (112) (119) --------- --------- 44,124 43,922 ========= ========= $ 837,975 $ 847,195 ========= ========= 3 4 HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) (DOLLARS ARE IN THOUSANDS) THREE MONTHS ENDED MARCH 31, ----------------------- 1997 1996 -------- -------- Interest revenues Loans $ 16,330 $ 14,362 Investment securities 1,501 1,068 -------- -------- 17,831 15,430 -------- -------- Interest costs Deposits 8,892 8,938 Short-term borrowings 780 -- Senior notes 483 471 -------- -------- 10,155 9,409 -------- -------- Net interest income before contractual interest on nonaccrual loans 7,676 6,021 Contractual interest due on nonaccrual loans (824) (629) -------- -------- Net interest income 6,852 5,392 Provision for credit losses 1,500 1,200 -------- -------- Net interest income after provision for credit losses 5,352 4,192 Noninterest revenues 732 440 Noninterest expenses Employee 2,769 2,294 Operating 1,054 1,049 Occupancy 754 723 Professional 348 448 SAIF premium and OTS assessment 372 585 Goodwill amortization 12 -------- -------- 5,297 5,111 -------- -------- Real estate operations, net 20 441 Gain (loss) on sale of loans (13) 153 Other revenues (expenses), net 193 -------- -------- Net earnings before income taxes 794 308 Income tax benefit 563 2,253 -------- -------- Net earnings $ 1,357 $ 2,561 ======== ======== Net earnings available for Common (NOTE 3) $ 852 $ 2,130 ======== ======== Net earnings per share (NOTE 3) $ 0.17 $ 0.41 ======== ======== Weighted average shares (NOTE 3) 5,142 5,151 ======== ======== 4 5 HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (UNAUDITED) (DOLLARS ARE IN THOUSANDS) ACCRUED CHANGE IN DIVIDENDS BALANCE AT EXERCISED UNREALIZED ON BALANCE AT DECEMBER 31, STOCK GAINS NET PREFERRED MARCH 31, 1996 OPTIONS (LOSSES) EARNINGS STOCK REPAYMENTS 1997 ------------ -------- ------- ------- --------- ---------- ------- Common stock $ 26 $ 26 Cumulative preferred stock, series A Capital in excess of par value Common stock 7,745 142 7,887 Cumulative preferred stock, series A 11,592 11,592 Unrealized gain (loss) on available-for-sale securities, net (132) (697) (829) Retained earnings 24,858 1,357 (607) 25,608 Treasury stock (48) (48) Loan to employee stock ownership plan (119) 7 (112) -------- -------- ------- ------- --------- ---------- ------- Total stockholders' equity $ 43,922 $ 142 $ (697) $ 1,357 $ (607) $ 7 $44,124 ======== ======== ======= ======= ========= ========== ======= 5 6 HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (DOLLARS ARE IN THOUSANDS) THREE MONTHS ENDED MARCH 31, ----------------------- 1997 1996 -------- -------- NET CASH FLOWS FROM OPERATING ACTIVITIES Net earnings $ 1,357 $ 2,561 Adjustments Provision (benefit) for income taxes (692) (2,253) Provision for estimated credit losses on loans 1,500 1,200 Provision for estimated credit losses on real estate owned 700 Net gain on sale of branches (202) Net recoveries from sales of real estate owned (24) (743) Loan fee and discount accretion (905) (562) Depreciation and amortization 445 360 FHLB dividends (110) (81) Goodwill amortization 12 Decrease (increase) in: Accrued interest receivable 81 (428) Other assets (2,340) (1,328) (Decrease) increase in other liabilities (15,365) 45 Other, net (42) (73) -------- -------- Net cash used by operating activities (16,095) (792) -------- -------- NET CASH FLOWS FROM INVESTING ACTIVITIES Investment securities Purchases (40,000) (89,966) Maturities 57,932 Mortgage-backed securities Principal amortization 33 Loans New loans funded (43,991) (35,826) Construction disbursements (17,950) (9,760) Payoffs 29,194 12,678 Sales proceeds 32,720 Principal amortization 4,336 4,146 Other, net (2,262) 3,129 Real estate owned Sale proceeds 5,728 10,829 Capitalized costs (2,256) (2,834) Redemption of FHLB stock Office property and equipment Sales proceeds 2,722 Additions (111) (40) -------- -------- Net cash used by investing activities (67,312) (14,237) -------- -------- 6 7 HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (DOLLARS ARE IN THOUSANDS) THREE MONTHS ENDED MARCH 31, ----------------------- 1997 1996 -------- -------- NET CASH FLOWS FROM FINANCING ACTIVITIES Net (decrease) growth in deposits (9,696) 16,857 Net change in borrowings 15,000 Net proceeds from exercise of options 142 Collection of ESOP loan 7 6 -------- -------- Net cash provided by financing activities 5,453 16,863 -------- -------- (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (77,954) 1,834 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 93,978 14,015 -------- -------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 16,024 $ 15,849 ======== ======== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the period for Interest $ 9,803 $ 8,697 Income taxes 129 Non-cash investing and financing activities Real estate acquired in settlement of loans 6,719 3,646 Loans originated to finance sales of real estate owned 2,192 7,478 Net change in unrealized gains (losses) on available-for-sale securities (697) (60) Transfer of held to maturity securities to available-for-sale 35,148 Loan activity Total commitments and permanent fundings $ 74,079 $ 64,770 Less: Change in undisbursed funds on construction commitments (1,958) (10,349) Loans originated to finance sales of real estate owned (2,192) (7,478) Non-cash portion of refinanced loans (6,300) Undisbursed portion of new lines of credit (1,688) (1,357) -------- -------- Net construction disbursements and loans funded $ 61,941 $ 45,586 ======== ======== 7 8 HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) MARCH 31, 1997 NOTE 1 - SUMMARY OF ACCOUNTING POLICIES The consolidated financial statements include the accounts of Hawthorne Financial Corporation and its wholly-owned subsidiary, Hawthorne Savings, F.S.B. ("Bank"), collectively referred to as the "Company". All material intercompany transactions and accounts have been eliminated. In the opinion of management, the unaudited consolidated financial statements contain all adjustments (consisting solely of normal recurring accruals) necessary to present fairly the Company's financial position as of March 31, 1997, and December 31, 1996, and the results of its operations and its cash flows for the three months ended March 31, 1997 and 1996. Certain information and note disclosures normally included in financial statements prepared in accordance with Generally Accepted Accounting Principles ("GAAP") have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Operating results for the three months ended March 31, 1997, are not necessarily indicative of the results that may be expected for any other interim period or the full year ending December 31, 1997. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 1996. NOTE 2 - RECLASSIFICATION Certain amounts in the 1996 consolidated financial statements have been reclassified, where practicable, to conform with classifications in 1997. 8 9 HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) MARCH 31, 1997 (amounts are in thousands, except for book value and per share data) NOTE 3 - BOOK VALUE AND EARNINGS PER SHARE The table below sets forth the Company's book value and earnings per share calculations for March 31, 1997 and 1996, using the Modified Treasury Stock Method as prescribed under GAAP. All other calculations shown, using alternate methods, are for informational purposes only. In the table below, (1) Warrants refers to the warrants issued by the Company in December 1995, which have an exercise price of $2.25 per share and can be exercised beginning three years from the issue date and for a period of ten years from the issue date, and (2) Preferred Stock refers to the Cumulative Perpetual Preferred Stock issued by the Company in December 1995, which carries an annual dividend equal to 18% of the face amount of the Preferred Stock, permits dividends thereon to be paid, under certain circumstances, in equivalent value of the Company's common stock and has an initial dividend payment in June 1997. THREE MONTHS ENDED MARCH 31, 1997 THREE MONTHS ENDED MARCH 31, 1996 ------------------------------------- --------------------------------------- MODIFIED MODIFIED TREASURY ACTUAL SHARES, TREASURY ACTUAL SHARES, STOCK ACTUAL WARRANTS, STOCK ACTUAL WARRANTS, METHOD SHARES AND OPTIONS METHOD SHARES AND OPTIONS -------- -------- ------- ------- ------------ ------- SHARES OUTSTANDING Common 2,617 2,617 2,617 2,599 2,599 2,599 Warrants 2,376 2,376 2,376 2,376 Options 672 672 696 696 Less Treasury shares (523) (520) -------- -------- ------- ------- ------------ ------- Total 5,142 2,617 5,665 5,151 2,599 5,671 ======== ======== ======= ======= ============ ======= STOCKHOLDERS' EQUITY Common $ 32,532 $ 32,532 $32,532 $29,260 $ 29,260 $29,260 Warrants 5,346 5,346 5,346 5,346 Options 3,360 3,360 3,444 3,444 Less Treasury shares (2) (5,298) (2,655) -------- -------- ------- ------- ------------ ------- Total $ 35,940 $ 32,532 $41,238 $35,395 $ 29,260 $38,050 ======== ======== ======= ======= ============ ======= NET EARNINGS (LOSS) Net earnings for the period $ 1,357 $ 2,561 Partial reduction in interest expense (1) 102 184 Preferred stock dividends (602) (615) -------- ------- Adjusted earnings available for Common $ 852 $ 2,130 ======== ======= BOOK VALUE PER SHARE $ 6.99 $ 12.43 $ 7.28 $ 6.87 $ 11.26 $ 6.71 ======== ======== ======= ======= ============ ======= EARNINGS PER SHARE $ 0.17 $ 0.29 $ 0.13 $ 0.41 $ 0.75 $ 0.34 ======== ======== ======= ======= ============ ======= - ---------- (1) Under the Modified Treasury Stock Method, it is assumed that the Company will use proceeds from the proforma exercise of the Warrants and Options to acquire 20% of the actual shares currently outstanding (Treasury shares) and use any remaining assumed proceeds to reduce the outstanding balance of the Company's Senior Notes. The partial reduction in interest expense of $104,000 and $184,000 for the three months ended March 31, 1997 and 1996, respectively, represents the proforma reduction in interest expense as a result of the proforma reduction in the outstanding balance of Senior Notes. (2) Treasury shares were assumed to be repurchased at the average closing stock price for the respective periods. 9 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW For the three months ended March 31, 1997, the Company reported net earnings of $1.4 million, or $0.17 per share, compared with net earnings of $2.6 million, or $0.41 per share for the same period in 1996. Results for both quarters are calculated using the Modified Treasury Stock Method which result in outstanding shares of 5.1 million and 5.2 million during the three months ended March 31, 1997 and 1996, respectively. The earnings per share amounts have been appropriately adjusted for the Company's preferred stock dividends. The Bank maintained core and risk-based regulatory capital ratios of 6.67% and 11.11%, respectively, at March 31, 1997, which are in excess of the regulatory minimums which define a "well capitalized" institution. Total assets at March 31, 1997 were $838 million, as compared with $847 million at December 31, 1996. Pretax earnings from the Company's core operations continued to increase during the March 1997 quarter, reaching their highest level since mid-1993. Core earnings are earnings after loan loss provisions and before interest on parent company indebtedness, income taxes and nonrecurring items. For the three-month periods ended March 31, 1997, December 31, 1996 and March 31, 1996, core earnings were $1.3 million, $1.2 million and $0.4 million, respectively, which amounts include loan loss provisions of $1.5 million, $1.0 million and $1.2 million, respectively. During the March 1997 quarter, the Company's net interest margin was 3.43% on average interest-earning assets of $800 million. For the December 1996 and March 1996 quarters, the Company's net interest margin and average interest-earning assets were 3.44% and $833 million, and 2.95% and $731 million, respectively. In December 1996, the Company sold approximately $60 million of loans, realizing a modest gain thereon. Though the proceeds from these loan sales had been reinvested in loans and securities by March 31, 1997, the results for the first quarter of 1997 were modestly impacted because such funds were not fully reinvested for the entire quarter. For the March 1997 quarter, real estate operations produced no net cost to the Company. For the December 1996 quarter, real estate operations produced a net cost of $0.4 million and such activities resulted in net revenues of $0.4 million for the March 1996 quarter. During the first quarter of 1997, the Company increased its deferred tax asset to $4.9 million by recording additional income tax benefits of $0.7 million. OPERATING RESULTS INTEREST MARGIN The Company's net interest margin, or the difference between the interest earned on loans and investment securities and the cost of deposits and borrowings, is affected by several factors, including (1) the level of, and the relationship between, the dollar amount of interest-earning assets and interest-bearing liabilities, (2) the maturity of the Company's adjustable-rate and fixed-rate loans and short-term investment securities and its deposits and borrowings, (3) the relationship between market interest rates and local deposit rates offered by competing institutions, and (4) the magnitude of the Company's nonperforming assets. The table below sets forth the Company's average balance sheet, and the related effective yields and costs on average interest-earning assets and interest-bearing liabilities, for the three months ended March 31, 1997 and 1996. In the table, interest revenues are net of interest associated with nonaccrual loans (dollars are in thousands). 10 11 THREE MONTHS ENDED ------------------------------------------------------------------------------ MARCH 31, 1997 MARCH 31, 1996 -------------------------------------- ------------------------------------ AVERAGE REVENUES/ YIELD/ AVERAGE REVENUES/ YIELD/ BALANCE COSTS COST BALANCE COSTS COST -------- -------- ------ -------- --------- ------ ASSETS Interest-earning assets Loans $688,597 $ 15,506 9.01% $649,251 $13,733 8.46% Cash and cash equivalents 58,945 738 5.01% 56,820 760 5.35% Investment securities 45,315 653 5.76% 18,176 227 5.00% Investment in capital stock of Federal Home Loan Bank 6,847 110 6.43% 6,407 81 5.06% -------- -------- -------- ------- Total interest-earning assets 799,704 17,007 8.51% 730,654 14,801 8.10% -------- ----- ------- ----- Noninterest-earning assets 31,064 35,636 -------- -------- Total assets $830,768 $766,290 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Interest-bearing liabilities Deposits $705,507 8,892 5.11% $707,562 8,938 5.08% Short-term borrowings 51,935 780 6.09% Senior notes 12,345 483 15.87% 12,049 471 15.85% -------- -------- -------- ------- Total interest-bearing liabilities 769,787 10,155 5.35% 719,611 9,409 5.26% -------- ----- ------- ----- Noninterest-bearing liabilities 17,065 6,445 Stockholders' equity 43,916 40,234 -------- -------- Total liabilities & stockholders' equity $830,768 $766,290 ======== ======== Net interest income $ 6,852 $ 5,392 ======== ======= Interest rate spread 3.16% 2.84% ===== ===== Net interest margin 3.43% 2.95% ===== ===== The table below summarizes the components of the changes in the Company's interest revenues and costs for the three months ended March 31, 1997 and 1996 (dollars are in thousands). THREE MONTHS ENDED MARCH 31, 1997 AND 1996 INCREASE (DECREASE) DUE TO CHANGE IN ------------------------------------------------- RATE AND NET VOLUME RATE VOLUME(1) CHANGE ------- ------- ------- ------- INTEREST REVENUES Loans (2) $ 832 $ 887 $ 54 $ 1,773 Cash and cash equivalents 28 (49) (1) (22) Investment securities 339 35 52 426 Investment in capital stock of Federal Home Loan Bank 6 22 1 29 ------- ------- ------- ------- 1,205 895 106 2,206 ------- ------- ------- ------- INTEREST COSTS Deposits (26) (20) (46) Short-term borrowings 780 780 Senior notes 12 12 ------- ------- ------- ------- 766 (20) -- 746 ------- ------- ------- ------- NET INTEREST INCOME $ 439 $ 915 $ 106 $ 1,460 ======= ======= ======= ======= - ---------- (1) Calculated by multiplying change in rate by change in volume. (2) Interest on loans is net of interest on nonaccrual loans and includes amortization of loan fees and discounts. 11 12 Net interest income increased by $1.5 million during the three months ended March 31, 1997, as compared to the three months ended March 31, 1996. This increase was primarily attributable to increases in interest income as a result of increases in the average balance and weighted average rate on loans and, to a lesser extent, investment securities, which more than offset an increase in interest costs, primarily as a result of an increase in the average balance of borrowings by the Company. The Company's net interest margin, expressed as a percentage of interest-earning assets, increased from 2.95% to 3.43% during the three months ended March 31, 1996 and 1997, respectively. The Company's interest rate spread increased from 2.84% to 3.16% during the three months ended March 31, 1996 and 1997, respectively, primarily as a result of an increase in the weighted average yield on loans from 8.46% to 9.01% during these respective periods. During the three months ended March 31, 1997, the Company originated $74.1 million of new permanent and construction loan commitments with a weighted average interest rate of 9.68% at origination. By comparison, new permanent and construction loan commitments during the three months ended March 31, 1996, were $64.8 million and carried a weighted average interest rate at origination of 9.98%. PROVISIONS FOR ESTIMATED CREDIT LOSSES ON LOANS For the three months ended March 31, 1997, the Company recorded credit loss provisions of $1.5 million, compared with provisions of $1.2 million recorded during the three months ended March 31, 1996. At March 31, 1997, nonperforming assets and performing loans classified "Substandard", "Doubtful" or "Loss" totaled $90.6 million compared with $87.9 million at March 31, 1996. Within these totals, the net carrying value of real estate owned totaled $21.0 million and $26.0 million, respectively, at March 31, 1997 and 1996. Loans delinquent 30 to 89 days, which the Company places on nonaccrual status as a matter of policy, declined to $5.1 million at March 31, 1997, from $10.1 million at December 31, 1996 and $12.8 million at March 31, 1996. The magnitude of the Company's nonperforming asset and classified performing loan portfolios remains substantially above peer levels and represents a significant portion of the Company's assets. These portfolios adversely affect the Company's operating results, through a combination of funding and management costs and incremental loss provisions. Further, these assets expose the Company to the potential for additional losses to the extent that borrowers are unable to make their payments to the Company, requiring the Company to pursue foreclosure of its collateral. As a result, management continues to diligently manage this portfolio of troubled assets and to measure in a timely fashion adverse portfolio migration trends and the adequacy of the Company's reserves for future credit losses. NONINTEREST REVENUES The table below sets forth the Company's non-interest revenues for the periods indicated (dollars are in thousands). THREE MONTHS ENDED MARCH 31, --------------------------- 1997 1996 CHANGE ---- ---- ------ Other loan and escrow fees $466 $268 $ 198 Deposit account fees 148 161 (13) Other revenues 118 11 107 ---- ---- ----- $732 $440 $ 292 ==== ==== ===== Other loan and escrow fees in 1997 were higher than in 1996 due primarily to increased loan production and loan prepayments. Other revenues were higher in 1997 than in 1996 due primarily to fees collected from the Company's check processor, pursuant to its servicing arrangement with the Company. 12 13 NONINTEREST EXPENSES The table below details the Company's operating costs for the periods indicated (dollars are in thousands). THREE MONTHS ENDED MARCH 31, ------------------------------ 1997 1996 CHANGE ------ ------ ------ Employee $2,769 $2,294 $ 475 Operating 1,054 1,049 5 Occupancy 754 723 31 SAIF insurance premium and OTS assessment 372 585 (213) Professional 348 448 (100) Goodwill 12 (12) ====== ====== ===== $5,297 $5,111 $ 186 ====== ====== ===== By the end of 1996, the Company had completed all of the hiring necessary to fully staff its various lending groups. These additional resources are necessary to meet the higher-than-expected demand for the Company's financing products. During 1996, the Company also expanded its investment in community-based organizations focused on attracting mortgage credit and other banking services. These increases in expenses are partially offset by the decline in the SAIF insurance premium as a result of the Company's improved financial condition and the special FDIC SAIF assessment paid in 1996. REAL ESTATE OPERATIONS The table below sets forth the revenues and costs attributable to the Company's real estate owned for the periods indicated. The compensatory and legal costs directly associated with the Company's property management and disposal operations are included in the table above in NONINTEREST EXPENSES (dollars are in thousands). THREE MONTHS ENDED MARCH 31, ------------------------------ 1997 1996 CHANGE ----- ----- ------ EXPENSES ASSOCIATED WITH REAL ESTATE OWNED Property taxes $ (21) $ (41) $ 20 Repairs, maintenance and renovation (13) (41) 28 Insurance (44) (36) (8) ----- ----- ----- (78) (118) 40 NET RECOVERIES FROM SALE OF PROPERTIES 24 744 (720) PROPERTY OPERATIONS, NET 74 515 (441) PROVISION FOR ESTIMATED LOSSES ON REAL ESTATE OWNED (700) 700 ----- ----- ----- $ 20 $ 441 $(421) ===== ===== ===== The costs included in the table above (and, therefore, excluded from operating costs (see NONINTEREST EXPENSES)), reflect holding costs directly attributable to the portfolio of real estate owned. Net recoveries from property sales represent the difference between the proceeds received from property disposal and the carrying value of such properties upon disposal. During the three months ended March 31, 1997 and March 31, 1996, the Company sold 40 properties generating net cash proceeds of $5.7 million and sold 51 properties generating net cash proceeds of $10.8 million, respectively. 13 14 Property operations principally include the net operating income (collected rental revenues less operating expenses and certain renovation costs) from foreclosed apartment buildings or receipt, following foreclosure, of similar funds held by receivers during the period the original loan was in default. The decline in income from this source during the March 1997 quarter was a result of a decline in the number of apartment buildings held by the Company. OTHER NON-OPERATING REVENUES AND EXPENSES Other non-operating revenues and expenses include gain and loss on sale of loans and other revenues and expenses. For the three months ended March 31, 1997, other non-operating revenues and expenses included $13,000 of additional expenses relating to loans sold in December 1996. For the three months ended March 31, 1996, other non-operating revenues included legal recoveries of $0.2 million and a gain of $0.2 million on the sale of $32.7 million in loans. INCOME TAXES The Company recorded an income tax benefit of $0.7 million and $2.3 million for the three months ended March 31, 1997 and 1996, respectively. At March 31, 1997, the Company had approximately $16.4 million of accumulated income tax benefits, consisting primarily of net operating loss carryforwards and future tax deductions which had not been recognized for financial statement purposes and are available to be utilized to shield future earnings from income taxes, both for financial reporting and income tax reporting purposes. The recognition of these accumulated income tax benefits is subject to limitations under GAAP and for regulatory capital purposes. The primary factor affecting the timing and magnitude of recognition of these accumulated income tax benefits is the current and future profitability of the Company. Additionally, no more than 10% of the Bank's regulatory capital can be represented by a deferred tax asset created pursuant to anticipated future utilization of an institution's income tax benefits. Should the Company cease to be profitable, or should the Company record substantial operating losses in the future, all or a portion of the deferred tax asset established to date may need to be reversed. Management believes that the Company's income tax accounting practices fully comport with generally accepted accounting principles and have been and are appropriate in the circumstances. FINANCIAL CONDITION, CAPITAL RESOURCES & LIQUIDITY AND ASSET QUALITY ASSETS CASH AND CASH EQUIVALENTS Cash and cash equivalents consist of cash on hand, deposits at correspondent banks and Federal funds sold. The Company maintains balances at correspondent banks to cover daily inclearings, wire activities and other charges. Cash and cash equivalents at March 31, 1997, were $16.0 million, a decrease from $94.0 million at December 31, 1996. This decrease in cash balances during the quarter resulted from the deployment of excess cash on hand at December 31, 1996 into securities and loans. 14 15 INVESTMENT SECURITIES During the three months ended March 31, 1997, the Company's Board of Directors granted to management the authority to purchase up to $200 million of investment securities during 1997. The interest margin projected to be generated by these securities purchases will supplement the Company's overall interest margin with no incremental credit risk borne by the Company. The Board's approval contemplated that the investment securities to be purchased would have expected durations of between three and seven years, would be financed with reverse repurchase agreements utilizing the purchased investment securities as collateral and would be hedged so as to substantially, though not entirely, mitigate the Company's interest rate risk. During the first quarter of 1997, the Company purchased $40 million of U.S. Government and agency securities pursuant to this strategy. Future purchases of investment securities pursuant to this strategy are dependent upon, among other things, the availability of excess capital not otherwise deployed in the Company's lending businesses and the general level and volatility of market interest rates. There can be no assurance that management of the Company will elect to implement this program to the extent authorized in the near term or at all. The cost basis and estimated fair value of investment securities available-for-sale are summarized as follows (dollars are in thousands): MARCH 31, 1997 --------------------------------------------- GROSS UNREALIZED ESTIMATED AMORTIZED ----------------- FAIR COST GAINS LOSSES VALUE ------- ---- ------- ------- U.S. Government $38,462 $ -- $ 328 $38,134 U.S. Government Agency 40,000 501 39,499 ------- ---- ------- ------- $78,462 $ -- $ 829 $77,633 ======= ==== ======= ======= DECEMBER 31, 1996 --------------------------------------------- GROSS UNREALIZED ESTIMATED AMORTIZED ----------------- FAIR COST GAINS LOSSES VALUE ------- ---- ------- ------- U.S. Government $38,503 $ - $ 132 $38,371 ======= ==== ======= ======= The cost basis and estimated fair value of investment securities available-for-sale at March 31, 1997, are summarized by contractual maturity as follows (dollars are in thousands): ESTIMATED FAIR COST BASIS VALUE YIELD ------- ------- ----- Due in less than one year $ 1,603 $ 1,599 5.23% Due in one year through five years 36,859 36,535 5.61% Due in more than five years 40,000 39,499 7.00% ------- ------- $78,462 $77,633 6.31% ======= ======= 15 16 LOANS GENERAL The two tables that follow set forth the composition of the Company's loan portfolio, and the percentage of composition by type of security, delineated by the year of origination and in total, as of the dates indicated (dollars are in thousands). MARCH 31, 1997 DECEMBER 31, 1996 ----------------------- ----------------------- BALANCE PERCENT BALANCE PERCENT --------- ------- --------- ------- PERMANENT LOANS Single family (1-4 units) Estate $ 125,656 16.3% $ 107,891 14.6% Conventional 167,604 21.7% 170,038 23.0% Project concentrations 59,568 7.7% 61,268 8.3% Multi-family (five or more units) 223,439 28.9% 220,707 29.6% Commercial real estate 70,973 9.2% 60,388 8.2% Land 14,036 1.8% 14,513 2.0% RESIDENTIAL CONSTRUCTION Single family 67,005 8.7% 56,306 7.6% Tract development 35,270 4.6% 33,791 4.6% OTHER 8,454 1.1% 15,684 2.1% --------- ----- --------- ----- GROSS LOANS RECEIVABLE 772,005 100.0% 740,586 100.0% ===== ===== LESS Participants' share (3,801) (1,413) Undisbursed loan funds (47,435) (46,646) Deferred loan fees and credits, net (8,887) (6,611) Allowance for estimated losses (13,657) (13,515) --------- --------- NET LOANS RECEIVABLE $ 698,225 $ 672,401 ========= ========= MARCH 31, 1997 ------------------------------------ POST-1994 PRE-1995 TOTAL -------- -------- -------- PERMANENT Single family (1-4 units) Estate $125,656 $ -- $125,656 Conventional 32,344 135,260 167,604 Project concentrations 1,922 57,646 59,568 Multi-family (five or more units) 94,328 129,111 223,439 Commercial real estate 63,813 7,160 70,973 Land 12,641 1,395 14,036 RESIDENTIAL CONSTRUCTION Single family (1-4) 67,005 67,005 Tract development 35,270 35,270 OTHER 8,440 14 8,454 -------- -------- -------- GROSS LOANS RECEIVABLE $441,419 $330,586 $772,005 ======== ======== ======== 16 17 The Company's loan portfolio is predominantly concentrated in Southern California real estate. At March 31, 1997, 46% of the Company's loan portfolio consisted of permanent loans secured by single family residences, 29% consisted of permanent loans secured by multi-unit residential properties, and 25% consisted of loans to finance commercial properties, the acquisition of land and construction. The table below sets forth the composition of the Company's new loan commitments for the period indicated (dollars are in thousands). FOR THE THREE MONTHS ENDED MARCH 31, 1997 -------------------------- TYPE OF SECURITY AMOUNT % - ----------------------------------- ------- ----- Single family homes (1-4 units) Estate (1) $19,900 26.8% Conventional 3,300 4.5 Multi-family (five or more units) (2) 9,400 12.7 Commercial 20,000 27.0 Construction and land (commitments) 19,900 26.6 Other 1,600 2.2 ------- ----- $74,100 100.0% ======= ===== - ---------- (1) Generally defined as individual loans with principal balances of more than $1.0 million. This amount includes unfunded commitments under lines of credit of $1.7 million. (2) Includes $1.9 million of financings provided in connection with sales of previously foreclosed properties. 17 18 ASSET QUALITY At March 31, 1997, nonperforming assets totaled $41.2 million, or 4.9% of total assets, and consisted of real estate owned, net ($21.0 million) and loan principal three or more payments past due ($20.2 million). At December 31, 1996 and March 31, 1996, nonperforming assets were $36.8 million (4.3% of total assets) and $39.2 million (5.1% of total assets), respectively. During the March 1997 quarter, two loans secured by estate homes and with an aggregate principal of $4.1 million became 90 or more days past due. These delinquencies caused the ratio of the allowance for credit losses to nonperforming loans to decrease to 67.39% at March 31, 1997 from 81.21% at December 31, 1996. Based in part on current, independent appraisals of the collateral securing these two loans, the Company believes that losses, if any, which may result from foreclosure and liquidation of the Company's collateral would not be material. Immediately following the end of the March 1997 quarter, the Company completed the all-cash sale of one property, carried at $3.8 million and sold for $4.0 million, and received full reinstatement of one delinquent loan, with principal of $1.0 million which was more than 90 days past due at the end of March. Had these post-quarter-end events been accomplished during the March 1997 quarter, the Company's ratio of nonperforming assets to total assets would have remained unchanged at March 31, 1997 from the ratio at the end of 1996. Loans delinquent 30 to 89 days, which the Company places on nonaccrual status as a matter of policy, declined to $5.1 million at March 31, 1997, from $10.1 million at December 31, 1996 and $12.8 million at March 31, 1996. Total nonaccruing assets were $47.7 million at March 31, 1997 ($42.9 million after giving effect to the post-March resolutions described above), as compared with $48.8 million at December 31, 1996 and $53.6 million at March 31, 1996. This trend is consistent with the Company's current and improving asset migration measures. The thrift industry is exposed to economic trends and fluctuations in real estate values. In recent periods, those trends have been recessionary in nature, particularly in Southern California. Accordingly, the trends have adversely affected both the delinquencies being experienced by institutions such as the Company and the ability of such institutions to recoup principal and accrued interest through acquisition and sale of the underlying collateral. No assurances can be given that such trends will not continue in future periods, creating increasing downward pressure on the earnings and capital of thrift institutions. 18 19 The table below sets forth the composition of the Company's classified assets at the dates indicated. Classified assets include owned properties, nonaccrual loans and performing loans which have been adversely classified pursuant to OTS regulations and guidelines ("Performing/Classified" loans) (dollars are in thousands). MARCH 31, DECEMBER 31, MARCH 31, 1997 1996 1996 --------- ------------ --------- PROPERTIES, NET OF RESERVES $ 20,977 $ 20,140 $ 25,960 NONPERFORMING LOANS (1) 20,266 16,643 13,217 -------- -------- -------- GROSS NONPERFORMING ASSETS 41,243 36,783 39,177 OTHER DELINQUENT LOANS (2) 5,119 10,082 12,810 PERFORMING LOANS CLASSIFIED LOSS, DOUBTFUL AND SUBSTANDARD (3) 49,370 46,987 48,770 -------- -------- -------- GROSS CLASSIFIED ASSETS $ 95,732 $ 93,852 $100,757 ======== ======== ======== GROSS CLASSIFIED LOANS (4) (5) $ 74,755 $ 73,712 $ 74,797 ======== ======== ======== LOANS RECEIVABLE (6) $711,882 $685,916 $629,225 ======== ======== ======== RESERVES ON LOANS Specific $ 2,886 $ 2,185 $ 3,729 General 10,771 11,330 11,624 -------- -------- -------- $ 13,657 $ 13,515 $ 15,353 ======== ======== ======== TOTAL RESERVES TO LOANS RECEIVABLE 1.9% 2.0% 2.4% TOTAL RESERVES TO CLASSIFIED LOANS 18.3% 18.3% 20.5% TOTAL RESERVES TO NONPERFORMING LOANS 67.4% 81.2% 116.2% GROSS NONPERFORMING ASSETS TO TOTAL ASSETS 4.9% 4.3% 5.1% - ---------- (1) Loans 90 days or more past due. All such loans are on nonaccrual status. (2) Loans 30 to 89 days past due. All such loans are on nonaccrual status. (3) Includes $1.3 million, $1.9 million and $1.6 million of performing loans on nonaccrual status at March 31, 1997, December 31, 1996 and March 31, 1996, respectively. (4) Includes $26.7 million, $28.6 million and $27.6 million of nonaccrual loans at March 31, 1997, December 31, 1996 and March 31, 1996, respectively. (5) At March 31, 1997, included $52.3 million of loans originated prior to 1995. (6) Net loans receivable are exclusive of the allowance for loan losses. The Company places loans on nonaccrual status when (1) they become one or more payments delinquent or (2) management believes that, with respect to performing loans, continued collection of principal and interest from the borrower is not reasonably assured. The carrying value of nonperforming assets (i.e., real estate owned and loans delinquent three or more payments) increased to $41.2 million, or 4.9% of total assets, at March 31, 1997, from $36.8 million, or 4.3% of total assets, at December 31, 1996, and $39.2 million, or 5.1% of total assets, at March 31, 1996. The carrying value of nonperforming assets peaked at more than $151.2 million in December 1993. As described above, the Company places any loan delinquent one or more payments on nonaccrual status and includes such amounts as loans in default for reporting purposes. At March 31, 1997, December 31, 1996 and March 31, 1996, the Company also had placed on nonaccrual status performing loans amounting to $1.3 million, $1.9 million and $1.6 million, respectively. 19 20 The table below shows the Company's gross classified loan portfolio as of March 31, 1997 (dollars are in thousands). CLASSIFIED LOANS ---------------------------------------------- OTHER PERFORMING NON-PERFORMING DELINQUENCIES LOANS TOTAL -------------- ------------- ---------- ------- Single family (1-4 units) Estate $ 6,959 $ 2,170 $ -- $ 9,129 Conventional 4,680 1,453 7,762 13,895 Project concentrations 5,855 1,496 9,910 17,261 Multi-family (five or more units) 2,716 23,612 26,328 Commercial real estate 2,572 2,572 Land 43 43 Residential construction Tract development 1,762 1,762 Other collateralized loans 13 3,752 3,765 ------- ------- ------- ------- Gross Loans Receivable $20,266 $ 5,119 $49,370 $74,755 ======= ======= ======= ======= ESTATE At March 31, 1997, six Estate loans were delinquent one or more payments. Subsequent to March 31, 1997, the delinquencies with respect to two loans, representing loan principal of $3.2 million, were cured through (1) cash collected from the borrower (loan principal of $1.0 million), and (2) liquidation of the Company's collateral by the borrower and payment to the Company of all amounts owned (loan principal of $2.2 million). CONVENTIONAL In the preceding table, conventional single family homes consist of defaulted and performing/classified loans secured by single family homes which are not part of an integrated development with respect to which the Company financed the construction of the development or financed the purchase of homes from the developer by individuals. At March 31, 1997, the Company (1) owned 11 homes which were being actively marketed for sale, (2) had 30 defaulted loans secured by single family conventional homes, and (3) had 32 loans which were performing but had been classified "Substandard". PROJECT CONCENTRATIONS Prior to 1994, the Company made permanent loans, amortizing over, and maturing at the end of, thirty years, to a large number of purchasers of individual units from developers in for-sale housing developments with respect to which the Company financed construction. A majority of these permanent "takeout" loans were originated during the period 1988 through 1992 and were made on terms that fell outside the parameters normally associated with conforming or conventional single family home loans. Because most of these loans were made on favorable terms to foster sales of units in developments in which unit sales were sluggish, and because the current retail value of units in many developments has declined significantly when compared with the stated purchase price paid by the Company's borrowers, the performance of this portfolio has been extremely poor. At March 31, 1997, the Company's aggregate investment in its portfolio of project concentrations (loan principal plus related real estate owned before reserves) consisted of 50 separate project concentrations totaling 20 21 $66.1 million. This represents a decrease from its peak in early 1994 of $30.4 million, or 32%, principally as the result of foreclosure of the Company's collateral, sales of foreclosed units and the acceptance of discounted payments from borrowers on several loans. At March 31, 1997, the Company owned 73 foreclosed units and 31 loans, representing $7.4 million of loan principal, were delinquent one or more payments. APARTMENT BUILDINGS At March 31, 1997, the Company owned five apartment buildings, and loans secured by six apartment buildings were delinquent one or more payments. The Company's foreclosed inventory and its defaulted loan collateral are predominantly located in the South Bay region of Los Angeles, are between five and ten years old and average less than 15 units in size, except for one building with 248 units, which had a carrying value of $3.8 million at March 31, 1997, and which was sold for $4.0 million in an all-cash transaction. COMMERCIAL At March 31, 1997, the Company owned one commercial property and had one loan which was performing but had been classified "Substandard". RESIDENTIAL CONSTRUCTION At March 31, 1997, the Company maintained investments in two residential construction developments previously acquired through foreclosure. One project, which represents 100 units in total, currently is in the final completion stage of construction on the final 18 units, the majority of which are in escrow to close in the second half of this year. The second project represents 40 units, all of which have been completed and are being marketed for sale. Approximately one half of the units have been sold or are in escrow. LAND At March 31, 1997, the Company's portfolio of owned land parcels consisted of two properties with a net carrying value of $1.3 million. OTHER COLLATERALIZED LOANS At March 31, 1997, the Company had two other collateralized loans which were performing but classified as "Substandard". These loans provided the financing for the acquisition of pools of notes. CREDIT LOSSES The Company maintains reserves against specific assets in those instances in which it believes that full recovery of the Company's gross investment is unlikely. As of March 31, 1997, the Company had established specific reserves based upon (1) management's strategy in managing and disposing of the asset and the corresponding financial 21 22 consequences, (2) current indications of property values from (a) completed, recent sales from the Company's property portfolio, (b) real estate brokers, and (c) potential buyers of the Company's properties, and (3) current property appraisals. In addition, management establishes general valuation allowances ("GVA") against its loan and property portfolios when sufficient information does not exist to support establishing specific reserves. The loss factors utilized to establish general reserves are based upon (1) the actual loss experience for similar loans and properties within the Company's portfolio, when such loss experience is available and representative of the assets being valued, or (2) estimates of current liquidation values for collateral securing performing loans for a representative sampling of each portfolio segment. The table below sets forth the amounts and percentages of general and specific reserves for the Company's loan and property portfolios as of March 31, 1997 (dollars are in thousands). LOANS ------------------------ PERFORMING DELINQUENT PROPERTIES TOTAL ---------- ---------- ---------- ------- AMOUNTS Specific reserves $ 523 $ 2,363 $ 9,250 $12,136 General reserves 9,073 1,698 409 11,180 ------- ------- ------- ------- Total reserves for estimated losses $ 9,596 $ 4,061 $ 9,659 $23,316 ======= ======= ======= ======= PERCENTAGES % of total reserves to gross investment 1.4% 16.0% 31.5% 3.1% % of general reserves to gross investment 1.3% 6.7% 1.3% 1.5% The table below summarizes the activity of the Company's reserves for the periods indicated (dollars are in thousands). THREE MONTHS ENDED MARCH 31, -------------------------- 1997 1996 --------- --------- LOANS Average loans outstanding $ 688,597 $ 654,259 ========= ========= Reserve balance at beginning of period $ 13,515 $ 15,192 Provision for estimated losses 1,500 1,200 Charge-offs: Permanent loans Single family (1-4 units) (413) (667) Multi-family (five or more units) (515) (582) Land (150) --------- --------- Net charge-offs (1,078) (1,249) Transfer (to) from property and other reserves (280) 210 --------- --------- Balance at end of period $ 13,657 $ 15,353 ========= ========= Ratio of net charge-offs to average loans outstanding during the period 0.16% 0.19% PROPERTIES Reserve balance at beginning of period $ 11,871 $ 15,725 Provision for estimated losses 700 Transfers from (to) loan reserves 280 (210) Charge-offs (2,492) (3,898) --------- --------- Balance at end of period $ 9,659 $ 12,317 ========= ========= 22 23 Because the Company's loan and property portfolios are not homogeneous, but rather consist of discreet segments with different collateral and borrower risk characteristics, management separately measures reserve adequacy, and establishes and maintains reserves for credit losses, for each identifiable segment of its property and loan portfolios. The table below summarizes credit loss reserves at the date indicated (dollars are in thousands). MARCH 31, 1997 ---------------------------------------------- % OF % OF LOANS ASSET TYPE PROPERTIES ASSET TYPE ------- ---------- ---------- ---------- PERMANENT Single family residences (1-4 units) Estate $ 521 0.4% $ 0.0% Conventional 1,868 1.1% 249 12.3% Project concentrations 4,842 8.1% 1,995 30.6% Multi-family (five or more units) 4,045 1.8% 189 3.8% Commercial real estate 1,340 1.9% 154 44.4% Land 91 0.7% 1,076 45.7% CONSTRUCTION Single family 340 0.5% Tract development 610 1.7% 5,996 41.5% ------- ------- $13,657 1.8% $ 9,659 31.5% ======= ======= REAL ESTATE OWNED Real estate acquired in satisfaction of loans is transferred from loans to properties at estimated fair values, less any estimated disposal costs. The difference between the fair value of the real estate collateral and the loan balance at the time of transfer is recorded as a loan charge-off. Any subsequent declines in the fair value of the properties after the date of transfer are recorded through the establishment of, or additions to, specific reserves. Recoveries and losses from the disposition of properties are also included in REAL ESTATE OPERATIONS. The table below summarizes the composition of the Company's real estate owned at the dates indicated (dollars are in thousands). MARCH 31, DECEMBER 31, MARCH 31, 1997 1996 1996 --------- ------------ --------- SINGLE FAMILY RESIDENCES Conventional $ 2,028 $ 2,660 $ 4,366 Project concentrations 6,518 7,117 5,778 MULTI-FAMILY (FIVE OR MORE UNITS) 4,945 3,215 10,940 CONSTRUCTION (TRACT DEVELOPMENTS) 14,446 16,156 15,238 LAND 2,352 2,517 1,609 COMMERCIAL 347 346 346 -------- -------- -------- GROSS INVESTMENT (1) 30,636 32,011 38,277 ALLOWANCE FOR ESTIMATED LOSSES (9,659) (11,871) (12,317) -------- -------- -------- NET INVESTMENT $ 20,977 $ 20,140 $ 25,960 ======== ======== ======== - ---------- (1) Loan principal at foreclosure, plus post-foreclosure capitalized costs, less cumulative charge-offs. 23 24 OFFICE PROPERTY AND EQUIPMENT At March 31, 1997, the Company's office property and equipment of $4.5 million was down from $4.7 million at December 31, 1996. The decrease was primarily due to normal depreciation. LIABILITIES GENERAL The Company derives funds principally from deposits and, to a lesser extent, from borrowings from the FHLB. In addition, recurring cash flows are generated from loan repayments and payoffs and, since late 1993, from sales of foreclosed properties. In addition to the Company's recurring sources of funds, the Company has generated funds by identifying certain of its securities and seasoned real estate loans as available-for-sale, and selling such assets in the open market. DEPOSITS Total deposits at March 31, 1997, were $708.1 million, a decrease from $717.8 million at December 31, 1996. The table below summarizes the balances, weighted average interest rates ("WAIR") and weighted average remaining maturities in months ("WARM") for the Company's deposits at the dates indicated (dollars are in thousands). MARCH 31, 1997 DECEMBER 31, 1996 ---------------------------- -------------------------- DESCRIPTION BALANCE WAIR WARM BALANCE WAIR WARM - ------------------------ -------- ---- ---- -------- ---- ---- Transaction accounts $ 72,835 1.51% $ 70,560 1.34% Certificates of deposit 7 day maturities 57,624 4.55% 58,212 4.44% Less than 6 months 90,281 5.38% 3 58,121 5.29% 3 6 months to 1 year 310,302 5.66% 5 345,938 5.57% 5 1 year to 2 years 146,475 5.71% 13 148,886 5.80% 14 Greater than 2 years 30,596 5.84% 12 36,092 5.86% 13 -------- ---- ---- -------- ---- ---- Total $708,113 5.13% 6 $717,809 5.10% 6 ======== ==== ==== ======== ==== ==== BORROWINGS A primary alternative funding source for the Company is a credit line through the FHLB with a maximum advance of up to 35% of total assets (of which 25% may be secured by mortgage collateral and 10% may be secured by securities). The FHLB system functions as a source of credit to savings institutions which are members of a Federal Home Loan Bank System. Advances are typically secured by the Company's mortgage loans and the capital stock of the FHLB owned by the Company. Subject to the FHLB of San Francisco's advance policies and requirements, these advances can be requested for any business purpose in which the Company is authorized to engage. In granting advances, the FHLB considers a member's creditworthiness and other relevant factors. 24 25 The balance and rate of the Company's FHLB advances at March 31, 1997, are summarized as follows (dollars are in thousands). TERM PRINCIPAL RATE ---------- --------- ---- 3 Months $15,000 5.64% 9 Months 25,000 5.99% 12 Months 25,000 6.24% ------- ---- $65,000 6.01% ======= ==== Of the $65.0 million in advances, $15.0 million was securitized by securities and $50.0 million was securitized by mortgage collateral. SENIOR NOTES The Company has Senior Notes, which have a face amount of $13.5 million, and an amortized book value of $12.4 million at March 31, 1997. The Senior Notes carry an annual stated interest rate of 12% and have an annual effective rate of approximately 16.5%, after the recording of original issue discount ("OID") of $1.5 million. The OID is accreted using the constant yield method over the five year term of the Senior Notes. Interest, which is required to be paid semi-annually at the stated interest rate, was prefunded for three years out of the proceeds of the Company's recapitalization in December 1995. This prefunded interest of $4.9 million was invested in U.S. Government securities. Thereafter, interest will be payable either in cash or, in certain circumstances as permitted by the relevant agreement, in an equivalent value (determined in accordance with the provisions of the relevant agreement) of common stock of the Company. CAPITAL On a parent-only basis, the Company's capital structure is comprised of common stockholders' equity and an aggregate of $27 million in Senior Notes and Cumulative Perpetual Preferred Stock with an annual dividend rate of 18%. For the quarter ended March 31, 1997, interest expense on the Senior Notes was $0.5 million, and accrued but unpaid dividends on the Cumulative Perpetual Preferred Stock was $0.6 million. Other parent company costs totaled $0.2 million in the period. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") and the capital regulations of the OTS thereunder require the Bank to maintain (1) Tangible Capital of at least 1.5% of Adjusted Total Assets (as defined in the regulations); (2) Core Capital of at least 3.0% of Adjusted Total Assets (as defined in the regulations); and (3) Total Risk-based Capital of at least 8.0% of Total Risk-weighted Assets (as defined in the regulations). 25 26 The following table summarizes the regulatory capital requirements under FIRREA for the Bank at March 31, 1997. As indicated in the table, the Bank's capital levels exceed all three of the currently applicable minimum FIRREA capital requirements (dollars are in thousands). TANGIBLE CAPITAL(2) CORE CAPITAL(2) RISK-BASED CAPITAL ------------------- ------------------ ------------------- BALANCE % BALANCE % BALANCE % -------- ----- -------- ----- -------- ----- Stockholders' equity $ 54,857 $ 54,857 $ 54,857 Adjustments General valuation allowances 7,110 Unrealized (gains) losses, net 806 806 806 -------- ----- -------- ----- -------- ----- Regulatory capital 55,663 6.67% 55,663 6.67% 62,773 11.11% Required minimum 12,516 1.50% 25,032 3.00% 45,212 8.00% -------- ----- -------- ----- -------- ----- Excess capital $ 43,147 5.17% $ 30,631 3.67% $ 17,561 3.11% ======== ===== ======== ===== ======== ===== Adjusted assets (1) $834,385 $834,385 $565,149 ======== ======== ======== - ---------- (1) The term "adjusted assets" refers to the term "adjusted total assets" as defined in 12 C.F.R. Section 567.1(a) for purposes of tangible and core capital requirements, and for purposes of risk-based capital requirements, refers to the term "risk-weighted assets" as defined in 12 C.F.R. Section 567.1(bb). (2) The tangible and core capital ratios were 6.27% at December 31, 1996. As of March 31, 1997 and December 31, 1996, the most recent notification from the OTS categorized the Company as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the institution's category. The Bank's actual capital amounts and ratios and the capital amounts and ratios required in order for an institution to be well capitalized and adequately capitalized are presented in the table below (dollars are in thousands). TO BE CATEGORIZED AS TO BE CATEGORIZED AS ADEQUATELY CAPITALIZED WELL CAPITALIZED UNDER PROMPT CORRECTIVE UNDER PROMPT CORRECTIVE ACTUAL ACTION PROVISIONS ACTION PROVISIONS ------------------- ----------------------- ------------------------- AMOUNT RATIOS AMOUNT RATIOS AMOUNT RATIOS ------- ------ ------- ------ ------- ------ AS OF MARCH 31, 1997 Total Capital (to Risk Weighted Assets) $62,773 11.11% $45,212 8.00% $56,515 10.00% Tier 1 Capital (to Risk Weighted Assets) 55,663 9.85% 22,606 4.00% 33,909 6.00% Tier 1 Capital (to Average Assets) 55,663 6.70% 33,231 4.00% 41,538 5.00% AS OF DECEMBER 31, 1996 Total Capital (to Risk Weighted Assets) $59,560 11.11% $42,879 8.00% $53,599 10.00% Tier 1 Capital (to Risk Weighted Assets) 52,803 9.85% 21,439 4.00% 32,159 6.00% Tier 1 Capital (to Average Assets) 52,803 6.55% 32,269 4.00% 40,336 5.00% The OTS has authority, after an opportunity for a hearing, to downgrade an institution from "well-capitalized" to "adequately capitalized" or to subject an "adequately capitalized" or "undercapitalized" institution to the supervisory actions applicable to the next lower category, if the OTS deems such action to be appropriate as a result of supervisory concerns. 26 27 CAPITAL RESOURCES AND LIQUIDITY The Company's liquidity position refers to the extent to which the Company's funding sources are sufficient to meet its current and long-term cash requirements. Federal regulations currently require a savings institution to maintain a monthly average daily balance of liquid and short-term liquid assets equal to at least 5.0% and 1.0%, respectively, of the average daily balance of its net withdrawable accounts and short-term borrowings during the preceding calendar month. The Bank had liquidity and short-term liquidity ratios of 9.60% and 4.95%, respectively, as of March 31, 1997, and 11.05% and 6.49%, respectively, as of December 31, 1996. The Company's current primary funding resources are deposit accounts, principal payments on loans, proceeds from property sales, advances from the FHLB and cash flows from operations. Other possible sources of liquidity available to the Company include reverse repurchase transactions involving the Company's investment securities, whole loan sales, commercial bank lines of credit, and direct access, under certain conditions, to borrowings from the Federal Reserve System. The cash needs of the Company are principally for the payment of interest on and withdrawals of deposit accounts, the funding of loans, operating costs and expenses, and holding and refurbishment costs on foreclosed properties. INTEREST RATE RISK MANAGEMENT The objective of interest rate risk management is to stabilize the Company's net interest income ("NII") while limiting the change in its net portfolio value ("NPV") from interest rate fluctuations. The Company seeks to achieve this objective by matching its interest sensitive assets and liabilities, and maintaining the maturity and repricing of these assets and liabilities at appropriate levels given the interest rate environment. When the amount of rate sensitive liabilities exceeds rate sensitive assets, the net interest income will generally be negatively impacted during a rising rate environment. The speed and velocity of the repricing of assets and liabilities will also contribute to the effects on net interest income. The Company utilizes two methods for measuring interest rate risk. Gap analysis is the first method, with a focus on measuring absolute dollar amounts subject to repricing within certain periods of time, particularly the one-year maturity horizon. In addition to utilizing gap analysis in measuring interest rate risk, the Company performs periodic interest rate simulations. These simulations provide the Company with an estimate of both the dollar amount and percentage change in NII under various interest rate scenarios. All assets and liabilities are subjected to tests of up to 400 basis points in increases and decreases in interest rates. Under each interest rate scenario, the Company projects its net interest income and the NPV of its current balance sheet. From these results, the Company can then develop alternatives to dealing with the tolerance thresholds. A principal mechanism used by the Company in the past for interest rate risk management was the origination of ARMs tied to the 11th DCOFI. The basic premise was that the Company's actual cost of funds would parallel the 11th DCOFI and, as such, the interest rate spread would generate the desired operating results. Adjustable rate mortgage loans ("ARMS") comprised almost all of the Company's loan originations during 1996. ARMs represented approximately 75% of the Company's loan portfolio at December 31, 1996 and 1995, respectively. The Company currently originates loans tied to multiple indices including London Interbank Offered Rate ("LIBOR"), CMT, prime, and 11th DCOFI. ARMs tied to 11th DCOFI are slower in responding to current interest rate environments than other types of variable rate loans because the index is a compilation of the average rates paid by member institutions of the 11th District of the FHLB. This index typically lags market rate changes in both directions. If interest rates on deposit accounts increase due to market conditions and competition, it may be anticipated that the Company will, absent offsetting factors, experience a decline in its net interest margin. A contributing factor would be the lag in upward pricing of the ARMs tied to the 11th DCOFI. However, the lag inherent in the 11th DCOFI will also cause the ARMs to remain at a higher rate for a longer period after interest rates on deposits begin to decline. The 11th DCOFI lag during a falling interest rate environment should benefit, in the short-term, the Company's Net Interest Margin, but 27 28 the actual dynamics of prepayments and the fact that ARMs reprice at various intervals may alter this expected benefit. The following table sets forth information concerning sensitivity of the Company's interest-earning assets and interest-bearing liabilities as of March 31, 1997 (dollars are in thousands). Such assets and liabilities are classified by the earlier of maturity or repricing date. OVER THREE OVER SIX OVER ONE THREE THROUGH THROUGH YEAR OVER MONTHS SIX TWELVE THROUGH FIVE OR LESS MONTHS MONTHS FIVE YEARS YEARS TOTAL --------- ---------- -------- ---------- --------- --------- INTEREST-EARNING ASSETS Cash and cash equivalents(1) $ 13,804 $ 100 $ -- $ -- $ -- $ 13,904 Investments and FHLB Stock 7,693 803 -- 36,535 39,500 84,531 Loans (2) 367,532 190,927 58,027 29,765 125,754 772,005 --------- --------- --------- --------- --------- --------- Total interest-earning assets $ 389,029 $ 191,830 $ 58,027 $ 66,300 $ 165,254 $ 870,440 ========= ========= ========= ========= ========= ========= INTEREST-BEARING LIABILITIES Deposits Demand $ 72,835 $ -- $ -- $ -- $ -- $ 72,835 CDs 207,149 133,404 204,123 90,602 -- 635,278 FHLB advances 65,000 -- -- -- -- 65,000 Senior Notes -- -- -- 12,385 -- 12,385 --------- --------- --------- --------- --------- --------- Total interest-bearing liabilities $ 344,984 $ 133,404 $ 204,123 $ 102,987 $ -- $ 785,498 ========= ========= ========= ========= ========= ========= Interest rate sensitivity gap $ 44,045 $ 58,426 $(146,096) $ (36,687) $ 165,254 $ 84,942 Cumulative interest rate sensitivity gap 44,045 102,471 (43,625) (80,312) 84,942 84,942 Cumulative interest rate sensitivity gap as a percentage of total interest-earning assets 11.3% 53.4% -75.2% -121.1% 51.4% 9.8% - ---------- (1) Contractual yield, exclusive of the amortization of loan fees deferred at origination. (2) Loans include $26.7 million of nonaccrual loans. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. 28 29 PART II - OTHER INFORMATION ITEM 1. Legal Proceedings On September 6, 1996, the Company and the Bank were named as defendants in a class action lawsuit entitled Stanley D. Mosler and Eileen C. Mosler vs. Hawthorne Savings and Loan Association, Hawthorne Financial Corporation, et. al., filed in the Superior Court of the State of California as Case No. BC154729 (the "Action"). The plaintiffs had previously filed an individual action alleging the same matters contained in the class action complaint. The individual action is scheduled for trial in July 1997. Plaintiffs contend they were entitled to a notice of availability of foreclosure counseling, which they allege they did not receive, before the Bank foreclosed. Plaintiffs contend that the alleged failure to provide counseling notices and the underbidding by the Bank of the loan amount at foreclosure resulted in damages to the purported class in an amount in excess of $40 million. The Company has been named and alleged to have liability based upon its relationship as trustee on the Deed of Trust securing the Bank's loans. The Company and the Bank filed responsive pleadings to the Action alleging that the complaint is defective on its face and that the plaintiffs are not proper representatives of the purported class. The court granted the Company and Bank's motion and dismissed the plaintiffs' case. The plaintiffs have appealed. The Bank has been named as a defendant in an action entitled Takaki vs. Hawthorne Savings and Loan Association, filed in the Superior Court of the State of California, Los Angeles, as Case No. YC021815. The plaintiffs were owners of real property which they sold in 1991 to a third party. The Bank provided escrow services in connection with the transaction. A substantial portion of the consideration paid to the plaintiffs took the form of a deed of trust secured by another property then owned by an affiliate of the purchaser. The value of the collateral securing this deed of trust ultimately proved to be inadequate. The plaintiffs allege that the Bank knew, or should have known, that the security for the plaintiffs' loan was inadequate and should have so advised them. The Bank disputes the plaintiffs' allegations and believes that the law in California is unambiguous that there is no duty which attaches to escrow providers to advise the parties to an escrow. Trial is scheduled to commence before the end of May 1997. The plaintiffs have claimed damages in excess of $5 million. The Company is involved in a variety of other litigation matters which, for the most part, arise out of matters and events which were alleged to have occurred prior to 1994. Many of these lawsuits either allege construction defects or allege improper servicing of the loan. In the opinion of management, none of these cases will have a material adverse effect on the Bank's or the Company's financial condition or operations. ITEM 2. Changes in Securities - None ITEM 3. Defaults upon Senior Securities - None ITEM 4. Submission of Matters to a Vote of Security Holders - None ITEM 5. Other Information - None ITEM 6. Exhibits and Reports on Form 8-K 1. Reports on Form 8-K The Company filed a Form 8-K on April 29, 1997, announcing financial results for the first quarter ended March 31, 1997. 2. Other required exhibits - None 29 30 Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HAWTHORNE FINANCIAL CORPORATION Dated May 15, 1997 /s/ NORMAN A. MORALES ---------------------------- Norman A. Morales Executive Vice President and Chief Financial Officer Dated May 15, 1997 /s/ JESSICA VLACO ---------------------------- Jessica Vlaco Senior Vice President and Principal Accounting Officer 30