UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED] FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] Commission File Number 33-93312 BEAL FINANCIAL CORPORATION (Exact name of registrant as specified in its charter) Texas 75-2583551 (State or other jurisdiction of incorporation or organization) (IRS Employer Identification No.) Suite 300, LB 66, 15770 North Dallas Parkway, Dallas, Texas 75248 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (972) 404-4000 Securities Registered Pursuant to Section 12(b) of the Act: None Securities Registered Pursuant to Section 12(g) of the Act: None (Title of class) 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 requirements for the past 90 days. YES X NO . Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] The aggregate market value of the voting stock held by non-affiliates of the registrant was $0, as all shares of the Registrant were held by affiliates of the Registrant at December 31, 1997. As of December 31, 1997, there were issued and outstanding 300,000 shares of the Registrant's Common Stock. DOCUMENTS INCORPORATED BY REFERENCE None. TABLE OF CONTENTS ITEM 1. BUSINESS..................................................................................... 1 General ............................................................................................. 1 Forward-Looking Statements............................................................................ 2 Lending Activities.................................................................................... 3 General. ................................................................................... 3 Loan Portfolio Composition................................................................... 4 Contractual Principal Repayments............................................................. 6 Geographic Distribution of Real Estate Secured Loans......................................... 7 Loan Acquisition, Resolution, Origination and Sale Activities......................................... 9 General. .................................................................................... 9 Originations, Purchases and Sales of Mortgage Loans.......................................... 11 Acquisition of Discounted Loans.............................................................. 13 One- to Four-Family Residential Mortgage Lending............................................. 14 Multi-Family and Commercial Real Estate Lending.............................................. 14 Construction, Development and Land Lending................................................... 16 Consumer Lending............................................................................. 16 Commercial Business Lending.................................................................. 17 Foreign Lending Activities................................................................... 17 Loan Delinquencies and Non-Performing Assets...........................................................18 Non-Accruing Loans........................................................................... 19 Accruing Loans Delinquent More than 90 Days...................................................19 Foreclosed Assets............................................................................ 19 Other Loans of Concern........................................................................20 Classified Assets............................................................................ 20 Allowance for Loan Losses.................................................................... 20 Investment Activities..................................................................................24 General. .................................................................................... 24 Sources of Funds...................................................................................... 25 General. .................................................................................... 25 Deposits..................................................................................... 25 Borrowings................................................................................... 27 Subsidiaries of the Company........................................................................... 28 Subsidiaries of the Bank...............................................................................29 Beal Nevada Corp., ("BNC")................................................................... 29 Beal Mortgage, Inc. ("BMI") and Beal Properties, Inc. ("BPI") and Beal/H.S., Inc. ("BHS")............................................................... 29 Loan Acceptance Corp. ("LAC").................................................................30 BRE, Inc. ("BRE").............................................................................30 Beal Affordable Housing, Inc. ("BAH")........................................................ 30 Foreign Lending Corporation ("FLC").......................................................... 31 Competition........................................................................................... 31 Employees............................................................................................. 31 Regulation............................................................................................ 32 General. .................................................................................... 32 The Conversion............................................................................... 32 Texas Law and Supervision by the Texas Department.............................................32 Federal Regulation of State-Chartered Savings Banks...........................................33 Insurance of Accounts and Regulation by the FDIC..............................................34 Regulatory Capital Requirements and Prompt Corrective Regulatory Action...................... 35 Limitations on Dividends and Other Capital Distributions......................................38 Liquidity.................................................................................... 38 Qualified Thrift Lender Test..................................................................38 Community Reinvestment Act................................................................... 38 Transactions with Affiliates................................................................. 39 Holding Company Regulation................................................................... 39 Federal Securities Law....................................................................... 39 Federal Reserve System....................................................................... 39 Federal Home Loan Bank System.................................................................40 ii Federal and State Taxation............................................................................ 40 Federal Taxation............................................................................. 40 Texas State Income Taxation.................................................................. 41 Delaware Taxation............................................................................ 41 ITEM 2. PROPERTIES................................................................................... 42 ITEM 3. LEGAL PROCEEDINGS............................................................................ 43 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...........................................43 ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.................... 43 ITEM 6. SELECTED FINANCIAL DATA...................................................................... 44 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.................................................................... 46 General ............................................................................................. 46 Financial Condition................................................................................... 46 Results of Operations................................................................................. 47 Average Balance, Interest and Average Yields and Rates........................................48 Rate/Volume Analysis......................................................................... 49 Comparison of Operating Results for the Fiscal Year Ended December 31, 1997 and the Twelve Months Ended December 31, 1996.............................................................. 50 Net Income................................................................................... 50 Net Interest Income.......................................................................... 50 Interest Income.............................................................................. 50 Interest Expense............................................................................. 50 Provision for Loan Losses.................................................................... 50 Non-Interest Income.......................................................................... 51 Non-Interest Expense......................................................................... 51 Income Taxes................................................................................. 51 Comparison of Operating Results for the Fiscal Years Ended June 30, 1996 and 1995..................... 51 Net Income................................................................................... 51 Net Interest Income.......................................................................... 51 Interest Income.............................................................................. 51 Interest Expense............................................................................. 51 Provision for Loan Losses.................................................................... 52 Non-Interest Income.......................................................................... 52 Non-Interest Expense......................................................................... 52 Year 2000.................................................................................... 52 Income Taxes................................................................................. 53 Liquidity and Capital Resources....................................................................... 53 Impact of Inflation and Changing Prices............................................................... 54 Ratios of Earnings to Fixed Charges................................................................... 54 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK................................................................................. 55 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION............................................59 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE...........................................................86 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS............................................................. 86 Directors of Beal Financial ...........................................................................86 Executive Officers of the Company..................................................................... 86 Board of Directors of the Bank........................................................................ 87 Executive Officers of the Bank.........................................................................88 Meetings and Committees of the Board of Directors of the Company and the Bank..........................89 Compensation Committee Interlocks and Insider Participation............................................90 iii Compensation of Directors............................................................................. 90 ITEM 11. EXECUTIVE COMPENSATION....................................................................... 91 Compensation of Executive Officers.................................................................... 91 Executive Bonus Plan.................................................................................. 91 Benefits.............................................................................................. 92 ITEM 12. STOCK OWNERSHIP OF CERTAIN BENEFICIAL OWNERS................................................. 93 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS............................................... 93 Certain Transactions.................................................................................. 93 ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON FORM 8-K..................................................................................... 94 iv PART I ITEM 1. BUSINESS General Beal Financial Corporation ("Beal Financial" and with its subsidiaries the "Company"), a Texas corporation, was organized by the stockholders of Beal Bank, SSB (the "Bank") for the purpose of acquiring all of the outstanding capital stock of the Bank, which it indirectly owns through its wholly owned subsidiary, Beal Banc Holding Company, a Delaware corporation. Beal Financial is owned primarily by D. Andrew Beal, Chairman of the Board of the Bank. Beal Financial, through Beal Banc Holding Company, acquired ownership of the Bank in July 1995 and is subject to regulation by the Office of Thrift Supervision (the "OTS"). The most significant asset of Beal Financial is its indirect ownership of the capital stock of the Bank. At December 31, 1997, the business of the Company consisted primarily of the business of the Bank and its subsidiaries. All references to the Company, unless otherwise indicated, prior to July 1, 1995 refer to its subsidiaries, including the Bank and its subsidiaries on a consolidated basis. In calendar year 1996, the Company changed its fiscal year end from June 30 to December 31 in connection with its tax election to be treated as a Subchapter S corporation. See "Federal and State Taxation - Federal Taxation." The Bank, a privately held Texas-chartered savings bank headquartered in Dallas, Texas, was originally chartered in 1988 as a Texas-chartered savings and loan association. Effective December 1, 1994, the Bank converted to a Texas savings bank charter. This conversion was made primarily to eliminate the duplicative regulation and supervision of the Bank by the OTS and the Federal Deposit Insurance Corporation (the "FDIC"). Prior to December 1994, the name of the Bank was "Beal Banc, S.A." See "Regulation." Beal Financial is subject to regulatory oversight and examination by the OTS and the Texas Savings and Loan Department (the "Texas Department"). The Bank is subject to regulation by the Texas Department, as its chartering authority, and by the FDIC as a result of its membership in the Savings Association Insurance Fund ("SAIF") administered by the FDIC, which insures the Bank's deposits up to the maximum extent permitted by law. The Bank also is subject to certain regulation by the Board of Governors of the Federal Reserve System ("Federal Reserve Board") and currently is a member of the Federal Home Loan Bank ("FHLB") of Dallas, one of the 12 regional banks which comprise the FHLB System. The Company's primary business has historically consisted of purchasing pools of performing and, to a lesser extent, purchasing and resolving non-performing mortgage loans, in each case such loans are secured by single-family (one to four units) residences, multi-family residential real estate (over four units), commercial real estate and, to a much lesser extent, undeveloped land and business assets. These loans are generally purchased at discounts from the principal balances of the loans ("discounted loans") primarily from the U.S. Department of Housing and Urban Development ("HUD"), the FDIC and private sector sellers located nationwide. The Company had purchased a significant amount of discounted loans from the Resolution Trust Company (the "RTC") prior to December 31, 1995, the date of the RTC's termination. Although, the Company's current business strategy emphasizes the ongoing identification and purchase of discounted loans, primarily secured by real estate, which management believes are undervalued due to market, economic and competitive conditions; due to the termination of the RTC and increased competition for these assets, the supply of discounted loans meeting the Company's investment criteria has steadily decreased, resulting in a decline in discounted loan purchases. See "- Loan Acquisition, Resolution, Origination and Sale Activities." The Company's current business strategy is to continue to opportunistically purchase discounted loans while attempting to leverage its core expertise by increasing its originations of multi-family and commercial real estate, construction, development and land loans. In this regard, the Company recently entered into an executive bonus plan with President David C. Meek, who has extensive experience in both asset resolution and in the origination of commercial real estate loans. The executive bonus plan is based upon the amount of earnings the Company derives from designated loan originations exceeding a hurdle rate of prime plus 1.5%. See "Item 11 - Incentive Compensation." The Company originates multi-family and commercial real estate, construction, development and land loans within its primary market area and other areas within the state of Texas. The Company considers its primary market area for deposits and loan originations to consist of Collin, Dallas, Denton, Ellis, Kaufman, Rockwall, Fort Bend, Harris, Liberty, Montgomery and Waller counties, Texas. These counties consist of communities comprising the Dallas and Houston metropolitan statistical areas, respectively. See "Subsidiaries of the Bank." In addition to its loan purchasing and lending activities, the Company is actively engaged in direct equity real estate investments, including the development of residential lots through the Bank's subsidiaries, Beal Mortgage, Inc. ("BMI"), Beal Properties Inc. ("BPI") and Beal/H.S. Inc. ("BHS") and through various single purpose subsidiaries. At December 31, 1997, the Company's real estate held for development totaled $23.5 million (excluding $2.6 million sold in the first quarter of 1998). BMI and BPI also held in the aggregate $10.3 million of income producing properties (primarily consisting of the buildings located adjacent to the Bank's corporate headquarters). See "- Subsidiaries of the Bank." In addition, Beal Financial purchased from the Bank in 1996 a 45.1% participation interest in sixteen loans for a payment of $18.5 million. The participation agreement provides that the Company's interest in the loans will be junior to the Bank's interest in that the principal amount of loans owed to the Bank will be repaid prior to the principal amount owed to the Company. Beal Financial's current interest, as of December 31, 1997, was $10.7 million and is secured by nine foreclosed properties. See "Lending Activities General." In addition, the Company is engaged in the ownership of multi-family projects that qualify for low-income housing tax credits through the Bank's subsidiary, Beal Affordable Housing ("BAH"). BAH has invested a total of $26.0 million in three affordable housing apartment buildings at December 31, 1997. See "Subsidiaries of the Bank" and "- Regulation - Federal Regulation of State-Chartered Savings Banks." The Bank funds its discounted loan purchases, loan originations and real estate investments primarily through the attraction of deposits from the general public, including brokered deposits, and, to a lesser extent, borrowings from the FHLB of Dallas and other sources. The Bank has branch offices located in Dallas and Houston, Texas and Winnetka, Illinois. The Bank has entered into a contract to sell the Winnetka branch. This transaction should be consummated during the second quarter of 1998. See "Sources of Funds - Deposits." At December 31, 1997, the Bank was a "well capitalized institution" as defined in FDIC regulations and had tier 1 capital to total assets ("leverage capital ratio"), tier 1 capital to risk-weighted assets ("tier 1 capital ratio") and total capital to risk-weighted assets ("total risk-based capital ratio") of 13.81%, 17.90% and 19.05%, respectively. The executive offices of the Company are located at 15770 N. Dallas Parkway, Suite 300, Dallas, Texas 75248. Its telephone number at that address is (972) 404-4000. Forward-Looking Statements When used in this Form 10-K or future filings by the Company with the Securities and Exchange Commission, in the Company's press releases or other public or shareholder 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 or by use of the negative of such terminology 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 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 factors, including regional and national economic conditions, particularly in the market areas the Company operates, changes in the domestic or foreign business, financial and securities markets, financial or legal conditions, changes in prevailing interest rates and the credit risks related to the Company's lending activities, and in the competitive and regulatory factors affecting financial institutions and the availability of and costs associated with sources of liquidity, all 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 Company does not undertake, and specifically disclaims any obligations, to revise any forward- looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. Lending Activities General. Commencing in 1990, the Company began purchasing pools of performing and, to a lesser extent, non-performing discounted loans. The discounted loans which have been acquired by the Company to date consist primarily of single-family and multi-family residential loans, commercial real estate loans, land, consumer and commercial business loans which have been acquired from the RTC, the FDIC and the HUD, primarily in auctions of pools of loans acquired by those agencies from failed financial institutions and to a much lesser extent, private sector sellers. At December 31, 1997 the Company's gross loan portfolio totaled $1.1 billion. The Company's unaccreted purchase discounts and fees at December 31, 1997 totaled $231.8 million. The Company's gross loan portfolio at December 31, 1997 was comprised primarily of one- to four-family residential mortgage loans (18.6%), commercial real estate loans (29.4%) and multi-family residential real estate loans (28.0%). The balance of the gross loan portfolio included land loans (6.2%), construction and development loans (8.6%), consumer loans (7.0%) and commercial business loans (2.2%). At December 31, 1997 the Company's net loan portfolio totaled $887.8 million. The Company's net loan portfolio at December 31, 1997 was comprised primarily of one- to four-family residential mortgage loans (19.9%), commercial real estate loans (29.7%) and multi-family residential real estate loans (26.2%). The balance of the net loan portfolio included land loans (5.8%), construction and development loans (9.0%), consumer loans (7.6%) and commercial business loans (1.8%). At December 31, 1997, approximately 22.5% of the Company's gross real estate mortgage loans (including one- to four-family junior lien loans classified as consumer loans) were secured by real estate properties located in Texas. The Company also has loans secured by real estate properties (including one- to four-family junior lien loans) located in California and Florida, representing 19.6% and 15.2% of the Company's gross loan portfolio, respectively. At December 31, 1997, there were no other states where loans secured by real estate properties (including one- to four-family junior lien loans) exceeded 5%. The balance of the Company's real estate mortgage loans were secured by properties located in the northeast, the midwest, and throughout the rest of the United States. See "- Geographic Distribution of Real Estate Secured Loans." Texas law limits the maximum amount the Bank may lend to one borrower or group of related borrowers to the greater of $500,000, or 15%, of unimpaired capital and surplus. At December 31, 1997, the Bank's loan to one borrower limit was $28.2 million. At that date, the largest amount outstanding to any one borrower or group of affiliated borrowers was $20.9 million, net and is secured by a first lien on 720 acres of land and improvements in Harris County, Texas and a first lien on a 27 hole golf course, restaurant, 60 room hotel plus 208 acres of land to be developed located in Southern, California. The next largest relationship totaled $20.3 million, net and is secured by a first lien on 727 acres located in Denton County, Texas, and a pledge of a 49% partnership interest in a partnership which owns an additional 1,490 acres in Collin County, Texas. The Bank's third largest relationship totaled $18.3 million, net and consisted of seven letters of credit aggregating $16.8 million, net, which, if drawn against shall be secured by first liens on eight office buildings located in Houston, Texas and the balance of $1.5 million, secured by first liens on three small office buildings located in Houston, Texas. All of these loans are performing in accordance with their respective repayment terms. See "Multi-family and Commercial Real Estate Lending" and "Regulation - Texas Law and Supervision by the Texas Department". The Company has two other loans to any borrower or group of related borrowers in excess of $15.0 million, net (aggregating $31.6 million, net), three such lending relationships in excess of $10.0 million, net (aggregating $32.3 million), an additional four such lending relationships in excess of $7.5 million, net (aggregating $34.1 million), an additional eight such lending relationships in excess of $5.0 million, net (aggregating $58.3 million) and an additional 50 such lending relationships in excess of $2.0 million, net (aggregating $150.3 million). At December 31, 1997, 15 of these lending relationships in excess of $2.0 million, net, aggregating $75.7 million were non-performing. See "- Loan Delinquencies and Non-Performing Assets." Loan Portfolio Composition. The following table sets forth information concerning the composition of the Company's loan portfolio, in dollar amounts and in percentages (before deductions for loans in process, deferred fees and discounts and allowances for losses) as of the dates indicated. June 30, ----------------------------------------------------------------------------------- 1993 1994 1995 1996 ----------------- ------------------ ------------------ -------------------- Amount Percent Amount Percent Amount Percent Amount Percent ------ ------- ------ ------- ------ ------- ------ ------- Real Estate Loans: One- to four-family ............... $ 62,540 42.53% $ 67,169 21.81 $ 237,585 35.70% $ 273,780 22.47% Commercial ........................ 30,271 20.58 93,496 30.37 109,080 16.39 321,385 26.38 Multi-family ...................... 20,675 14.06 55,633 18.07 124,985 18.78 341,696 28.05 Construction or development ....... 3,893 2.65 27,100 8.80 51,284 7.71 85,133 6.99 Land .............................. 7,089 4.82 9,889 3.21 35,997 5.41 100,047 8.21 ------- ----- ------ ----- ------- ----- --------- ----- Total real estate loans ....... 124,468 84.64 253,287 82.26 558,931 83.99 1,122,041 92.10 Other Loans: Consumer Loans: One- to four-family - junior liens 9,993 6.79 19,549 6.35 44,999 6.77 50,146 4.12 Timeshares ....................... 1,599 1.09 18,249 5.93 11,668 1.75 7,809 .64 Other ............................ 3,747 2.55 7,139 2.32 4,791 .72 8,373 .69 ------ ----- ------ ----- ------ ---- --------- ----- Total consumer loans .......... 15,339 10.43 44,937 14.60 61,458 9.24 66,328 5.45 Commercial business loans ......... 7,253 4.93 9,662 3.14 45,060 6.77 29,886 2.45 ------ ----- ------ ----- ------ ---- --------- ----- 1,218,255 100.00% Total loans ................... 147,060 100.00% 307,886 100.00% 665,449 100.00% ------ ------ ------ ------ ------ ------ Less: Loans in process .................. 1,558 11,235 21,217 27,172 Deferred fees and discounts ....... 43,447 73,190 144,927 281,837 Allowance for loan losses ......... 1,245 3,547 6,137 11,832 Loans held for sale ............... -- -- 866 -- --------- --------- --------- --------- Total loans receivable, net .. $ 100,810 $ 219,914 $ 492,302 $ 897,414 --------- --------- --------- --------- --------- --------- --------- --------- December 31, ----------------------------------------- 1996 1997 ------------------ ------------------ Amount Percent Amount Percent ------ ------- ------ ------- Real Estate Loans: One- to four-family ............... $ 276,591 19.37% $ 213,584 18.60% Commercial ........................ 388,460 27.20 337,825 29.42 Multi-family ...................... 466,697 32.68 321,423 27.99 Construction or development ....... 74,437 5.21 98,503 8.58 Land .............................. 95,684 6.70 71,379 6.21 --------- ----- --------- ----- Total real estate loans ....... 1,301,869 91.16 1,042,714 90.80% Other Loans: Consumer Loans: One- to four-family - junior liens 77,528 5.43 71,465 6.22 Timeshares ....................... 6,446 .45 3,615 .31 Other ............................ 7,095 .50 5,003 .44 --------- ----- --------- ----- Total consumer loans .......... 91,069 6.38 80,083 6.97 Commercial business loans ......... 35,131 2.46 25,554 2.23 --------- ----- --------- ----- Total loans ................... 1,428,069 100.00% 1,148,351 100.00% ------ ------ ------ ------ Less: Loans in process .................. 16,364 16,806 Deferred fees and discounts ....... 344,312 231,800 Allowance for loan losses ......... 13,189 11,912 Loans held for sale ............... -- -- ----------- --------- Total loans receivable, net .. $ 1,054,204 $ 887,833 ----------- --------- ----------- --------- 4 The following table sets forth information concerning the composition of the Company's loan portfolio after deduction for loans in process, deferred fees and discounts, allowance for loan losses and loans held for sale at December 31, 1997. At December 31, 1997 ---------------------------------------------------------------------------------- Deferred Fees and Discounts as a Gross Deferred Allowance Percentage Loan Loans in Fees and for Loan of Gross Amount Process Discounts Losses Net Loans ---------- --------- ---------- ---------- -------- ---------- (Dollars In Thousands) REAL ESTATE LOANS: One- to four-family - first liens..................... $ 213,584 $ --- $ 33,098 $ 4,051 $176,435 15.50% Commercial......................... 337,825 --- 72,170 1,986 263,669 21.36 Multi-family....................... 321,423 --- 87,072 1,316 233,035 27.09 Construction or development........ 98,503 16,806 1,548 16 80,133 1.57 Land............................... 71,379 --- 19,034 898 51,447 26.67 --------- ------ ------- ------ ------- Total real estate loans....... 1,042,714 16,806 212,922 8,267 804,719 20.42 OTHER LOANS: Consumer Loans: One- to four-family - junior liens................... 71,465 --- 7,713 1,756 61,996 10.79 Timeshares......................... 3,615 --- 615 642 2,358 17.01 Other.............................. 5,003 --- 1,132 684 3,187 22.63 --------- ------ ------- ------ ------- Total consumer loans............... 80,083 --- 9,460 3,082 67,541 11.81 Commercial business loans............ 25,554 --- 9,418 563 15,573 36.86 --------- ------ ------- ------ ------- Total other loans.............. 105,637 --- 18,878 3,645 83,114 17.87 --------- ------ ------- ------ ------- Total loans......................... 1,148,351 16,806 231,800 11,912 887,833 20.19 Less: Loans in process.................. 16,806 (16,806) --- --- --- Deferred fees and discounts....... 231,800 --- (231,800) --- --- Allowance for losses.............. 11,912 --- --- (11,912) --- --------- ------ ------- ------ ------- Total loans receivable, net.................................. $ 887,833 $ $ $ -- $887,833 --------- ------ ------- ------ ------- --------- ------ ------- ------ ------- 5 Contractual Principal Repayments. The following schedule illustrates the contractual maturity of the Company's loan portfolio at December 31, 1997. Loans which have adjustable or renegotiable interest rates are shown as maturing in the period during which the contract is due. The schedule does not reflect the effects of possible prepayments or enforcement of due-on-sale clauses. Real Estate --------------------------------------------------- Construction One- to Four- Multi- or Commercial Family family Commercial Development Land Consumer Business Total ------------- ------ ---------- ------------ ---- -------- ---------- ----- (Dollars in Thousands) Due During Periods Ending December 31, - ----------------------------- 1998 ........................ $ 5,044 $ 30,657 $ 39,200 $ 13,326 $ 8,985 $ 10,226 $ 4,013 $111,451 1999 to 2002 ................ 18,645 59,679 108,899 66,823 35,570 9,562 7,981 307,159 2003 and following .......... 156,797 144,015 117,556 -- 7,790 50,835 4,142 481,135 -------- -------- -------- -------- -------- -------- -------- -------- Total ................... $180,486 $234,351 $265,855 $ 80,149 $ 52,345 $ 70,623 $ 16,136 $899,745 Less: Allowance for loan losses . 4,051 1,316 1,986 16 898 3,082 563 11,912 -------- -------- -------- -------- -------- -------- -------- -------- Total loans receivable, net $176,435 $233,035 $263,669 $ 80,133 $ 51,447 $ 67,541 $ 15,573 $887,833 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- 6 The total amount of gross loans due after December 31, 1998, which have predetermined interest rates is $474.7 million, while the total amount of gross loans due after such date which have floating or adjustable interest rates is $313.6 million. Scheduled contractual principal repayments do not reflect the actual maturities of loans because of prepayments and, in the case of conventional mortgage loans, due-on-sale clauses. The average life of mortgage loans, particularly fixed-rate loans, tends to increase when current mortgage loan rates are substantially higher than rates on existing mortgage loans and, conversely, decrease when rates on existing mortgages are substantially higher than current mortgage loan rates. Further, as a result of the use of the level yield method or "interest method" of accretion of the purchase discount pursuant to generally accepted accounting principles, to the extent loan repayments exceed scheduled loan amortizations, the accretion of the remaining purchase discount, if any, would be accelerated. Geographic Distribution of Real Estate Secured Loans. The Company's loans are secured by properties located throughout the United States. Some of these loans are located in states which are reported to be experiencing adverse economic conditions, including a general softening in real estate markets and the local economies, which may result in increased loan delinquencies and loan losses. The Company attempts to address this geographic risk by only purchasing loans that meet the Company's underwriting and investment standards. Management believes that purchasing loans secured by properties located across the country results in a diversified loan portfolio and overall lower risk. As of December 31, 1997, the Company's gross real estate collateralized loans (excluding junior liens secured by one- to four-family real estate totaling $71.5 million) were geographically distributed as follows: Outstanding Non-performing Total Real Estate Secured Balance at Percent Balance at Loans By Geographic December 31, of Total December 31, Percent of Location 1997 Outstanding 1997 Non-performing - --------------------------------------------- ------------ ----------- -------------- -------------- Texas....................................... $ 234,248 22.47% $ 6,290 3.28% California.................................. 204,693 19.63 34,307 17.87 Florida..................................... 158,637 15.21 54,574 28.42 Massachusetts............................... 45,377 4.35 31,271 16.29 Colorado.................................... 37,548 3.60 7,637 3.98 Illinois.................................... 33,645 3.23 15 --- All others.................................. 328,566 31.51 57,900 30.16 ------------ ------ ---------- ------- Total real estate loan portfolio.......... $1,042,714 100.00% $191,994 100.00% ------------ ------ ---------- ------- ------------ ------ ---------- ------- At December 31, 1997, there were no other loan concentrations in any other state which exceeded three percent of the total real estate loan portfolio. 7 The following tables set forth the geographic distribution of the Company's real estate loans by loan type at December 31, 1997. Outstanding Non-performing Balance at Percent Balance at One- to Four-Family December 31, of Total December 31, Percent of Loans By Geographic Location 1997 Outstanding 1997 Non-performing - -------------------------------------------- ----------- ----------- -------------- -------------- Florida..................................... $ 58,604 27.44% $ 1,287 7.03% Texas....................................... 36,060 16.88 4,320 23.62 California.................................. 31,944 14.96 4,412 24.12 Massachusetts............................... 10,551 4.93 1,476 8.07 Alabama..................................... 6,676 3.13 157 .86 Virginia.................................... 6,610 3.10 316 1.73 All others.................................. 63,139 29.56 6,324 34.57 -------- ------ ------- ------ Total One- to Four- Family Loans.......... $213,584 100.00% $18,292 100.00% -------- ------ ------- ------ -------- ------ ------- ------ Outstanding Non-performing Balance at Percent Balance at Commercial Real Estate December 31, of Total December 31, Percent of Loans By Geographic Location 1997 Outstanding 1997 Non-performing - -------------------------------------------- ----------- ----------- ------------- -------------- California.................................. $ 72,946 21.59% $15,004 38.39% Texas....................................... 64,588 19.12 537 1.37 Florida..................................... 46,794 13.85 10,814 27.67 Illinois.................................... 24,999 7.40 --- --- Tennessee................................... 12,438 3.68 144 .37 Virginia.................................... 11,778 3.49 252 .64 All others.................................. 104,282 30.87 12,334 31.56 -------- ------ ------- ------ Total Commercial Real Estate Loans........ $337,825 100.00% $39,085 100.00% -------- ------ ------- ------ -------- ------ ------- ------ Outstanding Non-performing Balance at Percent Balance at Multi-Family December 31, of Total December 31, Percent of Loans By Geographic Location 1997 Outstanding 1997 Non-performing - -------------------------------------------- ------------ ----------- -------------- ----------------- California.................................. $ 52,866 16.45% $ 12,044 9.68% Florida..................................... 47,873 14.89 38,152 30.67 Texas....................................... 32,691 10.17 699 .56 Massachusetts............................... 30,907 9.62 29,643 23.83 Colorado.................................... 24,036 7.48 7,637 6.14 Louisiana................................... 14,747 4.58 6,660 5.35 South Carolina.............................. 14,097 4.39 12,018 9.66 Missouri.................................... 13,484 4.19 7,657 6.16 Kansas...................................... 13,469 4.19 36 .03 Arkansas.................................... 12,478 3.88 1,829 1.47 Georgia..................................... 10,767 3.35 --- --- Connecticut................................. 10,146 3.16 --- --- All others.................................. 43,862 13.65 8,019 6.45 ---------- ------ ---------- -------- Total Multi-Family........................ $321,423 100.00% $124,394 100.00% ---------- ------ ---------- -------- ---------- ------ ---------- -------- 8 Outstanding Non-performing Balance at Percent Balance at Construction and Development December 31, of Total December 31, Percent of Loans By Geographic Location 1997 Outstanding 1997 Non-performing - -------------------------------------------- ----------- ----------- --------------- -------------- Texas....................................... $82,672 83.93% $ --- ---% California.................................. 15,390 15.62 --- --- All others.................................. 441 .45 --- --- --------- -------- ------ ----- Total Construction and Development Loans.................................. $98,503 100.00% $ --- ---% --------- -------- ------ ----- --------- -------- ------ ----- Outstanding Non-performing Balance at Percent Balance at Land Loans December 31, of Total December 31, Percent of By Geographic Location 1997 Outstanding 1997 Non-performing - -------------------------------------------- ------------ ----------- --------------- -------------- California.................................. $31,547 44.20% $ 2,848 27.86% Texas....................................... 18,237 25.55 735 7.19 Florida..................................... 5,366 7.52 4,321 42.27 Colorado.................................... 3,207 4.49 --- --- New Mexico.................................. 3,162 4.43 19 .18 All others.................................. 9,860 13.81 2,300 22.50 -------- ------ -------- ------ Total Land Loans.......................... $71,379 100.00% $10,223 100.00% -------- ------ -------- ------ -------- ------ -------- ------ The following table sets forth the geographic distribution of the Company's junior lien loans secured by one- to four-family real estate at December 31, 1997. Outstanding Non-performing Balance at Percent Balance at One- to Four-Family Junior Lien December 31, of Total December 31, Percent of Loans By Geographic Location 1997 Outstanding 1997 Non-performing - -------------------------------------------- ------------ ----------- -------------- -------------- California.................................. $15,583 21.81% $ 2,585 22.78 Texas....................................... 13,679 19.14 1,407 12.40 Louisiana................................... 7,916 11.08 381 3.36 New York.................................... 5,644 7.92 929 8.19 Connecticut................................. 5,122 7.17 971 8.56 New Jersey.................................. 4,455 6.23 2,398 21.13 Florida..................................... 3,849 5.38 375 3.30 Arizona..................................... 2,514 3.52 --- --- All others.................................. 12,683 17.75 2,301 20.28 ------- ----- ------- ----- Total One- to Four- Family Junior Lien Loans............................. $71,465 100.00% $11,347 100.00% ------- ----- ------- ----- ------- ----- ------- ----- Loan Acquisition, Resolution, Origination and Sale Activities General. The Company historically has invested and intends to continue to invest a significant amount of its assets in discounted loans. The Company believes that under appropriate market conditions the acquisition of discounted loans offers a better return than the origination of mortgage loans. Historically, discounted loans purchased by the Company generally have collateral coverage which is substantially in excess of the purchase price of the loan. In addition, the Company believes that discounted loans can be purchased on terms which result in the investment having a total return which is substantially in excess of an equivalent investment in originated mortgage loans. 9 It should be noted, however, that the acquisition of discounted loans has become more competitive in the marketplace, in part because of the presence of additional competitors for discounted loans offered by the HUD, the FDIC and private sector sellers and because the HUD and the FDIC generally sought to increase the number of purchasers of assets sold by them. The Company continues to review and bid to acquire a substantial amount of performing discounted loans and, to a lesser extent, non-performing discounted loans. There can be no assurance, however, that the Company will be able to continue to acquire discounted loans in the future at either the same volumes or the same level of discounts as experienced in the past. Moreover, the significant earnings achieved by the Company on the discounted loan portfolio in recent periods may be attributable in part to early resolution of the least difficult non-performing loans in acquired pools. As a result, there can be no assurance that the level of earnings on discounted loans experienced by the Company to date are necessarily indicative of the results to be experienced in future periods or that there will not be substantial periodic variations in the results from such activities. Prior to entering the discounted loan business, management of the Company, particularly, Chairman D. Andrew Beal, had loan acquisition and resolution and real estate management experience. His experience assisted the Company in developing the procedures and systems which are necessary to evaluate and acquire discounted loans and to resolve such loans in a timely and profitable manner. All reviews of discounted loans are initially performed through Loan Acceptance Corporation ("LAC"), a wholly owned subsidiary of the Bank, of which D. Andrew Beal is President. LAC places bids on pools of discounted loans in anticipation of assigning its interest in the loan pool to the Bank following acceptance of its bid. All purchases by the Bank are made within the parameters set by the Board of Directors of the Bank for loan purchases and originations, as discussed below. Although the Company has focused in prior years on the acquisition of discounted loans, in 1998 the Company began focusing on increasing its origination of multi-family and commercial real estate, as well as construction, development and land loans. This effort is being managed by President Meek. President Meek is a former executive officer of a real estate management company responsible for a national portfolio of income producing properties. Previously, he also had served in various executive capacities with large financial institutions with responsibility for the origination of multi-family and commercial real estate loans, as well as real estate development and sales activities. Since joining the Company in 1996, Mr. Meek has focused on the resolution of non-performing discounted loans. Consistent with the intent of the executive bonus plan entered into between Mr. Meek and the Company in February, 1998, Mr. Meek is focusing on the Company's multi-family and commercial real estate, construction, development and land lending origination platform in order to increase the Company's loan originations. The Company believes that the expertise of Mr. Meek and its other officers with respect to these higher yielding loans may result in the origination of loans where the Company may receive not only a stated fixed or adjustable interest rate, but, especially with respect to construction, development and land loans, also a percentage of gross revenues or a percentage of the proceeds received upon the sale of the property securing repayment of the loan. See also "- Multi-Family and Commercial Real Estate Lending" and "Construction, Development and Land Lending." The Bank's Junior Loan Committee, comprised of President Meek, Executive Vice President Farmer, Senior Vice President-Lending Saurenmann, Senior Vice President - Commercial Loans Enright and Vice President - Loan Servicing O'Neal may approve loan originations and purchases when the net book value is $250,000 or less. With respect to a modification or extension of any existing loans, the Junior Loan Committee may approve when the (total amount due from the borrower including accrued but unpaid interest, and related fees and expenses) (the "Borrower Balance") is $250,000 or less. (Any three members shall constitute a quorum.) The Bank's Senior Loan Committee, comprised of Chairman Beal, President Meek, Executive Vice President Farmer, Senior Vice President - Lending Saurenmann and Senior Vice President - Commercial Loans Enright, may approve all loan purchases and originations from $250,000 to $1.0 million in net book value. In addition, this committee may approve a modification or extension of an existing loan when the Borrower Balance is from $250,000 to $1.0 million. (Any three members shall constitute a quorum.) 10 The Bank's Executive Loan Committee, comprised of Chairman Beal, President Meek and Directors Blanton, Fults, Goldstein and Weinstein (with Directors Farmer, Arnold and Eastland substituting for a missing member) may approve, with at least three affirmative votes, all loan purchases and originations in excess of $1.0 million in net book value. In addition, this committee may approve a modification or extension of an existing loan with a Borrower Balance, in excess of $1.0 million. Notwithstanding the above, full Bank Board approval is required for all purchases of non-performing assets which would result in the Bank's ratio of classified assets to total capital exceeding or projected to exceed 70% at any month-end. (A quorum is defined as four members, two of which must be non-officer Directors.) Loan sales, sales of foreclosed assets and other significant loan related transactions are approved in accordance with written policies requiring approval by a designated officer, two officers or by an appropriate Committee based on the type of transaction and the Borrower Balance of the asset. Originations, Purchases and Sales of Mortgage Loans. For the year ended December 31, 1997, the Company purchased $130.4 million of loans, net of discount compared to $308.0 million, $524.7 million, and $346.2 million net of discounts, during the twelve months ended December 31, 1996 and the years ended June 30, 1996 and 1995, respectively, and originated $76.6 million of loans for the year ended December 31, 1997, compared to $132.5 million, $138.4 million and $76.4 million during the twelve months ended December 31, 1996 and the year ended June 30, 1996 and 1995, respectively. The Company services $838.5 million of its gross loan portfolio directly, including virtually all of its multi-family and commercial real estate loans, construction and land loans. The Company relies on approximately 140 other entities to service the remaining $309.5 million of its gross loans. Of this amount, at December 31, 1997, six entities individually service loans in excess of $9.8 million, aggregating $213.0 million, or 68.8% of the Company's loans serviced by others. No other entity services individually in excess of $6.4 million of the Company's gross loan portfolio. The Company attempts to consolidate the loan servicing when feasible, taking into consideration the relative costs and performance of the servicing entity. 11 The following table shows the loan origination, purchase, sale and repayment activities of the Company for the periods indicated. Twelve Months Year Ended Ended Year Ended June 30, December 31, December 31, ------------------- ------------- ------------ 1995 1996 1996 1997 --------- --------- ------------- ------------ Originations by type: Adjustable rate: Real estate - one- to four-family.................. $ 240 $ -- $ 2,013 $ --- - multi-family....................... 529 2,452 4,835 4,684 - commercial......................... 9,687 3,942 4,438 4,651 - construction or development........ 53,840 97,887 97,174 47,342 - land............................... 5,625 17,534 7,700 --- Commercial Business............................... 3,400 780 --- 5,000 -------- -------- -------- -------- Total adjustable-rate....................... 73,321 122,595 116,160 61,677 Fixed rate: Real estate - one- to four-family.................. --- --- --- --- - multi-family....................... --- 1,236 485 --- - commercial......................... --- 10,198 12,369 2,147 - land............................... --- 1,312 --- 10,785 Consumer - one- to four-family junior liens........ --- 42 42 --- - other.............................. --- 3,032 2,935 1,984 Commercial Business................................ 3,093 17 517 --- Total fixed-rate............................ 3,093 15,837 16,348 14,916 Total loans originated...................... 76,414 138,432 132,508 76,593 Purchases: Real estate - one- to four-family.................. 253,107 82,291 40,095 9,166 - multi-family....................... 68,512 314,616 206,066 24,740 - commercial......................... 52,474 226,495 100,978 112,873 - construction....................... --- --- --- 716 - land............................... 25,563 62,074 10,412 8,233 Consumer - one- to four-family - junior liens..... 21,251 34,947 38,829 520 - other.............................. 1,123 5,105 116 14 Commercial business................................ 33,426 7,223 12,418 1,447 ------- ------- ------- ------ Total loans purchased, gross................ 455,456 732,751 408,914 157,709 Purchase discounts................................. 109,284 208,078 100,900 27,291 ------- ------- ------- ------ Total loans purchased, net.................. 346,172 524,673 308,014 130,418 Percentage of purchase discounts to total gross loans purchased................... 24.0% 28.4% 24.7% 17.3% ------- ------- ------- ----- Sales and Repayments: Real estate - one- to four-family.................. 52,257 1,886 1,002 --- - multi-family....................... 7,283 5,644 9,698 --- - commercial......................... 2,616 3,102 2,498 --- Consumer - one- to four-family - junior liens..... 5,007 --- 3 --- Commercial business................................ --- --- --- --- ------- ------- ------- -------- Total loans sold............................ 67,163 10,632 13,201 --- Principal repayments.............................. 70,131 258,197 330,819 333,592 -------- -------- -------- --------- Total sales and repayments.................. 137,294 268,829 344,020 333,592 Other reductions: Transfers to real estate owned.............. 7,725 22,118 41,876 83,144 Unearned discounts.......................... (19,327) (38,926) (52,946) (44,673) Decrease in other items, net................ 24,506 277 1,734 2,596 -------- -------- -------- --------- Net Increase (decrease)........................... $272,388 $410,807 $105,838 $(167,648) -------- -------- -------- --------- -------- -------- -------- --------- 12 Acquisition of Discounted Loans. Many of the discounted loans purchased by the Company are performing loans. In order to determine the amount that it will bid to acquire performing discounted loans, the Company considers, among other factors, the yield expected to be earned, the geographic location of the loans, servicing restrictions, if any, the type and value of the collateral securing the loan and the length of time during which the loan has performed in accordance with its repayment terms. In order to determine the amount that it will bid to acquire non-performing discounted loans, in addition to the factors stated above, the Company estimates the amounts it will realize through its collection efforts or foreclosure and sale of the security property, net of expenses, and the length of time and costs required to complete the collection or foreclosure process. Prior to acquiring a pool of loans, LAC utilizes primarily third-party subcontractors to conduct an acquisition review of each loan pool. This review includes an evaluation of the seller's representations and warranties and of the adequacy of the applicable loan documentation (e.g., the existence of a note, including confirmation of the interest rate and outstanding loan balance, mortgage, title policy, borrower financial statements, tax returns, environmental reports, etc.). The current value of the security property is estimated utilizing various methods, considering, among other factors, the type of property, the loan balance, the recourse nature of the debt, the age and performance of the loan, and the resources of the borrower. For example, a performing, well seasoned pool of single family loans may receive a relatively limited collateral value review consisting of a drive by appraisal of select properties by a local broker, or in some cases, obtaining multiple broker opinions of value on all loans in the pool. As the value and complexity of the property increases, LAC's efforts to value the property also increase. For larger, more complex loans, LAC personnel may visit the collateral property, conduct an internal rental analysis of competing properties, or order asset searches on the borrowers and/or guarantors to identify other sources of repayment. New title searches and tax reports may also be obtained. LAC may also retain environmental consultants to review potential environmental issues. The amount of resources devoted to valuing collateral property is determined on a case by case basis for each pool acquired. An estimated value is prepared for each loan or pool of loans. The factors considered by LAC include the current status of the loan and the borrower (including payment history, bankruptcy and litigation considerations) taxes due, and, if non-performing, estimated foreclosure costs and length of time to conduct a foreclosure sale in the applicable state, estimated current market value of the property based on a limited marketing period, costs of taxes and insurance and maintenance of the property during the marketing period and fees and other costs incurred in connection with the sale of the property. The resulting price to be bid by LAC is generally at a discount from both the principal balance of the loan and the estimated value of the underlying collateral. All bids are prepared by or subject to the approval of LAC's President, D. Andrew Beal. If LAC is the successful bidder, a bid deposit, if required, will be forwarded to the selling entity. Prior to a loan being acquired, the Company's lending personnel, supplemented if necessary or appropriate by subcontractors, (generally different than the ones who conducted the initial evaluation review) perform a more in-depth review of the loan documents to determine and categorize the extent of loan documentation deficiencies and review LAC's analysis of value. The Company reviews loans by conducting a comprehensive inspection of all documentation relating to the loans and by obtaining current credit reports, when appropriate. Depending on the circumstances, the Company's due diligence team may use local counsel and engineering and environmental experts, to assist in the evaluation and verification of this information and the gathering of other information not previously made available by the seller. For example, there may be maintenance and occupancy problems associated with the collateral which this additional review may reveal. Based upon the review performed by the Company's lending personnel, a recommendation is made to the appropriate Company loan committee which determines whether the Company should purchase the loans covered by the bid. In the event that the Company's applicable loan committee declines to purchase the loans, the right to purchase may be sold to a third party or LAC may forfeit its deposit or be subject to additional penalties as set forth in the contract, including the remedy of specific performance. Upon purchase, each loan file is then reviewed by the loan servicing department to ensure the adequacy and completeness of the documentation securing the Company's interest in the underlying collateral and to correct loan documentation, and as appropriate, other file deficiencies. Large loans are assigned to a loan officer. Loan resolution alternatives for non-performing loans consist primarily of the following: (i) the borrower brings the loan current in accordance with original or modified terms, (ii) the borrower repays the loan, (iii) the Company sells the loan to a 13 third party to resolve, (iv) the borrower agrees to deed the property to the Company in lieu of foreclosure, in which case it is classified as a foreclosed asset and held for sale by the Company, and (v) the Company forecloses on the loan and the property is either acquired at the foreclosure sale by a third party or by the Company, in which case it is classified as a foreclosed asset owned and held for sale by the Company. The loan officer evaluates all available information and pursues the best expected means of resolving the loan on the Company's behalf. In this regard, because the Company generally acquires the loan at a substantial discount from the outstanding principal balance of the loan and the value of the underlying collateral, the Company has the ability to modify the loan terms or otherwise make concessions to a borrower in the loan resolution process and still meet or exceed the targeted return to the Company. In the event of the bankruptcy of the borrower, the loan officer works closely with the Company's outside counsel. The loan officer determines the appropriate course of action, such as filing a proof of claim, moving to have the stay lifted or establishing procedures for monitoring the bankruptcy plan. The loan officer may also order property inspections and ensures that a current broker's opinion or appraisal is in the loan file. Property inspections continue until the loan is brought current or refinanced or the property is sold. A current broker's opinion of value is confirmed or an appraisal is also obtained prior to any foreclosure sale for bidding purposes. If a security property becomes a foreclosed asset, the Company obtains a new appraisal unless a current acceptable appraisal is available. The Company then determines whether any repairs should be made to the property and the initial price to list the property under circumstances which are intended to result generally in a quick sale of the property. The Company then markets the property and supervises the management of the property until it is sold. The Company also generally retains a management firm to manage its commercial and multi-family foreclosed assets. For information about the Company's foreclosed assets, see "- Loan Delinquencies and Non-Performing Assets." The Company generally anticipates a three to eighteen month period to resolve large non-performing commercial and multi-family real estate loans, which is longer than it generally takes to resolve the Company's discounted non-performing single-family residential loans due to the complexity and wide variety of issues that may occur with respect to a delinquent commercial or multi-family real estate loan. Unlike single-family residential loans, however, commercial and multi-family real estate loans frequently provide some income to the Company, which may be the case even in a bankruptcy situation if a receiver has been appointed for the property. One- to Four-Family Residential Mortgage Lending. At December 31, 1997, the Company's one- to four-family residential mortgage loans totaled $213.6 million, or 18.6% of the Company's gross loan portfolio. At that date, the Company's net one- to four-family residential mortgage loan portfolio totaled $176.4 million, or 19.9% of the Company's net loan portfolio. The Company generally does not originate one- to four-family residential loans other than loans made to facilitate the sale of foreclosed assets, however, the Company has purchased such loans from correspondent financial institutions and brokers. Consistent with its asset/liability objectives, the Company may sell a portion of the purchased one- to four-family residential mortgage loans to the FNMA and other secondary market purchasers after the loan files have been reviewed and deficiencies corrected by Bank personnel to ensure loan documentation complies with the purchaser's standards. Multi-Family and Commercial Real Estate Lending. Although the Company has historically originated a limited amount of loans for the purchase, construction, refurbishing and development of commercial and multi-family real estate, the Company has recently begun to focus on increasing originations of these loans. Substantially all of the multi-family and commercial real estate loans originated by the Company are secured by properties located in the Company's primary market area and within the state of Texas. At December 31, 1997, $337.8 million, or 29.4% of the Company's gross loan portfolio, consisted of 855 loans secured by commercial real estate and $321.4 million, or 28.0% of the Company's gross loan portfolio, consisted of 478 loans secured by multi-family residential properties. At that date, $263.7 million, or 29.7% of the Company's net loan portfolio, consisted of loans secured by commercial real estate and $233.0 million, or 26.3% of the Company's net loan portfolio, consisted of loans secured by multi-family residential properties. 14 Included in the multi-family residential portfolio are 56 loans aggregating $164.0 million in gross principal amount at December 31, 1997 ($103.9 million net of purchase discount). These loans were purchased from HUD primarily in three purchases occurring in October 1995, September 1996 and December 1996. All of these HUD Loans are secured by first mortgage liens. In addition, the Company has second mortgage liens on two of these properties. Properties which secure the HUD loans are located in 22 states throughout the country. The HUD Loans were acquired by HUD pursuant to various insurance programs of the FHA. Under programs of the FHA, a lending institution may assign a defaulted FHA-insured loan to HUD because of an economic hardship on the part of the borrower which precludes the borrower from making the scheduled principal and interest payment on the loan. Once a loan is assigned to HUD, the FHA insurance is paid and the loan is no longer insured. As a result, none of the HUD Loans are insured by the FHA. HUD assistance to borrowers is provided in the form of Provisional Workout Agreements ("PWA") which are forbearance agreements under which the borrower either makes a monthly payment less than or equal to the original monthly payment or makes a monthly payment more than the original monthly payment to make up for arrearages. These agreements vary in duration. Under the terms of the contract governing the sale of the HUD Loans, the Company is obligated to comply with the terms of any PWA until the term of the agreement expires or is canceled pursuant to its terms or there is a default under the PWA. The terms of commercial and multi-family real estate loans originated by the Company are individually negotiated on a case by case basis, however, these loans generally have terms ranging up to seven years with adjustable rates of interest. Rates on these loans generally float with changes in the prime rate. Such loans generally do not contain caps on the maximum amount of interest which may be charged over the term of the loan but may contain a floor below which the interest rate on the loan may not fall. In addition to the payment of principal and interest on these loans, the Company may receive an additional fee or a share in the profits from the project upon the completion of the construction or refurbishment of the underlying property. The Company's commercial and multi-family real estate loans provide for recourse against the security property and, in most circumstances, require the borrower to be personally liable for all or a portion of the loan. Multi-family and commercial real estate loans are generally underwritten in amounts of up to 85% of the lesser of cost or the appraised value of the underlying property. Appraisals on properties securing multi-family and commercial real estate loans originated by the Company are generally performed by an independent fee appraiser designated by the Company before the loan is made. All appraisals on multi-family and commercial real estate loans are reviewed by the Company's management. In addition, the Company's underwriting procedures require verification of the borrower's credit history, financial statements, references and income projections for the property. While the Company continues to monitor both purchased and originated multi-family and commercial real estate loans through its semi-annual asset review process, updated appraisals are not normally obtained after loan purchase or origination unless the Company's asset review process raises questions regarding the value of the collateral. In order to monitor the adequacy of cash flows on income-producing properties, the borrower is notified semi-annually, requesting financial statements and other information from the borrower and guarantor, including but not limited to information pertaining to rental rates and income, maintenance costs and an update of real estate property tax payments. Multi-family and commercial real estate loans generally present a higher level of risk than do loans secured by one- to four-family residences. This greater risk is due to several factors, including the concentration of principal in a limited number of loans and borrowers, the effects of general economic conditions on commercial properties and the increased difficulty of evaluating and monitoring these types of loans. Furthermore, the repayment of loans secured by multi-family and commercial real estate is typically dependent upon the successful operation of the related real estate project. If the cash flow from the project is reduced (for example, if leases are not obtained or renewed), the borrower's ability to repay the loan may be impaired. Commercial real estate loans also involve many of the same risks discussed below regarding construction loans. The Company has attempted to minimize these risks through its underwriting and investment standards and by lending primarily on existing income-producing properties. At December 31, 1997, $163.5 million, or 24.8% of the multi-family and commercial real estate gross loan portfolio, 15 was delinquent 90 days or more, substantially all of which was purchased non-performing. At that date, net non-performing multi-family and commercial real estate loans totaled $145.8 million. Construction, Development and Land Lending. The Company initiated a single-family construction and development lending program in January 1993. In August 1996, the Company decided to cease single-family construction lending while continuing development lending. The Company originates development loans to developers, based on demonstrated experience and financial condition, primarily for the development of single family lots. These loans increase the yield on, and the proportion of interest rate sensitive loans in, the Company's portfolio. At December 31, 1997, development loans totaled $97.6 million or 8.5% of its gross loan portfolio and $79.3 million, net, or 8.9% of the Company's net loan portfolio. At December 31, 1997 the Bank had 11 development loans in excess of $2.0 million, all of which are to develop properties located in Texas, except for one development property located in Southern California. See "Lending Activities General." All of these loans are performing in accordance with their respective repayment terms. At December 31, 1997, the Company's single-family construction loan portfolio totaled approximately $861,000. In addition to development loans, the Company originates and has purchased land loans secured by residential lots and land held for the development of single-family lots and, to a much lesser extent, loans secured by land utilized for agricultural or ranching purposes. As of December 31, 1997, land loans totaled $71.4 million, or 6.2% of the Company's gross loan portfolio. At that date, net land loans totaled $51.4 million, or 5.8% of the Company's net loan portfolio. At December 31, 1997 the Bank has four land loans in excess of $2.0 million, with net balances of $10.6 million, $5.6 million, $4.5 million and $4.1 million, secured by land in the metropolitan areas of Los Angeles and Dallas. All of these loans are performing in accordance with their respective repayment terms. Land loans originated by the Company are generally underwritten in amounts up to 65% of appraised value and typically have terms that are individually negotiated on a case-by-case basis. The majority of land loans have adjustable rates of interest and some may have a profit participation interest. Development and land lending is generally considered to involve a higher level of credit risk than permanent one- to four-family residential lending, due to the concentration of principal in a limited number of loans and borrowers and/or the effects of general economic conditions on development projects, real estate developers, managers or homebuilders. In addition, the nature of these loans is such that they are more difficult to evaluate and monitor. These loans also involve many of the same risks discussed regarding commercial and multi-family loans and tend to be more sensitive to general economic conditions than many other types of loans. The Company's risk of loss on a development loan is dependent largely upon the accuracy of the initial estimate of the property's value upon completion of the project and the estimated cost (including interest) of the project. Because of the uncertainties inherent in estimating developmental costs and the market for the project upon completion, it is relatively difficult to evaluate accurately the total loan funds required to complete a project, the related loan-to-value ratios and the likelihood of ultimate success of the project. If the estimate of development cost proves to be inaccurate, the Company may be required to advance funds beyond the amount originally committed in order to permit completion of the project. If the estimate of value proves to be inaccurate, the Company may be confronted, at or prior to the maturity of the loan, with a project having a value which is insufficient to assure full repayment. When loan payments become due, borrowers may experience cash flow from the property which is not adequate to service total debt. In such cases, the Company may be required to modify the terms of the loan. The Company attempts to mitigate these risks by dealing primarily with experienced developers. In addition the Company monitors the development's progress prior to each draw against the loan. See "- Loan Delinquencies and NonPerforming Assets." At December 31, 1997, there were no single-family construction loans, no development loans and 34 land loans with aggregate gross principal balances of $10.2 million delinquent 90 days or more. At that date, net non-performing land loans totaled $6.2 million. Consumer Lending. The Company's consumer loan portfolio primarily consists of purchased one-to four family junior lien loans, and to a much lesser extent, loans secured by timeshare agreements and other collateral. At December 31, 1997, the gross consumer loan portfolio totaled $80.1 million, or 7.0% of the gross loan portfolio, and was predominately comprised of fixed-rate loans. At that date, net consumer loans totaled $67.5 million, or 7.6% of the Company's net loan portfolio. 16 Prior to May, 1996, the Company indirectly originated and purchased one- to four-family junior lien loans from correspondent financial institutions, brokers and home improvement contractors. Although the loan documentation utilized was the seller's, the Company approved the loan prior to purchase utilizing the Company's underwriting standards and, in the case of home improvement contractors, funded the loan upon assignment. The underwriting standards employed included a determination of the applicant's payment history on other debts and an assessment of the ability to meet existing obligations and payments on the proposed loan. Although creditworthiness of the applicant was a consideration, because these loans were generally made to credit-impaired borrowers, the primary consideration in the underwriting process was a comparison of the value of the security in relation to the proposed loan amount. One- to four-family junior lien loans were generally made at fixed rates for terms of up to 15 years. Generally, such loans did not exceed 90% of the property's appraisal value less the amount owed, if any, on any other mortgages or liens. One- to four-family junior lien loans are secured by a lien on the underlying real estate. The Company required a title search on all one- to four-family junior lien loans. Consumer loans may entail greater risk than do residential mortgage loans, particularly in the case of consumer loans which are unsecured. In some cases, the collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance. In addition, consumer loan collections are dependent on the borrower's continuing financial stability and thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which may be recovered on such loans. At December 31, 1997, there were 981 consumer loans with aggregate gross principal balances of $12.9 million delinquent in excess of 90 days. Commercial Business Lending. At December 31, 1997, the Company had $25.6 million in commercial business loans outstanding, or 2.2% of the Company's gross loan portfolio, all of which were purchased discounted loans. At that date, the Company had $15.6 million of net commercial business loans outstanding, or 1.8% of the Company's net loan portfolio. The Company's loans include loans to finance accounts receivable, inventory and equipment. Management does not currently contemplate any significant increase in the ratio of this portfolio to the Company's total loan portfolio. Unlike residential mortgage loans, which generally are made on the basis of the borrower's ability to make repayment from his or her employment and other income, and which are secured by real property whose value tends to be more easily ascertainable, commercial business loans are of higher risk and typically are made on the basis of the borrower's ability to make repayment from the cash flow of the borrower's business. As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself. Further, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. Foreign Lending Activities. The Company primarily conducted its foreign lending in a subsidiary, 100% owned by Beal Bank, known as Foreign Lending Corporation ("FLC"). As of December 31, 1997, FLC held one loan with a principal balance of $4.6 million. This loan was originated in 1997 under the Company's now discontinued Mexican lending program and is performing in accordance with its loan repayment terms. The Company is not currently seeking any foreign lending opportunities. Should the Bank decide to pursue in the future any foreign lending opportunities, it will require prior written approval from the Texas Department. At December 31, 1997, the Company had less than $1.8 million in principal balance of loans that were originated in the United States which are primarily secured by the right to use time-share properties located in various countries. 17 Loan Delinquencies and Non-Performing Assets When a borrower fails to make a required payment on a loan, the Company attempts to cause the delinquency to be cured by contacting the borrower. A past due notice is sent when the loan is 10 days past due. A delinquency notice is sent 15 days after the due date and a late charge is assessed in accordance with the loan terms. If the delinquency is not cured by the 30th day, a default warning is sent to the borrower. Other written and verbal contacts may be made with the borrower between five and 90 days after the due date. If the delinquency continues for a period of 90 days, the Company usually institutes appropriate action to foreclose on the property. If foreclosed, the property is sold and may be purchased by the Company. Delinquent consumer loans are handled in a generally similar manner. The Company's procedures for repossession and sale of consumer collateral are subject to various requirements under the consumer protection laws of the applicable state. The following table sets forth the Company's loan delinquencies by type, by amount and by percentage of type at December 31, 1997. Loans Delinquent For: -------------------------------------------------------------- 60-89 Days 90 Days and Over Total Delinquent Loans -------------------------------- --------------------------- ------------------------------ Percent Percent Percent of Loan of Loan of Loan Number Amount Category Number Amount Category Number Amount Category ------ ------ -------- ------ ------ -------- ------ ------ --------- (Dollars in Thousands) Real Estate: One- to four-family - first liens ....... 104 $ 3,281 1.54% 495 $ 18,292 8.56% 599 $ 21,573 10.10% Commercial .......... 12 2,725 .81 81 39,085 11.57 93 41,810 12.38 Multi-family ........ 4 901 .28 54 124,394 38.70 58 125,295 38.98 Construction or development ....... 1 365 .37 -- -- -- 1 365 .37 Land ................ 5 780 1.09 34 10,223 14.32 39 11,003 15.41 --- ----- --- --- ------- ----- --- ------- ----- Total real estate . 126 8,052 .77 664 191,994 18.41 790 200,046 19.19 Other Loans: Consumer Loans: One- to four-family - junior lien ....... 57 861 1.20 595 11,347 15.88 652 12,208 17.08 Timeshares .......... 11 26 .72 355 1,026 28.38 366 1,052 29.10 Other ............... 5 30 .60 31 519 10. 37 36 549 10.97 --- ----- --- --- ------- ----- --- ------- ----- Total consumer loans 73 917 1.15 981 12,892 16.10 1,054 13,809 17.24 Commercial business ... 4 78 .31 51 7,554 29.56 55 7,632 29.87 Total other loans .. 77 995 .94 1,032 20,446 19.35 1,109 21,441 20.30 Total loans ........ 203 9,047 .79 1,696 212,440 18.50 1,899 221,487 19.29 Less: Unearned discounts .... 1,536 82,508 84,044 Total Loans, net .. $ 7,511 .85% $ 129,932 14.63% $137,443 15.48% -------- ----------- -------- -------- ----------- -------- At December 31, 1997, the Company's non-performing loans included 229 loans aggregating $18.0 million for which foreclosure proceedings had been commenced. At that date, 439 loans involved borrowers involved in bankruptcy proceedings representing approximately $73.5 million of delinquent loans in the Company's loan portfolio. 18 The following table sets forth the amounts and categories of non-performing assets in the Company's loan portfolio. Loans are placed on non-accrual status when the collection of principal and/or interest become doubtful. Such loans remain on non-accrual status until the earlier of legal foreclosure, or relinquishment of control of the collateral by the borrower, or the collection of principal or interest is no longer doubtful. For all years presented, the Company has had no troubled debt restructurings (which involve forgiving a portion of interest or principal on any loans below net book value or making loans at a rate materially less than that of market rates). Foreclosed assets include assets acquired in settlement of loans. June 30, December 31, -------- ------------ 1993 1994 1995 1996 1996 1997 ---- ---- ---- ---- ---- ---- (Dollars in Thousands) Non-accruing loans: Real estate: One- to four-family..................... $ 1,732 $ 3,185 $11,093 $ -- $ -- $ 18,292 Commercial.............................. 248 14,492 16,816 35,004 59,903 37,345 Construction or development............. --- --- 93 156 --- --- Multi-family............................ 580 4,883 9,507 51,934 174,046 108,493 Land.................................... 2,433 3,282 8,056 7,961 4,687 6,245 Consumer: One- to four-family - junior liens...... 193 1,185 2,850 10,157 13,863 11,347 Timeshares.............................. 554 1,019 1,673 1,630 1,624 1,026 Other consumer.......................... 525 476 545 641 1,835 519 Commercial business....................... 78 2,320 7,357 7,777 9,562 7,554 Purchase discounts...................... (1,864) (14,063) (22,011) (59,978) (122,283) (77,827) ------- ------- ------- -------- -------- -------- Total (net)......................... 4,479 16,779 35,979 55,282 143,237 112,994 Accruing loans delinquent more than 90 days: Real estate: One- to four-family..................... --- 583 --- 21,159 30,382 --- Multi-family............................ --- 106 --- 55,247 30,318 1,740 Commercial.............................. 200 77 --- 17,811 23,818 15,901 Land.................................... --- --- --- 5,444 4,760 --- Consumer: One to four-family - junior liens....... --- 80 --- --- --- 3,978 Purchase discounts...................... (62) (347) --- (32,363) (29,221) (4,681) ------- ------- ------- -------- -------- -------- Total (net)......................... 138 499 --- 67,298 60,057 16,938 Foreclosed assets: Real estate: One- to four-family..................... 651 481 1,525 1,799 4,858 5,379 Commercial.............................. 302 1,456 3,026 9,148 13,466 41,341 Multi-family............................ --- --- 3,633 15,010 24,781 64,461 Construction or development............. 1,987 --- --- 300 250 245 Land.................................... --- 365 570 1,456 872 2,867 Consumer: Timeshares.............................. --- --- 36 32 402 21 -- -- Total (net)......................... 2,940 2,302 8,790 27,745 44,629 114,314 ------- ------- ------- -------- -------- -------- Total non-performing assets............... $ 7,557 $19,580 $44,769 $150,325 $247,923 $244,246 ------- ------- ------- -------- -------- -------- ------- ------- ------- -------- -------- -------- Total as a percentage of total assets..... 6.36% 7.95% 7.07% 11.84% 17.77% 17.88% ------- ------- ------- -------- -------- -------- ------- ------- ------- -------- -------- -------- 19 For the year ended December 31, 1997 gross interest income which would have been recorded had the non-accruing loans been current in accordance with their original terms amounted to $13.6 million. The amount that was included in interest income on such loans was $8.8 million for the year ended December 31, 1997. Other Loans of Concern. In addition to the non-performing assets set forth in the previous table, as of December 31, 1997 the Company had approximately 16 loans totaling $10.7 million of net loans, of which $10.3 million, net, are commercial and multi-family real estate loans, with respect to which known information about the possible credit problems of the borrowers or the cash flows of the security properties have caused management to have concern as to the ability of the borrowers to comply with present loan repayment terms and which may result in the future inclusion of such items in the non-performing asset categories. The largest other loan of concern totaled $1.6 million, net, at December 31, 1997. Classified Assets. The FDIC requires the classification of a savings bank's problem assets. Management of the Company classifies all problem assets as "substandard," "doubtful" or "loss." An asset is considered "substandard" if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. "Substandard" assets include those characterized by the "distinct possibility" that the insured institution will sustain "some loss" if the deficiencies are not corrected. An asset may also be classified substandard if no loss is expected, however, the time it will take to resolve the deficiency is uncertain. Assets classified as "doubtful" have all of the weaknesses inherent in those classified "substandard," with the added characteristic that the weaknesses present make "collection or liquidation in full," on the basis of currently existing facts, conditions, and values, "highly questionable and improbable." Assets classified as "loss" are those considered "uncollectible" and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. When the Company classifies problem assets as either substandard or doubtful, it may establish general allowances for loan losses in an amount deemed prudent by management. General allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When the Company classifies problem assets as "loss," it will charge off such amount. The Company reviews its asset portfolio and classifies certain assets semi-annually. In addition, the Company's determination as to the classification of its assets and the amount of its valuation allowances is reviewed by the Texas Department and the FDIC during their examinations of the Company, which may result in the establishment of additional general or specific loss allowances. The Company reviews the problem loans and other assets to determine whether any loans or other assets require classification on a monthly basis. Net classified assets of the Company as of the date indicated were as follows: December 31, 1997 ---------------------- (Dollars In Thousands) Substandard ......................................... $102,699 Doubtful ............................................ 1,525 -------- Total Classified Assets ........................ $104,224 -------- -------- Allowance for Loan Losses. The allowance for loan losses is established through provisions for loan losses based on management's evaluation of the risk inherent in its loan portfolio and changes in the nature and volume of its loan activity. Such evaluation includes a review of the loan portfolio including those loans of which full collectibility may not be reasonably assured, current economic conditions, historical loan loss experience, loan volume and growth, the composition of the loan portfolio and other factors that warrant recognition in providing for an adequate allowance for loan losses. The Company also developed certain asset review policies and procedures which established minimum general loan loss reserves for all types of loans. In determining the general reserves under these policies historical charge-offs and recoveries, changes in the mix and levels of the various types of loans, fair values, 20 the current loan portfolio and current economic conditions are considered. These policies also require additional reserves for all delinquent and classified loans. See "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations." The Company establishes a specific allowance against a given loan when management perceives a problem in that loan that may result in a loss. The Company continues to monitor and modify its allowances for general and specific loan losses as economic conditions dictate. Although the Company maintains its allowance for loan losses at a level which it considers to be adequate to provide for potential losses, there can be no assurances that such losses will not exceed the estimated amounts. In addition, various regulatory agencies periodically review the allowance for loan losses and may require that additions be made based upon their judgment of information available to them at the time of their examination. Real estate properties acquired through, or in lieu of loan foreclosure are initially recorded at fair value less estimated cost to sell at date of foreclosure. Valuations are periodically performed by management and an allowance for losses is established by a charge to operations if the carrying value of a property exceeds its estimated net realizable value. 21 The following table sets forth an analysis of the Company's allowance for loan losses at the dates indicated. Twelve Months Year Ended Ended Year Ended June 30, December 31, December 31, -------------------------------- ------------ ------------ 1993 1994 1995 1996 1996 1997 ---- ---- ---- ---- ---- ----- Balance at beginning of period.............. $550 $1,245 $3,547 $ 6,137 $ 10,406 $13,189 Charge-offs: One- to four-family....................... 30 174 440 845 1,366 2,177 Commercial................................ --- 36 534 28 232 740 Multi-family.............................. --- --- --- 80 90 --- Construction and development.............. --- --- --- 35 --- --- Land...................................... --- 203 39 362 60 687 Consumer.................................. 59 173 449 858 805 1,169 Commercial business....................... --- --- --- 1,177 1,121 183 ------- ------ -------- ------- ---------- --------- 89 586 1,462 3,385 3,674 4,956 Recoveries: One- to four-family....................... --- --- 2 1 --- 112 Consumer.................................. --- --- 5 18 32 157 Commercial business....................... --- --- --- 17 3 --- -------- ------ -------- -------- ----------- ---------- Net charge-offs............................. 89 586 1,455 3,349 3,639 4,687 Additions charged to operations............. 784 2,888 4,045 9,044 6,422 3,410 ------- ------- ------- -------- --------- -------- Balance at end of period.................... $1,245 $ 3,547 $6,137 $11,832 $13,189 $11,912 ====== ======= ====== ======= ======= ======= Ratio of net charge-offs during the period to average loans outstanding during the period......................... .11% .40% .40% .44% .38% .49% Ratio of net charge-offs during the period to average non-performing assets..... 1.80% 4.32% 4.52% 2.95% 1.84% 1.96% 22 The distribution of the Company's allowance for loan losses at the dates indicated is summarized as follows: June 30, ----------------------------------------------------------------------------------------------- 1993 1994 1995 ------------------------------ ------------------------------ ------------------------------- Percent Percent Percent of Loans of Loans of Loans Loan in Each Loan in Each Loan in Each Amount of Amounts Category Amount of Amounts Category Amount of Amounts Category Loan Loss by to Total Loan Loss by to Total Loan Loss by to Total Allowance Category Loans Allowance Category Loans Allowance Category Loans --------- -------- -------- --------- -------- -------- --------- -------- -------- (Dollars In Thousands) One- to four-family ........ $ 114 $ 62,540 42.52% $ 90 $ 67,169 21.81% $1,881 $237,585 35.70% Multi-family ............... 110 20,675 14.06 139 55,633 18.07 604 109,080 16.39 Commercial real estate ..... 216 30,271 20.58 303 93,496 30.37 1,276 124,985 18.78 Construction and development 17 3,893 2.65 50 27,100 8.80 88 51,284 7.71 Land ....................... 101 7,089 4.82 81 9,889 3.21 474 35,997 5.41 One- to four-family junior liens ..................... 92 9,993 6.80 29 19,549 6.35 577 44,999 6.76 Timeshares ................. -- 1,599 1.09 -- 18,249 5.93 595 11,668 1.75 Other consumer ............. 200 3,747 2.55 151 7,139 2.32 266 4,791 .72 Commercial business ........ 200 7,253 4.93 151 9,662 3.14 376 45,060 6.78 Unallocated ................ 195 -- -- 2,553 -- -- -------- -------- ------ -------- ------- ----- ------ ------- ----- Total ................. $ 1,245 147,060 100.00 $ 3,547 307,886 100.00% $6,137 665,449 100.00% -------- ------ -------- ------ ------ ------- -------- ------ -------- ------ ------ ------- Less: Loans in process ......... 1,558 11,235 21,217 Loans held for sale, net . -- -- 866 Deferred fees and discounts .............. 43,447 73,190 144,927 Allowance for loan losses 1,245 3,547 6,137 ----- ----- ----- Total loans receivable, net ..... $100,810 $219,914 $ 492,302 -------- -------- --------- -------- -------- --------- June 30, December 31, -------------------------------- ---------------------------------------------------------------- 1996 1996 1997 -------------------------------- ------------------------------- ------------------------------- Percent Percent Percent of Loans of Loans of Loans Loan in Each Loan in Each Loan in Each Amount of Amounts Category Amount of Amounts Category Amount of Amounts Category Loan Loss by to Total Loan Loss by to Total Loan Loss by to Total Allowance Category Loans Allowance Category Loans Allowance Category Loans --------- -------- -------- --------- -------- -------- --------- -------- --------- One- to four-family ........ $ 3,153 $ 273,780 22.47% $ 3,183 $ 276,591 19.37% $ 4,051 $ 213,584 18.60% Multi-family ............... 239 341,696 28.05 1,157 466,697 32.68 1,316 321,423 27.99 Commercial real estate ..... 2,788 321,385 26.38 2,706 388,460 27.20 1,986 337,825 29.42 Construction and development 19 85,133 6.99 7 74,437 5.21 16 98,503 8.58 Land ....................... 752 100,047 8.21 596 95,684 6.70 898 71,379 6.22 One- to four-family junior liens ...................... 1,873 50,146 4.12 1,680 77,528 5.43 1,756 71,465 6.22 Timeshares ................. 374 7,809 .64 372 6,446 .45 642 3,615 .31 Other consumer ............. 1,138 8,373 .69 1,135 7,095 .50 684 5,003 .43 Commercial business ........ 1,496 29,886 2.45 2,353 35,131 2.46 563 25,554 2.23 Unallocated ................ -- -- -- -- -- -- -- -- -- ------- --------- ------ ------- --------- ------ ------- ---------- ------ Total .... $11,832 1,218,255 100.00% $13,189 1,428,069 100.00% $11,912 $1,148,351 100.00% -------- ------ -------- ------ ------ ------- -------- ------ -------- ------ ------ ------- Less: Loans in process ......... 27,172 16,364 16,806 Loans held for sale, net . -- -- -- Deferred fees and discounts .............. 281,837 344,312 231,800 Allowance for loan losses 11,832 13,189 11,912 -------- ---------- ----------- Total loans receivable, net ..... $897,414 $1,054,204 $ 887,833 -------- ---------- ----------- -------- ---------- ----------- 23 Investment Activities General. The investment policy of the Company, which is established by the Investment Committee and approved by the Company's and Bank's Board of Directors, is designed primarily to provide a portfolio of high quality, diversified instruments while seeking to optimize net interest income within acceptable limits of interest rate risk, credit risk and liquidity. Generally, the investment policy of the Company is to invest funds in interest-bearing deposits in banks, FHLB overnight deposits, FHLB of Dallas stock and Government National Mortgage Association ("GNMA") securities based upon the Company's liquidity needs and performance objectives. It is the Company's general policy to purchase investment securities which are U.S. Government securities and federal agency obligations and other issues rated investment grade. The Bank must maintain minimum levels of investments that qualify as liquid assets under the Texas Department regulations. Liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to the return on loans. The Bank maintains its liquidity at a level believed adequate to meet requirements of normal daily activities, repayment of maturing debt and potential deposit outflows. Cash flow projections are regularly reviewed and updated to assure that adequate liquidity is maintained. At December 31, 1997, the Bank's liquidity ratio was 19.1%. See "Regulation Liquidity." Texas-chartered savings banks have the authority to invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, certain certificates of deposit of insured banks and savings institutions, certain bankers' acceptances, repurchase agreements and federal funds. Subject to various restrictions, Texas- chartered savings banks may also invest their assets in commercial paper, investment grade corporate debt securities and mutual funds whose assets conform to the investments that a Texas- chartered savings bank is otherwise authorized to make directly. The following table sets forth the composition of the Company's investment in FHLB Stock, interest-bearing deposits with banks and mortgage-backed securities at the dates indicated. June 30, December 31, -------------------------------------- --------------------------------------- 1995 1996 1996 1997 --------------- ----------------- ----------------- --------------- Book % of Book % of Book % of Book % of Value Total Value Total Value Total Value Total ----- ----- ----- ----- ----- ----- ------ ----- (Dollars in Thousands) FHLB stock ................. $ 7,475 100.0% $ 9,340 100.00% $ 9,618 100.00% $10,203 100.00% ------- ----- --------- ------ ---------- ------ ------- ------ ------- ----- --------- ------ ---------- ------ ------- ------ Interest-bearing deposits with banks .............. $31,044 100.00 $ 54,838 100.00% $ 65,491 100.00% $150,219 100.00% ------- ------ --------- ------ --------- ------ -------- ------ ------- ------ --------- ------ --------- ------ -------- ------ Mortgage-backed securities: GNMA ....................... $40,184 98.70% $ 199,429 102.43% $ 125,386 101.17% $110,079 98.84% Gross unrealized gain (loss) -- -- (1,328) (.68) 1,090 .88 3,722 3.34 Unamortized premium (discount) .............. 530 1.30 (3,402) (1.75) (2,537) (2.05) (2,425) (2.18) ------- ------ --------- ------ --------- ------ -------- ------ Total mortgage-backed securities ........... $40,714 100.00% $ 194,699 100.00% $ 123,939 100.00% $111,376 100.00% ------- ------ --------- ------ --------- ------ -------- ------ ------- ------ --------- ------ --------- ------ -------- ------ The Company's investment securities portfolio at December 31, 1997, contained neither tax-exempt securities nor securities of any issuer with an aggregate book value in excess of 10% of the Company's stockholders' equity, excluding those issued by the United States Government, or its agencies. 24 Sources of Funds General. Beal Financial's primary source of funds are dividends which may be paid by the Bank. In addition, Beal Financial has the ability to access the capital markets, if necessary. The Bank's primary sources of funds are deposits, amortization and prepayment of loan principal, borrowings, and funds provided from operations and, from time to time, sales of assets. Management of the Bank closely monitors rates and terms of competing sources of funds on a regular basis and generally utilizes the sources which are the most cost effective. Borrowings, predominantly from the FHLB of Dallas, may be used on a short-term basis to compensate for reductions in deposits or deposit inflows at less than projected levels, and may be used on a longer-term basis to support expanded purchasing activities. Deposits. The Bank's deposits consist of statement savings accounts, commercial demand deposit accounts, money market and certificate accounts. Certificates of deposit are the primary source of deposits because they generally are more responsive to market interest rates than other types of deposits, and thus more attractive to depositors. The Bank relies primarily on competitive pricing policies, advertising, and customer service to attract and retain these deposits. In this regard, the Bank generally prices its deposits at or above the highest rates offered by its competitors. In addition to retail deposits, from time to time the Bank obtains wholesale deposits through deposit brokers which solicit funds from their customers for deposit with the Bank. Brokered deposits amounted to $140.8 million or 14.1% of deposits at December 31, 1997. Brokered deposits generally are more responsive to changes in interest rates than retail deposits and, thus, are more likely to be withdrawn from the Bank upon maturity as changes in interest rates and other factors are perceived by investors to make other investments more attractive. Although, the Bank currently does not have any plans to increase its brokered deposits, the amount may vary depending on the Bank's need for liquidity and loan purchase activity. The Bank believes that it competes effectively for deposits; however, the Bank's ability to attract and retain deposits and the Bank's cost of funds have been, and will continue to be, significantly affected by general economic conditions, changes in money market and prevailing interest rates and competition. The rates paid on deposit accounts offered by the Bank have allowed it to be competitive in obtaining funds and to respond with flexibility to changes in consumer demand. The Bank has become more susceptible to short-term fluctuations in deposit flows, as customers have become more interest rate conscious. The Bank manages the pricing of its deposits in keeping with its asset/liability management and profitability objectives. Based on its experience, the Bank believes that its statement savings and money market accounts are relatively stable sources of deposits. However, the ability of the Bank to attract and maintain certificate accounts, and the rates paid on these deposits, has been and will continue to be significantly affected by market conditions. 25 The following table sets forth the dollar amount of savings deposits in the various types of deposit programs offered by the Bank at the dates indicated. June 30, December 31, ---------------------------------------- -------------------------------------- 1995 1996 1996 1997 ------------------- ------------------- ---------------- ------------------- Percent Percent Percent Percent Amount of Total Amount of Total Amount of Total Amount of Total -------- -------- ------ -------- ------ -------- ------ -------- (Dollars in Thousands) Transactions and Savings Deposits: Money Market Accounts................. $ 57,616 12.58% $159,689 17.92$ 188,468 18.06% $169,321 16.91% Commercial Demand..................... 1,522 .33 2,813 .31 2,871 .28 14,272 1.42 Savings Deposits...................... 827 .18 893 .10 653 .06 1,193 .12 -------- ----- ---------- ------ --------- ------- -------- ----- Total Non-Certificates................ 59,965 13.09 163,395 18.33 191,992 18.40 184,786 18.45% -------- ------ --------- ------ --------- ------- ------- ----- Certificates: 2.01 - 4.00%........................ 152 .03 --- --- --- --- 2 --- 4.01 - 6.00%........................ 95,473 20.84 658,279 73.86 687,755 65.91 785,865 78.47 6.01 - 8.00%........................ 301,981 65.91 69,630 7.81 163,688 15.69 30,823 3.08 8.01 - 10.00%....................... 594 .13 --- --- --- --- --- --- --------- ---------------- ------- --------- ------- --------- ------- Total Certificates.................... 398,200 86.91 727,909 81.67 851,443 81.60 816,690 81.55 -------- ------ --------- ------- --------- ------- --------- ----- Total Deposits(1)..................... $458,165 100.00% $891,304 100.00% $1,043,435 100.00 $1,001,476 100.00% -------- ------ --------- ------- --------- ------- --------- ----- -------- ------ --------- ------- --------- ------- --------- ----- (1) At December 31, 1997, the average rates paid on non-certificate deposit accounts and certificate accounts were 4.7% and 5.7%, respectively. The following table sets forth the savings flows at the Bank during the periods indicated. New deposits, net refers to the amount of deposits during a period less the amount of withdrawals during the period. Twelve Months Year Ended Ended December 31, Year Ended June 30, December 31, ------------ ------------------- ------------- 1995 1996 1996 1997 ---- ---- ---- ----- (Dollars in Thousands) Opening balance............................. $186,048 $458,165 $ 985,961 $1,043,435 New deposits, net........................... 267,454 407,482 26,406 (70,120) Interest credited........................... 4,663 25,657 31,068 28,161 -------- -------- ---------- ---------- Ending balance.............................. $458,165 $891,304 $1,043,435 $1,001,476 -------- -------- ---------- ---------- -------- -------- ---------- ---------- Net increase (decrease)..................... $272,117 $433,139 $ 57,474 $(41,959) -------- -------- ---------- ---------- -------- -------- ---------- ---------- Percent increase (decrease)................. 146.26% 94.54% 5.83% (4.02)% -------- -------- ---------- ---------- -------- -------- ---------- ---------- 26 The following table shows rate and maturity information for the Bank's certificates of deposit as of December 31, 1997. 4.00- 6.00- Percent 5.99% 7.99% Total of Total ----- ----- ----- -------- Certificate accounts maturing in quarter ending: March 31, 1998.................... $246,983 $41,140 $288,123 35.28% June 30, 1998..................... 268,205 8,052 276,257 33.83 September 30, 1998................ 145,199 2,832 148,031 18.13 December 31, 1998................. 65,498 446 65,944 8.07 March 31, 1999.................... 4,972 3,152 8,124 .99 June 30, 1999..................... 1,456 426 1,882 .23 September 30, 1999................ 3,333 798 4,131 .51 December 31, 1999................. 2,948 2,520 5,468 .67 March 31, 2000.................... 195 4,046 4,241 .52 June 30, 2000..................... 58 1,004 1,062 .13 September 30, 2000................ 888 772 1,660 .20 December 31, 2000................. 6,610 4,009 10,619 1.30 Thereafter........................ 1,146 2 1,148 .14 ------- --------- -------- ------ Total.......................... $747,491 $69,199 $816,690 100.00% -------- ------- -------- ------ -------- ------- -------- ------ Percent of Total............... 91.53% 8.47% 100.00% ------ ------ The following table indicates the amount of the Bank's certificates of deposit by time remaining until maturity as of December 31, 1997. Maturity -------------------------------------------------------------------- Over Over 3 Months 3 to 6 6 to 12 Over or Less Months Months 12 months Total -------- ------- --------- ---------- ------- (In Thousands) Certificates of deposit less than $100,000....... $134,747 $221,227 $171,228 $25,134 $552,336 Certificates of deposit of $100,000 or more...... 155,050 55,322 40,780 13,202 264,354 --------- ---------- --------- -------- -------- Total certificates of deposit.................... $ 289,797 $276,549 $212,008 $38,336 $816,690 --------- ---------- --------- -------- -------- --------- ---------- --------- -------- -------- Borrowings. Although deposits are the Bank's primary source of funds, the Bank's policy has been to utilize borrowings when they are a less costly source of funds. In addition, the Bank has relied upon selective borrowings for liquidity needs. The Bank obtains FHLB advances upon the security of certain of its residential first mortgage loans, and other assets, including FHLB stock, provided certain standards related to the creditworthiness of the Bank have been met. At December 31, 1997, advances were secured by stock in the FHLB totaling $10.2 million, qualifying first mortgage loans of approximately $132.0 million, other real estate of $3.9 million and GNMA securities of $50.0 million. FHLB advances are available for investment, purchasing and lending activities and other general business purposes. FHLB advances are made pursuant to several different credit programs, each of which has its own interest rate, which may be fixed or adjustable, and range of maturities. At December 31, 1997, the Bank's other borrowings consisted primarily of loans to the Bank's subsidiaries from unaffiliated third party lenders secured by certain real estate held for development or sale. On August 9, 1995, Beal Financial issued $57.5 million of 12.75% Senior Notes due on August 15, 2000 (the "Senior Notes"). Of this amount, $46.3 million was contributed to the Bank in the form of paid in capital. The 27 remaining net proceeds of the Senior Notes were retained by Beal Financial for the maintenance of a reserve equal to the annual interest expense on the Senior Notes and general operating expenses. Interest on the Senior Notes is payable semi-annually on February 15 and August 15 of each year. The Senior Notes are redeemable, in whole or in part at the option of Beal Financial. See Note H to the Notes to Consolidated Financial Statements of the Company. For additional information relating to borrowings, see Notes G and H to the Notes to Consolidated Financial Statements of the Company. At December 31, 1997, FHLB advances totaled $110.0 million, representing 8.1% of total assets. FHLB advances were used for liquidity and loan investment purposes. The following table sets forth the maximum month-end balance and average balance of FHLB advances and other borrowings for the periods indicated. Twelve Months Ended Year Ended Year Ended June 30, December 31, December 31, -------------------- ------------ ------------ 1995 1996 1996 1997 ---- ---- ---- ---- (Dollars In Thousands) Maximum Balance: FHLB advances ... $182,173 $185,000 $185,000 $146,000 Senior notes, net -- 57,051 57,094 57,188 Other borrowings 5,059 61,326 21,756 14,748 Average Balance: FHLB advances ... $123,184 $ 45,052 $ 41,146 $ 19,181 Senior notes, net -- 50,093 57,042 57,141 Other borrowings 2,803 25,894 28,931 10,401 The following table sets forth certain information as to the Company's borrowings at the dates indicated. June 30, December 31, --------------------- ----------------------- 1995 1996 1996 1997 ---- ---- ---- ---- (Dollars in Thousands) FHLB advances ..................................... $111,000 $185,000 $146,000 $110,000 Senior notes, net ................................. -- 57,051 57,094 57,188 Other borrowings .................................. 4,898 21,468 14,748 7,599 -------- -------- -------- -------- Total borrowings ............................. $115,898 $263,519 $217,842 $174,787 -------- -------- -------- -------- -------- -------- -------- -------- Weighted average interest rate of FHLB advances ... 6.67% 5.55% 6.33% 6.65% Weighted average interest rate of Senior notes, net ---% 13.00% 13.00% 13.00% Weighted average interest rate of other borrowings 9.54% 8.44% 8.24% 8.03% Subsidiaries of the Company In addition to the Bank, Beal Financial's organized subsidiaries include Beal Banc Holding Company, a Delaware corporation, which was organized for tax purposes by the Company in 1993 to hold all of the outstanding stock of the Bank in connection with its reorganization into the holding company form. This corporation is not 28 expected to engage in any activities other than holding the stock of the Bank. The sole director and president of this corporation is D. Andrew Beal. During calendar year 1996, the Company purchased the inactive Bank subsidiaries Beal Delaware Corp. and its subsidiary BBT from the Bank and invested, through BBT, $2.6 million in a joint venture to develop 533 acres of land located in Austin, Texas zoned for light industrial and commercial/retail use. In addition, the Company formed a new single purpose subsidiary to invest approximately $575,000 in a limited partnership to develop property in McKinney, Texas. Subsidiaries of the Bank As a Texas-chartered savings bank, the Bank is permitted by federal regulations to have subsidiaries engage only in those subsidiary activities which are permissible for a subsidiary of a national bank. The FDIC may approve other activities for a subsidiary provided that the Bank meets its applicable minimum capital standards and the FDIC determines that the conduct of the activity of the subsidiary will not pose a significant risk to the SAIF. Under state law, a Texas-chartered savings bank is permitted to invest an unlimited amount in operating subsidiaries which are engaged solely in activities permissible for the Bank to engage in directly. The amount which a Texas-chartered savings bank may invest in other service corporation subsidiaries may not exceed 10% of the savings bank's total assets without the prior approval of the Texas Department. At December 31, 1997, the net book value of the Bank's investment in its subsidiaries was approximately $507.1 million (including $29.5 million invested in other service corporation subsidiaries). Under FDIC regulations, if a savings bank's subsidiary is engaged in activities not permissible for a national bank subsidiary, it may only engage in such activities with the approval of the FDIC. In the absence of such approval, the subsidiary must be divested. The Company has received regulatory approval for its real estate investment and development activities to date. See "- Regulation - Federal Regulation of State-Chartered Savings Banks." The activities of the Bank's principal operating subsidiaries are briefly described below. Beal Nevada Corp., ("BNC"). During the fourth quarter of 1997, the Bank formed BNC, a Nevada corporation for tax planning purposes. BNC is a 99% limited partner in Loan Participant Partners, Ltd., with Property Acceptance Corp. ("PAC"), a wholly-owned subsidiary of the Bank, as the 1% general partner. This partnership owns an interest in a pool of loans transferred from the Bank. The Bank's investment in BNC and PAC was $388.6 million and $3.9 million, respectively, at December 31, 1997. Beal Mortgage, Inc. ("BMI"), Beal Properties, Inc. ("BPI") and Beal/H.S., Inc ("BHS"). BMI and BPI are Texas corporations and BHS is a Nevada corporation. These corporations were organized to engage in certain real estate development activities including the acquisition and development of land and direct investments in real estate development projects. At December 31, 1997, the Bank's investment in BMI, BPI and BHS totaled $9.0 million, $6.2 million and $14.3 million, respectively. BMI, BPI and BHS are engaged in holding real estate held for investment and in real estate development projects. The purchase and development of property may be financed by the Bank or an unrelated third party. Once developed, the lots are sold to builders primarily for the construction of single-family dwellings. The Company intends to expand its direct investment activities in the future, subject to market conditions and regulatory approval. The Board of Directors of the Bank has determined to limit the Bank's investment in real estate development and investment activities to an amount which would enable the Bank to maintain capital, as calculated in accordance with generally accepted accounting principles, at 6% of total assets, after deduction of its investment in real estate. In addition, the Bank's individual investment in BMI, BPI and BHS is limited by the FDIC to 10% of Tier I capital and 20% of Tier 1 capital on an aggregate basis, provided that Tier I capital is at least 6% after deduction of the Bank's investment in its real estate subsidiaries. See " Regulation - Federal Regulation of State-Chartered Savings Bank" and "Regulatory Capital Requirements and Prompt Corrective Regulatory Action." A description of their real estate investment activities is briefly described below. 29 BHS through a Texas limited partnership owned with other affiliates of the Company, purchased in July, 1997 for $12.2 million, 204 lots plus approximately 135 acres (to be developed into an additional 225 lots) located in Highland Village, Texas. Since the purchase, 26 lots have been sold for approximately $1.9 million. BMI's Coppell, Texas development, was purchased in May 1995 for approximately $4.8 million, and originally consisted of approximately 200 acres. When BMI purchased the property, the sales contract included an option to one of the sellers to repurchase approximately 50 acres of the land for $2.2 million. This option was exercised in January, 1997 with the Bank providing an acquisition and development loan to the purchaser for $5.3 million. BMI also sold an additional 65.5 acres of single family land to the same purchaser for $2.1 million in cash in June, 1997. In addition, 27 acres were sold to the State of Texas for a freeway right of way for $1.7 million. After these three sale transactions, BMI currently retains two commercial tracts of approximately 21 and 10 acres, respectively, located at the intersection of the future freeway and a major local thoroughfare. BMI also has invested in a single family real estate development consisting of 68 acres located in Mesquite, Texas platted for 302 lots. The land was purchased in July, 1995 for $1.1 million. Since purchase, Phase I has been fully developed with 119 of 123 total lots under contract to a national homebuilder. This national home builder has an option to purchase all lots to be developed in Phases II and III. Phase II is currently in pre-construction, with Phase III preliminary platted and engineered. BMI also has invested in a single-family development located in Corinth, Texas. BMI's original investment of $914,000 has been reduced to $58,000 as of December 31, 1997 and consists of three remaining lots. This investment was initially Phase III of a BMI development which originally contained 32 acres with 127 lots. BPI also has a $1.4 million investment in Phases IV, VII and VIII of the same development, containing a total of 88 acres. Phase IV development has been completed with 115 of 145 lots sold to one national home builder. Phases VII and VIII of this development have been preliminary platted for 189 lots, plus five acres of commercial frontage on a state highway. BMI also holds $10.3 million in the aggregate of other real estate for investment, the largest component of which is Beal Bank Center II, an office building purchased in March 1995 and located adjacent to the Company's headquarters. At December 31, 1997, Beal Bank Center II had a book value of $8.4 million (subject to a $6.0 million first mortgage lien from an unaffiliated lender) and was 83% occupied. Two remaining properties held by BMI for investment had book values of $1.0 million and $860,000, respectively, at December 31, 1997. BPI also has $3.4 million invested through a Texas limited partnership to own a 229 acre commercial/industrial park in Houston, Texas. At December 31, 1997, BPI had an additional investment in land with a book value of approximately $1.0 million. Loan Acceptance Corp. ("LAC"). LAC was formed in July 1994 to bid on third-party loan pools, the majority of which are sold by the FDIC or the RTC. This activity was formerly conducted through BMI. At December 31, 1997, the Bank's investment in LAC totaled $992,000. See "- Lending Activities - Loan Acquisition, Resolution, Origination and Sale Activities." BRE, Inc. ("BRE"). BRE is a Texas corporation organized to hold loans and other assets which management of the Bank believes bear more than the normal risk of exposure to litigation. The most common problems with these assets include environmental contingencies and litigious histories of certain borrowers. At December 31, 1997, BRE held 16 mortgage loans (11 single-family and five multi-family and commercial real estate loans) totaling $2.2 million and 10 foreclosed real estate properties (one land and nine multi-family and commercial properties) totaling $11.0 million. BRE has performed full environmental reviews on all of its properties with minimal environmental problems found. The properties are operational and BRE plans to actively market the properties for sale. At December 31, 1997, the Bank's investment in BRE totaled $13.6 million. Beal Affordable Housing, Inc. ("BAH"). BAH was organized in November 1994 to develop affordable housing apartment buildings to take advantage of certain tax benefits under Section 42 of the Internal Revenue Code. BAH owns a 98% limited partnership interest in the three limited partnerships described below. BMI owns a 1% 30 interest in and serves as the managing general partner for each limited partnership and a Texas-based, non-profit organization owns the remaining 1% interest in each limited partnership. The limited partners will receive 100% of any profits or cash distributions on their respective projects and will incur 100% of any cash related operating deficiencies and losses. Each of the projects is managed by a non-affiliated fee management company which specialize in the management of affordable housing properties. At December 31, 1997, the Company's investment in BAH totaled $26.7 million. It is anticipated that BAH will receive tax credits of approximately $2.4 million per year for the next nine years. The limited partnerships are required to maintain minimum occupancy levels of qualified low-income tenants continuously throughout the 15-year compliance period beginning in the year the first low-income housing credit is claimed. Failure to comply with this occupancy requirement will result in recapture of all or part of the credits previously claimed. Each of the limited partnerships are in compliance with the required occupancy levels at December 31, 1997. Foreign Lending Corporation ("FLC"). FLC was established by the Bank for the purpose of originating, servicing or holding loans made to foreign borrowers with assets or collateral outside the United States, and/or domestic borrowers with collateral in foreign countries. FLC will also hold and manage to disposition any assets acquired in satisfaction of debt as a result of this lending activity. At December 31, 1997, the Bank's investment in FLC totaled $5.1 million which was invested in one loan. The Bank is not currently seeking new foreign lending activities. See "- Foreign Lending." Lending and purchasing loans on properties outside the United States is subject to risks, including exposure to currency fluctuations, the imposition of government controls, the need to comply with a wide variety of foreign laws, political and economic instability, changes in tariffs and taxes, the greater difficulty of administering business overseas and general economic conditions. In addition, the laws of certain foreign countries may not protect the Company's property interests to the same extent as do the laws of the United States. The Company also owns other single purpose subsidiaries formed to hold foreclosed property for tax planning purposes. The Company's net investment in such subsidiaries at December 31, 1997 was $39.4 million. Competition The Company faces strong competition, both in purchasing discounted loans and originating real estate and other loans and in attracting deposits. Competition in purchasing discounted loans and originating real estate loans comes primarily from other savings institutions, commercial banks, mortgage bankers, real estate brokers and other private investors. Commercial banks and finance companies provide vigorous competition in consumer lending. The Company competes for real estate and other loan originations principally on the basis of the interest rates and loan fees it charges, the types of loans it originates and the quality of services it provides to borrowers. Some of the Company's competitors, however, have higher lending limits than does the Company. The Company attracts substantially all of its deposits through newspaper advertisements and its branch offices, within the States of Texas. Competition for those deposits is principally from other savings institutions and commercial banks and other financial intermediaries. The Company competes for these deposits by offering deposit accounts at very competitive rates. Employees At December 31, 1997, the Company, including its subsidiaries, had a total of 106 employees. The Company's employees are not represented by any collective bargaining group. Management considers its employee relations to be good. 31 Regulation General. The Bank is a Texas-chartered savings bank and is subject to broad regulation and oversight by the Texas Department extending to all its operations. The Bank is also a member of the FHLB of Dallas and is subject to certain limited regulation by the Federal Reserve Board. The Bank is a member of the SAIF, which together with the BIF are the two deposit insurance funds administered by the FDIC. Accordingly, the deposits of the Bank are insured by the FDIC up to applicable limits and such insurance is backed by the full faith and credit of the United States Government. As a result, the FDIC has certain regulatory and examination authority over the Bank. As the savings and loan holding company of the Bank, the Company is also subject to regulation and oversight by OTS and the Texas Department. The purpose of the regulation of the Company and other holding companies is to protect the subsidiary savings bank. Certain of these regulatory requirements and restrictions are discussed below. See "- Federal Regulation of State Chartered Savings Banks" and "- Insurance of Accounts and Regulation by the FDIC." Insured depository institutions, such as the Bank, and their institution-affiliated parties, which include the Company, may be subject to potential enforcement actions by the FDIC and the Texas Department for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by such agencies or any written agreement with such agencies. See "- Texas Law and Supervision by the Texas Department." The OTS may also bring enforcement actions due to its supervision of the Company. The Conversion. Effective December 1, 1994, the Bank converted from a Texas-chartered savings and loan association to a Texas-chartered savings bank. As a result, the FDIC replaced the OTS as the Bank's primary federal regulator. In connection with the Bank's reorganization to the holding company form, effective July 1, 1995, OTS approved the Company's application to become a savings and loan holding company. See "- Qualified Thrift Lender Test and "- Holding Company Regulation." Texas Law and Supervision by the Texas Department. As a state-chartered savings bank, the Bank is governed by the provisions of the Texas Savings Bank Act (the "Texas Act") and rules and regulations of the Texas Department. The Texas Act and regulations of the Texas Department are administered by the Commissioner. Certain of these rules and regulations are discussed below. The Bank is required to file reports with the Texas Department concerning its financial condition and activities in addition to obtaining regulatory approval prior to engaging in certain transactions. The Texas Department conducts periodic examinations of the Bank in order to assess its compliance with regulatory requirements. As a result of such examinations, the Texas Department may require various corrective actions. See "Risk Factors - Capital and Other Regulatory Matters." The Texas Act and the regulations promulgated pursuant thereto impose restrictions on the amount and types of loans that may be made by a state savings bank, which in some cases, are slightly broader than those applicable to federally chartered savings associations; however, the Texas statute also permits a state savings bank to engage in any activity permissible for national banks. Under the Texas Act, however, the Bank must devote a majority of its assets to residential real estate lending. The Commissioner has general supervisory authority over savings banks and their holding companies. Upon his finding that a savings bank is engaging in or is about to engage in unsafe or unsound practices, or is engaging in or is about to engage in a violation of its articles of incorporation or bylaws, or is engaging in or is about to engage in a violation of any law, rule or supervisory order applicable to the savings bank or a violation of any condition that the Commissioner or the Finance Commission of the State of Texas has imposed upon the savings bank by written order, directive or agreement, or has filed materially false or misleading information in a filing required under the Act, or has failed to maintain proper books and records, he may order the savings bank or its holding company to discontinue the violation or practice. Upon failure of any savings bank, its holding company or any participating person to comply with his order, the Commissioner may bring an enforcement action which can include issuing a cease and desist order, the imposition of civil money penalties, or placing the institution under the control of a 32 conservator. Furthermore, if it appears doubtful to the Commissioner that a savings bank subject to such a conservatorship order can be successfully rehabilitated, the Commissioner may close and liquidate the savings bank. The Bank's general permissible lending limit for loans-to-one borrower is equal to the greater of $500,000 or 15% of unimpaired capital and surplus (except for loans fully secured by certain readily marketable collateral, in which case, this limit is increased to 25% of unimpaired capital and surplus). At December 31, 1997, the Bank's lending limit under this restriction was $28.2 million. The Bank is in compliance with the loans-to-one borrower limitation. A change in control (as defined below) of a savings bank (which includes the Company for this purpose) requires the prior approval of the Commissioner. For the purposes of Texas law, control is be deemed to exist if any person owns or controls 25% or more of the voting securities of a savings bank. There is a rebuttable presumption of control if any person owns or controls 10% or more of the voting securities of the savings bank. The Commissioner also has the authority to regulate and examine the holding companies of Texas- chartered savings banks. Each holding company is required by Texas law to register with the Commissioner within 90 days after becoming a holding company. Such holding companies, like the Company, must file periodic reports concerning their operations with the Commissioner. The Commissioner also has enforcement powers over such holding companies similar to those applicable to savings banks. In addition to the laws of Texas specifically governing savings banks and their holding companies, the Bank and the Company are also subject to Texas corporate law, to the extent such law does not conflict with the laws specifically governing savings banks and their holding companies. Federal Regulation of State-Chartered Savings Banks. The Bank's deposits are insured by the FDIC. As an insurer of deposits, the FDIC has extensive authority over the Bank. The FDIC issues regulations, conducts examinations, requires the filing of reports and generally supervises the operations of institutions for which it provides deposit insurance. The Bank is subject to the rules and regulations of the FDIC to the same extent as all other state banks that are not members of the Federal Reserve System. The approval of the FDIC is required prior to any merger or consolidation, certain changes in control and the establishment or relocation of any branch office of the Bank. This supervision and regulation is intended primarily for the protection of the deposit insurance fund. With respect to a change in control, federal law provides that no person directly or indirectly or acting in concert with one or more persons, may acquire "control" of a savings institution, such as the Bank (which includes the Company for this purpose) at any time without giving 60 days' prior notice to the FDIC and having received no FDIC objection to such acquisition of control, unless the transaction involves an acquisition of control by a company or other entity, in which case, the transaction would be subject to the approval of the OTS, rather than the FDIC. Control, as defined under federal law, means the power, directly or indirectly, to direct the management or policies of the institution or to vote 25% or more of any class of voting securities of the institution. In general, acquisition of 10% or more of any class of voting stock, constitutes a rebuttable determination of control if (i) the institution has any class of securities registered under the Securities and Exchange Act of 1934 or (ii) the person is the largest shareholder of such class of securities immediately following the acquisition. In determining whether to disapprove a notice of change in control, the FDIC must consider, among other things, the competitive effect of the transaction, the financial condition of the acquiror and the competence, integrity and experience of the acquiror and any proposed management personnel. The determination of control may be rebutted by submission to the FDIC of a statement setting forth facts and circumstances which would support a finding that no control relationship will exist and containing certain undertakings. The Bank is also subject to certain capital adequacy guidelines issued by the FDIC. See "- Regulatory Capital Requirements." 33 Federal law also prohibits insured state-chartered banks, including savings banks such as the Bank, from making equity investments of a type, or in an amount, that are not permissible for national banks. In general, equity investments include equity securities, partnership interests and equity interests in real estate. Under these regulations, non-permissible investments must have been divested by no later than December 19, 1996. Federal law also prohibits such banks from engaging as principal in any activity not permissible for a national bank without FDIC approval. Subsidiaries of such insured banks may also not engage as principal in any activity that is not permissible for a subsidiary of a national bank without FDIC approval. Through its service corporations, BMI, BPI and BHS, the Bank engages in real estate development and investment activities ("Real Estate Activities"), which activities are not permissible for a national bank. The FDIC has authorized (the "FDIC Order") the Bank and its subsidiaries to continue to engage in these Real Estate Activities provided that they comply with certain requirements. These measures include requiring that any subsidiary through which the Real Estate Activities are conducted (each a "Real Estate Subsidiary") is operated to ensure its separate corporate existence, submission of an annual investment plan to the FDIC, measures to address concentration of risk, and calculating the Bank's compliance with regulatory capital standards exclusive of any investment in a Real Estate Subsidiary. See "- Insurance of Accounts and Regulation by the FDIC and Regulatory Capital Requirements and Prompt Corrective Action." See "Subsidiaries of the Bank." The FDIC and the other federal banking regulators have issued safety and soundness guidelines on matters such as loan underwriting and documentation, internal controls and audit systems, interest rate risk exposure, asset growth, asset quality, earnings and compensation and other employee benefits. The FDIC has adopted final regulations providing that any institution it supervises which fails to comply with these guidelines must submit a compliance plan. A failure to submit a plan or to comply with an approved plan will subject the institution to further enforcement action. In addition, the OTS also has extensive enforcement authority over the Company. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease-and- desist or removal orders and to initiate injunctive actions. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with the OTS. See "- Holding Company Regulation." Insurance of Accounts and Regulation by the FDIC. The Bank is a member of the SAIF, which is administered by the FDIC. The Bank is subject to the rules and regulations of the FDIC to the same extent as all other state banks that are not members of the Federal Reserve System. This supervision and regulation is intended primarily for the protection of the deposit insurance fund. In addition, the FDIC may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the FDIC. The FDIC also has the authority to initiate enforcement actions against savings banks and may terminate the deposit insurance if it determines that the institution has violated any law or regulation or has engaged or is engaging in unsafe or unsound practices, or is in an unsafe or unsound condition. Such enforcement actions may include the assessment of civil money penalties against the institution and its management, the imposition of a cease and desist order or supervisory agreement restricting any and all of the activities of the institution or requiring corrective action to be taken, the prohibition of dividends or other distributions of capital and the prohibition of a person from serving the institution in such capacity as a director, officer or employee. Any such enforcement action could be substantial and adversely affect the Bank, and thereby adversely affect the Company's ability to meet its obligations with respect to the Senior Notes. See "-Federal Regulation of State-Chartered Savings Banks." The FDIC's deposit insurance premiums are assessed through a risk-based system, under which all insured depository institutions are placed into one of nine categories and assessed insurance premiums based upon their level of capital and supervisory evaluation. Under the system, institutions classified as well capitalized (i.e., a leverage ratio of at least 5%, a ratio of Tier 1 or leverage capital to risk-weighted assets ("Tier 1 capital") of at least 6% and a risk-based capital ratio of at least 10%) and considered healthy pay the lowest premium while institutions that are less than adequately capitalized (i.e., leverage or Tier 1 capital ratios of less than 4% or a risk-based capital ratio of less than 8%) and considered of substantial supervisory concern pay the highest premium. The current assessment schedule for both BIF and SAIF insured institutions ranges from 0 to .27% of deposits. Risk classification of all insured institutions is made by the FDIC for each semi-annual assessment period. Deposit insurance premiums for the fiscal year ended December 31, 1997, totaled $677,000. 34 Under the FDIC Order, the Bank's capital category will be determined exclusive of its investment in any Real Estate Subsidiary for purposes of deposit insurance premium assessments except in determining whether the Bank has become critically undercapitalized. The FDIC is authorized to increase assessment rates, on a semiannual basis, if it determines that the reserve ratio of the SAIF will be less than the designated reserve ratio of 1.25% of SAIF insured deposits. In setting these increased assessments, the FDIC must seek to restore the reserve ratio to that designated reserve level, or such higher reserve ratio as established by the FDIC. The FDIC may also impose special assessments on SAIF members to repay amounts borrowed from the United States Treasury or for any other reason deemed necessary by the FDIC. Prior to the enactment of legislation recapitalizing the SAIF in November 1996, a portion of the SAIF assessment imposed on savings associations was used to repay obligations issued by a federally chartered corporation to provide financing ("FICO") for resolving the thrift crisis in the 1980s. Although SAIF- insured institutions will continue to be subject to a FICO assessment, the legislation also requires assessments to be made on BIF-assessable deposits for this purpose. Effective January 1, 1997, that assessment will be limited to 20% of the rate imposed on SAIF assessable deposits until the earlier of December 31, 1999 or when no savings association continues to exist, thereby imposing a greater burden on SAIF member institutions such as the Bank. Thereafter, however, assessments on BIF-member institutions will be made on the same basis as SAIF-member institutions. The rates established by the FDIC in 1997 to implement this requirement for all FDIC-insured institutions was 6.48 basis points assessment on SAIF deposits and 1.3 basis points on BIF deposits until BIF insured institutions participate fully in the assessment. These rates may be revised in the future based upon changes in the BIF and SAIF assessment base. The FDIC has promulgated regulations implementing limitations on brokered deposits pursuant to the requirements of federal law. Under the regulations, well capitalized institutions are not subject to any brokered deposit limitations, while adequately capitalized institutions are able to accept, renew or roll over brokered deposits only (i) with a waiver from the FDIC and (ii) subject to the limitation as to all such deposits that they do not pay an effective yield which exceeds by more than (a) 75 basis points the effective yield paid on deposits of comparable size and maturity in such institution's normal market area for deposits accepted in its normal market area or (b) 120% for retail deposits and 130% for wholesale deposits, respectively, the current yield on comparable maturity U.S. Treasury obligations for deposits accepted outside the institution's normal market area. Undercapitalized institutions are not permitted to accept brokered deposits, and may not solicit any deposits by offering any effective yield that exceeds by more than 75 basis points the prevailing effective yields on insured deposits of comparable maturity in the institution's normal market area or in the market area in which such deposits are being solicited. At December 31, 1997, the Bank qualified as a well capitalized institution and, as a result, was not subject to restrictions on brokered deposits. See "- Sources of Funds-Deposits." Regulatory Capital Requirements and Prompt Corrective Regulatory Action. All state-chartered institutions such as the Bank, which report to the FDIC as their primary federal regulator, must maintain regulatory capital in accordance with FDIC regulations. The FDIC has adopted a minimum leverage ratio of Tier 1 capital to average total assets of 3% for banks that have a uniform composite ("CAMELS") supervisory rating of 1. Higher leverage ratios are required to be considered well capitalized under the prompt corrective action provisions of federal law. The FDIC is also authorized to impose higher capital requirements on institutions on a case-by-case basis. The FDIC has also issued guidelines to implement the risk-based capital requirements. The guidelines require a minimum ratio of qualifying total capital to risk-weighted assets of 8%. The guidelines are intended to establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations, take off-balance sheet items into account in assessing capital adequacy and minimize disincentives to holding liquid, low-risk assets. Under these guidelines, assets and credit equivalent amounts of off-balance sheet items, such as letters of credit and outstanding loan commitments, are assigned to one of several risk categories, which range from 0% for risk-free assets, such as cash and certain U.S. government securities, to 100% for relatively high-risk assets, such as loans and investments in fixed assets, premises and other real estate owned. The aggregate dollar amount of each category is then multiplied by the risk-weight associated with that 35 category. The resulting weighted values from each of the risk categories are then added together to determine the total risk-weighted assets. The FDIC may also require an institution to maintain additional capital to account for the concentration of credit risk, the risk of non-traditional activities and for interest rate risk. Pursuant to the FDIC Order, the Bank must maintain a Tier 1 capital ratio of 6% after excluding the amount of its investment in BMI or any other subsidiary (such as BPI and BHS) through which it conducts Real Estate Activities. In addition, the aggregate investment in any one such subsidiary is limited to 10% of Tier 1 capital, and with respect to all such subsidiaries is limited to 20% of Tier 1 capital. A banking organization's qualifying total capital consists of two components: Tier 1 capital (leverage capital) and Tier 2 capital (supplementary capital). Tier 1 capital consists primarily of common stock, related surplus and retained earnings, qualifying noncumulative perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries. Intangibles, such as goodwill, are generally deducted from Tier 1 capital; however, purchased mortgage servicing rights and purchased credit card relationships may be included, subject to certain limitations. At least 50% of the banking organization's total regulatory capital must consist of Tier 1 capital. Tier 2 capital may consist of (i) the allowance for possible loan and lease losses in an amount up to 1.25% of risk-weighted assets and (ii) certain permanent and non-permanent capital instruments such as cumulative preferred stock and subordinated debt. The inclusion of the foregoing elements of Tier 2 capital are subject to certain requirements and limitations. On October 13, 1997, the Texas Department notified the Bank's Board of Directors that the Department was rescinding the requirement that the Bank maintain minimum capital requirements of 9% for leverage capital and 11% for risk-based capital, based on a business plan submitted to the Texas Department by the Bank and the Department's evaluation of the Bank's latest examination as of March 31, 1997. The business plan generally anticipates a significant decline in total assets, however, the Bank will continue to originate loans that are within the Bank's loan policy, as approved by the Board, and continue to purchase loan packages; a continued improvement in the Company's level of classified assets; the discontinuation of the Company's foreign lending program; and the Bank maintaining a leverage capital ratio of at least 10%. The Texas Department must be provided with 30 days prior written notice of any actions planned or anticipated that might reasonably be expected to result in a material deviation from the business plan. For purposes of such advance notification, material deviation would include, but not necessarily be limited to, material deviations in capital levels, total asset growth or bulk asset purchases in any quarter, or any resumption of foreign lending. As a result of the recent decision to focus on loan originations, the Bank is preparing a new business plan which reflects an anticipated increase in loan originations. The following table sets forth the Bank's compliance with its regulatory capital requirements at December 31, 1997: At December 31, 1997 ----------------------------------------------- Required Actual --------------------- -------------------- Amount Percent Amount Percent ------ ------- ------ ------- (Dollars in Thousands) Leverage capital ........ $ 67,373 5.00% $186,116 13.81% Tier 1 risk-based capital 62,387 6.00 186,116 17.90 Total risk-based capital 103,978 10.00 198,028 19.05 36 When assessing the Bank's capital adequacy the federal banking agencies, including the FDIC with respect to the Bank, must take into consideration the risk of loss from changes in the value of the institution's assets and liabilities due to changes in interest rates. The agencies have adopted a policy statement that provides guidance to institutions on the management of interest rate risk. Although the FDIC may require the Bank to maintain additional capital to address such risk, the Bank believes that in light of its interest rate risk profile it should not be required to maintain additional capital. The FDIC is authorized and, under certain circumstances required, to take certain actions against any state-chartered bank that fails to meet its capital requirements. The FDIC is generally required to restrict the activities of an "undercapitalized institution" (generally defined to be one with less than either a 4% leverage capital ratio, a 4% Tier 1 capital ratio or an 8% risk-based capital ratio). Any such institution must submit a capital restoration plan and until such plan is approved by the FDIC may not increase its assets, acquire another institution, establish a branch or engage in any new activities, and generally may not make capital distributions. The FDIC is authorized to impose the additional restrictions, discussed below, that are applicable to significantly undercapitalized institutions. Any institution that fails to comply with its capital plan or is "significantly undercapitalized" (i.e., Tier 1 or core capital ratios of less than 3% or a risk-based capital ratio of less than 6%) must be made subject to one or more of additional specified actions and operating restrictions mandated by federal law. These actions and restrictions include requiring the issuance of additional voting securities; limitations on asset growth; mandated asset reduction; changes in senior management; divestiture, merger or acquisition of the institution; restrictions on executive compensation; and any other action the FDIC deems appropriate. An institution that becomes "critically undercapitalized" (i.e., a tangible capital ratio of 2% or less) is subject to further mandatory restrictions on its activities in addition to those applicable to significantly undercapitalized associations. In addition, the FDIC must appoint a receiver or conservator for an institution, with certain limited exceptions, within 90 days after it becomes critically undercapitalized. Under the FDIC Order, the Bank's capital category will be determined exclusive of its investment in any Real Estate Subsidiary for purposes of these prompt corrective regulations except in determining whether the Bank has become critically undercapitalized. In the event that the Bank fails to remain well capitalized at the and of any quarter as a result of these conditions, it is required to notify the FDIC within 15 days and to file an acceptable plan for restoring capital to the well-capitalized level. Any undercapitalized institution is also subject to other possible enforcement actions by the FDIC. Such actions could include a capital directive, a cease-and-desist order, civil money penalties, the establishment of restrictions on all aspects of the association's operations or the appointment of a receiver or conservator or a forced merger into another institution. If the FDIC determines that an institution is in an unsafe or unsound condition or is engaged in an unsafe or unsound practice it is authorized to reclassify a well capitalized institution as an adequately capitalized association and if the institution is adequately capitalized, to impose the restrictions to an undercapitalized institution. If the institution is undercapitalized, the FDIC is authorized to impose the restrictions applicable to a significantly undercapitalized institution. The purpose of these provisions is to resolve the problems of insured depository institutions at the least possible long-term cost to the appropriate deposit insurance fund. Any undercapitalized depository institution must submit an acceptable capital restoration plan to the appropriate federal banking agency 45 days after becoming undercapitalized. In addition, each company controlling an undercapitalized depository institution must provide a guarantee that the institution will comply with the capital plan until the depository institution has been adequately capitalized on an average basis during each of four consecutive calendar quarters and must otherwise provide adequate assurances of performance. The aggregate liability of such guarantee is limited to the lesser of (a) an amount equal to 5% of the depository institution's total assets at the time the institution became undercapitalized or (b) the amount which is necessary to bring the institution into compliance with all capital standards applicable to such institution as of the time the institution fails to comply with its capital restoration plan. Finally, the FDIC may impose any of the additional restrictions or sanctions that it may impose on significantly undercapitalized institutions if it determines that such action will further the purpose of the provisions. 37 The imposition by the FDIC of any of these measures on the Bank may have a substantial adverse effect on the Company's operations and profitability. Limitations on Dividends and Other Capital Distributions. Under Texas law, a savings bank may declare and pay dividends out of current and retained income so long as the savings bank meets its capital requirements. The Bank is required to provide notice to the OTS at least 30 days' prior to the declaration of a dividend by the Bank to the Company. In a letter from the OTS dated June 30, 1997, the OTS acknowledged that notice has been given by the Bank to pay additional dividends, as needed, up to 100% of earnings for the fiscal year-ended December 31, 1997. The FDIC has the authority to prohibit the Bank from engaging in an unsafe or unsound practice in conducting its business and under such authority could impose dividend restrictions. Further, the FDIC has established guidelines with respect to the maintenance of appropriate levels of capital by savings banks under its jurisdiction. Compliance with the standards set forth in such guidelines and the restrictions that are or may be imposed under the prompt corrective action provisions described herein could limit the amount of dividends which the Bank may pay to the Company. In addition, federal law prohibits an insured depository from paying dividends on its stock or interest on its debentures (if such interest is required to be paid only out of net profits) or distribute any of its capital assets while it is in default in the payment of any assessment due to the FDIC. Liquidity. All Texas savings banks, including the Bank, are required to maintain minimum levels of liquid assets as defined by the Texas Department. A Texas savings bank is required to maintain liquidity in an amount not less than 10% of an amount equal to its average daily deposits for the most recently completed calendar quarter in cash or readily marketable securities. At December 31, 1997, the Bank's liquidity ratio was 19.1%. Qualified Thrift Lender Test. All state-chartered savings banks with holding companies governed by the OTS, including the Bank, are required to meet a qualified thrift lender ("QTL") test to avoid certain restrictions on their operations. One version of this test requires a savings association to have at least 65% of its portfolio assets (as defined by regulation) in qualified thrift investments on a monthly average for nine out of every 12 months on a rolling basis. Such assets primarily consist of residential housing related loans and investments. At December 31, 1997, the Bank met the test for the twelve month period. In the event that the Bank should fail to qualify as a QTL, it would not be able to requalify for a period of five years. Upon such a failure, the Company would lose its status as a savings and loan holding company and would be required to register as a bank holding company and become subject to the activity restrictions applicable to such companies. See "- Holding Company Regulation." Community Reinvestment Act. Under the Community Reinvestment Act ("CRA"), all FDIC insured institutions have a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the FDIC, in connection with the examination of the Bank, to assess the institution's record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications, such as a merger or the establishment of a branch, by such institution. An unsatisfactory rating may be used as the basis for the denial of an application by the FDIC. The Bank received a "satisfactory" rating on its last CRA examination. Subsequent to that examination, the Bank applied for and received approval from the FDIC, to be designated as a wholesale institution for purposes of evaluation under the revised CRA. The federal banking agencies, including the FDIC, revised the CRA regulations and the methodology for determining an institution's compliance with the CRA. Due to the heightened attention being given to the CRA in the past few years, certain financial institutions have been required to devote additional funds for investment and lending in its local community. At December 31, 1997, no additional requirements have been imposed on the Bank. There can be no assurances that additional requirements will not be imposed on financial institutions, including the Bank, in the future. In addition, the Texas Act and regulations impose a requirement that a savings bank maintain investments equal to at least fifteen percent of its local area deposits in first and second lien residential mortgage loans or 38 foreclosed residential mortgage loans originated from within the Bank's local service area; home improvement loans; interim residential construction loans; mortgage backed securities secured by loans from within the bank's local service area; and loans for community reinvestment purposes. The Bank's local service area is currently delineated to include Collin, Dallas, Denton, Ellis, Fort Bend, Harris, Johnson, Kaufman, Liberty, Montgomery, Parker, Rockwall, Tarrant and Waller Counties, Texas. At December 31, 1997, the Bank was in compliance with the requirements of the Texas Act. Transactions with Affiliates. The Bank is subject to certain restrictions imposed by federal and state law on any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of, the Company or other affiliates, the purchase of or investments in stock or other securities thereof, the taking of such securities as collateral for loans and the purchase of assets of the Company or other affiliates. Such restrictions prevent the Company and such other affiliates from borrowing from the Bank unless the loans are secured in accordance with federal law. Further, such transactions by the Bank with the Company or with any other affiliate is limited to 10% of the Bank's capital and surplus (as defined by federal regulations) and such secured loans and investments are limited, in the aggregate, to 20% of the Bank's capital and surplus (as defined by federal law). In addition, any transaction with an affiliate of the Bank must be on terms and under circumstances that are substantially the same as a comparable transaction with a non-affiliate. Additional restrictions on transactions with affiliates may be imposed on the Bank under the prompt corrective action provisions. Holding Company Regulation. The Company is a unitary savings and loan holding company subject to regulatory oversight by the OTS. As such, the Company is registered with and files reports with the OTS and is subject to regulation and examination by the OTS. In addition, the OTS has enforcement authority over the Company and its non-savings bank subsidiaries which also permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the subsidiary savings bank. The Company is also subject to regulation by the Texas Department. See "- Texas Law and Supervision by the Texas Department." As a unitary savings and loan holding company, the Company generally is not subject to activity restrictions. If the Company acquires control of another savings association as a separate subsidiary, it would become a multiple savings and loan holding company, and the activities of the Company and any of its subsidiaries (other than the Bank or any other SAIF-insured savings institution) would become subject to such restrictions unless such other institutions each qualify as a QTL and were acquired in a supervisory acquisition. If the Bank fails the QTL test, the Company must register as, and will become subject to, the restrictions applicable to bank holding companies. The activities authorized for a bank holding company are more limited than are the activities authorized for a unitary or multiple savings and loan holding company. See "- Qualified Thrift Lender Test." The Company must obtain approval from the OTS before acquiring control of any other savings association. Such acquisitions are generally prohibited by federal law if they result in a multiple savings and loan holding company controlling savings associations in more than one state. However, such interstate acquisitions are permitted based on specific state authorization or in a supervisory acquisition of a failing savings institution. Federal Securities Law. The Senior Notes are registered with the SEC under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). As a result, the Company is subject to certain information, insider trading restrictions and other requirements of the SEC under the Exchange Act. The Senior Notes held by persons who are affiliates (generally officers, directors and principal shareholders) of the Company may not be resold without registration or unless sold in accordance with certain resale restrictions. If the Company meets specified current public information requirements, each affiliate of the Company is able to sell in the public market, without registration, a limited number of securities in any three-month period. Federal Reserve System. The Federal Reserve Board requires all depository institutions to maintain non-interest bearing reserves at specified levels against their transaction accounts (primarily checking, NOW and Super NOW checking accounts). At December 31, 1997, the Bank was in compliance with these reserve requirements. The 39 balances maintained to meet the reserve requirements imposed by the Federal Reserve Board may be used to satisfy liquidity requirements that may be imposed by the Texas Department. See "Liquidity." Savings associations are authorized to borrow from the Federal Reserve Bank "discount window," but Federal Reserve Board regulations require associations to exhaust other reasonable alternative sources of funds, including FHLB borrowings, before borrowing from the Federal Reserve Bank. Federal Home Loan Bank System. The Bank is a member of the FHLB of Dallas, which is one of 12 regional FHLBs, that administers the home financing credit function of savings associations. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans to members (i.e., advances) in accordance with policies and procedures established by the board of directors of the FHLB. These policies and procedures are subject to the regulation and oversight of the Federal Housing Finance Board. All advances from the FHLB are required to be fully secured by sufficient collateral as determined by the FHLB. In addition, all long-term advances are required to provide funds for residential home financing. As a member, the Bank is required to purchase and maintain stock in the FHLB of Dallas. At December 31, 1997, the Bank had $10.2 million in FHLB stock, which was in compliance with this requirement. In past years, the Bank has received substantial dividends on its FHLB stock. Over the past five calendar years such dividends have averaged 5.30% and were 5.95% for calendar year 1997. Under federal law, the FHLBs are required to provide funds for the resolution of troubled savings associations and to contribute to low- and moderately priced housing programs through direct loans or interest subsidies on advances targeted for community investment and low- and moderate-income housing projects. These contributions have affected adversely the level of FHLB dividends paid and could continue to do so in the future. These contributions could also have an adverse effect on the value of FHLB stock in the future. A reduction in value of the Bank's FHLB stock may result in a corresponding reduction in the Bank's capital. Federal and State Taxation Federal Taxation. Beal Financial Corporation filed with the Internal Revenue Service on March 13, 1997, to elect Subchapter S status for federal income tax purposes effective January 1, 1997. This election covered all subsidiaries of Beal Financial, including the Bank, except for BAH and BRE-N, Inc. (an inactive subsidiary), which elected to remain Subchapter C Corporations for federal tax purposes. Concurrent with the change to Subchapter S status, Beal Financial and all subsidiaries changed their tax and fiscal year ends to December 31 from the previous June 30 year ends. Therefore, Beal Financial and subsidiaries filed a consolidated Subchapter C federal tax return for the six months ended December 31, 1996 and will file a consolidated Subchapter S federal tax return for the year ended December 31, 1997. In the future, Beal Financial and all subsidiaries electing Subchapter S status will not pay any federal taxes on net income. The only exception will involve possible Subchapter C tax liability on net built-in gains as of January 1, 1997, which may potentially be recognized during the 10 year period ending December 31, 2006. Recognition of built-in gains/losses are subject to certain limitations. At January 1, 1997, the Company had net unrealized built-in gains of approximately $80.0 million. For the year ended December 31, 1997, the Company recorded federal tax expense of $3.2 million related to the recognition of built-in gains. BAH and BRE-N will continue to pay federal income taxes as C-Corporations. Except as discussed above, the future tax liability for the taxable earnings of Beal Financial and subsidiaries will be the responsibility of the shareholders of Beal Financial. It is anticipated that future dividends to shareholders will be made to meet their tax liability related to the earnings of Beal Financial. The Company and its subsidiaries filed consolidated federal income tax returns on a fiscal year basis using the accrual method of accounting. Savings associations, such as the Bank, that file federal income tax returns as part of a consolidated group are required by applicable U.S. Department of the Treasury regulations to reduce their taxable 40 income for purposes of computing the percentage bad debt deduction for losses attributable to activities of the non-savings association members of the consolidated group that are functionally related to the activities of the savings association member. The percentage of specially computed taxable income that was used to compute a savings association's bad debt reserve deduction under the percentage of taxable income method (the "percentage bad debt deduction") was 8%. The percentage bad debt deduction thus computed was reduced by the amount permitted as a deduction for non-qualifying loans under the experience method. The availability of the percentage of taxable income method permitted qualifying savings associations to be taxed at a lower effective federal income tax rate than that applicable to corporations generally (approximately 32.2% assuming the maximum percentage bad debt deduction). In August 1996, legislation was enacted that repealed the reserve method of accounting (including the percentage of taxable income method) used by many thrifts, including the Bank, to calculate their bad debt reserve for federal income tax purposes. As a result, large thrifts such as the Bank must recapture that portion of the reserve that exceeds the amount that could have been taken under the specific charge-off method for post-1987 tax years. The legislation also requires thrifts to account for bad debts for federal income tax purposes on the same basis as commercial banks for tax years beginning after December 31, 1995. The recapture will occur over a six-year period, the commencement of which will be delayed until the first taxable year beginning after December 31, 1997, provided the institution meets certain residential lending requirements. As a Subchapter-S Corporation, recapture will be treated as a built-in gain in the year recognized. To the extent earnings appropriated to a savings association's bad debt reserves for "qualifying real property loans" and deducted for federal income tax purposes exceed the allowable amount of such reserves computed under the experience method and to the extent of the association's supplemental reserves for losses on loans ("Excess"), such Excess may not, without adverse tax consequences, be utilized for the payment of cash dividends or other distributions to a shareholder (including distributions on redemption, dissolution or liquidation) or for any other purpose (except to absorb bad debt losses). As of December 31, 1997, the Bank's Excess for tax purposes totaled approximately $12.0 million. The management of the Company does not believe that the legislation will have a material impact on the Company or the Bank. The Bank and its consolidated subsidiaries have been audited by the IRS with respect to consolidated federal income tax returns through June 30, 1995. With respect to years examined by the IRS, all deficiencies have been satisfied. In the opinion of management, any examination (including returns of subsidiaries and predecessors of, or entities merged into, the Company or Bank) would not result in a deficiency which could have a material adverse effect on the financial condition of the Company, the Bank and their consolidated subsidiaries. Texas State Income Taxation. The Company, the Bank and their subsidiaries currently file Texas franchise tax returns. Texas imposes a franchise tax on the taxable income of savings institutions and other corporations. The Company and the Bank each pay an annual franchise tax equal to the greater of $2.50 per $1,000 of taxable capital apportioned to Texas, or $45.00 per $1000 net taxable earned surplus apportioned to Texas. Taxable earned surplus is the federal corporate taxable income of each company within the corporate group determined on a separate company basis with certain modifications. Delaware Taxation. As a Delaware holding company, the Beal Banc Holding Company is exempt from the Delaware corporate income tax but is required to file an annual report with and pay an annual fee to the State of Delaware. The Beal Banc Holding Company is also subject to an annual franchise tax imposed by the State of Delaware. 41 ITEM 2. PROPERTIES The Company conducts its business at its headquarters and branch offices. The following table sets forth information relating to each of the Company's properties as of December 31, 1997. Owned Total Location Year or Approximate Acquired Leased Square Footage Book Value -------- ------ -------------- ---------- (In Thousands) Corporate Headquarters: Beal Bank Center I 1992 Owned 167,138 $4,739 15770 North Dallas Parkway Dallas, Texas Branch Office: 5100 Westheimer 1995 Leased 5,064 -- Houston, Texas Branch Office: 874 Green Bay Road 1997 Leased 2,500 -- Winnetka, Illinois 60093 The Company acquired Beal Bank Center I in 1992 and currently occupies 39,659 square feet in the building. At December 31, 1997, the building was 98.0% occupied. At December 31, 1997, the Company's total investment in the property was $6.3 million with a net book value of $4.7 million. The total net book value of the Bank's premises and equipment (including land, building and leasehold improvements and furniture, fixtures and equipment) at December 31, 1997 was $6.3 million. 42 ITEM 3. LEGAL PROCEEDINGS The Company is involved in various legal proceedings occurring in the ordinary course of business. Management of the Company, based on discussions with litigation counsel, believes that such proceedings will not have a material adverse effect on the financial position or results of operations of the Company. There can be no assurance that any of the outstanding legal proceedings to which the Company is a party will not be decided adversely to the Company's interests and have a material adverse effect on the financial position or results of operations of the Company. Set forth below is a summary description of the only lawsuit involving the Company claiming damages in excess of $500,000. Kenneth L. Musgrave vs. Beal Banc, S.A.; Cause No. 43,536-A in the 42nd District Court of Taylor County, Texas. In April 1994, the Bank acquired a promissory note with the face amount of $1.5 million (the "Note") executed by the plaintiff ("Plaintiff") from the FDIC. Thereafter, the Plaintiff negotiated with representatives of the Bank to settle the outstanding balance owed on the Note. Those negotiations stalled and the Bank foreclosed on the two pieces of property securing the Note in September 1994. Plaintiff filed suit against the Bank wherein he has asserted claims against the Bank and certain of the Bank's officers and directors for (a) intentional infliction of emotional distress; (b) breach of "duty to deal honestly and in good faith;" (c) wrongful acceleration of the Note and wrongful foreclosure; and (d) fraud. All of the Plaintiff's claims arise out of the negotiations he conducted with representatives of the Bank to settle his debt on the Note. The Plaintiff claims that the Bank deliberately made various misrepresentations about its ownership of the Note, its willingness to settle his indebtedness on the Note and its conditional acceptance of his settlement offers in order to lull the Plaintiff into a position where the Bank would be able to foreclose on the properties securing repayment of the Note. The Plaintiff seeks $20.0 million in actual damages and $40.0 million in punitive damages. His alleged actual damages are based upon his contention that the value of the foreclosed properties exceeded the amount of his indebtedness to the Bank at the time of the foreclosures and the fact that he will lose approximately $2.0 million per year for the next ten years because he will not be able to bid on note packages offered for sale by the FDIC as a result of the Bank's foreclosure on his properties. The trial court granted summary judgement in favor of all Defendants on August 4, 1997. The Plaintiff filed a Notice of Appeal on November 13, 1997. However, in January, 1998, the Court of Appeals dismissed Plaintiff's appeal because it was untimely filed. Therefore, the case has been successfully concluded in favor of the Bank. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders of the Company during the quarter ended December 31, 1997. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS There is no public market in the Company's common stock. The common stock is held of record by two stockholders. See "Security Ownership of Certain Beneficial Owners and Management - Common Stock." 43 ITEM 6. SELECTED FINANCIAL DATA The following tables present, for the fiscal years indicated, certain summary historical data for the Company. In the opinion of management, all adjustments (which consist of normal recurring accruals) necessary for a fair presentation of the results of operations for such periods have been included. This data should be read in conjunction with the separate consolidated financial statements and related notes included herein. At June 30, At December 31, ------------------------------------------------- ----------------------- 1993 1994 1995 1996 1996 1997 ---------- ---------- ---------- ---------- ---------- ---------- (Dollars In Thousands) Selected Financial Condition Data: Total assets ..................... $ 118,849 $ 246,308 $ 632,866 $1,269,279 $1,394,906 $1,365,754 Loans receivable, net ............ 100,810 219,914 493,168 897,414 1,054,204 887,833 Mortgage-backed securities ....... -- 1,999 40,714 194,699 123,939 111,376 Deposits ......................... 92,826 186,048 458,165 891,304 1,043,433 1,001,476 Total borrowings ................. 8,203 27,932 115,898 263,519 217,842 174,787 Stockholders' equity ............. 16,211 27,023 52,400 93,172 116,797 160,820 Twelve Months Ended Year Ended Year Ended June 30, December 31, December 31, ------------------------------------------------- ------------ ------------ 1993 1994 1995 1996 1996 1997 ---------- ---------- ---------- ---------- ------------ ------------ (Dollars In Thousands) Selected Operations Data: Total interest income ............ $ 21,706 $ 34,580 $ 63,795 $ 140,948 $ 177,339 $ 169,181 Total interest expense ........... 3,639 6,559 20,981 56,818 67,708 67,856 ---------- ---------- ---------- ---------- ---------- ---------- Net interest income .............. 18,067 28,021 42,814 84,130 109,631 101,325 Provision for loan losses ........ 784 2,888 4,045 9,044 6,423 3,410 ---------- ---------- ---------- ---------- ---------- ---------- Net interest income after provision for loan losses ................. 17,283 25,133 38,769 75,086 103,208 97,915 Gain on sales of interest-earning assets ........................... 994 451 9,408 8,413 6,101 550 Gain on sales of real estate ..... -- 912 4,412 7,068 10,776 13,708 Other non-interest income ........ 406 173 109 1,202 2,615 3,013 ---------- ---------- ---------- ---------- ---------- ---------- Total non-interest income ........ 1,400 1,536 13,929 16,683 19,492 17,271 Total non-interest expense ....... 5,113 9,085 12,145 22,456 38,588 22,144 ---------- ---------- ---------- ---------- ---------- ---------- Income before income taxes ....... 13,570 17,584 40,553 69,313 84,112 93,042 Income taxes ..................... 5,115 6,772 15,176 25,153 30,280 6,408 ---------- ---------- ---------- ---------- ---------- ---------- Net income ....................... $ 8,455 $ 10,812 $ 25,377 $ 44,160 $ 53,832 $ 86,634 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- 44 Twelve Months Ended Year Ended June 30, December 31, Year Ended ----------------------------------- ----------- December 31, 1993 1994 1995 1996 1996 1997 ------ ------ ------ ----- ------ ------------ Selected Financial Ratios and Other Data: Performance Ratios: Return on assets (ratio of net income to average total assets) .................... 9.15% 6.06% 5.76% 4.46% 4.36% 6.66% Return on equity (ratio of net income to average equity) .......................... 71.77 51.23 64.76 64.51 57.10 59.77 Interest rate spread information, average during period ............................ 20.61 16.92 10.50 9.43 9.64 8.72 Net interest margin(1) .................... 21.03 17.15 10.65 9.32 9.68 8.86 Ratio of operating expense to average total assets ................................... 5.53 5.09 2.74 2.27 3.13 1.71 Ratio of average interest-earning assets to average interest-bearing liabilities ..... 109.90 105.62 102.89 98.30 102.29 102.60 Quality Ratios: Net non-performing assets to total assets, at end of period ......................... 6.36 7.95 7.07 11.84 17.77 17.88 Allowance for loan losses to net non- performing loans ......................... 27.80 21.14 17.06 9.65 6.49 9.17 Allowance for loan losses to loans receivable, net .......................... 1.24 1.62 1.24 1.32 1.25 1.34 Net charge-offs to average loans, net ..... .11 .40 .41 .39 .38 .49 Equity Ratios: Equity to total assets, at end of period .. 13.64 10.97 8.28 7.34 8.37 11.78 Average equity to average assets .......... 12.74 11.83 8.84 6.91 7.64 11.19 Ratio of Earnings to Fixed Charges: Excluding interest on deposits ............ 64.1:1 23.9:1 6.6:1 7.4:1 8.1:1 10.4:1 Including interest on deposits ............ 4.5:1 3.5:1 2.3:1 1.4:1 1.4:1 1.5:1 Other Data: Number of full-service offices ............ 1 1 2 3 3 3 - ----------------- (1) Net interest income divided by average interest-earning assets. 45 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General The Company's results of operations are dependent primarily on net interest income, which is determined by the difference between the yield earned on interest-earning assets and rates paid on interest-costing liabilities ("interest rate spread"). The yield on interest-earning assets is enhanced by the accretion of unearned discounts, which are recognized on the level yield method as dictated by generally accepted accounting principles. Results of operations are also affected by the Company's provision for loan losses, the level of operating expenses, and the net gain (loss) from loans or other assets which have been sold. Due to the substantial discounts generally associated with the majority of the Company's purchased loans, the gains recognized upon the sales of such loans or the underlying collateral have been significant in prior years. The Company's results of operations are also significantly affected by prevailing economic conditions, competition, regulatory factors, and the monetary and fiscal policies of governmental agencies. The Company's primary business of purchasing discounted loans and assets is influenced by the general level of product available from U.S. government agencies and private sellers and the competition for such loans from other purchasers. Deposit flows and cost of funds are influenced by prevailing market rates of interest primarily on competing investments, account maturities, and the levels of personal income and savings in the Company's market areas. Future changes in applicable law, regulations or government policies may also have a material impact on the Company. Financial Condition The Company's total assets remained unchanged at $1.4 billion at December 31, 1997 and December 31, 1996, respectively. The asset composition changed, however, with net loans decreasing approximately $167.6 million, due to loan payoffs and foreclosure of non-performing loans, exceeding loan originations and discounted loan purchases. In addition, cash balances increased $84.5 million and real estate held for investment or sale increased $74.0 million. The increase in cash and cash equivalents was the result of normal operations. The increase in real estate held for investment or sale was primarily the result of additional foreclosures occurring as part of the normal resolution process for non-performing assets. The Company had total assets of $1.4 billion at December 31, 1996 representing an increase of $125.6 million or 9.9%, from $1.3 billion at June 30, 1996. The increase resulted primarily from an increase in net loans receivable of $156.8 million, an increase in cash and cash equivalents of $10.6 million and an increase in real estate held for investment or sale of $18.4 million; partially offset by a decrease in securities available for sale of $70.8 million. The increase in net loans receivable was due primarily to the Company being the successful bidder on loan pools sold by various U.S. governmental agencies and to a lesser extent, to loan origination activity. The increase in cash and cash equivalents was the result of normal operations, including proceeds received from the sale of certain mortgage-backed securities from the securities available for sale portfolio. The increase in real estate held for investment or sale was primarily the result of additional real estate direct investments by the Bank's subsidiaries. Total assets increased $636.4 million or 100.6%, from $632.9 million at June 30, 1995 to $1.3 billion at June 30, 1996. The increase resulted primarily from an increase in net loans receivable of $405.1 million and an increase in securities available for sale of $154.0 million. The increase in net loans receivable was due primarily to the Company being the successful bidder on loan pools sold by various U.S. governmental agencies. The increase in securities available for sale resulted from the purchase of mortgage backed securities, purchased primarily for liquidity and to maintain regulatory compliance with the QTL requirements. In addition, real estate held for investment or sale increased $36.4 million or 88.4%, from $41.2 million at June 30, 1995 to $77.6 million at June 30, 1996. The increase was primarily due to the increased investment in residential developments. 46 Total liabilities decreased $73.2 million from December 31, 1996 to December 31, 1997, primarily due to a decrease of $42.0 million in deposits and a decrease in Federal Home Loan Bank advances of $36.0 million. The decrease in deposits and advances from the FHLB reflect the decrease in net loan receivables. Total liabilities increased $102.0 million, or 8.7% from $1.2 billion at June 30, 1996 to $1.3 billion at December 31, 1996, primarily due to an increase in deposits of $152.1 million, or 17.1%, partially offset by a decline in FHLB advances of $39.0 million, a decline in other borrowings of $6.7 million and a decline of $4.5 million in other liabilities. The $152.1 million increase in deposits was made up of a $194.6 million increase in retail deposits from the Bank's three branches, offset by a $42.5 million decrease in brokered deposits. Advances from the FHLB of Dallas were repaid with the increased deposits and proceeds from the sale of mortgage backed securities. Total liabilities increased $595.6 million, or 102.6% from $580.5 million at June 30, 1995 to $1.2 billion at June 30, 1996, primarily due to FHLB advances and the issuance of $57.5 million of Senior Notes and increases in deposits. Savings deposits increased $433.1 million, or 94.5%, from $458.2 million at June 30, 1995 to $891.3 million at June 30, 1996. Of the $433.1 million net increase in savings deposits, $141.3 million were generated by the sale of certificates of deposits through various brokers, $179.7 million was due to deposits generated at the Company's branch located in Houston, Texas, which opened in April 1995 and $9.5 million was due to deposits generated at the Company's branch located in Winnetka, Illinois, which opened in March, 1996. Advances from the FHLB increased by $74.0 million to fund loan purchases. Stockholders' equity increased $44.0 million or 41.0% from $116.8 million at December 31, 1996 to $160.8 million at December 31, 1997. Stockholders' equity increased $23.6 million, or 25.4%, from $93.2 million at June 30, 1996 to $116.8 million at December 31, 1996. Stockholders' equity increased $40.8 million, or 77.8%, from $52.4 million at June 30, 1995 to $93.2 million at June 30, 1996. These increases were due to earnings, net of dividends paid to stockholders of $45.6 million. The Company anticipates future dividends to be significant, subject to limitations imposed upon the Company by the Trust Indenture (the "Indenture") governing the Senior Notes. The Indenture limits dividends to 50% of consolidated net income since August 1, 1995. At December 31, 1997, under the terms of the Indenture, the Company would have been permitted to dividend an additional $30.8 million. Results of Operations General. The level of net income experienced by the Company in the years ended June 30, 1996, 1995, and the year ended December 31, 1997 resulted primarily from (i) the significant increase in the average balance of interest-earning assets as a result of the Company's efforts to return non-performing loans to performing status and (ii) gains on the sales of loans and gains on sale of real estate. Gains on the sales of loans and real estate generally are dependent on various factors which are not necessarily within the control of the Company, including market and economic conditions. As a result, there can be no assurance that the gains on sales of loans and real estate reported by the Company in prior periods will be reported in future periods or that there will not be substantial periodic variation in the results from such activities. 47 Average Balance, Interest and Average Yields and Rates. The following tables present for the periods indicated the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. No tax equivalent adjustments were made. All average balances are monthly average balances. Non-accruing loans have been included in the table as loans carrying a zero yield. Year Ended June 30, Twelve Months Ended December 31, --------------------------------------------------------------- ---------------------------------- 1995 1996 1996 ------------------------------ ------------------------------- --------------------------------- Average Interest Average Interest Average Interest Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ Balance Paid Rate Balance Paid Rate Balance Paid Rate ----------- ---------- ------ ----------- ---------- ------ ----------- ---------- ------- (Dollars in Thousands) Interest-Earning Assets: Loans receivable(1) .......... $ 359,317 $ 61,185 17.03% $ 760,906 $ 131,544 17.29% $ 947,653 $ 164,675 17.38 Mortgage-backed securities ... 18,694 1,328 7.10 99,495 6,916 6.95 145,995 10,434 7.15 Interest-earning deposits .... 15,993 896 5.60 36,890 2,183 5.92 31,463 1,781 5.66 FHLB stock ................... 6,381 386 6.05 4,984 305 6.12 7,649 449 5.87 ---------- ---------- ---------- ---------- ---------- ---------- Total interest-earning assets(1) ................. $ 400,385 63,795 15.93 $ 902,275 140,948 15.62 $1,132,760 177,339 15.66 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Interest-Bearing Liabilities: Savings deposits ............. 29,276 1,435 4.90 127,126 6,099 4.80 158,392 8,111 5.12 Certificate accounts ......... 233,875 12,282 5.25 669,269 39,816 5.95 821,848 47,781 5.81 Senior notes, net ............ -- -- -- 50,093 6,904 13.78 57,042 7,918 13.88 Borrowings ................... 125,987 7,264 5.77 71,360 3,999 5.60 70,077 3,898 5.56 ---------- ---------- ---------- ---------- ---------- ---------- Total interest-bearing liabilities ............... $ 389,138 20,981 5.39 $ 917,848 56,818 6.19 $1,107,359 67,708 6.11 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Net interest income ........... $ 42,814 $ 84,130 $ 109,631 ---------- ---------- ---------- ---------- ---------- ---------- Net interest rate spread ...... 10.54% 9.43% 9.54% Net earning assets ............ $ 11,247 $ (15,573) $ 25,401 ---------- ---------- ---------- ---------- ---------- ---------- Net yield on average interest- earning assets .............. 10.69% 9.32% 9.68% Average interest-earning assets to average interest-bearing liabilities ................. 102.89% 98.30% 102.29% Year Ended December 31, ------------------------------------- 1997 ------------------------------------- Average Interest Outstanding Earned/ Yield/ Balance Paid Rate ----------- --------- ---------- Interest-Earning Assets: Loans receivable(1) .......... $ 967,265 $ 157,458 16.28% Mortgage-backed securities ... 117,141 8,407 7.18 Interest-earning deposits .... 49,653 2,730 5.50 FHLB stock ................... 9,835 586 5.96 ---------- --------- Total interest-earning assets(1) ................. $1,143,894 169,181 14.79 ---------- --------- ---------- Interest-Bearing Liabilities: Savings deposits ............. 185,233 9,025 4.87 Certificate accounts ......... 847,937 48,955 5.77 Senior notes, net ............ 57,131 7,986 13.98 Borrowings ................... 28,286 1,890 6.68 ---------- --------- Total interest-bearing liabilities ............... $1,118,587 67,856 6.07 ---------- --------- ---------- Net interest income ........... $ 101,325 --------- --------- Net interest rate spread ...... 8.72% Net earning assets ............ $ 25,307 ----------- ----------- Net yield on average interest- earning assets .............. 8.86% Average interest-earning assets to average interest-bearing liabilities ................. 102.26% - ------------------------ (1) Calculated net of deferred loan fees, loan discounts, loans in process and loss reserves. 48 Rate/Volume Analysis. The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between the changes related to outstanding balances and that due to the changes in interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate. Twelve Months Ended December 31, 1996 vs Year Ended June 30, Year Ended 1995 vs. 1996 December 31, 1997 --------------------------------- --------------------------------- Increase Increase (Decrease) (Decrease) Due to Total Due to Total -------------------- Increase ------------------- Increase Volume Rate (Decrease) Volume Rate (Decrease) -------- -------- -------- -------- -------- -------- (Dollars in Thousands) Interest-Earning Assets: Loans receivable ................... $ 50,403 $ 357 $ 50,760 $ 34 $ 1,021 $ 1,055 Loans receivable - discount ........ 19,009 590 19,599 3,479 (11,751) (8,272) -------- -------- -------- -------- -------- -------- Loans receivable - total ........... 69,412 947 70,359 3,513 (10,730) (7,217) Mortgage-backed securities ......... 5,616 (28) 5,588 (2,071) 44 (2,027) Interest-earning deposits .......... 1,234 53 1,287 999 (50) 949 Other .............................. (86) 5 (81) 130 7 137 -------- -------- -------- -------- -------- -------- Total interest-earning assets .... $ 76,176 $ 977 77,153 $ 2,571 $(10,729) (8,158) -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- Interest-Bearing Liabilities: Savings deposits ................... $ 4,694 $ (30) $ 4,664 $ 1,281 $ (367) $ 914 Certificate accounts ............... 25,700 1,834 27,534 1,503 (329) 1,174 Senior notes, net .................. 6,904 -- 6,904 12 56 68 Borrowings ......................... (3,067) (198) (3,265) (3,031) 1,023 (2,008) -------- -------- -------- -------- -------- -------- Total interest-bearing liabilities $ 34,231 $ 1,606 35,837 $ (235) $ 383 148 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- Change in net interest income ....... $ 41,316 $ (8,306) -------- -------- -------- -------- 49 Comparison of Operating Results for the Fiscal Year Ended December 31, 1997 and Twelve Months Ended December 31, 1996 Net Income. For the fiscal year ended December 31, 1997, net income of $86.6 million represented an increase of $32.8 million, or 60.9% from $53.8 million for the twelve months ended December 31, 1996. As discussed in more detail below, the increase in net income was primarily due to a decrease of $23.9 million in income tax expense as a result of the Company's election of Subchapter S tax status, a decrease of $3.0 million in the provision for loan losses and a decline of $16.4 million in non-interest expense, partially offset by a $8.3 million decline in net interest income. Net Interest Income. Net interest income decreased $8.3 million, or 7.6%, from $109.6 million for the twelve months ended December 31, 1996 to $101.3 million for the year ended December 31, 1997. Although the average balance of interest-earning assets remained virtually unchanged, the net interest spread, however, decreased from 9.5% for the twelve months ended December 31, 1996 to 8.7% for the year ended December 31, 1997. Interest Income. Interest income decreased $8.2 million, or 4.6%, from $177.4 million for the twelve months ended December 31, 1996 to $169.2 for the year ended December 31, 1997. The increase of $1.1 million in interest income on loans including fees was offset by a decrease of $8.3 million in purchased discount accretion and $941,000 in interest income on investment securities. The average balance of interest earning assets increased slightly, however, this increase was offset by a decrease in the yield on interest earning assets by .82% for the year ending December 31, 1997, as compared to the twelve months ended December 31, 1996. This decrease in yield was primarily due to a decrease in yield on loans, net, from 17.38% for the twelve months ended December 31, 1996 to 16.28% for the year ended December 31, 1997. Interest Expense. Interest expense increased $148,000, or 0.22%, from $67.7 million for the twelve months ended December 31, 1996 to $67.9 million for the year ended December 31, 1997. The average balance of interest-bearing liabilities remained virtually the same, increasing only $11.2 million during the year ended December 31, 1997 reflecting the increase in deposit accounts and comparable decline in other borrowings during the year. The four basis point decrease in the average cost of interest-bearing liability from 6.11% for the twelve month period ended December 31, 1996 to 6.07% for the year ended December 31, 1997 was primarily due to the shift from higher cost FHLB advances to deposit accounts. Provision for Loan Losses. The provision for loan losses is determined by management as an amount sufficient to maintain the allowance for loan losses at a level considered adequate to absorb future losses inherent in the loan portfolio in accordance with generally accepted accounting principles. The provision for loan losses decreased $3.0 million, or 46.9% for the twelve months ended December 31, 1997 primarily as a result of a decline in net loans receivable and non-performing loans. The Company establishes an allowance for loan losses based upon a systematic analysis of risk factors in the loan portfolio. This analysis includes an evaluation of the Company's loan portfolio, past loan loss experience, current economic conditions, loan volume and growth, composition of the loan portfolio and other relevant factors. Management's analysis results in the establishment of allowance amounts by loan type based on allocations by asset classification and specific allocations based on asset reviews. The allowance for loan losses as a percentage of net non-performing loans was 9.2% at December 31, 1997 as compared to 6.5% at December 31, 1996. The primary reason for the increase in this ratio was due to a decrease in net non-performing loans of $73.4 million from $203.3 million at December 31, 1996 to $129.9 million at December 31, 1997. Although management believes that it uses the best information available to determine the allowance, unforeseen market conditions could result in adjustment and net income could be significantly affected if circumstances differ substantially from the assumptions used in making the final determination. Future additions to the Company's allowance will be the result of periodic loan, property and collateral reviews and thus cannot be predicted with absolute certainty in advance. In addition, regulatory agencies, as an integral part of the examination process, periodically review the Company's allowance for loan losses. Such agencies may require the Company to recognize 50 additions to the allowance level based upon their judgment of the information available to them at the time of their examination. Non-Interest Income. Total non-interest income decreased $2.2 million, or 11.4% to $19.5 million for the twelve months ended December 31, 1996 to $17.3 million for the year ended December 31, 1997. This decrease was primarily due to a decrease of $5.5 million in the income attributable to gain on sale of loans and a $6.4 million decrease in gain of sales of securities available for sale, partially offset by an increase of $8.2 million on the gain on sale of real estate transactions and a $1.1 million increase in other real estate operations. Non-Interest Expense. Non-interest expense decreased $16.4 million, or 42.6%, from $38.6 million at December 31, 1996 to $22.1 million at December 31, 1997, primarily due to a decrease in salaries and employee benefits of $11.2 million, $10.5 million of which related to a bonus paid to the Bank's Chairman, Andrew Beal in December 1996. The SAIF deposit insurance premium decreased $2.8 million, of which $2.2 million related to the one time assessment to recapitalize the SAIF which was paid in 1996. In addition, other operating expenses decreased by $1.5 million during the year ended December 31, 1997. Income Taxes. Income taxes decreased $23.9 million, or 78.8%, from $30.3 million for the twelve months ended December 31, 1996 to $6.4 million for the twelve months period ended December 31, 1997. This decrease was due to the Company's election of Subchapter S tax status at December 31, 1996. Comparison of Operating Results for the Fiscal Years Ended June 30, 1996 and 1995 Net Income. The Company had net income of $44.2 million for the fiscal year ended June 30, 1996, as compared to $25.4 million for the fiscal year ended June 30, 1995. As discussed in more detail below, the increase in net income of $18.8 million, or 74.0%, was due primarily to an increase in net interest income of $41.3 million and an increase in non-interest income of $2.8 million, which more than offset the increases in the provision for loan losses of $5.0 million, non-interest expense of $10.3 million and income taxes of $10.0 million. Net Interest Income. Net interest income increased $41.3 million, or 96.5%, from $42.8 million in fiscal 1995 to $84.1 million in fiscal 1996, due to an increase in average interest-earning assets during fiscal 1996. The average balance of interest-earning assets increased $501.9 million during this period primarily due to an increase in discounted loans purchased from the HUD and FDIC and, to a lesser extent, increased loan originations and purchases of mortgage-backed securities. In addition, net interest rate spread decreased from 10.54% for fiscal 1995 to 9.43% for fiscal 1996 primarily due to the purchase of lower yielding mortgage-backed securities and interest expense on the Senior Notes. Interest Income. Interest income increased by $77.1 million, or 120.9%, from $63.8 million at June 30, 1995 to $140.9 million at June 30, 1996. Of the total increase in interest income, $50.4 million was due to the increase in average interest-earning assets and $19.6 million was due to the increase in the purchase discount accretion. The increase in average interest- earning assets was primarily due to the increase in discounted loans purchased from the HUD and the FDIC and, to a lesser extent, increased mortgage-backed securities. The increase in the average balance of interest-earning assets more than offset the 31 basis point decrease in the average yield on interest-earning assets from 15.93% during fiscal 1995 to 15.62% during fiscal 1996. This decrease in yield was due in part to increases in lower yielding mortgage-backed securities and in interest-earning deposits. Interest Expense. Interest expense increased by $35.8 million, or 170.8%, from $21.0 million for fiscal 1995 to $56.8 million for fiscal 1996 due primarily to an increase in the average balance of interest-bearing liabilities and, to a lesser extent, the issuance of the Senior Notes. An increase in certificate accounts accounted for $25.7 million of the increase and the issuance of the Senior Notes accounted for $6.9 million of the increase. The average balance of savings deposits and certificate accounts increased $97.9 million and $435.4 million, respectively, between the two periods due to the opening of two new branch offices, increased rates paid on savings and certificate accounts and increased deposit solicitation efforts as a result of management's decision to utilize such deposits to fund the purchase of discounted loans. The average rate paid on certificate accounts increased from 5.25% during fiscal 1995 to 5.95% 51 for fiscal 1996. The increase in rates paid on deposits was due to increases in market rates of interest and management's decision to pay higher rates to obtain deposits. Provision for Loan Losses. The provision for loan losses is determined by management as an amount sufficient to maintain the allowance for loan losses after net charge-offs at a level considered adequate to absorb future losses inherent in the loan portfolio in accordance with generally accepted accounting principles. The increase of $5.0 million, or 123.6%, in the provision for loan losses from June 30, 1995 to June 30, 1996 was the result of an increase in the average outstanding balance of net loans receivable of $401.6 million, or 111.8%. In addition, at June 30, 1996, net non-accruing loans totaled $55.3 million, as compared to $36.0 million at June 30, 1995. The allowance for loan losses as a percentage of net non-performing loans was 17.1% at June 30, 1995 as compared to 9.7% at June 30, 1996. The primary reason for the decline in this ratio was due to the purchase of multi-family non-performing loans for $132.6 million. Management believes that the underlying collateral value is sufficient to cover the Company's basis in these loans. Non-Interest Income. Total non-interest income increased $2.8 million, or 19.8% to $16.7 million for fiscal 1996 from $13.9 million for fiscal 1995. This increase was primarily due to an increase in gain on real estate transactions of $3.6 million and an increase of $1.1 million in other real estate operations, net, partially offset by a $1.0 million decrease in gains on certain assets. Other real estate operations income, net, increased primarily due to an increase of $822,000 in real estate investment income. During fiscal 1996, the Company increased its earnings on real estate investments primarily due to the operations of two office buildings and three low income multi-family housing developments. The increase of $3.6 million in gains on real estate transactions was primarily due to an increase in foreclosures. During fiscal 1996, the Company discontinued the home improvement operations of Beal Acceptance Corporation, a wholly owned subsidiary of the Bank. The Company does not anticipate a material effect on operations as a result of this action. Non-Interest Expense. Non-interest expense increased $10.3 million, or 84.9%, from $12.2 million for fiscal 1995 to $22.5 million for fiscal 1996 primarily due to an increase in salaries and employee benefits of $3.3 million and an increase in other operating expenses of $4.4 million. The increases in operating expenses, primarily due to the Company's purchasing activities and resultant increase in asset size were principally legal expenses, loan acquisition and origination expenses, loan servicing expenses, audit expenses and marketing expenses. The increase of $3.3 million in salaries and employee benefits was due to the addition of an average of 48 full-time equivalent employees as a result of the Company's increased asset size and an increase in annual bonuses of $614,000. Total full-time equivalent employees at June 30, 1996 were 113 compared to 93 at June 30, 1995. In addition, occupancy expense increased $1.1 million. Lastly, deposit insurance premiums increased $861,000 due the Company's deposit growth. Year 2000. The Company is currently in the process of conducting a comprehensive review of its computer systems to identify the systems that could be affected by the "Year 2000" problem. The Year 2000 problem is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's programs that have time sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a major system failure or miscalculations. Management anticipates that the enhancements necessary to prepare its systems for the year 2000 will be completed in a timely manner. The majority of the Company's information processing capabilities are currently provided by third party vendors. The Company is aware of the risks to third parties, including vendors (and to the extent appropriate, depositors and borrowers) and the potential adverse impact on the Company resulting from failures by these parties to adequately address the Year 2000 problem. The Company has been communicating with its outside data processing service bureau, as well as other third party service providers (and to the extent appropriate, depositors and borrowers) to assess their progress in evaluating their systems and implementing any corrective measures required by them to be prepared for the year 2000. To date, the Company has not been advised by any of its primary vendors that they do 52 not have plans in place to address and correct the issues associated with the Year 2000 problem; however, no assurance can be given as to the adequacy of such plans or to the timeliness of their implementation. The Company anticipates that it will incur internal staff costs as well as consulting and other expenses related to the enhancements necessary to prepare the systems for the year 2000. Based on the Company's current knowledge and investigations, the expense of the year 2000 project as well as the related potential effect on the Company's earnings is not expected to have a material effect on the Company's financial position or results of operations. Income Taxes. Income taxes increased $10.0 million from $15.2 million for fiscal 1995 to $25.2 million for fiscal 1996 due to an increase in taxable income for the 1996 period. The effective tax rate for federal income taxes was 34.8% for the 1995 period as compared to 33.1% for the 1996 period. The rate decrease was due primarily to the utilization of tax credits generated by BAH. As a result of the increase in the Company's taxable income, the Company is currently subject to the highest federal corporate tax rate of 35%. Liquidity and Capital Resources Beal Financial's primary sources of funds are dividends from the Bank and interest earned on its investments. The Bank's primary sources of funds for operations are deposits obtained from its market area, principal and interest payments on loans, and advances from the FHLB of Dallas and to a lesser extent, from the sale of assets. While maturities and 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 primary investing activity of the Company is the purchase of discounted loans from the HUD and FDIC through the sealed bid process or auctions and other private sector sellers. During the year ended December 31, 1997 and the twelve months ended December 31, 1996, the Company purchased $130.4 million and $308.0 million of net loans, respectively. During the years ended June 30, 1996 and, 1995, the Company purchased $524.7 million and $346.2 million of net loans, respectively. Loan originations for the year ended December 31, 1997 and the twelve months ended December 31, 1996 were $76.6 million and $132.5 million, respectively. Loan originations for the years ended June 30, 1996 and 1995 were $138.4 million and $76.4 million, respectively. The Company's primary financing activity is the attraction of deposits. During the fiscal years ended June 30, 1996 and 1995, the Company experienced a net increase in deposits of $433.2 million and $272.1 million, respectively. During the year ended December 31, 1997 and the twelve months ended December 31, 1996, the Company experienced a net increase (decrease) in deposits of $(42.0) million and $57.5 million, respectively. The Company also utilizes FHLB advances to fund the Bank's discounted loan purchases. During the year ended December 31, 1997, the twelve months ended December 31, 1996 and the years ended June 30, 1996 and 1995, the Company's net financing activity (proceeds less repayments) with the FHLB totaled $(36.0) million $(39.0) million, $74.0 million and $86.0 million, respectively. The Company had other borrowings of $64.7 million at December 31, 1997, including $57.1 million of Senior Notes. The Company has the ability to borrow additional funds from the FHLB of Dallas by pledging additional assets as collateral, subject to certain restrictions. At December 31, 1997, the Company had an undrawn advance arrangement with the FHLB for $26.0 million. The Bank is required to maintain minimum levels of liquid assets as defined by the Texas Department. A Texas savings bank is required to maintain liquidity in an amount not less than 10% of an amount equal to its average daily deposits for the most recently completed calendar quarter in cash or readily marketable securities. At December 31, 1997, the Bank's liquidity ratio was 19.1%. The Company's most liquid asset is cash and cash equivalents. The level of cash and cash equivalents is dependent on the Company's operating, financing, and investing activities during any given period. At June 30, 1996 and 1995, cash and cash equivalents totaled $55.4 million and $31.5 million, respectively. At December 31, 1997 and 1996 cash and cash equivalents totaled $150.8 million and $65.9 million, respectively. 53 The Company anticipates that it will have sufficient funds available to meet its current commitments. At December 31, 1997, the Company had commitments to originate one loan of $7.0 million. Certificates of deposits which are scheduled to mature in one year or less at December 31, 1997 totaled $778.4 million reflecting consumer preference for short-term investments in the current interest rate environment. Due to the Company's high interest rate spread, management has typically relied upon interest rate sensitive short-term deposits to fund its loan purchases. The Company believes the potential interest rate risk is acceptable in view of the Company's belief that it can maintain an acceptable net interest spread. The Company further believes that based on the levels of retention of such deposits in the recent past, that a significant portion of such deposits will remain with the Company. At December 31, 1997, the Bank exceeded each of its three capital requirements. The following is a summary of the Bank's regulatory capital position at December 31, 1997. At December 31, 1997 ------------------------------------------ Required Actual -------------------- ------------------- Amount Percent Amount Percent --------- --------- --------- -------- (Dollars in Thousands) Leverage capital ........ $ 67,373 5.00% $186,116 13.81% Tier 1 risk-based capital 62,387 6.00 186,116 17.90 Total risk-based capital 103,978 10.00 198,028 19.05 The Company anticipates based on the amount of dividends to stockholders expected to be declared by the Board of Director's in 1998, that the Bank's regulatory capital ratios will be reduced. It is the Company's intention that any such dividends would be limited to ensure that the Bank maintains its capital ratios in excess of the ratios necessary to be classified as a "well capitalized institution" as defined in FDIC regulations. See Item 1. Business - Regulation - Insurance of Accounts and Regulation by the FDIC." Impact of Inflation and Changing Prices The Consolidated Financial Statements and Notes thereto presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Bank's operations. Nearly all the assets and liabilities of the Company are financial, unlike most industrial companies. As a result, the Company's performance is directly impacted by changes in interest rates, which are indirectly influenced by inflationary expectations. Since the Company has historically placed more emphasis on increasing net interest margin rather than on matching the maturities of interest rate sensitive assets and liabilities, changes in interest rates may have a greater impact on the Company's financial condition and results of operations. Changes in investment rates do not necessarily move to the same extent as changes in the price of goods and services. Ratios of Earnings to Fixed Charges The Company's consolidated ratios of earnings to fixed charges for the year ended December 31, 1997 are set forth below. Earnings used in computing the ratios shown consist of earnings from continuing operations before taxes and interest expenses. Fixed charges, excluding interest of deposits, represent interest expense on borrowings. Fixed charges, including interest on deposits, represent all of the foregoing items plus interest on deposits. Interest expense (other than on deposits) includes interest on FHLB of Dallas borrowings, the Senior Notes and other borrowed funds. 54 For the Year Ended December 31, 1997 ----------------- Excluding interest on deposits............... 10.4:1 Including interest on deposits............... 1.5:1 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Asset/liability Management The interest rate sensitivity of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities will mature or reprice within the same 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 repricing within that same period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities, and is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. Generally, during a period of rising interest rates, a negative gap would adversely affect net interest income while a positive gap could result in an increase in net interest income. Conversely during a period of falling interest rates, a negative gap would result in an increase in net interest income and a positive gap would adversely affect net interest income. Management monitors the Bank's interest rate risk as one component of its business risk. The Bank has an Investment Committee consisting of the Chairman of the Board, the President, the Executive Vice President and two outside Directors. The Bank's Senior Vice President/Controller and Senior Vice President/Compliance also attend all Investment Committee meetings. This committee meets at least quarterly to review the Bank's interest rate risk position and profitability and to make recommendations for adjustments to the Bank's Board of Directors. This committee also reviews the Bank's portfolio, formulates investment strategies and oversees the timing and implementation of transactions to assure attainment of the Board's objectives in the most effective manner. In addition, the Committee reviews on a quarterly basis the Bank's asset/liability position, including the sensitivity of the market value of portfolio equity based on various interest rate scenarios. In managing its asset/liability mix, the Bank has, depending on the relationship between long- and short-term interest rates, market conditions and consumer preference, placed more emphasis on increasing net interest margin than on better matching the interest rate sensitivity of its assets and liabilities in an effort to enhance net interest income. Management believes that due to the high yield the Bank earns on its assets resulting from accretion of purchased discount, the increased net interest income resulting from a mismatch in the maturity of its asset and liability portfolios can, during periods of declining or stable interest rates, provide high enough returns to justify the increased exposure to sudden and unexpected increases in interest rates. In addition, the majority of the Bank's loan originations, renewals, or modifications are made at adjustable interest rates to improve the interest rate sensitivity of the Bank's loan portfolio. The Bank believes that it has the ability to restructure its liabilities very quickly by extending the maturities of FHLB advances and pricing deposits to attract funds with longer terms to maturity. It should be noted that an extension of maturities may result in a higher cost of funds. As indicated in the table below, at December 31, 1997, the Bank's interest-bearing liabilities repricing in one year or less exceeded interest-earning assets maturing during the same period by $529.1 million, resulting in a one-year negative gap equal to 50.0% of its interest-earning assets at that date. Despite the Bank's negative gap position, management believes that the Bank's interest rate risk is acceptable given its high yield on earning assets. This high yield is a direct result of (i) purchasing performing loans at a discount, (ii) prepayments of loans in full that have been purchased at a discount and (iii) successfully resolving non-performing loans so that they are performing and thus begin to amortize the discount as the loans are paid down. 55 The following table sets forth the interest rate sensitivity of the Bank's net assets and liabilities at December 31, 1997 on the basis of the following assumptions. It is assumed that adjustable-rate assets and liabilities would reprice at their earliest repricing date and fixed-rate assets and liabilities would reprice on their contractual maturity date. Money market deposit accounts ("MMDA's") and savings deposits are assumed to reprice in accordance with FIDICIA Section 305 guidelines, as follows: Fifteen percent of MMDA's are assumed to reprice in 0-3 months, 45% in 3-12 months and 40% in 1-3 years; savings deposits are assumed to reprice at 5% in 0-3 months, 15% in 3-12 months, 40% in 1-3 years and 40% in 3-5 years. All prepayment assumptions are based on the Bank's historical experience while liability repricing assumptions are based on industry averages used for the purpose of assessing interest rate sensitivity, which the Company believes does not differ materially from its historical experience. Balances in all instruments are kept stable with the assumption that runoff is reinvested in the same instrument. Nonaccrual loans are not reflected below. Maturing or Repricing -------------------------------------------------------------------------------- Over 1 Over 2 Over 3 Over 5 1 Year Year to Years to Years to Years to Over 10 or Less Two Years Three Years 5 Year 10 Years Years Total ----------- ----------- ----------- ----------- ----------- ----------- ----------- (Dollars in Thousands) Fixed rate one- to four-family, commercial real estate and construction loans .............. $ 27,831 $ 48,180 $ 50,257 $ 95,508 $ 65,373 $ 129,177 $ 416,326 Adjustable rate one- to four- family, commercial real estate and construction loans .......... 142,067 4,029 11,080 139,136 506 451 297,269 Commercial business loans ........ 1,324 2,437 27 6,806 1,682 823 13,099 Consumer loans ................... 32,836 881 2,191 3,676 7,127 13,346 60,057 Interest-earning deposits ........ 150,039 -- -- -- -- -- 150,039 FHLB Stock ....................... 10,203 -- -- -- -- -- 10,203 Securities available for sale and other investments .............. 111,376 111,376 ----------- ----------- ----------- ----------- ----------- ----------- ----------- Total interest-earning assets 475,676 55,527 63,555 245,126 74,688 143,797 1,058,369 Money market accounts ............ 101,593 33,864 33,864 -- -- -- 169,321 Commercial demand ................ 14,272 -- -- -- -- -- 14,272 Savings deposits ................. 239 239 239 476 -- -- 1,193 Certificate accounts ............. 778,354 19,606 17,582 1,148 -- -- 816,690 Subordinated debt, net ........... -- -- 57,188 -- -- -- 57,188 FHLB advances .................... 110,000 -- -- -- -- -- 110,000 Other borrowings ................. 304 -- 923 6,015 -- 357 7,599 ----------- ----------- ----------- ----------- ----------- ----------- ----------- Total interest-bearing liabilities ...................... 1,004,762 53,709 109,796 7,639 -- 357 1,176,263 Interest-earning assets less interest-bearing liabilities .... (529,086) 1,818 (46,241) 237,487 74,688 143,440 (117,894) Cumulative interest-rate sensitivity gap ................. (529,086) (527,268) (573,509) (336,022) (261,334) (117,894) (117,894) Cumulative interest-rate gap as a percentage of total assets at December 31, 1997 ............ (38.74%) (38.61%) (41.99%) (24.60%) (19.13%) (8.63%) (8.63%) Cumulative interest-rate gap as a percentage of interest-earning assets at December 31, 1997 ..... (49.99%) (49.82%) (54.19%) (31.75%) (24.69%) (11.14%) (11.14%) Cumulative interest-rate gap as a percentage of interest-bearing liabilities at December 31, 1997 (44.99%) (44.83%) (48.76%) (28.57%) (22.22%) (10.02%) (10.02%) 56 Certain shortcomings are inherent in the method of analysis presented in the foregoing table. Although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rate. 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 of assets and liabilities may lag behind changes in market interest rates. Certain assets, such as adjustable-rate mortgages, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. In the event of a change in interest rates, prepayment and early withdrawal levels would significantly change the results set forth in the foregoing table. The ability of many borrowers to service their debt may decrease in the event of an interest rate increase. The table below sets forth, as of December 31, 1997, the estimated changes in (i) the Bank's market value of portfolio equity ("MVPE") (i.e., the present value of expected cash flows from assets, liabilities and off-balance sheet contracts) and (ii) the Bank's net interest income on December 31, 1997, presented on an annualized basis which would result from the designated instantaneous changes in the U.S. Treasury yield curve. Yields used in the table to compute Net Interest Income and MVPE reflect actual effective yields for the quarter ended December 31, 1997, annualized. Percentage Change in: --------------------------------------------- Net Interest Income MVPE Change Change Dollar Percent Change in ----------------------- ------------------- Net in Net in Net Change Change Interest Rates Board Projected Board Projected Interest Interest Interest in in (Basis Points) Limit %(1) Change % Limit %(1) Change % Income Income Income % MVPE MVPE MVPE - -------------- ---------- --------- ---------- --------- -------- -------- --------- -------- -------- ---------- (Dollars in Thousands) +400 (75)% (8.8)% (75)% (25.8)% $92,508 $(8,927) (8.8)% $143,597 $(49,917) (25.8)% +300 (50) (6.6) (50) (20.1) 94,749 (6,686) (6.6) 154,636 (38,878) (20.1) +200 (35) (4.4) (35) (13.9) 96,985 (4,450) (4.4) 166,575 (26,939) (13.9) +100 (25) (2.2) (25) (7.2) 99,213 (2,222) (2.2) 179,502 (14,012) (7.2) 0 101,435 193,514 -100 (25) 2.2 (25) 7.9 103,651 2,216 2.2 208,722 15,208 7.9 -200 (35) 4.6 (35) 20.7 106,128 4,693 4.6 233,633 40,119 20.7 -300 (55) 7.0 (55) 32.7 108,525 7,090 7.0 256,709 63,195 32.7 -400 (75) 9.3 (75) 45.8 110,915 9,480 9.3 282,114 88,600 45.8 - ------------------- (1) Reflects the limits established by the Board of Directors. As indicated in the table above, management has structured its assets and liabilities to increase net interest margin rather than minimize its exposure to interest rate risk. As a result, the changes in the Bank's MVPE reflected above exceed industry averages. In the event of a 400 basis point change in interest rates, the Bank would experience a 45.8% increase in MVPE and a $9.5 million increase in net interest income in a declining rate environment and a 25.8% decrease in MVPE and a $8.9 million decrease in net interest income in a rising rate environment. The Bank's asset and liability structure results in a decrease in MVPE in a rising interest rate environment and an increase in MVPE in a declining interest rate scenario. During periods of rising rates, the value of monetary assets and monetary liabilities decline. Conversely, during periods of falling rates, the value of monetary assets and liabilities increase. However, the amount of change in value of specific assets and liabilities due to changes in rates is not the same in a rising rate environment as in a falling rate environment (i.e., the amount of value increase under a specific rate decline may not equal the amount of value decrease under an identical upward rate movement). The decrease in MVPE in a rising interest rate environment is the result of management's use of relatively short-term liabilities to fund its purchases of loans with substantially longer terms to maturities. While this results in a decrease in MVPE during a rising rate environment and an increase in MVPE in a falling rate environment, management believes that the level of the Bank's net interest spread enables the Bank to incur this additional interest rate risk. Management of the Bank believes that the assumptions used by it to evaluate the vulnerability of the Bank's operations to changes in interest rates approximate actual experience and considers them reasonable; however, the interest rate sensitivity of the Bank's assets and liabilities and the estimated effect of changes in interest rates on the Bank's net interest income and MVPE could vary substantially if different assumptions were used or actual experience 57 differs from the historical experience on which they are based. In addition, in evaluating the Bank's exposure to interest rate risk, certain other shortcomings inherent in the method of analysis presented in the foregoing table must be considered. 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. Further, in the event of a change in interest rates, prepayments and early withdrawal levels would likely deviate significantly from those assumed in calculating the table. Finally, the ability of many borrowers to service their debt may decrease in the event of an interest rate increase. As a result, the actual effect of changing interest rates may differ substantially from that presented in the foregoing table. 58 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION BEAL FINANCIAL CORPORATION AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page ---- Report of Independent Certified Public Accountants ............................ 60 Consolidated Financial Statements: Consolidated Balance Sheets as of December 31, 1997 and 1996 .................. 61 Consolidated Statements of Income for the year ended December 31, 1997, the six months ended December 31, 1996 and the years ended June 30, 1996 and 1995 ...................................................................... 62 Consolidated Statements of Stockholders' Equity for the year ended December 31, 1997, the six months ended December 31, 1996 and the years ended June 30, 1996 and 1995 .................................... 63 Consolidated Statements of Cash Flows for the year ended December 31, 1997, the six months ended December 31, 1996 and the years ended June 30, 1996 and 1995....................................................................... 64 Notes to Consolidated Financial Statements .................................... 67 59 Report of Independent Certified Public Accountants Board of Directors Beal Financial Corporation We have audited the accompanying consolidated balance sheets of Beal Financial Corporation and Subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, stockholders' equity and cash flows for the year ended December 31, 1997, the six months ended December 31, 1996, and for each of the two years in the period ended June 30, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe 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 consolidated financial position of Beal Financial Corporation and Subsidiaries as of December 31, 1997 and 1996, and the consolidated results of their operations and their consolidated cash flows for the year ended December 31, 1997, the six months ended December 31, 1996, and each of the two years in the period ended June 30, 1996, in conformity with generally accepted accounting principles. Dallas, Texas March 16, 1998 60 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands, except per share data) December 31, ---------------------------- 1997 1996 ---------- ---------- ASSETS Cash $ 630 $ 449 Interest-bearing deposits with Federal Home Loan Bank 150,219 65,491 ---------- ---------- Cash and cash equivalents 150,849 65,940 Accrued interest receivable 13,071 16,361 Securities - available for sale 111,376 123,939 Loans receivable, net 887,833 1,054,204 Federal Home Loan Bank stock 10,203 9,618 Real estate held for investment or sale 176,682 102,680 Premises and equipment, net 6,351 6,802 Other assets 9,389 15,362 ---------- ---------- $1,365,754 $1,394,906 ---------- ---------- ---------- ---------- LIABILITIES Deposit accounts $1,001,476 $1,043,433 Federal Home Loan Bank advances 110,000 146,000 Senior notes, net 57,188 57,094 Other borrowings 7,599 14,748 Other liabilities 28,673 16,834 ---------- ---------- Total liabilities 1,204,936 1,278,109 COMMITMENTS AND CONTINGENCIES -- -- STOCKHOLDERS' EQUITY Common stock, $1 par value per share; authorized 375 shares; issued and outstanding 300 shares 300 300 Additional paid-in capital 2,740 2,740 Unrealized gain on available for sale securities, net of taxes of $381 at December 31, 1996 3,722 709 Retained earnings 154,056 113,048 ---------- ---------- Total stockholders' equity 160,818 116,797 ---------- ---------- $1,365,754 $1,394,906 ---------- ---------- ---------- ---------- The accompanying notes are an integral part of these statements. 61 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share data) Six months Year Ended ended Year ended June 30, December 31, December 31, ---------------------- 1997 1996 1996 1995 ------------ ------------ -------- ------- Interest income: Loans, including fees $112,785 $ 51,726 $ 92,618 $ 41,858 Purchase discount accretion 44,673 30,451 38,926 19,327 Investment securities 11,723 5,875 9,404 2,610 -------- -------- ------- ------- Total interest income 169,181 88,052 140,948 63,795 Interest expense: Deposits 57,980 28,221 45,915 13,717 Federal Home Loan Bank advances and other borrowings 1,890 1,758 3,999 7,264 Senior notes 7,986 3,962 6,904 -- -------- -------- ------- ------- Total interest expense 67,856 33,941 56,818 20,981 -------- -------- ------- ------- Net interest income 101,325 54,111 84,130 42,814 Provision for loan losses 3,410 3,314 9,044 4,045 -------- -------- ------- ------- Net interest income after provision for loan losses 97,915 50,797 75,086 38,769 Noninterest income: Gains on real estate transactions 13,708 6,434 7,068 4,412 Other real estate operations, net 2,486 1,202 1,108 -- Gain on sales of loans 550 1,701 8,413 8,620 Gain on sales of securities available for sale -- -- -- 788 Other operating income 527 723 94 109 -------- -------- ------- ------- Total noninterest income 17,271 10,060 16,683 13,929 Noninterest expense: Salaries and employee benefits 8,318 15,615 8,232 4,944 Occupancy and equipment 2,392 1,143 2,049 922 SAIF deposit insurance premium 676 2,605 1,332 471 Loss on sales of securities available for sale -- 437 587 -- Other operating expense 10,758 6,851 10,256 5,808 -------- -------- ------- ------- Total non-interest expenses 22,144 26,651 22,456 12,145 -------- -------- ------- ------- Income before income taxes 93,042 34,206 69,313 40,553 Income taxes 6,408 12,152 25,153 15,176 -------- -------- ------- ------- NET INCOME $ 86,634 $ 22,054 $ 44,160 $ 25,377 -------- -------- ------- ------- -------- -------- ------- ------- Income per common share $288.78 $73.51 $147.20 $84.59 -------- -------- ------- ------- -------- -------- ------- ------- Weighted average number of common shares outstanding 300 300 300 300 -------- -------- ------- ------- -------- -------- ------- ------- The accompanying notes are an integral part of this statement. 62 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (In thousands) Unrealized gain (loss) on Common stock Additional securities ----------------- paid-in available Retained Shares Amount capital for sale earnings Total ------ ------ ---------- --------------- -------- ------- Balance at June 30, 1994 300 $300 $2,740 $ -- $ 23,983 $ 27,023 Net income -- -- -- -- 25,377 25,377 ----- ----- ------ ----- -------- -------- Balance at June 30, 1995 300 300 2,740 -- 49,360 52,400 Net income -- -- -- -- 44,160 44,160 Net unrealized loss on securities available for sale, net of tax benefit of $466 -- -- -- (862) -- (862) Dividends paid -- -- -- -- (2,526) (2,526) ----- ----- ------ ----- -------- -------- Balance at June 30, 1996 300 300 2,740 (862) 90,994 93,172 Net income -- -- -- -- 22,054 22,054 Net unrealized gain on securities available for sale, net of tax expense of $847 -- -- -- 1,571 -- 1,571 ----- ----- ------ ----- -------- -------- Balance at December 31, 1996 300 300 2,740 709 113,048 116,797 Net income -- -- -- -- 86,634 86,634 Net unrealized gain on securities available for sale -- -- -- 3,013 -- 3,013 Dividends declared -- -- -- -- (45,626) (45,626) ----- ----- ------ ----- -------- -------- Balance at December 31, 1997 300 $300 $2,740 $3,722 $154,056 $160,818 ----- ----- ------ ----- -------- -------- ----- ----- ------ ----- -------- -------- The accompanying notes are an integral part of this statement. 63 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Six months Year ended ended Year ended June 30, December 31, December 31, ---------------------- 1997 1996 1996 1995 ------------ ------------ -------- -------- Operating activities Net income $ 86,634 $ 22,054 $ 44,160 $ 25,377 Adjustments to reconcile net income to net cash provided by (used in) operating activities Depreciation and amortization 2,468 1,071 1,791 585 Accretion of purchase discount (44,673) (30,451) (38,926) (19,327) Provision for loan losses 3,410 3,314 9,044 4,045 Amortization of bond premium and underwriting costs 654 297 477 -- Gains on real estate transactions (13,708) (6,434) (7,068) (4,412) Gain on sales of loans (550) (1,701) (8,413) (8,620) (Gain) loss on sales of securities available for sale -- 437 587 (788) Loss on sale of premises and equipment 7 71 -- -- Changes in operating assets and liabilities Accrued interest receivable (1,361) (1,249) (11,102) (3,822) Prepaid expenses and other assets (334) (191) (4,515) (3,300) Other liabilities and accrued expenses 2,225 (7,573) 14,842 1,098 --------- -------- -------- -------- Net cash provided by (used in) operating activities 34,772 (20,355) 877 (9,164) 64 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED (In thousands) Six months Year ended ended Year ended June 30, December 31, December 31, ------------------------ 1997 1996 1996 1995 ------------ ------------ ---------- ---------- Investing activities Proceeds from sales of loans $ 26 $ 8,477 $ 19,045 $ 64,469 Proceeds from sales of securities available for sale -- 68,134 151,744 43,372 Proceeds from paydowns of securities available for sale 15,306 4,674 10,954 116 Proceeds from sales of real estate 34,929 16,446 11,067 11,087 Purchase of loans and bid deposits on loan purchases (130,418) (273,885) (541,173) (374,403) Purchases of securities available for sale -- (318,769) (81,426) (Purchase) sales of Federal Home Loan Bank stock (585) (278) (1,865) (5,902) Purchase of real estate held for investment or sale (17,395) (10,525) (18,519) (28,776) Loan originations and advances, less loan collections 266,850 111,791 136,265 49,499 Purchases of premises and equipment, net (443) (412) (1,406) (2,488) -------- -------- -------- -------- Net cash provided by (used in) investing activities 168,270 (75,578) (552,657) (324,452) 65 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED (In thousands) Six months Year ended ended Year ended June 30, December 31, December 31, -------------------- 1997 1996 1996 1995 ------------ ------------ ------ ------ Financing activities Net increase (decrease) in deposit accounts $ (41,958) $ 152,130 $ 433,168 $ 272,117 Proceeds from long-term debt 162 1,158 17,776 2,501 Repayments of long-term debt (7,311) (7,785) (3,767) (535) (Repayments) advances from the Federal Home Loan Bank (36,000) (39,000) 74,000 86,000 Proceeds from issuance of senior notes -- -- 54,492 -- Cash dividend paid (33,026) -- (26) -- --------- --------- --------- --------- Net cash provided (used in) by financing activities (118,133) 106,503 575,643 360,083 --------- --------- --------- --------- Increase in cash and cash equivalents 84,909 10,570 23,863 26,467 Cash and cash equivalents at beginning of period 65,940 55,370 31,507 5,040 --------- --------- --------- --------- Cash and cash equivalents at end of period $ 150,849 $ 65,940 $ 55,370 $ 31,507 --------- --------- --------- --------- --------- --------- --------- --------- Supplemental disclosure of cash flow information Cash paid during the period for Interest $ 66,661 $ 36,319 $ 19,049 $ 50,707 Income taxes 2,215 18,780 5,550 19,668 Supplemental disclosures of noncash investing and financing activities Real estate acquired in foreclosure or in settlement of loans $ 89,850 $ 27,615 $ 6,752 $ 22,520 Assumption of majority stockholders' indebtedness in lieu of cash dividend $ -- $ -- $ 2,500 $ 2,500 The accompanying notes are an integral part of these statements. 66 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands) NOTE A - NATURE OF OPERATIONS AND SUMMARY OF ACCOUNTING POLICIES Nature of Operations: Beal Financial Corporation (the Company), through its subsidiary, Beal Bank ssb (the Bank), collectively, (the Corporation) operates three branches in Dallas and Houston, Texas and Winnetka, Illinois. The Bank's primary business consists of purchasing pools of loans generally at a discount from the principal balances of the loans. These loans are generally purchased from the Resolution Trust Corporation ("RTC"), the Federal Deposit Insurance Corporation ("FDIC"), and the U.S. Department of Housing and Urban Development ("HUD"). The Bank also provides loans and banking services to consumer and commercial customers in the market areas in which its branches are located. A summary of the significant accounting policies of the Corporation applied in the preparation of the accompanying consolidated financial statements follows. The accounting principles followed by the Corporation and the methods of applying them are in conformity with both generally accepted accounting principles and prevailing practices of the banking industry. Basis of Presentation: The accompanying consolidated financial statements include the accounts of the Corporation, its subsidiaries including the Bank and subsidiaries of the Bank, and partnerships in which subsidiaries are the 1% general and 98% limited partner. All significant intercompany transactions and balances are eliminated. Use of Estimates in the Preparation of Financial Statements: In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Actual results could differ from those estimates. Loans: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are stated at unpaid principal balances less the allowance for loan losses, loans in process and net deferred loan origination fees and discounts. A loan is identified as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. For impaired loans the accrual of interest is discontinued when the net carrying value of the loan equals the net realizable value of the underlying collateral. Impairments of loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, its observable market price, or fair value of collateral if the loan is collateral dependent. Discounts on mortgage loans purchased by the Corporation are amortized to income using the interest method over a remaining period which is the longer of the contractual maturity or the remaining amortization term of the note. Upon early payoff, any remaining discount collected is taken into income and reflected in the financial statements as interest income. Discounts on loans originated are recognized over the lives of the loans using methods that approximate the interest method. Loans held for sale are carried at the lower of cost or estimated fair value. 67 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands) NOTE A - NATURE OF OPERATIONS AND SUMMARY OF ACCOUNTING POLICIES - Continued Loans in process of foreclosure are classified as loans until legal title is transferred. Investment Securities: The Corporation classifies investments as available for sale and records them at fair value, with unrealized gains and losses, net of income taxes, excluded from earnings and reported as a separate component of stockholders' equity. Realized gains and losses on securities are reported in income in the year of sale. Loan-Origination Fees, Commitment Fees, and Related Costs: Loan fees and certain direct loan origination costs are deferred, and the net fee or cost is recognized as an adjustment to interest income using the interest method over the estimated life of the loans based on the Corporation's historical prepayment experience. Commitment fees and costs relating to commitments, for which the likelihood of exercise is remote, are recognized over the commitment period on a straight-line basis. If the commitment is exercised during the commitment period, the remaining unamortized commitment fee at the time of exercise is recognized over the life of the loan as an adjustment of yield. Allowance for Loan Losses: The allowance for loan losses is maintained at a level believed adequate by management to absorb potential losses in the loan portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loan loss experience, current economic conditions, volume, growth, composition of the loan portfolio, and other relevant factors. The allowance is increased by provisions for loan losses charged to operations. Management believes the allowance for loan losses 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 addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Real Estate Held for Investment and Sale: Real estate properties held for investment are carried at the lower of cost, including cost of improvements and amenities incurred subsequent to acquisition, or net realizable value (fair value). Costs relating to development and improvement of the real estate are capitalized, whereas costs relating to the holding of property are expensed. Real estate properties acquired through or in lieu of loan foreclosure are initially recorded at fair value less cost to sell at the date of foreclosure. Valuations are periodically performed by management, and an allowance for losses is established by a charge to operations if the carrying value of a property exceeds its fair value. Income Per Common Share: Income per common share is based on the weighted average number of common shares outstanding during each year. There are no common stock equivalents. Statements of Cash Flows: For purposes of reporting cash flow, cash and cash equivalents include cash on hand, amounts due from banks and interest-bearing deposits in other banks. 68 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands) NOTE A - NATURE OF OPERATIONS AND SUMMARY OF ACCOUNTING POLICIES - Continued Premises and Equipment: Premises and equipment are stated at cost, less accumulated depreciation based on the estimated useful lives of the assets, as follows: Buildings and improvements 10-45 years Furniture and equipment 3-10 years Depreciation is computed using the straight-line method. Income Taxes: Prior to January, 1997, the Corporation and its subsidiaries filed a Federal income tax return on a consolidated basis. Deferred tax assets and liabilities were 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. Effective January 1, 1997, the Corporation and all of its subsidiaries, except for Beal Affordable Housing, Inc. and BRE-N, Inc., elected to be taxed as S Corporations, and their federal income taxes will be the responsibility of the Corporation's stockholders. Off-Balance Sheet Financial Instruments: In the ordinary course of business, the Corporation has entered into off-balance sheet financial instruments consisting of commitments to extend credit and letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received. Fair Values of Financial Instruments: The Corporation provides disclosures regarding financial instruments as prescribed by generally accepted accounting principles. These disclosures do not purport to represent the aggregate net fair value of the Corporation. Further, the fair value estimates are based on various assumptions, methodologies and subjective considerations which vary widely among different financial institutions and which are subject to change. The following methods and assumptions were used by the Corporation in estimating financial instruments' fair values: Cash and cash equivalents: The balance sheet carrying amounts approximate the estimated fair values of such assets. Investment securities: Fair values for investment securities are based on quoted market prices, if available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. Loans: For variable rate loans that reprice frequently and entail no significant change in credit risk, fair values are based on the carrying values. The fair values of other loans are estimated based on discounted cash flow analysis using interest rates currently offered for loans with similar terms to borrowers of similar credit quality. 69 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands) NOTE A - NATURE OF OPERATIONS AND SUMMARY OF ACCOUNTING POLICIES - Continued Deposit Liabilities: The fair values estimated for demand deposits (interest and non-interest bearing accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair values. Fair values of fixed rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered to a schedule of aggregated expected maturities. Federal Home Loan Bank Advances and Other Borrowings: Fair values for Federal Home Loan Bank advances and other borrowings are based upon current market rates for instruments with similar maturities. Senior Notes: Fair value for senior notes is based upon the closing market price at December 31, 1997. NOTE B - FORMATION OF HOLDING COMPANY On April 5, 1995, the Company filed an application with the Office of Thrift Supervision for approval to acquire, indirectly, 100% of the outstanding common stock of the Bank in exchange for 100% of the Company's common stock. The application was approved on June 29, 1995 and the acquisition was effective on July 1, 1995. The accompanying financial statements for the year ended June 30, 1995 reflect the results of operations of the Bank and its subsidiaries. In connection with the acquisition of the Bank's common stock, the Company assumed certain related indebtedness of $2,500 from the majority shareholder. This amount has been reflected in stockholders' equity as a dividend. 70 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands) NOTE C - LOANS RECEIVABLE A substantial portion of the Corporation's loan portfolio consists of first mortgage loans in Texas, California, Florida and Illinois. A borrower's ability to pay in full is dependent, in some respects, upon the general economic condition of the geographic location of the underlying collateral. Loans receivable consisted of the following: December 31, ------------------------ 1997 1996 --------- --------- Real estate loans One-to-four family first liens $ 213,584 $ 276,591 Multifamily 321,423 466,697 Commercial 337,825 388,460 Construction and development 98,503 74,437 Land 71,379 95,684 ------- ------- Total real estate loans 1,042,714 1,301,869 Other loans Consumer loans One-to-four family junior lien 71,465 77,528 Timeshares 3,615 6,446 Other 5,003 7,095 ------ ------ Total consumer loans 80,083 91,069 Commercial business loans 25,554 35,131 ------- ------- Total other loans 105,637 126,200 -------- -------- Total loans 1,148,351 1,428,069 Less: Loans in process (16,806) (16,364) Deferred fees and discounts (231,800) (344,312) Allowance for loan losses (11,912) (13,189) -------- -------- Total loans receivable, net $ 887,833 $1,054,204 -------- -------- -------- -------- The amount of loans being serviced by the Corporation for others was approximately $36,484 and $46,402 at December 31, 1997 and 1996, respectively. 71 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands) NOTE C - LOANS RECEIVABLE - Continued Transactions in the allowance for loan losses were as follows: Six months Year ended ended Year ended June 30, December 31, December 31, -------------------- 1997 1996 1996 1995 ------------ ------------ -------------------- Balance at beginning of year $13,189 $11,832 $ 6,137 $ 3,547 Provision for loan losses 3,410 3,314 9,044 4,045 Charge-offs (4,956) (1,978) (3,385) (1,462) Recoveries 269 21 36 7 ------- ------- ------- ------- Balance at end of year $11,912 $13,189 $11,832 $ 6,137 ------- ------- ------- ------- ------- ------- ------- ------- In the normal course of business, the Corporation acquires pools of loans at a discount from their unpaid contractual principal balance. The unearned discount is then accreted over the life of the loans using the interest method. In the Corporation's due diligence procedures and bidding, it takes into consideration potential loans to be modified in determining the price it is willing to pay for a particular pool. In connection with these loan purchases, the Corporation subsequently may modify the terms of certain loans included in the pools. The Corporation does not consider these to be troubled debt restructurings. The effective interest rate on the Corporation's modified loans is equal to or greater than the rate the Corporation would be willing to accept for a new loan with comparable risk. At December 31, 1997 and 1996, all significant impaired loans have been determined to be collateral dependent and have been measured utilizing the fair value of the collateral. The Corporation's recorded investment in impaired loans and the related valuation allowance are as follows: December 31, 1997 December 31, 1996 ----------------------- ------------------------- Recorded Valuation Recorded Valuation investment allowance investment allowance ---------- --------- ---------- --------- Impaired loans - valuation allowance required $ 9,412 $2,186 $ 12,755 $3,454 Impaired loans - no valuation allowance 79,914 -- 153,677 -- ------- ------ -------- ------ Total impaired loans $89,326 $2,186 $166,432 $3,454 ------- ------ -------- ------ ------- ------ -------- ------ 72 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands) NOTE C - LOANS RECEIVABLE - Continued The valuation allowance for impaired loans is included in the allowance for loan losses. The average recorded investment in impaired loans for the year ended December 31, 1997, the six months ended December 31, 1996, and the year ended June 30, 1996 was $132,277, $136,000 and $94,007, respectively. Interest income on impaired loans for the year ended December 31, 1997, the six months ended December 31, 1996 and the year ended June 30, 1996 was $8,576, $3,830 and $8,206, respectively. Interest income foregone under the original terms of impaired loans for the year ended December 31, 1997, the six months ended December 31, 1996 and the year ended June 30, 1996 was approximately $4,189, $4,341 and $5,400, respectively. Nonaccrual and renegotiated loans for which interest has been reduced totaled approximately $57,990 at June 30, 1995. Interest income foregone under the original terms of such loans was approximately $3,578 for the year ended June 30, 1995. NOTE D - REAL ESTATE HELD FOR INVESTMENT OR SALE Real estate held for investment or sale is comprised of the following: December 31, ------------------------ 1997 1996 -------- -------- Real estate held for development and rental $ 64,390 $ 59,773 Real estate held for sale 113,852 44,630 -------- -------- 178,242 104,403 Less accumulated depreciation (1,560) (1,723) -------- -------- Total real estate held for investment or sale $176,682 $102,680 -------- -------- -------- -------- Income from real estate development and rental activities which has not been significant is included in other income in the statements of income. Real estate held for sale was acquired by foreclosure or by deed in lieu of foreclosure. 73 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands) NOTE E - SECURITIES AVAILABLE FOR SALE Securities available for sale consist of the following: Gross Gross Amortized unrealized unrealized Fair cost gains losses value --------- ---------- ---------- -------- Mortgage-backed securities: December 31, 1997 $107,655 $3,721 $ -- $111,376 December 31, 1996 122,849 1,090 -- 123,939 At December 31, 1997, mortgage-backed securities valued at approximately $11,570 were pledged to another institution for the benefit of a customer of the Bank. The mortgage-backed securities at December 31, 1997 are scheduled to mature in 2025 and 2026. NOTE F - DEPOSITS December 31, --------------------------------------------------- 1997 1996 --------------------- --------------------- Amount Percent Amount Percent ---------- ------- --------- ------- Noninterest-bearing demand deposits $ 14,272 1.4% $ 2,870 .2% Statement savings deposits (4.7% at December 31, 1997) 1,193 .1 653 .1 Money market demand deposit accounts (4.9% at December 31, 1997) 169,321 17.0 188,466 18.1 -------- ----- -------- ----- 184,786 18.5 191,989 18.4 Certificates of deposit 3.51% to 4.00% 2 -- -- -- 4.01% to 4.50% 1 -- 138 -- 4.51% to 5.00% 1,524 .2 25,039 2.4 5.01% to 5.50% 198,607 19.8 220,903 21.2 5.51% to 6.00% 585,733 58.4 441,676 42.3 6.01% to 6.50% 13,329 1.3 133,013 12.7 6.51% to 7.00% 2,960 .3 16,522 1.6 7.01% to 7.50% 14,522 1.5 14,153 1.4 7.51% to 8.00% 12 -- -- -- ---------- ----- ---------- ----- Total certificates of deposit 816,690 81.5 851,444 81.6 ---------- ----- ---------- ----- Total deposits $1,001,476 100.0% $1,043,433 100.0% ---------- ----- ---------- ----- ---------- ----- ---------- ----- 74 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands) NOTE F - DEPOSITS - Continued The aggregate amount of deposits with a minimum denomination of $100 or more was approximately $377,183 at December 31, 1997 and $228,690 at December 31, 1996. At December 31, 1996, the scheduled maturities of certificates of deposit were as follows: December 31, ------------ 1998 $778,354 1999 19,606 2000 17,582 2001 576 2002 572 -------- $816,690 -------- -------- Interest expense on deposits consists of the following: Six months Year ended ended Year ended June 30, December 31, December 31, -------------------- 1997 1996 1996 1995 ------------ ----------- -------- -------- Savings deposits $ 9,025 $ 4,683 $ 6,675 $ 1,435 Certificates of deposit 48,955 23,538 39,240 12,282 ------- ------- ------- ------- $57,980 $28,221 $45,915 $13,717 ------- ------- ------- ------- ------- ------- ------- ------- NOTE G - FEDERAL HOME LOAN BANK ADVANCES Pursuant to collateral agreements with the Federal Home Loan Bank (FHLB), advances are collateralized by all stock in the FHLB, certain premises and equipment and certain qualifying first mortgage loans, with a total collateral value of approximately $119,029 at December 31, 1997. The FHLB advances of $110,000 at December 31, 1997 bear interest of rates ranging from 6.3% to 7.1% and mature in January 1998. NOTE H - SENIOR NOTES On August 9, 1995, the Company issued $57,500 of 12.75% Senior Notes due on August 15, 2000 at a discount of $500 which is being accreted over the life of the notes. Interest is payable semi-annually on February 15 and August 15 of each year. The Senior Notes are redeemable, in whole or in part, at the option of the Company. 75 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands) NOTE I - REGULATORY MATTERS The Company is not subject to capital adequacy requirements by its primary regulator, the Office of Thrift Supervision. The Bank is subject to various regulatory capital requirements administered by the Texas Savings and Loan Department (the Department) and the Federal Deposit Insurance Corporation (FDIC), collectively, (regulators). Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total risk based and tier I capital to risk-weighted assets, and of leverage capital to total assets. Management believes, as of December 31, 1997, that the Bank meets all capital adequacy requirements to which it is subject. Texas savings banks, including the Bank, are required to maintain a daily balance of liquid assets at least equal to 10% of the average daily balance of deposits for the preceding quarter. At December 31, 1997 and 1996, the Bank's liquidity ratio was 19.11% and 16.53%, respectively. The most recent notification from the regulators categorized the Bank 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 Bank's category. To be categorized as well capitalized by the federal banking agencies, the Bank must maintain minimum total risk-based, tier I risk-based, and leverage ratios as set forth in the table below. To be well capitalized under For capital prompt corrective Actual adequacy purposes action provisions ---------------- --------------------------- ---------------------------- Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ --------------- ------ ---------------- December 31, 1997 Total risk based capital 198,028 19.05% 83,182 greater than 8% 103,978 greater than 10% Tier I risk based capital 186,116 17.90% 41,591 greater than 4% 62,387 greater than 6% Leverage capital 186,116 13.81% 53,898 greater than 4% 67,373 greater than 5% December 31, 1996 Total risk based capital 150,703 14.03% 85,903 greater than 8% 107,379 greater than 10% or equal to or equal to Tier I risk based capital 137,514 12.81% 42,951 greater than 4% 64,427 greater than 6% or equal to or equal to Leverage capital 137,514 10.05% 54,722 greater than 4% 68,403 greater than 5% or equal to or equal to 76 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands) NOTE J - INCOME TAXES The following items give rise to deferred tax assets and liabilities in the consolidated balance sheet: December 31, 1996 ------------ Deferred tax assets Accrued interest receivable $2,870 Loan acquisition cost 352 Deferred loan fees 80 Accrued expenses 109 Allowance for loan loss 486 Real estate held for investment or sale 177 Premises and equipment 139 Unrealized loss on investment securities -- Other 777 ------ Gross deferred tax asset 4,990 Deferred tax liabilities Loan discounts 176 Allowance for loan losses -- FHLB stock dividends 281 Gains on real estate transactions 1,785 Accrued interest 2,442 Unrealized gains on investment securities 382 Other -- ------ Gross deferred tax liability 5,066 Net deferred tax liability $ (76) ------ ------ Taxes on income consisted of the following: Six months Year ended ended Year ended June 30, December 31, December 31, ------------------- 1997 1996 1996 1995 ------------ ------------ ---- ---- Federal Current $3,249 $11,214 $21,095 $13,646 Deferred -- (1,251) 1,249 (57) ------ ------- ------- ------- 3,920 9,963 22,344 13,589 State - current and deferred 3,159 2,189 2,809 1,587 ------ ------- ------- ------- $6,408 $12,152 $25,153 $15,176 ------ ------- ------- ------- ------ ------- ------- ------- 77 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands) NOTE J - INCOME TAXES - Continued On March 13, 1997, the Corporation filed an application with the Internal Revenue Service to elect S Corporation status for federal income tax purposes effective January 1, 1997. This election covered all subsidiaries of the Corporation except Beal Affordable Housing, Inc., and BRE-N, Inc. As a result of the aforementioned application, beginning January 1, 1997, the Corporation and all of its subsidiaries electing S Corporations status will no longer pay federal income taxes, except for the federal taxes related to the recognition of built-in gains which existed at January 1, 1997. At January 1, 1997, the Corporation had net unrealized built-in gains of approximately $80,000 which may potentially be recognized during the ten-year recognition period beginning on January 1, 1997. For the year ended December 31, 1997 the Corporation recorded federal tax expense of $3,249 related to the recognition of built-in gains. Except as discussed above, beginning January 1, 1997, the liability for federal income taxes of the Corporation will be the responsibility of its stockholders. Income taxes for financial reporting purposes differed from the amount computed by applying the statutory federal income tax rate to the income before income taxes for the years ended below as follows: Six months ended Year ended June 30, December 31, ------------------- 1996 1996 1995 ------------ ---- ---- Computed tax at statutory Federal income tax rate $11,972 $24,260 $14,193 Increase (decrease) in taxes resulting from State tax, net of federal tax benefit 1,246 2,195 1,047 Tax credits (1,182) (1,469) -- Other 116 167 (64) ------- ------- ------- Total $12,152 $25,153 $15,176 ------- ------- ------- ------- ------- ------- NOTE K - OTHER OPERATING EXPENSE Other operating expense consists of the following: Six months Year ended ended Year ended June 30, December 31, December 31, ------------------- 1997 1996 1996 1995 ------------ ------------ ---- ---- Advertising and promotion $ 248 $ 448 $ 714 $ 584 Office supplies and expense 250 127 394 267 Legal and professional 6,448 3,327 3,599 1,351 Expenses related to loan purchases 630 1,108 2,409 1,375 Loan servicing fees 2,376 1,332 2,278 1,611 Other 806 509 862 620 ------- ------ ------- ------ $10,758 $6,851 $10,256 $5,808 ------- ------ ------- ------ ------- ------ ------- ------ 78 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands) NOTE L - COMMITMENTS AND CONTINGENCIES The Corporation's financial statements do not reflect various commitments to extend credit or commitments to purchase loans which arise in the normal course of business and which involve elements of credit risk, interest rate risk or liquidity risk. At December 31, 1997, there were commitments to purchase loans of $44,078. Unfunded commitments to extend credit were $20,806. Commitments to purchase loans are agreements to purchase certain loans at a specified percentage of the outstanding principal balance as long as all conditions established in the contract are met. Commitments do not have a fixed expiration date. Since the conditions in the contract may not be met for all loans covered by the commitments, the total commitments do not necessarily represent future cash requirements. Collateral on the loans consists primarily of single family residences. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee by the customer. Since many of the commitments are expected to expire without being funded, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit is based on management's credit evaluation. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment and liens on real estate. The Corporation is a defendant in various matters in litigation which have arisen in the normal course of business. In the opinion of management, such litigation will not have a material effect on the Corporation's consolidated financial position or results of operations. NOTE M - FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair values of the Corporation's financial instruments were as follows: December 31, 1997 December 31, 1996 ------------------- ------------------ Carrying Fair Carrying Fair amount value amount value ----------- ----------- ----------- ------------ Financial assets: Cash and cash equivalents $ 150,849 $ 150,849 $ 65,940 $ 65,940 Securities available for sale 111,376 111,376 123,939 123,939 Loans receivable 887,833 897,201 1,054,204 1,055,653 Financial liabilities: Deposit liabilities (1,001,476) (1,002,057) (1,043,433) (1,043,981) Federal Home Loan Bank advances (110,000) (110,000) (146,000) (146,000) Other borrowings (7,599) (7,599) (14,748) (14,748) Senior notes (57,188) (59,404) (57,094) (60,950) 79 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands) NOTE N - CONDENSED PARENT COMPANY ONLY FINANCIAL STATEMENTS Beal Financial Corporation Balance Sheet December 31, ------------------------- 1997 1996 --------- --------- Assets Cash $ 17,906 $ 9,624 Investment in subsidiary 189,846 145,062 Loans receivable, net -- 18,500 Real estate held for investment 14,190 3,162 Other assets 14,694 2,655 --------- --------- $236,636 $179,003 --------- --------- --------- --------- Liabilities and stockholders' equity Senior notes $ 57,188 $ 57,094 Other borrowings -- 1,775 Other liabilities 18,630 3,337 Stockholder's equity: Common stock 300 300 Additional paid-in capital 2,740 2,740 Retained earnings 154,056 113,048 Unrealized gain on available for sale securities 3,722 709 --------- --------- Total stockholders' equity 160,818 116,797 --------- --------- $236,636 $179,003 --------- --------- --------- --------- 80 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands) NOTE N - CONDENSED PARENT COMPANY ONLY FINANCIAL STATEMENTS - CONTINUED Statement of Income Six months Year ended ended Year ended December 31, December 31, June 30, 1997 1996 1996 ------------ ------------ ---------- Income Equity in undistributed earnings of subsidiary $41,771 $ 53 $45,648 Dividends from subsidiary 47,369 25,000 3,181 Interest income 5,817 -- -- --------- ---------- ---------- Total income 94,957 25,053 48,829 Interest expense Federal Home Loan Bank advances and other borrowings 36 66 162 Senior notes 7,986 3,962 6,903 --------- ---------- ---------- Total interest expense 8,022 4,028 7,065 Noninterest expense Salary and employee benefits -- 15 2 Other operating expenses 285 436 116 --------- ---------- ---------- Total noninterest expense 285 451 118 --------- ---------- ---------- Income before taxes 86,650 20,574 41,646 Income tax expense (benefit) 16 (1,480) (2,514) --------- ---------- ---------- Net income $86,634 $22,054 $44,160 --------- ---------- ---------- --------- ---------- ---------- 81 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands) NOTE N - CONDENSED PARENT COMPANY ONLY FINANCIAL STATEMENTS - CONTINUED Statement of Cash Flows Six months Year ended ended Year ended December 31, December 31, June 30, 1997 1996 1996 ------------ ------------ ---------- Operating activities Net income $ 86,634 $22,054 $ 44,160 Adjustments to reconcile net income to net cash used in operating activities Equity in undistributed earnings of subsidiary (54,362) (53) (45,648) Accretion of purchase discount (4,820) -- -- Changes in operating assets and liabilities Increase in other assets (12,418) (2,916) (2,900) Increase in other liabilities 15,388 744 2,635 --------- --------- -------- Net cash provided by (used in) operating activities 30,422 19,829 (1,753) Investing activities Capital contributed to subsidiary (10) -- (46,252) Purchase of loans -- (18,500) -- Cash repayment of loans 12,670 -- -- --------- --------- -------- Net cash provided by (used in) investing activities 12,660 (18,500) (46,252) Financing activities Repayments of other borrowings (1,774) (125) (600) Proceeds from issuance of senior notes -- -- 57,051 Dividends paid (33,026) -- (26) --------- --------- -------- Net cash provided by (used in) financing activities (34,800) (125) 56,425 --------- --------- -------- Net increase in cash and cash equivalents 8,282 1,204 8,420 Cash and cash equivalents, beginning of year 9,624 8,420 -- --------- --------- -------- Cash and cash equivalents, end of year $ 17,906 $ 9,624 $ 8,420 --------- --------- -------- --------- --------- -------- 82 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands, except per share data) NOTE O - SUMMARY OF QUARTERLY FINANCIAL INFORMATION (UNAUDITED) - CONTINUED For the year ended December 31, 1997 ---------------------------------------------- 1st 2nd 3rd 4th -------- ------- ------- ------- Interest income $ 54,945 $37,531 $34,261 $42,444 Interest expense 17,555 16,929 16,327 17,045 -------- ------- ------- ------- Net interest income 37,390 20,602 17,934 25,399 (Provision) credit for losses (933) 261 (1,764) (974) Other income 2,651 3,397 6,430 4,793 Other expenses (4,602) (5,625) (6,490) (5,427) -------- ------- ------- ------- Income before income tax 34,506 18,635 16,110 23,791 Income tax expense 1,203 961 999 3,245 -------- ------- ------- ------- Net income $ 33,303 $17,674 $15,111 $20,546 -------- ------- ------- ------- -------- ------- ------- ------- Income per common share $ 111.01 $ 58.91 $ 50.37 $ 68.49 -------- ------- ------- ------- -------- ------- ------- ------- 83 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands, except per share data) NOTE O - SUMMARIZED QUARTERLY FINANCIAL INFORMATION (UNAUDITED) - CONTINUED For the six months ended December 31, 1996 -------------------- 1st 2nd -------- -------- Interest income $46,743 $ 41,309 Interest expense 16,718 17,223 -------- -------- Net interest income 30,025 24,086 Provision for losses (334) (2,980) Other income 4,022 6,038 Other expenses (9,288) (17,363) -------- -------- Income before income tax 24,425 9,781 Income tax expense 8,749 3,403 -------- -------- Net income $15,676 $ 6,378 -------- -------- -------- -------- Income per common share $52.25 $21.26 -------- -------- -------- -------- 84 BEAL FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (In thousands, except per share data) NOTE O - SUMMARY OF QUARTERLY FINANCIAL INFORMATION (UNAUDITED) - CONTINUED For the year ended June 30, 1996 ----------------------------------------------- 1st 2nd 3rd 4th ------- ------- ------- -------- Interest income $21,807 $29,854 $45,448 $43,839 Interest expense 9,629 13,422 17,014 16,753 ------- ------- ------- -------- Net interest income 12,178 16,432 28,434 27,086 Provision for losses (1,366) (4,569) (927) (2,182) Other income 3,018 4,233 2,819 6,613 Other expenses (5,089) (5,430) (4,632) (7,305) ------- ------- ------- -------- Income before income tax 8,741 10,666 25,694 24,212 Income tax expense 3,100 3,925 9,205 8,923 ------- ------- ------- -------- Net income $ 5,641 $ 6,741 $16,489 $15,289 ------- ------- ------- -------- ------- ------- ------- -------- Income per common share $ 18.80 $ 22.47 $ 54.96 $ 50.97 ------- ------- ------- -------- ------- ------- ------- -------- NOTE P - 401 (K) PLAN The Corporation offers a 401(k) plan to all full time employees who have reached the age of 21 and completed three months of service. The Company matches 50% of the employees' contribution up to 6% of base salary. For the year ended December 31, 1997, the Corporation made matching contributions of $107. 85 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS Directors of Beal Financial The Board of Directors of Beal Financial currently consists of four members including D. Andrew Beal, Timothy M. Fults, Bernard L. Weinstein and David C. Meek. Each member of Beal Financial's Board of Directors is also a director of the Bank. See "Board of Directors of the Bank." Directors Beal and Fults have served as such since Beal Financial's incorporation in September 1993, Director Weinstein has served since June 1995, and Director Meek was appointed in February 1996. The directors of Beal Financial are elected at each annual meeting of stockholders for terms of one year. Executive Officers of the Company The executive officers of Beal Financial, who are currently directors or executive officers of Beal Bank, are identified below. The executive officers of Beal Financial are elected annually by Beal Financial's Board of Directors. The executive officers of Beal Financial do not receive any remuneration in their capacity as Beal Financial executive officers. Name Position with Company - ---------------------- ---------------------------- D. Andrew Beal Chairman of the Board David C. Meek President David R. Farmer Senior Vice President and Treasurer Timothy M. Fults Secretary Margaret M. Curl Vice President/Assistant Secretary James W. Lewis, Jr. Vice President/Assistant Treasurer 86 Board of Directors of the Bank The Board of Directors of Beal Bank is presently composed of nine members. The following table sets forth certain information with respect to the current directors of the Bank. Under the Bank's Bylaws, directors are elected annually by stockholders for terms of one year. Except as described herein, there are no arrangements or understandings between the persons named and any other person pursuant to which such director was selected. Term of Director Office Name Age(1) Position(s) Held Since Expires - -------------- ------- ------------------------------------------------- ------ -------- D. Andrew Beal 45 Chairman of the Board 1985 1998 David C. Meek 53 President, Chief Executive Officer and Director 1996 1998 David R. Farmer 49 Executive Vice President, Chief Operating Officer 1993 1998 and Director Timothy M. Fults 44 Director and Secretary 1985 1998 Bernard L. Weinstein 55 Director 1991 1998 Susan D. Arnold 55 Director 1992 1998 Lawrence C. Blanton 61 Director 1992 1998 R. Michael Eastland 52 Director 1992 1998 David L. Goldstein, CPA 39 Director 1993 1998 - --------------------- (1) At December 31, 1997. The business experience of each director is set forth below. All directors have held their present positions for at least the past five years, except as otherwise indicated. D. Andrew Beal. Mr. Beal is Chairman of the Board of the Company, a position he has held since June 1995. Mr. Beal has been Chairman of the Board of the Bank since its formation in 1985. He is the owner of approximately 99% of the Company's outstanding common stock. Mr. Beal has been involved in buying and operating apartment complexes since the mid 1970s. Mr. Beal is a member of various real estate groups located in the Dallas area and a member and supporter of various civic organizations. David C. Meek. Mr. Meek is President and Chief Executive Officer of the Company and the Bank. Mr. Meek joined the Bank as President in January 1996. Immediately prior to joining the Bank, Mr. Meek was a self-employed investor and consultant. From February 1991 until January 1995, Mr. Meek was President/Chief Executive Officer/Chief Operating Officer of Coventry Properties, Inc., and Partnership Services, Inc., real estate management corporations located in Dallas, Texas. David R. Farmer. Mr. Farmer is a Senior Vice President and Treasurer of the Company and Executive Vice President- Chief Operating Officer of the Bank. Mr. Farmer joined the Bank as Chief Financial Officer and was elected as a Director of the Bank in February 1993. Mr. Farmer also currently holds various other management positions with the Bank's subsidiaries. Prior to joining the Bank in February 1993, Mr. Farmer was a self-employed consultant from June 1990 to February 1993 and Senior Vice President and Chief Operating Officer of Murray Federal Savings and Loan Association in Dallas, Texas from June 1987 until June 1990. Timothy M. Fults. Mr. Fults is the Secretary of the Company and the Bank, positions he has held since September 1993 and June 1995, respectively. Mr. Fults is a self-employed trial attorney engaged in the practice of law in the Dallas, Texas area. Bernard L. Weinstein. Dr. Weinstein has been a Professor of Applied Economics at the University of North Texas in Denton, Texas since June 1989. Dr. Weinstein has also taught at Rensselaer Polytechnic Institute, the State University of New York, the University of Texas at Dallas and Southern Methodist University. Dr. Weinstein has authored or co-authored numerous books and articles on the subject of economic development, public policy and 87 taxation. Dr. Weinstein currently serves as a director and consultant to various non-public companies, non-profit organizations and government agencies. Susan D. Arnold. Mrs. Arnold is the President of Coldwell Bankers/Paula Stringer Realtors located in Dallas, Texas, a position she has held since 1996. Mrs. Arnold was previously the President of Murray Realtors from 1980 to 1996, which was acquired by Coldwell Bankers/Paula Stringer Realtors in 1996. Mrs. Arnold is a former director of both the Greater Dallas Board of Realtors and the Texas Association of Realtors and the former President of the Greater Dallas Association of Realtors. Mrs. Arnold currently holds various positions with numerous community service organizations. Lawrence C. Blanton. Mr. Blanton is President of Crest Mortgage Corporation of Dallas, Texas since April, 1997. He previously was the Chairman and Chief Executive Officer of Providers Funding Corporation of Dallas, Texas from 1989 to 1996, a medical receivables financing company. Mr. Blanton has over 25 years of commercial lending experience. R. Michael Eastland. Mr. Eastland has been the Executive Director and Chief Executive Officer of the North Central Texas Council of Governments located in Arlington, Texas since December 1992. Prior thereto, Mr. Eastland was the City Manager for the City of Carrollton, Texas from June 1984 to December 1992. Mr. Eastland has over 25 years of service in municipal positions in various Texas localities. He has also served as President and a member of the board of the Texas City Management Association Board. Mr. Eastland is also a former President of the North Texas City Management Association. David L. Goldstein, CPA. Mr. Goldstein is a self employed information systems consultant. In addition, he served as an information systems consultant with Work Flow Design, Inc., an information systems consulting firm located in Dallas, Texas from April 1996 through July 1997. From November 1993 to August 1994, he was Vice President of Advanced Thought Systems, an information systems consulting firm located in Dallas, Texas, and a consultant with Compucom, a systems integration company located in Dallas, Texas, from March 1993 to November 1993. He was a consultant with Coopers & Lybrand, a national accounting and consulting firm, from July 1990 to March 1993 and Corporate Controller of Singer Management Company, a family amusement company located in Carrollton, Texas, from February 1983 to July 1990. Executive Officers of the Bank The executive officers of the Bank are elected annually by the Board of Directors of the Bank. Except as described herein, there are no arrangements or understandings between the person named and any other person pursuant to which such officer was selected. The following information as to business experience during the past five years is supplied with respect to each executive officer of the Bank who does not serve on the Bank's Board of Directors. Margaret M. (Molly) Curl. Ms. Curl, age 43 has been the Senior Vice President of the Bank since February 1994. She is also the Bank's compliance and CRA officer, positions she has held since March 1994. Ms. Curl also holds various positions with the Bank's subsidiaries. Prior to joining the Bank in 1994, Ms. Curl was employed by Grant Thornton LLP, a national accounting firm located in Dallas, Texas, as a Senior Associate from August 1993 to February 1994 and a Senior Consulting Manager from October 1986 to August 1993. Ms. Curl was employed by the Office of the Comptroller of the Currency, the primary regulator of national banks, as Manager of the Licensing Division from 1983 to 1984, as a National Bank Examiner from 1980 to 1984 and as an Assistant National Bank Examiner from 1975 to 1980. Ms. Curl is also a certified public accountant. William T. Saurenmann. Mr. Saurenmann, age 49 is the Senior Vice President-Lending of the Bank. Prior to such time, he was a Vice President of the Bank from August 1991 to November 1994 and an independent consultant to the Bank from May 1991 through August 1991. Mr. Saurenmann is also a Vice President in virtually all of the Bank's subsidiaries. Prior to joining the Bank in 1991, he was Senior Vice President - Lending of San Jacinto Savings 88 and Loan Association, Houston, Texas, from October 1990 to May 1991 and Vice President of Murray Federal Savings and Loan Association, Dallas, Texas, from April 1982 to October 1990. Stephen K. O'Neal. Mr. O'Neal, age 42, has been a Vice President of Loan Administration since joining the Bank in July 1996. From 1987 to 1995, Mr. O'Neal was employed in various positions with Metropolitan Federal Bank, f.s.b., an $8 billion financial institution headquartered in Minneapolis, Minnesota, including Vice President and Manager of Commercial Loan Servicing and Asset Management. Prior to that Mr. O'Neal was employed with Grant Thornton LLP, a national public accounting firm located in Dallas, Texas from 1986 to 1987 as a Manager in the consulting department. Mr. O'Neal is also a certified public accountant. Clark E. Enright. Mr. Enright, age 45, joined the Bank in February 1996 as the Vice President - Special Assets Department and was appointed Senior Vice President-Commercial Loans in October 1996. Prior to such time, Mr. Enright served as President and Chief Executive Officer of Kelly, Enright and Associates, Inc., a corporation involved in all levels of property administration as well as receivable management, investment and mortgage banking, venture capital and litigation support. He was Senior Vice President/Manager - Special Assets Division of San Jacinto Savings Association in Houston, Texas from 1988 to 1991. James W. Lewis, Jr. Mr. Lewis, age 54, has been a Vice President of Accounting/Operations and Treasurer of the Bank since February 1993. Mr. Lewis was appointed Senior Vice President-Controller in October 1996. He is also the Assistant Secretary and Treasurer of BMI, BPI and Assistant Secretary and Treasurer of various Bank subsidiaries. Prior to being appointed to his current positions, Mr. Lewis was an Executive Vice President of the Bank from December 1988 until February 1993. Mr. Lewis is also a certified public accountant. Richard L. Killmon. Mr. Killmon, age 62, joined the Bank as Vice President-Retail Operations in April 1995. Prior to such time, Mr. Killmon served as a self-employed management consultant with Richard L. Killmon & Associates located in Tyler, Texas since 1991. He was Vice President of First Pinnacle, Inc., a financial institution holding company located in Dallas, Texas, from 1989 to 1991. Mr. Killmon has had extensive operational experience with various consulting firms and several large commercial banks located primarily in Texas. Meetings and Committees of the Board of Directors of the Company and the Bank Meetings and Committees of the Company. Meetings of the Company's Board of Directors are generally held on an as needed basis. For the year ended December 31, 1997, the Board of Directors met twelve times. During the year ended December 31, 1997, no incumbent director of the Company attended fewer than 90% of the aggregate of the total number of Board meetings and the total number of meetings held by the committees of the Board of Directors on which they served. The Board of Directors of the Company has a standing Audit Committee. The Company's Audit Committee recommends independent auditors to the full Board, reviews the results of the auditors' services, reviews with management and the internal auditor the systems of internal control and internal audit reports and assures that the books and records of the Company and the Bank are kept in accordance with applicable accounting principles and standards. The members of the Audit Committee are Directors Fults and Weinstein. During the year ended December 31, 1997, this committee met three times. The Bank has standing Executive, Executive Loan, Audit, Investment and Compensation Committees. Set forth below is a description of the Bank's primary committees. The Executive Committee is comprised of Directors Beal, Meek, Farmer and Weinstein. The Committee meets when necessary in lieu of the full board of directors. Certain matters that would come under the purview of the full board are addressed by the Executive Committee in lieu of a full board meeting. This committee did not meet during the year ended December 31, 1997. 89 The Executive Loan Committee was formed in December 1994 and is comprised of Directors Beal, Meek, Fults, Blanton, Weinstein and Goldstein with directors Arnold, Farmer and Eastland as alternates. The Committee meets when necessary and approves all loans or purchases in excess of $1.0 million. This Committee met 33 times during the year ended December 31, 1997. The Audit Committee maintains a liaison with the Bank's independent auditors and the Bank's internal auditor throughout the year and reviews the adequacy of the Bank's internal controls. The Committee is composed of Directors Eastland, Fults and Goldstein. This Committee met three times during the year ended December 31, 1997. The Investment Committee meets monthly to review the Bank's current or planned activities to ensure adequate liquidity, to maintain a high quality of diversified investments, and to provide collateral for pledging requirements. The Committee also acts as the Bank's asset/liability management committee and reviews the Bank's interest rate risk position and profitability on a quarterly basis and makes recommendations for adjustments in the Bank's asset liability management strategy to the full board. The Committee is comprised of Directors Beal, Meek, Farmer, Weinstein and Goldstein. This Committee met eight times during the year ended December 31, 1997. The Compensation Committee is comprised of Directors Eastland, Arnold and Weinstein. The Committee meets on an as needed basis to establish the compensation of the Chief Executive Officer, approve the compensation of senior officers and the compensation and benefits paid to employees of the Bank. This Committee did not meet during the year ended December 31, 1997. Compensation Committee Interlocks and Insider Participation During the year ended December 31, 1997, the Compensation Committee was comprised of non-employee Directors Eastland, Arnold and Weinstein. Compensation of Directors Cash Compensation. Mr. Beal receives a salary of $120,000 in his capacity as Chairman of the Board of the Company and the Bank and does not receive compensation as an officer in various Bank subsidiaries. Non-employee directors of the Company were paid fees of $500 per meeting for attendance at regular meetings of the Company's Board of Directors and $200 per committee meeting attended. Non-employee directors of the Bank were paid fees of $1,500 per meeting for attendance at regular meetings of the Bank's Board of Directors. Directors are also paid $200 for each committee meeting attended. In addition, all non-employee directors of the Bank were paid a $10,000 bonus during the year ended December 31, 1997. 90 ITEM 11. EXECUTIVE COMPENSATION Compensation of Executive Officers The following table sets forth the compensation paid or accrued by the Company for services rendered by the Company's Chairman of the Board, Chief Executive Officer and the other four most highly compensated executive officers of the Company in 1997 (the "Named Officers"). SUMMARY COMPENSATION TABLE(1) Annual Compensation ------------------- All Other Salary Bonus Compensation Name and Principal Position Year ($) ($) ($)(1) --------------------------- ---- ------ ------ -------------- D. Andrew Beal, Chairman of the 1997 $120,000 $ --- $ N/A Board(2) 1996 120,000 10,500,000 N/A 1995 120,000 --- N/A David C. Meek, President and 1997 200,000 150,000 6,000 Chief Executive Officer(2) 1996 200,000 638,390 4,894 1995 N/A N/A N/A David R. Farmer, Executive Vice 1997 135,000 125,000 3,881 President and Chief 1996 147,980 125,000 3,747 Operating Officer 1995 149,555 102,500 3,615 William T. Saurenmann, Senior Vice 1997 100,000 90,000 3,000 President-Lending 1996 103,845 105,000 2,622 1995 91,666 102,500 2,724 Clark Enright, Senior Vice President/ 1997 98,623 185,000 1,538 Commercial Loans(3) 1996 77,916 82,500 1,250 1995 N/A N/A N/A (1) Includes the Company's contribution to the 401(k) Plan and life insurance premiums paid. (2) Mr. Meek served as a Bank consultant starting in September 1995 until his appointment as President and Chief Executive Officer in January 1996. (3) Mr. Enright joined the Bank in February 1996. Executive Bonus Plan In February, 1998, Mr. Meek and the Company entered into an executive bonus plan (the "Plan"). The Plan provides that Mr. Meek shall be entitled to bonus compensation equal to ten percent of the earnings (as described below) in excess of prime plus 150 basis points attributable to a designated pool of loans. The earnings, losses and related expenses from each loan (including profit, losses and expenses resulting from the sale of the underlying collateral if foreclosed upon) shall be aggregated in determining the amount of the bonus. Bonus calculations shall be determined in the sole discretion and judgment of the board of directors. Mr. Meek shall be entitled to bonus compensation for the life of the loan pool regardless of whether or not he remains employed by the Company or its subsidiaries. The initial loan pool is comprised of certain loans originated by the Company and its subsidiaries after January 1, 1997, aggregating approximately $62.2 million. New loan originations shall become a part of the loan pool when specifically identified in writing by both Mr. Meek and Mr. Beal and ratified by the board of directors. Loans shall be removed from the loan pool once a loan is paid in full (including any profit participation interest), an amount less than full payment is accepted as payment in full, or the underlying collateral obtained through the foreclosure or deed in lieu of foreclosure is sold. 91 Earnings subject to the bonus calculation are intended to include all income and expenses attributable to the loan pool assets including interest income, profit participation payments, release fees, loan origination or renewal fees and income or losses created from former loans or assets in the loan pool, all charge-offs, write downs and specific loan loss provisions, expenses of collection, attorneys fees, as well as any other income or expenses attributable to the loan pool as determined by the board of directors (except that cost of funds (i.e., interest paid to depositors) and normal non-default servicing costs shall not be included as expenses). Expenses incurred during Mr. Meek's employment which are directly attributable to loans held in the pool shall be deducted from earnings. Bonuses shall be calculated as of October 1 of each year and paid on December 1 of each year. Twenty-five percent of the bonus amount shall be retained as a reserve and seventy-five percent shall be paid to Mr. Meek. All remaining reserves shall be paid to Mr. Meek when no assets remain in the loan pool. No bonus shall be paid that would result in a failure to maintain the 25% reserve amount, and prior bonus payments shall be refunded by Mr. Meek to the extent the reserve is below 25% as calculated at the time of any bonus calculation. Upon final resolution of all assets in the pool, in the event that Mr. Meek has been overpaid in total bonus payments, Mr. Meek has agreed to immediately repay any overpayments to the Company. Under certain circumstances, including the failure by the Company to make timely payments to holders of the Senior Notes, payment of any bonus due shall be deferred. In this event, the Company shall owe Mr. Meek interest on the delinquent payment(s) at a rate of prime plus 150 basis points, compounded monthly, until such payments and applicable interest is paid in full. The maximum bonus amount to be paid pursuant to the Plan shall not exceed $3.0 million. Benefits General. The Bank currently maintains an employee benefit program providing, among other benefits, major medical insurance, dental benefits, disability insurance and life insurance. The Bank also maintains a 401(k) plan for the benefit of its employees. 401(k) Plan. The Bank maintains the Beal Bank 401(k) Plan, designed to be qualified under Section 401(k) of the Code (the "401(k) Plan"). The 401(k) Plan covers all full-time salaried employees of the Bank. Any employee of the Bank or its subsidiaries over the age of 21 is eligible to participate in the 401(k) Plan following the completion of three months of service to the Bank or any of its subsidiaries. Under the 401(k) Plan, a participant may elect to defer up to a maximum of $9,500 of his salary for calendar 1997 to the 401(k) Plan. The Bank makes discretionary matching and profit-sharing contributions to the 401(k) Plan, up to a maximum of 25% of the participant's compensation for the plan year. "Compensation" for purposes of the 401(k) Plan generally includes a participant's base compensation, including amounts contributed to the 401(k) Plan by the employer. A Participant is always 100% vested in his or her salary deferral contributions and the earnings thereon. A Participant becomes vested in Bank contributions to the 401(k) Plan at the rate of 25% per year commencing with the completion of two years of service. Participants can allocate their salary deferral contributions and the Bank's contributions to the 401(k) Plan, if any, among one or more of the six investment options available under the 401(k) Plan. These investment options include two fixed interest funds, a bond fund, a bond and stock fund and two growth stock funds. The 401(k) Plan provides for in-service hardship distributions of a participant's salary deferral contributions. Distributions from the 401(k) Plan are made upon termination of service in the form of a lump sum. The Bank's contributions to the 401(k) Plan on behalf of the Named Officers are included in the Summary Compensation Table. 92 ITEM 12. STOCK OWNERSHIP OF CERTAIN BENEFICIAL OWNERS The following table sets forth information as of December 31, 1997 regarding the share ownership of those persons or entities known by management to beneficially own the Company's Common Stock. Except as set forth below, no other director or executive officer owns any shares of the Company's Common Stock. Shares Beneficially Percent Name and Address of Beneficial Owner Owned of Class - ---------------------------------------------------- ------------ -------- D. Andrew Beal, Chairman of the Board of the Company 297,000 99.0% and the Bank Suite 902, 15770 N. Dallas Parkway Dallas, TX 75248 Timothy M. Fults, Director and Secretary of the Company and Director and Secretary of the Bank 3,000 1.0% 5956 Sherry Lane #800 Dallas, TX 75225 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Certain Transactions The Bank has a policy of granting loans to eligible directors, officers, employees and members of their immediate families for the financing of their personal residence and for consumer purposes. Loans to such individuals for commercial purposes are limited to the lesser of $100,000, or 15% of the Bank's net worth. All such loans to directors, officers, employees and their immediate families are made in the ordinary course of business and on the same terms, including collateral and interest rates, as those prevailing at the time for comparable transactions with unaffiliated parties and do not involve more than normal risk of collectibility. All transactions with related parties are also approved by at least a majority of the disinterested members of the Board of Directors. All loans by the Bank to its directors and executive officers are subject to federal regulations restricting loan and other transactions with affiliated persons of the Bank. Federal regulations currently require that all loans to directors and executive officers be made on terms and conditions comparable to those for similar transactions with non-affiliates. At December 31, 1997, there were no loans outstanding to any director, executive officer, member of their immediate families or business interest of such individuals, except for one loan to a member of Mr. Beal's family. This loan was made on terms and conditions comparable to those for similar transactions with non-affiliates. From time to time Mr. Beal has made loans to the Bank and its subsidiaries. He has also provided his personal guarantee on loans made to the Bank or its subsidiaries by unaffiliated lenders. All of these transactions were on the same terms as those prevailing at the time for comparable transactions with unaffiliated parties except that the loans made by Mr. Beal to the Bank's subsidiaries were interest-free. The amount of interest if a market rate were to have been used, would not be material to the financial condition or results of operations of the Bank. Mr. Beal currently rents office space from the Bank, for which he pays $500 per month. In addition, a company affiliated with Mr. Beal currently rents space from the Company at the rate of $7,458 per month. The Board of Directors believes that the rental rate charged is equivalent to the rental rate which would be charged to an unaffiliated party for each leased space. In connection with the Company's indirect acquisition of the Bank's outstanding capital stock, the Company assumed the obligation to repay a $2.5 million debt obligation of D. Andrew Beal. The proceeds from this borrowing were used for the initial capitalization of the Bank. This obligation is secured in full by a certificate of deposit owned by D. Andrew Beal. The debt had a balance of $1.8 million at January 1, 1997 and was repaid in full in April, 1997. 93 ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON FORM 8-K (a)(1) Financial Statements: The following information appearing in Part I, Item 8 of this Form 10-K is incorporated herein by reference. Independent Auditor's Report Consolidated Statements of Financial Condition at December 31, 1997 and 1996 and at June 30, 1996 and 1995 Consolidated Statements of Income for the Year Ended December 31, 1997, the Six Months Ended December 31, 1996 and the Years Ended June 30, 1996 and 1995 Consolidated Statements of Changes in Stockholders' Equity for the Year Ended December 31, 1997, the Six Months Ended December 31, 1996 and the Years Ended June 30, 1996 and 1995 Consolidated Statements of Cash Flows for the Year Ended December 31, 1997, the Six Months Ended December 31, 1996 and the Years Ended June 30, 1996 and 1995 Notes to Consolidated Financial Statements (a)(2) Financial Statement Schedules: All financial statement schedules have been omitted as the information is not required. 94 (a)(3) Exhibits: Reference to Prior Filing Regulation or Exhibit S-K Number Exhibit Attached Number Document Hereto - ----------- -------------------------------------------------------------- ------------ 2 Plan of Acquisition, Reorganization, Arrangement, None Liquidation or Succession 3.1 Certificate of Incorporation * 3.2 Bylaws * 4.1 Form of Indenture dated as of August 11, 1995, with * respect to the Registrant's 12-3/4% Senior Notes, due August 15, 2000. 4.2 Specimen Senior Note (found at Sections 2.02 and 2.03 of * the Form of Indenture filed as Exhibit 4.1) 9 Voting Trust Agreement None 10 Material contracts: (a) Employment Agreement with Margaret Curl * (b) Executive Bonus Plan with David C. Meek ** 11 Statement re: computation of per share earnings Not required 12 Statement re: computation of ratios Not required 13 Annual Report to Security Holders Not required 16 Letter re: change in certifying accountants Not required 18 Letter re: change in accounting principles None 21 Subsidiaries of Registrant ** 22 Published report regarding matters submitted to vote of None security holders 23 Consents of Experts and Counsel None 24 Power of Attorney Not required 27 Financial Data Schedule ** 99 Additional Exhibits Not applicable * Filed as exhibits to the Company's Registration Statement on Form S-1 under the Securities Act of 1993, filed with the Securities and Exchange Commission on June 7, 1995 (Registration No. 33-93212). All of such previously filed documents are hereby incorporated herein by reference in accordance with Item 601 of Regulation S-K. ** Exhibit filed herewith. (b) Reports on Form 8-K No reports on Form 8-K were filed during the quarter ended December 31, 1997. 95 INDEX TO EXHIBITS Exhibit Number Document - --------- --------------------------------------------------------------------------------------- 3.1 Certificate of Incorporation* 3.2 Bylaws* 4.1 Form of Indenture dated as of August 11, 1995, with respect to the Registrant's 12-3/4% Senior Notes, due August 15, 2000* 4.2 Specimen Senior Note (found at Sections 2.02 and 2.03 of the Form of Indenture filed as Exhibit 4.1)* 10 Material contracts: (a) Employment Agreement with Margaret Curl* (b) Executive Bonus Plan with David C. Meek** 21 Subsidiaries of Registrant** 27 Financial Data Schedule** * Filed as exhibits to the Company's Registration Statement on Form S-1 under the Securities Act of 1993, filed with the Securities and Exchange Commission on June 7, 1995 (Registration No. 33-93212). All of such previously filed documents are hereby incorporated herein by reference in accordance with Item 601 of Regulation S-K. ** Exhibit filed herewith. 96