-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Wpnngl5osoadNO1P5E5KVqcT/p0udK1bWRvs/DCWxeEpCZ798oViL0oV4ebfWu8I c6zN0A9bzVYWSgAQw5JNaw== 0000914317-98-000223.txt : 19980403 0000914317-98-000223.hdr.sgml : 19980403 ACCESSION NUMBER: 0000914317-98-000223 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980402 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: R&G FINANCIAL CORP CENTRAL INDEX KEY: 0001016933 STANDARD INDUSTRIAL CLASSIFICATION: ASSET-BACKED SECURITIES [6189] IRS NUMBER: 660532217 STATE OF INCORPORATION: PR FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-21137 FILM NUMBER: 98585909 BUSINESS ADDRESS: STREET 1: 280 JESUS T. PINERO AVE CITY: HATO REY, SAN JUAN STATE: PR ZIP: 00918 MAIL ADDRESS: STREET 1: 280 JESUS T PINERO AVE CITY: HATO REY, SAN JUAN STATE: PR ZIP: 00918 10-K 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES - ----- EXCHANGE ACT OF 1934 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 Commission File No.: 0-21137 R&G FINANCIAL CORPORATION - -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Puerto Rico 66-0532217 - ---------------------------------------- ---------------------- (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification Number) 280 Jesus T. Pinero Avenue Hato Rey, San Juan, Puerto Rico 00918 - ---------------------------------------- ---------------------- (Address of Principal (Zip Code) Executive Offices) Registrant's telephone number, including area code: (787) 758-2424 Securities registered pursuant to Section 12(b) of the Act: Not Applicable Securities registered pursuant to Section 12(g) of the Act: Class B Common Stock (par value $.01 per share) - -------------------------------------------------------------------------------- (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 filing 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. As of March 20, 1998, the aggregate value of the 4,777,285 shares of Class B Common Stock of the Registrant issued and outstanding on such date, which excludes 147,189 shares held by all directors and officers of the Registrant as a group, was approximately $149.0 million. This figure is based on the last known trade price of $31.19 per share of the Registrant's Class B Common Stock on March 20, 1998. Number of shares of Class B Common Stock outstanding as of March 20, 1998: 4,924,474 DOCUMENTS INCORPORATED BY REFERENCE List hereunder the following documents incorporated by reference and the Part of the Form 10-K into which the document is incorporated: (1) Portions of the Annual Report to Stockholders for the fiscal year ended December 31, 1997 are incorporated into Parts II and IV. (2) Portions of the definitive proxy statement for the Annual Meeting of Stockholders are incorporated into Part III. PART I Item 1. Business General R&G Financial Corporation (the "Company" or "R&G Financial") is the holding company for R&G Mortgage Corp., a Puerto Rico mortgage banking company ("R&G Mortgage") and R-G Premier Bank of Puerto Rico, a Puerto Rico-chartered commercial bank (the "Bank"). The Company was organized under Puerto Rico law in March 1996. In July 1996, the Company acquired the 88.1% ownership interest in the common stock of the Bank and the 100% ownership interest in the common stock of R&G Mortgage held by the Company's Chairman of the Board and Chief Executive Officer, Mr. Victor J. Galan, in exchange for shares of Class A common stock of the Company. In August 1996, the Company conducted an underwritten public offering of Class B common stock. In December 1996, the Company acquired the remaining 11.9% ownership interest in the common stock of the Bank. At December 31 1997, the Company had total consolidated assets of $1.5 billion, total consolidated borrowings of $627.9 million, total consolidated deposits of $722.4 million, and total consolidated stockholders' equity of $138.1 million. After taking into consideration an 80% stock dividend paid in 1997, as of December 31, 1997, the Company had 9,220,278 Class A shares of common stock outstanding, all of which were owned by Mr. Galan, and 4,924,474 publicly held Class B shares of common stock outstanding. Mr. Victor J. Galan, the Chairman of the Board, Chief Executive Officer and controlling shareholder of R&G Financial, originally organized R&G Mortgage in 1972. In February 1990, R&G Mortgage acquired a 74.7% interest in a two branch federal savings and loan association with total assets of $52.9 million, which was re-named R&G Federal Savings Bank. Recognizing the complementary operational aspects and cross selling opportunities that are inherent in operating both a mortgage bank and banking institution, during 1990 Mr. Galan successfully integrated both the Bank's and R&G Mortgage's operations, which structure has since been emulated in Puerto Rico. Embarking on a retail branch expansion strategy, the Bank in 1993 acquired a two branch savings and loan association with total assets of $78.6 million and, in June 1995, acquired from a commercial bank $77.2 million in deposits and, after consolidation, six branch offices. In November 1994, the Bank converted to a Puerto Rico-chartered commercial bank and took its present name. R&G Financial competes for business in Puerto Rico by providing a wide range of financial services to residents of all of Puerto Rico's major cities through branch offices and mortgage banking facilities at 18 locations. The operations of both R&G Mortgage and the Bank have expanded substantially during the 1990's, due in large part to R&G Mortgage's emergence as the second largest originator of loans secured by single-family residential properties in Puerto Rico. During the year ended December 31, 1997, R&G Mortgage originated approximately 28.4% of all single-family residential loans originated in Puerto Rico, which has resulted in significant growth in its servicing portfolio as well as facilitated rapid expansion of the Bank's franchise and operations. R&G Mortgage's servicing portfolio has increased by 91.3% since December 31, 1991 and, at December 31, 1997, R&G Mortgage serviced approximately 56,400 accounts with an 1 aggregate loan balance of $3.0 billion. The Bank's asset size, which amounted to $996.3 million at December 31, 1997, has increased by $943.4 million since R&G Mortgage became affiliated with the Bank in February 1990, while the branch office network had increased from two to 15 offices. R&G Financial has generally sought to achieve long-term financial strength and profitability by increasing the amount and stability of its net interest income and non-interest income. R&G Financial has sought to implement this strategy by (i) establishing and emphasizing the growth of its mortgage banking activities, including growing its loan servicing operation; (ii) expanding its retail banking franchise in order to achieve increased market presence and to increase core deposits; (iii) enhancing R&G Financial's net interest income by increasing R&G Financial's loans held for investment, particularly single-family residential loans; (iv) developing new business relationships through an increased emphasis on commercial real estate and commercial business lending; (v) diversifying R&G Financial's retail products and services, including an increase in consumer loan originations (such as credit cards); (vi) meeting the banking needs of its customers through, among other things, the offering of trust and investment services; and (vii) controlled growth and the pursuit of a variety of acquisition opportunities when appropriate. The Company is subject to regulation and supervision by the Board of Governors of the Federal Reserve System ("Federal Reserve Board") and is subject to various reporting and other requirements of the Securities and Exchange Commission ("SEC"). R&G Mortgage. R&G Mortgage was originally organized in 1972. R&G Mortgage is engaged primarily in the business of originating first and second mortgage loans on single family residential properties secured by real estate which are either insured by the Federal Housing Administration ("FHA") or guaranteed by the Veterans Administration ("VA"). To a lesser extent, R&G Mortgage is also engaged in the origination of subprime--credit quality--residential mortgage loans through a wholly owned subsidiary ("Champion Mortgage Corporation") which commenced operations in October 1997. Pursuant to agreements entered into between R&G Mortgage and the Bank, non-conforming conventional single-family residential loans and consumer loans secured by real estate are also originated by R&G Mortgage for portfolio retention by the Bank. The Bank retains the non-conforming conventional single-family residential loans because these loans generally do not satisfy resale guidelines of purchasers in the secondary mortgage market, primarily because of size or other underwriting technicalities at the time of origination. Jumbo loans may be packaged into collateralized mortgage obligations ("CMOs") and sold while loans with underwriting technicalities may be cured through payment experience and subsequently sold. During the years ended December 31, 1997, 1996 and 1995, R&G Mortgage originated a total of $598.2 million, $448.1 million and $322.7 million of loans, respectively. These aggregate originations include loans originated by R&G Mortgage directly for the Bank of $285.8 million, $211.3 million and $156.3 million during such respective periods, or 47.8%, 47.2% and 48.4%, respectively, of total originations. 2 R&G Mortgage pools FHA/VA loans into mortgage-backed securities which are guaranteed by the Government National Mortgage Association ("GNMA"), which securities are sold to securities broker dealers and other investors. Conventional loans may either be sold directly to agencies such as the Federal National Mortgage Association ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC") or to private investors, or which may be pooled into FNMA- or FHLMC-backed mortgage-backed securities which are generally sold to investors. During the years ended December 31, 1997, 1996 and 1995, R&G Mortgage sold $246.1 million, $244.8 million and $195.6 million of loans, respectively, which includes loans securitized and sold but does not include loans originated for the Bank. R&G Mortgage generally retains the servicing function with respect to the loans which have been securitized and sold. R&G Mortgage is subject to regulation and examination by the FHA, FNMA, FHLMC, GNMA, VA, the Department of Housing and Urban Development ("HUD") and the Office of the Commissioner of Financial Institutions ("OCFI") of Puerto Rico. R-G Premier Bank. The Bank's principal business consists of attracting deposits from the general public and tax-advantaged funds from eligible Puerto Rico corporations and using such deposits, together with funds obtained from other sources, to originate (through R&G Mortgage) and purchase loans secured primarily by residential real estate in Puerto Rico, and to purchase mortgage-backed and other securities. To a lesser extent but with increasing emphasis over the past few years, the Bank also originates consumer loans, commercial business loans and loans secured by commercial real estate. Such loans offer higher yields, are generally for shorter terms and facilitate the Bank's provision of a full range of financial services to its customers. The Bank also offers trust services through its Trust Department. Total loan originations by the Bank during the years ended December 31, 1997, 1996 and 1995 amounted to $89.0 million, $122.8 million and $124.6 million, respectively. The Bank's deposits are insured by the Federal Deposit Insurance Corporation ("FDIC") and it is regulated and examined by the FDIC as its primary federal regulatory agency as well as by the OCFI. Affiliated Transactions. As an integral part of R&G Mortgage's acquisition of a controlling interest in the Bank in February 1990, R&G Mortgage and the Bank entered into various agreements which address how the parties would conduct themselves in specifically delineated affiliated transactions (the "Affiliated Transaction Agreements"). Under federal law and regulations, certain transactions between a federally insured financial institution and an affiliate, such as the Bank and R&G Mortgage, are regulated. Generally, these provisions regulate extensions of credit to directors, officers and principal shareholders of the Bank, and establish standards for the terms of, limit the amount of, and establish collateral requirements with respect to, various transactions between federally insured financial institutions and its affiliates. See generally "Regulation - R&G Financial - Limitations on Transactions with Affiliates." The Affiliated Transaction Agreements include a Master Purchase, Servicing and Collections Agreement (the "Master Purchase Agreement"), a Master Custodian Agreement, a Master Production Agreement, a Securitization Agreement and a Data Processing Computer Service Agreement. In accordance with applicable regulations, the terms of these agreements were negotiated at arm's length on the basis that they are substantially the same, or at least as 3 favorable to the Bank, as those prevailing for comparable transactions with, or involving, other nonaffiliated companies. Pursuant to the Master Production Agreement, the Bank, on a monthly basis, determines its loan production targets and goals (the "Loan Production Goals") and R&G Mortgage assists the Bank to reach its Loan Production Goals by, among other things: (i) advertising, promoting and marketing to the general public; (ii) interviewing prospective borrowers and initial processing of loan applications, consistent with the Bank's underwriting guidelines and Loan Production Goals previously established; and (iii) providing personnel and facilities with respect to the execution of any loan agreement approved by the Bank. In exchange for these services, the Bank remits to R&G Mortgage a percentage of the processing or originating fees charged to the borrowers under loan agreements, as set forth in the agreements. See "-Lending Activities of the Bank - Originations, Purchases and Sales of Loans." The Master Purchase Agreement provides for the sale by the Bank to R&G Mortgage of the servicing rights to all first and second mortgage loans secured by residential properties which become part of the Bank's loan portfolio. The Master Purchase Agreement further provides that R&G Mortgage will service all other loans held in the Bank's loan portfolio (including single-family residential loans retained by the Bank and certain commercial real estate loans), although R&G Mortgage does not actually acquire such servicing rights. The Master Purchase Agreement further provides that R&G Mortgage exclusively will service such loans and that the Bank will process payments of such loans, all according to a fee schedule. See " - Mortgage Banking Activities - Loan Originations, Purchases and Sales of Loans." Under the Securitization Agreement, R&G Mortgage renders securitization services with respect to the pooling of some of the Bank's mortgage loans into mortgage-backed securities. With respect to securitization services rendered, the Bank pays a securitization fee of 25 basis points. The Master Custodian Agreement provides that the Bank shall be the custodial agent for R&G Mortgage of certain documentation related to the issuance by R&G Mortgage of GNMA, FNMA or FHLMC mortgage-backed certificates. In consideration of these services, the Bank receives a fee for each mortgage note included in a mortgage-backed certificate per year for which it acts as custodian, as set forth in the agreement. See "- Mortgage Banking Activities Loan Originations, Purchases and Sales of Loans." Mortgage Banking Activities Loan Originations, Purchases and Sales. During the years ended December 31, 1997, 1996 and 1995, R&G Mortgage originated a total of $598.2 million, $448.1 million and $322.7 million of loans, respectively. These aggregate originations include loans originated by R&G Mortgage directly for the Bank of $285.8 million, $211.3 million and $156.3 million during the years ended December 31, 1997, 1996 and 1995, respectively, or 48%, 47% and 48%, respectively, of total originations. The loans originated by R&G Mortgage for the Bank are 4 comprised primarily of conventional residential loans and, to a lesser extent, consumer loans secured by real estate. R&G Mortgage is engaged to a significant extent in the origination of FHA-insured and VA-guaranteed single-family residential loans which are primarily securitized into GNMA mortgage-backed securities and sold to institutional and/or private investors in the secondary market. During the years ended December 31, 1997, 1996 and 1995, R&G Mortgage originated $280.1 million, $222.0 million and $154.9 million, respectively, of FHA/VA loans, which represented 46.8%, 49.5% and 48.0%, respectively, of total loans originated during such respective periods. R&G Mortgage also originates conventional single-family residential loans which are either insured by private mortgage insurers or do not exceed 80% of the appraised value of the mortgaged property. During the years ended December 31, 1997, 1996 and 1995, R&G Mortgage originated $265.9 million, $204.9 million and $151.9 million, respectively, of conventional single-family residential mortgage loans. Substantially all conforming conventional single-family residential loans are securitized and sold in the secondary market while substantially all non-conforming conventional single-family residential loans are originated by R&G Mortgage on behalf of the Bank and either held by the Bank in its portfolio or subsequently securitized by R&G Mortgage and sold in the secondary market. Non-conforming loans generally consist of loans which, primarily because of size or other underwriting technicalities which may be cured through seasoning, do not satisfy the guidelines for resale of FNMA, FHLMC, GNMA and other private secondary market investors at the time of origination. Management believes that these loans are essentially of the same credit quality as conforming loans. During the years ended December 31, 1997, 1996 and 1995, non-conforming conventional loans represented approximately 39%, 42% and 43%, respectively, of R&G Mortgage's total volume of mortgage loans originated, substantially all of which were originated by R&G Mortgage on behalf of the Bank. During the years ended December 31, 1997, 1996 and 1995, 77.5%, 88.9% and 81.0% of loans originated by R&G Mortgage on behalf of the Bank consisted of single-family residential loans during such respective periods. R&G Mortgage originates single-family residential, construction and commercial real estate loans on behalf of the Bank pursuant to the terms of a Master Production Agreement between R&G Mortgage and the Bank. See "- Lending Activities of the Bank - Origination, Purchase and Sale of Loans." While R&G Mortgage makes available a wide variety of mortgage products designed to respond to consumer needs and competitive conditions, it currently emphasizes 15-year and 30-year conventional first mortgages and 15-year and 30-year FHA loans and VA loans. Substantially all of such loans consist of fixed-rate mortgages. The average loan size for FHA/VA mortgage loans and conventional mortgage loans is approximately $68,200 and $73,000, respectively. 5 R&G Mortgage also offers second mortgage loans up to $125,000 with a maximum term of 15 years. The maximum loan-to-appraised value ratio on second mortgage loans permitted by R&G Mortgage is 75% (including the amount of any first mortgage). In addition, R&G Mortgage also offers real estate secured consumer loans up to $40,000 with a maximum term of 10 years. The maximum loan-to-appraised value ratio on real estate secured consumer loans permitted by R&G Mortgage is 80%. R&G Mortgage will secure such loans with either a first or second mortgage on the property. R&G Mortgage's loan origination activities are conducted out of its offices and mortgage banking centers. Residential mortgage loan applications are attributable to walk-in customers, existing customers and advertising and promotion, referrals from real estate brokers and builders, loan solicitors and mortgage brokers. At December 31, 1997, R&G Mortgage employed 66 loan originators who are compensated in part on a commission basis. Loan origination activities performed by R&G Mortgage include soliciting, completing and processing mortgage loan applications and preparing and organizing the necessary loan documentation. Loan applications are examined for compliance with underwriting criteria and, if all requirements are met, R&G Mortgage issues a commitment to the prospective borrower specifying the amount of the loan and the loan origination fees, points and closing costs to be paid by the borrower or seller and the date on which the commitment expires. R&G Mortgage also purchases FHA loans and VA loans from other mortgage bankers for resale to institutional investors and other investors in the form of GNMA mortgage-backed securities. R&G Mortgage's strategy is to increase its servicing portfolio primarily though internal originations through its branch network and, to a lesser extent, purchases from third parties. Purchases of loans from other mortgage bankers in the wholesale loan market is generally limited to FHA loans and VA loans and such purchases provide R&G Mortgage with a source of low cost production that allows R&G Mortgage to continue to increase the size of its servicing portfolio. R&G Mortgage purchased $158.5 million, $45.6 million and $19.5 million of loans from third parties during the years ended December 31, 1997, 1996 and 1995, respectively. 6 The following table sets forth loan originations, purchases and sales by R&G Mortgage for the periods indicated.
Year Ended December 31, ------------------------------------ 1997 1996 1995 -------- -------- -------- (Dollars in Thousands) Loans Originated For the Bank: Conventional loans(1): Number of loans ..................... 3,390 2,756 2,226 Volume of loans ..................... $233,488 $190,072 $140,363 FHA/VA loans: Number of loans ..................... -- -- -- Volume of loans ..................... -- $ -- $ -- Consumer loans(2): Number of loans ..................... 2,318 1,004 974 Volume of loans ..................... $ 52,287 $ 21,208 $ 15,944 Total loans: Number of loans ..................... 5,708 3,760 3,200 Volume of loans ..................... $285,775 $211,280 $156,307 Percent of total volume ............. 35% 43% 46% For Third Parties: Conventional loans(1): Number of loans ..................... 444 214 151 Volume of loans ..................... $ 32,419 $ 14,835 $ 11,496 FHA/VA loans: Number of loans ..................... 4,107 3,117 2,313 Volume of loans ..................... $280,053 $221,967 $154,916 Total loans: Number of loans ..................... 4,551 3,331 2,464 Volume of loans ..................... $312,472 $236,802 $166,412 Percent of total volume ............. 39% 48% 48% -------- -------- -------- Total loan originations ........... $598,247 $448,082 $322,719 ======== ======== ======== Loans Purchased For R&G Mortgage: Number of loans ....................... 2,052 583 305 Volume of loans (3) ................... $158,456 $ 45,604 $ 19,525 Percent of total volume ............... 20% 9% 6% GNMA Pools Purchased for R&G Mortgage: Volume of loans ....................... $ 51,537 -- -- Percent of total volume ............... 6% -- -- -------- -------- -------- Total loan originations and purchases $808,240 $493,686 $342,244 ======== ======== ========
7
Year Ended December 31, ----------------------------------------- 1997 1996 1995 --------- --------- --------- (Dollars in Thousands) Loans Sold To Third Parties(4): Conventional loans(1): Number of loans ...................... 429 178 151 Volume of loans ...................... $ 39,495 $ 12,560 $ 11,999 FHA/VA loans: Number of loans ...................... 2,775 3,564 2,252 Volume of loans(3) ................... $ 206,643 $ 232,254 $ 183,607 Total loans: Number of loans ...................... 3,204 3,742 2,403 Volume of loans ...................... $ 246,138 $ 244,814 $ 195,606 Percent of total volume .............. 30% 50% 57% --------- --------- --------- Adjustments: Loans originated for the Bank .......... $ 276,327 $(211,280) $(156,307) Loans amortization ..................... (5,086) (7,224) (1,960) --------- --------- --------- Increase (decrease) in loans held for sale $ 271,241 $ 30,368 $ (11,629) ========= ========= ========= Average Initial Loan Origination Balance: The Bank: Conventional loans(1) ................ $ 69 $ 69 $ 63 FHA/VA loans ......................... -- -- -- Third Parties: Conventional loans(1) ................ $ 73 69 76 FHA/VA loans ......................... 68 71 63 Total Average Initial Balance: Conventional loans(1) ................ 69 69 64 FHA/VA loans ......................... 68 71 63 Refinancings(5): The Bank ............................... 30% 33% 58% Third Parties .......................... 31% 24% 26%
- -------------- (1) Includes non-conforming loans. (2) All but $1.5 million and $3.3 million of such loans were secured by real estate at December 31, 1996 and 1995, respectively. (3) Excludes $7.9 million and $36.1 million of loans purchased from another financial institution and securitized and sold to the same financial institution during 1996 and 1995, respectively. (4) Includes loans converted into mortgage-backed securities. (5) As a percent of the total dollar volume of loans originated by R&G Mortgage for the Bank or third parties, as the case may be. In the case of the Bank, refinancings do not necessarily represent refinancings of loans previously held by the Bank. 8 All loan originations, regardless of whether originated through R&G Mortgage or purchased from third parties, must be underwritten in accordance with R&G Mortgage's underwriting criteria, including loan-to-appraised value ratios, borrower income qualifications, debt ratios and credit history, investor requirements, necessary insurance and property appraisal requirements. R&G Financial's underwriting standards also comply with the relevant guidelines set forth by HUD, VA, FNMA, FHLMC, bank regulatory authorities, private mortgage investment conduits and private mortgage insurers, as applicable. R&G Mortgage's underwriting personnel, while operating out of its loan offices, make underwriting decisions independent of R&G Mortgage's mortgage loan origination personnel. Typically, when a mortgage loan is originated, the borrower pays an origination fee. These fees are generally in the range of 0% to 7% of the principal amount of the mortgage loan, and are payable at the closing of such loan. R&G Mortgage receives these fees on mortgage loans originated through its retail branches. R&G Mortgage may charge additional fees depending upon market conditions and regulatory considerations as well as R&G Mortgage's objectives concerning mortgage loan origination volume and pricing. R&G Mortgage incurs certain costs in originating mortgage loans, including overhead, out-of-pocket costs and, in some cases, where the mortgage loans are subject to a purchase commitment from private investors, related commitment fees. The volume and type of mortgage loans and of commitments made by investors vary with competitive and economic conditions (such as the level of interest rates and the status of the economy in general), resulting in fluctuations in revenues from mortgage loan originations. Generally accepted accounting principles ("GAAP") require that general operating expenses incurred in originating mortgage loans be charged to current expense. Direct origination costs and origination income must be deferred and amortized using the interest method, until the repayment or sale of the related mortgage loans. Historically, the value of servicing rights which result from R&G Mortgage's origination activities has exceeded the net costs attributable to such activities. R&G Mortgage customarily sells most of the loans that it originates, except for those originated on behalf of the Bank pursuant to the Master Production Agreement. See "-Lending Activities of the Bank - Origination, Purchases and Sales of Loans." The loans originated by R&G Mortgage (including FHA loans, VA loans and conventional loans) are secured by real property located in Puerto Rico and constitute "eligible investments" which results in favorable tax treatment under U.S. and Puerto Rico tax laws. See "- Puerto Rico Secondary Mortgage Market and Favorable Tax Treatment." During the years ended December 31, 1997, 1996 and 1995, R&G Mortgage sold $246.1 million, $244.8 million and $195.6 million of loans, respectively, which includes loans securitized and sold but does not include loans originated by R&G Mortgage on behalf of the Bank. With respect to such loan sales, $206.6 million or 83.9%, $232.3 million or 94.9% and $183.6 million or 93.9% consisted of GNMA-guaranteed mortgage-backed securities of FHA loans or VA loans packaged into pools of $1 million or more ($2.5 million to $5 million for serial notes as described below). These securities were sold primarily to securities broker-dealers and other investors in Puerto Rico. 9 Certain GNMA-guaranteed mortgage-backed securities sold by R&G Mortgage are in the form of GNMA serial notes which permit the investor to receive interest monthly and to select among several expected maturity dates of the notes included in an issue, with each maturity having a specific yield. GNMA serial notes are sold in pools of $2.5 million to $5 million. GNMA serial notes are sold to securities broker-dealers in packages consisting of notes of different yields and maturities, which range from one to 30 years and have an average maturity of 12 years, taking into account historical experience with prepayments of the underlying mortgages. The rates on the serial notes or GNMA pools must be 1/2 of 1% less than the rates on the mortgages comprising the pool. Upon completion of the necessary processing, the GNMA-guaranteed mortgage-backed securities are either offered to the public directly through the Bank's Trust Department or indirectly through securities broker-dealers. During the years ended December 31, 1997, 1996 and 1995, R&G Mortgage issued GNMA serial notes totalling approximately $397.2 million, $236.4 million and $184.4 million, respectively. Conforming conventional loans originated or purchased by R&G Mortgage are generally sold directly to FNMA, FHLMC or private investors for cash or are grouped into pools of $1 million or more in aggregate principal balance and exchanged for FNMA or FHLMC-issued mortgage-backed securities, which R&G Mortgage sells to securities broker-dealers. In connection with any such exchanges, R&G Mortgage pays guarantee fees to FNMA and FHLMC. The issuance of mortgage-backed securities provides R&G with flexibility in selling the mortgages which it originates or purchases and also provides income by increasing the value and marketability of the loans. Mortgage loans that do not conform to GNMA, FNMA or FHLMC requirements (so-called "non-conforming loans") are generally originated on behalf of the Bank and either retained in the Bank's portfolio, sold to financial institutions or other private investors or securitized into "private label" CMOs through grantor trusts or other mortgage conduits and sold through securities broker-dealers. Non-conforming loans consist of jumbo loans or loans that do not satisfy all requirements of FNMA, FHLMC and GNMA at the time of origination of the loan (such as missing tax returns, slightly higher loan-to-value ratios, etc.). Each CMO normally consists of several classes of senior, subordinate and residual certificates. The residual certificates evidence a right to receive payments on the mortgage loans after payment of all required amounts on the senior and subordinate certificates then due. Some form of credit enhancement, such as an insurance policy, letter of credit or subordination, will generally be used to increase the credit rating of the senior certificates and thereby improve their marketability. During the year ended December 31, 1995, R&G Mortgage and the Bank completed sales of approximately $38.2 million of CMOs in securitization transactions. There were no sales in 1997 or 1996. In connection with such transactions, either the Bank or R&G Mortgage generally retains the residual certificates issued by the respective trusts as well as the subordinate certificates issued in such transactions. As of December 31, 1997, R&G Mortgage held CMOs (which were primarily issued by R&G Mortgage) with a fair value of $15.2 million and residual certificates issued in CMO transactions involving R&G Mortgage and the Bank with a fair value of $7.9 million. In addition, the Bank held CMO subordinated certificates and 10 residual certificates from one of its issues with a fair value of $8.4 million at December 31, 1997. See "- Investment Activities." Currently a liquid secondary market for subordinate or residual certificates does not exist in Puerto Rico. The value of residual certificates is subject to substantial fluctuations as a result of changes in prevailing interest rates. However, such residuals often exhibit elasticity and convexity characteristics which R&G Financial can utilize to hedge other components of its portfolio. See "Management's Discussion and Analysis of Financial Condition and Results of Operation" incorporated by reference in Item 7 hereof. While R&G Mortgage's exchanges of mortgage loans into agency securities and sales of mortgage loans are generally made on a non-recourse basis, R&G Mortgage also engages in the sale or exchange of mortgage loans on a recourse basis. In the past, recourse sales often involved the sale of non-conforming loans to FNMA, FHLMC and local financial institutions. R&G Financial estimates the fair value of the retained recourse obligation at the time mortgage loans are sold. Normally, the fair value of any retained recourse is immaterial because R&G Mortgage is able to resell repurchased loans for at least their carrying costs. Accordingly, as of December 31, 1997, R&G Financial did not deem it necessary to establish reserves for possible losses related to its recourse obligations. At December 31, 1997, R&G Mortgage had loans in its servicing portfolio with provisions for recourse in the principal amount of approximately $374.4 million, as compared to $290.9 million and $238.2 million as of December 31, 1996 and 1995, respectively. Of the recourse loans existing at December 31, 1997, approximately $340.5 million in principal amount consisted of loans sold to FNMA and FHLMC and converted into mortgage-backed securities of such agencies, and approximately $33.9 million in principal amount consisted of non-conforming loans sold to other private investors. Pursuant to the terms of the Master Purchase Agreement, R&G Mortgage renders securitization services with respect to the pooling of some of the Bank's mortgage loans into mortgage-backed securities. With respect to the securitization services rendered, the Bank pays a securitization fee of 25 basis points. In addition, pursuant to the terms of a Master Custodian Agreement entered into by R&G Mortgage and the Bank, the Bank acts as the custodial agent for R&G Mortgage of certain documentation related to the issuance by R&G Mortgage of GNMA or FHLMC mortgage-backed certificates. In consideration of these services, the Bank receives an annual fee of $5.0 for each mortgage note included in a mortgage-backed certificate for which it acts as custodian. See also "- General - Affiliated Transactions" and "Regulation - R&G Financial - Limitations on Transactions with Affiliates." Loan Servicing. R&G Mortgage acquires servicing rights through its mortgage loan originations (including originations on behalf of the Bank) and purchases from third parties. When R&G Mortgage sells the mortgage loans it has originated or purchased, it generally retains the rights to service such loans and receives the related servicing fees. Loan servicing includes collecting principal and interest and remitting the same to the holders of the mortgage loans or mortgage-backed securities to which such mortgage loan relates, holding escrow funds for the payment of real estate taxes and insurance premiums, contacting delinquent borrowers, supervising foreclosures in the event of unremedied defaults and generally administering the loans. R&G Mortgage receives annual loan servicing fees ranging from 0.25% to 0.50% of the 11 declining outstanding principal balance of the loans serviced plus any late charges. In general, R&G Mortgage's servicing agreements are terminable by the investor for cause without penalty or after payment of a termination fee ranging from 0.5% to 1.0% of the outstanding principal balance of the loans being serviced. R&G Mortgage's servicing portfolio has grown significantly over the past several years. At December 31, 1997, R&G Mortgage's servicing portfolio totalled $3.0 billion and consisted of a total of 56,442 loans. At December 31, 1997, R&G Mortgage's servicing portfolio included $448.9 million of loans serviced for the Bank or 15.0% of the total servicing portfolio. Substantially all of the mortgage loans in R&G Mortgage's servicing portfolio are secured by single (one-to-four) family residences. All of R&G Mortgage's mortgage servicing portfolio is comprised of mortgages secured by real estate located in Puerto Rico. Pursuant to the terms of a Master Purchase Agreement, the Bank sells to R&G Mortgage the servicing rights to all first and second mortgage loans secured by residential properties which become part of the Bank's loan portfolio. The Master Purchase Agreement further provides that R&G Mortgage will service all other loans held in the Bank's loan portfolio (including single-family residential loans retained by the Bank and certain commercial real estate loans), although R&G Mortgage does not actually acquire such servicing rights. The Bank pays R&G Mortgage servicing fees with respect to the loans serviced by R&G Mortgage on behalf of the Bank. In addition, pursuant to the Master Purchase Agreement, the Bank processes payments of all loans originated by R&G Mortgage on behalf of the Bank. In connection therewith, R&G Mortgage pays the Bank a fee equal to between $0.50 and $1.00 per loan. See also "- General - Affiliated Transactions" and "Regulation - R&G Financial - Limitations on Transactions with Affiliates." R&G Mortgage's mortgage loan servicing portfolio is subject to reduction by reason of normal amortization, prepayments and foreclosure of outstanding mortgage loans. Additionally, R&G Mortgage may sell mortgage loan servicing rights from time to time. 12 The following table sets forth certain information regarding the total loan servicing portfolio of R&G Mortgage for the periods indicated.
Year Ended December 31, -------------------------------------------------- 1997 1996 1995 ---------------- ---------------- ---------------- (Dollars in Thousands) Composition of Servicing Portfolio at End of Period: Conventional and other mortgage loans(1)................... $1,148,739 $ 971,327 $ 811,269 FHA/VA loans............................................... 1,852,149 1,578,842 1,486,931 ---------- ---------- ---------- Total servicing portfolio(2)............................. $3,000,888 $2,550,169 $2,298,200 ========== ========== ========== Activity in the Servicing Portfolio: Beginning servicing portfolio.............................. $2,550,169 $2,298,200 $2,114,743 Add: Loan originations and purchases....................... 778,126 506,696 325,870 Servicing of portfolio loans acquired............... 5,301 36,478 239,414 Less: Sale of servicing rights............................. -- 42,080 196,895(3) Run-offs(4)......................................... 332,708 249,125 184,932 ---------- ---------- ---------- Ending servicing portfolio................................. $3,000,888 $2,550,169 $2,298,200 ========== ========== ========== Number of loans serviced(5)................................ 56,442 50,979 48,240 Average loan size(5)....................................... $ 53 $ 50 $48 Average servicing fee rate(5).............................. 0.532% 0.532% 0.505%
- -------------- (1) Includes non-conforming loans. (2) At the dates shown, included $448.9 million, $323.8 million and $290.8 million of loans serviced for the Bank, respectively, which constituted 15.0%, 12.70% and 12.65% of the total servicing portfolio, respectively. (3) R&G Mortgage sold servicing rights during 1994 and recognized a gain of $2.9 million. Pursuant to a subservicing agreement with the purchaser of the servicing rights, R&G Mortgage continued to service the loans subject to such sale and they remained in R&G Mortgage's servicing portfolio until 1995. (4) Run-off refers to regular amortization of loans, prepayments and foreclosures. Includes one-time transfer in 1997 of $49.0 million of mortgage loans to a financial institution who acquired a commercial bank whose loans were being serviced by R&G Mortgage. (5) At December 31, 1997, R&G Mortgage was servicing 6,507 loans for the Bank with an average loan size of approximately $69,000 and at an average servicing rate of 0.284%. Amounts include late and other miscellaneous charges. 13 The following table sets forth certain information at December 31, 1997 regarding the number of, and aggregate principal balance of, the mortgage loans serviced by R&G Mortgage for the Bank and for third parties at various mortgage interest rates.
At December 31, 1997 ------------------------------------------------------------------------------ Loans Serviced Loans Serviced for the Bank for Third Parties ---------------------------------- ----------------------------------- Number of Aggregate Number of Aggregate Loans Principal Balance Loans Principal Balance Mortgage Interest Rate ------------- -------------------- -------------- -------------------- (Dollars in Thousands) (Dollars in Thousands) Less than 7.00%............ 51 $ 2,646 2,734 $ 136,804 7.00% - 7.49%.............. 260 24,693 8,325 520,445 7.50% - 7.99%.............. 562 57,188 15,127 833,118 8.00% - 8.49%.............. 2,732 201,968 7,442 454,494 8.50% - 8.99%.............. 1,818 119,252 7,803 338,867 9.00% - 9.49%.............. 478 24,183 3,102 114,954 9.50% - 9.99%.............. 167 7,380 2,445 68,646 10.00% - 10.49%............ 135 3,964 981 33,224 10.50% - 10.99%............ 154 4,146 596 16,801 11.00% or more............. 150 3,438 1,380 34,677 ----- -------- ------ ---------- 6,507 $448,858 49,903 $2,552,030 ===== ======== ====== ========== At December 31, 1997 --------------------------------- Total Loans Serviced --------------------------------- Number of Aggregate Loans Principal Balance Mortgage Interest Rate ------------ -------------------- (Dollars in Thousands) Less than 7.00%............ 2,785 $139,450 7.00% - 7.49%.............. 8,585 545,138 7.50% - 7.99%.............. 15,689 890,306 8.00% - 8.49%.............. 10,174 656,462 8.50% - 8.99%.............. 9,621 458,119 9.00% - 9.49%.............. 3,580 139,137 9.50% - 9.99%.............. 2,612 76,026 10.00% - 10.49%............ 1,116 37,188 10.50% - 10.99%............ 750 20,947 11.00% or more............. 1,530 38,115 ------ ---------- 56,442 $3,000,888 ====== ==========
The amount of principal prepayments on mortgage loans serviced by R&G Mortgage was $87.2 million, $72.5 million and $68.2 million for the years ended December 31, 1997, 1996 and 1995, respectively. This represented approximately 2.9%, 2.8% and 3.0% of the aggregate principal amount of mortgage loans serviced during such periods. The primary means used by R&G Mortgage to reduce the sensitivity of its servicing fee income to changes in interest and prepayment rates is the development of a strong internal origination capability that has allowed R&G Mortgage to continue to increase the size of its servicing portfolio even in times of high prepayments. Servicing agreements relating to the mortgage-backed securities programs of FNMA, FHLMC and GNMA, and certain other investors, require R&G Mortgage to advance funds to make scheduled payments of principal, interest, taxes and insurance, if such payments have not been received from the borrowers. During the years ended December 31, 1997, 1996 and 1995, the monthly average amount of funds advanced by R&G Mortgage under such servicing agreements was $1.4 million, $1.3 million and $4.4 million, respectively. Funds advanced by R&G Mortgage pursuant to these arrangements are generally recovered by R&G Mortgage within 30 days. In connection with its loan servicing activities, R&G Mortgage holds escrow funds for the payment of real estate taxes and insurance premiums with respect to the mortgage loans it services. At December 31, 1997, R&G Mortgage held $58.8 million of such escrow funds, $50.2 million of which were deposited in the Bank and $8.6 million of which were deposited with other financial institutions. The escrow funds deposited with the Bank lower its overall cost of funds 14 and is a means of compensating it for processing mortgages checks received by R&G Mortgage, while the escrow funds deposited with other financial institutions serve as part of R&G Mortgage's compensating balances which permit R&G Mortgage to borrow funds from such institutions (pursuant to certain warehouse lines of credit) at rates that are lower than would otherwise apply. See "- Sources of Funds - Borrowings." The degree of risk associated with a mortgage loan servicing portfolio is largely dependent on the extent to which the servicing portfolio is non-recourse or recourse. In non-recourse servicing, the principal credit risk to the servicer is the cost of temporary advances of funds. In recourse servicing, the servicer agrees to share credit risk with the owner of the mortgage loans such as FNMA or FHLMC or with an insurer or guarantor. Losses on recourse servicing occur primarily when foreclosure sale proceeds of the property underlying a defaulted mortgage are less than the then outstanding principal balance and accrued interest of such mortgage loan and the cost of holding and disposing of such underlying property. At December 31, 1997, R&G Mortgage was servicing mortgage loans with an aggregate principal amount of $374.4 million on a recourse basis. During the last three years, losses incurred due to recourse servicing have not been significant. R&G Mortgage's general strategy is to retain the servicing rights related to the mortgage loans it originates and purchases. Nevertheless, there is a market in Puerto Rico for servicing rights, which are generally valued in relation to the present value of the expected income stream generated by the servicing rights. Among the factors which influence the value of a servicing portfolio are servicing fee rates, loan balances, loan types, loan interest rates, the expected average life of the underlying loans (which may be reduced through foreclosure or prepayment), the value of escrow balances, delinquency and foreclosure experience, servicing costs, servicing termination rights of permanent investors and any recourse provisions. During the year ended December 31, 1995, R&G Mortgage sold servicing rights on $196.9 million of mortgage loans. Although R&G Mortgage may on occasion consider future sales of a portion of its servicing portfolio, management does not anticipate sales of servicing rights to become a significant part of its operations. The market value of, and earnings from, R&G Mortgage's mortgage loan servicing portfolio may be adversely affected if mortgage interest rates decline and mortgage loan prepayments increase. In a period of declining interest rates and accelerated prepayments, income generated from R&G Mortgage's mortgage loan servicing portfolio may also decline. Conversely, as mortgage interest rates increase, the market value of R&G Mortgage's mortgage loan servicing portfolio may be positively affected. See Note 1 to R&G Financial's Notes to Consolidated Financial Statements for a discussion of SFAS No. 122 and the treatment of servicing rights, incorporated by reference into Item 8 hereof. 15 Mortgage Loan Delinquencies and Foreclosures. The following table shows the delinquency statistics for R&G Mortgage's servicing portfolio at the dates indicated.
Year Ended December 31, ---------------------------------------------------------------------------------------- 1997 1996 1995 -------------------------- -------------------------- -------------------------- Percent of Percent of Percent of Number of Servicing Number of Servicing Number of Servicing Loans Portfolio Loans Portfolio Loans Portfolio ------------ ------------ ------------ ------------ ------------ ------------ Loans delinquent for: 30-59 days.......................... 2,531 4.48% 2,775 5.44% 3,366 6.98% 60-89 days.......................... 572 1.01 533 1.05 906 1.88 90 days or more..................... 778 1.38 646 1.27 988 2.05 ----- ---- ----- ---- ----- ----- Total delinquencies(1)............ 3,881 6.87% 3,954 7.76% 5,260 10.90% ===== ==== ===== ==== ===== ===== Foreclosures pending(2)............... 681 1.21% 693 1.36% 459 0.95% ===== ==== ===== ==== ===== =====
- ----------------- (1) Includes at December 31, 1997, an aggregate of $26.4 million of delinquent loans serviced for the Bank, or .88% of the total servicing portfolio and $2.7 million of delinquent loans held in R&G Mortgage's own portfolio. (2) At December 31, 1997, the Bank had foreclosures pending on $12.2 million of loans being serviced by R&G Mortgage, which constituted 0.41% of the servicing portfolio. R&G Mortgage had foreclosures pending on $2.1 of loans it is servicing for its own portfolio at December 31, 1997. While delinquency rates in Puerto Rico are generally higher than in the mainland United States, these rates are not necessarily indicative of future foreclosure rates or losses on foreclosures. Real estate owned as a result of foreclosures ("REO") related to R&G Mortgage's mortgage banking business arise primarily through foreclosure on mortgage loans repurchased from investors either because of breach of representations or warranties or pursuant to recourse arrangements. As of December 31, 1997, 1996 and 1995, R&G Mortgage held REO with a book value of approximately $165,000, $0 and $0, respectively. Sales of REO resulted in gains to R&G Mortgage of $145,000 and $30,000 for the years ended December 31, 1997 and 1995, respectively, and a net loss to R&G Mortgage of $57,000 for the year ended December 31, 1996. There is no liquid secondary market for the sale of R&G Mortgage's REO. With respect to mortgage loans securitized through GNMA programs, R&G Mortgage is fully insured as to principal by the FHA and VA against foreclosure loans. As a result of these programs, foreclosure on these loans had generated no loss of principal as of December 31, 1997. R&G Mortgage, however, incurs about $3,000 per loan foreclosed in interest and legal charges during the time between payment by R&G Mortgage and FHA or VA reimbursement. For the years ended December 31, 1997, 1996 and 1995, total expenses related to FHA or VA loans foreclosed amounted to $189,000, $302,000 and $230,000, respectively. Although FNMA and FHLMC are obligated to reimburse R&G Mortgage for principal and interest payments advanced 16 by R&G Mortgage as a servicer (except for recourse servicing), the funding of delinquent payments or the exercise of foreclosure rights involves costs to R&G Mortgage which may not be recouped. Such nonrecouped expenses have to date been immaterial. Any significant adverse economic developments in Puerto Rico could result in an increase in defaults or delinquencies on mortgage loans that are serviced by R&G Mortgage or held by R&G Mortgage pending sale in the secondary mortgage market, thereby reducing the resale value of such mortgage loans. Puerto Rico Secondary Mortgage Market and Favorable Tax Treatment. In general, the Puerto Rico market for mortgage-backed securities is an extension of the United States market with respect to pricing, rating of the investment instruments, and other matters. However, United States and Puerto Rico tax laws provide an economic incentive for Puerto Rico residents and Section 936 Corporations (defined below) to invest in certain mortgage loans and mortgage-backed securities originated in Puerto Rico, including FHA and VA loans and GNMA certificates, thereby tending to increase the secondary market demand for, and the resale value of, such mortgage loans and mortgage-backed securities. These tax advantages also favorably affect R&G Financial's net interest income by helping create a pool of lower-cost funds that R&G Financial can access through financial intermediaries such as banks and broker-dealers and use to fund mortgage loans and mortgage-backed securities pending sale. Under various Puerto Rico industrial incentives acts (the "Industrial Incentives Acts"), certain investment income earned by qualified manufacturing entities or service enterprises that have grants of tax exemption issued thereunder ("Exempt Companies"), is exempt from Puerto Rico income tax. Investment income that qualifies for this exemption includes interest on certain mortgage loans and interest on funds of Exempt Companies ("936 Funds") placed with eligible institutions in Puerto Rico (primarily savings and loan associations, commercial banks and registered broker-dealers), provided such funds are invested in certain "eligible activities" in accordance with regulations promulgated by the OCFI, including certain mortgage loans and mortgage-backed securities. The Industrial Incentives Acts also encourage investment in Puerto Rico by allowing Exempt Companies to reduce the otherwise applicable 10% tax (the "Tollgate Tax") on distributions to shareholders by investing their exempt industrial development income ("IDI") in Puerto Rico for fixed periods of time, generally from five years to ten years. A new Industrial Incentive Act was approved by the Government of Puerto Rico effective January 1, 1998: the Tax Incentive Act of 1998 (the "1998 TIA"). Grants issued under the 1998 TIA will provide for a flat rate of tax on the operating income of Exempt Companies. The same types of investment income that qualified for exemption under the Industrial Incentive Acts will continue to be exempt under the 1998 TIA. Because grantees of tax exemption under the 1998 TIA will not be subject to Tollgate Taxes, they will not have an incentive to invest their IDI in qualifying investments in Puerto Rico, as grantees under the Industrial Incentive Acts presently do in order to reduce their Tollgate Taxes. It should be noted, however, that Exempt Companies currently operating pursuant to grants issued under the Industrial Incentives Acts generally will not be affected by the provisions of the 1998 TIA. Although such Exempt Companies may renegotiate their grants under the 1998 TIA, an amount of IDI equal to the IDI derived in the taxable year preceding the change to the 1998 TIA (or, if greater, the average annual IDI by 17 taking the three years, out of the previous five years, where the highest amount of IDI is derived) will continue to be subject to the tax treatment, including Tollgate Taxes, provided in the Industrial Incentive Act under which their grant was originally issued. Most Exempt Companies are United States corporations which operate in Puerto Rico under Section 936 of the Code. Corporations that meet certain requirements and elect the benefits of Section 936 ("Section 936 Corporations") are entitled to credit against their United States corporate income tax a portion of such tax attributable to (i) income derived from sources outside the United States from the active conduct of a trade or business within Puerto Rico or from the sale or exchange of substantially all assets used in the active conduct of such trade or business ("Active Business Income") and (ii) qualified possession source investment income ("QPSII"). QPSII generally includes interest derived from mortgage loans secured by real property located in Puerto Rico and mortgage-backed securities consisting of such mortgage loans as well as interest on deposits with financial institutions in Puerto Rico which in turn use such funds to finance the origination of mortgage loans and other qualifying assets. The credit provided for QPSII tends to increase the demand for Puerto Rico mortgage loans and mortgage-backed securities as well as to reduce funding costs for mortgage banking institutions. The Omnibus Budget Reconciliation Act of 1993 (the "OBRA Amendments") and the Small Business Job Protection Act of 1996 (the "SBJPA") amended various provisions of Section 936. The OBRA Amendments, which are generally effective for taxable years beginning after December 31, 1993, permit a taxpayer to compute the tax credit available under Section 936 (the "936 Credit") as under prior law but limit the amount of credit allowed with respect to Active Business Income under one of two alternatives to be selected at the option of the taxpayer. Under the first alternative, the limit is equal to a fixed percentage of the amount of tax credit allowable under prior law (the "Fixed Percentage Method"). This fixed percentage commenced at 60% for taxable years beginning in 1994 and is reduced by 5% per year until 1998. For taxable years beginning in 1998, such percentage would be 40%. Under the second alternative (the "Economic Activity Method"), which is based on the amount of economic activity conducted by the taxpayer in Puerto Rico, the credit may not exceed the sum of the following three components: (i) 60% of the qualified possession wages and the allocable fringe benefits paid by the taxpayer, (ii) applicable percentages of certain depreciation deductions claimed for regular tax purposes by the taxpayer with respect to qualified tangible property and (iii) a portion of the possession income taxes paid by the taxpayer except where the taxpayer uses the profit-split method for determining its income. The OBRA Amendments did not limit the 100% credit available under Section 936 for QPSII, including income received from investment in certain Puerto Rico mortgage loans and mortgage-backed securities. The SBJPA repealed (i) the 936 Credit attributable to QPSII generally for income received or accrued after June 30, 1996, and (ii) the 936 Credit attributable to Active Business Income for taxable years beginning after December 31, 1995. The SBJPA, however, provided grandfather rules under which a Section 936 Corporation that had elected the benefits of the Section 936 Credit and which was engaged in active trade or business within Puerto Rico on October 13, 1995 (an "Existing Claimant") would be eligible to claim the 936 Credit attributable to Active Business Income during a transition period. A corporation may also qualify as an Existing Claimant if it 18 acquires all the assets of a trade or business of a corporation that meets the active trade or business requirement and the election requirement is satisfied. The amount and computation method of the 936 Credit during the transition period depends upon whether a Section 936 Corporation is using the Economic Activity Method or the Fixed Percentage Method. A Section 936 Corporation that is an Existing Claimant and uses the Economic Activity Method may continue to determine its 936 Credit attributable to Active Business Income as under present law for taxable years beginning after December 31, 1995 and before January 1, 2002. For taxable years beginning after December 31, 2001 and before January 1, 2006, a Section 936 Corporation's Active Business Income eligible for the 936 Credit is subject to a cap, described below. A Section 936 Corporation that is an Existing Claimant and is using the Fixed Percentage Method may continue to determine its 936 Credit attributable to Active Business Income under the existing rules for taxable years beginning after December 31, 1995 and before January 1, 1998. For taxable years beginning after December 31, 1997 and before January 1, 2006, the Section 936 Corporation's Active Business Income that is eligible for the 936 Credit is also subject to a cap. For taxable years beginning after December 31, 2005, the 936 Credit attributable to Active Business Income is terminated. Under the cap rules for both the Economic Activity Method and the Fixed Percentage Method, the income eligible for the 936 Credit is limited to the "adjusted base period income" of the Section 936 Corporation. Computation of the "adjusted base period income" involves three steps: (i) the Section 936 Corporation base period years are determined (which are, generally, three of the Section 936 Corporation's five most recent years ending before October 14, 1995, determined by disregarding the taxable years in which the Section 936 Corporation's Active Business Income was the highest and the lowest); (ii) Active Business Income of the Section 936 Corporation in each of the base period years is adjusted for inflation; and (iii) the income in the base period years, as adjusted for inflation, is averaged. In response to certain proposals put forth by the Government of Puerto Rico (the "Puerto Rico Government Proposals"), the SBJPA added Section 30A to the Code ("Section 30A"). The Puerto Rico Government Proposals included a ten-year grandfather period for the existing 936 Credit and the creation of a new tax credit for qualifying corporations that invest in "economically developing jurisdictions." Section 30A incorporates in part the Puerto Rico Government Proposals and provides for an income tax credit to domestic corporations operating in Puerto Rico. This new credit is determined under guidelines similar to the Economic Activity Method. The modification of Section 936 as enacted into law could have an adverse effect on the general economic condition of Puerto Rico, R&G Financial's service area, by reducing incentives for investment in Puerto Rico. Any such adverse effect on the general economy of Puerto Rico could lead to an increase in mortgage delinquencies and a reduction in the level of residential construction and demand for mortgage loans. The elimination of the credit for QPSII could also lead to a decrease in the amount of 936 Funds invested in Puerto Rico financial assets by 936 Corporations, thereby increasing funding costs and decreasing liquidity in the Puerto Rico financial market. The magnitude of the impact of any such changes on R&G Financial's profitability or financial condition cannot be determined at this time. R&G Financial has taken steps to attempt to reduce the impact of any such adverse changes by diversifying its sources of 19 funding and identifying additional investors for its mortgage products. During recent periods, the disparity between the cost of 936 Funds and other sources of funding such as the Eurodollar market has decreased, thereby reducing the adverse effect that the loss of such funding could have on the profitability of R&G Financial. In the absence of the 936 Credit and as a means of continuing to defer U.S. income taxation, subsidiaries of multi-national companies operating under Section 936 of the Code may transfer their operations to a corporation organized under Puerto Rico law, or under the laws of foreign countries. Generally, a non-U.S. corporation is not subject to United States income taxes to the extent it does not derive U.S. source income and may be entitled to defer U.S. income taxation until dividends are repatriated to the United States. Under Section 954 of the Code, foreign subsidiaries of multi-national companies whose parent corporation is incorporated in the U.S. are not subject to federal income tax on profits on products which they manufacture. Though a Puerto Rico corporation, or a foreign corporation operating in Puerto Rico, is subject to local Puerto Rico taxes, the benefits under the Industrial Incentives Acts and the 1998 TIA for companies that manufacture or provide services in Puerto Rico, would continue to be available. In addition, under Section 901 and 902 of the Code and subject to certain limitations and exceptions, U.S. shareholders of a Puerto Rico or other non-U.S. corporation would be allowed to claim a foreign tax credit with respect to income tax paid in Puerto Rico. United States shareholders are also not required to recognize income attributable to manufacturing operations of a Puerto Rico or other non-U.S. corporation as a general rule under Subpart F of the Code. However, under Section 367 of the Code, multi-national corporations may be required to recognize income upon the transfer of operations to a Puerto Rico or other non-U.S. corporation, depending upon the nature and value of the property transferred. Several multi-national 936 Corporations have taken such steps since the legislation with respect to Section 936 was first introduced in the U.S. Congress. In July 1997, the Government of Puerto Rico amended the tax law that provided Puerto Rico income tax exemption on interest income generated by FHA and VA loans secured by real estate property located in Puerto Rico and mortgage-backed securities secured by such mortgage loans ("GNMAs"). Under the amended law, FHA and VA loans closed prior to August 1, 1997 will continue to be exempt. The interest income on FHA and VA mortgage loans originated on or after August 1, 1997 for purposes other than to finance the acquisition of new housing, and GNMAs secured by such loans, are no longer exempt, and are taxable at a preferential 17% tax rate to individuals and certain taxpayers other than corporations. FHA and VA loans to finance the purchase of new housing, and GNMAs secured by such loans, continue to be exempt. Individuals who are bona fide residents of Puerto Rico are also not subject to United States federal income tax on income from Puerto Rico sources, including interest income derived from mortgage loans originated in Puerto Rico whose mortgagors are residents of Puerto Rico. The exemption for interest earned on qualifying FHA loans, VA loans and GNMA certificates tends to increase the demand for these products and the price R&G Financial may obtain upon their sale. There can be no assurance that the tax exempt treatment of interest on FHA and VA loans will not be further reviewed or modified in the future. Any change in Puerto Rico's political status could result in the elimination or modification of these tax benefits described above. 20 Lending Activities of the Bank General. At December 31, 1997, R&G Financial's loans receivable, net totalled $765.1 million, which represented 50.6% of R&G Financial's $1.5 billion of total assets. At December 31, 1997, $733.1 million or 95.8% of R&G Financial's loans receivable, net were held by the Bank. The principal category of loans in R&G Financial's portfolio are conventional loans which are secured by first liens on single-family residences. Conventional residential real estate loans are loans which are neither insured by the FHA nor partially guaranteed by the VA. At December 31, 1997, $475.5 million or 99.7% of R&G Financial's first mortgage single-family residential loans consisted of conventional loans. The other principal categories of loans in R&G Financial's loans receivable, net portfolio are second mortgage residential real estate loans, construction loans, commercial real estate loans, commercial business loans and consumer loans. 21 Loan Portfolio Composition. The following table sets forth the composition of R&G Financial's loan portfolio by type of loan at the dates indicated. Except as noted in the footnotes to the table, all of the loans are held in the Bank's loan portfolio.
December 31, ------------------------------------------------------------------------------ 1997 1996 1995 ----------------------- ---------------------- ---------------------- Amount Percent Amount Percent Amount Percent ----------- ---------- ------------ --------- ------------ --------- (Dollars in Thousands) Residential real estate - first mortgage(1)....................................... $476,729 61.25% $370,876 60.75% $282,498 58.23% Residential real estate - second mortgage.......................................... 17,831 2.29 15,757 2.58 14,372 2.96 Residential construction............................ 13,367 1.72 5,351 .88 15,046 3.10 Commercial construction and land acquisition....................................... 5,785 .74 5,700 .93 5,523 1.14 Commercial real estate.............................. 81,722 10.50 69,514 11.39 61,862 12.74 Commercial business................................. 38,069 4.89 31,063 5.09 27,816 5.74 Consumer loans: Loans secured by deposits......................... 12,472 1.60 9,409 1.54 7,497 1.55 Real estate secured consumer loans................ 81,252 10.44 42,893 7.03 33,381 6.88 Unsecured consumer loans.......................... 51,162 6.57 59,864 9.81 37,180 7.66 ------- ------ ------- ------ ------- ------ Total loans receivable.......................... 778,389 100.00% 610,427 100.00% 485,175 100.00% ------- ------ ------- ------ ------- ------ Less: Allowance for loan losses......................... (6,772) (3,332) (3,510) Loans in process.................................. (6,218) (2,430) (5,727) Deferred loan fees................................ 172 41 (266) Unearned interest................................. (512) (955) (1,831) ------- ------- ------- (13,330) (6,676) (11,334) ------- ------- ------- Loans receivable, net(2).......................... $765,059 $603,751 $473,841 ======== ======== ======== December 31, ---------------------------------------------------------- 1994 1993 --------------------------- -------------------------- Amount Percent Amount Percent ------------- ------------- -------------- ----------- (Dollars in Thousands) Residential real estate - first mortgage(1)....................................... $194,707 62.14% $137,396 60.95% Residential real estate - second mortgage.......................................... 13,298 4.24 11,135 4.94 Residential construction............................ 12,039 3.84 3,940 1.75 Commercial construction and land acquisition....................................... 1,062 0.34 1,084 0.48 Commercial real estate.............................. 43,029 13.72 30,290 13.44 Commercial business................................. 14,102 4.51 15,417 6.84 Consumer loans: Loans secured by deposits......................... 5,829 1.86 3,815 1.69 Real estate secured consumer loans................ 29,279* 9.34* 22,355* 9.92* Unsecured consumer loans.......................... * * * * ------- ------ ------- ------ Total loans receivable.......................... 313,345 100.00% 225,432 100.00% ------- ------ ------- ------ Less: Allowance for loan losses......................... (2,887) (3,029) Loans in process.................................. (5,945) (1,531) Deferred loan fees................................ (424) (456) Unearned interest................................. (2,475) (3,796) ------- ------- (11,731) (8,812) ------- ------- Loans receivable, net(2).......................... $301,614 $216,620 ======== ========
(1) Includes $33.9 million, $49.7 million and $55.2 million of residential real estate - first mortgage loans which are held by R&G Mortgage at December 31, 1997, 1996 and 1995, respectively. (2) Does not include mortgage loans held for sale of $46.9 million, $54.5 million, $21.3 million, $22.0 million and $174.2 million at December 31, 1997, 1996, 1995, 1994 and 1993, respectively. * R&G Financial is unable to distinguish these two sub-categories of consumer loans during the years ended December 31, 1994 and 1993. 22 Contractual Principal Repayments and Interest Rates. The following table sets forth certain information at December 31, 1997 regarding the dollar amount of loans maturing in R&G Financial's total loan portfolio based on the contractual terms to maturity. Loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less.
Due 1-5 years Due 5 or more after years after Due 1 year December 31, December 31, or less 1997 1997 Total(1) ----------- ------------- -------------- ----------- (In Thousands) Residential real estate........................... $ 77 $ 683 $493,724 $494,484 Residential construction.......................... 13,443 -- -- 13,443 Commercial real estate(2)......................... 21,342 25,296 40,869 87,507 Commercial business............................... 6,224 25,305 6,540 38,069 Consumer: Loans on savings................................ 6,572 5,320 580 12,472 Real estate secured consumer loans.............. 2,342 8,741 70,169 81,252 Unsecured consumer loans........................ 3,677 41,213 6,272 51,162 ------- -------- -------- -------- Total(3).......................................... $53,677 $106,558 $618,154 $778,389 ======= ======== ======== ========
- --------------- (1) Amounts have not been reduced for the allowance for loan losses, loans in process, deferred loan fees or unearned interest. (2) Includes $5.8 million of commercial construction and land acquisition loans. (3) Does not include mortgage loans held for sale. 23 The following table sets forth the dollar amount of total loans due after one year from December 31, 1997, as shown in the preceding table, which have fixed interest rates or which have floating or adjustable interest rates.
Floating or Fixed rate adjustable-rate Total -------------------- ----------------------- ----------------------- (In Thousands) Residential real estate..................... $494,407 $ -- $494,407 Residential construction.................... -- -- -- Commercial real estate(1)................... 4,652 61,513 66,165 Commercial business......................... 23,613 8,232 31,845 Consumer: Loans on savings.......................... 5,900 -- 5,900 Real estate secured consumer loans........ 78,910 -- 78,910 Unsecured consumer loans.................. 47,485 -- 47,485 -------- -------- -------- Total.................................... $654,967 $ 69,745 $724,712 ======== ======== ========
- --------------- (1) Includes $5.8 million of commercial construction and land acquisition loans. Scheduled contractual amortization of loans does not reflect the expected term of R&G Financial's loan portfolio. The average life of loans is substantially less than their contractual terms because of prepayments and, with respect to conventional loans originated for the Bank after February 1994, due-on-sales clauses, which give R&G Financial the right to declare a conventional loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase when current mortgage loan rates are higher than rates on existing mortgage loans and, conversely, decrease when rates on existing mortgage loans are lower than current mortgage loan rates (due to refinancing of adjustable-rate and fixed-rate loans at lower rates). Under the latter circumstance, the weighted average yield on loans decreases as higher-yielding loans are repaid or refinanced at lower rates. 24 Origination, Purchase and Sales of Loans. The following table sets forth loan originations, purchases and sales by the Bank for the periods indicated.
Year Ended December 31, ------------------------------------------------------- 1997 1996 1995 ------------------ ----------------- ------------------ (Dollars in Thousands) Loan originations: Loans originated by R&G Mortgage: Residential mortgages................................ $221,451 $187,845 $126,599 Commercial mortgages................................. 555 -- -- Construction loans................................... 11,482 2,227 13,764 Consumer loans....................................... 52,287 21,208 15,944 Total loans originated by R&G Mortgage............. 285,775 211,280 156,307 Other loans originated: Commercial real estate............................... 37,129 36,140 48,497 Commercial business.................................. 15,393 33,318 21,556 Consumer loans: Loans on deposit..................................... 19,711 13,988 12,546 Real estate secured consumer loans................... -- 80 3,436 Unsecured consumer loans............................. 16,742 39,312 38,589 Total other loans originated....................... 88,975 122,838 124,624 Loans purchased(1)................................... 60,646 8,047 807 Total loans originated and purchased............... 435,396 342,165 281,738 Loans sold(2)........................................ (107,217) (49,726) (75,093) Loan principal reductions............................ (133,837) (114,792) (78,519) Net increase before other items, net................. 194,329 177,647 128,126 Loans securitized and transferred to mortgage-backed securities......................... (11,346) (43,673) (17,631) Other increases (decreases).......................... -- -- 179 Net increase in loan portfolio....................... $182,996 $133,974 $110,674
- -------------- (1) Comprised of conventional, commercial real estate and secured consumer loans purchased from other financial institutions aggregating $54.0 million, $4.6 million and $2.0 million, respectively, in the year ended December 31, 1997, and conventional loans of $8.1 million and $807,000 in the years ended December 31, 1996 and 1995. (2) Loans sold by the Bank in 1995 include approximately $55.2 million of loans sold to two commercial banks which have been recognized in R&G Financial's Consolidated Financial Statements as a transfer of loans with recourse. Accordingly, the aggregate principal amount of the loans have been reported as an asset in R&G Financial's Consolidated Financial Statements. See "Sources of Funds - Borrowings." R&G Financial, through the Bank, originates for both investment and sale mortgage loans secured by residential real estate (secured by both first and second mortgage liens) as well as 25 construction loans (for residential real estate), commercial real estate loans, commercial business loans and consumer loans. Pursuant to the Master Production Agreement, R&G Mortgage will assist the Bank in meeting its loan production targets and goals by, among other things, (i) advertising, promoting and marketing to the general public; (ii) interviewing prospective borrowers and conducting the initial processing of the requisite loan applications, consistent with the Bank's underwriting guidelines; and (iii) providing personnel and facilities with respect to the execution of loan agreements approved by the Bank. R&G Mortgage performs the foregoing loan origination services on behalf of the Bank with respect to residential mortgage loans, some commercial real estate loans and construction loans. R&G Mortgage receives from the Bank 75% of the applicable loan origination fee with respect to loans originated by R&G Mortgage on behalf of the Bank pursuant to the terms of the Master Production Agreement. During the years ended December 31, 1997, 1996 and 1995, R&G Mortgage received $5.2 million, $4.5 million and $3.6 million, respectively, of loan origination fees with respect to loans originated by R&G Mortgage on behalf of the Bank pursuant to the terms of the Master Production Agreement. These fees are eliminated in consolidation in R&G Financial's Consolidated Financial Statements. See also "- General Affiliated Transactions" and "Regulation - R&G Financial - Limitations on Transactions with Affiliates." The Bank originates commercial real estate, commercial business and consumer loans. Applications for commercial real estate, commercial business and unsecured consumer loans are taken at all of the Bank's branch offices and may be approved by various lending officers of the Bank within designated limits, which are established and modified from time to time to reflect an individual's expertise and experience. All loans in excess of an individual's designated limits are referred to an officer with the requisite authority. In addition, the Management Credit Committee is authorized to approve all loans not exceeding $2.5 million, and the Executive Committee of the Board of Directors is authorized to approve all loans exceeding $2.5 million. All loans originated or purchased by the Bank must be approved by one of the three committees set forth above. Management of the Bank believes that its relatively centralized approach to approving loan applications ensures strict adherence to the Bank's underwriting guidelines while still allowing the Bank to approve loan applications on a timely basis. The Bank also purchases conventional loans secured by first liens on single-family residential real estate from unrelated financial institutions. Such loan purchases are underwritten by the Bank pursuant to the same guidelines as direct loan originations. Loans purchased by the Bank are from time to time securitized by R&G Mortgage and sold by the Bank. During the years ended December 31, 1997, 1996 and 1995, the Bank purchased $60.6 million, $8.1 million and $807,000 of loans, respectively. During the years ended December 31, 1997, 1996 and 1995, the Bank sold $107.2 million, $49.7 million and $75.1 million of loans. These loans, which were primarily nonconforming loans at the time of origination, were generally sold in packages in privately negotiated transactions with FNMA and FHLMC. 26 Pursuant to the Master Purchase Agreement, the Bank sells to R&G Mortgage the servicing rights to all first and second mortgage loans secured by residential properties which are or will become part of the Bank's loan portfolio once the Bank has a commitment to sell the loans. The Master Purchase Agreement further provides that R&G Mortgage will service all other loans held in the Bank's portfolio (including single-family residential loans retained by the Bank, commercial real estate, commercial business and consumer loans (although R&G Mortgage does not actually acquire such servicing rights)). In addition, pursuant to the Master Purchase Agreement, the Bank processes payments on all loans serviced by R&G Mortgage on behalf of the Bank. Finally, under the Master Purchase Agreement, R&G Mortgage renders securitization services with respect to the pooling of some of the Bank's mortgage loans into mortgage-backed securities. See "- Mortgage Banking Activities." At December 31, 1997, R&G Financial's five largest loans-to-one borrower and their related entities amounted to $1.5 million, $1.3 million, $1.2 million, $800,000 and $711,000. The largest loan concentration is a loan to a developer of a new shopping center in Carolina. The project is in its final stages of completion. The second largest loan concentration consists of a commercial loan for the financing of new equipment for a medical laboratory located in Bayamon. The third largest loan concentration is an interim construction loan with an aggregate balance of $681,000 to a developer of 55 single family detached residential units located in Humacao with the balance comprised of other commercial loans. The fourth largest loan concentration represents a cash collateral personal loan at the Bank's Mayaguez branch. The fifth largest loan consist of a commercial working capital line of credit secured by the assignment of lease contracts. All of R&G Financial's five largest loan concentrations were performing in accordance with their terms as of December 31, 1997. Single-Family Residential Real Estate Loans. The Bank has historically concentrated its lending activities on the origination of loans secured by first mortgage liens on existing single-family residences. At December 31, 1997, $476.7 million or 61.3% of R&G Financial's total loans held for investment consisted of such loans, $475.5 million or 99.7% of which consisted of conventional loans. The Bank's first mortgage single-family residential loans consist exclusively of fixed-rate loans with terms of between 15 and 30 years. As evidenced by this statistic, the Puerto Rico residential mortgage market has not been receptive to long-term adjustable rate mortgage loans. The Bank's first mortgage single-family residential loans typically do not exceed 80% of the appraised value of the security property. Pursuant to underwriting guidelines adopted by the Board of Directors, the Bank can lend up to 95% of the appraised value of the property securing a first mortgage single-family residential loan provided the Bank obtains private mortgage insurance with respect to the top 25% of the loan. The Bank also originates loans secured by second mortgages on single-family residential properties. At December 31, 1997, $17.8 million or 2.3% of R&G Financial's total loans held for investment consisted of second mortgage loans on single-family residential properties. The Bank offers such second mortgage loans in amounts up to $125,000 for a term not to exceed 15 27 years. The loan-to-value ratio of second mortgage loans generally is limited to 75% of the property's appraised value (including the first mortgage). Construction Loans. In recent years, the Bank has been active in originating loans to construct single-family residences. These construction lending activities generally are conducted throughout Puerto Rico, although loans are concentrated in areas contiguous to Bank branches. At December 31, 1997, residential construction loans amounted to $13.4 million or 1.7% of R&G Financial's total loans held for investment, while commercial construction and land acquisition loans amounted to $5.8 million or 0.7% of total loans held for investment. The Bank primarily offers construction loans to individual borrowers for the purpose of constructing single-family residences. Substantially all of the Bank's construction lending to individuals is originated on a construction/permanent mortgage loan basis. Construction/permanent loans are made to individuals who hold a contract with a general contractor acceptable to the Bank to construct their personal residence. The construction phase of the loan provides for monthly payments on an interest only basis at a designated fixed rate for the term of the construction period, which generally does not exceed nine months. Thereafter, the permanent loan is made at then market rates, provided that such rate shall not be more than 2% greater than the interim construction rate. R&G Mortgage's construction loan department approves the proposed contractors and administers the loan during the construction phase. The Bank's construction/permanent loan program has been successful due to its ability to offer borrowers a single closing and, consequently, reduced costs. At December 31, 1997, the Bank's construction loan portfolio included 127 construction/permanent loans with an aggregate principal balance of $12.7 million. The Bank has also originated construction loans to developers on a very limited basis to develop single family residential properties. The Bank does not intend to actively engage in this business and will primarily undertake such investments to accommodate a valued developer client if the Bank determines that the project is worthy and the risk is acceptable. At December 31, 1997, the Bank had one residential construction loan outstanding to develop a single-family subdivision, consisting of 55 units in Humaco. The loan, which involved a $1.2 million credit facility for the fourth phase of the project, had an outstanding balance of $681,000 at December 31, 1997. The loan is performing in accordance with its terms. This loan is referenced in the discussion of the Bank's largest loan concentrations above. In addition to the foregoing, at December 31, 1997, the Bank had seven land acquisition loans with outstanding balances ranging from $186,000 to $650,000, and an aggregate balance of $2.9 million, which were made in connection with projects to construct single-family residences. The Bank and the financial institution which made the interim construction loan have entered into an agreement pursuant to which the Bank is to be paid a percentage of the proceeds from each home as it is released upon construction and sale. The Bank expects to make the permanent construction loan on some of these projects. The Bank does not expect to be active in this business. 28 The Bank intends to continue to increase its involvement in single-family residential construction lending. Such loans afford the Bank the opportunity to increase the interest rate sensitivity of its loan portfolio. Construction lending is generally considered to involve a higher level of risk as compared to permanent single-family residential lending, due to the concentration of principal in a limited number of loans and borrowers and the effects of general economic conditions on real estate developers and managers. Moreover, a construction loan can involve additional risks because of the inherent difficulty in estimating both a property's value at completion of the project and the estimated costs (including interest) of the project. The nature of these loans is such that they are generally more difficult to evaluate and monitor. The Bank has taken steps to minimize the foregoing risks by, among other things, limiting its construction lending primarily to residential properties. In addition, the Bank has adopted underwriting guidelines which impose stringent loan-to-value (80% with respect to single-family residential real estate), debt service and other requirements for loans which are believed to involve higher elements of credit risk and by working with builders with whom it has established relationships or knowledge thereof. At December 31, 1997, $368,000 of the Bank's construction loans were classified as non-performing. Commercial Real Estate Loans. The Bank has also originated mortgage loans secured by commercial real estate. At December 31, 1997, $81.7 million or 10.5% of R&G Financial's total loans held for investment consisted of such loans. As of such date, the Bank's commercial real estate loan portfolio consisted of approximately 775 loans with an average principal balance of $105,000. At December 31, 1997, $6.0 million of R&G Financial's commercial real estate loans were classified as nonperforming. Commercial real estate loans originated by the Bank are primarily secured by office buildings, retail stores, warehouses and general purpose industrial space. Although terms vary, commercial real estate loans generally are amortized over a period of 7-15 years and have maturity dates of five to seven years. The Bank will originate these loans with interest rates which adjust monthly in accordance with a designated prime rate plus a margin, which generally is negotiated at the time of origination. Such loans will have a floor but no ceiling on the amount by which the rate of interest may adjust over the loan term. Loan-to-value ratios on the Bank's commercial real estate loans are currently limited to 80% or lower. As part of the criteria for underwriting commercial real estate loans, the Bank generally requires a debt coverage ratio (the ratio of net cash from operations before payment of debt service to debt service) of 1.30 or more. It is also the Bank's general policy to seek additional protection to mitigate any weaknesses identified in the underwriting process. Additional coverage may be provided through mortgage insurance, secondary collateral and/or personal guarantees from the principals of the borrower. Commercial real estate lending entails different and significant risks when compared to single-family residential lending because such loans typically involve large loan balances to single borrowers and because the payment experience on such loans is typically dependent on the successful operation of the project or the borrower's business. These risks can also be significantly affected by supply and demand conditions in the local market for apartments, offices, warehouses or other commercial space. The Bank attempts to minimize its risk exposure by limiting the extent of its commercial lending generally. In addition, the Bank imposes stringent 29 loan-to-value ratios, requires conservative debt coverage ratios, and continually monitors the operation and physical condition of the collateral. Although the Bank has begun to increase its emphasis on commercial real estate lending, management does not currently anticipate that its portfolio of commercial real estate loans will grow significantly as a percentage of the total loan portfolio. Commercial Business Loans. Beginning in 1991, the Bank began emphasizing commercial business loans, including working capital lines of credit, inventory and accounts receivable loans, equipment financing (including equipment leases), term loans, insurance premiums loans and loans guaranteed by the Small Business Administration. Depending on the collateral pledged to secure the extension of credit, maximum loan to value ratios are 75% or less, with exceptions permitted to a maximum of 80%. Loan terms may vary from one to 15 years. The interest rates on such loans are generally variable and are indexed to a designated prime rate, plus a margin. The Bank also generally obtains personal guarantees from the principals of the borrowers. At December 31, 1997, commercial business loans amounted to $38.1 million or 4.9% of total loans held for investment. Although the Bank has begun to increase its emphasis on commercial business lending, management does not currently anticipate that its portfolio of commercial business loans will grow significantly as a percentage of the total loan portfolio. Consumer Loans. The Bank has begun to emphasize the origination of real estate secured consumer loans in order to provide a full range of financial services to its customers and because such loans generally have shorter terms and higher interest rates than other mortgage loans. At December 31, 1997, $144.9 million or 18.6% of R&G Financial's total loans held for investment consisted of consumer loans. This amount is comprised mostly of real estate secured consumer loans (which are originated by R&G Mortgage), but the Bank also offers loans secured by deposit accounts, credit card loans and other secured and unsecured consumer loans. Most of the Bank's consumer loans are secured and have been primarily obtained through newspaper advertising, although loans are also obtained from existing and walk-in customers. Although the Bank has begun to increase its emphasis on collateralized consumer lending, management does not currently anticipate that its portfolio of consumer loans will grow significantly as a percentage of the total loan portfolio. The Bank currently offers loans secured by deposit accounts, which amounted to $12.5 million at December 31, 1997. Such loans are originated generally for up to 90% of the account balance, with a hold placed on the account restricting the withdrawal of the account balance. The Bank offers real estate secured loans in amounts up to 75% of the appraised value of the property, including the amount of any existing prior liens. Real estate secured consumer loans have a maximum term of 10 years, which may be extended within the sole discretion of the Bank, and an interest rate which is set at a fixed rate based on market conditions. The Bank secures the loan with a first or second mortgage on the property and will originate the loan even if another institution holds the first mortgage. At December 31, 1997, real estate secured consumer loans totalled $81.2 million. In November 1995, the Bank began issuing credit cards in its own name. At December 31, 1997, credit card receivables totalled $2.3 million. 30 Consumer loans generally have shorter terms and higher interest rates than mortgage loans but generally involve more credit risk than mortgage loans because of the type and nature of the collateral and, in certain cases, the absence of collateral. In addition, consumer lending collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely effected by job loss, divorce, illness and personal bankruptcy. In many cases, any repossessed collateral for a defaulted consumer loan will not provide an adequate source of repayment of the outstanding loan balance because of improper repair and maintenance of the underlying security. The remaining deficiency may not warrant further substantial collection efforts against the borrower. At December 31, 1997, $4.0 million of consumer loans were classified as non-performing. Asset Quality General. When a borrower fails to make a required payment on a loan, R&G Financial attempts to cure the deficiency by contacting the borrower and seeking payment. Contacts are generally made between the 10th and 15th day after a payment is due. In most cases, deficiencies are cured promptly. If a delinquency extends beyond 15 days, the loan and payment history is reviewed and efforts are made to collect the loan. While R&G Financial generally prefers to work with borrowers to resolve such problems, when the account becomes 90 days delinquent in the case of mortgage loans, R&G Financial does institute foreclosure or other proceedings, as necessary, to minimize any potential loss. In the case of consumer loans, the Bank refers the file for collection action after 60 days. Loans secured by real estate are placed on non-accrual status when, in the judgment of management, the probability of collection of interest is deemed to be insufficient to warrant further accrual. When such a loan is placed on non-accrual status, previously accrued but unpaid interest is deducted from interest income. As a matter of policy, the Bank does not accrue interest on loans past due 90 days or more which are secured by real estate. The Bank generally takes the same position in the case of consumer loans. Real estate acquired by the Bank as a result of foreclosure or by deed-in-lieu of foreclosure are classified as real estate owned until sold. Pursuant to a statement of position ("SOP 92-3") issued by the American Institute of Certified Public Accountants in April 1992, which provides guidance on determining the balance sheet treatment of foreclosed assets in annual financial statements for periods ending on or after December 15, 1992, there is a rebuttable presumption that foreclosed assets are held for sale and such assets are recommended to be carried at the lower of fair value minus estimated costs to sell the property, or cost (generally the balance of the loan on the property at the date of acquisition). After the date of acquisition, all costs incurred in maintaining the property are expensed and costs incurred for the improvement or development of such property are capitalized up to the extent of their net realizable value. The Bank's accounting for its real estate owned complies with the guidance set forth in SOP 92-3. 31 The following table sets forth the amounts and categories of R&G Financial's non-performing assets at the dates indicated. R&G Financial did not have any troubled debt restructurings at any of the periods presented. Except as otherwise indicated in the footnotes to the table, the non-performing assets are assets of the Bank.
December 31, ------------------------------------------------------------------------------ 1997 1996 1995 1994 1993 ------------- ---------------- ----------- ------------- -------------- (Dollars in Thousands) Non-accruing loans: Residential real estate(1)............ $21,619 $12,991 $7,921 $4,963 $3,678 Residential construction.............. 368 363 -- -- -- Commercial real estate................ 6,000 3,141 1,903 789 1,311 Commercial business................... 765 823 -- -- -- Consumer.............................. 1,217 686 40 -- -- Other (2) ............................ 117 726 -- -- -- ------ ------ ----- ----- ----- Total............................... 30,086(3) 18,730 9,864 5,752 4,989 ------ ------ ----- ----- ----- Accruing loans greater than 90 days delinquent: Residential real estate............... -- -- -- -- -- Residential construction.............. -- -- 611 -- -- Commercial real estate................ -- -- -- -- -- Commercial business................... 54 22 8 10 70 Consumer.............................. 172 134 94 -- -- ------ ----- ------ ------- ------ Total accruing loans greater than 90 days delinquent................ 226 156 713 10 70 ------ ------ ----- ------ ------ Total non-performing loans.......... 30,312 18,886 10,577 5,762 5,059 ------ ------ ------ ----- ----- Real estate owned, net of reserves(4)... 1,715 834 654 722 699 Other repossessed assets................ 85 31 -- -- -- -- -- -- -- -- 1,800 865 654 722 699 ------- Total non-performing assets......... $32,112 $19,751 $11,231 $6,484 $5,758 ======= ======= ======= ====== ====== Total non-performing loans as a percentage of total loans......... 3.89% 3.09% 2.18% 1.84% 2.24% ======= ======= ======= ====== ====== Total non-performing assets as a percentage of total assets........ 2.12% 1.90% 1.32% 1.04% 1.07% ======= ======= ======= ====== ======
- ------------- (1) Includes residential real estate secured by both first and second mortgage loans. Also includes $2,610,000, $882,000, $918,000, and $736,000 consumer loans secured by first and second mortgages on residential real estate at December 31, 1997, 1996, 1995, 1994 and 1993, respectively. (2) Comprised of insurance premium financing contracts, primarily commercial and, to a lesser extent, personal. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Results of Operation -- Provision for Loan Losses" incorporated by reference in Item 7 hereof. (3) As of December 31, 1997, comprised of 365 loans secured by residential real estate, 47 loans secured by commercial real estate, 8 construction loans, 59 commercial business loans and 143 consumer loans. 32 (4) Includes properties held by R&G Mortgage of $165,000 and $43,000 as of December 31, 1997 and 1994, respectively. As of December 31, 1997, the Bank had 20 residential properties aggregating $1,550,000. While the level of total non-performing assets of R&G Financial has increased on an absolute basis during the periods presented, from $5.8 million at December 31, 1993 to $32.1 million at December 31, 1997, R&G Financial's net loans receivable portfolio has increased by 253% during this period, from $216.6 million at December 31, 1993 to $765.1 million at December 31, 1997. Thus, total non-performing assets as a percent of total assets increased from 1.07% at December 31, 1993 to 2.12% at December 31, 1997. Non-performing residential loans increased by $8.6 million or 64.6% from December 31, 1996 to December 31, 1997. The average loan balance on non-performing mortgage loans amounted to $60,000 at December 31, 1997. As of such date, 174 loans with an aggregate balance of $12.5 million (including 9 consumer loans secured by real estate with an aggregate balance of $250,000) were in the process of foreclosure. The total delinquency ratio on residential mortgages, including loans past due less than 90 days, slightly increased from 4.87% in 1996 to 4.93% in 1997. The Company's loss experience on such portfolio has been minimal over the last several years. Non-performing commercial real estate loans increased by $2.9 million or 91.0% from December 31, 1996 to December 31, 1997. The number of loans delinquent over 90 days amounted to 47 loans at December 31, 1997, with an average balance of $99,000. The largest non-performing commercial real estate loan as of December 31, 1997 had a balance of $550,000. Non-performing commercial business loans consist of 14 loans which are 90% guaranteed by the Small Business Administration with an aggregate balance of $1.5 million and 42 commercial leases amounting to $731,000. These loans have a combined average loan size of $39,000. The majority of loans in this portfolio were originated during 1995 and 1996. The largest non-performing commercial business loan as of December 31, 1997 had a $270,000 balance. It is the policy of the Bank to maintain an allowance for estimated losses on loans and to increase such allowance when, based on management's evaluation, a loss becomes both probable and estimable (i.e., the loss is likely to occur and can be reasonably estimated). Major loans and major lending areas are reviewed periodically to determine potential problems at an early date. Also, management's periodic evaluation considers factors such as loss experience, current delinquency data, known and inherent risks in the portfolio, identification of adverse situations which may affect the ability of debtors to repay the loan, the estimated value of any underlying collateral and assessment of current economic conditions. Additions to the allowance are charged to income. Such provisions are based on management's estimated value of any underlying collateral, as applicable, considering the current and anticipated operating conditions of the borrower. Any recoveries are credited to the allowance. 33 The following table sets forth an analysis of R&G Financial's allowance for loan losses during the periods indicated, which is maintained on the Bank's loan portfolio.
At and For the Year Ended December 31, --------------------------------------------------------------------------- 1997 1996 1995 1994 1993 ---------------- -------------- -------------- -------------- -------------- (Dollars in Thousands) Balance at beginning of period......... $ 3,332 $3,510 $2,887 $3,029 $1,230 ------- ------ ------ ------ ------ Charge-offs: Residential real estate.............. 13 45 53 -- -- Construction......................... -- 50 -- -- -- Commercial real estate............... 170 -- -- -- -- Commercial business.................. 480 110 91 3 56 Consumer............................. 3,953 1,922 365 139 90 Other ............................... 761 2,535(1) -- -- -- ------- ------ ------ ------ ------ Total charge-offs.................. 5,377 4,662 509 142 146 ------- ------ ------ ------ ------ Recoveries: Residential real estate.............. 21 -- 1 -- -- Construction......................... -- -- -- -- -- Commercial real estate............... 50 -- -- -- -- Commercial business.................. 32 31 85 -- 20 Consumer............................. 344 195 96 -- 242 Other................................ 2,000(2) -- -- -- -- ------- ------ ------ ------ ------ Total recoveries................... 2,447 226 182 -- 262 ------- ------ ------ ------ ------ Net charge-offs........................ 2,930 4,436 327 142 (116) ------- ------ ------ ------ ------ Allowance for loan losses acquired from Caribbean Federal.................... -- -- -- -- 1,683 Provision for losses on loans.......... 6,370 4,258 950(3) -- -- ------- ------ ------ ------ ------ Balance at end of period............... $ 6,772 $ 3,332 $3,510 $2,887 $3,029 ======= ======= ====== ====== ====== Allowance for loan losses as a percent of total loans outstanding........... .87% .55% 0.72% 0.92% 1.34% ======= ======= ====== ====== ====== Allowance for loan losses as a percent of non-performing loans.............. 22.43% 17.64% 33.19% 50.10% 59.87% ======= ======= ====== ====== ====== Ratio of net charge-offs to average loans outstanding.................... 0.40% 0.75% 0.08% 0.05% (0.06)% ======= ======= ====== ====== ======
- ------------------ (1) Comprised of $2.5 million of loans from the Bank insurance premiums financing portfolio. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Results of Operations -- Provision for Loan Losses" incorporated by reference in Item 7 hereof. (2) Corresponds to $2.0 million received on January 15, 1998 from the Company's fidelity insurance carrier accounted for as a recovery of loans previously charged-off as of December 31, 1997. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Results of Operations -- Provision for Loan Losses" incorporated by reference in Item 7 hereof. (3) Includes $500,000 transferred to the provision for loan losses which R&G Financial determined was excess valuation reserves on mortgage loans held for sale. 34 The following table sets forth information concerning the allocation of R&G Financial's allowance for loan losses (which is maintained on the Bank's loan portfolio) by loan category at the dates indicated.
December 31, -------------------------------------------------------------------------------------------- 1997 1996 1995 --------------------------- ----------------------------- ------------------------- Percent of Percent of Percent of Loans in Loans in Loans in Each Each Each Category to Category to Category to Amount Total Loans Amount Total Loans Amount Total Loans ------------ -------------- ----------- ----------------- ---------- -------------- (Dollars in Thousands) Residential real estate..... $ 593 8.76% $ 810 24.31% $2,094 59.66% Construction................ 7 0.10 51 1.53 32 0.90 Commercial real estate...... 1,386 20.47 489 14.68 -- -- Commercial business......... 806 11.90 109 3.27 782 22.28 Consumer.................... 3,980 58.77 1,873 56.21 602 17.16 ------ ------ ------ ------ ------ ------ Total....................... $6,772 100.00% $3,332 100.00% $3,510 100.00% ====== ====== ====== ====== ====== ====== December 31, -------------------------------------------------------- 1994 1993 ------------------------- -------------------------- Percent of Percent of Loans in Loans in Each Each Category to Category to Amount Total Loans Amount Total Loans ---------- -------------- ---------- -------------- Residential real estate..... $1,962 67.95% $2,029 66.99% Construction................ -- -- -- -- Commercial real estate...... -- -- -- -- Commercial business......... 403 13.96 576 19.02 Consumer.................... 522 18.09 424 13.99 ------ ------ ------ ------ Total....................... $2,887 100.00% $3,029 100.00% ====== ====== ====== ======
35 Investment Activities General. R&G Financial's securities portfolio is managed by investment officers in accordance with a comprehensive written investment policy which addresses strategies, types and levels of allowable investments and which is reviewed and approved annually by the respective Boards of Directors of the Bank and R&G Mortgage. The management of the securities portfolio is set in accordance with strategies developed by the Bank's Interest Rate Risk, Budget and Investments Committee ("IRRBICO"). As discussed under "- Mortgage Banking Activities," R&G Mortgage is primarily engaged in the origination of mortgage loans and the securitization of such loans into mortgage-backed and related securities and the subsequent sale of such securities to securities broker-dealers and other investors in the secondary market. As a result of R&G Mortgage's securitization activities, R&G Mortgage maintains a substantial portfolio of GNMA mortgage-backed securities. At December 31, 1997, R&G Mortgage held GNMA mortgage-backed securities with a fair value of $375.7 million which are classified as held for trading. Such securities generally remain in R&G Mortgage's portfolio for between 90 and 180 days. In addition, during 1994 and 1995, R&G Mortgage sold through grantor trusts $201.4 million and $38.1 million, respectively, of CMOs and retained a portion of the residual interests related thereto. In addition, in 1995, R&G Mortgage purchased from the Bank $4.6 million of mortgage-backed residuals relating to the Bank's 1993 issuance of CMOs. At December 31, 1997, R&G Mortgage's CMOs and CMO residuals, which are classified as held for trading, had an amortized cost of $23.8 million and a fair value of $23.1 million. The Bank's Investment Policy authorizes the Bank to invest in U.S. Treasury obligations (with a maturity up to five years), U.S. Agency obligations, FNMA, GNMA and FHLMC mortgage-backed certificates, investment grade municipal obligations (with a maturity of up to five years), bankers' acceptances and Federal Home Loan Bank ("FHLB") notes (with a maturity of up to five years), investment grade commercial paper (with a maturity of up to 9 months), federal funds (with a maturity of six months or less), certificates of deposit in other financial institutions (including Eurodollar deposits), repurchase agreements (with a maturity of six months or less), investment grade corporate bonds (with a maturity of five years or less) and certain mortgage-backed derivative securities (with a weighted average life of less than ten years). At December 31, 1997, the Bank's securities portfolio consisted of $44.0 million of securities held for investments, consisting of $18.4 million of tax-free mortgage-backed securities, $14.9 million of other mortgage backed securities, and $10.4 million of Puerto Rico Government obligations and other Puerto Rico securities, and $310,000 U.S. Treasury securities. In addition, at December 31, 1997, the Bank had a securities portfolio classified as available for sale with a fair value of $121.9 million, consisting of $37.6 million of mortgage-backed securities, $4.9 million of FHLB stock, $8.4 million of CMOs and CMO residuals, $30.9 million U.S. Treasury securities and $40.1 million of U.S. Government agency securities. Finally, at December 31, 1997, $1.7 million of the Bank's securities were classified as held for trading, consisting of $1.7 million of GNMA certificates. 36 In February 1996, the Company entered into various agreements with an independent investment management firm whereby such firm has been appointed as investment advisor with respect to a portion of the Company's securities portfolio for trading purposes. Such firm had also been engaged by the Company to, among other things, assist it in achieving the objectives established by the Company's IRRBICO through the execution of various hedging strategies. During 1997, the Company discontinued hedging activities for its mortgage backed securities held for trading and available sale after management determined that the relatively low volatility of such securities and current market conditions did not warrant hedging against such assets. In late 1997, the Company also discontinued trading activities through the advisory firm; the Bank's Treasury Department continues from time to time to conduct certain trading activities mainly through investments in U.S. Treasury securities. 37 The following table presents certain information regarding the composition and period to maturity of R&G Financial's securities portfolio held to maturity as of the dates indicated below. All of such securities are assets of the Bank.
December 31, ----------------------------------------------------------------------------------------- 1997 1996 ---------------------------------------- ------------------------------------------ Weighted Weighted Carrying Market Average Carrying Market Average Value Value Yield Value Value Yield ------------ ----------- ----------- ------------ ------------ --------------- (Dollars in Thousands) Mortgage-backed securities: GMNA Due within one year........... $ -- $ -- --% $ -- $ -- --% Due from one-five years....... 49 50 10.00 -- -- -- Due from five-ten years....... -- -- -- 97 100 10.00% Due over ten years............ 18,321 17,705 6.05 21,591 20,571 6.03 FNMA Due within one year............. -- -- -- -- -- -- Due from one-five years......... -- -- -- -- -- -- Due from five-ten years......... -- -- -- -- -- -- Due over ten years.............. 14,675 15,164 7.17 15,895 16,124 7.18 FHLMC Due within one year............. -- -- -- -- -- -- Due from one-five years......... -- -- -- -- -- -- Due from five-ten years......... -- -- -- -- -- -- Due over ten years.............. 281 266 6.00 317 309 5.38 Investment Securities: Puerto Rico Government obligations Due within one year............. 4,433 4,439 5.39 -- -- -- Due from one-five years......... -- -- -- 4,960 4,930 5.38 Due from five-ten years......... 5,920 5,910 5.34 -- -- -- Due over ten years.............. 30 30 8.37 -- -- -- U.S. Government Agency Due within one year............. -- -- -- -- -- -- Due within one-five years....... 310 311 6.13 310 311 6.13 Due within five-ten years....... -- -- -- -- -- -- Due over ten years.............. -- -- -- -- -- -- Commercial paper: Due within one year............. -- -- -- 2,982 2,982 5.55 Due within one-five years....... -- -- -- -- -- -- Due within five-ten years....... -- -- -- -- -- -- Due over ten years.............. -- -- -- -- -- -- Total Securities held for investment.................. $44,019 $43,875 6.18% $46,152 $45,327 6.34% December 31, -------------------------------------- 1995 -------------------------------------- Weighted Carrying Market Average Value Value Yield ---------- ----------- ----------- (Dollars in Thousands) Mortgage-backed securities: GMNA Due within one year........... $ -- $ -- --% Due from one-five years....... -- -- -- Due from five-ten years....... 118 108 10.00 Due over ten years............ 24,617 23,681 6.03 FNMA Due within one year............. -- -- -- Due from one-five years......... -- -- -- Due from five-ten years......... -- -- -- Due over ten years.............. 16,623 16,623 7.18 FHLMC Due within one year............. -- -- -- Due from one-five years......... -- -- -- Due from five-ten years......... -- -- -- Due over ten years.............. 373 373 5.50 Investment Securities: Puerto Rico Government obligations Due within one year............. 377 377 2.69 Due from one-five years......... 1,042 1,000 6.25 Due from five-ten years......... -- -- -- Due over ten years.............. 627 619 4.25 U.S. Government Agency Due within one year............. -- -- -- Due within one-five years....... -- -- -- Due within five-ten years....... -- -- -- Due over ten years.............. -- -- -- Commercial paper: Due within one year............. -- -- -- Due within one-five years....... -- -- -- Due within five-ten years....... -- -- -- Due over ten years.............. -- -- -- Total Securities held for investment.................. $43,777 $42,781 6.42%
38 The following table presents certain information regarding the composition and period to maturity of R&G Financial's held for trading and available for sale mortgage-backed and investment securities portfolio as of the dates indicated below.
December 31, -------------------------------------------- 1997 -------------------------------------------- Weighted Amortized Fair Average Cost Value Yield --------------- ----------- ----------- Mortgage-Backed Securities Available for Sale(1): FNMA mortgage-backed securities Due within one year............................. $ -- $ -- --% Due from one-five years......................... -- -- -- Due from five-ten years......................... -- -- -- Due over ten years.............................. $9,468 9,670 7.00 FHLMC mortgage-backed securities Due within one year............................. -- -- -- Due from one-five years......................... 71 70 9.00 Due from five-ten years......................... 360 368 9.38 Due over ten years.............................. 27,104 27,513 6.86 CMO residuals and other mortgage-backed securities (2) Due within one year............................. -- -- -- Due from one-five years......................... -- -- -- Due from five-ten years......................... -- -- -- Due over ten years.............................. 7,007 8,382 8.125 Investment Securities Available for Sale(1) U.S. Treasury Due within one year............................. 773 772 5.22 Due from one-five years......................... 30,010 30,100 5.85 Due from five-ten years......................... -- -- -- Due over ten years.............................. -- -- -- U.S. Government Agency Due within one year............................. -- -- -- Due from one-five years......................... 35,145 35,105 6.15 Due from five-ten years......................... 5,023 4,981 6.73 Due over ten years.............................. -- -- -- FHLB stock........................................ 4,906 4,906 6.61 -------- -------- ---- $119,867 $121,867 6.59% ======== ======== ==== Securities held for trading(3): GNMA certificates................................. $367,177 $377,362 6.78% CMO certificates.................................. 16,200 15,228 5.95 CMO residuals(4).................................. 7,630 7,868 8.00 U.S. Treasury Bills............................... 581 581 5.23 -------- -------- ---- $391,588 $401,039 6.77% ======== ======== ==== December 31, ----------------------------------------- 1996 ---------------------------------------- Weighted Amortized Fair Average Cost Value Yield ----------- ------------ ------------ (Dollars in Thousands) Mortgage-Backed Securities Available for Sale(1): FNMA mortgage-backed securities Due within one year............................. $ -- $ -- --% Due from one-five years......................... -- -- -- Due from five-ten years......................... -- -- -- Due over ten years.............................. 10,563 10,293 6.99 FHLMC mortgage-backed securities Due within one year............................. -- -- -- Due from one-five years......................... 56 60 9.01 Due from five-ten years......................... 474 487 9.25 Due over ten years.............................. 32,454 31,806 6.77 CMO residuals and other mortgage-backed securities (2) Due within one year............................. -- -- -- Due from one-five years......................... -- -- -- Due from five-ten years......................... -- -- -- Due over ten years.............................. 7,067 8,195 8.125 Investment Securities Available for Sale(1) U.S. Treasury Due within one year............................. -- -- -- Due from one-five years......................... -- -- -- Due from five-ten years......................... -- -- -- Due over ten years.............................. -- -- -- U.S. Government Agency Due within one year............................. 1,500 1,500 6.00 Due from one-five years......................... 20,502 20,361 6.18 Due from five-ten years......................... 5,026 4,865 6.73 Due over ten years.............................. -- -- -- FHLB stock........................................ 4,247 4,247 6.30 ------- ------- ---- $81,889 $81,814 6.75% ======== ======== ==== Securities held for trading(3): GNMA certificates................................. 83,848 84,460 6.53% CMO certificates.................................. 16,200 15,147 5.95 CMO residuals(4).................................. 8,489 8,539 8.00 U.S. Treasury Bills............................... 1,370 1,316 5.72 ------- ------- ---- $109,907 $109,462 6.55% ======== ======== ==== December 31, ----------------------------------------- 1995 ---------------------------------------- Weighted Amortized Fair Average Cost Value Yield -------------- ---------- ---------- (Dollars in Thousands) Mortgage-Backed Securities Available for Sale(1): FNMA mortgage-backed securities Due within one year............................. $ -- $ -- --% Due from one-five years......................... -- -- -- Due from five-ten years......................... -- -- -- Due over ten years.............................. 14,846 14,946 7.12 FHLMC mortgage-backed securities Due within one year............................. -- -- -- Due from one-five years......................... -- -- -- Due from five-ten years......................... 1,122 1,180 8.90 Due over ten years.............................. 36,353 36,759 6.94 CMO residuals and other mortgage-backed securities (2) Due within one year............................. -- -- NA Due from one-five years......................... -- -- NA Due from five-ten years......................... -- -- NA Due over ten years.............................. 7,126 8,123 8.125 Investment Securities Available for Sale(1) U.S. Treasury Due within one year............................. -- -- -- Due from one-five years......................... -- -- -- Due from five-ten years......................... -- -- -- Due over ten years.............................. -- -- -- U.S. Government Agency Due within one year............................. -- -- -- Due from one-five years......................... -- -- -- Due from five-ten years......................... -- -- -- Due over ten years.............................. -- -- -- FHLB stock........................................ 3,280 3,280 7.68 -------- -------- ---- $ 62,727 $ 64,288 6.42% ======== ======== ==== Securities held for trading(3): GNMA certificates................................. $ 87,656 $ 88,448 6.71% CMO certificates.................................. 16,200 15,570 5.95 CMO residuals(4).................................. 10,248 9,791 8.00 U.S. Treasury Bills............................... -- -- -- -------- -------- ---- $114,104 $113,809 6.72% ======== ======== ====
(Footnotes on following page) 39 - --------------- (1) All securities are held in the Bank's investment securities portfolio. (2) Comprised of subordinated tranches and residuals from the Bank's 1992 Grantor Trust. (3) Except for GNMA Certificates with a fair value of $1.7 million, $1.7 million and $1.8 million as of December 31, 1997, 1996 and 1995, and U.S. Treasury Bills with a fair value of $770,000 at December 31, 1996, all of such securities are held in R&G Mortgage's securities portfolio. (4) Represents residuals purchased from the Bank in 1995 from its 1993 CMO Grantor Trust, and from R&G Mortgage's CMO Grantor Trusts. A substantial portion of R&G Financial's securities are held in mortgage-backed securities. Mortgage-backed securities (which also are known as mortgage participation certificates or pass-through certificates) represent a participation interest in a pool of single-family or multi-family mortgages, the principal and interest payments on which are passed from the mortgage originators, through intermediaries (generally U.S. Government agencies and government sponsored enterprises) that pool and repackage the participation interests in the form of securities, to investors such as R&G Financial. Such U.S. Government agencies and government sponsored enterprises, which guarantee the payment of principal and interest to investors, primarily include the FHLMC, the FNMA and the GNMA. The FHLMC is a public corporation chartered by the U.S. Government and owned by the 12 Federal Home Loan Banks and federally-insured savings institutions. The FHLMC issues participation certificates backed principally by conventional mortgage loans. The FHLMC guarantees the timely payment of interest and the ultimate return of principal within one year. The FNMA is a private corporation chartered by the U.S. Congress with a mandate to establish a secondary market for conventional mortgage loans. The FNMA guarantees the timely payment of principal and interest on FNMA securities. FHLMC and FNMA securities are not backed by the full faith and credit of the United States, but because the FHLMC and the FNMA are U.S. Government-sponsored enterprises, these securities are considered to be among the highest quality investments with minimal credit risks. The GNMA is a government agency within HUD which is intended to help finance government-assisted housing programs. GNMA securities are backed by FHA-insured and VA-guaranteed loans, and the timely payment of principal and interest on GNMA securities are guaranteed by the GNMA and backed by the full faith and credit of the U.S. Government. Because the FHLMC, the FNMA and the GNMA were established to provide support for low- and middle-income housing, there are limits to the maximum size of loans that qualify for these programs. For example, the FNMA and the FHLMC currently limit their loans secured by a single-family, owner-occupied residence to $227,150. To accommodate larger-sized loans, and loans that, for other reasons, do not conform to the agency programs, a number of private institutions have established their own home-loan origination and securitization programs. 40 Mortgage-backed securities typically are issued with stated principal amounts, and the securities are backed by pools of mortgages that have loans with interest rates that are within a range and have varying maturities. The characteristics of the underlying pool of mortgage, i.e., fixed-rate or adjustable-rate, as well as prepayment risk, are passed on to the certificate holder. The life of a mortgage-backed pass-through security thus approximates the life of the underlying mortgages. R&G Financial's securities portfolio includes CMOs. CMOs have been developed in response to investor concerns regarding the uncertainty of cash flows associated with the prepayment option of the underlying mortgagor and are typically issued by government agencies, government sponsored enterprises and special purpose entities, such as trusts, corporations or partnerships, established by financial institutions or other similar institutions. A CMO can be collateralized by loans or securities which are insured or guaranteed by the FNMA, the FHLMC or the GNMA. In contrast to pass-through mortgage-backed securities, in which cash flow is received pro rata by all security holders, the cash flow from the mortgages underlying a CMO is segmented and paid in accordance with a predetermined priority to investors holding various CMO classes. By allocating the principal and interest cash flows from the underlying collateral among the separate CMO classes, different classes of bonds are created, each with its own stated maturity, estimated average life, coupon rate and prepayment characteristics. Mortgage-backed securities generally increase the quality of R&G Financial's assets by virtue of the insurance or guarantees that back them, are more liquid than individual mortgage loans and may be used to collateralize borrowings or other obligations of R&G Financial. At December 31, 1997, $40.2 million or 8.6% of R&G Financial's mortgage-backed securities was pledged to secure various obligations of R&G Financial (excluding repurchase agreements). The FDIC has issued a statement of policy which states, among other things, that mortgage derivative products (including CMOs and CMO residuals) which possess average life or price volatility in excess of a benchmark fixed rate 30-year mortgage-backed pass-through security are "high-risk mortgage securities," are not suitable investments for depository institutions, and if considered "high risk" at purchase must be carried in the institution's trading account or as assets held for sale, and must be marked to market on a regular basis. In addition, if a security was not considered "high risk" at purchase but was later found to be "high risk" based on the tests, it may remain in the held-to-maturity portfolio as long as the institution has positive intent to hold the security to maturity and has a documented plan in place to manage the high risk. At December 31, 1997, the Bank's CMOs and CMO residuals, which had a fair value of $8.4 million, were designated as "high-risk mortgage securities" and classified as available for sale. Sources of Funds General. R&G Financial will consider various sources of funds to fund its investment and lending activities and evaluates the available sources of funds in order to reduce R&G Financial's overall funding costs. Deposits, reverse repurchase agreements, warehouse lines of 41 credit, notes payable, FHLB advances, subordinated capital notes and sales, maturities and principal repayments on loans and securities have been the major sources of funds for use in R&G Financial's lending and investing activities and for other general business purposes. Deposits. Deposits are the major sources of the Bank's funds for lending and other investment purposes. Consumer and commercial deposits are attracted principally from within the Bank's primary market area through the offering of a broad selection of deposit instruments, including passbook, NOW and Super NOW, checking and commercial checking and certificates of deposit ranging in terms from 7 days to 10 years. Included among these deposit products are $197.0 million of certificates of deposit with balances of $100,000 or more, which amounted to 27.0% of the Bank's total deposits at December 31, 1997. Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. The Bank attempts to price its deposits in order to promote deposit growth. The Bank regularly evaluates the internal costs of funds, surveys rates offered by competing institutions, reviews the Bank's cash flow requirements for lending and liquidity and executes rate changes when deemed appropriate. The Bank does not currently obtain funds through brokers, although at December 31, 1997 it held $7.5 million of deposits acquired from money desks in the United States. The principal methods currently used by the Bank to attract deposit accounts include offering a wide variety of services and accounts and competitive interest rates. The Bank utilizes traditional marketing methods to attract new customers and savings deposits, including advertising. The following table presents the average balance of each deposit type and the average rate paid one each deposit type of the Bank for the periods indicated.
December 31, ---------------------------------------------------------------------------------- 1997 1996 1995 ------------------------- ------------------------ ------------------------ Average Average Average Average Average Average Balance Rate Paid Balance Rate Paid Balance Rate Paid ------------- ---------- ----------- ----------- ----------- ----------- (Dollars in Thousands) Passbook...................... $75,958 3.79% $73,216 3.77% $ 59,860 3.66% NOW and Super NOW accounts 86,843 3.84 78,183 3.85 65,135 3.82 Checking...................... 23,859 -- 20,451 -- 6,050 -- Commercial checking(1)........ 46,301 -- 30,173 -- 24,601 -- Certificates of deposit....... 435,743 6.02 359,525 6.05 276,187 6.25 -------- ---- -------- ---- -------- ---- Total deposits.............. $668,704 4.85% $561,548 4.90% $431,833 5.05% ======== ==== ======== ==== ======== ====
- ---------------- (1) Includes $50.2 million, $10.6 million and $9.7 million of escrow funds of R&G Mortgage at December 31, 1997, 1996 and 1995, respectively, maintained with the Bank. 42 The following table sets forth the maturities of the Bank's certificates of deposit having principal amounts of $100,000 or more at December 31, 1997.
Amount ---------------------- (In Thousands) Certificates of deposit maturing: Three months or less.............................................. $59,977 Over three through six months..................................... 30,802 Over six through twelve months.................................... 56,249 Over twelve months................................................ 49,934 ------- Total........................................................... $196,962 =======
Borrowings. R&G Financial's business requires continuous access to various funding sources, both short and long-term. R&G Mortgage's primary source of short-term funds is through sales of securities to investment dealers under agreements to repurchase ("reverse repurchase agreements"). The Bank also from time to time utilizes reverse repurchase agreements when they represent a competitive short-term funding source. In a reverse repurchase agreement transaction, R&G Financial will generally sell a mortgage-backed security agreeing to repurchase either the same or a substantially identical security on a specified later date (generally not more than 90 days) at a price less than the original sales price. The difference in the sale price and purchase price is the cost of the use of the proceeds. The mortgage-backed securities underlying the agreements are delivered to the dealers who arrange the transactions. For agreements in which R&G Financial has agreed to repurchase substantially identical securities, the dealers may sell, loan or otherwise dispose of R&G Financial's securities in the normal course of their operations; however, such dealers or third party custodians safe-keep the securities which are to be specifically repurchased by R&G Financial. Reverse repurchase agreements represent a competitive cost funding source for R&G Financial. Nevertheless, R&G Financial is subject to the risk that the lender may default at maturity and not return the collateral. The amount at risk is the value of the collateral which exceeds the balance of the borrowing. In order to minimize this potential risk, R&G Financial only deals with large, established investment brokerage firms when entering into these transactions. Reverse repurchase transactions are accounted for as financing arrangements rather than as sales of such securities, and the obligations to repurchase such securities is reflected as a liability in R&G Financial's Consolidated Financial Statements. As of December 31, 1997, R&G Financial had $328.3 million of reverse repurchase agreements outstanding, $334.2 million of which represented borrowings of R&G Mortgage. At December 31, 1997, the weighted average interest rate on R&G Financial's reverse repurchase agreements amounted to 5.81%. R&G Mortgage's loan originations are also funded by borrowings under various warehouse lines of credit provided by two unrelated commercial banks ("Warehouse Lines"). At December 31, 1997, R&G Mortgage was permitted to borrow under such Warehouse Lines up to $138.4 million, $75.2 million of which was drawn upon and outstanding as of such date. The 43 Warehouse Lines are used by R&G Mortgage to fund loan commitments and must generally be repaid within 180 days after the loan is closed or when R&G Mortgage receives payment from the sale of the funded loan, whichever occurs first. Until such sale closes, the Warehouse Lines provide that the funded loan is pledged to secure the outstanding borrowings. The Warehouse Lines are also collateralized by certificates of deposit, a general assignment of mortgage payments receivable, an assignment of certain mortgage servicing rights and an assignment of key man life insurance policies on Mr. Victor J. Galan, R&G Financial's Chairman of the Board and Chief Executive Officer. In addition, some of the Warehouse Lines are personally guaranteed by Mr. Galan. Certain of these warehousing lines of credit impose restrictions on R&G Mortgage with respect to the maintenance of minimum levels of net worth and working capital and limitations on the amount of indebtedness and dividends which may be declared. The interest rate on funds borrowed pursuant to the Warehouse Lines is based upon a specified prime rate less a negotiated amount or, if available, a designated Puerto Rico Section 936 funds rate (which is lower than the prime rate) plus a negotiated amount. By maintaining compensating balances, R&G Mortgage is able to borrow funds under the Warehouse Lines at a lower interest rate than would otherwise apply. These compensating balances are comprised of a portion of the escrow accounts maintained by R&G Mortgage for principal and interest payments and related tax and insurance payments on loans its services. At December 31, 1997, the weighted average interest rate being paid by R&G Mortgage under its Warehouse Lines amounted to 5.85%. The Warehouse Lines include various covenants and restrictions on R&G Mortgage's operations, including maintenance of minimum levels of net worth and debt service, minimum levels and ratios with respect to outstanding indebtedness and restrictions on the amount of dividends which can be declared and paid by R&G Mortgage on its common stock. Management of R&G Financial believes that as of December 31, 1997, it was in compliance with all of such covenants and restrictions and does not anticipate that such covenants and restrictions will limit its operations. Although the Bank's primary source of funds is deposits, the Bank also borrows funds on both a short and long-term basis. The Bank actively utilizes 936 Notes as a primary borrowing source. The 936 Notes have original terms to maturity of between five and seven years and are payable semiannually at either a variable interest rate (84% of the three-month LIBOR rate less .125%, and 96% of the three month LIBID rate or a fixed interest rate (ranging from 5.55% to 7.15%). The Bank is able to obtain such low cost funds by investing the proceeds in eligible activities as proscribed under Puerto Rico law, which provide tax advantages under Puerto Rico tax laws and under U.S. federal tax laws for U.S. corporations which are operating in Puerto Rico pursuant to Section 936 of the Code. See " - Mortgage Banking Activities - Puerto Rico Secondary Mortgage Market and Favorable Tax Treatment." At December 31, 1997, $38.6 million of the 936 Notes were secured by marketable securities, while $45.5 million were secured by standby letters of credit issued by the FHLB of New York (which are, in turn, secured by first mortgage loans, securities and cash deposits). The 936 Notes contain certain provisions which indemnify the holders thereof from the federal tax liability which would be incurred, plus any 44 penalties and interest, if the Bank did not invest the proceeds as required in eligible activities, and also provide for a "gross up" provision which permits the Bank to continue the obligation at an adjusted interest rate based on LIBOR in the event the interest on the 936 Notes is subject in whole or in part to federal and/or Puerto Rico income tax. At December 31, 1997, the Bank had $84.1 million of 936 Notes outstanding, $23.6 million of which matures in 1999, $25.0 million of which matures in 2000 and $35.5 million of which matures in 2001. The Bank obtains both fixed-rate and variable-rate short-term and long-term advances from the FHLB of New York upon the security of certain of its residential first mortgage loans, securities and cash deposits, provided certain standards related to the credit-worthiness of the Bank have been met. FHLB of New York advances are available for general business purposes to expand lending and investing activities. Advances from the FHLB of New York are made pursuant to several different credit programs, each of which has its own interest rate and range of maturities. At December 31, 1997, the Bank had access to $223.4 million in advances from the FHLB of New York, and had two FHLB of New York advances aggregating $42.0 million outstanding as of such date, which mature in January 1998 and have a weighted average interest rate of 6.03%. In addition, at December 31, 1997, the Bank maintained $51.3 million in standby letters of credit with the FHLB of New York, which secured $45.5 million of outstanding 936 Notes payable and $4.1 million of 936 certificates of deposit. At December 31, 1997, the Bank had pledged specific collateral aggregating $112.9 million to the FHLB of New York under its advances program and to secure the letters of credit. The Bank maintains collateral with the FHLB of New York in excess of applicable requirements in order to facilitate any necessary additional borrowings by the Bank in the future. In June 1991, the Bank issued $3.3 million of subordinated capital notes bearing interest at 8% payable on a quarterly basis. The subordinated notes are guaranteed by R&G Mortgage and by the Chairman of the Board and Chief Executive Officer of R&G Financial, and are secured by an irrevocable standby letter of credit issued by an unrelated commercial bank. Pursuant to the terms of the subordinated notes, the Bank is required to deposit with an established sinking fund in seven equal annual installments (the first of which began in September 1992 and the last of which is scheduled for June 1998, when the notes mature) cash or other permitted investments in an amount sufficient to retire one-seventh ($464,000) of the aggregate principal amount of the subordinated notes. The standby letter of credit is reduced in equal proportion to the deposits to such sinking fund. In December 1995, the Bank sold single-family residential mortgage loans with an aggregate outstanding balance of approximately $55 million to two commercial banks. In connection with the foregoing, R&G Mortgage assumed certain recourse provisions and guaranteed a specific yield to the purchasers of the loans. In addition, the purchasers of the loans have the right, at their option, to require R&G Mortgage to purchase the mortgage loans at any time after December 2000. Management has estimated its liability, if any, under the foregoing recourse provisions to be immaterial as of December 31, 1997. In R&G Financial's Consolidated Financial Statements, R&G Financial has recognized the foregoing transaction as a transfer of loans with recourse. Accordingly, the proceeds from such transaction (amounting to $34.4 45 million at December 31, 1997) have been reported as a secured borrowing in R&G Financial's Consolidated Financial Statements. Similarly, the aggregate outstanding principal balance of the related loans (amounting to $33.9 million as of December 31, 1997) have been reported as an asset in R&G Financial's Consolidated Financial Statements. The following table sets forth certain information regarding the short-term borrowings of R&G Financial at or for the dates indicated.
At or For the Year Ended December 31, ---------------------------------------------------- 1997 1996 1995 ------------------ --------------- ---------------- (Dollars in Thousands) R&G Mortgage: Securities sold under agreements to repurchase: Average balance outstanding....................... $187,682 $ 93,653 $ 99,145 Maximum amount outstanding at any month-end during the period............................... 334,203 108,240 112,507 Balance outstanding at end of period.............. 334,203 97,444 87,958 Average interest rate during the period........... 6.03% 5.00% 5.87% Average interest rate at end of period............ 5.85% 5.67% 5.47% Notes Payable: Average balance outstanding....................... $67,558 $40,805 $ 24,521 Maximum amount outstanding at any month-end during the period............................... 93,523 85,135 31,626 Balance outstanding at end of period.............. 75,204 40,342 30,130 Average interest rate during the period........... 5.92% 5.32% 5.46% Average interest rate at end of period............ 5.85% 4.97% 5.27% The Bank: FHLB of New York advances: Average balance outstanding....................... $23,524 $ 6,366 $ 11,796 Maximum amount outstanding at any month-end during the period............................... 42,200 15,000 13,562 Balance outstanding at end of period.............. 42,200 15,000 6,007 Average interest rate during the period........... 5.80% 5.84% 6.00% Average interest rate at end of period............ 6.03% 5.75% 6.74% Securities sold under agreements to repurchase: Average balance outstanding....................... $39,090 $ 6,954 $ 7,737 Maximum amount outstanding at any month-end during the period............................... 63,088 19,000 14,673 Balance outstanding at end of period.............. 48,080 -- 10,525 Average interest rate during the period........... 5.55% 4.74% 5.16% Average interest rate at end of period............ 5.56% --% 5.11% Notes Payable: Average balance outstanding....................... $85,034 $85,365 $ 30,597 Maximum amount outstanding at any month-end during the period............................... 86,500 111,500 51,000 Balance outstanding at end of period.............. 84,100 86,500 51,000 Average interest rate during the period........... 6.60% 5.55% 6.42% Average interest rate at end of period............ 5.97% 5.82% 5.93%
46 Trust and Investment Services R&G Financial also provides trust and investment services through the Bank's Trust Department. Services offered include custodial services, the administration of IRA accounts and the sale to investors of mortgage-backed securities guaranteed by GNMA. As of December 31, 1997, the Bank's Trust Department administered approximately 6,135 trust accounts, with aggregate assets of $23.3 million as of such date. In addition, during the year ended December 31, 1997, the Bank's Trust Department sold $39.9 million of GNMA mortgage-backed securities. The Bank receives fees dependent upon the level and type of service provided. The administration of the Bank's Trust Department is performed by the Trust Committee of the Board of Directors of the Bank. Personnel As of December 31, 1997, R&G Financial (on a consolidated basis) had 809 full-time employees and 42 part-time employees. The employees are not represented by a collective bargaining agreement and R&G Financial believes that it has good relations with its employees. Regulation Set forth below is a brief description of certain laws and regulations which, together with the descriptions of laws and regulations contained elsewhere herein, are deemed material to an investor's understanding of the extent to which R&G Financial, R&G Mortgage and the Bank are regulated. The description of these laws and regulations, as well as descriptions of laws and regulations contained elsewhere herein, does not purport to be complete and is qualified in its entirety by reference to applicable laws and regulations. R&G Financial General. R&G Financial is a registered bank holding company pursuant to the Bank Holding Company Act of 1956, as amended (the "BHCA"). The Company became a bank holding company in July 1996 through its acquisition of Mr. Victor Galan's 88.1% interest in the Bank (which excludes his required qualifying shares as a director of the Bank) in exchange for R&G Financial's Class A Common Stock. R&G Financial acquired the remaining interest in the Bank in December 1996. R&G Financial, as a bank holding company, is subject to regulation and supervision by the Federal Reserve Board and the OCFI. R&G Financial is required to file annually a report of its operations with, and is subject to examination by, the Federal Reserve Board and the OCFI. BHCA Activities and Other Limitations. The BHCA prohibits a bank holding company from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any bank, or increasing such ownership or control of any bank, without prior approval of the 47 Federal Reserve Board. No approval under the BHCA is required, however, for a bank holding company already owning or controlling 50% of the voting shares of a bank to acquire additional shares of such bank. The BHCA also prohibits a bank holding company, with certain exceptions, from acquiring more than 5% of the voting shares of any company that is not a bank and from engaging in any business other than banking or managing or controlling banks. Under the BHCA, the Federal Reserve Board is authorized to approve the ownership of shares by a bank holding company in any company, the activities of which the Federal Reserve Board has determined to be so closely related to banking or to managing or controlling banks as to be a proper incident thereto. In making such determinations, the Federal Reserve Board is required to weigh the expected benefit to the public, such as greater convenience, increased competition or gains in efficiency, against the possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The Federal Reserve Board has by regulation determined that certain activities are closely related to banking within the meaning of the BHCA. These activities include operating a mortgage company, such a R&G Mortgage, finance company, credit card company, factoring company, trust company or savings association; performing certain data processing operations; providing limited securities brokerage services; acting as an investment or financial advisor; acting as an insurance agent for certain types of credit-related insurance; leasing personal property on a full-payout, non-operating basis; providing tax planning and preparation services; operating a collection agency; and providing certain courier services. The Federal Reserve Board also has determined that certain other activities, including real estate brokerage and syndication, land development, property management and underwriting of life insurance not related to credit transactions, are not closely related to banking and a proper incident thereto. Limitations on Transactions with Affiliates. Transactions between financial institutions and any affiliate are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a financial institution is any company or entity which controls, is controlled by or is under common control with the financial institution. In a holding company context, the parent holding company of a financial institution (such as R&G Financial) and any companies which are controlled by such parent holding company are affiliates of the financial institution. Generally, Sections 23A and 23B (i) limit the extent to which the financial institution or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such institution's capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the institution or subsidiary as those provided to a non-affiliate. The term "covered transaction" includes the making of loans, purchase of assets, issuance of a guarantee and other similar transactions. In addition to the restrictions imposed by Sections 23A and 23B, no financial institution may (i) loan or otherwise extend credit to an affiliate, except for any affiliate which engages only in activities which are permissible for bank holding companies, or (ii) purchase or invest in any stocks, bonds, debentures, notes or similar obligations of any affiliate, except for affiliates which 48 are subsidiaries of the financial institution. See "- General - Affiliated Transactions" for a discussion of the affiliated transactions conducted by R&G Mortgage and the Bank. In addition, Sections 22(h) and (g) of the Federal Reserve Act places restrictions on loans to executive officers, directors and principal stockholders. Under Section 22(h), loans to a director, an executive officer and to a greater than 10% stockholder of a financial institution, and certain affiliated interests of either, may not exceed, together with all other outstanding loans to such person and affiliated interests, the financial institution's loans to one borrower limit (generally equal to 15% of the institution's unimpaired capital and surplus). Section 22(h) also requires that loans to directors, executive officers and principal stockholders be made on terms substantially the same as offered in comparable transactions to other persons unless the loans are made pursuant to a benefit or compensation program that (i) is widely available to employees of the institution and (ii) does not give preference to any director, executive officer or principal stockholder, or certain affiliated interests of either, over other employees of the savings institutions. Section 22(h) also requires prior board approval for certain loans. In addition, the aggregate amount of extensions of credit by a financial institution to all insiders cannot exceed the institution's unimpaired capital and surplus. Furthermore, Section 22(g) places additional restrictions on loans to executive officers. Capital Requirements. The Federal Reserve Board has adopted capital adequacy guidelines pursuant to which it assesses the adequacy of capital in examining and supervising a bank holding company and in analyzing applications to it under the BHCA. The Federal Reserve Board capital adequacy guidelines generally require bank holding companies to maintain total capital equal to 8% of total risk-adjusted assets, with at least one-half of that amount consisting of Tier I or core capital and up to one-half of that amount consisting of Tier II or supplementary capital. Tier I capital for bank holding companies generally consists of the sum of common stockholders' equity and perpetual preferred stock (subject in the case of the latter to limitations on the kind and amount of such stocks which may be included as Tier I capital), less goodwill and, with certain exceptions, intangibles. Tier II capital generally consists of hybrid capital instruments; perpetual preferred stock which is not eligible to be included as Tier I capital; term subordinated debt and intermediate-term preferred stock; and, subject to limitations, general allowances for loan losses. Assets are adjusted under the risk-based guidelines to take into account different risk characteristics, with the categories ranging from 0% (requiring no additional capital) for assets such as cash to 100% for the bulk of assets which are typically held by a bank holding company, including multi-family residential and commercial real estate loans, commercial business loans and consumer loans. Single-family residential first mortgage loans which are not past-due (90 days or more) or non-performing and which have been made in accordance with prudent underwriting standards are assigned a 50% level in the risk-weighing system, as are certain privately-issued mortgage-backed securities representing indirect ownership of such loans. Off-balance sheet items also are adjusted to take into account certain risk characteristics. In addition to the risk-based capital requirements, the Federal Reserve Board requires bank holding companies to maintain a minimum leverage capital ratio of Tier I capital to total assets of 3.0%. Total assets for this purpose does not include goodwill and any other intangible assets 49 and investments that the Federal Reserve Board determines should be deducted from Tier I capital. The Federal Reserve Board has announced that the 3.0% Tier I leverage capital ratio requirement is the minimum for the top-rated bank holding companies without any supervisory, financial or operational weaknesses or deficiencies or those which are not experiencing or anticipating significant growth. Other bank holding companies will be expected to maintain Tier I leverage capital ratios of at least 4.0% to 5.0% or more, depending on their overall condition. R&G Financial is in compliance with the above-described Federal Reserve Board regulatory capital requirements. Financial Support of Affiliated Institutions. Under Federal Reserve Board policy, R&G Financial will be expected to act as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances when it might not do so absent such policy. The legality and precise scope of this policy is unclear, however, in light of recent judicial precedent. In addition, any capital loans by a bank holding company to a subsidiary bank is subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary bank. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment. The Bank General. The Bank is incorporated under the Puerto Rico Banking Act of 1933, as amended (the "Puerto Rico Banking Law") and is subject to extensive regulation and examination by the OCFI, the FDIC and certain requirements established by the Federal Reserve Board. The federal and Puerto Rico laws and regulations which are applicable to banks regulate, among other things, the scope of their business, their investments, their reserves against deposits, the timing of the availability of deposited funds and the nature and amount of and collateral for certain loans. There are periodic examinations by the OCFI and the FDIC to test the Bank's compliance with various regulatory requirements. This regulation and supervision establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulation, whether by the OCFI, the FDIC or the U.S. Congress or Puerto Rico legislature could have a material adverse impact on R&G Financial, R&G Mortgage, the Bank and their operations. FDIC Insurance Premiums. The Bank currently pays deposit insurance premiums to the FDIC based on a risk-based assessment system established by the FDIC for all Savings Association Insurance Fund ("SAIF") and Bank Insurance Fund ("BIF") member institutions. Under applicable regulations, institutions are assigned to one of three capital groups which is based solely on the level on an institution's capital - "well capitalized," "adequately capitalized" 50 and "undercapitalized". These three groups are then divided into three subgroups which reflect varying levels of supervisory concern, from those which are considered to be healthy to those which are considered to be of substantial supervisory concern. The matrix so created results in nine assessment risk classifications, with rates ranging from .0% for well capitalized, healthy institutions to .27% for undercapitalized institutions with substantial supervisory concerns. The Bank was classified as a "well-capitalized" institution as of December 31, 1997. An additional assessment is added to the regular SAIF-assessment and the regular BIF-assessment, respectively, until December 31, 1999 in order to cover Financing Corporation debt service payments. Such additional assessments amount to 6.3 basis points and 1.3 basis points for SAIF insured deposits and BIF insured deposits, respectively. The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is aware of no existing circumstances which would result in termination of the Bank's deposit insurance. Recapitalization of SAIF. Both the SAIF and the BIF, the federal deposit insurance fund that covers commercial bank deposits, are required by law to attain and thereafter maintain a reserve ratio of 1.25% of insured deposits. Certain of the Bank's deposits were required to continue to be insured by the SAIF following its 1994 conversion from a federally chartered savings bank to a Puerto Rico chartered commercial bank. The approximately $77.2 million of deposits acquired by the Bank in 1995 from a Puerto Rico commercial bank are BIF insured and subject to deposit insurance assessments at BIF rates. Both the SAIF and the BIF are required by law to attain and thereafter maintain a reserve ratio of 1.25% of insured deposits. The BIF has achieved the required reserve ratio, and as a result, the FDIC reduced the average deposit insurance premium paid by BIF-insured banks to a level substantially below the average premium previously paid by savings institutions. Banking legislation was enacted on September 30, 1996 to eliminate the premium differential between SAIF-insured institutions and BIF-insured institutions. The legislation provided that all insured depository institutions with SAIF-assessable deposits as of March 31, 1995 pay a special one-time assessment to recapitalize the SAIF. Pursuant to this legislation, the FDIC promulgated a rule that established the special assessment necessary to recapitalize the SAIF at 65.7 basis points of SAIF-assessable deposits held by affected institutions as of March 31, 1995. The Bank's one-time special assessment amounted to $1.6 million net of related tax benefits. The payment of such special assessment had the effect of immediately reducing the Bank's capital by such an amount and reducing future assessment rates for the Bank, effective January 1, 1997, to those previously applicable to BIF insured institutions. 51 Capital Requirements. The FDIC has promulgated regulations and adopted a statement of policy regarding the capital adequacy of state-chartered banks which, like the Bank, will not be members of the Federal Reserve System. These requirements are substantially similar to those adopted by the Federal Reserve Board regarding bank holding companies, as described above. The FDIC's capital regulations establish a minimum 3.0% Tier I leverage capital requirement for the most highly-rated state-chartered, non-member banks, with an additional cushion of at least 100 to 200 basis points for all other state-chartered, non-member banks, which effectively will increase the minimum Tier I leverage ratio for such other banks to 4.0% to 5.0% or more. Under the FDIC's regulation, the highest-rated banks are those that the FDIC determines are not anticipating or experiencing significant growth and have well diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity, good earnings and, in general, which are considered a strong banking organization and are rated composite 1 under the Uniform Financial Institutions Rating System. Leverage or core capital is defined as the sum of common stockholders' equity (including retained earnings), noncumulative perpetual preferred stock and related surplus, and minority interests in consolidated subsidiaries, minus all intangible assets other than certain qualifying supervisory goodwill and certain purchased mortgage servicing rights. The FDIC also requires that banks meet a risk-based capital standard. The risk-based capital standard for banks requires the maintenance of total capital (which is defined as Tier I capital and supplementary (Tier 2) capital) to risk weighted assets of 8%. In determining the amount of risk-weighted assets, all assets, plus certain off balance sheet assets, are multiplied by a risk-weight of 0% to 100%, based on the risks the FDIC believes are inherent in the type of asset or item. The components of Tier I capital are equivalent to those discussed above under the 3% leverage capital standard. The components of supplementary capital include certain perpetual preferred stock, certain mandatory convertible securities, certain subordinated debt and intermediate preferred stock and general allowances for loan and lease losses. Allowance for loan and lease losses includable in supplementary capital is limited to a maximum of 1.25% of risk-weighted assets. Overall, the amount of capital counted toward supplementary capital cannot exceed 100% of core capital. At December 31, 1997, the Bank met each of its capital requirements. In August 1995, the FDIC and other federal banking agencies published a final rule modifying their existing risk-based capital standards to provide for consideration of interest rate risk when assessing capital adequacy of a bank. Under the final rule, the FDIC must explicitly include a bank's exposure to declines in the economic value of its capital due to changes in interest rates as a factor in evaluating a bank's capital adequacy. In addition, in August 1995, the FDIC and the other federal banking agencies published a joint policy statement for public comment that describes the process the banking agencies will use to measure and assess the exposure of a bank's net economic value to changes in interest rates. In June 1996, the FDIC and other federal banking agencies adopted a joint policy statement on interest rate risk policy. Because market conditions, bank structure, and bank activities vary, the agencies concluded that each bank needs to develop its own interest rate risk management program tailored to its needs 52 and circumstances. The policy statement describes prudent principles and practices that are fundamental to sound interest rate risk management, including appropriate board and senior management oversight and a comprehensive risk management process that effectively identifies, measures, monitors and controls risks. Activities and Investments. The activities and equity investments of FDIC-insured, state-chartered banks (which under the Federal Deposit Insurance Act includes banking institutions incorporated under the laws of Puerto Rico) are generally limited to those that are permissible for national banks. Under regulations dealing with equity investments, an insured state bank generally may not directly or indirectly acquire or retain any equity investment of a type, or in an amount, that is not permissible for a national bank. An insured state bank is not prohibited from, among other things, (i) acquiring or retaining a majority interest in a subsidiary, (ii) investing as a limited partner in a partnership the sole purpose of which is direct or indirect investment in the acquisition, rehabilitation or new construction of a qualified housing project, provided that such limited partnership investments may not exceed 2% of the bank's total assets, (iii) acquiring up to 10% of the voting stock of a company that solely provides or reinsures directors', trustees' and officers' liability insurance coverage or bankers' blanket bond group insurance coverage for insured depository institutions, and (iv) acquiring or retaining the voting shares of a depository institution if certain requirements are met. In addition, an insured state-chartered bank may not, directly, or indirectly through a subsidiary, engage as "principal" in any activity that is not permissible for a national bank unless the FDIC has determined that such activities would pose no risk to the insurance fund of which it is a member and the bank is in compliance with applicable regulatory capital requirements. Any insured state-chartered bank directly or indirectly engaged in any activity that is not permitted for a national bank must cease the impermissible activity. Puerto Rico Banking Law. As a commercial bank organized under the laws of the Commonwealth, the Bank is subject to supervision, examination and regulation by the OCFI pursuant to the Puerto Rico Banking Law. The Puerto Rico Banking Law requires that at least ten percent (10%) of the yearly net income of the Bank be credited annually to a reserve fund. This apportionment shall be done every year until the reserve fund shall be equal to the sum of the Bank's paid-in common and preferred stock capital. As of December 31, 1997, the Bank had credited $2.2 million to such reserve fund. The Puerto Rico Banking Law also provides that when the expenditures of a bank are greater than the receipts, the excess of the former over the latter shall be charged against the undistributed profits of the bank, and the balance, if any, shall be charged against the reserve fund, as a reduction thereof. If there is no reserve fund sufficient to cover such balance in whole or in part, the outstanding amount shall be charged against the capital account and no dividend shall be declared until said capital has been restored to its original amount and the reserve fund to 20% of the original capital. In addition, every bank is required by the Puerto Rico Banking Law to maintain a legal reserve which shall not be less than 20% of its demand liabilities, except 53 government deposits (federal, state and municipal) which are secured by actual collateral. The reserve is required to be made up of any of the following instruments or any combination of them: (i) legal tender of the United States; (ii) checks on banks or trust companies located in any part of Puerto Rico, to be presented for collection during the day following that on which they are received; (iii) money deposited in other banks provided said deposits are authorized by the Commissioner, subject to immediate collection; and (iv) federal funds sold and securities purchased under agreements to resell, provided such funds are repaid on or prior to the close of the next business day. Under the Puerto Rico Banking Law, the Bank is permitted to make loans to any one person, firm, partnership or corporation, up to an aggregate amount of fifteen percent (15%) of the paid-in capital and reserve fund of the Bank. As of December 31, 1997, the legal lending limit for the Bank under this provision was approximately $6.6 million and its maximum extension of credit to any one borrower, including affiliates thereof, was $1.5 million. If such loans are secured by collateral worth at least twenty-five percent (25%) more than the amount of the loan, the aggregate maximum amount may reach one-third of the paid-in capital of the Bank, plus its reserve fund. There are no restrictions on the amount of loans to subsidiaries of banks, and loans to non-banking affiliates of the Bank, which are subject however to the lending limitations set forth in Sections 23A and 23B of the Federal Reserve Act; or loans that are secured by mortgages by real estate, or loans that are wholly secured by bonds, securities and other evidences of indebtedness of the United States or the Commonwealth, or by current debt bonds, not in default, of municipalities or instrumentalities of the Commonwealth. The Puerto Rico Banking Law also authorizes the Bank to conduct certain financial and related activities directly or through subsidiaries. The Puerto Rico Banking Law also prohibits Puerto Rico banks from making loans secured by their own stock, and from purchasing their own stock, unless such purchase is necessary to prevent losses because of a debt previously contracted in good faith. The stock so purchased by the bank must be sold in a private or public sale within one year from the date of purchase. The rate of interest that the Bank may charge on mortgage and other types of loans to individuals in Puerto Rico is subject to Puerto Rico's usury laws. Such laws are administered by the Financing Board, which consists of the Commissioner of Financial Institutions, the President of the Government Development Bank, the Chairman of the Planning Board and the Puerto Rico Secretaries of Commerce, Treasury and Consumer Affairs and three representatives from the private sector. The Financing Board promulgates regulations which specify maximum rates on various types of loans to individuals. The Financing Board has adopted a regulation, Regulation 26-A, which fixes the maximum rate (which is adjusted on a weekly basis) which may be charged on residential first mortgage loans. Effective April 1996, the Financing Board eliminated the regulations that set forth the maximum interest rates that could be charged on non-federal government guaranteed loans. Interest rates on consumer loans and commercial loans are not subject to any limitations by Regulation 26-A. Regulatory Enforcement Authority. Applicable banking laws include substantial enforcement powers available to federal banking regulators. This enforcement authority includes, 54 among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions against banking organizations and institution-affiliated parties, as defined. 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 regulatory authorities. R&G Mortgage The mortgage banking business conducted by R&G Mortgage is subject to the rules and regulations of FHA, VA, FNMA, FHLMC and GNMA with respect to originating, processing, selling and servicing mortgage loans and the issuance and sale of mortgage-backed securities. Those rules and regulations, among other things, prohibit discrimination and establish underwriting guidelines which include provisions for inspections and appraisals, require credit reports on prospective borrowers and fix maximum loan amounts and, with respect to VA loans, fix maximum interest rates. Moreover, lenders are required annually to submit to FNMA, FHA, FHLMC, GNMA and VA audited financial statements, and each regulatory entity has its own financial requirements. R&G Mortgage's affairs are also subject to supervision and examination by FNMA, FHA, FHLMC, GNMA, HUD and VA at all times to assure compliance with the applicable regulations, policies and procedures. Mortgage origination activities are subject to, among others, the Equal Credit Opportunity Act, Federal Truth-in-Lending Act and the Real Estate Settlement Procedures Act and the regulations promulgated thereunder. R&G Mortgage's mortgage loan production activities are subject to the Federal Truth-in-Lending Act and Regulation Z promulgated thereunder. The Truth-in-Lending Act contains disclosure requirements designed to provide consumers with uniform, understandable information with respect to the terms and conditions of loans and credit transactions in order to give them the ability to compare credit terms. The Truth-in-Lending Act provides consumers a three day right to cancel certain credit transactions, including any refinance mortgage or junior mortgage loan on a consumer's primary residence. R&G Mortgage is required to comply with the Equal Credit Opportunity Act of 1974, as amended ("ECOA"), and Regulation B promulgated thereunder, which prohibit creditors from discriminating against applicants on the basis of race, color, sex, age or marital status, and restrict creditors from obtaining certain types of information from loan applicants. It also requires certain disclosures by lenders regarding consumer rights and requires lenders to advise applicants of the reasons for any credit denial. In instances where the applicant is denied credit or the rate or charge for loan increases as a result of information obtained from a consumer credit agency, another statute, The Fair Credit Reporting Act of 1970, as amended, requires the lenders to supply the applicant with the name and address of the reporting agency. The Federal Real Estate Settlement Procedures Act ("RESPA") imposes, among other things, limits on the amount of funds a borrower can be required to deposit with R&G Mortgage in any escrow account for the payment of taxes, insurance premiums or other charges. 55 R&G Mortgage is also subject to regulation by the OCFI, with respect to, among other things, licensing requirements and the record-keeping, examination and reporting requirements of the Puerto Rico Mortgage Banking Institutions Law (the "Mortgage Banking Law"). R&G Mortgage is licensed by the OCFI as a mortgage banking institution in Puerto Rico. Such authorization to act as a mortgage banking institution must be renewed as of January 1 of each year. In the past, R&G Mortgage has not had any difficulty in renewing its authorization to act as a mortgage banking institution, and management is unaware of any existing practices, conditions or violations which would result in R&G Mortgage being unable to receive such authorization in the future. The Mortgage Banking Law requires the prior approval of the OCFI for the acquisition of control of any mortgage banking institution licensed under the Mortgage Banking Law. For purposes of the Mortgage Banking Law, the term "control" means the power to direct or influence decisively, directly or indirectly, the management or policies of a mortgage banking institution. The Mortgage Banking Law provides that a transaction that results in the holding of less than 10% of the outstanding voting securities of a mortgage banking institution shall not be considered a change of control. Pursuant to the Mortgage Banking Law, upon receipt of notice of a proposed transaction that may result in change of control, the OCFI is obligated to make such inquires as it deems necessary to review the transaction. Under the Mortgage Banking Law, the determination of the OCFI whether or not to authorize a proposed change of control is final and non-appealable. As is the case with the Bank, the rate of interest that R&G Mortgage may charge on mortgage loans to individuals is subject to Puerto Rico's usury laws. Such laws are administered by the Financing Board which promulgates regulations that specify maximum rates on various types of loans to individuals. Regulation 26-A promulgated by the Financing Board fixes the maximum rate (which is adjusted on a weekly basis) which may be charged on residential first mortgage loans. Effective April 1996, the Financing Board eliminated the regulations that set forth the maximum interest rates that could be charged on non-federal government guaranteed loans. 56 Item 2. Properties. The Company's principal executive office is located at 280 Jesus T. Pinero Avenue, Hato Ray, San Juan, Puerto Rico 00918. The following table sets forth the net book value (including leasehold improvements and equipment) and certain other information with respect to the offices and other properties of R&G Financial at December 31, 1997, all of which properties are leased.
Net Book Value Description/Address Lease Term Expiration of Property - -------------------------------------------------------- -------------------------------------- ------------------- (In Thousands) The Bank: Hato Rey Branch(1)(2)(3) November 30, 1998 $1,056 280 Jesus T. Pinero Avenue Two (2) five year options Hato Rey, PR 00919 Los Jardines Branch September 4, 1999 125 Los Jardines de Guaynabo Shopping Center One (1) ten year option PR Road No. 20 Guaynabo, PR 00969 San Patricio Branch July 31, 2007 107 San Patricio Plaza Ortegon Street Guaynabo, PR 00969 Bayamon Branch(2)(3) May 31, 2001 251 42-43 Betances Avenue One (1) ten year option Urb. Hermanas Davila Bayamon, PR 00959 Bayamon East January 10, 2001 478 Road #174, Lote 100 Urb. Ind. Minillas Bayamon, PR 00959 Arecibo Branch(3) December 31, 2001 123 Marginal Vista Azul Two (2) five year options Corner San Daniel Avenue Arecibo, PR 00612 Manati Branch(3) August 8, 2009 492 Plaza Puerta del Sol Four (4) five year options PR Road No. 2, Km. 49.7 Manati, PR 00674 Carolina Branch(3) July 31, 2003 154 65th Infantry Avenue Corner San Marcos Street Carolina, PR 00985
57
Net Book Value Description/Address Lease Term Expiration of Property - -------------------------------------------------------- -------------------------------------- ------------------- (In Thousands) Trujillo Alto Branch(4) October 31, 2004 121 Trujillo Alto Shopping Center Trujillo Alto, PR 00976 Santurce Branch April 30, 1999 362 1077 Ponce de Leon Avenue Three (3) six year options Santurce, PR 00917 Laguna Gardens Branch(4) April 30, 1999 147 Laguna Gardens Shopping Center One (1) five year option Isla Verde Carolina, PR 00979 Plaza Carolina Branch(4) May 31, 2000 197 Plaza Carolina Mall Carolina, PR 00985 Norte Shopping Branch(4) April 30, 2000 69 Norte Shopping Center Two (2) five year options Baldorioty de Castro Avenue San Juan, PR 00907 Vega Baja Branch(4) May 31, 2003 365 Cabo Caribe Development One (1) five year option PR Road No. 2, Marginal Vega Baja, PR 00693 Mayaguez Branch(3) April 30, 1997 636 McKinley Street Four (4) five year options Corner Dr. Vady Mayaguez, PR 00680 Branch locations to be -- 318 opened in early 1998 Operations Center(2) January 10, 2001 2,328 ----- Road #174, Lote #100 Urb. Ind. Minillas Bayamon, PR 00959 7,329
58
Net Book Value Description/Address Lease Term Expiration of Property - -------------------------------------------------------- -------------------------------------- ------------------- (In Thousands) R&G Mortgage: Caguas Office July 31, 2000 6 D-9 Degetau Street One (1) five year option Urb. San Alfonso Caguas, PR 00725 Ponce Office May 1, 1998 7 25 Las Americas Avenue Ext. Buena Vista Ponce, PR 00731 Fajardo Office May 16, 1999 8 51 Celis Aguilera Street One (1) five year option Fajardo, PR 00738 Los Jardines Office(5) August 1, 2006 19 Los Jardines de Guaynabo Shopping Center One (1) five year option PR Road No. 20 Guaynabo, PR 00969 San Patricio Office(5) May 1, 1998 12 K-4 Ebano Street One (1) five year option Ponderosa Building San Patricio Guaynabo, PR 00969 Hato Rey Office(2)(3) December 31, 2002 2,050 280 Jesus T. Pinero Avenue Two (2) five year options Hato Rey, PR 00919 Bayamon Office(2)(3) May 30, 2001 28 42-43 Betances Avenue One (1) ten year option Urb. Hermanas Davila Bayamon, PR 00959 Arecibo Office(3) January 1, 2002 10 Marginal Vista Azul Two (2) five year options Corner San Daniel Avenue Arecibo, PR 00612 Manati Office(3)(6) October 30, 1998 17 Plaza Puerta del Sol One (1) five year option PR Road No. 2, Km. 49.7 Manati, PR 00674
59
Net Book Value Description/Address Lease Term Expiration of Property - -------------------------------------------------------- -------------------------------------- ------------------- (In Thousands) Carolina Office(3)(6) October 30, 1998 15 65th Infantry Avenue One (1) five year option Corner San Marcos Street Carolina, PR 00985 Mayaguez Office(3)(6) October 30, 1998 27 ----- McKinley Street One (1) five year option Corner Dr. Vady Mayaguez, PR 00680
(1) Also serves as the main office of R&G Financial. (2) Leased from VIG Leasing, S.E., which is owned by the family of Victor J. Galan, Chairman of the Board and Chief Executive Officer of R&G Financial. (3) The Bank and R&G Mortgage each maintain separate offices in the same building. (4) Facility includes an R&G Mortgage Banking Center. (5) The Bank maintains an office at this location in a separate facility. (6) Office is subleased from the Bank. Item 3. Legal Proceedings. The Company is not involved in any pending legal proceedings other than nonmaterial legal proceedings occurring in the ordinary course of business. Item 4. Submission of Matters to a Vote of Security-Holders. Not applicable. 60 PART II. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Shares for the Company's Class B common stock are traded nationally under the symbol "RGFC" on the NASDAQ National Market. The following table shows market price information for the Company's Class B common stock. The prices set forth below represent the high and low prices during the quarterly periods indicated as adjusted for an 80% stock split paid in September 1997:
Price Per Share ----------------------------------------------- Dividends High Low Paid ------------------- ------------------------- ------------------------- September 30, 1996(1) $10.42 $ 9.17 $ -- December 31, 1996 $14.31 $ 9.86 $0.0347 March 31, 1997 $15.55 $12.64 $0.0382 June 30, 1997 $14.44 $12.92 $0.0417 September 30, 1997 $22.50 $14.17 $0.0431 December 31, 1997 $22.00 $18.875 $0.0457
(1) The Company's Class B common stock commenced trading on August 27, 1996. At December 31, 1997 the Company had approximately 97 stockholders of record, which does not take into consideration investors who hold their stock through brokerage and other firms. Item 6. Selected Financial Data. The information required herein is incorporated by reference from pages 23 to 24 of the Registrant's 1997 Annual Report. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The information required herein is incorporated by reference from pages 26 to 40 of the Registrant's 1997 Annual Report. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. The information required herein is incorporated by reference from pages 29 to 30 of the Registrant's 1997 Annual Report. 61 Item 8. Financial Statements and Supplementary Data. The information required herein is incorporated by reference from pages 42 to 77 of the Registrant's 1997 Annual Report. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. Not applicable. PART III. Item 10. Directors and Executive Officers of the Registrant. The information required herein is incorporated by reference from pages 2 to 7 of the Registrant's Proxy Statement dated March 23, 1998 ("Proxy Statement"). Item 11. Executive Compensation. The information required herein is incorporated by reference from pages 12 to 15 of the Registrant's Proxy Statement. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information required herein is incorporated by reference from pages 8 to 11 of the Registrant's Proxy Statement. Item 13. Certain Relationships and Related Transactions. The information required herein is incorporated by reference from pages 15 to 18 of the Registrant's Proxy Statement. PART IV. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) Documents Filed as Part of this Report (1) The following financial statements are incorporated by reference from Item 8 hereof (see Exhibit 13): Independent Auditors' Report. Consolidated Statements of Financial Condition as of December 31, 1997 and 1996. 62 Consolidated Statements of Income for the Years Ended December 31, 1997, 1996 and 1995. Consolidated Statements of Cash Flows for the Years Ended December 31, 1997, 1996 and 1995. Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1997, 1996 and 1995. Notes to Consolidated Financial Statements. (2) All schedules for which provision is made in the applicable accounting regulation of the SEC are omitted because of the absence of conditions under which they are required or because the required information is included in the consolidated financial statements and related notes thereto. 63 (3) The following exhibits are filed as part of this Form 10-K, and this list includes the Exhibit Index. No. Description - ------------ -------------------------------------------------------------- 2.0 Amended and Restated Agreement and Plan of Merger by and between R&G Financial Corporation, the Bank and R-G Interim Premier Bank, dated as of September 27, 1996.(1) 3.1 Certificate of Incorporation of R&G Financial Corporation.(2) 3.2 Certificate of Amendment to Certificate of Incorporation of R&G Financial Corporation.(2) 3.3 Bylaws of R&G Financial Corporation.(2) 4.0 Specimen of Stock Certificate of R&G Financial Corporation.(2) 10.1 Master Purchase, Servicing and Collection Agreement between R&G Mortgage and the Bank dated February 16, 1990, as amended on April 1, 1991, December 1, 1991, February 1, 1994 and July 1, 1994.(2) 10.2 Master Custodian Agreement between R&G Mortgage and the Bank dated February 16, 1990, as amended on June 27, 1996.(2) 10.3 Master Production Agreement between R&G Mortgage and the Bank dated February 16, 1990, as amended on August 30, 1991 and March 31, 1995.(2) 10.4 Data Processing Computer Service Agreement between R&G Mortgage and R-G Premier Bank dated December 1, 1994.(2) 10.5 Securitization Agreement by and between R&G Mortgage and the Bank, dated as of July 1, 1995.(2) 10.6 R&G Financial Corporation Stock Option Plan.(2)(*) 13.0 1997 Annual Report to Stockholders. 21.0 Subsidiaries of the Registrant - Reference is made to "Item 1. Business" for the required information. 27.0 Financial Data Schedule. 99.1 Valuation Report on Minority Interest of Bank Stockholders, prepared by Friedman, Billings, Ramsey & Co., Inc., dated June 13, 1996.(2) 99.2 Update to Valuation on Minority Interest of Bank Stockholders, prepared by Friedman, Billings, Ramsey & Co., Inc., dated September 27, 1996.(1) - -------------------- (1) Incorporated by reference from the Registration Statement on Form S-4 (Registration No. 333-13199) filed by the Registrant with the Securities and Exchange Commission ("SEC") on October 1, 1996. (2) Incorporated by reference from the Registration Statement on Form S-1 (Registration No. 333-06245) filed by the Registrant with the SEC on June 18, 1996, as amended. (*) Management contract or compensatory plan or arrangement. (3)(b) Reports on Form 8-K. None. 64 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. R&G FINANCIAL CORPORATION By: /s/ Victor J. Galan ------------------------------------ Victor J. Galan Chairman of the Board, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. /s/ Victor J. Galan March 27, 1998 - -------------------------- Victor J. Galan Chairman of the Board, President and Chief Executive Officer (principal executive officer) /s/ Joseph R. Sandoval March 27, 1998 - ----------------------------- Joseph R. Sandoval Vice President and Chief Financial Officer (principal financial and accounting officer) /s/ Ana M. Armendariz March 27, 1998 - ------------------------- Ana M. Armendariz Director and Treasurer /s/ Ramon Prats March 27, 1998 Ramon Prats Executive Vice President and Director /s/ Enrique Umpierre-Suarez March 27, 1998 - ---------------------------- Enrique Umpierre-Suarez Director and Secretary /s/ Victor L. Galan Fundora March 27, 1998 - ---------------------------- Victor L. Galan Fundora Director /s/ Juan J. Diaz March 27, 1998 - ---------------------------------- Juan J. Diaz Director /s/ Pedro Ramirez March 27, 1998 Pedro Ramirez Director /s/ Laureno Carus Abarca March 27, 1998 - ------------------------------ Laureno Carus Abarca Director /s/ Eduardo McCormack March 27, 1998 Eduardo McCormack Director /s/ Gilberto Rivera-Arrega March 27, 1998 Gilberto Rivera-Arreaga Director /s/ Benigno R. Fernandez March 27, 1998 - -------------------------------- Benigno R. Fernandez Director EX-13 2 1997 Annual Report R-G Financial Corporation 25 Years Providing Customer Satisfaction Financial Highlights (In Thousands, except for Per Share Data)
1997 1996 1995 ---- ---- ---- Loan Production $906.3 $624.6 $467.7 Revenues 77.6 58.2 44.7 Net Earnings 23.5 13.2 10.4 Total Assets 1,511 1,038 853 Servicing Portfolio 3,001 2,550 2,298 Common Shareholders' Equity 138.1 115.6 70.3 Diluted Earnings per Share 1.62 1.19 1.12 Common Shareholders' Equity per Share 9.76 8.17 7.11
Mission Statement We will strive for long-term financial strength and profitability by centering our strategy on customer satisfaction. We seek to be a high-performance financial organization that delivers one-stop financial services to its clients; that is recognized as the best provider of value-added, service oriented financial services; and that offers services of unmatched quality in terms of accessibility, responsiveness and turnaround time. We will achieve these goals by making available a growing number of services and products within an environment that is both technologically advanced and friendly. 1 The beginning of the company, 25 years ago was based on mortgage lending. At the time this represented a large opportunity for growth, being a market where commercial banks had not ventured into home lending, the economy was strong and the people's needs were pressing for new homes and facilities. R-G began with that vision and commitment. Less than 10 years ago, customers focused on personal service and traditional branches. Now satisfaction is redefined by advanced technologies, more products, faster services and the convenience of electronic banking. Our emphasis is on people. We offer innovative concepts, leading edge technologies and a knowledgeable personnel able to handle different situations, make decisions and solve problems. This customer focus defines all our areas of business. We not only focus on when and where we provide services, but on how fast and how well we do this. Listening to customers and addressing their needs, directs and defines the way R-G delivers its array of products and services. Learning from 25 years of experience and being able to foresee and take action on market changes and trends has kept the Company ahead of its competitors in customer satisfaction. 2 Our 25th Anniversary Last year we celebrated our 25th year of operations. The quality that has defined R-G throughout this quarter of a century has been its dedication to customer satisfaction. Providing superior products and services to our customers is a challenge we have undertaken with passion and commitment, and we have met the challenge through the professionalism and knowledge of our skilled employees. They are the people who, every day, deliver excellent service to each and every one of our customers. Listening to our customers, addressing their needs and anticipating how these needs will change is the way R-G has kept ahead of its competitors. Customer satisfaction will continue to be our guiding principle as we embark on our next 25 years. 3 [BLANK] 4 Board of Directors of R-G Financial Corporation: [GRAPHIC - PHOTO OF BOARD OF DIRECTORS] (From left to right) Gilberto Rivera Arreaga Eduardo McCormack Laureano Carus Abarca Juan J. Diaz Enrique Umpierre Suarez Victor L. Galan Pedro Ramirez Benigno R. Fernandez Ramon Prats, Victor J. Galan Ana M. Armendariz (not pictured) 5 About the Company R-G Financial Corporation -the holding company for R-G Mortgage Corporation and R-G Premier Bank of Puerto Rico- is a financial services company with 25 years of operations and a history of outstanding growth in Puerto Rico. Since its inception in 1972 as R-G Mortgage, the Company has succeeded in its highly competitive market by focusing on customer satisfaction. Decisions about technology, pricing, services and facilities are all driven by customers' needs and expectations. R-G now provides a complete range of financial services through branch offices and mortgage banking facilities in 18 different locations throughout the island. R-G Mortgage has become the leading residential mortgage lender and servicer on the island. Innovation in services, products and technology has been key to the growth of the Company. R-G originates FHA, VA and conventional mortgages, conforming to Freddie Mac and Fannie Mae guidelines; non-conforming products and credit quality subprime first-lien mortgages; consumer mortgage loans; and second mortgage loans. R-G Financial securitizes and sells its loan production to investors or holds such loans in its banking portfolio, retaining the right to service these loans. R-G Financial has a loan servicing operation which serves nearly 60,000 homeowners. Its rapidly expanding banking operation offers a variety of complementary financial products, including all types of deposit and savings accounts. A Private Banking department sells investment products to individuals, including GNMA pools and mutual funds. 6 The Company has surpassed the expectations of competitors and knowledgeable financial experts. During the year ended December 31, 1997, R-G Mortgage originated 28.4% of all single-family residential loans in Puerto Rico, resulting in significant growth in its servicing portfolio. In 1990 R-G began its banking operation with R-G Premier Bank. The Bank offers a variety of financial products and services, including residential loans, commercial mortgage loans, leases on commercial properties and equipment, consumer loans and credit cards. At R-G we continuously invest in leadership, encouraging innovation and embracing change. 7 [GRAPHIC -- PHOTO of Victor J. Galan] LETTER TO STOCKHOLDERS 1997 The Year in Review During 1997 we celebrated our 25th anniversary. We commenced operations in 1972 with five employees and the minimum amount of capital ($100,000) required to be licensed as an FHA/VA Approved Mortgagee at that time. Since then, our capital has grown more than 1,300 times. After a quarter of a century of work and dedication to mortgage lending and banking, our Company has become a financial leader in Puerto Rico. We are ready to continue our expansion either within or outside of the island. We are currently serving more than 125,000 customers through our mortgage and commercial banking operations. The retention of this clientele is the best recognition of these 25 years of hard work and dedication. The Company has grown continuously since its inception, through both internal and external expansion. We have opened new branches, acquired mortgage operations , (for example United Mortgage in 1987) and acquired other banks (such as Guaynabo Federal Savings in 1990 and Caribbean Federal Savings in 1993). In 1995 we added new locations by purchasing seven branches from another bank. We now have a total of 18 branches, counting both our banking and our mortgage company locations. 8 Our corporate structure also has been expanded and revamped. In a 1996 restructuring, R-G Financial Corporation was organized as the holding company for R-G Premier Bank, which had previously been converted from a thrift institution into a commercial bank under the supervision of the FDIC and Puerto Rico's Commissioner of Financial Institutions. Also in 1996, R-G Mortgage was made a subsidiary of R-G Financial, and R-G Financial became a public company. In 1997 we organized Champion Mortgage as a subsidiary of R-G Mortgage, dedicated to the origination of residential non-conforming and subprime loans. Champion Mortgage commenced operations in the last quarter of 1997 and has already originated a substantial number of new loans. These loans are presently in portfolio, and will be securitized and sold in the secondary market in the near future. These 25 years have shown us that the only formula for achieving growth in banking is providing superior service to our clients. This is the reason why we have made customer satisfaction the theme of our Annual Report. We believe that without superior service, there is no reason for a banking operation of any size to survive. We have attained a leadership position because we have the key quality necessary for successful competition with larger local and multinational operations established in Puerto Rico - "a passion for service." Last year, our strategy of expansion supported by superior service produced the following accomplishments: [GRAPHIC -- PHOTO of Victor J. Galan and Ramon Prats] 9 o Earnings rose to a record of $23.5 million, increasing 78% from 1996 earnings of $13.2 million. On a per share basis, R-G Financial earned $1.62 in 1997, compared to $1.19 the previous year, an increase of 36%. Our compound annual growth rate for the period 1972-1997 was 1,380%. o The Board of Directors declared an 80% stock split in August 1997 which became effective in September of the same year. Total shares outstanding as of December 31, 1997 increased to 14,144,752. During 1997 we completed the stock exchange with minority stockholders of Guaynabo Federal. Based on the closing price of R-G Financial's stock at February 28, 1998, Guaynabo shareholders who had invested $1,000 in 1987 would have achieved an average annual return of 19.4% after completion of the conversion. The decision to split the Company's common stock was part of our ongoing effort to increase the liquidity of R-G's stock. o We increased dividends to $0.13 per share from $0.09 per share in 1996. For the quarter ended December 31, 1997, the dividend was increased to $0.20 on an annual basis, a 9% increase from the annualized rate of 0.183% of the prior quarterly dividend. This was our fifth consecutive increase since the Company went public in August 1996. We plan to continue increasing our future dividend payments proportionately to our increases in profit. o Our stock price climbed from $8.05 (as adjusted for our stock split) at the time of our initial public offering on August 22, 1996, to $27.25 at the close of operations on February 28, 1998, representing an increase of 238%. Our market capitalization increased proportionately to $385.4 million as of the latter date. 10 o Total revenues for our operation amounted to $71.3 million compared to $53.9 million for 1996. Our net interest income of $30.2 million represented a significant portion of our total revenues. The balance, in the amount of $41.1 million, consisted of fees generated mostly from the servicing of our mortgage portfolio, the origination and sale of loans and banking services. o Net interest income grew by 22% in 1997, while total fee income grew by 40%. o Loan production, including residential and commercial mortgage lending, plus consumer and commercial business lending, reached an all time high of $906.3 million in 1997. This represented a 45% increase from the $624.6 million of 1996. We achieved this substantial growth through a very strong advertising effort and investment in media. o Our residential and commercial mortgage originations translated into a market share of 26.6%, based on an estimated total mortgage market of $3.2 billion in Puerto Rico last year. Our 1997 market share represented a 670 basis point increase from 1996. o We increased our servicing portfolio to 56,400 loans with a total balance of $3.0 billion, an increase of $451 million or 18%. We estimate the total value of our servicing portfolio at $54 million as of December 31, 1997, or $33 million above the value reflected in our books under Statement of Financial Accounting Standards No. 125. Our servicing portfolio continues to be a strong source of revenue. Servicing income increased to $13.2 million in 1997, from $13.0 million in 1996. Revenues from servicing were to some extent affected by a decrease in delinquencies, which reduced income from late charges. 11 o Credit quality remained stable in our mortgage portfolio. Our delinquency rate (loans past due more than 30 days) was reduced to 3.47% from 3.68%, mainly through the use of new credit scoring systems in the loan application process. We achieved this decline in spite of a 45% rise in bankruptcy cases (to 15,636) in Puerto Rico last year. o Charge-offs for the year increased to $5.4 million, consisting mostly of losses in the consumer loans portfolio. Delinquencies in our Consumer Loan Division increased by 207 basis points to 4.15%; net charge-offs increased 11.1%. o We strengthened our credit loss reserves during the year, increasing the provision for loan losses to $8.4 million. (This amount includes $2.0 million received from our insurance carrier as settlement of a claim we filed related to certain irregularities discovered in our insurance premium financing business during the third quarter of 1996.) Reserves approximate to 60% of total non-performing loans as of December 31, 1997, excluding our residential loan portfolio, in which losses have historically been minimal. o Loans sold during 1997 were substantial totaling $364.3 million. These sales consisted of $206.6 million of residential FHA mortgage loans and $157.7 million of residential conventional loans. The Company was cited in 1997, by the Mortgage Marketplace magazine, as the number one seller of mortgage loans in the secondary market in Puerto Rico and number 72 in the nation. o Our securities portfolio increased by 141% in 1997, growing to $566.9 million from $235.2 million in 1996. These investments represented 38% of total assets as of December 31, 1997, and with a yield of 6.68% generated revenues of $26.8 million. Since most of these securities are tax-free GNMAs, the Company was able to reduce its taxes for 1997 to an effective tax rate of 27% from 31% in 1996. 12 o Deposits increased by 17% to $722.4 million in 1997 from $615.6 million in 1996. This growth was mainly due to a very strong promotional campaign designed to generate core deposits and to expand our Private Banking business. New deposits with our Private Banking Group rose substantially, and these accounts will lead to additional business in 1998 as the Private Banking Group provides other products and services to these customers. The overall increase in deposits was also due to the introduction of new accounts - the "Global" which provides access to various products such as credit cards and Automatic Teller Machines (ATMs); the "Esencial," which is a basic savings account with access to ATMs; and the "Conveniente," which is designed for the customers who have a small volume of transactions and use a minimum amount of checks. Early in 1998 we plan to introduce the "Dinoro," a special account for children. The average per branch deposit size increased 17% to $48.1 million in 1997, versus $40.9 million in 1996. o During 1997 we completed the remodeling of the seven branches acquired from another bank in a prior year. We also completed our 13,000 square foot Operations Center in Bayamon, and expanded our main building in Hato Rey by about 10,000 square feet. As part of the Hato Rey work, we constructed a parking facility for approximately 350 cars. In January 1998 we began a new expansion of our central offices to increase their total size to 68,000 square feet. 13 o Shareholders' equity of $138.1 million as of December 31, 1997, was up 19% from $115.6 million in 1996. Core capital represented 9.16% of our total assets, and risk based capital 17.85% (on a consolidated basis), substantially exceeding the minimums required by our regulators. We are pleased with the Company's results for 1997. We significantly increased loan originations and added to our inventory $446.1 million of unsold loans on our balance sheet to expand our earning-assets base, resulting in record total assets of $1.5 billion. These accomplishments led to strong growth in revenues and net income, and should also translate into future increased profitability. We believe that the Company's dominant position in the mortgage sector, combined with its rapidly expanding banking operation and subprime business, will continue producing asset and earnings growth in the future. This will boost the value of our shares . The future is bright for R-G. Market demand is strong accross all our business lines, and we have the internal and external financial resources we need to continue our planned growth. As always, I am grateful for the support of our shareholders, customers and employees, and the guidance of our Board of Directors. R-G Financial intends to remain a leader in banking and mortgage banking in Puerto Rico, and a leader in providing customer satisfaction, as has been during these initial 25 years. We expect 1998 to be another very good year for R-G in 1998, which will translate into long-term value for our stockholders. Very truly yours, /s/Victor J. Galan Victor J. Galan 14 Providing Customer Satisfaction Through Diverse Locations A good branch network is critical for any institution which offers community and mortgage banking in Puerto Rico. During 1997, R-G continued to expand the number of its branches. During 1998 we will extend our existing branch structure in three important markets within the metropolitan San Juan area- Guaynabo, where we will open one additional branch at Pinero and Martinez Nadal Avenues; Rio Piedras with another branch at El Senorial; and Bayamon, with one branch in Plaza del Sol Shopping Center. We will also open branch offices outside of metropolitan San Juan -in Ponce, Caguas and Fajardo. These six additional branches will give us a market presence in 21 different locations after we consolidate certain existing branches. In addition, we are planning to remodel our present branches in San Patricio and Bayamon (Betances Avenue branch), providing additional space and drive-in facilities for our clients. We are in the process of building new locations or acquiring existing facilities to continue expanding at our current rate of five new branches per year on average. Home Office: Mayaguez Hato Rey McKinley Street 280 Jesus T. Pinero Dr. Vady Corner Branches: Vega Baja Hato Rey Cabo Caribe Development 280 Jesus T. Pinero Road #2 Marginal San Patricio Norte Shopping Center Gonzalez Giusti Ave. Baldorioty de Castro Ave. Guaynabo Santurce #1077 Ponce de Leon Ave. Los Jardines Shopping Center Plaza Carolina Bayamon Plaza Carolina Mall #42-43 Betances Ave. Hermanas Davila Caguas Degetau D-9 Trujillo Alto San Alfonso Development Trujillo Alto Plaza Fajardo Carolina #51 Celis Aguilera Street 65 Infantry Ave. San Marco Ponce Las Americas Ave. Manati #25 Buena Vista Exit Puerta del Sol Plaza Road #2, km. 49.7 Bayamon II Aguas Buenas Ave. Arecibo Lot #40 Vista Azul Marginal Minillas Industrial Development San Daniel Ave. Corner Laguna Gardens Laguna Gardens Shopping Center 15 Providing Customer Satisfaction Through Technological Advances We want customers to have the most convenient service possible, no matter how and where they bank with us. As the world speeds up, there is less time for routine tasks such as banking. Technology enables customers to bank with R-G virtually any hour of the day, from almost anywhere. Electronic tools allow funds to be managed nearly at the speed of thought. R-G's effective management of support operations depends largely on how it approaches technology. For R-G, therefore, technology creates another competitive advantage. We believe that a sophisticated technology platform is essential to support our continued growth. Our strong technological systems will enable us to increase our revenues, run our operations more effectively and better serve our customers. Continually expanding and improving these systems, therefore, is an important priority for our Company. For example, we are continuing to expand the use of technology in our credit card, personal loan and mortgage-refinancing operations. We have improved the software supporting our inbound and outbound telemarketing efforts. And we have organized an Electronic Branch responsible for marketing point-of-sale terminals, cash management systems for commercial operations, and PC and Internet banking services. During 1997 we installed credit-scoring systems in our mortgage and banking subsidiaries. One of these systems, which we created, consists of proprietary scoring cards that allow our Underwriting Department to approve or reject any type of loan in a very short period of time. Other credit-scoring systems are the ones used by Fannie Mae and Freddie Mac. Additionally, all our branches have been interconnected with our Consumer Department. 16 With these technological advances, we have improved the efficiency of our operations and expedited the processing of new loan applications. Most loan approvals, for example, are now extended in no more than one hour. By using technology, we have also expedited the sale of conforming loans in the secondary market. We provide full service electronic banking support to all our customers. Our remote banking system can process customer transactions (such as account inquiries and statement downloads) through a telephone automatic response system, through dedicated PC banking and through the Internet. Last year, the automatic voice response system was expanded to handle bill payments. And we are also providing interactive banking services via Internet and PC Banking. In 1997 we completed the installation of our Imaging system, which automatically reads all transactions that are processed in our Proof and Transit Department. We also installed special touch-screen terminals in all our branches to give customers access to information about their bank accounts. Since June 1997, all clients have been receiving photocopies of their checks in their monthly statements or on a diskette from which they can copy the image of checks processed onto their personal computers. 17 Providing Customer Satisfaction Through Electronic Banking We live in a world of ever-changing technology, which directly affects the banking business. Opportunities arise rapidly, and we are constantly challenged to determine which ones offer the best prospects for growth and customer satisfaction. We continuously search for new ways to provide superior service by staying ahead of technology and staying ahead of market needs. For example, as a complement to our electronic transfers system, in 1996 we introduced Cash Management, a state-of-the-art software package through which commercial customers can execute certain transactions from their own premises directly into their account. In 1997 the Company also introduced a proprietary PC Banking software package which has exceeded expectations. The ATM card introduced in 1995 is now being used by 19,000 account holders. The card gives customers the flexibility to have their purchases automatically debited to their checking accounts. Over 960,000 purchases have been made through this method. In 1997 we gave customers the added convenience of paying bills by phone ("Phono Pago"). The number of such transactions has grown to more than 3,000 per month and continues to increase. 18 Providing Customer Satisfaction Through Personal Service With less time than ever for routine tasks, and faced with a barrage of competitive messages, consumers look for banking companies they can trust and with whom they can build long-lasting relationships. They want the highest-quality service, and one-stop-shop access to a full array of banking services: checking, savings, loans, mortgages, credit cards. Satisfying all these needs is our mission and passion. We provide not only convenience, speed and competitive prices - but personal attention as well. Residential mortgage lending remains the bedrock of our business. Over the last 25 years we have provided satisfaction to 150,000 customers by helping them purchase their homes. We have constantly applied the knowledge gained during those years to make our service even better - through extended hours, drive-through branches, deposit slots for mortgage payments and additional locations. Through the use of technology, we have shortened the time it takes to get a mortgage and close on a purchase. By continuously improving and innovating in our mortgage programs and branch services, we have remained at the forefront of the mortgage business in Puerto Rico. 19 Providing Customer Satisfaction Through New Housing New housing was our initial pillar. In our early years we arranged interim financing for builders with local and US banks or REITS (real estate investment trusts), and provided the end loans after completion of construction. Today we offer the full gamut of services to builders and developers of new housing, including land and development loans, construction loans and permanent loans for residential and commercial properties. 1. Altamira Fajardo, PR 58 units o Average selling price of $93,500 Provided interim construction loan and permanent financing in the amount of $3,939,000. 2. Ciudad Cristiana Humacao , PR 158 units o Average selling price of $47,000. Providing interim construction loan for the rehabilitation and site improvements and permanent financing in the amount of $4,450,000. Obtained affordable Housing Program Grant from the Federal Home Loan Bank of New York in the amount of $455,000 for downpayment and closing cost assistance. 3. Villas de Cambalache Rio Grande , PR 254 units o Average selling price of $95,000 Participating in the interim financing and providing permanent financing in the amount of $23,000,000 4. Valle Costero Santa Isabel, PR 281 units o Average selling price of $65,000 Providing permanent financing in the amount of $17,500,000 5. Ciudad Real Vega Baja, PR 320 units o Average selling price of $90,000. Providing permanent financing in the amount of $28,000,000. 6. Alborada, El Condominio Bayamon , PR 252 units o Average selling price of $110,000 Providing permanent financing in the amount of $26,500,000. 7. Villas de Buenaventura Yabucoa, PR 500 units o Average selling price of $64,000 Providing permanent financing in the amount of $31,000,000. Affordable housing units with downpayment and interest subsidies from the Puerto Rico Housing Bank. 20 8. Berwind Beach Resort Rio Grande, PR 104 units o Average selling price of $150,000. Provided land acquisition loan and permanent financing in the amount of $14,000,000. 9. Los Flamboyanes Gurabo, PR 315 units o Average selling price of $85,000 Providing permanent financing in the amount of $28,000,000 10. Borinquen Valley Caguas, PR 188 units o Average selling price of $60,000 Participating in the interim financing and providing permanent financing in the amount of $11,200,000. 11. Montecasino Heights Toa Alta, PR 497 units o Average selling price of $110,000 Providing permanent financing in the amount of $50,000,000. 12. Chalets de Cupey Rio Piedras, PR 96 units o Average selling price of $115,000 Providing permanent financing in the amount of $11,000,000. 21 [BLANK] 22 SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA OF R&G FINANCIAL The following table presents selected consolidated financial and other data of R&G Financial for each of the five years in the period ended December 31, 1997. The selected consolidated financial data should be read in conjunction with the Consolidated Financial Statements of R&G Financial, including the accompanying Notes, presented elsewhere herein. In the opinion of management, this information reflects all adjustments, consisting only of normal recurring accruals and adjustments, necessary for a fair presentation.
At or For the Year Ended December 31, 1997 1996 1995 1994 1993 - ------------------------------------------------------------------------------------------------------------------------------------ (Dollars in Thousands, except for per share data) Selected Balance Sheet Data: Total assets(1) $1,510,746 $1,037,798 $ 853,206 $622,499 $538,069 Loans receivable, net 765,059 603,751 473,841 301,614 216,620 Mortgage loans held for sale 46,885 54,450 21,318 22,021 174,221 Mortgage-backed and investment securities held for trading 401,039 110,267 113,809 124,522 -- Mortgage-backed securities available for sale 46,004 50,841 61,008 13,300 10,241 Mortgage-backed securities held to maturity 33,326 37,900 41,731 84,122 39,122 Investment securities available for sale 75,863 30,973 3,280 1,878 -- Investment securities held to maturity 10,693 5,270 2,046 2,182 4,957 Cash and cash equivalents(2) 68,366 98,856 104,195 45,622 66,958 Deposits 722,418 615,567 518,187 380,148 312,151 Securities sold under agreements to repurchase 382,283 97,444 98,483 108,922 -- Notes payable 159,304 126,842 81,130 45,815 133,913 Other borrowings(3) 76,359 65,463 67,315 18,092 14,479 Subordinated notes(4) 3,250 3,250 3,250 3,250 3,071 Stockholders' equity 138,054 115,633 66,385 55,970 49,531 Stockholders' equity per share(5) $ 9.76 $ 8.17 $ 7.11 $ 5.99 $ 5.30 Selected Income Statement Data: Revenues: Net interest income after provision for loan losses $ 30,160 $ 24,665 $ 20,323 $ 19,137 $ 14,253 Loan administration and servicing fees 13,214 13,029 11,030 11,046 9,326 Net gain on sale of investments available for sale 107 642 -- -- 394 Net gain on sale of loans and servicing rights 24,033 11,709 8,384 2,899 29,026 Other(6) 3,751 3,872 4,028 1,667 1,179 - ------------------------------------------------------------------------------------------------------------------------------------ Total revenue 71,265 53,917 43,765 28,951 54,178 - ------------------------------------------------------------------------------------------------------------------------------------ Expenses: Employee compensation and benefits 13,653 10,793 8,284 5,252 8,590 Office occupancy and equipment 7,131 5,531 4,711 4,488 3,395 SAIF special assessment -- 2,508 -- -- -- Other administrative and general 18,252 15,424 13,731 13,269 14,561 - ------------------------------------------------------------------------------------------------------------------------------------ Total expenses 39,036 34,257 26,726 23,009 26,546 - ------------------------------------------------------------------------------------------------------------------------------------ At or For the Year Ended December 31, 1997 1996 1995 1994 1993 - ------------------------------------------------------------------------------------------------------------------------------------ Income before minority interest in the Bank and income taxes 32,229 19,660 17,039 5,942 27,632 Minority interest in the Bank's earnings -- 538 743 500 812 Income taxes 8,732 5,922 5,847 856 9,633 Cumulative effect of change in accounting principle -- -- -- 867 -- - ------------------------------------------------------------------------------------------------------------------------------------ Net income $ 23,497 $ 13,200(7) $ 10,449 $ 5,452 $ 17,187 - ------------------------------------------------------------------------------------------------------------------------------------ Diluted earnings per share(5) $ 1.62 $ 1.19(7) $ 1.12 $ 0.58 $ 1.84 - ------------------------------------------------------------------------------------------------------------------------------------ Selected Operating Data(8): Performance Ratios and Other Data: Mortgage loans originated(9) $ 545,960 $ 426,874 $ 306,775 $ 488,071 $ 834,680 Loan servicing portfolio 3,000,888 2,550,169 2,298,200 2,114,743 2,000,530 Return on average assets(8) 1.85% 1.38% 1.47% 0.91% 4.07% Return on average equity(8) 18.69 15.54 17.08 10.34 41.98 Equity to assets at end of period 9.13 11.14 7.78 8.94 9.21 Interest rate spread(10) 2.88 3.00 2.93 3.24 3.66 Net interest margin(10) 3.12 3.24 3.26 3.48 3.92 Average interest-earning assets to average interest-bearing liabilities 104.61 104.60 106.50 105.60 106.08 Total other expenses to average total assets 3.08 3.59 3.80 3.84 6.29 Full-service Bank offices 15 15 14 8 8 R&G Mortgage offices(11) 11 11 12 12 13 Cash dividends declared per share .13 .14(12) -- -- -- Asset Quality Ratios(13): Non-performing loans to total loans at end of period 3.89% 3.09% 2.18% 1.84% 2.24% Non-performing assets to total assets at end of period 2.12 1.90 1.32 1.04 1.07 Allowance for loan losses to total loans at end of period 0.87 0.55 0.72 0.92 1.34 Allowance for loan losses to total non-performing loans at end of period 22.34 17.64 33.19 50.10 59.87 Bank Regulatory Capital Ratios(14): Tier 1 risk-based capital ratio 13.10% 13.91% 10.53% 11.03% N/A Total risk-based capital ratio 14.00 14.79 11.66 13.59 N/A Tier 1 leverage capital ratio 7.34 8.45 6.25 5.95 N/A
24 - ------------------ (1) At December 1997, R&G Mortgage and the Bank had total assets of $489.3 million and $996.3 million, respectively, before consolidation. (2) Comprised of cash and due from banks, securities purchased under agreements to resell, time deposits with other banks and federal funds sold, all of which had original maturities of 90 days or less. (3) Comprised of long-term debt, advances from the Federal Home Loan Bank ("FHLB") of New York and other secured borrowings. See Notes 10 and 11 of R&G Financial's Notes to Consolidated Financial Statements. (4) Represents a seven-year subordinated capital note of the Bank issued in 1991, which is subject to an annual sinking fund requirement. See Note 12 of R&G Financial's Notes to Consolidated Financial Statements. (5) As adjusted to reflect stock split declared by the Company effective September 25, 1997. See Note 14 of R&G Financial's Notes to Consolidated Financial Statements. (6) Comprised of change in provision for cost in excess of market value of loans available for sale, net gain on trading account, and other miscellaneous revenue sources, including Bank service charges, fees and other income. (7) Includes one time special Savings Association Insurance Fund ("SAIF") assessment of $2,508,380 or $1,642,990 after tax ($0.15 per share on a diluted basis) incurred in the September 1996 quarter to recapitalize the SAIF of the Federal Deposit Insurance Corporation ("FDIC"). Without giving effect to this one-time special assessment, net income and diluted earnings per share would have been $14,842,507 and $1.34, respectively, and return on average assets and return on average equity would have been 1.55% and 17.48%, respectively. (8) With the exception of end of period ratios, all ratios for R&G Mortgage are based on the average of month end balances while all ratios for the Bank are based on average daily balances. All ratios are annualized where appropriate. (9) Represents total originations by R&G Mortgage for the Bank as well as loans originated and sold to third parties. (10) Interest rate spread represents the difference between R&G Financial's weighted average yield on interest-earning assets and the weighted average rate on interest-bearing liabilities. Net interest margin represents net interest income as a percent of average interest-earning assets. See "Management's Discussion and Analysis of Financial Condition and Results of Operations of R&G Financial." (11) R&G Mortgage maintains a total of 11 offices that are separate from Bank branch offices. A total of seven of these offices are located in the same building or facility as the Bank branch. The table does not include an additional seven Mortgage Banking Centers which are located in the Bank's offices. (12) Includes $500,000 or $0.05 per share paid on the Class A Common Stock in March 1996 prior to the Company's initial public offering. Amount is based on weighted average number of shares of Common Stock (Class A and Class B) outstanding. (13) Non-performing loans consist of R&G Financial's non-accrual loans and non-performing assets consist of R&G Financial's non-performing loans and real estate acquired by foreclosure or deed-in-lieu thereof. The increase in non-performing loans during 1997 is a function of the increase in the size of the Bank's loan portfolio, as well as to a significant increase in recent years in the level of non-performing residential real estate loans due to delays in the foreclosure process. Excluding the residential loan portfolio, the allowance for loan losses to total non-performing loans at December 31, 1997 amounted to 60.5%. (14) All of such ratios were in compliance with the applicable requirements of the FDIC. Prior to 1994, the Bank operated as a savings and loan association. As such, the Bank was subject to the capital ratios of the Office of Thrift Supervision and not those of the FDIC and was at all times in capital compliance therewith. 25 Management Discussion and Analysis of Financial Condition and Results of Operations of R&G Financial General R&G Financial, through its subsidiaries, is primarily engaged in a wide range of real estate secured lending activities, including the origination, servicing, purchase and sale of mortgages on single-family residences, the securitization and sale of various mortgage-backed and related securities and the holding and financing of mortgage loans and mortgage-backed and related securities for sale or investment. R&G Financial also originates for its portfolio commercial real estate loans, residential construction loans, commercial business loans and consumer loans. Finally, R&G Financial provides a variety of trust and investment services to its customers. R&G Financial has generally sought to achieve long-term financial strength and profitability by increasing the amount and stability of its net interest income and other non-interest income. R&G Financial has sought to implement this strategy by (i) establishing and emphasizing the growth of its mortgage banking activities, including growing its loan servicing operation; (ii) expanding its retail banking franchise (the Bank has expanded its branch system from two offices at February 1990 to 15 offices at December 31, 1997) and, without taking into consideration possible branch acquisition opportunities, the Bank presently anticipates opening approximately three branches per year during the next several years, all in order to achieve increased market presence and to increase core deposits; (iii) enhancing R&G Financial's net interest income by increasing R&G Financial's loans held for investment, particularly single-family residential loans; (iv) developing new business relationships through an increased emphasis on commercial real estate and commercial business lending; (v) diversifying R&G Financial's retail products and services, including an increase in consumer loan originations (such as credit cards); (vi) meeting the banking needs of its customers through, among other things, the offering of trust and investment services; and (vii) controlled growth and the pursuit of a variety of acquisition opportunities when appropriate. R&G Financial attempts to control its overall operating expenses, notwithstanding R&G Financial's recent growth and expansion activities. Asset and Liability Management General. Changes in interest rates can have a variety of effects on R&G Financial's business. In particular, changes in interest rates affect the volume of mortgage loan originations, the interest rate spread on loans held for sale, the amount of gain on the sale of loans, the value of R&G Mortgage's loan servicing portfolio and the Bank's net interest income. A substantial increase in interest rates could also affect the volume of R&G Mortgage's loan originations for both the Bank and third parties by reducing the demand for mortgages for home purchases, as well as the demand for refinancings of existing mortgages. Conversely, a substantial decrease in interest rates will generally increase the demand for mortgages. To the extent that interest rates in future periods were to increase substantially, R&G Financial would expect overall originations to decline. A decrease in the volume of R&G Financial's mortgage originations could result in a decrease in the amount of R&G Mortgage's mortgage origination income and portfolio generated net interest income to the Bank. The principal objective of R&G Financial's asset and liability management function is to evaluate the interest-rate risk included in certain balance sheet accounts, determine the appropriate level of risk given R&G Financial's business focus, operating environment, capital and liquidity requirements and performance objectives, establish prudent asset concentration guidelines and manage the risk consistent with Board approved guidelines. Through such management, R&G 26 Financial seeks to reduce the vulnerability of its operations to changes in interest rates and to manage the ratio of interest rate sensitive assets to interest rate sensitive liabilities within specified maturities or repricing dates. The Bank's asset and liability management function is under the guidance of the Interest Rate Risk, Budget and Investments Committee ("IRRBICO"), which is chaired by the Chief Executive Officer and comprised principally of members of the Bank's senior management and at least three members of the Board of Directors. The IRRBICO meets once a month to review, among other things, the sensitivity of the Bank's assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activity and maturities of investments and borrowings. In connection therewith, the IRRBICO generally reviews the Bank's liquidity, cash flow needs, maturities of investments, deposits and borrowings and current market conditions and interest rates. The Bank's primary IRRBICO monitoring tool is asset/liability simulation models, which are prepared on a monthly basis and are designed to capture the dynamics of balance sheet, rate and spread movements and to quantify variations in net interest income under different interest rate environments. The Bank also utilizes market-value analysis, which addresses the change in equity value arising from movements in interest rates. The market value of equity is estimated by valuing the Bank's assets and liabilities. The extent to which assets have gained or lost value in relation to the gains or losses of liabilities determines the appreciation or depreciation in equity on a market-value basis. Market value analysis is intended to evaluate the impact of immediate and sustained interest-rate shifts of the current yield curve upon the market value of the current balance sheet. A more conventional but limited IRRBICO monitoring tool involves an analysis of the extent to which assets and liabilities are "interest rate sensitive" and measuring an institution's interest rate sensitivity "gap." An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity "gap" is defined as the difference between interest-earning assets and interest-bearing liabilities maturing or repricing within a given time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds interest rate sensitive assets. During a period of rising interest rates, a negative gap would tend to adversely affect net interest income, while a positive gap would tend to result in an increase in net interest income. During a period of falling interest rates, a negative gap would tend to result in an increase in net interest income, while a positive gap would tend to affect net interest income adversely. At December 31, 1997, R&G Financial's interest-bearing liabilities which mature or reprice within one year exceeded R&G Financial's interest-earning assets with similar characteristics by $202.2 million, or 13.38% of total assets. While a conventional gap measure may be useful, it is limited in its ability to predict trends in future earnings. It makes no presumptions about changes in prepayment tendencies, deposit or loan maturity preferences or repricing time lags that may occur in response to a change in the interest rate environment. R&G Mortgage. The profitability to R&G Mortgage of its mortgage loan originations is in part a function of the difference between long-term interest rates, which is the rate at which R&G Mortgage originates mortgage loans for third parties, and short-term interest rates, which is the rate at which R&G Mortgage finances such loans until they are sold. Generally, short-term interest rates are lower than long-term interest rates and R&G Mortgage benefits from the difference, or the spread, during the time the mortgage loans are held by R&G Mortgage pending sale. A decrease in this spread would have a negative effect on R&G Mortgage's net interest income and profitability, and there can be no assurance that the spread will not decrease. R&G Mortgage generally attempts to reduce this risk by attempting to limit the amount of mortgage loans held pending sale and, as market conditions permit, entering into forward commitments with respect to a portion of its mortgage loan originations. As a general matter, R&G Mortgage attempts to limit its exposure to this interest rate risk through the sale of substantially all loans within 180 days of origination. A mortgage-banking company is generally exposed to interest rate risk from the time the interest rate on the customer's mortgage loan application is established through the time the mortgage loan closes, and until the time the company commits to sell the mortgage loan. In order to limit R&G Mortgage's exposure to interest rate risk through the time the mortgage loan closes, R&G Mortgage generally does not lock-in or guarantee the customer a specific interest rate on such loans through the closing date but rather offers customers an interest rate that will be based on a prevailing market rate that adjusts weekly. Moreover, in order to limit R&G Mortgage's exposure to interest rate risk through the time the loan is sold or committed to be sold, R&G Mortgage may, depending upon market conditions, enter into forward commitments to sell a portion of its mortgage loans to investors for delivery at a future time. At December 31, 1997, R&G Mortgage had $17.8 million of pre-existing commitments by third-party investors to purchase mortgage loans. To the extent that R&G Mortgage originates or commits to originate loans without pre-existing commitments by investors to purchase such loans or is not otherwise hedged against changes in interest rates ("unhedged loans"), R&G Mortgage will be subject to the risk of gains or losses through adjustments to the carrying value of loans held for sale or on the actual sale of such loans (the value of unhedged loans fluctuates inversely with changes in interest rates). Finally, R&G Mortgage carries an inventory of mortgage-backed and related securities (primarily fixed-rate GNMA certificates). Generally, the value of fixed-rate mortgage-backed securities declines when interest rates rise and, conversely, increases when interest rates fall. At December 31, 1997, R&G Mortgage held $398.8 million of mortgage-backed and related securities (all of which carried fixed interest rates) which were classified as held for trading and reported at fair value, with unrealized gains and losses included in earnings. Accordingly, declines in the value of R&G Mortgage's securities held for trading could have a negative impact on R&G Financial's earnings regardless of whether any securities were actually sold. In order to hedge the interest rate risk with respect to R&G Mortgage's mortgage-backed and related securities portfolio, R&G Mortgage may utilize a variety of interest rate contracts such as interest rate swaps, collars, caps, options or futures (primarily Eurodollar certificates of deposit and U.S. Treasury note contracts). R&G Mortgage will use such hedging instruments based upon market conditions as well as the level of market rates of interest. In determining the amount of its portfolio to hedge, R&G Mortgage will consider the volatility of prices of its mortgage-backed and related securities (Puerto Rican tax-exempt GNMAs are generally less volatile than their U.S. counterparts). For taxable GNMAs, R&G Mortgage enters into forward sales commitments for 30, 60 and 90 days to reduce its interest rate risk. At December 31, 1997, R&G Mortgage was not a party to any interest rate swaps, collars, caps, floors, options or futures. 27 The Bank. The results of operations of the Bank are substantially dependent on its net interest income, which is the difference between the interest income earned on its interest-earning assets and the interest expense paid on its interest-bearing liabilities. At December 31, 1997, the Bank's interest-earning assets included a portfolio of loans receivable, net (not including mortgage loans held for sale) of $733.1 million and a portfolio of investment securities and mortgage-backed securities (including held to maturity, held for trading and available for sale) of $167.5 million. Because the Bank's interest-earning assets have longer effective maturities than its interest-bearing liabilities, the yield on the Bank's interest-earning assets generally will adjust more slowly than the cost of its interest-bearing liabilities and, as a result, the Bank's net interest income generally would be adversely affected by increases in interest rates and positively affected by comparable declines in interest rates. In addition to affecting net interest income, changes in interest rates also can affect the value of the Bank's interest-earning assets, which are comprised of fixed and adjustable-rate instruments. At December 31, 1997, $1.6 million or 1.0% of the Bank's mortgage-backed and investment securities were classified as held for trading (which consisted solely of mortgage-backed and related securities), and are reported at fair value, with unrealized gains and losses included in earnings. In addition, at December 31, 1997, $121.9 million or 72.7% of the Bank's mortgage-backed and investment securities were classified as available for sale and are reported at fair value, with unrealized gains and losses excluded from earnings and reported net of taxes as a separate component of stockholders' equity. The Bank has sought to limit its exposure to interest rate risk both internally through the management of the composition of its assets and liabilities and externally through the use of a variety of hedging instruments. Internal hedging through balance sheet restructuring generally involves the attraction of longer-term funds (i.e., certificates of deposit, FHLB advances or 936 Notes), the origination of adjustable-rate and/or shorter-term loans (such as commercial real estate, commercial business and consumer loans) or the investment in certain types of mortgage-backed derivative securities such as CMOs and mortgage-backed residuals (which often exhibit elasticity and convexity characteristics which the Bank can utilize to hedge other components of its portfolio). External hedging involves the use of interest rate swaps, collars, caps, options and futures to reduce interest rate risk on all mortgage-backed securities (excluding CMOs) which are available for sale. At December 31, 1997, mortgage-backed securities available for sale had a fair value of $46.0 million. The Bank generally uses interest rate swaps, collars, caps, options and futures to effectively fix the cost of short-term funding sources which are used to purchase interest-earning assets with longer effective maturities, such as mortgage-backed securities and fixed-rate residential mortgage loans which do not meet the criteria for sale to the FNMA or the FHLMC in the secondary market. Such agreements thus reduce the impact of increases in interest rates by preventing the Bank from having to replace funding sources at a higher cost prior to the time that the interest-earning asset which was acquired with such source matures or reprices and thus can be replaced with a higher-yielding asset. At December 31, 1997, the Bank was a party to three interest rate swap agreements. An interest rate swap is an agreement where one party (generally the Bank) agrees to pay a fixed-rate of interest on a notional principal amount to a second party (generally a broker) in exchange for receiving from the second party a variable-rate of interest on the same notional amount for a predetermined period of time. No actual assets are exchanged in a swap of this type and interest payments are generally netted. The Bank's existing interest rate swap agreements have an aggregate notional amount of approximately $50.0 million and expire from September 17, 1999 to October 9, 2001. With respect to such agreements, the Bank makes fixed interest payments ranging from 5.06% to 5.79% and receives payments based upon the three-month London Interbank Offer Rate ("LIBOR") and Libid. The net expense (income) relating to the Bank's fixed-pay interest rate swaps amounted to approximately $293,000, $61,000 and $(187,000) during the years ended December 31, 1997, 1996 and 1995, respectively. Such interest rate contracts have reduced the imbalance between the Bank's interest-earning assets and interest-bearing liabilities within shorter maturities, thus, reducing the Bank's exposure to increases in interest rates that may occur in the future. As discussed above, the Bank may also enter into interest rate collars, caps, options and futures. However, at December 31, 1997, the Bank was not a party to any such interest rate contracts. An interest rate cap consists of a guarantee given by one party, referred to as the issuer (i.e., a broker), to another party, referred to as the purchaser (i.e., the Bank), in exchange for the payment of a premium, that if interest rates rise above a specified rate on a specified interest rate index, the issuer will pay to the purchaser the difference between the then current market rate and the specified rate on a notional principal amount for a predetermined period of time. No funds are actually borrowed or repaid. Similarly, an interest rate collar is a combination of a purchased cap and a written floor at different rates. Accordingly, an interest rate collar requires no payments if interest rates remain within a specified range, but will require the Bank to be paid if interest rates rise above the cap rate or require the Bank to pay if interest rates fall below the floor rate. Interest rate futures are commitments to either purchase or sell designated instruments (such as Eurodollar certificates of deposit and U.S. Treasury note contracts) at a future date for a specified price. Futures contracts are generally traded on an exchange, are marked to market daily and subject to initial and maintenance margin requirements. Options are contracts which grant the purchaser the right to buy or sell the underlying asset by a certain date for a specified price. 28 The following table summarizes the anticipated maturities or repricing of R&G Financial's interest-earning assets and interest-bearing liabilities as of December 31, 1997, based on the information and assumptions set forth in the notes below.
Four to More Than More Than Within Three Twelve One Year to Three Years Over Five Months Months Three Years to Five Years Years Total (Dollars in Thousands) Interest-earning assets(1): Loans receivable: Residential real estate loans $ 34,807 $ 67,276 $ 109,729 $ 81,473 $ 200,416 $ 493,701 Construction loans 1,567 5,582 -- -- -- 7,149 Commercial real estate loans 84,522 72 219 271 2,428 87,512 Consumer loans 21,873 43,179 53,351 18,852 7,104 144,359 Commercial business loans 38,481 117 -- -- -- 38,598 Mortgage loans held for sale 7,272 21,707 17,693 -- -- 46,672 Mortgage-backed securities(2)(3) 63,013 179,139 130,547 51,478 44,405 468,582 Investment securities(3) 27,785 54,062 1,477 1,660 2,137 87,121 Other interest-earning assets(4) 35,759 -- -- -- -- 35,759 - ------------------------------------------------------------------------------------------------------------------------------------ Total $ 315,079 $ 371,134 $ 313,016 $ 153,734 $ 256,490 $1,409,453 ==================================================================================================================================== Interest-bearing liabilities: Deposits(5): NOW and Super NOW accounts(6) $ 4,764 $ 13,340 $ 14,666 $ 11,880 $ 50,644 $ 95,294 Passbook savings accounts(6) 2,073 5,917 13,611 11,025 47,003 79,629 Checking and commercial checking(6) 4,575 12,809 14,082 11,407 48,631 91,504 Certificates of deposit 129,485 218,321 69,994 27,539 9,054 454,393 FHLB advances 42,000 -- -- -- -- 42,000 Reverse repurchase agreements(7) 392,283 -- -- -- -- 392,283 Other borrowings(8) 92,214 20,599 84,100 -- -- 196,913 - ------------------------------------------------------------------------------------------------------------------------------------ Total 667,394 270,986 196,453 61,851 155,332 1,352,016 - ------------------------------------------------------------------------------------------------------------------------------------ Effect of hedging instruments (50,000) -- 10,000 40,000 -- -- - ------------------------------------------------------------------------------------------------------------------------------------ $ 617,394 $ 270,986 $ 206,453 $ 101,851 $ 155,332 $1,352,016 ==================================================================================================================================== Excess (deficiency) of interest-earning assets over interest-bearing liabilities $ (302,315) $ 100,148 $ 106,563 $ 51,883 $ 101,158 -- ==================================================================================================================================== Cumulative excess (deficiency) of interest-earning assets over interest-bearing liabilities $ (302,315) $ (202,167) $ (95,604) $ (43,721) $ 57,437 -- ==================================================================================================================================== Cumulative excess (deficiency) of interest-earning assets over interest-bearing liabilities as a percent of total assets (20.01)% (13.38)% (6.33)% (2.89)% 3.80% -- ====================================================================================================================================
29 - ---------------- (1) Adjustable-rate loans are included in the period in which interest rates are next scheduled to adjust rather than in the period in which they are due, and fixed-rate loans are included in the periods in which they are scheduled to be repaid, based on scheduled amortization, in each case as adjusted to take into account estimated prepayments based on forecasts used by the OTS in their model for market value of portfolio equity ("MVPE") discussed below. (2) Reflects estimated prepayments in the current interest rate environment. (3) Includes securities held for trading, available for sale and held to maturity. (4) Includes securities purchased under agreement to resell, time deposits with other banks and federal funds sold. (5) Does not include non-interest-bearing deposit accounts. (6) Although the Bank's negotiable order of withdrawal ("NOW") and Super NOW accounts, passbook savings accounts and checking accounts are subject to immediate withdrawal, management considers a substantial amount of such accounts to be core deposits having significantly longer effective maturities based on the Bank's retention of such deposits in changing interest rate environments. The above table assumes that funds will be withdrawn from the Bank at annual rates for NOW accounts and for checking and commercial checking accounts, ranging from 10% for 0-12 months, 19% for 1-5 years, 41% for 5-10 years, 65% for 10-20 years and 100% thereafter; and, for passbook savings accounts, ranging from 5% for 0-12 months, 19% for 1-5 years, 40% for 5-10 years, 65% for 10-20 years and 100% thereafter. (7) Includes $10,000,000 federal funds purchased. (8) Comprised of warehousing lines and notes payable, subordinated notes and other secured borrowings. Although "gap" analysis is a useful measurement device available to management in determining the existence of interest rate exposure, its static focus as of a particular date makes it necessary to utilize other techniques in measuring exposure to changes in interest rates. For example, gap analysis is limited in its ability to predict trends in future earnings and makes no presumptions about changes in prepayment tendencies, deposit or loan maturity preferences or repricing time lags that may occur in response to a change in the interest rate environment. As a result, R&G Financial, through simulation models, also analyzes on a monthly basis the estimated effects on net interest income and equity under multiple rate scenarios, including increases and decreases in interest rates amounting to 400, 300, 200 and 100 basis points. The IRRBICO regularly review interest rate risk by forecasting the impact of alternative interest rate scenarios on net interest income and on R&G Financial's MVPE, which is defined as the net present value of an institution's existing assets, liabilities and off-balance sheet instruments, and by evaluating such impact against the maximum potential changes in net interest income and MVPE. The following table sets forth at December 31, 1997 the estimated percentage change in R&G Financial's MVPE based on the indicated changes in interest rates.
MVPE(2) - -------------------------------------------------------------------------------- Change in Change as a Interest Rates Percentage Percentage (in Basis Points)(1) Amount of Change Change of Assets - -------------------------------------------------------------------------------- (Dollars in Thousands) +400 $(33,853) (25.8)% (2.24)% +300 (24,997) (19.1) (1.65) +200 (16,371) (12.5) (1.08) +100 (8,127) (6.2) (.54) -- -- -- -- -100 15,367 11.7 1.02 -200 30,577 23.3 2.02 -300 47,891 36.5 3.17 -400 88,716 67.7 5.87
- -------------- (1) Assumes an instantaneous uniform change in interest rates at all maturities. (2) Based on R&G Financial's pre-tax MVPE of $131.1 million at December 31, 1997, which is approximately $7.0 million below R&G Financial's stockholders' equity calculated in accordance with generally accepted accounting principles as of such date. Management of R&G Financial believes that all of the assumptions used in the foregoing analysis to evaluate the vulnerability of its operations to changes in interest rates approximate actual experience and considers them reasonable; however, the interest rate sensitivity of R&G Financial's assets and liabilities and the estimated effects of changes in interest rates on R&G Financial's net interest income and MVPE indicated in the above table could vary substantially if different assumptions were used or if actual experience differs from the projections on which they are based. Changes in Financial Condition General. At December 31, 1997, R&G Financial's total assets amounted to $1.5 billion, as compared to $1.0 billion at December 31, 1996. The $473 million or 45.6% increase in total assets during the year ended December 31, 1997 was primarily the result of a $161.3 million or 26.7% increase in loans receivable, net, and a $292.3 million or 270.3% increase in mortgage-backed securities held for trading, which are attributable to the origination of $906.3 million of loans, primarily single-family residential loans, before reduction for repayments and sales, and a $40.1 million increase in securities available for sale, which is primarily the result of purchases during the year of approximately $42.0 million of such securities, net of maturities and sales. 30 Cash and Money Market Investments. Cash and money market investments (consisting of cash and due from banks, securities purchased under agreements to resell, time deposits with other financial institutions and federal funds sold) amounted to $68.4 million and $98.9 million as of December 31, 1997 and 1996, respectively. Loans Receivable and Mortgage Loans Held for Sale. At December 31, 1997, R&G Financial's loans receivable, net amounted to $765.1 million or 50.6% of total assets, as compared to $603.8 million or 58.2% as of December 31, 1996. The growth in R&G Financial's loans receivable, net reflects R&G Financial's strategy of increasing its loans held for investment, including residential mortgage, construction, commercial real estate and commercial business loans. During the years ended December 31, 1997, 1996 and 1995, total loans originated and purchased by the Bank (including loans originated by R&G Mortgage on behalf of the Bank) amounted to $435.4 million, $342.2 million and $281.7 million, respectively. At December 31, 1997, R&G Financial's allowance for loan losses (all of which is maintained in the Bank's loan portfolio) totalled $6.8 million, which represented a $3.4 million or 103.2% increase from the level maintained at December 31, 1996. At December 31, 1997, R&G Financial's allowance represented approximately 0.87% of the total loan portfolio and 22.34% of total non-performing loans, as compared to 0.55% and 17.64% at December 31, 1996. The increase in the allowance for loan losses is attributable to the provision of $6.4 million for loan losses during the year, which was primarily attributable to the overall growth in the loan portfolio, and to a lesser extent, an increase in consumer loan delinquencies during the year, offset by net write-offs during the year totalling approximately $2.9 million. Net write-offs are net of $2.0 million received as settlement of an insurance claim filed by the Company in 1996 accounted for as a recovery of loans previously charged off. See "Results of Operations - Provision for Loan Losses." Management of R&G Financial believes that its allowance for loan losses at December 31, 1997 was adequate, based upon, among other things, the significant level of single-family residential loans within R&G Financial's portfolio (as compared to commercial real estate, commercial business and consumer loans, which are considered by management to carry a higher degree of credit risk) and the low level of loan charge-offs normally experienced by the Company with respect to its loan portfolio. However, there can be no assurances that additions to such allowance will not be necessary in future periods, which could adversely affect R&G Financial's results of operations. At December 31, 1997 and 1996, mortgage loans held for sale amounted to $46.9 million and $54.5 million, respectively. Mortgage loans held for sale primarily reflects loans which are in the process of being securitized and sold. The level of mortgage banking activities is highly dependent upon market and economic factors. Securities Held for Trading, Available for Sale and Held for Investment. R&G Financial maintains a substantial portion of its assets in mortgage-backed and investment securities which are classified as either held for trading, available for sale or held to maturity in accordance with SFAS No. 115. At December 31, 1997, R&G Financial's aggregate mortgage-backed and investment securities totalled $566.9 million or 37.5% of total assets, as compared to $234.5 million or 22.6% at December 31, 1996, respectively. Securities held for trading consist primarily of FHA and VA loans which have been securitized as GNMA pools and are being held for sale either to institutions in the secondary market or private investors through the Bank's Trust Department. At December 31, 1997 and 1996, securities held for trading amounted to $400.4 million and $108.1 million, respectively. At December 31, 1997, all but $1.6 million of such securities were held by R&G Mortgage. Pursuant to SFAS No. 115, securities held for trading are reported at fair value with unrealized gains and losses included in earnings. Securities available for sale consist of mortgage-backed and related securities (FNMA and FHLMC certificates as well as CMOs and CMO residuals) and U.S. Government agency securities, all of which were held by the Bank. At December 31, 1997 and 1996, securities available for sale totalled $121.9 million and $81.8 million, respectively. Pursuant to SFAS No. 115, securities available for sale are reported at fair value with unrealized gains and losses excluded from earnings, and reported as a separate component of stockholders' equity. Securities held to maturity consist of mortgage-backed securities (GNMA, FNMA and FHLMC certificates), Puerto Rico Government obligations and other Puerto Rico securities, all of which were held by the Bank. At December 31, 1997 and 1996, securities held to maturity totalled $44.0 million and $43.2 million, respectively. Securities held to maturity are accounted for at amortized cost. At December 31, 1997 and 1996, R&G Financial's securities held to maturity had a market value of $43.8 million and $42.3 million, respectively. Mortgage Servicing Asset. As of December 31, 1997 and 1996, R&G Financial reported $21.2 million and $12.6 million of mortgage servicing rights, respectively. Effective January 1, 1995, R&G Financial adopted SFAS No. 122, "Accounting for Mortgage Servicing Rights," and, in connection therewith, R&G Financial is required to recognize both purchased and originated mortgage servicing rights as assets in its Consolidated Financial Statements. However, R&G Financial is not permitted to recognize retroactively mortgage servicing rights originated prior to the date of its adoption of SFAS No. 122 until the related loans are sold. SFAS No. 122 also requires R&G Financial to assess the fair value of its mortgage servicing rights on a quarterly basis and to determine any potential impairment. Any future decline in interest rates which results in an acceleration in mortgage loan prepayments could have an adverse effect on R&G Financial's mortgage servicing rights, the value of which is dependent upon the cash flows from the underlying mortgage loans. Deposits. At December 31, 1997, deposits totalled $722.4 million, as compared to $615.6 million at December 31, 1996. The $106.8 million or 17.4% increase in deposits during the year ended December 31, 1997 was primarily due to promotions in connection with new accounts and competitive pricing. One of the Bank's strategies is to increase its core deposits, which provide a source of fee income and the ability to cross-sell other products and services. As a result, core deposits (consisting of passbook, NOW and Super NOW and checking and commercial checking accounts) increased from $210.4 million or 34.2% of total deposits at December 31, 1996 to $266.4 million or 36.7% of total deposits at December 31, 1997. 31 Borrowings. Other than deposits, R&G Financial's primary sources of funds consist of securities sold under agreements to repurchase (consisting of agreements to purchase on a specified later date the same or substantially identical securities) ("repurchase agreements"). At December 31, 1997 and 1996, reverse repurchase agreements totalled $382.3 million and $97.4 million, respectively. Notes payable consist primarily of warehouse lines of credit (which are used to fund loan commitments of R&G Mortgage) and Section 936 promissory notes (which represents a low cost source of short and intermediate-term funds for the Bank). At December 31, 1997, notes payable amounted to $159.3 million, as compared to $126.8 million at December 31, 1996. The $32.5 million or 25.6% increase in notes payable during the year ended December 31, 1997 reflected $34.9 million of increased warehouse lines, which was partially offset by a $2.4 million reduction in 936 Notes. Advances from the FHLB of New York amounted to $42.0 million and $15.0 million at December 31, 1997 and 1996, respectively. At December 31, 1996, all FHLB advances were scheduled to mature within 30 days, with an average interest rate of 6.03%. In December 1995, the Bank sold single-family residential mortgage loans with an aggregate outstanding balance of approximately $55 million to two commercial banks. In connection with these transactions and in consideration of higher servicing fees, R&G Mortgage assumed certain recourse obligations. In addition, the purchasers of the loans have the right, at their option, to require R&G Mortgage to purchase the mortgage loans beginning on specified dates in December 2000. Management has estimated its liability, if any, under the foregoing recourse provisions to be immaterial as of December 31, 1997. In R&G Financial's Consolidated Financial Statements, R&G Financial has recognized the foregoing transaction as a transfer of loans with recourse. Accordingly, the proceeds from such transaction (amounting to $34.4 million and $50.5 million at December 31, 1997 and 1996, respectively) have been reported as other secured borrowings in R&G Financial's Consolidated Financial Statements. In June 1991, the Bank issued $3.3 million of subordinated capital notes bearing interest at 8% payable on a quarterly basis. The subordinated notes are guaranteed by R&G Mortgage and by the Chairman of the Board and Chief Executive Officer of R&G Financial, and are secured by an irrevocable standby letter of credit issued by an unrelated commercial bank. Pursuant to the terms of the subordinated notes, the Bank is required to deposit in an established sinking fund in seven equal annual installments (the first of which was made in September 1992 and the last of which is scheduled for June 1998, when the notes mature) cash or other permitted investments in an amount sufficient to retire one-seventh ($464,000) of the aggregate principal amount of the subordinated notes. The standby letter of credit is reduced in equal proportion to the deposits to such sinking fund. Stockholders' Equity. Stockholders' equity increased from $115.6 million at December 31, 1996 to $138.1 million at December 31, 1997. The $22.5 million or 19.5% increase in stockholders' equity during 1997 was primarily due to the $23.5 million net income for the year and an increase in unrealized gains on securities available for sale from a $102,000 loss at December 31, 1996 to an unrealized gain of $1.2 million at December 31, 1997. The increases in stockholders' equity were slightly offset by dividends paid during the year of $2.4 million. Results of Operations General. R&G Financial's results of operations depend substantially on its net interest income, which is the difference between interest income on interest-earning assets, which consist primarily of loans, money market investments and mortgage-backed and investment securities, and interest expense on interest-bearing liabilities, which consist primarily of deposits and short and long-term borrowings. R&G Financial's results of operations are also significantly affected by its provisions for loan losses, resulting from R&G Financial's assessment of the adequacy of its allowance for loan losses; the level of its other income, including net gain (loss) on sale of loans, unrealized gain (loss) on trading securities and loan administration and servicing fees; the level of its operating expenses, such as employee compensation and benefits and office occupancy and equipment expense; and income tax expense. R&G Financial's major business activities consist of: (i) the origination by R&G Mortgage of real estate mortgage loans for sale and the servicing by R&G Mortgage of real estate mortgage loans for the Bank and other third parties; and (ii) attracting deposits from the general public and using such deposits, together with other borrowings, for investment principally by the Bank in loans (single-family residential mortgage loans, construction loans, commercial real estate loans, commercial business loans and consumer loans), and in mortgage-backed and investment securities. To a much more limited extent, R&G Financial also provides trust and investment services to the public through the Bank's Trust Department. 32 The following table reflects the principal revenue sources of the Bank and R&G Mortgage and the percentage contribution of each component for the periods presented.
Year Ended December 31, 1997 1996 1995 Amount Percent Amount Percent Amount Percent - ------------------------------------------------------------------------------------------------------------------------------------ (Dollars in Thousands) The Bank: Net interest income after provision for loan losses $25,544 35.84% $20,884 38.73% $17,944 41.00% Net gain on sale of loans 5,436 7.63 1,355 2.51 1,250 2.85 Net gain on sale of investment securities 107 0.15 642 1.19 -- -- Market valuation allowance on loans held for sale -- -- -- -- 856 1.96 Other income(1) 2,915 4.09 3,664 6.80 2,368 5.41 - ------------------------------------------------------------------------------------------------------------------------------------ 34,002 47.71 26,545 49.23 22,418 51.22 - ------------------------------------------------------------------------------------------------------------------------------------ R&G Mortgage: Net interest income 4,616 6.48 3,781 7.01 2,379 5.44 Loan administration and servicing fees 13,214 18.54 13,029 24.17 11,030 25.20 Net gain on origination and sale of loans 18,597 26.10 10,354 19.20 7,134 16.30 Other income(1) 836 1.17 208 0.39 804 1.84 - ------------------------------------------------------------------------------------------------------------------------------------ 37,263 52.29 27,372 50.77 21,347 48.78 - ------------------------------------------------------------------------------------------------------------------------------------ $71,265 100.00% $53,917 100.00% $43,765 100.00%
- ---------------- (1) Comprised of service charges, fees and other for the Bank and other miscellaneous revenue sources for the Bank and R&G Mortgage. R&G Financial reported net income of $23.5 million, $13.2 million and $10.4 million during the years ended December 31, 1997, 1996 and 1995, respectively. Net income increased by $10.3 million or 78.01% during the year ended December 31, 1997, as compared to 1996, due to a $7.6 million increase in net interest income and a $11.9 million increase in total other income, which were partially offset by a $7.3 million increase in total operating expenses, (excluding the one-time SAIF special assessment of $2.5 million in 1996), and a $2.1 million or 49.6% increase in the provision for loan losses. Net income increased by $2.8 million or 26.3% during the year ended December 31, 1996, as compared to 1995, due to a $12.6 million increase in net interest income and a $5.8 million increase in total other income, which were partially offset by a $7.5 million increase in total operating expenses, ($5.0 million if the one-time SAIF special assessment were excluded), and a $3.3 million or a 348% increase in the provision for loan losses. Net Interest Income. Net interest income is determined by R&G Financial's interest rate spread (i.e., the difference between the yields earned on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities. Net interest income totalled $36.5 million, $28.9 million and $21.3 million during the years ended December 31, 1997, 1996 and 1995, respectively. Net interest income increased by $7.6 million or 26.3% during the year ended December 31, 1997, as compared to the year ended December 31, 1996, due to an increase in R&G Financial's average net interest earning assets of $11.9 milion during the year, offset by a decrease in the Company's interest rate spread from 3.00% in 1996 to 2.88% in 1997. Net interest income increased by $7.7 million or 36.0% during 1996 due to an increase in R&G Financial's interest rate-spread from 2.93% for 1995 to 3.00% for 1996, which was partially offset by a decrease in the ratio of average interest-earning assets to average interest-bearing liabilities from 106.5% for 1995 to 104.6% for 1996. 33 The following table presents for R&G Financial for the periods indicated the total dollar amount of interest 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, and the net interest margin. The table does not reflect any effect of income taxes. All average balances are based on the average of month-end balances for R&G Mortgage and average daily balances R&G Mortgage and the average daily balances for the Banm+pin each case during the periods presented.
Year Ended December 31, 1997 1996 Average Yield/ Average Yield/ Balance Interest Rate (1) Balance Interest Rate (1) - ------------------------------------------------------------------------------------------------------------------------------------ (Dollars in Thousands) Interest-Earning Assets: Cash and cash equivalents(2) $30,967 $1,674 5.41% $43,072 $2,322 5.39% Investment securities held for trading 5,466 328 5.07 2,271 116 5.11 Investment securities available for sale 51,105 3,205 6.27 19,102 1,193 6.25 Investment securities held to maturity 15,095 777 5.15 10,069 515 4.35 Mortgage-backed securities held for trading 249,930 17,174 6.87 136,618 9,258 6.78 Mortgage-backed securities available for sale 44,693 3,200 7.16 50,633 3,602 7.11 Mortgage-backed securities held to maturity 35,642 2,152 6.04 40,403 2,478 6.27 Loans receivable, net(3)(4) 732,064 68,514 9.36 587,730 54,044 9.20 FHLB of New York stock 4,710 311 6.60 3,999 258 6.45 - ------------------------------------------------------------------------------------------------------------------------------------ Total interest-earning assets 1,169,672 $97,335 8.32% 893,897 $73,786 8.25% ==================================================================================================================================== Non-interest-earning assets 98,880 61,480 - ------------------------------------------------------------------------------------------------------------------------------------ Total assets $1,268,552 $955,377 ==================================================================================================================================== Interest-Bearing Liabilities: Deposits $668,704 $32,434 4.85% $561,548 $27,518 4.90% Securities sold under agreements to repurchase 226,771 13,483 5.95 100,607 5,024 4.99 Notes payable 151,440 9,616 6.35 126,171 7,284 5.77 Subordinated debt(5) 3,250 324 9.97 3,250 332 10.21 Other borrowings(6) 67,973 4,948 7.28 63,118 4,705 7.45 - ------------------------------------------------------------------------------------------------------------------------------------ Total interest-bearing liabilities 1,118,138 $60,805 5.44% 854,694 $44,863 5.25% ==================================================================================================================================== Non-interest-bearing liabilities 24,680 15,766 - ------------------------------------------------------------------------------------------------------------------------------------ Total liabilities 1,142,818 870,460 Stockholders' equity 125,734 84,917 - ------------------------------------------------------------------------------------------------------------------------------------ Total liabilities and stockholders' equity $1,268,552 $955,377 ==================================================================================================================================== Net interest income; interest rate spread(7) $36,530 2.88% $28,923 3.00% ==================================================================================================================================== Net interest margin(7) 3.12% 3.24% ==================================================================================================================================== Average interest-earning assets to average interest-bearing liabilities 104.61% 104.60% ==================================================================================================================================== Year Ended December 31, 1995 Average Yield/ Balance Interest Rate (1) - ------------------------------------------------------------------------------------------- (Dollars in Thousands) Interest-Earning Assets: Cash and cash equivalents(2) $10,000 $605 6.05% Investment securities held for trading -- -- -- Investment securities available for sale -- -- -- Investment securities held to maturity 16,211 972 6.00 Mortgage-backed securities held for trading 130,184 8,595 6.60 Mortgage-backed securities available for sale 16,006 1,193 7.45 Mortgage-backed securities held to maturity 72,173 4,841 6.71 Loans receivable, net(3)(4) 405,784 37,078 9.14 FHLB of New York stock 2,976 227 7.63 - ------------------------------------------------------------------------------------------- Total interest-earning assets 653,334 $53,511 8.19% =========================================================================================== Non-interest-earning assets 50,365 - ------------------------------------------------------------------------------------------- Total assets $703,699 =========================================================================================== Interest-Bearing Liabilities: Deposits $431,833 $21,829 5.05% Securities sold under agreements to repurchase 107,026 6,437 6.01 Notes payable 55,118 3,025 5.49 Subordinated debt(5) 3,250 339 10.43 Other borrowings(6) 16,201 609 3.76 - ------------------------------------------------------------------------------------------- Total interest-bearing liabilities 613,428 $ 32,239 5.26% =========================================================================================== Non-interest-bearing liabilities 29,093 - ------------------------------------------------------------------------------------------- Total liabilities 642,521 Stockholders' equity 61,178 - ------------------------------------------------------------------------------------------- Total liabilities and stockholders' equity $703,699 =========================================================================================== Net interest income; interest rate spread(7) $ 21,272 2.93% =========================================================================================== Net interest margin(7) 3.26% =========================================================================================== Average interest-earning assets to average interest-bearing liabilities 106.50% ===========================================================================================
(Footnotes on following page) 34 - ----------------- (1) At December 31, 1997, the yields earned and rates paid were as follows: cash and cash equivalents, 5.54%; investment securities held to maturity, 5.67%; investment securities available for sale, 6.08%; mortgage-backed securities held for trading, 6.00%; mortgage loans held for sale, 8.39%; loans receivable, net, 9.30%; FHLB of New York stock, 7.05%; total interest-earning assets, 8.10%; deposits, 4.82%; securities sold under agreements to repurchase, 5.81%; notes payable, 6.45%; other borrowings, 6.89%; subordinated debt, 9.46%; total interest-bearing liabilities, 5.41%; interest rate spread, 2.69%. (2) Comprised of cash and due from banks, securities purchased under agreements to resell, time deposits with other banks and federal funds sold. (3) Includes mortgage loans held for sale and non-accrual loans. (4) Interest income on loans include loan fees amounting to $334,000, $277,000 and $578,000 during the years ended December 31, 1997, 1996 and 1995, respectively or .49%, .44% and 1.27% of interest income on loans during such respective periods. (5) Represents a seven-year subordinated capital note of the Bank issued in 1991, which is subject to an annual sinking fund requirement. (6) Comprised of long-term debt, advances from the FHLB of New York and other secured borrowings. (7) Interest rate spread represents the difference between R&G Financial's weighted average yield on interest-earning assets and the weighted average rate on interest-bearing liabilities. Net interest margin represents net interest income as a percent of average interest-earning assets. The following table describes the extent to which changes in interest rates and changes in volume of interest-related assets and liabilities have affected R&G Financial's interest income and interest expense during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (change in volume multiplied by prior year rate), (ii) changes in rate (change in rate multiplied by prior year volume), and (iii) total change in rate and volume. The combined effect of changes in both rate and volume has been allocated in proportion to the absolute dollar amounts of the changes due to rate and volume.
Year Ended December 31, - ------------------------------------------------------------------------------------------------------------------------------------ 1997 vs. 1996 1996 vs. 1995 - ------------------------------------------------------------------------------------------------------------------------------------ Increase Total Increase Total (Decrease) Increase (Decrease) Increase Due to (Decrease) Due to (Decrease) - ------------------------------------------------------------------------------------------------------------------------------------ Rate Volume Rate Volume - ------------------------------------------------------------------------------------------------------------------------------------ (Dollars in Thousands) Interest-Earning Assets: Cash and cash equivalents(1) $ 5 $ (653) $ (648) $ (284) $ 2,001 $ 1,717 Investment securities held for trading 49 163 212 -- 116 116 Investment securities available for sale 1,535 477 2,012 -- 1,193 1,193 Investment securities held to maturity 5 257 262 (89) (368) (457) Mortgage-backed securities held for trading 131 7,785 7,916 238 425 663 Mortgage-backed securities held to maturity (180) (146) (326) (1,298) (1,065) (2,363) Mortgage-backed securities available for sale 26 (428) (402) (172) 2,581 2,409 Loans receivable, net(4) 7,834 6,636 14,470 8,653 8,313 16,966 FHLB of New York stock 7 46 53 (47) 78 31 - ------------------------------------------------------------------------------------------------------------------------------------ Total interest-earning assets $ 9,412 $ 14,137 $ 23,549 $ 7,001 $ 13,274 $ 20,275 ==================================================================================================================================== Interest-Bearing Liabilities: Deposits $ (335) $ 5,251 $ 4,916 $ (868) $ 6,557 $ 5,689 Securities sold under agreements to repurchase 2,071 6,388 8,459 (1,027) (386) (1,413) Notes payable 853 1,479 2,332 359 3,900 4,259 Subordinated debt(2) (8) -- (8) (7) -- (7) Other borrowings(3) (124) 367 243 2,332 1,764 4,096 - ------------------------------------------------------------------------------------------------------------------------------------ Total interest-bearing liabilities $ 2,457 $ 13,485 15,942 $ 789 $ 11,835 12,624 ==================================================================================================================================== Increase (decrease) in net interest income $ 7,607 $ 7,651 ====================================================================================================================================
(Footnotes on following page) 35 - ----------------- (1) Comprised of cash and due from banks, securities purchased under agreements to resell, time deposits with other banks and federal funds sold. (2) Represents a seven-year subordinated capital note of the Bank issued in 1991, which is subject to an annual sinking fund requirement. (3) Comprised of long-term debt, advances from the FHLB of New York and other secured borrowings. (4) Includes mortgage loans held for sale. Interest Income. Total interest income increased by $23.5 million or 31.9% during the year ended December 31, 1997, as compared to December 31, 1996, and increased by $20.3 million or 37.9% during the year ended December 31, 1996 over the year ended December 31, 1995. Interest income on loans, the largest component of R&G Financial's interest-earning assets, increased by $14.4 million or 26.7% during the year ended December 31, 1997, as compared to the year ended December 31, 1996, and increased by $17.0 million or 46.0% during 1996 over the year ended December 31, 1995. Such increases were primarily the result of increases in the average balance of loans receivable of $144.3 million and ????????????????????? ????????????????????????????????? 31, 1997 and 1996, respectively. One of R&G Financial's strategies in recent years has been to grow R&G Financial's loans held for investment. Interest income on mortgage-backed and investment securities (which, for purposes of this discussion, includes securities held for trading, available for sale and held to maturity) increased by $9.7 million or 56.4% during the year ended December 31, 1997, as compared to the year ended December 31, 1996, and increased by $1.6 million or 10.0% during the year ended December 31, 1996 over the year ended December 31, 1995. The increase in interest income on mortgage-backed and investment securities during the year ended December 31, 1997 was due primarily to an increase in the average balance of investment securities of $40.2 million, together with a $102.6 million increase in the average balance of mortgage-backed securities during the period. The increase in investment securities reflects purchases of approximately $50.2 million during the year, net of maturities and sales, with excess liquidity during the year; the increase in mortgage backed securities is primarily associated with a 60.2% increase in FHA/VA mortgage loan originations (which are subsequently converted into GNMA mortgage backed securities) during 1997. The increase in interest income on mortgage-backed and investment securities during 1996 was primarily due to a $15.2 million increase in the average balance of investment securities together with an increase of $9.3 million in the average balance of mortgage-backed securities during the period. Interest income on cash and cash equivalents (consisting of cash and due from banks, securities purchased under agreements to resell, certificates of deposit with other financial institutions and federal funds sold) decreased by $648,000 or 27.9% during the year ended December 31, 1997, as compared to the year ended December 31, 1996, and increased by $1.7 million or 283.8% during the year ended December 31, 1996. The decrease during the year ended December 31, 1997 was due primarily to a decrease in the average balance of cash and cash equivalents during the period of $12.1 million. The increase in interest earned on money market investments during 1996 reflected the increase in the average balance of $33.1 million, which was partially offset by a decrease in the yield from 6.05% to 5.39%. The fluctuations in yields earned by R&G Financial on its money market investments reflect the general fluctuations in short-term market rates of interest during the periods presented. Interest Expense. Total interest expense increased by $15.9 million or 35.5% during the year ended December 31, 1997, as compared to the year ended December 31, 1996, and increased by $12.6 million or 39.2% during the year ended December 31, 1996. Interest expense on deposits, the largest component of R&G Financial's interest-bearing liabilities, increased by $4.9 million or 17.9% during the year ended December 31, 1997, as compared to the year ended December 31, 1996, and increased by $5.7 million or 26.1% during the year ended December 31, 1996. The increases in interest expense on deposits during the years ended December 31, 1997 and 1996 were primarily due to increases in the average balance of deposits of $107.2 million and $129.7 million during such respective periods. During 1997, the average rate paid on deposits decreased by 5 basis points as a result of a general decrease in market rates of interest. In 1996, the average rate paid on deposits decreased by 15 basis points as a result of general decrease in market rates of interest. Interest expense on repurchase agreements increased significantly by $8.5 million or 168.4% during the year ended December 31, 1997, as compared to the year ended December 31, 1996, and decreased by $1.4 million or 21.9% during the year ended December 31, 1996. The increase in interest expense on repurchase agreements during 1997 was due primarily to an increase in the average balance of repurchase agreements outstanding of $126.2 million, together with an increase in the average rate paid thereon of 96 basis points. R&G Financial generally uses repurchase agreements to repay warehouse lines of credit which are used to fund loan originations. The repurchase agreements are collateralized by mortgage-backed securities held for trading. The fluctuations in the average balance of repurchase agreements during the periods presented is therefore a function both of the amount of originations by R&G Financial as well as the level of mortgage-backed securities held for trading which are available to collateralize such agreements. The decrease in interest expense on repurchase agreements during 1996 was primarily due to a decrease in the average rate paid thereon of 102 basis points. Interest expense on notes payable (consisting of warehouse lines of credit and promissory notes) increased by $2.3 million or 32.0% during the year ended December 31, 1997, as compared to the year ended December 31, 1996, and increased by $3.9 million or 116.5% during the year ended December 31, 1996. The increase during the year ended December 31, 1997 was primarily due to an $25.6 million increase in the average balance of warehousing lines as R&G Mortgage made increased use of such lines due to increased mortgage loan originations. The increase during the year ended December 31, 1996 was due to a $71.1 million increase in the average balance of notes payable, as the Bank converted short term 936 funds to medium term 936 Notes to fund increased consumer and commercial lending. Interest expense on other borrowings (consisting of subordinated notes, advances from the FHLB of New York and other secured borrowings) increased by $234,000 or 4.6% during the year ended December 31, 1997, as compared to the year ended December 31, 1996, and increased by $4.4 million or 727.2% during the year 36 ended December 31, 1996. The increase in interest expense on other borrowings during 1997 was due primarily to an increase in the average balance of such borrowings due to increased use of FHLB advances for short term funding needs. The increase during the year ended December 31, 1996 was primarily due to a $46.9 million increase in the average balance of such borrowings together with a 369 basis point increase in the average rate paid thereon. The increases were primarily due to a $56.0 million transfer of loans with recourse transaction in December 1995 which is reported as other secured borrowings in R&G Financial's Consolidated Financial Statements. Provision for Loan Losses. The provision for loan losses is charged to earnings to bring the total allowance to a level considered appropriate by management based on R&G Financial's loss experience, current delinquency data, known and inherent risks in the portfolio, the estimated value of any underlying collateral and an assessment of current economic conditions. While management endeavors to use the best information available in making its evaluations, future allowance adjustments may be necessary if economic conditions change substantially from the assumptions used in making the initial evaluations. R&G Financial made provisions to its allowance for loan losses of $6.4 million, $4.3 million and $950,000 during the years ended December 31, 1997, 1996 and 1995, respectively. The increase in the provision for loan losses taken by the Company during 1997 was primarily based on the increase of the Company's loan portfolio during the period, as the Company experienced a 45% increase in the volume of loan originations during 1997 as well as to increased net charge-offs associated primarily with consumer loans. Puerto Rico financial institutions, including the Company, experienced increased bankruptcies and resulting delinquencies over the past year. During the year, management adopted more stringent consumer underwriting procedures to address problems experienced generally in the market for personal loans, and has determined to emphasize collateralized consumer lending instead of personal loans. The increase in the provision for loans losses during 1996 primarily reflects action taken with respect to certain potential loan losses related to the operation of the Bank's insurance premiums financing business. As previously reported, the Bank believes that there were irregularities with respect to the Bank's former insurance premium financing business. Management, based on a review of the collectibility of the loans in question, established reserves of approximately $2.5 million in 1996 to cover estimated losses expected to result from this matter at the time. On January 15, 1998, the Company received $2 million as part of a settlement of a claim filed by the Company in late 1996 with its fidelity insurance carrier. The settlement was recorded as a recovery of loans previously charged-off and reflected as an addition to the Company's allowance for loan losses as of December 31, 1997. The $950,000 provision during 1995 reflected R&G Financial's increased consumer loan originations and an increase in loan charge-offs related thereto. Management believes that its allowance for loan losses at December 31, 1997, was adequate based upon, among other things, the significant level of single-family residential loans within R&G Financial's portfolio (as compared to commercial real estate, commercial business and consumer loans, which are considered by management to carry a higher degree of credit risk) and the low level of loan charge-offs normally experienced by the Company with respect to its loan portfolio. Nevertheless, there can be no assurances that additions to such allowance will not be necessary in future periods, particularly if the growth in R&G Financial's real estate lending, including commercial lending, as well as the increased bankruptcies and resulting delinquencies, continue. Other Income. The following table sets forth information regarding other income for the periods shown.
Year Ended December 31, 1997 1996 1995 - ----------------------------------------------------------------------------------------------- (In Thousands) Net gain on origination and sale of loans $ 24,033 $ 11,709 $ 8,384 Change in allowance for cost in excess of market value of loans held fmasale -- -- 856 Net gain on sale of investment securities available for sale 107 642 -- Net loss on trading account (854) (66) -- Loan administration and servicing fees 13,214 13,029 11,030 Service charges, fees and other 4,605 3,938 3,172 - ----------------------------------------------------------------------------------------------- Total other income $ 41,105 $ 29,252 $ 23,442 ===============================================================================================
37 Total other income increased by $11.9 million or 40.5% during the year ended December 31, 1997, as compared to the prior year and increased by $5.8 million or 24.8% during the year ended December 31, 1996. Net gain on sale of loans amounted to $24.0 million, $11.7 million and $8.4 million during the years ended December 31, 1997, 1996 and 1995, respectively. Net gain on sale of loans reflects the income generated from R&G Financial's origination and purchase of single-family residential real estate loans and the subsequent securitization and sale of such loans. During the years ended December 31, 1997, 1996 and 1995, R&G Mortgage originated and purchased $470.9 million, $282.4 million and $185.9 million, respectively, and sold $246.1 million, $244.8 million and $195.6 million of mortgage loans, respectively. In addition, the Bank sold $118.2 million, $49.7 million and $75.1 million of loans from its portfolio during such respective periods. R&G Financial's mortgage banking operations are highly dependent upon market and economic conditions. During the years ended December 31, 1997, 1996 and 1995, R&G Financial recognized net profit (loss) on trading securities of $9.7 million, $(96,000) and $2.1 million, respectively, which are included in net gains on sales of loans. Such gains and losses reflect fluctuations in the market value of primarily FHA and VA loans which have been securitized into GNMA mortgage-backed securities and are being held for sale either to institutions in the secondary market or private investors through the Bank's Trust Department. The increase in net profits in trading securities in 1997 is primarily related to a $170.9 million or 63.9% increase in the origination and purchase of FHA and VA loans during the year. In addition, during the years ended December 31, 1997 and 1996, R&G Financial recognized $854,000 and $66,000, respectively, of net losses on trading activities and from hedge positions on certain investment securities available for sale. The loss experienced during 1997 is primarily related to an increase in hedging activities as well as increased volatility in market interest rates during the period. In 1994, R&G Financial established an $856,000 provision to reflect a decline in the market value of loans held for sale as a result of the increase in market rates of interest which occurred during the second half of the year. During the year ended December 31, 1995, market rates of interest subsequently declined and R&G Financial was able to sell such mortgage loans without recognizing any losses. As a result, R&G Financial reversed the prior $856,000 provision during the year ended December 31, 1995. No provision was required in 1997 or 1996. During the years ended December 31, 1997, 1996 and 1995, R&G Financial recognized loan administration and servicing fees (consisting of loan servicing fees) of $13.2 million, $13.0 million and $11.0 million, respectively. The increase in loan administration and servicing fees over the periods reflects the increase in R&G Financial's loan servicing portfolio from 43,572 loans with an aggregate principal balance of $2.1 billion at January 1, 1995 to 56,442 loans with an aggregate principal balance of $3.0 billion at December 31, 1997. Service charges, fees and other amounted to $4.6 million, $3.9 million and $3.2 million during the years ended December 31, 1997, 1996 and 1995, respectively. The $667,000 or 16.9% increase during 1997 was primarily due to increased service charges associated with new deposit products and an increasing deposit base, as well as increases in the loan portfolio. The $766,000 or 24.1% increase during the year ended December 31, 1996 over the prior year was primarily attributable to increased service charges from deposit accounts, primarily associated with certain branch acquisitions during 1995. Operating Expenses. The following table sets forth certain information regarding operating expenses for the periods shown.
Year Ended December 31, 1997 1996 1995 - -------------------------------------------------------------------------------- (In Thousands) Employee compensation and benefits $13,653 $10,793 $ 8,284 Office occupancy and equipment 7,131 5,531 4,711 SAIF special assessment -- 2,508 -- Other administrative and general 18,252 15,424 13,731 - -------------------------------------------------------------------------------- Total operating expenses $39,036 $34,257 $26,726 ================================================================================
Total operating expenses increased by $4.8 million or 13.9% during the year ended December 31, 1997, as compared to the year ended December 31, 1996 and increased by $7.5 million or 28.2% during the year ended December 31, 1996 over 1995. Without taking into consideration the one-time $2.5 million assessment to recapitalize the SAIF, total operating expenses would have increased by $7.3 million or 23.0% in 1997 and by $5.0 million or 18.8% in 1996. The increase in total operating expenses during the year ended December 31, 1997 reflects a 45% increase in total loan production during the year as well as increased costs associated with the opening of a new branch office in Bayamon in June 1997 and the remodeling work at six branch locations acquired in June 1995 from another financial institution in Puerto Rico. The increase in total operating expenses during the year ended December 31, 1996 was primarily due to increases in each major category. The 1995 branch acquisition was the primary reason for the increases in compensation and benefits, occupancy and other miscellaneous expenses during 1996. Employee compensation and benefits expense amounted to $13.6 million, $10.8 million and $8.3 million during the years ended December 31, 1997, 1996 and 1995, respectively. The $2.9 million or 26.5% increase in such expense during the year ended December 31, 1997 is primarily associated with increased bonus payments due to greater loan production during the year. The $2.5 million or 30.3% increase in such expense during the year ended December 31, 1996 was due to an increase in employees as a result of the Bank's June 1995 branch acquisition. Office occupancy and equipment expense amounted to $7.1 million, $5.5 million and $4.7 million during the years ended December 31, 1997, 1996 and 1995, respectively. The $1.6 million or 28.9% increase in office occupancy and equipment expenses during 1997 were related to the opening of the new branch in Bayamon and to the completion of remodeling work at the six branches acquired in 1995. The $820,000 or 17.4% increase in such expense recognized by R&G Financial during the year ended December 31, 1996 reflects the Bank's 1995 branch acquisition. The Company incurred a special assessment in 1996 of $2.5 million ($1.5 million net of taxes) as the result of federal legislation signed into law to recapitalize the federal deposit insurance fund. The legislation enacted by the U.S. Congress 38 recapitalized the SAIF by a one-time charge of approximately $0.657 for every $100 of assessable deposits held at March 31, 1995. As a result, the Bank's insurance premiums, which had amounted to $0.23 for every $100 of assessable deposits, was reduced to $0.064 for every $100 of assessable deposits beginning January 1, 1997. Other administrative and general expenses, which consist primarily of advertising, license and property taxes, amortization of servicing asset, insurance, telephone, printing and supplies and other miscellaneous expenses, amounted to $18.3 million, $15.4 million and $13.7 million during the years ended December 31, 1997, 1996 and 1995, respectively. The $2.8 million or 18.3% increase in such expenses during the year ended December 31, 1997 is also primarily associated with increased loan production during the year. The $1.7 million or 12.3% increase in such expenses during 1996 was primarily the result of general growth in the operations of R&G Financial and the addition of new products and services offered. Income Taxes. R&G Financial's income tax provision amounted to $8.7 million during the year ended December 31, 1997, as compared to income tax expense of $5.9 million and $5.8 million during the years ended December 31, 1996 and 1995, respectively. During 1996, R&G Mortgage and the Puerto Rico Treasury Department settled all taxes due for the years 1989 through and including 1992 which were under audit. The settlement reached was for $1.6 million. The effect of this settlement was to record additional income tax expense during 1996 of $400,000. The remainder of the settlement was reserved for during prior periods. R&G Financial's effective tax rate amounted to 27.1%, 31.0% and 35.9% during the years ended December 31, 1997, 1996 and 1995, respectively. The decrease in R&G Financial's effective tax rate during the last several years is due primarily to an increase in the Company's exempt interest income. Liquidity and Capital Resources Liquidity. Liquidity refers to R&G Financial's ability to generate sufficient cash to meet the funding needs of current loan demand, savings deposit withdrawals, principal and interest payments with respect to outstanding borrowings and to pay operating expenses. It is management's policy to maintain greater liquidity than required in order to be in a position to fund loan purchases and originations, to meet withdrawals from deposit accounts, to make principal and interest payments with respect to outstanding borrowings and to make investments that take advantage of interest rate spreads. R&G Financial monitors its liquidity in accordance with guidelines established by R&G Financial and applicable regulatory requirements. R&G Financial's need for liquidity is affected by loan demand, net changes in deposit levels and the scheduled maturities of its borrowings. R&G Financial can minimize the cash required during the times of heavy loan demand by modifying its credit policies or reducing its marketing efforts. Liquidity demand caused by net reductions in deposits are usually caused by factors over which R&G Financial has limited control. R&G Financial derives its liquidity from both its assets and liabilities. Liquidity is derived from assets by receipt of interest and principal payments and prepayments, by the ability to sell assets at market prices and by utilizing unpledged assets as collateral for borrowings. Liquidity is derived from liabilities by maintaining a variety of funding sources, including deposits, advances from the FHLB of New York and other short and long-term borrowings. R&G Financial's liquidity management is both a daily and long-term function of funds management. Liquid assets are generally invested in short-term investments such as securities purchased under agreements to resell, federal funds sold and certificates of deposit in other financial institutions. If R&G Financial requires funds beyond its ability to generate them internally, various forms of both short and long-term borrowings provide an additional source of funds. At December 31, 1997, R&G Financial had $63.2 million in borrowing capacity under unused warehouse lines of credit and $223.4 million in borrowing capacity under a line of credit with the FHLB of New York. R&G Financial has generally not relied upon brokered deposits as a source of liquidity, and does not anticipate a change in this practice in the foreseeable future. At December 31, 1997, R&G Financial had outstanding commitments (including unused lines of credit) to originate and/or purchase mortgage and non-mortgage loans of $443.6 million. Certificates of deposit which are scheduled to mature within one year totalled $368.6 million at December 31, 1997, and borrowings that are scheduled to mature within the same period amounted to $512.7 million. R&G Financial anticipates that it will have sufficient funds available to meet its current loan commitments. Capital Resources. The FDIC's capital regulations establish a minimum 3.0% Tier I leverage capital requirement for the most highly-rated state-chartered, non-member banks, with an additional cushion of at least 100 to 200 basis points for all other state-chartered, non-member banks, which effectively will increase the minimum Tier I leverage ratio for such other banks to 4.0% to 5.0% or more. Under the FDIC's regulations, the highest-rated banks are those that the FDIC determines are not anticipating or experiencing significant growth and have well diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity, good earnings and, in general, which are considered a strong banking organization and are rated composite 1 under the Uniform Financial Institutions Rating System. Leverage or core capital is defined as the sum of common stockholders' equity (including retained earnings), noncumulative perpetual preferred stock and related surplus, and minority interests in consolidated subsidiaries, minus all intangible assets other than certain qualifying supervisory goodwill and certain purchased mortgage servicing rights. The FDIC also requires that banks meet a risk-based capital standard. The risk-based capital standard for banks requires the maintenance of total capital (which is defined as Tier I capital and supplementary (Tier 2) capital) to risk weighted assets of 8%. In determining the amount of risk-weighted assets, all assets, plus certain off balance sheet assets, are multiplied by a risk-weight of 0% to 100%, based on the risks the FDIC believes are inherent in the type of asset or item. The components of Tier I capital are equivalent to those discussed above under the 3% leverage capital standard. The components of supplementary capital include certain perpetual preferred stock, certain mandatory convertible securities, certain subordinated debt and intermediate preferred stock and general allowances for loan and lease losses. Allowance for loan and lease losses includable in supplementary capital is limited to a maximum of 1.25% of risk-weighted assets. Overall, the amount of capital counted toward supplementary capital cannot exceed 100% of core capital. At December 31, 1997, the Bank met each of its capital requirements, with Tier I leverage capital, Tier I risk-based capital and total risk-based capital ratios of 7.34%, 13.10% and 14.00%, respectively. 39 In addition, the Federal Reserve Board has promulgated capital adequacy guidelines for bank holding companies which are substantially similar to those adopted by FDIC regarding state-chartered banks, as described above. R&G Financial is currently in compliance with such regulatory capital requirements. Inflation and Changing Prices R&G Financial's Consolidated Financial Statements and related data presented in this Annual Report 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 (except with respect to securities which are carried at market value), without considering changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, substantially all of the assets and liabilities of R&G Financial are monetary in nature. As a result, interest rates have a more significant impact on R&G Financial's performance than the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or in the same magnitude as the prices of goods and services. Year 2000 Issue The Company has already reviewed all computer-based applications and has developed a company-wide action plan for the century change for the year 2000. The Company's goal is to have all systems and applications compliant with the century change by late 1998. The Company has completed a preliminary cost estimate totaling $300,000 related to the year 2000 project. Costs incurred in 1997 related to updating the Company's computer application systems in preparation for the year 2000 were insignificant. The Company expects to continue to incur costs related to this project through the year 1999, however, none of these costs are expected to have a significant impact in the results of operations of the Company in any single period. The Company estimates that costs associated with upgrading or modifying existing internal use software for the year 2000 should be minimal. In the Company's case, most of the costs are related to purchases of hardware (mostly desktop computers) to replace existing equipment, and such equipment is almost fully depreciated at this time. Accordingly, based on presently available information, the Company expects that costs associated with the year 2000 issue should not have a significant effect in the results of operations of the Company. Recent Accounting Pronouncements Set forth below are recent accounting pronouncements which may have a future effect on R&G Financial's operations. These pronouncements should be read in conjunction with the significant accounting policies which R&G Financial has adopted that are set forth in R&G Financial's Notes to Consolidated Financial Statements. In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income." This Statement requires (1) the classification of items of other comprehensive income by their nature in a financial statement; (2) the display of the accumulated balance of other comprehensive income by their nature in a financial statement; and (3) the display of the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of the statement of financial position. For the Company, unrealized gains and losses on certain investments in debt securities will be the only other comprehensive income item to be included in comprehensive income. This Statement is effective for fiscal years beginning after December 15, 1997. Reclassification of financial statements for earlier periods provided for comparative purposes is required. This Statement affects only financial statement presentation and, therefore, management believes that its adoption will not have material effect if any, on the Company's financial position or results of operations. In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." This Statement requires that a public business enterprise report financial and descriptive information about its reportable segments. Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. It also requires reporting descriptive information about the way that the operating segments were determined, the products and the services provided by the operating segments, differences between the measurements used in reporting segment information and those used in the enterprise's general purpose financial statements, and the changes in the measurement of the segment amount from period to period. Management has not yet made a determination on the business lines of the Company that fulfill the segment definition described above. This Statement is effective for fiscal years beginning after December 15, 1997. Reclassification of financial statements for earlier periods provided for comparative purposes is required. This Statement affects only financial statement presentation and disclosure and therefore management believes it will not have a material effect, if any, on the Company's financial position or results of operations. 40 Report OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of R&G Financial Corporation In our opinion, the accompanying consolidated statements of financial condition and the related consolidated statements of income, of changes in stockholders' equity and of cash flows present fairly, in all material respects, the financial position of R&G Financial Corporation (the Company) and its subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. 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 of these statements in accordance with generally accepted auditing standards which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/Price Waterhouse Price Waterhouse San Juan, Puerto Rico February 2, 1998 Certified Public Accountants (of Puerto Rico) License No. 10 Expires on December 1, 1998 Stamp 1457911 of the P.R. Society of Certified Public Accountants has been affixed to the file copy of this report 41
R&G Financial Corporation Consolidated Statements of Financial Condition December 31, 1997 and 1996 1997 1996 - --------------------------------------------------------------------------------------------------------------- Assets Cash and due from banks $ 32,607,001 $ 31,989,944 Money market investments: Securities purchased under agreements to resell 16,000,000 19,633,178 Time deposits with other banks 16,758,722 33,232,809 Federal funds sold 3,000,000 14,000,000 Mortgage loans held for sale, at lower of cost or market 46,885,323 54,450,159 Mortgage - backed securities held for trading, at fair value 400,457,456 108,916,528 Mortgage - backed securities available for sale, at fair value 46,003,849 50,841,165 Mortgage - backed securities held to maturity, at amortized cost (estimated market value: 1997 - $33,185,672; 1996 - $37,104,391) 33,326,472 37,899,847 Investment securities held for trading, at fair value 581,332 1,350,827 Investment securities available for sale, at fair value 75,863,353 30,973,260 Investment securities held to maturity, at amortized cost (estimated market value: 1997 - $10,655,981; 1996 - $5,241,146) 10,692,802 5,269,850 Loans receivable, net 765,059,419 603,750,621 Accounts receivable, including advances to investors, net 7,358,663 5,764,331 Accrued interest receivable 10,345,722 6,632,250 Servicing asset 21,212,998 12,595,020 Premises and equipment 9,527,559 7,767,680 Other assets 15,064,845 12,730,060 - --------------------------------------------------------------------------------------------------------------- $ 1,510,745,516 $ 1,037,797,529 =============================================================================================================== Liabilities and Stockholders' Equity Liabilities: Deposits $ 722,418,494 $ 615,567,481 Federal funds purchased 10,000,000 -- Securities sold under agreements to repurchase 382,282,810 97,444,448 Notes payable 159,304,315 126,842,099 Advances from FHLB 42,000,000 15,000,000 Other secured borrowings 34,359,168 50,462,619 Accounts payable and accrued liabilities 15,871,770 9,998,768 Other liabilities 3,205,043 3,599,222 - --------------------------------------------------------------------------------------------------------------- 1,369,441,600 918,914,637 - --------------------------------------------------------------------------------------------------------------- Subordinated notes 3,250,000 3,250,000 - --------------------------------------------------------------------------------------------------------------- Commitments and contingencies -- -- - --------------------------------------------------------------------------------------------------------------- Stockholders' equity: Preferred stock, $.01 par value, 10,000,000 shares authorized, none issued -- -- Common stock: Class A - $.01 par value, 10,000,000 shares authorized, 9,220,278 issued and outstanding in 1997 (1996 - 5,122,377) 92,203 51,223 Class B - $.01 par value, 15,000,000 shares authorized, 4,924,474 issued and outstanding in 1997 (1996 - 2,735,839) 49,245 27,360 Additional paid-in capital 38,347,818 38,410,683 Retained earnings 96,129,140 75,784,804 Capital reserves of the Bank 2,215,172 1,460,707 Unrealized gain (loss) on securities available for sale, net 1,220,338 (101,885) - --------------------------------------------------------------------------------------------------------------- 138,053,916 115,632,892 - --------------------------------------------------------------------------------------------------------------- $ 1,510,745,516 $ 1,037,797,529 ===============================================================================================================
The accompanying notes are an integral part of these financial statements. 42
R&G Financial Corporation Consolidated Statements of Income Years Ended December 31, 1997, 1996 and 1995 1997 1996 1995 - ------------------------------------------------------------------------------------------------------------------------------------ Interest income: Loans $ 68,513,571 $ 54,081,908 $ 37,039,388 Money market and other investments 6,295,443 4,364,861 1,805,345 Mortgage-backed securities 22,525,876 15,338,950 14,666,922 - ------------------------------------------------------------------------------------------------------------------------------------ Total interest income 97,334,890 73,785,719 53,511,655 - ------------------------------------------------------------------------------------------------------------------------------------ Less - interest expense: Deposits 32,434,559 27,517,852 21,829,433 Securities sold under agreements to repurchase 13,483,500 5,023,794 6,436,327 Notes payable 9,615,560 7,283,593 3,363,930 Secured borrowings 3,583,471 4,189,845 -- Other 1,688,034 847,607 608,984 - ------------------------------------------------------------------------------------------------------------------------------------ 60,805,124 44,862,691 32,238,674 - ------------------------------------------------------------------------------------------------------------------------------------ Net interest income 36,529,766 28,923,028 21,272,981 Provision for loan losses 6,370,000 4,258,047 950,000 - ------------------------------------------------------------------------------------------------------------------------------------ Net interest income after provision for loan losses 30,159,766 24,664,981 20,322,981 - ------------------------------------------------------------------------------------------------------------------------------------ Other income: Net gain on origination and sale of loans 24,032,714 11,708,974 8,384,071 Change in allowance for cost in excess of market value of loans held for sale -- -- 855,834 Net profit (loss) on trading account (853,700) (65,656) -- Net gain on sales of investment securities available for sale 107,430 641,798 -- Loan administration and servicing fees 13,213,948 13,029,053 11,029,995 Service charges, fees and other 4,604,670 3,937,878 3,171,949 - ------------------------------------------------------------------------------------------------------------------------------------ 41,105,062 29,252,047 23,441,849 - ------------------------------------------------------------------------------------------------------------------------------------ Total revenues 71,264,828 53,917,028 43,764,830 - ------------------------------------------------------------------------------------------------------------------------------------ Operating expenses: Employee compensation and benefits 13,652,754 10,793,301 8,283,809 Office occupancy and equipment 7,131,497 5,531,129 4,711,312 SAIF special assessment -- 2,508,380 -- Other administrative and general 18,251,497 15,424,117 13,730,724 - ------------------------------------------------------------------------------------------------------------------------------------ 39,035,748 34,256,927 26,725,845 - ------------------------------------------------------------------------------------------------------------------------------------ Income before minority interest and income taxes 32,229,080 19,660,101 17,038,985 Minority interest in the Bank -- 538,168 742,527 - ------------------------------------------------------------------------------------------------------------------------------------ Income before income taxes 32,229,080 19,121,933 16,296,458 - ------------------------------------------------------------------------------------------------------------------------------------ Income tax expense: Current 6,263,549 5,687,865 3,555,868 Deferred 2,468,319 234,552 2,291,478 - ------------------------------------------------------------------------------------------------------------------------------------ 8,731,868 5,922,417 5,847,346 - ------------------------------------------------------------------------------------------------------------------------------------ Net income $ 23,497,212 $ 13,199,516 $ 10,449,112 ==================================================================================================================================== Earnings per common share: Basic $ 1.66 $ 1.21 $ 1.12 ==================================================================================================================================== Diluted $ 1.62 $ 1.19 $ 1.12 ====================================================================================================================================
The accompanying notes are an integral part of these financial statements. 43
R&G Financial Corporation Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1997, 1996 and 1995 Common Stock Common Stock Additional Class A Class B Paid-in Capital Shares Amount Shares Amount Class A Class B - ------------------------------------------------------------------------------------------------------------------------------------ Balance at December 31, 1994 5,189,044 $51,890 $362,710 Transfer to capital reserves Net income Net change in unrealized gain (loss) on securities available for sale, net of tax - ------------------------------------------------------------------------------------------------------------------------------------ Balance at December 31, 1995 5,189,044 51,890 362,710 Issuance of common stock (including 66,667 Class B shares exchanged for Class A shares in August): August (66,667) (667) 2,435,000 $ 24,350 (5,333) $ 31,344,398 December 300,839 3,010 6,708,908 Transfer to capital reserves Cash dividends declared on common stock Net income Net change in unrealized gain (loss) on securities available for sale, net of tax - ------------------------------------------------------------------------------------------------------------------------------------ Balance at December 31, 1996 5,122,377 51,223 2,735,839 27,360 357,377 38,053,306 Transfer to capital reserves Common stock split on September 25, 1997: Stock split 4,097,901 40,980 2,188,635 21,885 (40,980) (21,885) Cash paid in lieu of fractional shares Cash dividends declared on common stock Net income Net change in unrealized gain on securities available for sale, net of tax - ------------------------------------------------------------------------------------------------------------------------------------ Balance at December 31, 1997 9,220,278 $92,203 4,294,474 $49,245 $316,397 $38,031,421 ==================================================================================================================================== R&G Financial Corporation Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1997, 1996 and 1995 Unrealized gain Capital (loss) on securities Retained reserves available for sale earnings Total - ------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1994 $ 986,180 $ 54,569,219 $55,969,999 Transfer to capital reserves $666,767 (666,767) Net income 10,449,112 10,449,112 Net change in unrealized gain (loss) on securities available for sale, net of tax (33,931) (33,931) - ------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1995 666,767 952,249 64,351,564 66,385,180 Issuance of common stock (including 66,667 Class B shares exchanged for Class A shares in August): August 31,362,748 December 6,711,918 Transfer to capital reserves 793,940 (793,940) Cash dividends declared on common stock (972,336) (972,336) Net income 13,199,516 13,199,516 Net change in unrealized gain (loss) on securities available for sale, net of tax (1,054,134) (1,054,134) - ------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1996 1,460,707 (101,885) 75,784,804 115,632,892 Transfer to capital reserves 754,465 (754,465) Common stock split on September 25, 1997: Stock split Cash paid in lieu of fractional shares (12,659) (12,659) Cash dividends declared on common stock (2,385,752) (2,385,752) Net income 23,497,212 23,497,212 Net change in unrealized gain on securities available for sale, net of tax 1,322,223 1,322,223 - ------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1997 $2,215,172 $1,220,338 $96,129,140 $138,053,916 ===================================================================================================================
The accompanying notes are an integral part of these financial statements. 44
R&G Financial Corporation Consolidated Statements of Cash Flows Years Ended December 31, 1997, 1996 and 1995 1997 1996 1995 - ------------------------------------------------------------------------------------------------------------------------------------ Cash flows from operating activities: Net income $ 23,497,212 $ 13,199,516 $ 10,449,112 - ------------------------------------------------------------------------------------------------------------------------------------ Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 2,659,888 2,142,275 1,794,454 Amortization of premium (accretion of discount) on investments and mortgage - backed securities, net (371,816) 199,955 89,111 Amortization of deferred loan origination fees and accretion of discount on loans purchased (258,324) (411,219) (366,332) Amortization of excess servicing receivable -- 77,530 131,067 Amortization of servicing rights 1,837,414 1,213,606 1,497,803 Compensation cost on common shares granted -- 290,000 -- Change in allowance for cost in excess of market value of loans held for sale -- -- (855,834) Provision for loan losses 6,370,000 4,258,047 950,000 Provision for bad debts in accounts receivable 300,000 300,000 572,092 Gain on sales of mortgage loans (2,721,154) (599,935) (264,953) Gain on sales of investment securities available for sale (107,430) (641,798) -- Minority interest in earnings of the Bank -- 538,168 742,527 Decrease (increase) in mortgage loans held for sale 7,564,836 (33,131,819) 1,558,060 Net (increase) decrease in mortgage-backed securities held for trading (291,540,928) 5,662,504 14,914,098 Net decrease (increase) in investment securities held for trading 769,495 (1,350,827) -- (Increase) decrease in interest and accounts receivable (5,607,804) (3,065,914) 1,148,109 Other increases in other assets (1,986,644) (3,606,714) (1,812,808) Increase in notes payable 34,862,216 10,212,067 7,915,435 Increase (decrease) in accounts payable and accrued liabilities 5,128,545 (1,542,763) 6,442,758 (Decrease) increase in other liabilities (394,179) 1,167,645 934,566 - ------------------------------------------------------------------------------------------------------------------------------------ Total adjustments (243,495,885) (18,289,192) 35,390,153 Net Cash (used in) provided by operating activities (219,998,673) (5,089,676) 45,839,265 - ------------------------------------------------------------------------------------------------------------------------------------ Cash flows from investing activities: Purchases of investment securities available for sale and held to maturity (83,021,527) (47,623,969) (377,000) Proceeds from sales and maturities of investment securities available for sale 36,265,089 63,127,623 -- Proceeds from maturities of investment securities held to maturity -- 377,000 -- Principal repayments on mortgage-backed securities 9,475,202 10,554,678 8,636,250 Proceeds from sale of loans 120,955,837 50,326,054 20,201,648 Net originations of loans (285,970,693) (227,155,954) (210,377,522) Purchases of FHLB stock, net (658,757) (967,700) (1,401,700) Acquisition of premises and equipment (3,914,192) (2,592,494) (2,926,306) Net (increase) decrease in foreclosed real estate (853,716) (572,814) 83,488 Acquisition of servicing rights (10,455,392) (5,598,965) (5,289,651) - ------------------------------------------------------------------------------------------------------------------------------------ Net cash used in investing activities (218,178,149) (160,126,541) (191,450,793) - ------------------------------------------------------------------------------------------------------------------------------------ 45 R&G Financial Corporation Consolidated Statements of Cash Flows Years Ended December 31, 1997, 1996 and 1995 (continued) 1997 1996 1995 - ------------------------------------------------------------------------------------------------------------------------------------ Cash flows from financing activities: Proceeds from issuance of notes payable $-- $ 60,500,000 $ 27,400,000 Payments on notes payable (2,400,000) (25,000,000) -- Proceeds from issuance of long-term debt -- -- 2,000,000 Payments of long-term debt -- (5,323,899) (1,200,274) Increase in deposits - net 106,750,114 97,160,090 137,928,057 Increase (decrease) in securities sold under agreements to repurchase - net 284,838,362 (1,038,740) (10,437,272) Increase in federal funds purchased 10,000,000 -- -- Proceeds from secured borrowings -- -- 55,983,501 Payments on secured borrowings (16,103,451) (5,520,882) -- Advances from FHLB 161,700,000 16,000,000 -- Repayment of advances from FHLB (134,700,000) (7,000,000) (7,500,000) Proceeds from issuance of common stock to minority shareholders -- -- 10,321 Proceeds from issuance of common stock on initial public offering -- 31,072,748 -- Cash dividends on common stock (2,385,752) (972,336) -- Payment of cash in lieu of fractional shares on stock split (12,659) -- -- - ------------------------------------------------------------------------------------------------------------------------------------ Net cash provided by financing activities 407,686,614 159,876,981 204,184,333 - ------------------------------------------------------------------------------------------------------------------------------------ Net (decrease) increase in cash and cash equivalents (30,490,208) (5,339,236) 58,572,805 Cash and cash equivalents at beginning of year 98,855,931 104,195,167 45,622,362 - ------------------------------------------------------------------------------------------------------------------------------------ Cash and cash equivalents at end of year $ 68,365,723 $ 98,855,931 $ 104,195,167 ==================================================================================================================================== Cash and cash equivalents include: Cash and due from banks $ 32,607,001 $ 31,989,944 $ 32,559,429 Securities purchased under agreements to resell 16,000,000 19,633,178 21,694,675 Time deposits with other banks 16,758,722 33,232,809 44,930,015 Federal funds sold 3,000,000 14,000,000 5,011,048 - ------------------------------------------------------------------------------------------------------------------------------------ $ 68,365,723 $ 98,855,931 $ 104,195,167 ====================================================================================================================================
The accompanying notes are an integral part of these financial statements. 46 R&G FINANCIAL CORPORATION Notes to Consolidated Financial Statements December 31, 1997 and 1996 1. Reporting Entity and Summary of Significant Accounting Policies Reporting entity The accompanying consolidated financial statements of R&G Financial Corporation (the "Company") include the accounts of R&G Mortgage Corp. ("R&G Mortgage"), a Puerto Rico corporation, and R-G Premier Bank of Puerto Rico (the "Bank"), a commercial bank chartered under the laws of the Commonwealth of Puerto Rico. The Company was formed in March 1996 for the sole purpose of becoming the parent corporation and sole stockholder of R&G Mortgage and the Bank. On July 19, 1996 the Company acquired the 88% ownership interest of the Bank and the 100% ownership interest of R&G Mortgage held by the Company's Chairman of the Board and Chief Executive Officer (CEO). In consideration of the acquisition of such interests, the Company issued the CEO 5,189,044 shares of its Class A $.01 par value newly issued common stock (the Class A shares), in exchange for his 100% ownership interests. The transaction was accounted for at historical cost in a manner similar to pooling of interests accounting. On December 2, 1996 the Company also acquired the remaining 12% minority ownership interest in the Bank which was held by approximately 200 other stockholders (the Minority Bank Stockholders) through the issuance of 300,839 Class B $.01 par value common stock (the Class B shares) of the Company. The Minority Bank Stockholders received, in exchange for their aggregate 12% interest in the Bank's common stock, an aggregate of 300,839 of shares of the Company's Class B shares which was determined based on an independent valuation of the Bank. This transaction was accounted for under the purchase method of accounting resulting in the recognition of goodwill totaling approximately $2,578,000 which is being amortized over a 15 year period. On August 27, 1996, the Company sold 2,348,333 Class B shares of its common stock to the general public in an underwritten offering. The Company's CEO also converted 66,667 of his Class A shares into Class B shares and sold such shares in the public offering. As a result of such transaction, an aggregate of 2,415,000 Class B shares were publicly issued and are now traded on NASDAQ. The Company received gross proceeds of $35.0 million in the transaction, which resulted in estimated net proceeds of $31.1 million after payment of the underwriting discount and expenses. Immediately following the Company's initial public offering, the Company issued an additional 20,000 Class B shares to the Company's Vice Chairman of the Board in consideration for his past and ongoing services, which shares were not registered in such offering. R&G Mortgage is engaged primarily in the business of originating FHA insured, VA guaranteed, and privately insured first and second mortgage loans on residential real estate (1 to 4 families). R&G Mortgage pools FHA and VA loans into GNMA (Government National Mortgage Association) mortgage-backed securities and collateralized mortgage obligation (CMO) certificates for sale to permanent investors. Upon selling the loans, it retains the rights to service the loans. R&G Mortgage is also a Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FHLMC) Seller-Servicer of conventional loans. R&G Mortgage is licensed by the Secretary of the Treasury of Puerto Rico as a mortgage company and is duly authorized to do business in the Commonwealth of Puerto Rico. 47 The Bank provides a full range of banking services through fifteen branches located mainly in the northern part of the Commonwealth of Puerto Rico. As discussed in Note 17 to the consolidated financial statements, the Bank is subject to the regulations of certain federal and local agencies, and undergoes periodic examinations by those regulatory agencies. The accounting and reporting policies of the Company conform with generally accepted accounting principles. The following is a description of the significant accounting policies: Basis of consolidation All significant intercompany balances and transactions have been eliminated in the accompanying consolidated financial statements. Use of estimates in the preparation of financial statements The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period, and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements. Actual results could differ from those estimates. Securities purchased under agreements to resell The Company purchases securities under agreements to resell the same securities. Amounts advanced under these agreements represent short-term loans and are reflected as assets in the consolidated statement of financial condition. Investment securities Investments in debt and equity securities are classified at the time of purchase into one of three categories: Held to maturity- debt securities which the Company has a positive intent and ability to hold to maturity. These securities are carried at amortized cost. Trading- debt and equity securities that are bought by the Company and held principally for the purpose of selling them in the near term. These securities are carried at fair value, with unrealized gains and losses included in earnings. Mortgage-backed securities that are held for sale in conjunction with mortgage banking activities are classified as trading securities. Available for sale- debt and equity securities not classified as either held-to-maturity or trading. These securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported net of taxes in a separate component of stockholders' equity. Premiums and discounts are amortized as an adjustment to interest income over the life of the related securities using a method that approximates the interest method. Realized gains or losses for securities classified as either available for sale or held to maturity are reported in earnings. Cost of securities sold is determined on the specific identification method. Loans and allowance for loan losses Loans are stated at their outstanding principal balance, less unearned interest and allowance for loan losses. Loan origination and commitment fees and costs incurred in the origination of new loans are deferred and amortized using the interest method over the life of the loans as an adjustment of interest yield. Unearned interest on installment loans is recognized as income under a method which approximates the interest method. Interest on loans not made on a discounted basis is credited to income based on the loan principal outstanding at stated interest rates. Management believes that the allowance for loan losses is adequate. It is the policy of the Bank to increase its valuation allowances for estimated losses on loans when, based on management's evaluation, a loss becomes both probable and estimable. Major loans and major lending areas are reviewed periodically to determine potential problems at an early date. Also, management's periodic evaluation considers factors such as loss experience, current delinquency data, known and inherent risks in the portfolio, identification of adverse situations which may affect the ability of debtors to repay, the estimated value of any underlying collateral and assessment of current economic conditions. Additions to allowances are charged to income. Any recoveries are credited to the allowance. The Company measures impairment of individual loans, except for loans that are valued at fair value or at the lower of cost or fair value, based on the present value of expected future cash flows discounted at the loan's effective interest rate, or, as a practical method, at the observable market price of the loan, or the fair value of the collateral if the loan is collateral dependent. The Company considers loans over $500,000 for individual impairment evaluations. The Company collectively performs impairment evaluations for large groups of small - balance homogeneous loans. Loans are considered impaired when, based on management's evaluation, a borrower will not be able to fulfill its obligation under the original terms of the loan. Interest income Recognition of interest on mortgage, consumer and other loans is discontinued when loans are 90 days or more in arrears on payment of principal or interest or earlier when other factors indicate that collection of interest or principal is doubtful. Loans for which the recognition of interest income has been discontinued are designated as non-accruing. Such loans are not reinstated to accrual status until interest is received currently and no other factors indicative of doubtful collection exist. Discounts and premiums on purchased mortgage loans are accreted (amortized) to income over the remaining life of the loans. Mortgage loans held for sale Mortgage loans intended for sale in the secondary market are carried at the lower of cost or estimated market, computed in the aggregate. The amount by which cost exceeds market value is accounted for as a valuation allowance. Changes in the valuation allowance are included in the determination of income in the period in which the change occurs. 48 Loan servicing fees Loan servicing fees, which are based on a percentage of the principal balance of the mortgage loans serviced, are credited to income as mortgage payments are collected. Late charges and miscellaneous other fees collected from mortgagors are credited to income when earned, adjusted for estimated amounts not expected to be collected. Loan servicing costs are charged to expense when incurred. Allowance for doubtful accounts The allowance for doubtful accounts is determined based on experience and results mainly from expenses incurred in the foreclosure of property not reimbursed by insurers on loans serviced for others. Servicing rights During 1995, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 122 - "Accounting for Mortgage Servicing Rights - an amendment of FASB Statement No. 65," which permits the prospective capitalization of servicing rights acquired through loan origination activities and requires that a portion of the cost of originating a mortgage loan be allocated to the mortgage servicing right. Previously, only servicing rights acquired through purchases were capitalized. To determine the fair value of the servicing rights, the Company uses the market prices of comparable servicing sale contracts. SFAS 122 prohibits retroactive application, therefore, mortgage servicing rights related to loans originated prior to the adoption of the Statement are not recognized in the Company's consolidated financial statements until the related loans are sold. The cost of acquiring the rights to service mortgage loans is capitalized and amortized in proportion to and over the period of net servicing income. SFAS 122 also requires that all mortgage servicing rights be evaluated for impairment. In determining impairment, servicing rights were disaggregated by interest rate, the latter considered their predominant risk characteristic. For purposes of measuring impairment, mortgage servicing rights are stratified by loan on the basis of interest rates. An impairment is recognized whenever the prepayment pattern of the mortgage loan indicates that the fair value of the related mortgage servicing rights is less than its carrying amount. An impairment is recognized by charging such excess to income. The Company determined that no reserve for impairment was required as of December 31, 1997 or 1996. As of December 31, 1997 and 1996 the fair value of capitalized mortgage servicing rights was approximately $24,566,000 and $15,984,000, respectively. In determining fair value, the Company considers the fair value of servicing rights with similar risk characteristics. Accounting for transfers and servicing of financial assets and extinguishment of liabilities In June 1996 the FASB issued SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," amending SFAS 122. SFAS 125 requires the recognition of financial assets and servicing assets controlled by the reporting entity, the derecognition of financial assets when control is surrendered, and the derecognition of liabilities when they are extinguished. Specific criteria are established for determining when control has been surrendered in the transfer of financial assets. This Statement requires that liabilities and derivatives incurred or obtained by transferors as part of a transfer of financial assets be initially measured at fair value, if practicable. It also requires that servicing assets and other retained interests in the transferred assets be measured by allocating the previous carrying amount between the assets sold, if any, and retained interest, if any, based on their relative fair values at the date of the transfer. Servicing assets and liabilities must be subsequently adjusted by (a) amortization in proportion to and over the period of estimated net servicing income and loss and (b) assessment for asset impairment or increased obligation based on their fair values. SFAS 125 modifies the accounting for interest-only strips ("IOs") or retained interests in securitizations, such as excess servicing fees receivable, that can be contractually prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment, and requires that they be classified as available for sale or as trading securities. Management has determined that excess servicing fees receivable retained by the Company as a result of securitization transactions or bulk sales will be held as trading securities IOs if made in connection with its mortgage banking activities, and available for sale if not made in connection with such activities. In addition, all residual interests and mortgage-backed securities previously retained by the Company as part of its mortgage banking activities securitization transactions will also be held as trading securities. The provisions of this Statement, except as indicated below, were effective for transfers and servicing of financial assets and extinguishment of liabilities occurring on or after January 1, 1997, and must be applied prospectively. Earlier or retroactive application is not permitted. In connection with the adoption of SFAS 125 effective January 1, 1997, the Company reclassified the asset previously shown on the Company's Consolidated Balance Sheet as "Mortgage Servicing Rights" to "Servicing Asset." In addition, the asset previously shown as "Excess Servicing Fees Receivable" was reclassified as "Interest Only Strips" and is now included in the Company's Consolidated Balance Sheet as a component of "Mortgage-Backed Securities held for trading." In December 1996, the FASB issued SFAS No. 127 to defer until January 1, 1998 the effective date applicable to the provisions of SFAS 125 that deal with secured borrowings and collateral. Additionally, the deferment provision would apply to transfers of financial assets for repurchase agreements, dollar rolls and securities lending. Based on presently available information management believes the application of those provisions of SFAS 125 effective in 1998 should not have a material adverse effect on the Company's financial condition or results of operations. Sale of servicing rights The sale of servicing rights is recognized upon executing the contract and title and all risks and rewards have irrevocably passed to the buyer. Gains and losses realized on such sales are recognized based upon the difference between the selling price and the carrying value of the related servicing rights sold. 49 Foreclosed real estate held for sale Other real estate owned comprises properties acquired in settlement of loans and recorded at fair value less estimated costs to sell at the date of acquisition. Costs relating to the development and improvement of the property are capitalized, whereas those relating to holding the property are expensed as incurred. 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. In providing allowances for losses, the cost of holding real estate, including interest costs, are considered. Gains or losses resulting from the sale of these properties are credited or charged to income. Premises and equipment Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful life of each type of asset. Major additions and improvements which extend the life of the assets are capitalized, while repairs and maintenance are charged to expense. Effective January 1, 1996 the Company adopted SFAS No. 121 - "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of." Under this Statement, long-lived assets and certain identifiable intangibles to be held and used must be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In performing the review for recoverability, an estimate of the future cash flows expected to result from the use of the asset and its eventual disposition must be made. If the sum of the future cash flows (undiscounted and without interest charges) is less than the carrying amount of the asset, an impairment loss is recognized for the difference, if any, between the discounted future cash flows and the carrying value of the asset. The application of this Statement had no effect on the Company's financial condition or results of operations for 1996. Goodwill and other intangibles Goodwill results from the acquisition in December 1996 of the 12% minority interest in the Bank as described in Note 1 to the consolidated financial statements, and from the acquisition of a mortgage banking institution and the Bank in prior years, which is being amortized over a fifteen year period. Accumulated amortization amounted to $1,363,045 and $1,059,636 as of December 31, 1997 and 1996, respectively. In addition, the Company has recorded as a deposit intangible the premium paid by the Bank over the value of deposits acquired resulting from the purchase of certain branches from a commercial bank in 1995. The premium paid, which approximated $1,351,000, was determined based on negotiations between the parties to the agreement and is being amortized over a 10 year period. Accumulated amortization amounted to approximately $342,000 and $204,000 at December 31, 1997 and 1996, respectively. Securities sold under agreements to repurchase The Company sells securities under agreements to repurchase the same or similar securities. Amounts received under these agreements represent short-term borrowings and the securities underlying the agreements remain in the asset accounts. Transfers of receivables with recourse Transfers of receivables with recourse are recognized as a sale if the Company surrenders control of the future economic benefits embodied in the receivables, its obligation under the recourse provisions can be reasonably estimated and the transferee cannot require the Company to repurchase the receivables except pursuant to the recourse provisions. Any transfers of receivables with recourse not meeting all of these conditions are recognized as a liability in the consolidated financial statements. Gains and losses realized on the sale of loans are recognized at the time of the sale of the loans or pools to investors, based upon the difference between the selling price and the carrying value of the related loans sold as adjusted for any estimated liability under recourse provisions. In most sales, the right to service the loans sold is retained by the Company. Interest rate risk management The Company enters into interest rate caps, swaps, options and/or futures contracts (primarily based on Eurodollar certificates of deposits and U.S. Treasury Notes) to manage its interest rate exposure. Such instruments are designated as hedges against future fluctuations in the interest rates of specifically identified assets or liabilities. Options and futures are reported at fair value within investments in the accompanying consolidated statement of financial condition; related gains or losses are reported in the statement of income. Interest rate swaps are not recognized in the consolidated statement of financial condition and are not marked to market. Net interest settlements on interest rate swaps are recorded as adjustments to interest income or expense. Employee benefits The Company and its subsidiaries have no post retirement benefit plans for its employees as of December 31, 1997. Income taxes The Company follows an asset and liability approach in the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. A valuation allowance is recognized for any deferred tax asset for which, based on management's evaluation, it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax asset will not be realized. 50 Capital reserve The Banking Act of the Commonwealth of Puerto Rico, as amended, requires that a minimum of 10% of net income of the Bank be transferred to capital surplus until such surplus equals the sum of the Bank's paid-in common and preferred stock capital. Stock option plans As discussed in Note 18 to the consolidated financial statements, the Company adopted a Stock Option Plan in June 1996 and granted stock options to certain employees thereunder in conjunction with the Company's initial public offering. Compensation cost on employee stock option plans is measured and recognized for any excess of the quoted market price of the Company's stock at the grant date over the amount an employee must pay to acquire the stock (intrinsic value-based method of accounting). Generally, stock options are granted with an exercise price equal to the face value of the stock at the date of the grant and, accordingly, no compensation cost is recognized. The Company adopted in 1996 the disclosure provisions of SFAS No. 123, "Accounting for Stock-Based Compensation." Fair value of financial instruments The reported fair values of financial instruments are based on a variety of factors. For a substantial portion of financial instruments, fair values represent quoted market prices for identical or comparable instruments. In a few other cases, fair values have been estimated based on assumptions concerning the amount and timing of estimated future cash flows and assumed discount rates reflecting varying degrees of risk. Accordingly, the fair values may not represent actual values of the financial instruments that could have been realized as of year end or that will be realized in the future. Earnings per share Basic earnings per common share is computed by dividing net income for the year by the weighted average number of shares outstanding during the period. Outstanding stock options granted under the Company's Stock Option Plan are included in the weighted average number of shares for purposes of the diluted earnings per share computation pursuant to SFAS No. 128 - "Earnings per Share." SFAS 128 replaces the presentation of primary EPS with a presentation of basic EPS. It also requires dual presentation of basic and diluted EPS computation on the face of the income statement for all entities with complex capital structures and requires reconciliation of the numerator and denominator of the diluted EPS computation. SFAS 128, which also applies to interim periods, was adopted by the Company in December 31, 1997. This Statement requires the restatement of all prior-period EPS data presented. Prior to the adoption of SFAS 128 the Company's capital structure was such that the presentation of the fully diluted EPS data was not necessary, and the prior period presentation of primary EPS data excluded outstanding stock options granted under the Company's stock option plan from the weighted average number of shares outstanding because their dilutive effect was insignificant. Accordingly, the basic EPS data presented under SFAS 128 is equivalent to the primary EPS data previously presented. Statement of cash flows For purposes of reporting cash flows, cash and cash equivalents include cash on hand and amounts due from banks and other highly liquid securities with an original maturity of three months or less. Changes in accounting standards In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income." This Statement requires (1) the classification of items of other comprehensive income by their nature in a financial statement; (2) the display of the accumulated balance of other comprehensive income by their nature in a financial statement; and (3) the display of the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of the statement of financial position. For the Company, unrealized gains and losses on certain investments in debt securities will be the only other comprehensive income item to be included in comprehensive income. This Statement is effective for fiscal years beginning after December 15, 1997. This Statement affects only financial statement presentation and, therefore, management believes that its adoption will not have a material effect, if any, on the Company's financial position or results of operations. In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." This Statement requires that a public business enterprise report financial and descriptive information about its reportable segments. Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Management has not yet made a determination on the business lines of the Company that fulfill the segment definition described above. This Statement is effective for fiscal years beginning after December 15, 1997. Reclassification of financial statements for earlier periods provided for comparative purposes is required. This Statement affects only financial statement presentation and disclosure and, therefore, management believes it will not have a material effect, if any, on the Company's financial position or results of operations. Reclassifications Certain reclassifications have been made to the 1996 and 1995 financial statements to conform to the 1997 financial statement presentation. 51 2. Mortgage Loans Held for Sale Mortgage loans held for sale consist of:
December 31, 1997 1996 - -------------------------------------------------------------------------------- Conventional loans $25,003,291 $ 9,254,440 FHA/VA loans 21,882,032 44,863,833 Construction loans -- 331,886 - -------------------------------------------------------------------------------- $46,885,323 $54,450,159 ================================================================================
The aggregate amortized cost and approximate market value of loans held for sale as of December 31, 1997 are as follows:
Amortized Gross unrealized Grosss unrealized Approximate cost holding gains holding losses market value - -------------------------------------------------------------------------------- $46,885,323 $1,465,427 $(5,498) $48,345,252 ================================================================================
Substantially all of the loans are pledged to secure various borrowings from lenders under mortgage warehousing lines of credit (see Note 9). The following table summarizes the components of gain on sale of mortgage loans held-for-sale and mortgage-backed securities held-for-trading:
Year ended December 31, 1997 1996 1995 - --------------------------------------------------------------------------------------- Proceeds from sales of mortgage loans and mortgage-backed securities $ 370,121,097 $ 297,606,773 $ 218,738,872 Mortgage loans and mortgage- backed securities sold (359,001,427) (290,777,907) (215,176,557) - --------------------------------------------------------------------------------------- Gain on sales, net 11,119,670 6,828,866 3,562,315 Deferred fees earned, net of loan origination costs and commitment fees paid 3,235,381 4,976,079 2,700,145 - --------------------------------------------------------------------------------------- 14,355,051 11,804,945 6,262,460 Net unrealized profit (loss) on trading securities 9,677,663 (95,971) 2,121,611 - --------------------------------------------------------------------------------------- Net gain on ?????????? sale of mortgage loans $ 24,032,714 $ 11,708,974 $ 8,384,071 =======================================================================================
Total gross loan origination fees totaled approximately $13,614,000, $13,041,000 and $9,488,000 during the years ended December 31, 1997, 1996 and 1995, respectively. Gross gains of $11,532,566, $7,479,507 and $4,057f352, and gross losses of $412,896, $650,641 and $496,037 were realized on the above sales during the years ended December 31, 1997, 1996 and 1995, respectively. 52 3. Investment Securities The carrying value and estimated fair value of investment securities by category and contractual maturities are shown below. The fair value of investment securities is based on quoted market prices and dealer ??????? except for the investment in Federal Home Loan Bank (FHLB) stock which is valued at its redemption value.
December 31, 1997 1996 Amortized Fair Amortized Fair cost value cost value - ------------------------------------------------------------------------------------------------------------------------------------ Investment securities held to maturity U.S. Treasury securities: Due within one year $ 309,839 $ 310,775 $ -- $ -- Due from one to five years -- -- 309,575 310,871 - ------------------------------------------------------------------------------------------------------------------------------------ 309,839 310,775 309,575 310,871 - ------------------------------------------------------------------------------------------------------------------------------------ Puerto Rico Government and Agencies obligations: Due within one year 4,433,177 4,439,474 -- -- Due from one to five years -- -- 1,034,998 1,012,500 Due from five to ten years 5,920,000 5,910,000 -- -- Due over ten years 29,786 29,786 574,453 566,951 - ------------------------------------------------------------------------------------------------------------------------------------ 10,382,963 10,379,260 1,609,451 1,579,451 - ------------------------------------------------------------------------------------------------------------------------------------ Corporate securities - Due within one year -- -- 3,350,824 3,350,824 - ------------------------------------------------------------------------------------------------------------------------------------ $10,692,802 $10,690,035 $ 5,269,850 $ 5,241,146 ==================================================================================================================================== Mortgage-backed securities held to maturity GNMA certificates: Due from one to five years $ 49,347 $ 50,128 $ -- $ -- Due from five to ten years -- -- 96,696 99,828 Due over ten years 18,321,595 17,704,769 21,590,649 20,571,360 - ------------------------------------------------------------------------------------------------------------------------------------ 18,370,942 17,754,897 21,687,345 20,671,188 - ------------------------------------------------------------------------------------------------------------------------------------ Federal National Mortgage Association (FNMA) certificates- Due over ten years 14,674,783 15,164,453 15,895,067 16,124,357 - ------------------------------------------------------------------------------------------------------------------------------------ Federal Home Loan Mortgage Corporation (FHLMC) certificates- Due over ten years 280,747 266,322 317,435 308,846 - ------------------------------------------------------------------------------------------------------------------------------------ $33,326,472 $33,185,672 $37,899,847 $37,104,391 ====================================================================================================================================
53 Expected maturities on debt securities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
December 31, 1997 1996 Amortized Fair Amortized Fair cost value cost value - ------------------------------------------------------------------------------------------------------------------------------------ Mortgage-backed securities available for sale CMO residuals and other mortgage-backed securities $ 7,006,610 $ 8,381,982 $ 7,066,610 $ 8,195,379 - ------------------------------------------------------------------------------------------------------------------------------------ FNMA certificates - Due over ten years 9,468,141 9,670,108 10,562,799 10,293,218 - ------------------------------------------------------------------------------------------------------------------------------------ FHLMC certificates: Due from one to five years 70,584 70,452 -- -- Due from five to ten years 359,980 368,203 529,902 547,027 Due over ten years 27,104,346 27,513,104 32,547,150 31,805,541 - ------------------------------------------------------------------------------------------------------------------------------------ 27,534,910 27,951,759 33,077,052 32,352,568 - ------------------------------------------------------------------------------------------------------------------------------------ $44,009,661 $46,003,849 $50,706,461 $50,841,165 ==================================================================================================================================== Investment securities available for sale US Treasury securities: Due within one year $ 773,156 $ 771,593 $ -- $ -- Due from one to five years 30,009,771 30,100,000 -- -- - ------------------------------------------------------------------------------------------------------------------------------------ 30,782,927 30,871,593 -- -- - ------------------------------------------------------------------------------------------------------------------------------------ U.S. Government and Agencies securities: Due within one year -- -- 1,500,000 1,500,000 Due from one to five years 35,145,089 35,104,828 25,527,679 25,225,950 Due from five to ten years 5,022,904 4,980,865 -- -- - ------------------------------------------------------------------------------------------------------------------------------------ 40,167,993 40,085,693 27,027,679 26,725,950 - ------------------------------------------------------------------------------------------------------------------------------------ 70,950,920 70,957,286 27,027,679 26,725,950 FHLB stock 4,906,067 4,906,067 4,247,310 4,247,310 - ------------------------------------------------------------------------------------------------------------------------------------ $75,856,987 $75,863,353 $31,274,989 $30,973,260 ====================================================================================================================================
Mortgage backed securities available for sale include interest only securities with an amortized cost of $2,363,942 as of December 31, 1997 and 1996, which are associated with the sale in prior years of collateralized mortgage obligations not related to the Company's mortgage banking activities. 54 Mortgage - backed securities held for trading:
December 31, 1997 1996 - -------------------------------------------------------------------------------- CMO Certificates $ 15,228,000 $ 15,147,000 CMO Residuals (interest only) 7,867,662 9,309,548 GNMA Certificates 377,361,794 84,459,980 - -------------------------------------------------------------------------------- $400,457,456 $108,916,528 ================================================================================
Unrealized gains and losses on securities held to maturity and available for sale follows:
December 31, 1997 1996 Gross unrealized Gross unrealized Gains Losses Gains Losses - ------------------------------------------------------------------------------------------------------------------------------------ Securities held to maturity: Puerto Rico and United States Government obligations $ 936 $ (37,757) $ 13,795 $ (42,499) Mortgage-backed securities 504,349 (645,149) 338,941 (1,134,397) - ------------------------------------------------------------------------------------------------------------------------------------ $ 505,285 (682,906) $ 352,736 $(1,176,896) ==================================================================================================================================== Securities available for sale: US Government obligations $ 113,223 $ (106,857) $ -- $ (301,729) Mortgage-backed securities 2,043,941 (49,753) 1,003,887 (869,183) - ------------------------------------------------------------------------------------------------------------------------------------ $ 2,157,164 $ (156,610) $ 1,003,887 $(1,170,912) ====================================================================================================================================
During 1997 and 1996 the Company had proceeds from the sale of investment securities held for trading of approximately $10,083,000 and $11,440,000, respectively; gains realized on such sales totaled approximately $31,000 and $44,000, respectively; no losses were realized. No investment securities held for trading were sold in 1995. During the years ended December 31, 1997 and 1996 proceeds from the sale of securities available for sale totaled approximately $7,915,000 and $48,950,000, respectively; gains realized in those sales totaled approximately $107,000 and $642,000, respectively; no losses were realized. There were no sales of securities available for sale during 1995. During 1997 the Company reclassified $773,000 investment securities held for trading to available for sale. During 1995, the Company reclassified investment securities from its available for sale to its held for trading portfolio with a carrying value of approximately $4,671,000 at the time of the transfer, resulting in an increase in net income of $470,092 at such time. As discussed in Notes 7, 8, 9, 10, 11 and 12 to the consolidated financial statements, investment and mortgage-backed securities, mortgage loans, and deposits at interest with banks amounting to approximately $696.0 million as of December 31, 1997 were pledged to secure certain deposits and securities sold under agreements to repurchase, advances from the FHLB, notes payable, subordinated notes and irrevocable standby letters of credit issued by the FHLB. 55 4. Loans and Allowance for Loan Losses Loans consist of the following:
December 31, 1997 1996 - -------------------------------------------------------------------------------- Real estate loans: Residential - first mortgage $ 476,652,596 $ 370,875,512 Residential - second mortgage 17,831,079 15,757,050 Land 76,400 -- Construction 13,367,513 5,351,115 Commercial 87,506,802 75,214,109 - -------------------------------------------------------------------------------- 595,434,390 467,197,786 Undisbursed portion of loans in process (6,218,039) (2,429,714) Net deferred loan fees 172,019 40,555 - -------------------------------------------------------------------------------- 589,388,370 464,808,627 - -------------------------------------------------------------------------------- Other loans: Commercial 38,598,227 31,062,947 Consumer: Loans secured by deposits 12,471,772 9,408,892 Loans secured by real estate 81,251,989 42,893,213 Other 50,632,418 59,864,037 Unamortized discount (151,460) (278,320) Unearned interest (360,195) (677,130) - -------------------------------------------------------------------------------- 182,442,751 142,273,639 - -------------------------------------------------------------------------------- Total loans 771,831,121 607,082,266 Allowance for loan losses (6,771,702) (3,331,645) - -------------------------------------------------------------------------------- $ 765,059,419 $ 603,750,621 ================================================================================
The changes in the allowance for loan losses follow:
Year ended December 31, 1997 1996 1995 - -------------------------------------------------------------------------------- Balance, beginning of year $ 3,331,645 $ 3,510,251 $ 2,887,099 Provision for loan losses 6,370,000 4,258,047 950,000 Loans charged-off (5,376,573) (4,662,407) (508,946) Recoveries 2,446,630 225,754 182,098 - -------------------------------------------------------------------------------- Balance, end of year $ 6,771,702 $ 3,331,645 $ 3,510,251 ================================================================================
As of December 31, 1997 the Company had three commercial loans classified as impaired totaling $1,570,642 in aggregate. Based on presently available information, the Company has determined that no reserves for impairment were necessary as of such date since the fair value of the collaterals securing such loans exceed their outstanding balances. No individual loans were impaired as of December 31, 1996. As of December 31, 1997, 1996 and 1995, loans on which the accrual of interest income had been discontinued amounted to approximately $29,968,000, $18,730,000 and $10,032,000, respectively. The additional interest income that would have been recognized during 1997, 1996 and 1995 had these loans been accruing interest amounted to approximately $1,095,000, $864,000 and $261,000, respectively. The Company has no material commitments to lend additional funds to borrowers whose loans were in non-accruing status at December 31, 1997. 56 5. Mortgage Loan Servicing The Company's fees for servicing mortgage loans generally range from .25% to .50% on the declining outstanding principal balances of the mortgage loans serviced. Servicing fees are collected on a monthly basis out of payments from mortgagors. The servicing agreements are terminable by permanent investors for cause without penalty or after payment of a termination fee ranging from .5% to 1% of the outstanding principal balance of the loans. At December 31, 1997 and 1996, the mortgage loans servicing portfolio amounted to approximately $2,552,030,000 and $2,226,406,000, respectively, excluding approximately $448,858,000 and $323,763,000, respectively, serviced for the Bank. The changes in the servicing asset of the Company follows:
Year ended December 31, 1997 1996 1995 - -------------------------------------------------------------------------------- Balance at beginning of period $ 12,595,020 $ 8,209,661 $ 4,417,813 Rights originated 8,057,574 4,172,868 2,285,331 Rights purchased 2,397,818 1,426,097 3,004,320 Scheduled amortization (1,837,414) (1,213,606) (1,497,803) - -------------------------------------------------------------------------------- Balance at end of period $ 21,212,998 $ 12,595,020 $ 8,209,661 ================================================================================
Among the conditions established in its various servicing agreements, the Company is committed to advance from its own funds any shortage of moneys required to complete timely payments to investors in GNMA mortgage-backed securities issued and in its FNMA and FHLMC portfolio. At December 31, 1997, the mortgage loan portfolio serviced for GNMA, FNMA and FHLMC and subject to the timely payment commitment amounted to approximately $1,779,252,000, $53,760,000 and $474,079,000, respectively (1996 - $1,543,242,000, $61,565,000, and $377,252,000). Total funds advanced as of December 31, 1997 in relation to such commitments amount to $782,000, $1,688,000 and $530,000 for escrow advances, principal and interest advances and foreclosure advances, respectively (1996 - $787,000, $1,313,000 and $344,000). In connection with mortgage servicing activities, the Company holds funds in trust for investors representing amounts collected primarily for the payment of principal, interest, real estate taxes and insurance premiums. Such funds are deposited in separate custodial bank accounts, some of which are deposited in the Bank. At December 31, 1997 and 1996, the related escrow funds include approximately $50,163,000 and $10,555,000, respectively, deposited in the Bank; these funds are included in the Company's consolidated financial statements. Escrow funds also include approximately $8,654,000 and $28,422,000 at December 31, 1997 and 1996, respectively, deposited with other banks and excluded from the Company's assets and liabilities. 57 6. Premises and Equipment Premises and equipment consist of:
December 31, 1997 1996 - -------------------------------------------------------------------------------- Furniture and fixtures $ 13,026,459 $ 10,135,761 Leasehold improvements 6,073,038 5,186,573 Autos 375,826 205,962 - -------------------------------------------------------------------------------- 19,475,323 15,528,296 Less - Accumulated depreciation and amortization (9,947,764) (7,760,616) - -------------------------------------------------------------------------------- $ 9,527,559 $ 7,767,680 ================================================================================
7. Deposits Deposits are summarized as follows:
December 31, 1997 1996 - -------------------------------------------------------------------------------- Passbook savings $ 79,628,833 $ 73,965,054 NOW accounts 27,644,104 24,555,925 Super NOW accounts 67,650,384 57,629,203 Regular checking accounts (non-interest bearing) 32,720,996 23,236,975 Commercial checking accounts (non-interest bearing) 58,783,328 31,007,473 - -------------------------------------------------------------------------------- 186,798,812 136,429,576 - -------------------------------------------------------------------------------- Certificates of deposit: Under $100,000 257,431,730 235,061,722 $100,000 and over 196,961,831 168,614,740 - -------------------------------------------------------------------------------- 454,393,561 403,676,462 - -------------------------------------------------------------------------------- Accrued interest payable 1,597,288 1,496,389 - -------------------------------------------------------------------------------- $722,418,494 $615,567,481 ================================================================================
The weighted average stated interest rate on all deposits at December 31, 1997 and 1996 was 4.82% and 5.07%, respectively. As of December 31, 1997, the Company had delivered investment securities with an amortized cost of approximately $1,500,000 and market value of approximately $1,490,000 as collateral for public funds' deposits of approximately $852,000. 58 8. Securities Sold Under Agreements to Repurchase At December 31, 1997 and 1996, the Company had repurchase agreements outstanding with interest ranging from 5.10% to 6.00% in 1997 and 5.48% to 5.75% in 1996. These agreements mature within thirty days. Information on these agreements follows:
December 31, 1997 1996 Approximate market Approximate market Repurchase and carrying value of Repurchase and carrying value of liability underlying securities liability underlying securities - ------------------------------------------------------------------------------------------------------------------------------------ Type of security U.S. Treasury securities $ 30,095,287 $ 30,326,667 $ -- $ -- U.S. Government and Agencies securities 5,580,000 5,995,405 -- -- GNMA 312,463,863 321,440,226 75,710,383 79,627,257 CMO Tranches 13,576,380 15,228,000 13,576,384 15,147,000 CMO Residuals 8,162,280 7,264,420 8,157,681 8,593,151 FHLMC 12,405,000 12,954,146 -- -- - ------------------------------------------------------------------------------------------------------------------------------------ $382,282,810 $393,208,864 $ 97,444,448 $103,367,408 ====================================================================================================================================
Maximum amount of borrowings outstanding at any month-end during 1997 and 1996 under the agreements to repurchase were $382,309,000 and $127,240,000, respectively. The approximate average aggregate balance outstanding during the periods were $226,771,000 and $100,607,000, respectively. The weighted average interest rate of such agreements was 5.81% and 3.99% at December 31, 1997 and 1996, respectively; the weighted average rate during 1997 and 1996 was 5.95% and 4.99%, respectively. Since repurchase agreements are short-term commitments to borrow funds, they can be assumed to reprice at least quarterly. Therefore, the outstanding balance of repurchase agreements is estimated to be its fair value. Securities sold under agreements to repurchase are classified by dealer as follows:
December 31, 1997 1996 Approximate market Approximate market Repurchase and carrying value of Repurchase and carrying value of liability underlying securities liability underlying securities - ------------------------------------------------------------------------------------------------------------------------------------ Citibank, N.A $197,112,165 $203,113,664 $ 56,330,448 $ 62,150,725 Merrill Lynch of Puerto Rico Inc. 152,493,000 156,861,232 11,200,000 11,742,604 Smith Barney Puerto Rico, Inc. 12,512,358 12,927,611 -- -- Paine Webber, Inc. of Puerto Rico -- -- 29,914,000 29,474,079 Popular Securities, Inc. 10,215,287 10,293,857 -- -- Prudential Securities, Inc. 9,950,000 10,012,500 -- -- - ------------------------------------------------------------------------------------------------------------------------------------ $382,282,810 $393,208,864 $ 97,444,448 $103,367,408 ====================================================================================================================================
The securities underlying such agreements were delivered to, and are being held by, the dealers with whom the securities sold under agreements to repurchase were transacted. The dealers may have sold, lent, or otherwise disposed of such securities to other parties in the normal course of their operations, but have agreed to resell the Company the same or similar securities at the maturities of the agreements. All agreements mature within thirty days. 59 9. Notes Payable Notes payable consist of:
December 31, 1997 1996 - ------------------------------------------------------------------------------------------------------------------------------------ Warehousing lines, bearing interest at a floating rate of 1.50% over the counterparty's cost of funds (5.85% in 1997 and 4.97% in 1996) $ 75,204,315 $ 40,342,099 Promissory notes maturing in 1999 paying semiannual interest at fixed annual rates ranging from 6.20% to 7.15% 23,600,000 23,600,000 Promissory notes maturing in 2000 paying semiannual interest at fixed annual rates ranging from 5.55% to 5.67% 15,000,000 15,000,000 Promissory note maturing in 2000 paying quarterly interest at a floating rate of 84% of the three month Libid rate less .125% (4.73% at December 31, 1997 and 4.62% at December 31, 1996) 10,000,000 10,000,000 Promissory note maturing in 2003 paying semiannual interest at a fixed annual rate of 5.50% (prepaid in 1997) -- 2,400,000 Promissory note maturing in 2001 paying quarterly interest at a floating rate of 96% of the three month Libid rate (5.34% at December 31, 1997 and 5.28% at December 31, 1996) 25,000,000 25,000,000 Promissory note maturing in 2001 paying semiannual interest at a fixed annual rate of 6.52% 10,500,000 10,500,000 - ------------------------------------------------------------------------------------------------------------------------------------ $159,304,315 $126,842,099 ====================================================================================================================================
As of December 31, 1997, the Company had various credit line agreements permitting the Company to borrow up to $138,425,000 in warehousing lines with banks; the unused portion of warehousing lines totaled approximately $63.2 million. Warehousing lines at December 31, 1997 are collateralized by approximately $111,727,000 in mortgage loans, an assignment of key man insurance policies on the Company's Chairman of the Board and Chief Executive Officer, and a general assignment of mortgage payments receivable. These borrowings bear interest at rates related to the respective counterparty's cost of funds or the Puerto Rico 936 funds market when available. Some of these borrowings are also guaranteed by the Chairman of the Board and Chief Executive Officer of the Company. Several credit line agreements impose certain restrictions on the Company of which the most important include maintaining net worth and debt service over certain defined minimums, and limitations on indebtedness and declaration of dividends. Management believes that at December 31, 1997 the Company was in compliance with the loan agreements. The following information relates to borrowings of the Company under the credit line agreements:
December 31, 1997 1996 - -------------------------------------------------------------------------------- Maximum aggregate borrowings outstanding at any month end $ 93,523,091 $ 85,134,732 ================================================================================ Approximate average aggregate borrowings outstanding during the year $ 68,159,621 $ 40,805,743 ================================================================================ Weighted average interest rate during the year computed on a monthly basis 5.92% 5.32% - -------------------------------------------------------------------------------- Weighted average interest rate at end of year 5.85% 4.97% - --------------------------------------------------------------------------------
60 Certain promissory notes totaling $38,600,000 at December 31, 1997 include pledge agreements where the Company has pledged certain negotiable securities as a guarantee for payment of some of the notes. The pledge agreements provide that the value of the pledged securities must not fall below 105% of the principal balance of the promissory note plus accrued interest on such amount. In the event that the securities' value falls below the stated percentage, the Company must deliver additional negotiable securities. At December 31, 1997 securities pledged in compliance with this requirement consist of investment and mortgage-backed securities with an amortized cost of approximately $38,950,000 and approximate market value of $39,010,000. At December 31, 1997 floating rate notes in the aggregate amount of $35,000,000 and fixed rate notes of $10,500,000 are guaranteed by letters of credit issued by the FHLB -NY. Promissory notes by maturity as of December 31, 1997 follows: 1999 $ 23,600,000 2000 25,000,000 2001 35,500,000 - -------------------------------------------------------------------------------- $ 84,100,000 ================================================================================ 10. Advances from The Federal Home Loan Bank of New York Advances from the FHLB are as follows:
December 31, Interest Maturity Rate 1997 1996 - ------------------------------------------------------------------------------------ January 7, 1998 6.15% $10,000,000 $ -- January 15, 1998 6.00% 32,000,000 -- February 28, 1997 5.78% -- 5,000,000 March 31, 1997 5.73% -- 5,000,000 June 27, 1997 5.74% -- 5,000,000 - ------------------------------------------------------------------------------------ $42,000,000 $15,000,000 - ------------------------------------------------------------------------------------ Weighted average stated interest rate 6.03% 5.75% ====================================================================================
The Bank receives advances from the FHLB under an Advances, Collateral Pledge and Security Agreement (the "Agreement"), which allows the Company to borrow up to $223.4 million. As of December 31, 1997 the unused portion under such line of credit was approximately $181.4 million. Under the Agreement, the Bank is required to maintain a minimum amount of qualifying collateral with a market value of at least 110% of the outstanding advances. In addition, the Bank maintains standby letters of credit with the FHLB amounting to approximately $51,300,000 at December 31, 1997. At December 31, 1997 the specific collateral (in the form of first mortgage notes) amounting to approximately $112,866,000 were pledged to the FHLB as part of the Agreement and to secure standby letters of credit. At December 31, 1997, the market value of the collateral indicated above was sufficient to comply with the provisions of the Agreement. 61 11. Other Secured Borrowings In December 1995, the Bank sold mortgage loans with an approximate outstanding balance of $55 million to two commercial banks (buyers). In connection with this transaction, R&G Mortgage assumed certain limited recourse provisions and guaranteed a specific yield of 7.75% to the buyers. In addition, the buyers have the right (put option) at their option, to require R&G Mortgage to purchase the mortgage loans in December 2000 or thereafter. Liability, if any, under the recourse provisions at December 31, 1997 is estimated by management to be insignificant. As part of the agreement, R&G Mortgage has the right to repurchase after December 1996 any group of loans sold. For any loan repurchases, R&G Mortgage is obligated to pay the buyers 50 basis points over the outstanding balance of the mortgage loans repurchased. The Company recognized the transaction as a transfer of loans with recourse not qualifying as a sale. Accordingly, the proceeds from the transaction were reported as a secured borrowing in the accompanying consolidated financial statements, with a balance of approximately $34,359,000 and $50,463,000 at December 31, 1997 and 1996, respectively. The outstanding principal of the related loans totaling approximately $33,868,000 and $49,740,000 have been included as assets at December 31, 1997 and 1996, respectively. 12. Subordinated Notes On June 14, 1991 the Bank issued $3,250,000 in subordinated capital notes bearing interest at 8% payable quarterly. These notes are guaranteed by R&G Mortgage and by the Company's Chairman of the Board and Chief Executive Officer, and by an irrevocable transferable letter of credit issued by a commercial bank. The Bank shall deposit in seven equal annual installments (the first of which was made in September 1992 and the last deposit is scheduled for June 1998) with a trustee for credit to an established sinking fund, cash or permitted investments in an amount sufficient to retire one-seventh (1/7) or $464,286, of the aggregate principal amount. Likewise, the letter of credit is reduced in equal proportion to the deposits in such sinking fund. Investments deposited in the Trust as of December 31, 1997 in compliance with this requirement consist of FHLMC Participation Certificates with an amortized cost of approximately $1,205,000 and approximate market value of $1,230,000, and $2,633,000 in special deposit accounts. 62 13. Income Taxes Under the Puerto Rico tax law R&G Mortgage's and the Bank's tax liability will be the greater of the tax computed under the regular tax system or the alternative minimum tax (AMT) system. The AMT is imposed based on 22% of regular taxable income after certain adjustments for preference items. An AMT credit may be claimed in future years for tax paid on an AMT basis in excess of the regular tax basis. R&G Mortgage and the Bank are separate taxable entities under the Puerto Rico Income Tax Law and are not entitled to file consolidated tax returns. The Bank is subject to Puerto Rico income tax on its income derived from all sources within and outside Puerto Rico. The Bank is also subject to United States income taxes on certain types of income from such source. However, any United States income tax paid by the Bank is, subject to certain conditions and limitations, creditable as a foreign tax credit against its Puerto Rico income tax liability. A portion of the Company's interest income arises from mortgage loans and mortgage-backed securities which are exempt for Puerto Rico income tax purposes. The elimination of exempt income, net of related expenses, from the determination of taxable income results in a reduction of its income tax liability. Deferred tax (assets) liabilities are as follows:
December 31, 1997 1996 - ------------------------------------------------------------------------------------- Deferred tax liabilities: Deferred net loan origination costs $ 346,286 $ 385,019 Unrealized gain on securities held for trading 3,696,685 -- Reserve for bad debts 45,885 -- CMO residuals (IOs) 1,096,090 1,313,501 Servicing assets 1,424,600 1,504,670 Unrealized gain on securities available for sale 780,216 -- - ------------------------------------------------------------------------------------- 7,389,762 3,203,190 - ------------------------------------------------------------------------------------- Deferred tax assets: Unrealized loss on securities available for sale -- (65,140) Allowance for loan losses (1,176,463) (272,593) Reserve for bad debts -- (11,483) Unrealized loss on securities held for trading -- (124,991) Other foreclosed property reserve (11,232) (22,805) Recourse contingency (61,653) -- Discount on tax credits purchased (247,960) -- Deferred gains on sale of loans and investment securities (378,600) (505,999) - ------------------------------------------------------------------------------------- (1,875,908) (1,003,011) - ------------------------------------------------------------------------------------- Net deferred tax liability $ 5,513,854 $ 2,200,179 =====================================================================================
63 The provision for income taxes of the Company varies from amounts computed by applying the applicable Puerto Rico statutory tax rate to income before taxes as follows:
($ in thousands) Year ended December 31, 1997 1996 1995 % of pretax % of pretax % of pretax Amount income Amount income Amount income - ------------------------------------------------------------------------------------------------------------------------------------ Computed income tax at statutory rate $ 12,569 39% $ 7,458 39% $ 6,845 42% Effect on provision of: Tax-exempt interest (2,947) (9) (2,352) (12) (1,661) (10) Non-deductible expenses 116 -- 423 2 663 4 Discount on tax credits purchased (1,006) (3) -- -- -- -- Tax settlement -- -- 393 2 -- - ------------------------------------------------------------------------------------------------------------------------------------ $ 8,732 27% $ 5,922 31% $ 5,847 36% ====================================================================================================================================
In early February 1998, the Puerto Rico Treasury Department began an income tax examination of R&G Mortgage's and the Bank's income tax returns for the year 1995. Management believes that no significant deficiencies should result from such examination, and accordingly, this matter should not have any significant adverse effect on the Company's financial condition or results of operations. In July 1997 the Government of Puerto Rico amended the tax law that provided tax exemption on interest income generated by FHA and VA loans secured by real estate property located in Puerto Rico and mortgage-backed securities secured by such mortgage loans (GNMAs). Under the amended law, FHA and VA loans closed prior to August 1, 1997, will continue to be exempt. The interest income on FHA and VA mortgage loans originated on or after August 1, 1997 for purposes other than to finance the acquisition of new housing, and GNMAs secured by such loans, are no longer exempt, and are taxable at a preferential 17% tax rate to individuals and certain other taxpayers other than corporations. FHA and VA loans to finance the purchase of new housing, and GNMAs secured by such loans, continue to be exempt. While the Company has benefited from the previously available tax exemption, management believes based on currently available information that the adoption of the enacted changes should not have a significant adverse effect in the results of operations of the Company. 64 14. Stockholders' Equity On July 15, 1997 the Company's Board of Directors authorized a nine-for-five stock split of the Company's $.01 par value Class A and Class B common stock (the "common stock"). The stock split was effected on September 25, 1997 in the form of a stock dividend of four shares of common stock for each five shares held of record on September 15, 1997. Prior to the declaration of the stock split, the Company had 7,858,216 shares of common stock outstanding. As a result of the split, 6,286,536 shares were issued and $62,865 were transferred from additional paid-in-capital to common stock. The stock split did not dilute shareholders' voting rights or their proportionate interest in the Company. All per share data included herein has been adjusted to reflect the stock split. The Company's average number of common shares outstanding used in the computation of basic earnings per common share was 14,144,752 (1996 - 10,920,661; 1995 - 9,340,279); the weighted average number of shares outstanding for the computation of diluted earnings per share was 14,521,252 (1996 - 11,049,866; 1995 - 9,340,279) after giving effect to outstanding stock options granted under the Company's Stock Option Plan. During 1997, cash dividends of $0.16875 (1996 - $0.03472) per common share amounting to $2,385,752 (1996 - $472,336) were paid. No cash dividends were paid in 1995. 15. Other Operating Expenses Other operating expenses consist of the following:
Year ended December 31, 1997 1996 1995 - -------------------------------------------------------------------------------- Advertising $ 3,154,189 $ 2,415,177 $ 1,586,351 Stationary and supplies 1,640,131 1,332,108 740,666 Telephone 871,029 751,518 597,058 License and other taxes 1,595,276 1,247,505 1,104,564 Deposit insurance 346,625 652,750 954,537 Other insurance 590,066 538,825 551,407 Legal and other professional services 2,193,687 1,304,967 890,992 Amortization of mortgage servicing asset 1,837,414 1,213,606 1,497,803 Guaranty fees 1,246,300 1,068,750 934,162 Other 4,776,780 4,898,911 4,873,184 - -------------------------------------------------------------------------------- $18,251,497 $15,424,117 $13,730,724 ================================================================================
16. Related Party Transactions During March 1996, the Company declared and paid $500,000 cash dividends to its Class A common stockholder. The Company leases some of its facilities from an affiliate, mostly on a month-to-month basis. The annual rentals under these agreements are approximately $1,420,000. Loans to directors, officers and employees of the Company were made in the ordinary course of business. Interest rates on such loans were substantially the same as those prevailing at the time for comparable transactions with unrelated parties and did not involve more than a normal risk of collectibility. At December 31, 1997 the aggregate amount of loans outstanding to officers, directors, and principal stockholders' of the Company and its subsidiaries were insignificant. 65 17. Regulatory Requirements The Company is approved by the Board of Governors of the Federal Reserve System (Federal Reserve Board) as a registered bank holding company pursuant to the Bank Holding Company Act of 1956, as amended. The Company became a bank holding company in connection with its acquisition of the 88.05% interest in the Bank held by the Company's Chairman of the Board and Chief Executive Officer (which excludes his required qualifying shares as a director of the Bank) in exchange for the Company's Class A Shares. The Company, as a bank holding company, is subject to regulation and supervision by the Federal Reserve Board and the Commissioner of the Office of Financial Institutions of the Commonwealth of Puerto Rico (the Commissioner). The Federal Reserve Board has established guidelines regarding the capital adequacy of bank holding companies, such as the Company. These requirements are substantially similar to those adopted by the FDIC for depository institutions, as set forth below. The Bank is incorporated under the Puerto Rico Banking Act, as amended, and is subject to extensive regulation and examination by the Commissioner, the FDIC and certain requirements established by the Federal Reserve Board. The mortgage banking business conducted by R&G Mortgage is subject to the rules and regulations of FHA, VA, FNMA, FHLMC, GNMA and the Commissioner with respect to originating, processing, selling and servicing mortgage loans and the issuance and sale of mortgage-backed securities. R&G Mortgage's affairs are also subject to supervision and examination by FNMA, FHA, FHLMC, GNMA, HUD and VA at all times to assure compliance with the applicable regulations, policies and procedures. Mortgage origination activities are subject to, among others, the Equal Credit Opportunity Act, Federal Truth-in-Lending Act and the Real Estate Settlement Procedures Act and the regulations promulgated thereunder. R&G Mortgage is a U.S. Department of Housing and Urban Development (HUD) approved non-supervised mortgagee. The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Company's assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Company'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 requires the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital to average assets (as defined). Failure to meet capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. As of December 31, 1997, the Company meets all capital adequacy requirements to which it is subject. As of December 31, 1997, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To beaction. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the table below. There are no conditions or events since that notification that management believes have changed the Bank's category. 66 The following table reflects the Company's and the Bank's actual capital amounts and ratios, and applicable regulatory capital requirements at December 31, 1997 and 1996:
To be well capitalized For capital under prompt corrective Actual adecuacy purposes action provisions Amount Ratio Amount Ratio Amount Ratio ($ in thousands) - ------------------------------------------------------------------------------------------------------------------------------------ As of December 31, 1997 Total capital (to risk weighted assets): Consolidated $139,411 17.85% $ 62,493 8% N/A N/A R-G Premier Bank only $ 74,822 14.00% $ 42,766 8% $ 53,457 10% Tier I capital (to risk weighted assets): Consolidated $132,639 16.98% $ 31,247 4% N/A N/A R-G Premier Bank only $ 70,050 13.10% $ 21,383 4% $ 32,074 6% Tier I capital (to average assets): Consolidated $132,639 9.16% $ 57,935 4% N/A N/A R-G Premier Bank only $ 70,050 7.34% $ 38,162 4% $ 47,702 5% As of December 31, 1996 Total capital (to risk weighted assets): Consolidated $113,644 17.45% $ 52,114 8% N/A N/A R-G Premier Bank only $ 67,866 14.79% $ 36,716 8% $ 45,895 10% Tier I capital (to risk weighted assets): Consolidated $109,627 16.83% $ 26,057 4% N/A N/A R-G Premier Bank only $ 63,849 13.91% $ 18,358 4% $ 27,537 6% Tier I capital (to average assets): Consolidated $109,627 8.80% $ 49,847 4% N/A N/A R-G Premier Bank only $ 63,849 8.45% $ 30,215 4% $ 37,769 5%
During 1996 the Company received a special assessment of approximately $2.5 million ($1.7 million net of taxes) as the result of federal legislation to recapitalize the SAIF administered by the FDIC. The legislation, enacted by the U.S. Congress, recapitalized the SAIF by a one-time charge of approximately $0.657 for every $100 of assessable deposits held at March 31, 1995. As a result, the Bank's insurance premiums, which had amounted to $0.23 for every $100 of deposits, were reduced to $0.064 for every $100 of deposits beginning January 1, 1997. 67 18. Stock Option Plan In June 1996 the Board of Directors of the Company adopted a Stock Option Plan, which is designed to attract and retain qualified personnel in key positions, provide officers and key employees with a proprietary interest in the Company as an incentive to contribute to the success of the Company, and reward key employees for outstanding performance and the attainment of targeted goals. The Stock Option Plan was approved by the Company's sole stockholder at the time in June 1996. An amount of Company common stock equal to 10% of the aggregate number of Class B Shares sold in the Company's initial public offering (241,500 shares, equivalent to 434,700 shares after giving effect to stock split) were authorized under the Stock Option Plan, which may be filled by authorized but unissued shares, treasury shares or shares purchased by the Company on the open market or from private sources. The Stock Option Plan provides for the grant of stock options at an exercise price equal to the fair market value of the Class B shares at the date of the grant. Stock options are available for grant to key employees of the Company and any subsidiaries. No options were issued prior to the public offering. In connection with the Company's initial offering on August 27,1996, the Company awarded options for 200,000 shares (360,000 shares as adjusted for stock split) to 28 employees of R&G Mortgage and the Bank at the initial public offering price of $14.50 per share. In January 1997 the Company awarded options for an additional 10,000 shares (18,000 shares as adjusted for stock split) to a certain employee. The maximum term of the options granted are ten years. Under the provisions of the Stock Option Plan, options can be exercised as follows: 20% after one year, 40% after two years, 60% after three years, 80% after four years and 100% after five years. As of December 31, 1997 none of the options granted have been exercised. The Company adopted in 1996 the disclosure provisions of SFAS No. 123, "Accounting for Stock-Based Compensation" (SFAS 123). Accordingly, no compensation cost has been recognized for the Company's Stock Option Plan. Had compensation cost for the Company's Stock Option Plan been determined based on the fair value of the options at the grant date consistent with the provisions of SFAS 123, the Company's net earnings and earnings per share for the years ended December 31, 1997 and 1996 would have been reduced to the pro forma amounts indicated below:
1997 1996 - -------------------------------------------------------------------------------- Net earnings - as reported $ 23,497,212 $ 13,199,516 - -------------------------------------------------------------------------------- Net earnings - pro forma $ 23,342,698 $ 13,143,675 - -------------------------------------------------------------------------------- Basic earnings per share - as reported $ 1.66 $ 1.21 - -------------------------------------------------------------------------------- Basic earnings per share - pro forma $ 1.65 $ 1.20 - -------------------------------------------------------------------------------- Diluted earnings per share - as reported $ 1.62 $ 1.19 - -------------------------------------------------------------------------------- Diluted earnings per share - pro forma $ 1.61 $ 1.19 - --------------------------------------------------------------------------------
The fair value of the option grants were estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions: Stock Price and Exercise Price - $14.50 for options granted based on the terms of the awards. Expected Option Term - 6 years. Expected Volatility - 42.54% for options granted calculated using weekly closing prices of three peer financial institutions given the Company's limited publicly trading history. Expected Dividend Yield - Calculated as the annualized quarterly dividend closest to the grant date divided by the stock price on the grant date. Risk-Free Interest Rate - 6.48% for options granted determined as the yield, on the date of grant, on a U.S. Treasury zero coupon bond with a maturity equal to the expected term of the option. 68 19 Profit Sharing Plan The Company has a profit sharing plan (the Plan) which covers substantially all regular employees. Annual contributions to the Plan are based on matching percentages up to 5% of employee salaries, based on the employee's years of service and on operational income, as defined by the Plan, and are deposited in a trust. Contributions to the Plan during the years ended December 31, 1997, 1996 and 1995 amounted to approximately $79,000, $72,000 and $120,000, respectively. 20. Commitments and Contingencies Commitments to developers providing end loans The Company has outstanding commitments for various projects in the process of completion. Total commitments amounted to approximately $443.6 million at December 31, 1997. All commitments are subject to prevailing market prices at time of closing with no market risk exposure for the Company or with firm back-to-back commitments extended in favor of the mortgagee. Loans in process Loans in process pending final approval and/or closing amounted to approximately $98.8 million at December 31, 1997. Commitments to buy and sell GNMA certificates As of December 31, 1997, the Company had open commitments to issue GNMA certificates in the amount of $119.0 million. Commitments to sell mortgage loans As of December 31, 1997 the Company had commitments to sell mortgage loans to third party investors amounting to $17.8 million. Lease commitments The Company is obligated under several noncancellable leases for office space and equipment rentals, all of which are accounted for as operating leases. The leases expire at various dates with options for renewals. As of December 31, 1997, minimum annual rental commitments under noncancellable operating leases for certain office space and equipment, including leases with an affiliate, were as follows: Year Amount - ------------------------------------- 1998 $ 2,106,792 1999 2,049,407 2000 1,935,473 2001 1,707,945 2002 1,505,233 Later years 3,031,047 - ------------------------------------- $12,335,897 ===================================== Rent expense amounted to approximately $2,483,000 in 1997, $2,171,000 in 1996 and $1,914,000 in 1995. Litigation The Company is a defendant in legal proceedings arising from normal business activities. Management believes, based on the opinion of legal counsel, that the final disposition of these matters will not have a material adverse effect on the Company's financial position or results of operations. On January 15, 1998 the Company received $2 million as part of a settlement with its fidelity insurance carrier on a claim filed by the Company in late 1996 as a result of certain irregularities discovered by the Company with respect to its former insurance premiums financing business. Based on a review of the collectibility of the loans in question at the time, management wrote-off loans amounting to approximately $2.5 million in 1996. The settlement was recorded as a recovery of loans previously charged-off and reflected as an addition to the Company's allowance for loan losses as of December 31, 1997. Others At December 31, 1997 the Company is liable under limited recourse provisions resulting from the sale of loans to several investors principally FHLMC. The principal balance of these loans, which are serviced by the Company, amounts to approximately $340.5 million at December 31, 1997. Liability, if any, under the recourse provisions at December 31, 1997 is estimated by management to be insignificant. 21. Supplemental Disclosure on the Statements of Cash Flows During 1997, 1996 and 1995, the Company paid interest amounting to approximately $60,846,000, $45,939,000 and $34,403,000, respectively, and income taxes of approximately $9,699,000, $7,573,000 (including $1,065,000 on settlement of a 1992 income tax examination) and $1,820,000, respectively. During 1997, 1996 and 1995 the Company securitized loans from its mortgage loan portfolio totaling approximately $11,346,000, $43,673,000 and $17,631,000, respectively. As discussed in Note 1 to the consolidated financial statements, during 1996 the Company granted 20,000 Class B common shares to its Vice Chairman of the Board in consideration for his past and ongoing services, recognizing $290,000 as compensation cost. 22. Financial Instruments with Off-Balance Sheet Risk and Concentrations of Credit Risk In the normal course of business, the Company uses various off-balance sheet financial instruments to satisfy the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include loan commitments and interest rate exchange agreements (swaps). These instruments involve, to varying degrees, elements of credit and interest rate in excess of the amount recognized in the statements of financial condition. The contract or notional amounts of these instruments, which are not included in the statements of financial condition, are an indicator of the Company's activities in particular classes of financial instruments. 69 The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments as it does for on-balance sheet instruments. For interest rate swap contracts, the contract or notional amounts do not represent exposure to credit loss. Instead, the amount potentially subject to credit loss is substantially less. Contractual commitments to extend credit are legally binding agreements to lend money to customers at predetermined interest rates for a specified period of time. Since many of the loan commitments may expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. To extend credit the Company evaluates each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management's credit evaluation of the counterparty. A geographic concentration exists within the Company's mortgage loans portfolio since most of the Company's business activity is with customers located in Puerto Rico. Interest rate swap agreements involve the exchange of fixed and floating rate interest payment obligations without the exchange of the underlying principal. Entering into interest rate agreements involves the risk of dealing with counterparties and their ability to meet the terms of the contracts, and also the interest rate risk associated with unmatched positions. The total amounts of financial instruments with off-balance sheet risk at December 31, 1997 follows: Financial instruments whose contract amounts represent potential credit risk: Commitments to extend credit excluding the undisbursed portion of loans in process: Unused lines of credit $ 8,876,000 ================================================================================ Financial instruments whose notional or contractual amounts exceed the amount of potential credit risk: Interest rate swap contracts $50,000,000 ================================================================================ A detail of interest rate swaps at December 31, 1997 follows: Notional Pay Fixed Receive Amount Maturity Rate Rate Floating - -------------------------------------------------------------------------------- $15,000,000 September 17, 1999 5.79% 3 months Libor 10,000,000 October 24, 2000 5.20% 3 months Libid 25,000,000 October 9, 2001 5.06% 3 months Libid The following table summarizes the changes in notional amounts of swaps outstanding during 1997: Beginning balance $ 45,000,000 New Swaps 15,000,000 Maturities (10,000,000) - -------------------------------------------------------------------------------- Ending balance $ 50,000,000 ================================================================================ As of December 31, 1997, interest rate swap maturities are as follows: 1999 $ 15,000,000 2000 10,000,000 2001 25,000,000 - -------------------------------------------------------------------------------- $ 50,000,000 ================================================================================ Net interest settlements on Swap agreements are recorded as an adjustment to interest expense on deposits. Net interest received amounted to approximately $187,000 during 1995; net payments amounted to approximately $293,000 and $61,000 during 1997 and 1996, respectively. 70 23. Supplemental Income Statement Information Employee costs and other administrative and general expenses are shown in the Consolidated Statements of Income net of direct loan origination costs. Direct loan origination costs are capitalized as part of the carrying cost of mortgage loans and are offset against mortgage loan sales and fees when the loans are sold, or amortized as a yield adjustment to interest income on loans held for investment. Total employee costs and other expenses before capitalization follow:
Year ended December 31, 1997 1996 1995 - -------------------------------------------------------------------------------- Employee costs $21,368,723 $17,357,976 $13,248,477 ================================================================================ Other administrative and general expenses $22,662,971 $18,916,546 $16,661,353 ================================================================================
Set forth below are the direct loan origination costs that were capitalized as part of the carrying cost of mortgage loans inventory or offset against mortgage loan sales and fees and interest income.
Year ended December 31, 1997 1996 1995 - -------------------------------------------------------------------------------- Offset against mortgage loan sales and fees $2,973,820 $7,173,028 $5,382,186 ================================================================================ Offset against interest income on loans $2,122,727 $1,937,403 $1,470,128 ================================================================================ Capitalized as part of loans held for sale and loans held for investment $7,030,896 $ 946,673 $1,042,983 ================================================================================
As part of the carrying costs in 1997 of the Company's mortagage loans inventory held for investment, the Company deferred loan origination fees totaling approximately $5,213,000. 71 24. Fair Value of Financial Instruments The estimated fair value of the Company's financial instruments as of December 31 are as follows:
1997 1996 Estimated Estimated Carrying Fair Carrying Fair Value Value Value Value (In thousands) - ------------------------------------------------------------------------------------------------------------------------------------ Financial Assets Cash and due from banks $ 32,607 $ 32,607 $ 31,990 $ 31,990 Money market investments 35,759 35,759 66,866 66,866 Mortgage loans held for sale 46,885 48,345 54,450 55,110 Mortgage-backed securities held for trading 400,457 400,457 108,917 108,917 Investment securities held for trading 581 581 1,351 1,351 Investment and mortgage-backed securities available for sale 116,961 116,961 77,567 77,567 Investment in Federal Home Loan Bank stock 4,906 4,906 4,247 4,247 Investment and mortgage-backed securities held to maturity 44,019 43,876 43,170 42,346 Loans, net 765,059 791,309 603,751 608,455 Accounts receivable 17,704 17,704 12,397 12,397 ==================================================================================================================================== Financial Liabilities Deposits: Non-interest bearing demand $ 91,504 $ 91,504 $ 54,244 $ 54,244 Savings and NOW accounts 174,923 156,859 156,150 141,813 Certificates of deposit 454,394 460,001 403,676 408,521 Securities sold under agreements to repurchase 392,283 392,283 97,444 97,444 Notes payable 159,304 161,418 126,842 128,692 Advances from FHLB 42,000 41,971 15,000 14,986 Other secured borrowings 34,359 35,019 50,463 50,712 Accounts payable and accrued liabilities 15,872 15,872 13,598 13,598 Subordinated notes 3,250 3,304 3,250 3,641 Unrecognized financial instruments - Interest rate swap agreements in a net receivable (payable) position* $ (14) $ 370 $ (44) $ (551) ====================================================================================================================================
* The amount shown under "carrying amount" represents net accrual arising from those unrecognized financial instruments. 72 The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Short-term financial instruments Short-term financial instruments, which include cash and due from banks, money market investments, accounts receivable, securities sold under agreements to repurchase, warehousing lines included in notes payable and accounts payable and accrued interest, have been valued at their carrying amounts reflected in the Consolidated Statements of Financial Condition as these are reasonable estimates of fair value given the relatively short period of time between origination of the instruments and their expected realization. Investment securities The fair value of investment securities is based on quoted market prices or dealer quotes except for the investments in FHLB stock which is valued at its redemption value. Loans The fair value for loans has been estimated for groups of loans with similar financial characteristics. Loans were classified by type such as commercial, commercial real estate, residential mortgage, and consumer. These asset categories were further segmented into various maturity groups, and by accruing and non-accruing groups. The fair value of accruing loans was calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. Prepayment experienced in previous periods when interest rates were at levels similar to current levels was assumed to occur for mortgage loans, adjusted for any differences in the outlook of interest rates. Other loans assume little or no prepayments. Non-accruing loans were assumed to be repaid after one year. Presumably this would occur either because the loan is repaid or collateral has been sold to satisfy the loan. The value of non-accruing loans was therefore discounted for one year at the going rate for new loans. Mortgage loans held for sale, except for loans from the Bank totaling $10,413,322 in 1997 and $6,538,190 in 1996, have been valued based on market quotations or committed selling prices in the secondary market. Loans held for sale from the Bank have been valued using the same methodology described in the first paragraph above. Deposits The fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, savings, and NOW accounts, and money market and checking accounts, is equal to the amount payable on demand. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities. The fair value estimates of deposits do not include the fair value of core deposits intangible. Borrowings The fair value of promissory notes included in notes payable, advances from FHLB, subordinated notes and other secured borrowings was determined using discounted cash flow analysis over the remaining term of the obligations using market rates for similar instruments. Interest rate swap agreements The fair value of interest rate swap agreements was determined taking into account the current interest rates at December 31, 1997. This value represents the estimated amount the Bank would pay to terminate the contract or agreement taking into account current interest rates and, when appropriate, the current credit worthiness of the counterparties. Limitations Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. In addition, the fair values presented do not attempt to estimate the value of the Company's fee generating businesses and anticipated future business activities, that is, they do not represent the Company's value as a going concern. Furthermore, the differences between the carrying amounts and the fair values presented may not be realized since, in many cases, the Company generally intends to hold these financial instruments to maturity and realize the recorded values. Reasonable comparability of fair values among financial institutions is not likely due to the wide range of permitted valuation techniques and numerous estimates that must be in the absence of secondary market prices. This lack of objective pricing standards introduces a greater degree of subjectivity to these derived or estimated fair values. Therefore, while disclosure of estimated fair values of financial instruments is required, readers are cautioned in using this data for purposes of evaluating the financial condition of the Company. 73 25. R&G Financial Corporation (Holding Company Only) Financial Information The following condensed financial information presents the financial position of R&G Financial Corporation (the Holding Company) only as of December 31, 1997 and 1996 and the results of its operations and its cash flows for the years then ended (since inception in 1996).
Statements of Financial Condition December 31, Assets 1997 1996 - -------------------------------------------------------------------------------- Cash $ 622,478 $ 810,920 Investment in R-G Premier Bank, at equity 47,407,575 3,417,333 Investment in R&G Mortgage, at equity 59,542,059 47,696,483 Investment in preferred stock of R-G Premier Bank, at cost 30,100,000 30,100,000 Accounts receivable - subsidiaries 423,178 290,000 - -------------------------------------------------------------------------------- Total assets $138,095,290 $116,314,736 ================================================================================ Liabilities and Stockholders' Equity - -------------------------------------------------------------------------------- Advances from subsidiaries $ -- $ 666,975 Other liabilities and accrued expenses 41,374 14,869 Stockholders' equity 138,053,916 115,632,892 - -------------------------------------------------------------------------------- Total liabilities and stockholders' equity $138,095,290 $116,314,736 ================================================================================ Statements of Income December 31, 1997 1996 - -------------------------------------------------------------------------------- Income: Dividends on Bank preferred stock $ 2,953,225 $ -- Management fees 423,178 -- Interest on certificates of deposit -- 12,164 - -------------------------------------------------------------------------------- 3,376,403 12,164 - -------------------------------------------------------------------------------- Operating expenses 384,707 10,811 - -------------------------------------------------------------------------------- Income before income taxes and equity in undistributed earnings of subsidiaries 2,991,696 1,353 Income taxes 8,079 338 - -------------------------------------------------------------------------------- Income before equity in undistributed earnings of subsidiaries 2,983,617 1,015 Equity in undistributed earings of subsidiaries 20,513,595 13,198,501 - -------------------------------------------------------------------------------- Net income $ 23,497,212 $ 13,199,516 ================================================================================
The Holding Company had no operations during the years ended December 31, 1997 and 1996. The principal source of income for the Holding Company consists of dividends on preferred stock held from R-G Premier Bank of Puerto Rico. The payment of dividends by the Bank to the Holding Company may be affected by certain regulatory requirements and policies, such as the maintenance of certain minimum capital levels. 74 Statements of Cash Flows
Year ended December 31, 1997 1996 - ------------------------------------------------------------------------------------------------------------------------------------ Cash flows from operating activities: Net income $ 23,497,212 $ 13,199,516 Adjustments to reconcile net income to cash provided by operating activities: Equity in undistributed earnings of subsidiaries (20,513,595) (13,198,501) Increase in accounts receivable - subsidiaries (423,178) -- Increase (decrease) in other liabilities and accrued expenses 26,505 (357,482) - ------------------------------------------------------------------------------------------------------------------------------------ Total adjustments (20,910,268) (13,555,983) - ------------------------------------------------------------------------------------------------------------------------------------ Net cash provided by (used in) operating activities 2,586,944 (356,467) - ------------------------------------------------------------------------------------------------------------------------------------ Cash flows from investing activities: Collections of advances to subsidiaries 290,000 -- Purchase of investment in preferred stock of the Bank -- (30,100,000) - ------------------------------------------------------------------------------------------------------------------------------------ Cash provided by (used in) investing activities 290,000 (30,100,000) - ------------------------------------------------------------------------------------------------------------------------------------ Cash flows from financing activities: Proceeds from issuance of common stock on initial public offering -- 31,072,748 Cash dividends on common stock (2,385,752) (472,336) Net advances from subsidiaries -- 666,975 Repayment of advances from subsidiaries (666,975) -- Payment of cash in lieu of fractional shares on stock split (12,659) -- - ------------------------------------------------------------------------------------------------------------------------------------ Net cash (used in) provided by financing activities (3,065,386) 31,267,387 - ------------------------------------------------------------------------------------------------------------------------------------ Net (decrease) increase in cash (188,442) 810,920 Cash at beginning of year 810,920 -- - ------------------------------------------------------------------------------------------------------------------------------------ Cash at end of year $ 622,478 $ 810,920 ====================================================================================================================================
75 26. Industry Segments The following summarized financial information presents the results of the Company's operations for the three year period ended December 31, 1997 for its traditional banking and mortgage banking activities:
1997 1996 Bank Mortgage Total Bank Mortgage Total - ---------------------------------------------------------------------------------------------------------------- Net interest income after provision of loan losses $25,543,992 $ 4,615,774 $30,159,766 $20,883,829 $ 3,781,152 $24,664,981 Other income: Net gain on origination and sale of loans 5,436,030 18,596,684 24,032,714 1,354,373 10,354,601 11,708,974 Change in allowance for cost in excess of market value of loans held for sale -- -- -- -- -- -- Net gain on sales of investment securities available for sale 107,430 -- 107,430 641,798 -- 641,798 Loan administration and servicing fees -- 13,213,948 13,213,948 -- 13,029,053 13,029,053 Service charges, fees and other 2,915,328 835,642 3,750,970 3,664,577 207,645 3,872,222 - ---------------------------------------------------------------------------------------------------------------- 34,002,780 37,262,048 71,264,828 26,544,577 27,372,451 53,917,028 - ---------------------------------------------------------------------------------------------------------------- Operating expenses: Salaries and employee benefits 7,654,668 5,998,086 13,652,754 6,062,221 4,731,080 10,793,301 Office occupancy and equipment 4,660,583 2,470,914 7,131,497 3,551,035 1,980,094 5,531,129 SAIF special assessment -- -- -- 2,508,380 -- 2,508,380 Other 8,803,210 9,448,287 18,251,497 7,698,577 7,725,540 15,424,117 - ---------------------------------------------------------------------------------------------------------------- 21,118,461 17,917,287 39,035,748 19,820,213 14,436,714 34,256,927 - ---------------------------------------------------------------------------------------------------------------- Income before income taxes (and minority interest in 1996 and 1995) $12,884,319 $19,344,761 $32,229,080 $ 6,724,364 $12,935,737 $19,660,101 ================================================================================================================ 1995 Bank Mortgage Total - -------------------------------------------------------------------- Net interest income after provision of loan losses $17,943,694 $ 2,379,287 $20,322,981 Other income: Net gain on origination and sale of loans 1,249,612 7,134,459 8,384,071 Change in allowance for cost in excess of market value of loans held for sale 855,834 -- 855,834 Net gain on sales of investment securities available for sale -- -- -- Loan administration and servicing fees -- 11,029,995 11,029,995 Service charges, fees and other 2,368,128 803,821 3,171,949 - -------------------------------------------------------------------- 22,417,268 21,347,562 43,764,830 - -------------------------------------------------------------------- Operating expenses: Salaries and employee benefits 4,330,248 3,953,561 8,283,809 Office occupancy and equipment 2,860,176 1,851,136 4,711,312 SAIF special assessment -- -- -- Other 6,406,237 7,324,487 13,730,724 - -------------------------------------------------------------------- 13,596,661 13,129,184 26,725,845 - -------------------------------------------------------------------- Income before income taxes (and minority interest in 1996 and 1995) $ 8,820,607 $ 8,218,378 $17,038,985 ====================================================================
76 27. Quarterly Financial Data (Unaudited): Following is a summary of selected financial information of the unaudited quarterly results of operations. In the opinion of management, all adjustments necessary for a fair presentation have been made.
(In thousands, except for per share data) 1997 March 31 June 30 Sept. 30 Dec. 31 - ------------------------------------------------------------------------------------------------------------------------------------ Total interest income $ 20,408 $ 22,764 $ 26,213 $ 27,950 Total interest expense (12,355) (14,173) (16,427) (17,850) Net interest income 8,053 8,591 9,786 10,100 Provision for loan losses (1,250) (1,695) (1,700) (1,725) Income before income taxes 7,650 7,536 8,402 8,641 Income tax expense (2,615) (2,158) (2,351) (1,608) Net income 5,035 5,378 6,051 7,033 Net income per common share - Basic $ .36 $ .38 $ .43 $ .49 Net income per common share - Diluted $ .35 $ .37 $ .42 $ .48 1996 March 31 June 30 Sept. 30 Dec. 31 - ------------------------------------------------------------------------------------------------------------------------------------ Total interest income $ 15,991 $ 18,355 $ 19,459 $ 19,981 Total interest expense (9,891) (11,009) (11,689) (12,274) Net interest income 6,100 7,346 7,770 7,707 Provision for loans losses (7) (350) (2,485) (1,416) SAIF special assessment -- -- 2,508 -- Income before income taxes 4,963 4,954 3,696 5,509 Income tax expense (2,035) (1,787) (1,229) (871) Net income 2,928 3,167 2,467 4,638 Net income per common share - Basic $ .31 $ .34 $ .22 $ .34 Net income per common share - Diluted $ .31 $ .34 $ .21 $ .33
77 [BLANK] 78 Corporate Information Board of Directors of R-G Financial Corporation: Victor J. Galan, Chairman of the Board and Chief Executive Officer Ramon Prats, Vice Chairman of the Board and Executive Vice President of RGM Ana M. Armendariz, Treasurer of the Board and Senior Vice President of Finance RGM Enrique Umpierre Suarez, Secretary of the Board and Attorney in private practice Benigno R. Fernandez, Senior Partner of Fernandez, Perez, Villariny & Co., CPA firm in Hato Rey, P.R. Eduardo McCormack, Retired Businessman. Previously worked for Bacardi Corp. in various functions of the business. Gilberto Rivera Arreaga, Executive Director and Administrator of the National College of Business & Technology, educational center in Bayamon, P.R. Juan J. Diaz, Senior Vice President-Loan Administration RGM Laureano Carus Abarca, Chairman of Alonso Carus Iron Works in Catano, P.R., manufacturers of metal products Pedro Ramirez, President & CEO of Empresas Nativas, Inc., local real estate development firm Victor L. Galan, Vice President Marketing Department of RGM Officers of R-G Financial Corporation: Senior Management Team: Victor J. Galan, Chairman, President and CEO Ramon Prats, Excecutive Vice President Juan J. Diaz, Senior Vice President Loan Administration Ana M. Armendariz, Senior Vice President Finance RGM Mario Ruiz, Senior Vice President Secondary Market Jose Sandoval, Vice President and Chief Financial Officer Jose L. Ortiz, Vice President Finance RGPB Ivan Velez, Vice President Operations William Martinez, Vice President Administration Sonia I. Vazquez, General Auditor Production Group: Dennis C. Tristani, Senior Vice President Commercial Loans RGPB Roberto Cordova, Senior Vice President Loan Production RGM Steven Velez, Senior Vice President Underwriting and Technology RGM Jeannette Miro, Vice President Marketing RGPB Ismenia Isidor, Vice President Closing Department RGM Edwin Reyes, Vice President Branch Administration RGPB Ricardo Agudo, Vice President New Housing RGM Victor L. Galan, Vice President Branch Administration RGM Stockholder Information Corporate Office R-G Plaza 280 JT Pinero Ave. San Juan, PR 00918 Telephone (787) 758-2424 Annual Meeting: April 23, 1998, at R-G Plaza , Hato Rey, PR Transfer Agent and Registrar: American Stock Transfer & Trust Co. 40 Wall Street- 46th Floor New York, NY 10005 Independent Public Accountants: Price Waterhouse Chase Manhattan Bldg. - 9th Fl. San Juan, PR 00918 Special Counsel: Elias, Matz, Tiernan & Herrick L.L.P. 734 15th Street N.W. - 12th Floor Washington , DC 20005 Mc Connell & Valdes 270 Munoz Rivera Ave. San Juan, PR 00918 Market Makers: Friedman Billings Ramsey & Co. 1001 19th Street North Arlington, VA 22209 PaineWebber Incorporated of PR American International Plaza Penthouse Floor 250 Munoz Rivera Ave. San Juan, PR 00918 Internet Website : http://www.rgonline.com (in Spanish and English) General Inquiries & Reports: R-G Financial is required to file an annual report on Form 10K for its fiscal year ended December 31, 1997 with the Securities and Exchange Commission. Copies of its Annual Report and quarterly reports may be obtained without charge by contacting: Sonia Colon , Administrative Assistant Telephone (787) 756-2801 Stock Listing: Symbol: RGFC-NASDAQ At December 31, 1997, the Company had 97 stockholders of record, which does not take into consideration investors who hold their stock through brokerage and other forms. The high and low prices and dividends paid per share (as adjusted for the Company's 80% stock split paid in 1997) for the Company's common stock during each quarter since the Company began trading on August 22, 1996 is as follows:
September 30 December 31 March 31 June 30 September 30 December 31 1996 1996 1997 1997 1997 1997 High $10.42 $14.31 $15.55 $14.44 $22.50 $22.0 Low 9.17 9.86 12.64 12.92 14.17 18.875 Dividends Paid - .0347 .0382 .0417 .0431 .0457
EX-27 3
9 YEAR DEC-31-1997 DEC-31-1997 32,607,001 16,758,722 3,000,000 400,435,545 121,867,202 44,019,274 43,841,653 765,059,419 6,771,702 1,510,745,516 722,418,494 631,196,293 19,076,813 0 0 0 38,489,266 99,564,650 1,510,745,516 68,513,571 28,821,319 0 97,334,890 32,434,559 60,805,124 36,529,766 6,370,000 9,785,093 39,035,748 32,229,080 32,229,080 0 0 23,497,212 1.66 1.62 8.32 29,968,266 226,727 0 33,583,021 3,331,645 5,376,573 2,446,630 6,771,702 6,771,702 0 0
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